AK Steel: Upgrade to Overweight, Street High Estimates & Target – J.P. Morgan

J.P. Morgan’s North America Metals & Mining team is making a major call on AK Steel (NYSE:AKS) upgrading the steel maker to Overweight from Neutral with a $22 price target (prev. $18)

While rising raw material cost pressures have been a well-documented concern for AK and will continue to be an issue this year, JPM thinks rising carbon steel prices and improving volumes will more than offset these headwinds. As a result, they are upgrading AKS to OW from N and raising their Dec 2011 price target to $22 from $18. AKS has also clearly stated that it is interested in securing some degree of raw material integration. While it will clearly not be an easy task to acquire quality iron ore or met coal assets at a reasonable price in the current market, they think any success on this front, given AKS’s generally conservative approach to capital deployment, would also be a positive for the stock.

Raising 2011E EPS to $1.05. JPM is increasing their 2011E EPS to $1.05 from $0.54 to reflect the recent increase in steel prices, their belief that they are sustainable, and a generally improving demand outlook. While AK will clearly be confronted with rising iron ore, met coal and scrap costs, the firm thinks price increases and improved operating performance from higher volumes (they are forecasting volumes of 6.1mm tons vs. 5.6mm in 2010) will more than offset these pressures. Given these volumes and supports to pricing (both from production discipline and raw material cost pressures), they think their estimate for a 2011 EBITDA margin of 5.9% is readily achievable. AK’s pension and OPEB expense is also expected to be down by roughly $20mm in 2011, or $0.10

Pricing should win out over costs
While rising raw material cost pressures have been a well-documented concern for the company (and the stock) and will continue to be an issue this year, JPM thinks rising steel prices and improving volumes will more than offset these headwinds. As shown in Figure 1 below, 1Q11 contract prices for global iron ore costs were up 4% over 4Q10, and, if current spot prices hold steady through the end of February, Q2 contract prices will increase by roughly 30% over Q1 levels. AKS will also see an increase in its met coal/coke costs, as a significant portion of its lower-priced contracts rolled off at the end of 2010. However, AK did sign its 2011 contracts before the recent Australian floods pushed met coal prices sharply higher, and will still see some benefit from its leftover, lower-priced contracts. JPM also notes that domestic steel producers can typically secure contract prices for met coal below freight-adjusted global prices given the importance of the long-term relationships between the domestic steel and coal companies.

Increasing PT to $22. JPM is raising their Dec 2011 price target to $22 from $18 to reflect their higher 2011 earnings estimates. Firm’s new target is based on a 7.0x multiple on their 2011E EBITDA, vs. AKS’s one-year forward average of 5.5x since 2002. However, their annualized 2H11E EBITDA would have their target price at a multiple in line with AKS’s long-term average. JPM thinks a premium to its historical average is warranted as 2011 is likely to be a depressed year for earnings, making the premium appropriate in their view. AKS currently trades at 4.1x their annualized 2H11E EBITDA.

Notablecalls: There are couple of reasons why this call is likely a major one:

– This is the 1st rating upgrade AKS has seen since 2009. If you don’t believe me, go and check it out. AK Steel has been the underdog of the space.

– J.P. Morgan’s team is well respected. Their 2011 EPS estimate is now towering 100% above Street consensus. Needless to say, the $22 price target is the new Street high.

This one is indeed a major one. So how to play it? If you want to buy size, you have to wait to til open. AKS was up 7-8% yesterday in reaction to earnings, so we may get a knee-jerk reaction before the stock resumes upward.

I’m guessing AKS can do 5-6% today putting 16.30-16.50 range in play.

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