Betting on AK Steel

Federico is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I have been recommending steel stocks such as Nucor (NYSE: NUE), US Steel (NYSE: X) or AK Steel (NYSE: AKS) since the end of last year. From November 2012, the results have only been good for Nucor (the stock is up by 13%), which is the US steel company with the strongest fundamentals and a rock solid balance sheet. On the other hand, financially weaker producers have performed poorly. Now might be the time to start considering those higher beta plays like US Steel or AK Steel, even if they have been losing value for at least the past two years.

Since November 2011, AKS and X have gone down by over 70% and 57%, respectively, but they are poised to benefit in 2013 from better volumes and higher steel prices. Given the undershoot in demand that took place from late 2011 to mid-2012 and the impact of the US housing market recovery, I am expecting much better volumes than most analysts. On the other hand, the increased demand and market dynamics in China should also help increase steel prices. Hence, I expect a quick recovery in the financial health of most steel producers, which is why I suggest an increase in exposure to high beta (strongly leveraged) players.

AKS is my favorite play within the space and, as a matter of fact, I have just bought bonds issued by the company (the 8.375% 2022 Senior notes). Despite being a risky investment, thanks to recent debt and equity issuances, the company will not face liquidity issues until 2018. That buys much needed time to reduce costs and increase production (the company has over $1.2 billion in available liquidity to face Capex and debt repayments). Besides, AKS' EBITDA is expected to increase from $182 million in 2012 up to $397 million in 2013.

Given its high risk (AKS´s net debt is expected to reach $1.5 billion by the end of this year) AKS offers investors attractive valuation multiples (now trades at a 6% discount to its historical EV/EBITDA multiple). The company trades at 2013 5.1x EV/EBITDA and 16x P/E. Even if lower beta player US Steel trades at similar levels (its 2013 expected multiples are 5.3x EV/EBITDA and 14x P/E) I prefer the riskier AKS. From my point of view, AKS might have a higher upside potential if my thesis results are right.

Even if that were to be true and AKS could have higher upside potential, X is also an opportunity given its high exposure to the growing US auto industry. Moreover, X also trades at a low valuation against peers and against its own historical average (X trades at a 22% discount to the group average and at a 16% discount to its historical EV/EBITDA multiple average).

If you didn't get into the steel sector yet, this might be the time to buy. The price catalyst should be the better than expected results that I consider steel companies will be able to report in the coming months (AKS should be presenting results by mid February). The ongoing de-leveraging among steel makers shall lead to lower invested capital and higher returns so, naturally, the Return On Invested Capital (ROIC) of steel makers should rise substantially. This may be a great year for steel makers. Its time to make your own bet.  

martinzaldua has no position in any stocks mentioned. The Motley Fool recommends Nucor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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