Nucor Dividend Surprisingly Steel-Like

| About: Nucor Corporation (NUE)


Nucor boasts industry leading returns thanks in part to its flexible, low-cost supply chain.

Nucor is a strong operating cash flow generator, and is the only steel company to boast an investment grade credit rating.

Despite its debt load and the cyclical nature of the steel industry, Nucor's dividend appears to be on solid ground.

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

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By The Valuentum Team

Nucor (NYSE:NUE) boasts industry leading returns (ROIC averaged over 14% from 2004-2015) thanks in part to its flexible, low-cost supply chain. The firm is the only North American steel producer with an investment grade credit rating, and strong operating cash flow generation through the course of the business cycle is a key driver of such an advantage as cash from operations from 2009-2015 averaged nearly $1.3 billion and only dipped below $1 billion in 2010. Free cash flow generation has improved in recent years due to strengthening cash from operations and capital spending cuts; free cash flow grew to just under $1.8 billion in 2015 from slightly negative in 2013.

The biggest threat to the health of Nucor's business is the poor structural characteristics of the steel industry. Global overcapacity and lower-cost foreign producers continuing to produce at high levels are expected to keep steel prices suppressed, which will continue to pressure Nucor's business. The firm's balance sheet health could be better; net debt was over $2.3 billion as of the end of the second quarter of 2016. The firm's recent agreement to acquire Independence Tube Corporation for $435 million will further dampen its balance sheet health.

Despite its debt load and the cyclical nature of the steel industry, Nucor's dividend appears to be on solid ground, based on its Dividend Cushion ratio of 1.6. Management has stated plans to grow the dividend in line with earnings, but competing uses of capital have the potential to impact the pace of dividend expansion moving forward, particularly in the form of growth investments in its business and share repurchases. Shares currently yield over 3.1%, but let's explore the rest of the firm's investment considerations as we work to determine the true attractiveness of shares in the context of the Valuentum investment methodology.

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Image source: Valuentum

Nucor's Investment Considerations

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Investment Highlights

• Nucor 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.

Business Quality

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Economic Profit Analysis

In our view, 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 9.6%, which is below the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of POOR.

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.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

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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 4.5% 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 100% from levels registered two years ago, while capital expenditures fell about 69% over the same time period.

Valuation Analysis

We think Nucor is worth $43 per share with a fair value range of $28-$58.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -5.4%.

Our model reflects a 5-year projected average operating margin of 10%, which is above Nucor's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For Nucor, we use a 9.8% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

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Image source: Valuentum

Margin of Safety Analysis

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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 $43 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 were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Nucor. We think the firm is attractive below $28 per share (the green line), but quite expensive above $58 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

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We estimate Nucor's fair value at this point in time to be about $43 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 $54 per share in Year 3 represents our existing fair value per share of $43 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.

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.