Cyclical as it is, one would expect the steel industry to be one of the major beneficiaries of an eminent global recovery. With the World Bank having recently increased its 2014 global growth outlook to 3.2% year-on-year from a previous projection of 3%, and the Federal Reserve trimming by USD 10 billion its asset purchases to USD 65 billion per month, citing a better economic climate in the US, bullish expectations for steelmakers would make sense. Nevertheless, headwinds such as still-low selling prices or subpar economic growth in the euro area raise doubts among investors. So which company would be the best fit for such an environment?
An option could be United States Steel Corp. (X), a steel giant with a long-held dominance in the American market, or, on the opposite end, Steel Dynamics Inc. (STLD), relative newcomer with more modern production techniques and high margins. For those investors like me who have their eyes set on longer-term investments, I would instead suggest Nucor Corp. (NUE). Let’s see why.
Structural overcapacity in the steel world is largely changing the rules by which suppliers compete. New demand patterns – like the replacement of steel parts in the automotive industry for aluminum parts or the unequal cycles that different economies are experiencing – are also shaping supply into a more “just-in-time” one. Thus, the current global economic volatility, which translates into constantly changing steel prices, is forcing producers to be more flexible. Hence, it’s increasingly becoming more important to possess a low per-unit cost structure than to be able to generate large economies of scale by producing bulky quantities.
Here’s where I see that Nucor hold its competitive advantage: electric arc furnaces (EAF). These furnaces, in spite of being more electricity intensive, require a much lower per-unit investment and are significantly more efficient in terms of labor. Adding to this, the fact the Nucor has shifted its raw material usage from pig iron to direct-reduced iron (DRI) by building a new production capacity that utilizes cheap natural gas is also a way in which management is attaining a low-cost strategy to outperform its competitors. Moreover, Nucor’s acquisition of ferrous scrap metal broker David J. Joseph Company allows it to avoid price volatility.
Steel Dynamics is also pointing towards a higher operational flexibility by using EAFs, while it has secured raw material provision by having in-house scrap metal and pig iron, hedging the company from variations in the price of inputs. What I consider that makes Nucor a more attractive bet than Steel Dynamics is that the latter is more leveraged, and so its expansion perspectives are less interesting. Nucor’s debt-to-equity ratio of 55% compares to Steel Dynamics’s of 71%, hence evidencing Steel Dynamics’s limitation to further growth.
Unlike these two low-cost producers, US Steel maintains an old fleet of blast furnaces, which are much less efficient than EAFs and require higher maintenance costs. This is of course contemplated by the company’s management, who is planning to replace some of its old furnaces for EAF as part of its Project Carnegie. In my view, however, given the volume that US Steel manages, the replacement of only some furnaces will not be enough to lower unit costs significantly in order to be as competitive and flexible as its peers. Therefore, although it boasts a large market share, US Steel, being a high-cost producer, will inevitably continue to lose dominance in the medium- to long-term as the market obliges steelmakers to adapt each time more to changes in demand and here’s when an efficient fleet weighs more than a large one. In fact, US Steel’s strategy is somehow being proved erroneous or, at least, antique, since it’s been posting negative net income for the last four years.
Even though Nucor doesn’t offer a cheap valuation – its P/E of 33.9x compares to Steel Dynamics’ 20.1x – I still consider that Nucor is the best fit for the reshaped steel industry. With a strong backwards integration, a very modern operational structure and a its financial robustness in terms of a not so leveraged balance sheet, Nucor is for me the best candidate to profit from the US and global recovery that will for sure impact the steel sector positively. Steel Dynamics would follow my preference order since it is carrying out similar cost-reduction efforts.
Among the investors that have already seen this are Steven Cohen (Trades, Portfolio), who has augmented his tenancy of Nucor shares by 1228.59% while reducing that of Steel Dynamics by 63.72% and that of Steel Dynamics by 79.78%, and Paul Tudor Jones (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Mark Hillman (Trades, Portfolio), who have all bought Nucor shares. They have, in my opinion, good reasons for having done it.
Disclosure: Damian Illia holds no position in any stocks mentioned.