Nucor Battling Overcapacity In The Steel Industry

| About: Nucor Corporation (NUE)

Summary

Nucor's business remains challenged as the modest pace of the global economic recovery and increased levels of steel imports have strained earnings.

No amount of consolidation can completely offset foreign steel-makers' trade advantages. Profit margins at Nucor are slim.

With additional steel production coming online around the world, the overcapacity problem will likely not ease up anytime soon.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

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Nucor's Investment Considerations

Investment Highlights

• Nucor (NYSE:NUE) makes steel and steel products. It may be North America's largest recycler, using scrap steel as its primary raw material, but it cannot escape the very poor structural characteristics of the industry in which it operates. No amount of consolidation can completely offset foreign steel-makers' trade advantages. Profit margins at Nucor are slim.

• The firm's business remains challenged. The modest pace of the global economic recovery and increased level of steel imports have kept the firm's earnings lower than they were during the five-year growth period that preceded the Great Recession in 2008.

• The US government recently announced tariffs of 266% on steel imports from China, while goods from Brazil, India, South Korea, Russia, Japan, and the UK are subject to smaller duties. The penalties for selling steel in the US at unfairly low prices may not fully satisfy US producers, but it is sure to help.

• The company continues to invest in down markets. Projects coming on line in coming periods will help the firm gain greater control of raw material costs and expand offerings of specialized, higher-margin products.

• Overcapacity in global steel production and a flood of imports continue to keep steel prices depressed. With additional steel production coming online around the world, the overcapacity problem will likely not ease up anytime soon.

• Despite the challenges in its business, we expect management to do everything it can to maintain its impressive dividend track record. The firm has raised its annual dividend for 43 consecutive years, or each year since it initiated the payout in 1973.

Business Quality

Economic Profit Analysis

In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Nucor's 3-year historical return on invested capital (without goodwill) is 9.4%, which is above the estimate of its cost of capital of 9.3%. As such, we assign the firm a ValueCreation™ rating of GOOD.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Nucor's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 0.9 (anything above 1 is considered strong).

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Nucor's free cash flow margin has averaged about 1.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Nucor, cash flow from operations increased about 12% from levels registered two years ago, while capital expenditures fell about 30% over the same time period.

In fiscal 2015, Nucor reported cash flow from operations of just under $2.2 billion and capital expenditures of less than $400 million, resulting in free cash flow of nearly $1.8 billion. This was nearly triple the firm's free cash flow generation in fiscal 2014.

Valuation Analysis

This is the strongest portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.

Our discounted cash flow model indicates that Nucor's shares are worth between $27-$55 each. Shares are currently trading at ~$48 per share, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.

The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $41 per share represents a price-to-earnings (P/E) ratio of about 18.4 times last year's earnings and an implied EV/EBITDA multiple of about 8 times last year's EBITDA.

Our model reflects a compound annual revenue growth rate of -2.1% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 1.8%. Our model reflects a 5-year projected average operating margin of 7.6%, which is above Nucor's trailing 3-year average.

Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Nucor, we use a 9.3% weighted average cost of capital to discount future free cash flows.

Click to enlargeMargin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $41 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

In the graph above, we show this probable range of fair values for Nucor. We think the firm is attractive below $27 per share (the green line), but quite expensive above $55 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Nucor's fair value at this point in time to be about $41 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Nucor's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $51 per share in Year 3 represents our existing fair value per share of $41 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Wrapping Things Up

Nucor may be North America's largest recycler, using scrap steel as its primary raw material, but it cannot escape the very poor structural characteristics of the industry in which it operates.

Overcapacity in global steel production and a flood of imports continue to keep steel prices depressed. With additional steel production coming online around the world, the overcapacity problem will likely not ease up anytime soon. Projects coming on line in coming periods will help the firm gain greater control of raw material costs and expand offerings of specialized, higher-margin products.

Nucor has a strong dividend track record, having increased its dividend every year for 43 consecutive years. The firm's Dividend Cushion ratio remains near parity at 0.9, and we don't think management will tarnish this record. Nevertheless, we're not interested in a firm in such a distressed industry, especially at current price levels. Nucor currently registers a 6 on the Valuentum Buying Index.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.