AK Steel and U.S. Steel Upgraded: What You Need to Know

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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...

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In a pair of the most curious upgrades I've seen in a while, German megabanker Deutsche Bank announced this morning that it is upgrading shares of both AK Steel (NYSE: AKS) and U.S. Steel (NYSE: X) to buy. The fact that one of these companies (AK) is profitable while the other (U.S.) is not makes the decision to name them both buys pretty curious. But it's the reasons Deutsche cites for its upgrades that are the most curious things of all.

Here's what you need to know about that.

1. Upgrading AK Steel

AK Steel stock currently costs $6.30 per share -- up 30% over the past year. But as explained by StreetInsider.com (requires subscription) today, Deutsche Bank thinks the stock is worth a whole lot more -- at least $10 a share. The reason: AK Steel made some bold moves to de-risk its balance sheet by first restructuring its debt, then conducting a follow-on stock offering in 2016, growing its share count from 177.9 million shares outstanding to 314.8 million.

That share issuance diluted AK's existing shareholders by more than 40%, but it put a lot of cash on AK's balance sheet, which now has $186 million in cash, according to data from S&P Global Market Intelligence.

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Deutsche also likes the fact that AK "is a premier supplier of automotive grade steels (~66% of shipments to the industry in 2016)."

2. And upgrading U.S. Steel, too

Deutsche shifts gears when upgrading U.S. Steel stock, moving from autos to energy. Firstly, the analyst says it expects U.S. Steel to benefit from an expected Trump administration response to steelmakers' Section 232 trade complaint against foreign steelmakers dumping steel on the U.S. market. This is an argument that's been made before, and made in support of U.S. Steel in particular.

What's more interesting, though, is Deutsche's secondary argument in favor of U.S. Steel: "US Steel will benefit from ... robust steel pricing and turnaround in its Tubular business on improving Oil & Gas drilling activity."

3. Somebody needs to buy Deutsche Bank a Wall Street Journal subscription

By this point, you may be asking yourself: Does Deutsche Bank not read the newspapers? Has it not heard that car sales have peaked and are headed back down, or that oil prices have fallen below $44 a barrel? (And does Deutsche Bank understand that when oil prices are low, oil companies tend to drill less and buy less pipe?)

Honestly, this seems a strange time to be recommending AK Steel stock because of its exposure to the automotive market, or U.S. Steel because of its exposure to oil pipelines. Advising the opposite would seem the more logical course of action.

The most important thing: Valuation

I also have to take issue with Deutsche Bank's argument that these stocks are cheap from a valuation perspective.

For one thing, AK Steel has reported GAAP losses in each of the past five years -- and U.S. Steel, too, has lost money in four of the past five years. Granted, both companies are currently generating positive free cash flow -- $73 million for AK Steel over the past 12 months, and $274 million for U.S. Steel. But even valuing them on free cash flow instead of GAAP earnings, AK Steel stock looks expensive to me at 27 times FCF (and it's even more expensive with debt factored into the picture). U.S. Steel, too, seems less than cheap at 13.4 times FCF (and nearly 20 times FCF adjusted for debt).

Most analysts are forecasting mid-single-digit growth rates for both stocks, and the slowdowns in cars and oil suggests those growth fears are probably accurate. Long story short, Deutsche Bank is making a very contrarian call here in recommending these two steel stocks today. I happen to think it's also a wrong call.

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