Byron Douglass, senior research analyst at Credit Derivatives Research, looks at an outright long on AK Steel Corp

AK Steel reported strong second-quarter revenues last week, as sales more than doubled since their nadir in 2009. With its CDS trading 3.75% upfront, selling protection is a solid play and will make for a fun ride.

AK Steel's fundamentals were hammered throughout the recession. Revenues, margins and cashflow all decreased substantially. However, recent data (the company released second-quarter earnings on 27 July) indicate that two of the three are recovering.

Exhibit 1 shows the time series of LTM interest coverage, which have had a superb reversal. Quarterly EBITDA has been positive for the past four quarters, resulting in LTM IC of 10.9x (Exhibit 1).

After hitting an absolute low back in 2009, revenue growth (year-on-year) is up 100% as second-quarter sales nearly hit US$1.6bn. Operating margins are also starting to turn upwards (by about 7%); however, to make up the short fall in cashflow they need to continue moving upwards.

Ongoing cash needs over the next 4-6 quarters will be of critical importance due to the negative cashflow. The company's total cash balance is down to US$129m (from over US$400m back in early 2009). This is largely due to a shortfall totalling more than US$300m (resulting from negative CFO (US$95m), dividend payments, pension obligations, capex and interest expense over the past six quarters) and debt reduction of around US$100m.

The company rolled its 2012 maturity out to 2020 in the second quarter, extending the bond's maturity while reducing its interest rate. Also, by making a US$110m pension contribution in the first two quarters, the company's 2010 pension obligations have been fulfilled (and thus freeing up more cash for the remainder of the year).

AK Steel still maintains an US$850m revolver due in February 2012, with more than US$700m available. Running into a liquidity crisis over the next year is not probable; however, eventual positive cashflow will be a necessity. The company forecasted required funding for 2011 and 2012 is now down to US$180m per year.

We expect AK Steel's CDS spread to tighten by at least 200bp. The expectation, from our quantitative credit model, is based on its overall leverage (total debt of US$502m against a US$1.5bn market cap), interest coverage and liquidity.

The long credit position benefits substantially from both roll down and carry, which will help offset potential adverse spread moves. By way of comparison, the company's 2020 bond (its only issue) trades with a z-spread of 500bp.

AK Steel's credit spread oscillated between 400bp and 800bp since the spring of 2009 (Exhibit 2). Based on the trading range, we set a stop loss on the position at 800bp.

Our biggest concern for the position is AK Steel's earnings quality. Though net income and EBITDA have been coming in at decent levels, CFO has also consistently been in the red. This results in positive earnings accruals, which are a harbinger for downward pressure on share prices.

That said, AK Steel's implied vol term structure has fallen dramatically since May (Exhibit 3). Given the decrease in equity-implied volatility and negative potential on its share price, the credit position can be hedged with downside or ATM puts.

Position
Sell US$10m notional AK Steel Corp 5Y CDS at 3.75% upfront.

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Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).