If you're a value investor, you might be interested in one of the more beaten-down sectors of the market: industrials, particularly U.S. steelmakers. In the first half of the year, U.S. steel prices plummeted as the lingering U.S.-China trade war stoked recession fears. At the same time, iron ore, a critical steel input, spiked in price following the Brumadinho Dam disaster in Brazil in January. That has squeezed the profits of steelmakers all around the world, including U.S. steel company AK Steel (NYSE: AKS).
Despite already falling 45% over the past year, the investing community still isn't optimistic about the company's future -- AK Steel's PE ratio is just 4.5.
Yet could today's fears be tomorrow's opportunity? While AK Steel gets a bad rap for being in an unexciting "old" economy business, the company is rapidly innovating in order to meet the future needs of steel customers, especially the auto sector. Here are the moves this steelmaker is making, and how the business could look a few years out.
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Dangers, or opportunities?
One of the main risks for AK Steel is that it generates almost two-thirds of its revenue from the North American auto market, and two major customers -- Ford (NYSE: F) and Fiat Chrysler (NYSE: FCAU) -- account for more than 10% of its revenue. That level of concentration means that the company could be vulnerable to turbulence in the auto sector.
As many know, auto stocks are somewhat controversial these days. For one thing, the sector is very cyclical, meaning if a recession hits car sales (and thus steel demand) will plummet. Second, the auto sector is facing a fair amount of disruption from both electric vehicles and the ride-hailing industry. Today, electric vehicle motors are often imported from other countries, and don't use AK Steel's bread-and-butter carbon steel.
Finally, even traditional autos are subject to the federally mandated CAFÉ fuel standards, which mandate that U.S. autos must achieve 54.5 mpg by 2025. That could cause auto-makers to use less steel, or alternatives such as aluminum. In fact, AK Steel noted in its recent annual report that one major automaker recently substituted aluminum for steel in the frames of some of its recent models.
How AK is adapting
But AK Steel isn't idly standing by. It has taken several decisive steps to innovate at a rapid pace and stay relevant, including:
Advanced high-strength steel: While some might think all steel is the same, there are a number of ways steel companies can mix materials, creating advanced-engineered alloys to improve certain factors. AK's third generation NEXMET advanced high-strength steel (AHSS) offers increased flexibility and significantly better strength than older steel generations. These superior properties allow engineers to design thinner and more lightweight parts for vehicles without cutting corners on safety requirements. Newer innovations like AHSS, which is just hitting the market, could help ward off the threat from aluminum.
Better stainless steels: It's not just the car's body that needs to be optimized for fuel economy, but other parts of the car as well, like exhaust pipes. That's because the more fuel-efficient engines of the future may burn gas at higher temperatures, putting a strain on the stainless steel exhaust. AK Steel is working on more heat-resistant stainless steels that can withstand higher temperatures, thus enabling next-generation engine designs.
Electrical steels: But what if electric vehicles make more headway against internal combustion engines than previously expected? AK Steel is also moving in that direction as well: It already makes electrical steels, which are not only used in electric vehicle motors, but also in transformers in the nation's electrical grid. In fact, AK Steel was recently awarded a three-year contract from the Department of Energy to develop such non-oriented electrical steels for use in EV and other industrial motors.
Of course, all of this innovation takes investment, as well as close collaboration with AK's automotive customers. To facilitate this, AK has taken up the task of buying or developing "downstream" businesses to take AK's raw steel and engineer it to customer specifications. These downstream businesses include the internally developed AK Tube, which makes advanced tubular products in autos, as well as Precision Partners, an Ontario-based business AK acquired in 2017.
Precision Partners makes very complex and advanced-engineered parts, and puts AK in much closer collaboration with its end customers. In addition, AK has its own advanced research and engineering innovation center in Middletown, Ohio, which is solely dedicated to introducing new steel technologies. By "going downstream," AK is becoming more of a co-developer of next-generation solutions, rather than merely manufacturing steel and selling it.
As long as AK keeps innovating and helping its customers get to a more fuel-efficient future, this steelmaker should survive, and may not be quite as risky as the market deems it today. Industrials can be very volatile, though, so remember allocate your investments in risky names like AK Steel responsibly.
Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
This article was originally published on Fool.com