This week, Durig Capital reviews one of the leading producers of steel products in the United States. AK Steel (NYSE:AKS) produces steel for the automotive, infrastructure and manufacturing sectors. There has been much talk of bringing back manufacturing jobs to the U.S., especially in the production and manufacturing of steel. AK Steel is one of the companies trying to ensure continued heavy manufacturing capabilities within the United States. It recently reported its second quarter results (for the three months ending June 30, 2019) with the following highlights:
- Net income increased by 18% over Q2 2018.
- Adjusted EBITDA increased 2% year-over-year.
- Net cash flow from operating activities for the six months ending June 30, 2019 was $136.2 million.
- Interest coverage for the first six months of 2019 was 2.0x.
For the third consecutive quarter, AK Steel surprised analysts by again beating earnings expectations. The company reported $0.21 earnings per share (EPS) for the quarter, beating the consensus estimate of $0.06 by $0.15. Not only is the company surprising analysts on earnings, it continues to reduce debt, repaying $95 million of borrowings under its credit facility in the second quarter. AK Steel’s 2025 bonds, couponed at 6.375%, are currently trading at a discount, which translates to a very competitive yield-to-maturity of about 10.0%. For investors looking to further diversify their portfolios, AK Steel could be the ideal prospect. And in light of the company’s continued strong performance, these bonds look to be an excellent addition to Durig Capital’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio, the aggregated performance of which is shown below.
Second Quarter 2019 Results
With its third consecutive beat on EPS, AK Steel reported its second quarter results. In spite of headwinds in carbon spot market pricing as compared to a year ago, the company posted increases in both net income and adjusted EBITDA.
- Net income for the second quarter was $66.8 million as compared to $56.6 million, up 18% from one year ago.
- Adjusted EBITDA was $151.5 million, up from $148.4 million in the second quarter 2018, representing a 2% increase.
- The company also repaid $95 million of borrowings under its credit facility during the second quarter.
- For the six months ending June 30, 2019, net cash flows from operating activities totaled $136.2 million.
Roger Newport, AK Steel’s Chief Executive Officer spoke about the company’s successes in the second quarter.
“We reported solid earnings for the second quarter, despite a dramatic decline in carbon spot market pricing from a year ago. This reflects our strategy to focus on value-added products with fixed-price contracts and to deemphasize sales to the volatile commodity spot market. As a result, we generated strong free cash flow that allowed us to meaningfully reduce debt in the quarter.”
About AK Steel
AK Steel is a leading producer of flat-rolled carbon, stainless and electrical steel products, primarily for the automotive, infrastructure and manufacturing, including electrical power, and distributors and converters markets. Through its subsidiaries, the company also provides customer solutions with carbon and stainless steel tubing products, die design and tooling, and hot-and cold-stamped components. Headquartered in West Chester, Ohio (Greater Cincinnati), the company has approximately 9,500 employees at manufacturing operations in the United States, Canada and Mexico, as well as facilities in Western Europe. AK Steel is a publicly held company traded over the New York Stock Exchange (NYSE) under the symbol AKS and is a component of the FORTUNE 500 – aligning the company with many of the most prominent corporations in America.
Since a majority of AK Steel’s business comes from the automotive industry, any legislation that can help the domestic car industry is welcomed and encouraged. Many people in the U.S. are familiar with the North American Free Trade Agreement (NAFTA) which went into effect in 1994. President Trump has been a vocal critic of NAFTA, at times threatening to withdraw U.S. participation in the agreement. Trump states that this agreement has been harmful to American workers and is lobbying for NAFTA v2.0, which is essentially the United States – Mexico – Canada Agreement (USMCA). In a nutshell, here are the provisions of USMCA which will benefit the automotive industry and by extension, companies like AK Steel.
- Automobiles must have 75% of their components made in the U.S., Canada or Mexico to qualify for zero tariffs, up from 62.5% under NAFTA.
- 40% to 45% of automotive components must be made by workers who earn at least $16 an hour by 2023.
All three countries have signed the agreement, but Mexico is the only one of the three that has ratified the deal. Canada’s Parliament and the U.S. Congress are still debating the finer points of the deal. The latest word on the street is that the U.S. may have a deal agreed upon by this fall, before the pending 2020 election starts to heat up.
Growth in the Use of Ultra High-Strength Steels
Within the automotive market, high strength steel has become a valued commodity. In pursuit of an increasingly efficient vehicle, automakers continue to strive to make vehicles lighter in order to promote fuel efficiency. The vehicles automakers produce today contain an average of 75 pounds of ultra high-strength steel (UHSS). That amount is estimated to grow more than four times to an average of 320 pounds per vehicle by 2025. Does UHSS materially reduce the weight of an automobile and / or its components? By replacing heavy steel with UHSS in components, the corresponding decrease in weight is between 10% and 60% depending on the specific component. This represents a significant weight reduction which, in turn, promotes additional fuel efficiencies. Because of this, auto manufacturers continue to increase the number of UHSS components in their vehicle designs. Between now and 2025, the use of UHSS is estimated to increase by a CAGR of 24%.
(Source: AK Steel April 2019 Investor Presentation)
In its most recent quarter, 64% of AK Steel’s net sales were in the Automotive sector. Correspondingly, the company has invested significantly in the development of its ultra-high strength steel products – NEXMET 1000 and NEXMET 1200. In conjunction with teams at its Precision Partners division, AK Steel’s research group continues to develop steel solutions for its customers.
Interest Coverage and Liquidity
Adequate Interest coverage is important for a bond issuer, as is liquidity. Interest coverage simply means the issuer generates enough cash flow to cover their current level of debt. Liquidity is important to cover any periodic shortfalls in cash flow. For the six months ending June 30, 2019, AK Steel had operating income of $147.8 million and interest income of $75.0 million for interest coverage of 2.0x. In terms of liquidity, as of June 30, 2019, AK Steel had a total liquidity of $1.1 billion, including $42.2 million in cash. This level of liquidity is enough to cover the company’s upcoming maturity of $149 million in exchangeable notes in November 2019. Also important to note is the company’s credit facility capacity was increased in April 2019 to $1.5 billion.
The risk for bondholders is whether AK Steel can continue to increase profitability while continuing to reduce debt. The automotive industry can be cyclical and can have that “feast or famine” mindset. Industries tied to auto manufacturing and sales can experience similar volatility. However, in spite of these things, AK Steel has continued to perform, even as carbon pricing has increased and the as the spot market price on carbon hot rolled coil has fallen significantly in recent months. For its most recent quarter, the company maintained its average flat rolled selling price as compared to Q2 2018 due to its focus on base price contracts and less emphasis on the volatile carbon commodity spot market. In consideration of these factors, the roughly 10.0% yield-to-maturity on AK Steel’s 2025 bonds does appear to outweigh the risks identified.
The focus should not be on individual bond selection, but rather how the components work within a professionally managed portfolio as a whole, such as Durig Capital’s FX2 Managed Income Portfolio.
In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.
Summary and Conclusion
AK Steel continues to forge ahead. While North American vehicle production for 2019 is expected to be slightly lower than 2018, it still remains very strong by historical standards. With pending legislation aimed at strengthening U.S. manufacturing, and specifically automobile manufacturing, AK Steel could well benefit from the ratification of the USMCA agreement now before Congress. AK Steel has been actively paying down debt over the past few years in an effort to improve its balance sheet. Demand for its high strength steel continues to grow. The company’s 2025 bonds are an opportunity for investors to further diversify their portfolios into the automotive sector. As these bonds are presently trading at a discount, the yield-to-maturity is an outstanding 10.0%, making these competitive yielding notes an ideal addition to Durig Capital’s Fixed Income 2 (FX2) High Yield Managed Income Portfolio, shown above.
Issuer: AK Steel Corp
Ratings: B3 / B-
Price: ~ 83.50
Yield to Maturity: ~ 10.0%
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Durig Capital provides investors with a specialized, transparent fiduciary service at a very low cost. Our FX2 (Discretionary Management) Portfolio over time has greatly outperformed our FX1 (Non-discretionary) Portfolio, giving significantly higher (at times double) the returns of FX1. Our professional service enables access to a broad spectrum of bond, high yields, and lower price points that are often found in less efficient markets, but not evidenced in many bond services. Most of our client accounts are custodied in their own name at TD Ameritrade Institutional, a large discount service provider that is SPIC insured, or at Interactive Brokers. We have now started offering our highly successful FX2 service to clients of other Registered Investment Advisors through segregated accounts at TD Ameritrade. Please ask us to learn how this might work for you and your current advisor.
Disclosure: Durig Capital and certain clients may hold positions in AK Steel’s October 2025 bonds.
Disclaimer: Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. The high yield strategies presented in this review by Durig Capital may not be suitable for all investors. This is not investment advice from Durig Capital, nor a specific recommendation to buy or sell securities. If you have any questions or concerns about its suitability for your personal investment, you should seek specific investment advice from a registered professional before making an investment decision.
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Randy Durig, Durig Capital, Inc.
A Registered Investment Advisor