Nucor (NYSE:NUE) is one of the smartest bets in the steel industry as the company enjoys the advantage of having a variable cost structure. As such, investors now have a good opportunity of buying this stock as it has dropped 9% in the past one month due to weakness in the steel market.
Variable cost structure and non-residential construction growth are positives
Recently, analysts at J.P. Morgan said:
"We remain cautious on the steel industry as the high U.S. steel price premium over Chinese prices should continue to attract imports into the U.S. and put downward pressure on domestic steel prices. Hot rolled coil prices have fallen 12% from a high of $700/ton this summer that was largely due in our view to temporary production outages which are now back in supply. Furthermore, we are concerned about China's rising cost-competitiveness and peaking steel intensity.
Within the steel group, we prefer Steel Dynamics and Nucor given their variable cost structures and significant leverage to an eventual recovery in non-residential construction activity."
Hence, Nucor's exposure to the non-residential construction and energy markets is another reason why the company's performance can be expected to remain strong in a challenging steel environment.
In fact, non-residential construction spending is expected to increase in the long run. According to Statista, new non-residential construction in the U.S. will grow from $355.4 billion at the end of last year to $456.35 billion at the end of 2018. As such, there is still a lot of room for growth that Nucor can tap going forward. Hence, it is not surprising to see that the company is expanding its production capacity, and is also intent on lowering costs.
Lower costs and higher production is the right way to tap a growing market
With the acquisition of Gallatin Steel for $770 million, Nucor is now the largest steelmaker (by capacity) in the U.S. This acquisition is quite important for Nucor in strategic terms. For instance, after the integration of Gallatin, Nucor's position in the flat-rolled hot band products market will strengthen, and it will also be able to tap the growing pipe and tube market. In addition, Gallatin will expand Nucor's geographical reach in the Midwest region, which consumes the highest amount of flat-rolled steel in the U.S. Moreover, Gallatin's location on the Ohio river will allow Nucor to receive direct-reduced iron (NYSE:DRI) from its Louisiana facility.
Thus, the acquisition seems to be a smart move as Nucor will be able to expand its production at a lower cost, and also bolster its position in key markets. In addition, Nucor is looking to aggressively cut costs at its other operations as well. For example, the steelmaker is rectifying the problems at its new Louisiana DRI facility that will improve its conversion cost and yield.
This facility provides high quality standards for DRI with metallization rates of 96% and carbon content exceeding 4%. As a result, its flat-rolled and SBQ steel mills have increased demand for Louisiana's DRI output. Also, considering the decline in iron ore prices and relatively stable scrap pricing, Nucor is confident that its DRI-based raw materials initiative will allow it to realize better financial results.
A risk to consider
However, there is a risk that investors need to be aware of. Apart from the headwinds mentioned above, the steel industry might also feel the pinch of a decline in crude oil pricing. As per a report:
"The energy sector, which has been buoyant due to shale discoveries and rising production of crude oil, accounts for 10% of steel consumption in the US."
Thus, as crude oil prices fall, energy companies might reduce infrastructure investments, while will impact demand for steel. As a result, Nucor might see some weakness in the energy segment. However, oil prices are expected to get better again in the long run, according to the EIA, so there is not much to worry about. Also, given Nucor's estimated growth rate and a strong cash flow position, the company should be able to manage the headwind.
From a fundamental perspective as well, Nucor is well-positioned to deliver long-term growth. The company has a trailing P/E ratio of 23.5, which is lower than the likes of U.S. Steel (NYSE:X), which has a trailing P/E ratio of 42. Nucor's forward P/E of 14.4 indicates earnings growth going forward. In addition, a PEG ratio of 0.52 and a price to sales ratio of 0.75 indicate that the stock is undervalued.
Moreover, Nucor's bottom line is slated to increase at 39% a year for the next half decade, and the company also has a decent dividend yield of 2.80%. Going forward, due to the company's focus on improving its cost structure, the expected growth in non-residential construction, and a leading position in the steel market in the U.S., Nucor looks like a good long-term bet.
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