New Zealand Markets open in 7 hrs 51 mins

AK Steel Upgraded: What You Need to Know

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

2017 has not been kind to investors in AK Steel (NYSE: AKS) stock. Over the past 12 months, shares of AK Steel have lost more than 42% of their value, and badly lagged the S&P 500, which is up 18%. On Halloween, AK played an especially nasty trick on its shareholders, reporting a reversal of last year's third-quarter profit in Q3 2017. According to data from StreetInsider.com, two analysts quickly cut their price targets on AK Steel stock (with top-15%-rated Cowen & Co. in particular cutting as low as $4 a share), while a third analyst downgraded the stock.

But could things finally be looking up for AK Steel? This morning, Swiss megabanker Credit Suisse announced it is upgrading AK Steel to outperform and assigning the stock a $7 price target. If Credit Suisse is right about this, it means that new investors today stand to earn as much as a 51% profit on AK Steel.

Here are three things you need to know.

Pouring molten steel in a foundry

One banker thinks AK Steel stock could be red-hot in 2018. Image source: Getty Images.

1. What went wrong last quarter

Let's start off with a quick recap of where things stand today. On Oct. 31, AK Steel management reported that its Q3 shipments of flat-rolled steel declined 2% year over year, partly as a result of slackening demand from the automotive industry. Higher average sales prices enabled the company to grow revenue regardless -- up 3% year over year to $1.49 billion. Regardless, higher raw materials costs, combined with a series of one-time charges, pushed AK Steel into a loss for the quarter -- $0.02 per diluted share, down from last year's Q3 $0.21-per share profit.

Despite this disappointing result, AK Steel has earned $166 million -- $0.37 per diluted share -- so far this year, significantly more than the $0.26 it had earned by this time last year.

2. What Credit Suisse thinks could go right next year

Things could get even better for AK Steel in 2018 -- or so says Credit Suisse. As StreetInsider.com reports, the analyst is predicting a "material expansion in margins in 2018" as steel prices march higher, helping to offset the rising cost of raw materials. Credit Suisse predicts that "scarcity" will lend special strength to the prices for "value-add products" such as corrosion-resistant coated steel and stainless or electrical steel, versus ordinary hot-rolled coil (HRC).

If Credit Suisse is right about this dynamic, it could be especially good news for AK Steel. According to the company's earnings report, HRC accounts for only about 12% of AK's shipments by volume. In contrast, roughly 14% of AK's business is stainless steel, and 53% coated. Thus, the company leans much more heavily toward the value-added side of the steel market -- and should benefit disproportionately if prices are stronger here than in HRC.

3. Cash is king

Of course, what really gets Credit Suisse excited about AK Steel is the valuation, which is "too compelling to ignore." With AK's share price down more than 40% over the past year, AK Steel stock currently costs just 12.6 times its trailing-12-month GAAP earnings. And with earnings expected to improve over the next 12 months, the company's forward price-to-earnings ratio is only 8.6.

Furthermore, Credit Suisse believes that if things go as it expects, AK Steel could greatly increase its cash output over the next year -- to the point where it will sport a "free cash flow yield" of 21% (i.e., an enterprise value-to-free-cash-flow ratio of about 5).

Is that realistic?

Bonus thing: Reality check

It would certainly be a nice change. But consider:

Through the first nine months of 2016, AK Steel generated positive free cash flow of $206 million. Last quarter's disappointing results, however, dropped AK's FCF for the first nine months of this year to just $67 million -- and the company's trailing-12-month result is a mere $36 million. Based on that last number, AK Steel's EV/FCF ratio today is a whopping 83.3 -- which is to say, the company's market capitalization, plus its net debt, are 83.3 times as much as the value of the cash profit it's generated over the past 12 months.

So what is Credit Suisse really saying here? For AK Steel to obtain Credit Suisse's predicted "21% 2018 FCF yield," the company will need to generate cash profits of $630 million next year -- 17.5 times more cash than it's generated over the past 12 months.

I have my doubts that such a significant turnaround in AK's fortunes is in the offing.

More From The Motley Fool

Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.