Nucor (NUE) is one of the largest steel producers in the U.S., and the largest “mini-mill” operator. The company claims to be North America’s largest recycler, recycling one ton of steel every two seconds. Nucor’s products include sheet steel (34% of 2010 sales by weight), bar (18%), structural (10%), plate (10%) and other. Most business is conducted in the U.S., but the company does have foreign operations and looks at international expansion as a strategic opportunity.
Nucor has tripled its sales in the past 10 years, helped by a series of acquisitions, which also expanded the company’s product range and added a supply base. Nucor has a flat organizational structure and prides itself on its corporate culture, where low-level employees share profits, and benefit from unique pay-for-performance.
Although Nucor is one of the largest steel makers in the U.S., it is not a traditional producer. Most of its production is based on recycling scrap metal using electric arc furnaces, unlike the traditional method of smelting iron ore in much larger blast furnaces. This technological difference represents a significant advantage for Nucor, making it much more flexible in times when production volumes need to be adjusted to shifts in external demand, as it can shut down furnaces much more quickly than traditional steel makers (blast furnaces are usually left running unless it is absolutely necessary to stop their operation). Nucor thus has lower fixed costs, making it more flexible and financially more robust in uncertain economic environments when demand for steel fluctuates. In addition, electric arc furnaces need significantly less energy to produce steel.
As a disadvantage of its technology, Nucor relies on a constant supply of scrap, as it is unlikely to produce steel from iron ore competitively. The risk of reduced scrap availability is somewhat mitigated by the ongoing efforts of authorities to stimulate recycling as a means of reducing pollution.
Nucor is actively researching new production technologies. The company has launched a facility (a “micro-mill”) to cast sheet metal directly from molten steel, reducing the amount of rolling required to produce the end product. This process, called Castrip®, can significantly reduce the size of the production facility, costs and emissions. Nucor is also running two pilot projects (in Australia and Brazil) to develop low-cost sources of iron for its mills. The company emphasizes that it continuously searches for ways to optimize its operations, which is critical for a company with huge capital assets and highly volatile raw material and final product prices. Nucor’s average capex over the last 10 years stood at $395 million per year, with the last five years seeing significantly more investment than the previous five years – $523 million versus $268 million per year on average. It is worth noting that the bulk of recent capex took place in 2008, with $1 billion spent on new facilities.
In the past decade, Nucor has grown significantly, with much of this growth coming from acquisitions. Nucor has acquired not only other steel producing facilities, but also companies along the vertical vector. Among its acquisitions was DJJ (purchased for $1.4 billion in 2008), one of the largest scrap yard operators in the U.S., with 59 such facilities, partially securing Nucor’s raw materials supply (but with much of it still externally sourced, the supply risk mentioned above remains) and reducing its price. Another large acquisition was Harris Steel Co. for $1 billion in 2007, which expanded the company’s product range. Nucor claims to be the most diversified steel producer in North America and that it does not focus on any single market. The company has made a point to highlight the fact that it has a very limited exposure to the U.S. automotive industry. Diversification should help alleviate the risks associated with particular industries.
At the same time, Nucor is primarily an American business, with most of its sales from the US. The company recognizes the benefits of international diversification and is expanding abroad, with joint ventures and subsidiaries in Europe, North Africa, Canada, Mexico and Trinidad. International operations, however, appear to be quite limited, as Nucor doesn’t even report the geographic distribution of its sales (and operations from foreign joint ventures are reported as a separate income item rather than on consolidated basis).
The largest risk Nucor is facing is the cyclical nature of its end market. Demand for steel and, consequently, its price are significantly affected by the health of the economy. Downturns cause a decline in both, while booms have an opposite effect. This was well-illustrated by Nucor’s financial performance in 2009: As tons shipped declined by 33%, prices also dropped by 32%, causing revenues to fall by 53%. At the same time, even when physical quantities shipped remain largely unchanged, price swings can be huge. For example, the 27% year-on-year revenue increase in the first half of 2011 was almost entirely driven by price movements, while physical quantities grew by a mere 5%. The effect is amplified by the fact that total market production capacity cannot be changed in line with demand, thus causing oversupply when demand falls, and shortages (or inventory depletions) when demand increases, leading to price swings. Some of the risk associated with raw material price volatility is mitigated by Nucor’s raw material surcharge to pass price changes on to customers.
Nucor is a significant consumer of electricity and natural gas. Power outages remain a risk (there have been precedents), while price of gas can fluctuate significantly. Nucor decided to partially mitigate the gas price risk through a seven-year working interest agreement with a natural gas production firm to drill on-shore natural gas wells in the U.S. (there are no details regarding the size of this operation and the impact on natural gas price risk exposure).
China, the most notable of emerging markets, has significant impact on Nucor, even if the company itself does not have operations there. China's economy is growing quickly, demanding much steel and other resources to fuel its growth (China has many large infrastructure projects, significant military spending and is promoting consumer spending). The country is one of the largest (and often the largest) consumers of natural resources on the planet, increasing competition for resources and driving up prices.
Growth in other emerging markets (including India) should also help maintain the global demand for steel in the long run. At the same time, China is home to many state-supported producers of cheap steel that compete with Nucor in its home market. It also affects Nucor through structural changes it causes in the U.S. economy. Cheap exports from China drive manufacturing out of the U.S., where most of Nucor’s customers are located. In the long run this could lead to a reduction in domestic manufacturing and, as a result, in the domestic demand for steel in the U.S., increasing competition for Nucor and driving down margins.
An important set of operational risks for Nucor is the same as for any manufacturer: environmental, health and safety, and regulatory. These risks typically materialize sooner or later and often all at once, especially when industrial accidents happen, which can pollute the environment, injure employees, affect people and businesses and lead to inquiries by authorities who can apply fines and penalties if compliance failures are discovered.
Moreover, with the recent trend to improve the environmental and health safety of manufacturing facilities, regulations are gradually tightened. This requires upgrades to facilities, which can increase costs, drain resources and increase non-compliance risk. In addition, tighter compliance requirements in domestic markets may create a disadvantage versus foreign competitors who may not have such strict norms (surely competitors in China do not face the same level of scrutiny).
Nucor claims a commitment to environmentally friendliness, but it is still one of the largest polluters in the US. This appears to be changing, as between 2002 and 2006 (latest data), Nucor has moved from 14th place to 24th in terms of air pollution in the U.S., according to the University of Massachusetts’ Political Economy Research Institute (Nucor’s toxic score declined by three times, although the volume of toxic releases declined only modestly).
Nucor has had its share of environmental trouble, including what the Environmental Protection Agency called “the largest and most comprehensive environmental settlement ever with a steel manufacturer” in 2000, when Nucor was to pay almost $100 million to settle an environmental lawsuit. Nucor is also a co-defendant in a class-action antitrust complaint, although the potential cost in case of an adverse ruling is difficult to assess at this stage.
Nucor prides itself on its corporate culture and organizational structure. The company has a relatively flat structure and small central staff. Operational decisions are made locally, and employees participate in a profit sharing program, scholarship program, employee stock purchase plan, extraordinary bonus and service awards program (none of these are available to executive officers). The company reports that its incentive-based pay mechanism reduces its payroll costs during difficult economic times and allows it to avoid shutting down facilities and laying off workers. Nucor reportedly has never fired a worker due to lack of work. At the same time, its workforce is not represented by unions, which removes a significant risk factor that many competitors face.
• More flexible than traditional steel producers
• Technological innovation leading to status as lowest-cost provider
• Effective vertical integration
• No labor union risks
• Strong financial health
• Economies of scale
• Barriers to entry
• Operational risks
• Environmental record
• Business concentration in the US
• Economic recovery in the near term
• Emerging markets should drive global demand and prices in the long run
• Should benefit from the growth in recycling in the long run
• Steel price swings
• Economic cycle affects demand
• Production depends on uninterrupted electric power supply
• Cost of energy and raw materials/scrap affects production costs
• Chinese steel competition
• Tightening environmental legislation
• Relocation of manufacturing outside the U.S. reduces client base
• Price-fixing litigation
Along with Korea’s Pohang Iron and Steel Company (POSCO) (PKX), Nucor has been at the cutting edge of advanced technology utilization that is used to implement innovative manufacturing techniques that have resulted in low-cost production and above-average returns on invested capital. Both companies have managed to maintain low leverage through strong operating cash flow generation and have healthier balance sheets when compared to the industry average. Compared to Nucor, POSCO’s heavy exposure to iron ore, coal, and nickel makes input cost management more challenging. In sum, we believe that Nucor has the most sustainable competitive advantages in the industry.
Table 1: DuPont Analysis (all components are five-year averages)
Net Profit margin
POSCO ADR (PKX)
ArcelorMittal SA (MT)
US Steel (X)
Key Growth and Profitability Metrics
In the past 10 years, Nucor’s revenues have almost tripled, from $4.1 billion in 2001 to $15.8 billion in 2010. Revenues grew at double-digit rates every year until 2009, when the global recession hit demand for steel and prices hard and halved Nucor’s revenues from $23.7 billion to $11.2 billion. Table 1 clearly shows the impact on recent growth rates.
Even with this large setback, Nucor’s 10-year CAGR is 16.1%. Gross and net margins move hand in hand, as the company has low fixed costs. Since Nucor has little power over the selling price of its products, however, its margins and earnings are anything but stable (Chart 1 and Table 2), reflecting swings in the economic cycle. As a result, free cash flows also show limited stability as fluctuations in profitability are complemented by changes in capex over the past 10 years.
The first half of 2011 has been quite positive for Nucor: The company increased its revenues by 27% year-on-year (mostly due to higher selling prices), and net margin gained three percentage points year-on-year, reaching 4.6%. ROE has improved from 1.9% in 2010 to 6.3% for the TTM period, and is getting closer to the 8.3% industry average. The same is true for the net margin — TTM net margin is 2.6% — about half of the industry average of 5.0%. It is worth noting that TTM ROE and ROA are at, or slightly above, the medians for the peer group.
Balance Sheet Data and Financial Health
Nucor has a healthy balance sheet, with $2.3 billion in cash and short-term investments. It has $4.3 billion debt, most of which is long-term with maturities in 2017 and beyond. The debt to equity ratio is 0.56, double the industry ratio of 0.25, but better than the median for peers of 0.78. The debt to equity ratio has almost doubled from the average of 0.29 in 2001-2005, driven in large part by debt-financed acquisitions in 2007 and 2008, as well as $1.2 billion of new debt issued in 2010 ($600 million in 30-year variable rate Gulf Opportunity Zone bonds to partially fund the construction of the DRI facility in Louisiana, and $600 million for “general corporate purposes, including repayment of debt” due in 2022).
The company also has $1.3 billion in undrawn credit facility. The company boasts that it has the highest credit rating of all North American steel producers, with an A rating from Standard and Poor’s and A2 from Moody’s. We believe that the company should not have any problems meeting its debt commitments or raising additional financing if it needs to.
Liquidity ratios are quite high, with the current ratio at 3.4x and quick ratio at 2.2x at the end of second quarter 2011. These ratios are roughly double the peers’ medians and about seven times higher than industry averages (as reported by Reuters). The interest coverage ratio of 2.5x compares favorably against peers (0.7x) and the industry (0.02x), but is many times below the levels recorded in the past (double- and triple-digit numbers in 2004-2008).
Nucor enjoys strong cash generation ability, which has grown (and declined) with revenues, but remained positive even throughout the difficult 2009, benefiting from low operating leverage. Nucor’s investing cash flows consist mainly of acquisitions and capital expenditures, with the average annual investing outflow tripling in 2006-2010 versus 2001-2005 (to $1.78 billion from $0.52 billion, excluding movements in short-term investments), as the company carried out a number of major acquisitions and stepped up its investment efforts.
Nucor’s cash generation ability means that the company has had to issue debt or stock only a few times in the past ten years, when investing needs could not be met with internal reserves. Its dividend policy, however, also means that the company will pay out dividends even when it needs cash for other purposes (as a result increasing debt and stock base by more than is strictly necessary). Nucor reports that it has been paying increasing dividends since 1973. Robust balance sheet and strong cash generation ability mean that the company should be able to continue paying dividends, as well as implement investments and seize acquisition opportunities without overstretching the balance sheet.
Although the company has a stock repurchase program with 27.2 million shares remaining authorized for repurchase, no repurchases were made recently.
Efficiency and Management
Fixed Assets Turnover
Days Sales Outstanding
Nucor’s receivables and inventory turnover ratios are below historical averages (12.2x and 8.5x in the past 10 years) due to declined sales, but above peers (8.9x and 5.8x) and significantly above industry averages (2.5x and 1.4x). The cash conversion cycle is currently slightly above the historical average — at 58 days versus 53 days, reflecting lower turnover in receivables, slightly offset by the lower turnover of payables (23 days versus 18). Turnover of fixed assets has accelerated from the historical average of 4.0.
As we mentioned above, Nucor has a relatively simple decentralized management structure, does not have a unionized workforce and has an incentive-based pay system. This approach minimizes fixed costs, provides flexibility during uncertain economic times, and avoids layoffs in downturns. Employees benefit from various programs (scholarships, profit sharing, etc.) that exclude executive officers. The latter also do not receive many of the perquisites that could be considered standard for large corporations (such as private jets, various compensations and allowances).
Moreover, Nucor claims that its executive compensation is set at or below the industry median, which leads to it regularly falls behind the industry average, according to the company. In 2010, executive compensation (excluding payments to former officers) consisted mostly of stock awards (35%), option awards (32%, consisting exclusively of $3.75 million worth of awards to CEO as a one-time payment to compensate for below-industry compensation), base salary (20%) and non-equity incentive pay (13%); bonus and other payments were virtually zero.
Incentive payments consist of annual and long-term components. Annual portion is determined by ROE and net sales growth versus “comparator group” (which includes industry peers and other large corporations, defined by Nucor as “capital intensive industrial and materials companies chosen for their superior financial performance”). Long-term incentives are determined by three-year return on average invested assets (ROAIC) versus comparator group companies.
Nucor’s corporate governance is generally good. The major issues are that its CEO and COO are also directors (the CEO is also the chairman of the board of directors and COO is the company’s president). The CEO also participates in the design of executive compensation, providing recommendations to the compensation committee, which is composed of independent directors. The fact that the CEO is also the chairman is somewhat offset by the company’s bylaws requiring that in such cases there must be an independent lead director who takes some of chairman’s responsibilities. The purpose of this extra layer is questionable, but it is worth mentioning that a shareholder proposal to vote for an independent chairman failed at the last annual shareholder meeting. It was also voted that the advisory vote to approve executive compensation be held every three years instead of annually.
Another issue is that shareholders have a rather narrow window of opportunity to make proposals for the next annual shareholder meeting of just 30 days to be guaranteed inclusion into the agenda.
Nucor’s CEO, Daniel R. DiMicco, has been serving the company for almost 30 years – since 1982, including at least 19 years in high-ranking positions. He became the CEO in 2000 and chairman in 2006. Mr. DiMicco is a metallurgist by education and a member of a number of industry bodies, such as the World Steel Association Board and Executive Committee, American Iron and Steel Institute (AISI) (Chairman/Vice Chairman), Department of Commerce U.S. Manufacturing Council. Currently, he is also a member of the board of directors of Duke Energy Corporation.
|EV / EBITDA||7.80|
|Price / Free Cashflows||9.38|
|Forward PE Ratio||10.09|
|Free Cash Flows Yield||10.66%|
|5 -Years EBITA Growth||-24.82%|
Earnings Power Value
The conservative, no growth estimate of Nucor’s value from the current EPV calculation is $34.64. This model, popularized by Professor Bruce Greenwald, assumes a discount rate of 11% and is based on the current earnings and assumes zero future growth, implying that the market is assigning low expectations on the future growth potential of the company. I do not believe that the U.S. will experience a double-dip recession, and economic activity is expected to grow and I expect Nucor to post at least 5-7% top-line growth in the next three to five years.
Discounted Cash Flow (FCF) Model
|Initial FreeCashFlows (normalized)||$ 1,056|
|1-5 years||6-10 years||10-15 years|
|FCF Growth Rate||10.00%||4.00%||3.00%|
|Terminal Growth Rate||2.00%||Discount||11.00%|
|Free Cash Flows||12,234|
|PV of Cash Flows||17,915|
|Intrinsic Value|| |
A Three-Stage DCF model which takes the five-year free cash flow average as the initial FCF, assumes 10% free cash flow growth in years one to five and an 11% discount rate yields an intrinsic value of approximately $50 per share. Given the high exposure to macroeconomic conditions and cyclicality of the industry, there is considerable uncertainty in DCF model outputs and a high margin of safety and a long-term investment horizon is therefore recommended. The EPV model provides an additional measure of confidence that the stock is undervalued.
In sum, Nucor has a durable economic moat, a shareholder-friendly management, and is positioned to ride out global macroeconomic weakness. Nucor appears to be substantially undervalued and, with a 40% margin of safety from the DCF model IV calculation, the target acquisition price for Nucor is approximately $30.
About the author:Margin of Safety Equity Research is a value-investing focused company providing equity research services, the Securities Analysis System investment software, stock valuation models, and other financial resources for value investors. Members of our subscription services have access to the Margin of Safety value-oriented portfolio and discounted access to our software.
We apply Buffett's and Charlie Munger's four filters in selecting stocks as part of a concentrated portfolio (10-15 equities). Criteria for selecting companies are:
1.They are strong businesses; as defined by high long-term cash generation, above-average return on invested capital, possession of favorable underlying economics and a durable ...More competitive advantage, good financial health, and above-average profit margins
2. We understand the business
3. They are run by competent management
4. They are available at bargain prices.
We require a 25-50% margin of safety, depending on the stability and economic moat for the company.
In addition to equity research services, we are a member of the Gerson Lehman Group Expert Counsel of Advisors and provide research/consulting services to investment banks.