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...
Steel investors wound down last week not with a bang, but a whimper, as U.S. Steel (X 0.67%) stock suffered a "double-downgrade" at the hands of investment bank Macquarie. Frightened by U.S. Steel's Q3 earnings guidance (tl;dr: there won't be any earnings, but losses instead), the analyst cut its rating to underperform and predicted that steel prices will "stay weak" for the remainder of this year.
And Macquarie isn't the only one worried -- nor is U.S. Steel the only steel stock getting downgraded.
In a pair of brand new downgrades, this morning J.P. Morgan announced it is cutting steel producer AK Steel (AKS) two notches to underweight. Without missing a beat, Goldman Sachs followed up with a similar downgrade of Schnitzer Steel Industries (SCHN -1.32%) to sell.
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AK Steel
Why all the pessimism about steel stocks all of a sudden? Let's take the downgrades one at a time and find out.
Beginning with J.P. Morgan's downgrade of AK Steel, StreetInsider.com reports that "lower steel spot pricing and lower pricing on annual contracts" are primarily to blame for the analyst's negative sentiment, while worries about the effect of striking General Motors workers on steel demand add an additional concern.
As the analyst explains, both "U.S. steel stocks and steel prices have been under pressure this year ... largely due to concerns about supply additions planned for the next several years, continued uncertainty surrounding trade, and some softening in demand."
Currently, hot-rolled coil steel is selling for about $568 a ton in the U.S. And while that's up a bit from prices as recently as July, it's down a good 34% from what steel fetched a year ago. J.P. Morgan believes prices "will likely fluctuate between $500 and 600/ton over the near to medium term," dipping first, then easing back toward today's rates "heading into 2020."
Still, the best investors can probably hope for from a trend like that one is that AK Steel's business right now is about as good as it's going to get for a while -- and with the stock trading for an enterprise value 21 times trailing free cash flow, the shares don't look all that attractive.
Schnitzer Steel
The more interesting downgrade today, if you ask me, is the one that Goldman Sachs just posted on scrap steel recycler Schnitzer Steel. Over the past year, Schnitzer's share price (down 13%) has held up better than those of many of its better-known rivals, including AK Steel (down 48%), ArcelorMittal (down 53%), and U.S. Steel (down 63%) -- and perhaps rightly so, as Goldman Sachs has a lot of nice things to say about the company.
"Schnitzer Steel has done a good job, in our opinion, at diversifying its geographical market, upgrading the quality of its scrap offerings, and improving operational efficiency," writes Goldman in a note covered on StreetInsider.
The company's "fiscal YTD 24% improvement in per-ton margins in the Automotive and Metals Recycling division (AMR) has been impressive." And yet, the analyst notes that "scrap markets are now showing signs of further weakening, and we are concerned that these deteriorating conditions add risk to SCHN's earnings profile," prompting Goldman's decision to downgrade its rating and cut its price target to $23 a share.
The upshot for investors
But here's the thing: In contrast to AK Steel, which although profitable and free-cash-flow positive, carries a massive debt load that makes its enterprise value much more expensive than its market capitalization alone might imply, Schnitzer Steel to me looks like a company in fine financial fettle.
With a $611 million market capitalization (roughly the size of AK Steel), Schnitzer is burdened by a much lighter debt load -- just $134 million net of cash. As a result, the stock's enterprise value-to-free-cash-flow ratio is a much more palatable 9.7.
Although I can't discount the risk of falling scrap metal prices that Goldman Sachs raises, Schnitzer's much more reasonable valuation -- combined with the stock's respectable 3.2% dividend yield, fully supported by cash flow -- suggests to me that the risk here is much more reasonable than the one that J.P. Morgan highlights at AK Steel.
Given my druthers, I think I'd certainly prefer an investment in Schnitzer Steel over one in AK Steel today.
