AK Steel Holding Corp. (NYSE: AKS) is seeing its shares surge on news that Bank of America Merrill Lynch issued a crucial upgrade for the stock. One has to recall that steel has been challenged as a sector, and this call represents massive upside if the firm is correct. The current valuation is one thing, but how cheap Merrill Lynch is putting the company’s forward multiples is almost mind-boggling.

Merrill Lynch raised AK Steel to Buy from Neutral and raised its price target to $10 from $9 in the call. Shares were at $6.42 prior to the call, and the after-call reaction had shares up more than 5% at $6.76. In short, this is close to 50% implied upside, if the Merrill Lynch team covering steel and metals is correct.

Merrill Lynch sees several issues helping this turnaround. First is a better global electrical steel demand environment. The firm next sees falling iron ore costs into the second half. Another boost is that AK Steel looks to have a better free cash flow story going out into 2015.

Monday’s upgrade signals that AK operations should be back to normal by the third quarter with the return of its Ashland, Ky., furnace and after playing catchup with customers. The team’s upgrade said:

AK Steel is the only beneficiary of lower iron ore prices of our coverage universe, as even with its Magnetation investment it still relies on third party iron ore for half its needs. Recent two-year low iron ore prices should start to benefit AK in the third quarter of 2014 and further in the fourth quarter of 2014. … While we still expect lower carbon steel prices in the second half, our upgrade reflects sustained low valuation and a newly more positive view on electrical steel, with channel checks expecting better second half pricing and demand globally, which can particularly help 2015E pricing.

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Another expected boost is coming from strength in Indian demand. Also, stainless prices were called up as 6% year-to-date. Estimates have been raised across the board:

• 2014: EPS of $0.25 raised to $0.27, revenue raised from $5.8791 billion to $5.8942 billion
• 2015: EPS of $1.10 raised to $1.20; revenue raised from $6.0621 billion to $6.1186 billion
• 2016: EPS of $1.30 raised to $1.55; revenue raised from $6.2103 billion to $6.2589 billion

If Merrill Lynch is right on forward valuations compared to the current share price, AK Steel’s price-to-earnings (P/E) ratio of 25 for this year will compress to 5.6 in 2015 and less than 4.5 for 2016.

Keep in mind that the 52-week range is $2.92 to $8.47, and the consensus analyst price target is only about $6.70.

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