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AK Steel and Steel Dynamics Stocks Downgraded: 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...

It's Thursday, and stocks fell again on concerns that a protracted trade war with China could get even longer, hurting the U.S. economy. Whatever the effects on the economy in general, however, one thing is clear:

One aspect of the trade war -- steel tariffs -- has been very good news for one slice of American industry: steelmakers.

As my Fool.com colleague Jason Hall reported last month, summing up the effects of a year's-worth of 25% tariffs on steel imports from China -- and from Canada, Mexico, and elsewhere -- these tariffs have effectively boosted profit margins at steelmakers such as AK Steel (NYSE: AKS), US Steel, Nucor, and Steel Dynamics (NASDAQ: STLD). But today, two of these companies are getting downgraded on Wall Street.

Why?

Molten steel pours in a foundry

Image source: Getty Images.

Easy tariff come, easy tariff go

Last Friday, the Trump administration announced that it had reached a deal to lift tariffs on imports of Canadian and Mexican steel. On Monday, Canada and Mexico reciprocated, officially removing their own steel tariffs against U.S. exports. So while tariffs remain in place as regards Chinese steel imports, tariffs on the arguably more important imports from nations closer to the U.S., with lower transportation costs on steel, have now gone away.

Credit Suisse thinks this could be bad news for AK Steel, and probably Steel Dynamics as well, potentially incentivizing nearby producers like Canada's Stelco to compete more aggressively for U.S. steel supply contracts, putting pressure on steel prices in the U.S.

Downgrading Steel Dynamics...

StreetInsider.com (subscription required) has the details. Beginning with a write-up on the Steel Dynamics downgrade, SI explains that Credit Suisse has removed its outperform rating from Steel Dynamics, downgrading the shares to neutral with a $29 price target.

With steel tariffs in place, U.S. steelmakers have enjoyed an upcycle in steel prices this past year. S&P Global Market Intelligence data show that Steel Dynamics is generating free cash flow at a stellar rate of $1.2 billion per year (a 20% free cash flow "yield" when measured against Steel Dynamics' $6.1 billion market cap). However, Credit Suisse is forecasting lower EBITDA for Steel Dynamics going forward (and presumably, lower free cash flow as well), as a result of new competition likely to emerge from Canada and Mexico combining with domestic overcapacity in steel production to result in lower steel prices.

Noting that over the past five to 10 years (in which tariffs were not in place), Steel Dynamics has averaged a free cash flow yield of only about 8%. With steel prices now turning downwards, the banker appears to be worrying that the company's FCF yield might return to historical norms -- which the analyst does not find "compelling" enough to justify giving a premium valuation to Steel Dynamics.

Concerns over the cost of building a new "greenfield" steel mill add to Credit Suisse's negative view on Steel Dynamics' future free cash flow.

...and downgrading AK Steel, too

The analyst has similar worries about AK Steel.

Like Steel Dynamics, AK has benefited from the current steel price "upcycle," notes StreetInsider in its write-up of the downgrade. Last year for example, free cash flow at the Ohioan steelmaker surged more than four times in value over 2017 levels to $213 million, according to S&P Global data. But this benefit already has begun fading, with AK posting negative free cash flow in Q1 2019, and Credit Suisse estimating total free cash flow of only about $120 million over the past year.

Furthermore, as the analyst sees it, AK Steel has failed to capitalize on the opportunity to pay down its net debt load during the upcycle in steel prices. Between actual debt and pension obligations, minus cash on hand, Credit Suisse estimates AK's total net debt at about $2.9 billion. (Steel Dynamics' net debt load, by the way, is only $1.5 billion, and with a much larger market cap to support it.)

Fearing therefore that AK Steel has significantly higher "balance sheet risk" in a market with declining steel prices and reduced profits, Credit Suisse decided today to downgrade AK Steel two notches -- all the way from outperform to underperform -- and is cutting its price target from $3.50 to just $1 per share.

What it means to investors

Now, how frightened should investors be by these downgrades? Judging from the stock price reactions (Steel Dynamics fell over 6%, but AK Steel dropped less than 4%), it's the SD downgrade that's proving more worrisome -- but I think that's a mistake.

Consider that analysts, who presumably have their fingers on the pulse of governmental tariff moves, nonetheless still peg Steel Dynamics for 12% annual earnings growth over the next five years. With Steel Dynamics stock trading for about five times earnings (and five times free cash flow as well), 12% growth seems to me plenty to justify the stock's valuation, and indeed arguably makes Steel Dynamics stock look cheap after today's sell-off.

In contrast, AK Steel's valuation of 4.4 times earnings and 5.2 times FCF looks only fairly priced relative to analysts' predicted 5% long-term growth rate for the company. Factor in AK's much more serious debt problem, and I agree with Credit Suisse that of the two, AK Steel is the stock in direr straits -- and the one more deserving of a sell rating.

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