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Merrill Lynch Makes Key Ratings Change in Metals Leaders

When analysts make rotation calls within a sector, or metals in this case, some investors overlook these calls. After all, a firm is just saying they now like one company versus another — and sometimes they are not even technically in the exact same segment within a sector. So what are investors to make of a Bank of America Merrill Lynch research call where the firm is recommending one steel and one aluminum company and ditching a key steel stock it has defended for quite some time?

Merrill Lynch’s Timna Tanners and P.T. Luther have taken the “less-bad” approach here, and AK Steel Holding Corp. (NYSE: AKS) has been downgraded to Neutral from Buy. Its price objective also was slashed to $4.00 from $6.00, versus a $2.90 prior close.

Merrill Lynch’s call now acknowledges a weaker steel price outlook and expects a more challenged cash flow view ahead. The firm sees second-half volumes likely to disappoint, and the analysts also incorporated a lower steel price outlook. Amazingly, the firm does see that AK Steel’s free cash flow should stay positive in its forecast. In short, it is a lower price and volume outlook that should bring less reward against risks from AK’s leveraged balance sheet.

Alcoa Inc. (NYSE: AA) may no longer be a Dow Jones Industrial Average component, but it is still the industry leader in aluminum. The Tanners and Luther report from Merrill Lynch upgraded Alcoa to Buy from Neutral, but the new price objective of $12.00 compared to the prior one of $13.00 and to a consensus analyst price target of $13.62.

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Merrill Lynch is looking to Alcoa’s downstream growth, and the firm sees less relevance to its aluminum operations on overall results. The analysts continue to like its benefit from growing use of aluminum in auto and aerospace offerings, its solid balance sheet, upside to future Firth Rixson and RTI contributions, and potential multiple expansion given its greater downstream focus.

While Merrill Lynch sees lower steel prices being the new normal, it has upgraded Reliance Steel & Aluminum Co. (NYSE: RS) to Buy from Neutral. The new price objective is $66.00, versus a $55.84 prior close. This premium in EBITDA valuation was based on Reliance’s steady track record of free cash flow generation. The firm noted that Reliance has a strong track record for cash generation, but falling prices have hurt its earnings power.

Downside risks in Reliance Steel & Aluminum include a delayed economic recovery, execution risk related its acquisition strategy and any sharp correction in prices. Upside risks, what could drive Reliance shares higher than its $66 price objective, were listed as follows: aggressive buybacks or dividend hikes, higher metal prices and more attractive consolidation opportunities versus what is now expected. The firm’s report said:

We upgraded shares of distributor Reliance to Buy as we find its low debt leverage and steady margin business attractive in a more challenging steel market. Strong construction demand and continued capital deployment for buybacks and dividends can propel shares higher, in our view.

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On the broader intra-sector rotational move here, Merrill Lynch said:

A more defensive stance seems prudent amid commodity price and China currency uncertainty, and we consider the exposure of different stocks to metal price risk in our recent ratings realignment. We capitulated on AK Steel in light of continued weak stainless and carbon pricing, and ahead of a repricing of annual contracts into 2016. We note that Alcoa’s aluminum exposure is increasingly less relevant and a steady margin business and strong cash flows make Reliance’s business model particularly compelling.

Alcoa shares were up only 2.2% to $9.70 after the first hour of trading on Tuesday, while broader markets were handily higher as well. Alcoa’s 52-week trading range is $7.97 to $17.75.

AK Steel was down 2% to $2.84, against a 52-week range of $2.38 to $10.31. Unfortunately, Merrill Lynch was one of the strongest defenders of AK Steel, and turnaround investors just lost one of their biggest supporters.

Reliance Steel & Aluminum shares were seen up 3.2%, at $57.62 early Tuesday. Reliance has a consensus analyst target price of $67.86 and a 52-week trading range of $50.63 to $73.96.

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By Jon C. Ogg