Nucor: The End of Steel?

Patrick Kirts co-wrote this article.

Recently the financial media has made much to do about all things related to commodities. We doubt that most investors or advisors understand how to approach investing in commodities outside of the ever increasing and complex ETFs sold to them.

The historic volatility and recent popularity of the commodity market should make us ask a greater question: Why bother? At our firm we buy a lot of shares in a focused group of undervalued companies and take profits appropriately. We stole this idea from most of the billionaire investors on the planet and have yet to see a better way. A great way to approach this is the large unloved firm.

Here we will focus on Nucor (NUE). Some will call it a ‘commodity’ or  ‘basic material’ play. We are more concerned that it makes profits, has real assets, and is well managed. Profits fund dividends, real assets protect us from permanent losses, and good management should sustain the first two. Add to that the recent selling pressure that appears to come from our fair-weather hedge fund friends, and you may have something of value.

Analysis

Nucor is the United States’ largest steel manufacturer, and one of the most diversified makers of steel products. It has pioneered the use of mini- and micro-mills, rather than old-fashioned large foundries, which have proven to be more energy efficient and more productive. It primarily recycles scrap steel in making its products, rather than using newly mined raw materials. Since 1973 it has paid a dividend that has been increased every year, and it has also paid supplemental dividends twelve times.

Amazingly, it has not had an unprofitable quarter in over four decades. Nucor’s ten-year earnings history shall be the first point of examination (all dollar amounts in millions).

 click to enlarge images

We see that the company has grown steadily since 2002, more than tripling its annual revenues in five years, with a particularly big jump in 2003-4. Indeed, 2003 seems to have been a critical year for the company, as its sales began to increase dramatically, but its actual earnings were at an all-time low, and both its operating margins (operating earnings divided by net sales) and its net profit margin (net earnings divided by net sales), were higher in every year after 2003 than in any year before.

It will be crucial to understand what happened in 2003 to result in this growth, whether it is sustainable, and whether it translates into a real increase in shareholder value. We have included the S&P Core Earnings for comparison with the company’s reported profits. It is encouraging that the two numbers track so closely, because it suggests transparency on the part of Nucor’s management; they are not engaging in accounting gimmicks to artificially boost their profits. The following chart contains other data vital to this analysis.

The steel industry experienced a severe cyclical downturn in 2001, from which it recovered in 2004. This period hurt the profitability of, or even bankrupted, other firms, but it allowed Nucor to expand.

We are generally wary of acquisitions and feel that they can destroy shareholder value, but in this case they seem to have been well executed and have led to supplemental dividends and the repurchase of 36.9 million shares since 2005 (it has since issued 25 million new shares to finance a large 2008 acquisition, discussed below).

In December 2002, Nucor made the largest (until this past year) acquisition in its history: the assets, including four bar mills, of Birmingham Steel Corporation, for approximately $615 million. We see that since this purchase not only sales, but also return on equity, stockholders’ equity, and free cash flow have all dramatically increased.

We see that this large acquisition has not had a negative effect on the company’s liquidity, as measured by the current ratio, nor has the balance sheet been overleveraged, because it was partially paid for with free cash flow. The great success of the Birmingham purchase is important because it serves as a model by which to judge two even larger acquisitions. In 2007 Nucor acquired Harris Steel for $1.06 billion, adding to its rebar fabrication capacity and other downstream business production.

In the first quarter of 2008, as part of its strategy to gain more control of raw materials it uses in production, it acquired The David J. Joseph Company for approximately $1.44 billion. This purchase allows Nucor to expand its direct ownership of the steel scrap supply chain (steel scrap is its largest cost) and acts as a partial hedge against scrap market volatility. Management’s philosophy, as stated in past annual reports and on the company website, is that continued profitability is more important than growth, and that they only pursue acquisitions which they think will enhance that potential.

While it seems that these acquisitions explain much of the dramatic growth of the firm, Nucor’s management also credits technological innovation, optimization of existing facilities, and most importantly its corporate culture. With only about seventy-five corporate employees, Nucor has no middle management. The general managers of different divisions are given a wide degree of autonomy in making decisions so as to best satisfy customers and address the concerns of neighbors. Compensation is structured to increase productivity and to eliminate conflicts of interest. At the bottom, workers in different units are offered weekly bonuses based on the productivity of their groups that can double or triple their earnings. At the top, executives’ salaries are less than those of their peers at other firms, and their bonuses are based on increases in profits and shareholder equity. This keeps management focused on benefitting investors. Other benefits are distributed in an egalitarian manner; for instance, all employees are enrolled in a program for college scholarships for their children. Nucor employees are among the most productive in the industry. Finally, safety is emphasized as the number one priority of the company, and management genuinely seems concerned for the welfare of its workers.

Conclusion

The uninterrupted stream of profits, the consistent increase in shareholder equity and the large return on equity in recent years, the success of the Birmingham Steel purchase, and the unique, egalitarian corporate culture at Nucor suggest to us that the company will maintain a long-term competitive advantage. To be fair, Nucor is not immune to the business cycle and their profits have and could shrink with the overall economy. How you play your cards in tough times defines success later in the game. Today, the news hypes stories about a global slowdown and hedge funds selling their hot commodity positions.

Currently, we believe Nucor is at an attractive valuation. Perhaps it is time for the common stock of Nucor to go back to its rightful owners.

Full disclosure: Portfolio, LLC is long NUE at the time of writing.

 

Comments

[helplessobs...:]

This is an insightful report on one of America's best run companies. Once the hot money gets out and value investing takes over NUE's shares will rise. In real estate it is: location, location, location; in investing it is: quality, quality, quality. In quality NUE measures up.

2008 Aug 15 03:32 PM

[Maine stoc...:]

I have owned this stock for about 8 years and love it! It has energetic and progressive leadership, seems very "levelheaded" and financially sound to me and I have been re-investing my dividends faithfully. It's a GREAT investment and company!

2008 Aug 15 08:50 PM