Investment Highlights
- Shares have underperformed the market but are well ahead of peers over the last five years
- Significant cost advantages help the company ride out industry weakness until market conditions improve
- Management has shown its commitment to shareholder cash return and the high payout ratio (92%) should come down to a more sustainable level within the next year
Nucor Corporation (NUE) is a $15.7 billion steel producer in the United States. Operations are integrated across the process from scrap collection through manufacturing. Sheet and bar products make up nearly half of volume sales with structural, plate and fabricated products each account for about 15% of volume.
The company has a significant cost advantage in its use of electric arc furnaces, compared to blast furnaces used by competitors. Arc furnaces are less energy- and labor-intensive than blast furnaces which has helped Nucor maintain higher operating margins relative to other producers. The company has also partnered with E&P Encana on a natural gas drilling program that provides it with low-cost natural gas to run its furnaces.
Despite these cost advantages, Nucor is still caught in the global oversupply condition that is hitting steel producers. Shares of Nucor are up 10.4% over the last five years while U.S. Steel (X) has fallen 30.0% and ArcelorMittal (MT) has plunged 57.5% over the period.
Fundamentals
Sales slipped almost 2% in 2013 though they have rebounded over the most recent quarters and are expected 8.0% higher this year. As with most major steel producers, the impetus has been on cost management over the last several years as the industry tries to work through the oversupply condition.
Nucor’s balance sheet is one of the strongest in the industry with debt only used for about a third of the capital structure. Current assets easily cover near-term liabilities though receivables have increased over the last couple of years.
Free cash flow was negative ($119 million) last year though only on an increase of $249 million in capital expenditures. The last two years have seen a massive boost in investment spending, averaging more than a billion dollars against an average of just $393 million in capital expenditures over the prior two years. Despite the volatility in earnings, cash flow from operations was still nearly $1.1 billion over the last four quarters and is consistently positive. The higher investment spending should pay off over the long-term as industry profitability improves.
Dividends and Growth
Shares pay a 2.9% yield, under the five-year average 3.5% yield. The dividend has suffered along with sales over the past few years with dividend growth of just 0.69% over the last three years. The current payout ratio of 92% is below the five-year average of 127% but still dangerously high.
Management has been steadfast in its cash return to shareholders but the payout ratio may be unsustainable unless profitability improves. The company has paid a dividend for 41 years and has increased the payout for four consecutive years. Nucor has not bought back any shares since the 2008 financial crisis but has a history of share repurchases in the past.
Valuation
The high payout ratio is alarming but stronger sales growth and earnings expected this year and next should support the dividend. Shares are trading for 30.7 times trailing earnings against an average multiple of 26.3 times over the last five years and an average multiple of 149.3 times for the industry. Earnings are expected to surge 37% in 2014 and 67% next year as cost advantages flow and higher sales drive the company’s profits.
The weak earnings environment and volatility over last several years makes valuations difficult but I believe the shares have real upside potential against peers and a good long-term pick on dividends. Even if earnings only increase to $2.68 per share next year, 20% below expectations, the payout ratio would come down to 53% and the price multiple would shrink to just over 18 times earnings. On a modest 20 times multiple, the shares would be worth at least $53.60 each for a 9% gain on top of the dividend yield. A slowly recovering economy in the United States, especially for housing and construction, should support steel demand and this Best of Breed is well-positioned to ride out any weakness.
