This Just In: 3 Big Buy Ratings in the Steel Sector

At long last, things are looking up for investors in the steel industry.

According to data fromFocus Economics, hot-rolled coil steel prices that bottomed late last year began perking up in 2016. Although steel prices remain just a fraction of what the metal sold for earlier in this decade, the improvement appears significant enough to have elicited new buy ratings out of a couple of Wall Street banks this morning.

In twin reports, New York-based broker Rosenblatt Securities and investment megabank Citigroup both picked new steel names to recommend Monday, includingAK Steel(NYSE: AKS),U.S. Steel(NYSE: X), and steel mini-mill operatorSteel Dynamics(NASDAQ: STLD).

Here are three things you should know about them.

Things are heating up in the steel sector. Image source: Getty Images.

1. AK Steel is smelting cash

Let's begin with AK Steel, arguably the strongest performer in the sector. Over the past 52 weeks, AK Steel shares have soared 72% -- nearly five times better than the S&P 500 at large -- and it may not be done yet.

This morning, Rosenblatt announced it is initiating coverage of AK Steel stock with a buy rating and a $6 price target that implies 28% upside from recent prices. According to a write-up, steel consumption is improving, cheap steel imports are slackening, and inventories are relatively tight in the sheet carbon steel market, leading to an expectation of "a higher price floor for the flat rolled product over the next 2-3 years."

Other analysts who follow the stock believe that AK Steel, which is currently losing money, could turn profitable next year -- and they may be right. According to data fromS&P Global Market Intelligence, AK generated more than $100 million in positive free cash flow last year, and its current run rate on FCF is close to triple that cash haul. GAAP profitability could be just around the corner for AK Steel.

2. U.S. Steel is Citi's top pick

Just down the street at Citigroup, U.S. Steel is the analyst's top pick. AsTheFly.comreports, Citi sees U.S. Steel boasting the highest operating leverage in the industry (i.e., high fixed costs that cost money when steel prices are low, but turn immensely profitable as steel prices rise), the highest short interest among steel bears, and consequently the "most upside to consensus estimates."

Like AK, U.S. Steel is currently losing money, but expected to turn things around next year. But while Citigroup prefers it over AK Steel (and in fact, Citi rates AK Steel only neutral), U.S. Steel is doing a somewhat less fantastic job in the cash production department. Free cash flow continued to run negative all through 2015, and over the last 12 months, U.S. Steel stock generated positive free cash flow of just $16 million.

While it's turning around, it's doing so slower than AK Steel.

3. Steel Dynamics is a proven winner

Not willing to bet your life's savings on a company thatmightturn things around? Steel Dynamics is a secondary Citigroup recommendation, but a proven performer with arguably the best record of the three stocks named so far.

Technically unprofitable last year, but profitable in each of the four years preceding, Steel Dynamics generated positive free cash flow in each of the past five years, and has churned out a whopping $820 millionin cash profit over the past 12 months. Citigroup rates it a buy, and as TheFlyrelates, calls Steel Dynamics stock "fundamentally undervalued relative to its sustainable ROIC."

The most important thing: Valuation

Wall Street's optimism notwithstanding, S&P Global Market Intelligence data suggest there are only limited growth prospects for these three steel stocks -- perhaps 4% to 5% annual earnings growth over the next five years. That makes buying them at the right price crucial.

On that score, AK Steel boasts a low market cap, but heavy debt load, combining to yield an enterprise value (EV) of $3.1 billion and an EV/FCF ratio of 10.8 -- not expensive, but not as cheap as the stock would look to someone who fails to factor in its crippling debt burden.

U.S. Steel, similarly indebted and with an enterprise value of $5.7 billion, and still negligible free cash flow, seems even less worthy of Wall Street endorsement. If Citigroup says it has a high short interest, well, there's good reason for that.

And Steel Dynamics? Honestly, at current valuations, this is the only one of the three that I would consider owning myself. Although it costs the most (enterprise value: $7.6 billion), the stock's superb free cash flow generation yields an EV/FCF ratio of 9.3. That's not a bad price for a stock expected to grow in the mid 5% range, and paying a 2.3% dividend yield.

It's not cheap enough to buy today, but given a pullback of reasonable magnitude on some non-critical news, Steel Dynamics is in the first rank of steel stocks that I'd be looking to buy in the future.

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Fool contributorRich Smithdoes not own shares of, nor is he short, any company named above. You can find him onMotley Fool CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 301 out of more than 75,000 rated members.

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