The frustrating reality of investing in commodity companies/stocks is that the stocks are not always (or even often) performing their best when the company’s financials are at their best, and vice versa. While Nucor (NUE) posted an excellent set of results for the third quarter, and along with Steel Dynamics (STLD) continues to reap the benefits of robust metal spreads, the shares have basically matched the S&P with a mid-to-high single-digit decline over the past few months.
It is possible that this steel cycle may prove to be “stronger for longer”, but I believe 2018 is quite likely the peak EBITDA year for Nucor for at least a few years. Even though the shares trade for what appears to be a low forward multiple on EBITDA, it’s tough to make profits in steel stocks when prices are falling, capacity is rising, and investors have moved on to sectors that they believe have/will have better earnings momentum.
Leveraging Strong Spreads And Internal Efficiency
These are the golden quarters for Nucor, as the company is reaping the benefit of healthy end-market demand, protectionism-boosted pricing, attractive input costs, and improving operational efficiency. Metal spreads for electric arc furnace operators like Nucor and Steel Dynamics are, depending upon the steel type, up anywhere from over 50% (for beams), 70% (for rebar), to over 100% (for plate) from their two-to-three-year lows, and that is allowing for substantial expansion in margins.
Nucor saw over 6% year-over-year growth in steel and steel product shipments in the third quarter, as well as over 20% year-over-year improvement in pricing realizations (closer to 30% for steel). Although scrap costs were higher (up 18% yoy), gross margin improved about eight points on strong price leverage and greater operating leverage (capacity utilization was up eight points to 92%), and the company nearly doubled its adjusted EBITDA.
Importantly, the strength was broad-based. Although sheet shipment growth was lackluster (barely up), major steel categories like sheet, bar, structural, and plate were all up more than 20%, with plate up more than 30%. Management also noted strong demand across its 24 end-markets, with only marine transport (barges, mainly) showing weakness.
Pricing Seems To Be Softening … And More Capacity Is Coming
As soon as steel prices started to rise, investors started worrying about the prospect of steelmakers reactivating idled capacity and/or beginning capacity expansion projects. Those worries have started to come home to roost, with close to 10 million tons per year of restarts, expansions, and new-builds on the books now, including the recently-announced 3Mtpa plant that Steel Dynamics wants to build in 2020.
Unlike a lot of boom-and-bust steelmakers (particularly blast furnace operators), Nucor has taken a more measured and consistent approach to capital deployment and expansion, including serial small-scale M&A and organic growth projects. More importantly, while Nucor does have nine growth projects on the books now, these projects are tied to specific markets that generally have something “special” about them that make them more than just commodity steel capacity additions.
The Gallatin plant expansion, for instance, will allow Nucor to use a range of slabs (up to 5” thick) and will be able to produce coil of more than six feet in width – a relatively rare capability that will allow Nucor to target attractive opportunities in areas like heavy equipment and pipe/tube. Nucor is also adding capacity in long products (as is Commercial Metals (CMC)) and is again looking for more specialized/niche market opportunities with these expansions.
Not all of Nucor’s capex deployment is about growth, though. The company is also choosing to reinvest in its long-troubled DRI Louisiana facility, with the decision to invest $200 million in re-engineering the process gas heater and designing a new raw material storage yard. These two areas have caused roughly 90% of the plant outages at DRI Louisiana, and fixing them seems like a credible use of capital as Nucor has long wanted to be able to control its direct reduced iron needs (instead of buying from suppliers like voestalpine (OTCPK:VLPNY). I understand Nucor not wanting to be at the mercy of another company’s ability to supply it with its iron needs, but management really needs to make sure these new investments fix the problems and bring long-awaited reliability to the operation.
As far as pricing goes, prices for hot-rolled coil have fallen by a mid-teens percentage from the summer highs. Some pricing weakness going into the fourth quarter is not unusual, but there are multiple reports out there now that steel mills are more willing to be “flexible” on pricing, particularly with larger customers, and that does nothing to ease concerns that the peak of this cycle is now past. While weakening prices will be bad for sentiment on steel stocks, it’s worth noting that operators like Nucor and Steel Dynamics will still be producing historically-strong profit margins for a while even as steel prices fall.
At the risk of repeating myself, it’s tough to make money in commodity stocks when prices are falling and capacity is rising. I believe Nucor will generate excellent free cash flow for multiple years (and will likely share at least some of it with shareholders), but the market is a “what have you done for me lately?” sort of place, and I do think that will prove to be a challenging headwind for share price appreciation.
I value Nucor at 6.5x forward EBITDA, or a slight discount to Steel Dynamics, and that still supports a fair value above $70 today. Unfortunately, with EBITDA likely to peak in 2018, it may well be hard for the stock to make much headway given what could be a 20%-plus drop in EBITDA from 2018 to 2020.
The Bottom Line
Given the relative valuations, I’m more inclined to buy/hold Steel Dynamics today over Nucor, but both are excellent, well-run steel companies that are going to generate significant free cash flow for at least a few more quarters. I may well be too bearish on how much stock price momentum can still be generated from this point, but without a strong case for higher steel prices, it will likely be hard to attract strong investor interest in these stocks in the near term.
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.