Monday's Top Upgrades (and Downgrades)

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This series, brought to you by Yahoo! Finance, looks at which upgrades and downgrades make sense, and which ones investors should act on. Today, it's steelmakers dominating the headlines, as marquee megabanker Goldman Sachs rethinks its position on the steel industry, issuing three new upgrades, and one downgrade.

The big picture
This morning, Goldman Sachs confirmed that while it agrees with other analysts that there's a condition of "oversupply" on the global steel market, Goldman thinks this risk has now been fully priced into the stocks of the major steelmakers. Now, it's time to look beyond "near-term headwinds" and begin positioning for an eventual turnaround in "this deeply cyclical sector."

"Supply-demand fundamentals for steel are starting to look more appealing," opines Goldman, and according to, the analyst thinks flat steel could be the first segment to make a comeback "as some supply has been taken out and demand drivers are firmly in place." Meanwhile, low prices for iron ore will keep steelmakers' costs down, making it easier for them to earn a profit.

So who does Goldman like as a play on this rebound? Take your pick: AK Steel (NYSE: AKS  ) . Bigger producer U.S. Steel (NYSE: X  ) . Mini-mill operator Steel Dynamics (NASDAQ: STLD  ) . All three of these won "buy" endorsements from Goldman today, with the analyst assigning price targets of $6, $30, and $22 to them, respectively.

On the other hand, one "steel company" that Goldman is less enthusiastic about is metals service center Reliance Steel & Aluminum (NYSE: RS  ) . That one alone got a downgrade today, to "neutral," with an $82 price target. Why?

Can you still rely on Reliance?
On the surface, Goldman's statement that it finds Reliance shares "fully valued" accords with the analyst's decision to downgrade. On the other hand, though, Goldman also said the stock will soon be worth $82, and that's 10% higher than where the stock trades today. Add in a tidy 1.8% dividend yield -- more than any of the other steel stocks named pay, with the exception of Steel Dynamics.

This suggests there's a good 12% profit left in Reliance stock, even after the company has already beaten the market with a 33% gain over the past year. What's more, Goldman's valuation estimate appears to be on the mark.

While Reliance shares may look expensive at 17 times earnings, and with a 10% projected growth rate, in fact the company's strong free cash flows (more than $650 million in cash profit generated over the past year) suggest the stock may a whole lot cheaper than it looks. I calculate a price-to-free cash flow ratio of less than 9.0 on the stock -- not bad for a 10% grower with a near-2% dividend yield. Accordingly, I think the stock's more of a bargain than Goldman is giving it credit for.

And how about the rest?
As for the actual steelmakers per se, I'm less sanguine. AK Steel is clearly the worst of the bunch here, with financials showing no profit whatsoever being generated for the past five straight years, and negative free cash flow for the past six. The company's sizable debt load -- more than $1.5 billion net of cash on hand -- and lack of a dividend do little to improve the company's attractiveness.

U.S. Steel looks a little bit better than that. While similarly "unprofitable" over the past half-decade, USX has a better history of generating real cash profit from its operations. Last year, the company produced $412 million in free cash flow, belying its $124 million "GAAP" loss. Over the past 12 months, the cash generation has slowed down a bit, with trailing free cash flow now at only $83 million. Still, that's better than nothing.

Best of the bunch
But honestly, of the three steelmakers receiving upgrades from Goldman today, it's Steel Dynamics that shows the most promise. Here we see free cash flow of $240 million, which is actually 23% more than Steel-D reports as its trailing net income. That means the stock may be cheaper than its 22 P/E ratio suggests.

Analysts see Steel Dynamics growing its profits at close to 25% annually over the next five years. I think that at 17 times free cash flow, the stock's a bargain. Add in the fact that Steel Dynamics boasts the biggest dividend yield of any of the stocks Goldman recommended today, and here, finally, is a Goldman Sachs rating that I agree with.

If you think the steel industry is poised to bounce back, Steel Dynamics is a good stock to look at to play the turnaround.

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Rich Smith

I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.

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