Is Nucor a Good Investment Opportunity?

| About: Nucor Corporation (NUE)

The steel industry has been whipsawed through the past couple of years from the summer of 2008 when prices reached all time highs through the economic downturn which saw drastic price drops and diminished demand, to the last few months which have seen steel prices rise again. While steel prices have not yet returned to all time highs, there have been significant increases. However, whipsawing prices is pretty much typical for steel products.

Nucor Corp. (NYSE:NUE) is the most valuable U.S. steel company, despite trailing United States Steel Corp. (NYSE:X) in total revenue. Globally, it also trails both ArcelorMittal (NYSE:MT) and Pohang Iron & Steel Co., Ltd. (NYSE:PKX). NUE has followed an extremely different trajectory from X throughout its history.

Nucor Profile

From Yahoo Finance:

Nucor Corporation, together with its subsidiaries, engages in the manufacture and sale of steel and steel products in North America and internationally. The company operates through three segments: Steel Mills, Steel Products, and Raw Materials. The Steel Mills segment offers hot-rolled steel products, including angles, rounds, flats, channels, sheet, wide-flange beams, pilings, billets, blooms, beam blanks, and plates; and cold-rolled steel products. The Steel Products segment provides steel joists and joist girders, steel deck, fabricated concrete reinforcing steel, cold finished steel, steel fasteners, metal building systems, light gauge steel framing, steel grating and expanded metal, and wire and wire mesh. The Raw Materials segment produces direct reduced iron (DRI); brokers ferrous and nonferrous metals, pig iron, hot briquetted iron, and DRI; supplies ferro-alloys; and processes ferrous and nonferrous scrap products.

The company’s operations also include international trading companies that buy and sell steel and steel products. It sells its hot-rolled steel and cold-rolled steel to steel service centers, fabricators, and manufacturers; steel joists and joist girders, and steel deck to general contractors and fabricators; and cold finished steel and steel fasteners to distributors and manufacturers. The company’s products are used in highways, bridges, reservoirs, utilities, hospitals, schools, airports, stadiums, and high-rise buildings. Nucor Corporation was founded in 1940 and is based in Charlotte, North Carolina.

Steel Producing Companies

Ticker

Name

Close 3/8/2011

Market Capitalization 3/8/2011 ($ Millions)

Annual Sales ($ Millions)

MT

ArcelorMittal

35.54

55,475

78,025

PKX

Pohang Iron & Steel Co., Ltd.

104.27

36,364

28,346

SID

National Steel Corporation

16.06

24,256

7,690

GGB

Gerdau S.A.

13.45

19,463

18,859

NUE

Nucor Corporation

47.20

14,911

15,845

MTL

Mechel Steel Group OAO

29.30

12,197

5,754

OTC:SMMLY

Sumitomo Metal Industries Ltd.

24.31

11,683

13,874

X

United States Steel Corporation

55.72

8,010

17,374

TX

Ternium S.A.

36.34

7,285

7,382

OTCPK:USNZY

Usinas Siderurgicas De Minas

12.43

6,299

7,402

STLD

Steel Dynamics, Inc.

18.20

3,966

6,301

CMC

Commercial Metals Company

15.76

1,804

6,306

SCHN

Schnitzer Steel Industries, Inc.

64.32

1,767

2,301

AKS

AK Steel Holding Corporation

15.02

1,656

5,968

OTCPK:HGVLY

Evraz Highveld Steel & Vanadium Ltd.

13.30

1,319

513

FSTR

L.B. Foster Company

41.24

423

475

ROCK

Gibraltar Industries, Inc.

11.25

342

685

ZEUS

Olympic Steel, Inc.

30.02

327

805

CHOP

China Gerui Advanced Materials Group Limited

5.54

252

219

USAP

Universal Stainless & Alloy Products, Inc.

33.75

229

189

SHLO

Shiloh Industries, Inc.

11.89

197

457

GSI

General Steel Holdings, Inc.

2.38

130

1,668

CPSL

China Precision Steel, Inc.

1.67

78

110

Click to enlarge

Data provided by Zacks.com services.

Discounted Cash Flow Analysis

I completed a discounted cash flow analysis on Nucor Corp. to evaluate it as a potential long investment. The discounted cash flow method is one of the basic tools for valuing companies. Essentially it states that the value of an enterprise is equal to its future cash flows discounted at an appropriate rate to account for the risk in those cash flows.

The appropriate discount rate is based on whether the cash flows have been adjusted for servicing debt or are prior to debt service. I used the unlevered free cash flow method which targets an enterprise value. The appropriate discount rate should then reflect both the cost of debt and the cost of equity. In this case, a weighted average cost of capital (WACC) is appropriate. The required equity return can be calculated using the Capital Asset Pricing Model (CAPM) with an equity risk premium, an equity beta, and a risk free rate (approximated by the 10 year U.S. Treasury bond rate). The unlevered free cash flow in its simplest form equals net income + depreciation/amortization – changes in working capital – capital expenditures + interest expense * (1 – tax rate).

WACC Component

Value

Risk Free Rate

3.5%

Beta

100.0%

Equity Risk Premium

6.0%

Required Equity Return

9.5%

Cost of Debt

6.0%

Tax Rate

35.0%

Debt Weighting

18.0%

Equity Weighting

82.0%

WACC

8.5%

Click to enlarge

Source: Yahoo!Finance

The key assumption in the WACC is the beta for the equity, I used 1 which is consistent with both Zacks.com and Yahoo Finance. It also matches my calculation against the S&P 500. The industry average pulled was around 1.7-1.8 with the range going from .8 to 2.6 for the larger steel producers. NUE’s relatively low beta suggests consistent operations and performance. NUE also shows very limited financial leverage.

The next key observation about the steel industry is that it cycles through good times and bad times. It is not that unusual for steel prices to rise by 40-70% over a single year period. This creates challenges when projecting forward. One of the key variables to consider here would be gross margin and long term growth. My base case assumptions were a restoration to 10% gross margin with a 5% long term growth.

One of the key issues is reviewing the historical margins and projecting forward a cycle average. The margins here are lower than the 2008 figures which was a record year for steel prices. However, prices are rising again, which could show these numbers, at least in the near term, to be underestimated.

Margins

Year

Status

Gross Margin

Operating Margin

Net Income Margin

2008

Historical

17.1%

13.5%

7.7%

2009

Historical

1.4%

-1.8%

-2.6%

2010

Historical

5.3%

2.9%

0.8%

2011

Projected

8.0%

5.5%

2.8%

2012

Projected

10.0%

7.5%

4.2%

2013

Projected

10.0%

7.5%

4.2%

2014

Projected

10.0%

7.5%

4.3%

2015

Projected

10.0%

7.5%

4.3%

2016

Projected

10.0%

7.5%

4.3%

Click to enlarge

Source: Yahoo Finance for historical data.

One of the other key variables here is estimating NUE’s required capital expenditures looking forward. The past two years have been at a reduced level around $300 million with 2008 though at $1 billion. A return to 2008 levels would dramatically impact the valuation. Forward capital expenditures were estimated at around 5% of beginning assets to reflect the recent average. However, with rising prices and increasing demand, in the near term this figure may rise higher.

Historical Capital Expenditures

Year

Capital Expenditures

Total Assets (end of year)

Total Assets (beginning of year)

Percentage (b-o-y)

2010

345

13,922

12,572

2.7%

2009

391

12,572

13,874

2.8%

2008

1,019

13,874

9,826

10.4%

2007

520

9,826

7,893

6.6%

2006

338

7,893

7,139

4.7%

2005

332

7,139

6,133

5.4%

Click to enlarge

Source: Nucor website for press release and Yahoo Finance

Putting it together resulted in the following free cash flow for valuation purposes.

Unlevered Free Cash Flow

Year

Status

Net Income

Depreciation

Change in Working Capital

Capital Expenditures

Unlevered Free Cash Flow

2008

Historical

1,831

549

39

(1,019)

(1,074)

2009

Historical

(294)

566

587

(391)

650

2010

Historical

134

512

(46)

(345)

(460)

2011

Projected

535

516

(272)

(557)

301

2012

Projected

872

522

(171)

(569)

1,182

2013

Projected

933

529

(117)

(589)

892

2014

Projected

997

538

(124)

(610)

937

2015

Projected

1,065

558

(131)

(793)

835

2016

Projected

1,138

590

(139)

(827)

896

Click to enlarge

Source: Historical figures are from Yahoo Finance. Projects are calculated based on key inputs and extrapolated from historicals.

The first observation is that if 2011 turns into a repeat of 2008, there could be substantial upside through increasing net income. However, it could also result in greater capital expenditures as Nucor ramps up production.

Comparable Analysis

After the discounted cashflow analysis, I compared NUE to its competitors based on forward P/E and price to book.

Comparable Companies

Ticker

Sales ($ Millions)

Price/Book

P/E (F1)

SID

7,690

5.5

9.7

MTL

5,754

2.6

8.2

AKS

5,968

2.6

19.9

X

17,374

2.1

15.3

NUE

15,845

2.0

18.6

SHLO

457

1.9

18.0

STLD

6,301

1.9

10.7

SCHN

2,301

1.8

15.9

FSTR

475

1.7

15.1

GGB

18,859

1.7

10.2

CHOP

219

1.7

4.9

USAP

189

1.4

13.5

CMC

6,306

1.4

24.2

ZEUS

805

1.3

18.0

PKX

28,346

1.2

8.7

TX

7,382

1.0

9.8

MT

78,025

0.8

13.3

GSI

1,668

0.8

4.6

ROCK

685

0.8

38.5

USNZY.PK

7,402

0.6

13.9

Average

10,603

1.7

14.5

Click to enlarge

Data provided by Zacks.com services.

This shows NUE to be a little above the average values in the industry. However, its strength during the recent downturn suggests that it warrants at least a slight premium in valuation.

Conclusion

NUE appears to be undervalued, especially in light of rapidly rising steel prices. As an industry leader, they have shown an ability to capture relatively high margins and exhibit flexibility. The key long term assumptions are a return to 10% gross margins in the long run and a 5% long term growth.

Valuation

Valuation Component

Value

Enterprise Value

$ 19,015

Debt and Liabilities

$ 4,504

Cash

$ 2,902

Potential Equity Value

$ 17,413

Current Equity Value

$ 14,911

Potential Appreciation

17%

Click to enlarge

With the potentially low valuation and increasing prospects for steel producers, NUE could be a good investment opportunity. Furthermore, during rising prices, NUE margins typically expand even though its raw materials include scrap steel.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer:This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.