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July 25, 2016 11:39 a.m. ET
Credit Suisse
Over the past several years domestic integrated steel mills have made substantive improvements to their cost base through asset optimization, overhead cost reductions, closure of inefficient or underutilized assets, and raw material cost reduction. Unfortunately, most of these benefits have been masked by very weak utilization rates driven by until recently sharply higher flat rolled imports and severe weakness in energy markets. We believe the second quarter will mark a clear inflection point for integrated cash costs.
We are increasing estimates to reflect better conversion costs, which we view as sustainable. We have increased our target price on United States Steel (ticker: X ) to $29 from $26 and our price target on AK Steel Holding ( AKS ) to $8 from $7 [both rated at Outperform]. We remain significantly above consensus for 2016 and 2017 earnings before interest, taxes, depreciation and amortization (Ebitda) estimates.
We forecast an inflection point in second-quarter operating costs. The past several quarters both AK Steel and U.S. Steel have experienced above-trend cost levels owing to restructuring costs, inefficiencies as blast-furnace operations were curtailed, low utilization rates, and in the case of U.S. Steel, high last-in first-out (LIFO) expense and weak mining Ebitda. Both U.S. Steel and AK Steel have successfully base-loaded remaining blast furnaces, which should drive very strong incremental margins in the second quarter.
We believe U.S. Steel has made significant improvements to lower its already industry-leading iron-ore-cost position through optimization efforts at Minntac and the idling of the higher-cost Keetac mine [both are Minnesota ore operations]. Both AK Steel and U.S. Steel should see sharply lower coking-coal costs in 2016 that will start to benefit the bottom line in the second quarter. While natural-gas prices have moved higher the past several months, the decline in domestic scrap prices has more than offset this increase.
We believe U.S. integrated producers are in the sweet spot of the steel value chain today as we see raw material costs lower in 2016, utilization rates sharply higher, and spot prices sharply higher. U.S. Steel has about 40%-45% exposure to annual contracts while AK Steel has about 65%-70% with the majority resetting in the first half of the calendar year. We estimate contract average sales prices (ASPs) were down about $70-$90 a ton in 2016 which reflects about 35%-40% linkage to spot-price deltas in fourth-quarter 2015 versus fourth-quarter 2014. If spot prices hold near $880 a ton for coated (versus base prices today of $830 a ton), fourth-quarter 2016 spot prices would be about $300 a ton higher year-on-year.
Integrated mills in the U.S. have started to close the return on invested capital (ROIC) gap versus electric arc furnace (EAF) producers by rationalizing high-cost capacity, obtaining more flexible labor agreements, and reducing legacy liabilities/expenses. The trade duties on value add sheet have fundamentally reset medium term scarcity premiums for those products, which should translate into sharply higher contract and spot ASPs going forward in our view.
-- Curt Woodworth
-- Gayle Podurgiel
-- Serena Rocha Calejon