Allegheny Technologies Stock Upgraded: Here's 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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Allegheny Technologies (NYSE: ATI) stock has been something of a "good news, bad news" story for investors this year. On the one hand, ATI shares have handily outperformed the rest of the stock market, rising 27% over the past 12 months versus the S&P 500's 14% gain. On the other hand, Allegheny Tech's sharp rise in stock price -- unaccompanied by a positive P/E ratio -- has made analysts leery of recommending it. On Wall Street, more analysts rate Allegheny Technologies stock a hold than a buy.

But at least no one is recommending selling Allegheny Technologies stock -- at least, not anymore.

Merrill Lynch reverses course

That wasn't always the case. In fact, as recently as Friday last week, the bankers at Bank of America's Merrill Lynch brokerage unit did recommend selling Allegheny Tech stock. (According to the scorecard on S&P Global Market Intelligence, Merrill was the only brokerage to do so.) But as StreetInsider.com (subscription required) reports, Merrill abruptly reversed course this morning and upgraded Allegheny Technologies stock two rungs, skipping a neutral rating and taking the stock all the way from underperform to buy. In so doing, Merrill Lynch also hiked its price target on the stock by 50%, from $16 to $24, in effect promising investors a 17% profit from buying Allegheny Technologies stock today.

Plane and simple

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What makes Merrill Lynch so suddenly optimistic about Allegheny Technologies stock?

Well, there's the booming market for airplanes, for one thing. The biggest part of Allegheny's business, you see, is manufacturing high-stress parts for industry, and the airplane industry in particular (where Allegheny is a specialist in making airplane engine parts). Merrill Lynch cites ramping production of 737 MAX airliners at Boeing and A320neo jetliners at Airbus as two key drivers of Allegheny's stock performance over the coming years.

At last report, Boeing still had a backlog of 3,827 737 MAX airplane orders awaiting production -- roughly two-thirds of the company's total backlog of 5,665 planes. Airbus's waiting list is even longer, with 5,520 single-aisle planes on order, amounting to 82.5% of the company's total backlog.

With so many of its customers' planes in backlog, Allegheny will be kept busy making plane parts -- and collecting payment on them -- for years to come (if not decades).

Smooth sailing for flat-rolled production

The other big part of Allegheny's business is producing sheets of stainless and other alloyed steels -- flat-rolled products, or FRP in industry parlance. And here, too, Merrill Lynch sees things rolling along quite nicely for Allegheny.

Over the course of the next five years, Merrill anticipates that 40% of Allegheny's workforce will be entering retirement. That sounds like a problem for Allegheny, but to Merrill's way of thinking, it may also be an opportunity as more expensive workers roll off the payroll, to be replaced by cheaper (and perhaps fewer) new hires -- cutting labor costs. At the same time, Merrill notes that "better commodity values" will boost Allegheny's profits in the short term, and predicts that will become evident as early as Q4 of this year.

What investors should watch

All of the above works out to a very bullish scenario for Allegheny Technologies stock, in Merrill Lynch's view. That being said, this stock is not without risks.

I've already mentioned that Allegheny Technologies has no profits. In fact, Allegheny hasn't booked a full-year GAAP profit in more than three years. On the plus side, it has recorded small quarterly profits in each of the past three quarters, so there's some indication that a turnaround may be underway.

However, Allegheny has posted negative free cash flow for four straight years, and its last two quarters featured negative cash burn as well -- so maybe things really aren't getting better as quickly as investors might wish them to improve.

The good news for investors is that we may not have to wait very long to find out if Merrill Lynch is right about Allegheny beginning a sustained turnaround. The company last reported earnings on July 25. While no official release date has been set for third-quarter earnings, chances are they'll roll out sometime around Oct. 25. Whether Allegheny stock is a buy will soon be apparent.

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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.