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Tuesday, July 9, 2013

Pension and Other Post-Retirement Obligations Dominate the Balance Sheet at AK Steel

Over the weekend, Barron’s ran this chart with one of its writers’ columns:

In Over Their Heads

These companies have pension liabilities that equal or exceed their market value. Below, each firm's liability as a percentage of market cap.

AK Steel                                 917%

Unisys                                    562

Resolute Forest Products        516

United States Steel                 439

Exelis                                     228

Navistar International             196

Alcoa                                    179

Goodyear Tire and Rubber    174

Huntington Ingalls Indus         174

General Motors                     173

RR Donnelley & Sons           171

J.C. Penney                          148

Northrop Grumman              142

Lockheed Martin                  133

Delta Air Lines                     132

Sears Holdings                     118

Raytheon                             116

Allegheny Technologies        105

Textron                                100

Boeing                                 100

Market capitalization data as of July 5, 2013. Liabilities data as of Fiscal Year End 2012. Sources: J.P. Morgan Asset Management, Bloomberg, company reports.

Struck by how large an outlier AK Steel was, I thought it would be interesting to look into it some more. 

First, I looked at its market cap over time.  Right now, AKS is a $3.25 stock.  Five years ago, back in July 2008, however, it was a $50 stock;  even in Q2 2010, it was a $25 stock.  At the earlier point, it would have had a post-retirement-to-market-cap ratio below 1:1.  At the later, it would have been around 1:1.  Now, however, it’s 9:1, according to Barron’s.  (All the other facts in this post come from, AKS’s 10-K for 2012, its Q for Q113, its year end press release and the May 2013 investor presentation on the IR page of its website).

Second, I looked at what were being counted as its pension liabilities.  AKS’s balance sheet shows an accumulated post-retirement obligation deficit of about $1.77B.  But its market cap, with 136MM shares outstanding, is about $440 million.  That is not a 9:1 ratio, so the Barron’s chart must be based on gross liabilities, ignoring the pension assets.  That doesn’t make a lot of sense to me.  So AKS’s ratio of net post-retirement obligations to equity market cap is nowhere near 9:1 but more like 4:1, a very different number.

Still, that's a lot of leverage and the $3.25 stock price signals the company has big problems going on, so (third) I  wondered what the rest of its balance sheet looked like. And it wasn’t pretty.  Here is a super-condensed version of the 12/31/12 b/s:

($ in millions)
($ in millions)
A/P & accrued liabs
A/R, net
Long-term Debt
Inventory, net of LIFO reserve
Pension & other post-retirement
Other liabs
Investments in JV’s etc
Deferred Tax and other misc intangible assets

The super-condensed balance sheet suggests AK Steel is “insolvent” on a “fair value” basis as such terms are defined  in the Bankruptcy Code:  it has total assets of $3.9B which include, however, deferred tax assets and other similarly non-marketable assets equal to roughly $0.4B  It has liabilities that would be difficult to dispute of almost $4B.. If we strip out the non-marketable intangible assets and liabilities, there is a negative net worth of about $0.5B.  (And that assumes the investments are worth book but who knows?)

Looked at as an EV multiple of EBITDA, it still appears to be balance-sheet insolvent.  EBITDA for 2012 was only $181 million and for 2011, $266 million, neither of which will support liabilities over $3B at a normal, let alone a steel industry, multiple.  EBITDA for the last quarter, although up substantially y/y, was only $67 million.  Things probably have not improved much in the quarter just ended; although they won’t announce earnings for another couple of weeks; their ASP will likely dip by 1% in 2Q13 to $1,055 per ton, the company disclosed last month. 

Fourth, I looked at its cash flow and liquidity.  Again, not pretty.As you can see from the following table, for the past three years, AK Steel has had increasing negative cash flow from operations, and increasing incurrence of debt.

Net Cash Flow from Operations
Net Cash Flow from Investing
Net Proceeds from Debt Issuance[1]

Source:  AK STEEL HOLDING CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2012, 2011 and 2010 (dollars in millions)

So it looks like they have burned over half a billion cash on an operating basis in the past three years, while maintaining capital investments at an average level of a quarter-billion a year, which I assume is rational in their industry, but funding it all through debt – over $1.1B of incremental debt.  Since debt is now over $1.4B, that means, since the start of ’10, they have quadrupled their long term debt.  It would be nice if they were getting the full benefit of QE’s low interest rates, but in fact the coupons are all north of 7.5%.  Interest expense last year was about $87 million and should be around $100 million this year.  On the bright side (and this is the only bright side I can find), there are no maturities in the next three years.

The company’s investor communications lately emphasize that they have over $1 billion of liquidity, taking into account over cash on their balance sheet and about $872 million of undrawn availability under an ABL.  However, cash on the balance sheet has dropped just $50 million in the first quarter, from $227 million to $171 million.  Q2 will not show as much a drop, but only because AKS issued $30 million of new debt in June.  Also, I have not looked at the revolver to see what, if any financial conditions there are to borrowing, and if there are, whether AKS can satisfy them.   Regardless, it does seem AKS should be able to scrape through 2013 if it can keep  EBITDA in the $66 million / quarter run rate. With $171 of beginning cash, plus 4X $67, of $268 of incoming EBITDA, they can cover $100 of interest expense and a capex run-rate of 250, if they're still capex-ing at that rate, for the next 12 months or so.

The only other glimmer of hope  is that AKS’ very heavy pension funding burden is projected to moderate by 2016 (when, btw, their ABL expires). In 2013-15, they project to spend nearly $740 million in pension and OPEB payments   At least that is down from the last three years, which took about  $860 million out of them.  I believe those payments are already deducted above the line in AKS’s EBITDA calculations.

So far the market is financing them and not panicking.    Their senior unsecured debt is rated B1/BB-, so relatively high up on the high-yield credit ladder.   The outlook is “solidly negative” however, in S&P’s view, so a downgrade could come at some point, and, frankly, the rating seems a little high to me  for the balance sheet.  The unsecured debt is quoted in the high 80’s, so not in distressed territory.  Its equity cap of $440 million probably reflects more of a long-term call option on the business if steel prices go up, given the current negative book net worth, leveraging off the fact there are no debt maturities for the next few years.  But given the cash flow projection I estimated in the preceding paragraph, how long-term is that call option really?  It might be as little as a year.  My guess is everyone is playing it a quarter or two at a time, hoping for steel prices to turn up again (good luck, last week's Economist carries a story titled "Steel: An Inferno of Unprofitability").  If they don’t do so by year-end, however, then sometime in 2014, notwithstanding the absence of  fixed debt maturities, AKS may find itself with liquidity challenges that will force it to start to access its revolver or find longer-term capital (at what will probably be a very steep price), because revolver banks very much don't like revolvers being drawn to provide permanent capital.  Otherwise they will face a restructuring or a sale to, likely, a foreign buyer sometime after 1H14..

[1]  Proceeds of debt incurrence, minus debt repayments & debt issuance costs