This Steelmaker's a Steal

In one sense, the steel industry can be considered a competition to see who can procure ready-to-melt iron units at the lowest cost. Whether the iron units are sourced from virgin iron ore, ferrous scrap metal, or high-iron-content complementary feedstocks, iron-related unit costs are a major driver in determining a steelmaker's position on the industry cost curve. Because steel products are largely undifferentiated and commodified products, a steelmaker's most likely route to earning an economic moat is by establishing itself as a definitive low-cost producer. Thanks in part to its direct-reduced iron production in Trinidad,  Nucor (NUE) already has access to low-cost iron units, and we give it a narrow Morningstar Economic Moat Rating. The company is also building out incremental DRI production in St. James Parish, Louisiana, and we believe it will further decrease its iron unit costs over our explicit forecast period.

Nucor manufactures steel using electric arc furnaces, which predominantly rely on ferrous scrap metal to provide iron units. EAFs are significantly less energy-intensive and offer more flexibility than their blast furnace counterparts, which often operate uninterrupted for years at a time and therefore are subject to a high degree of operating leverage.

Steel produced via EAFs is typically lower-quality and therefore not as ductile as steel produced via blast furnace. This is because recycled scrap metal is imbued with trace residuals of other elements to which it is exposed in production or in use. During the melting process, most residuals are oxidized and separated from the molten iron, although nonoxidizable residuals such as nickel, copper, chrome, molybdenum, and tin taint the purity of the steel produced, thereby making it more brittle and less workable.

Therefore, steel produced by EAF is typically associated with applications that require little additional processing; it is often used to produce structural beams, reinforcing bar, and other long-rolled steel products. With this in mind, steelmakers that employ EAFs tend to enjoy lower per-unit operating costs but are also limited as to the scope of products that they can offer.

This dynamic has led Nucor and other large-scale EAF operators to explore alternative methods of EAF steel production that allow them to manufacture more ductile steel, enabling them to compete across a wider platform of product categories. Historically, EAF operators have done so through the use of pig iron, pig iron nuggets, hot-briquetted iron, and direct-reduced iron. These high-iron-content complementary feedstocks are combined with ferrous scrap metal to allow for the introduction of high-purity, low-residual iron units sourced directly from virgin iron ore into the EAF melt, thereby improving the quality and workability of the steel produced.

Although these complementary feedstocks have been in use for some time and are also used by Nucor's EAF peers, Nucor has established a clear competitive edge over its competitors through its in-house production of DRI. In January 2007, the company started up a facility in Trinidad that offers 2 million metric tons of DRI production capacity per year. The Trinidad facility quickly made an impact on the per-unit operating costs of Nucor's steel mills, which was particularly helpful in 2008 and 2011 when ferrous scrap prices soared to new highs.

The company invested $750 million to build not only a second DRI production facility in St. James Parish, Louisiana, but also the infrastructure for a third facility at that site that would require an additional $600 million capital outlay if pursued. The two Louisiana facilities would each offer production capacity of 2.5 million metric tons of DRI per year, boosting the company's total DRI capacity to 7 million metric tons per year. The first of these two facilities initiated production in December 2013, and early results have been very encouraging.

We estimate that a representative ton of steel produced solely by the use of DRI in an EAF could be produced at a unit cost of $324. This is roughly 15% below the estimated $380 per ton unit cost for steel produced via the use of pig iron.

Our input cost assumptions rely on our department forecasts for the raw materials employed in steel production. For iron ore, we anticipate that iron ore spot prices will average $95 per short ton (62% fines, CFR China) over our five-year explicit forecast period. We expect metallurgical coal prices to average $150 per short ton and natural gas prices to average $4.75 per MMBtu. Our midcycle 2018 price forecasts for these three raw materials are $93 per short ton, $166 per short ton, and $5.40 per MMBtu, respectively (in nominal terms).

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The Louisiana DRI project enjoys a wide margin of safety with regard to the magnitude by which natural gas prices would have to increase before the cost advantage of the DRI operation is eliminated. Per our estimates, natural gas prices would have to climb to around $9.80 per MMBtu before Nucor's DRI-based production method would no longer reflect favorable unit costs relative to steel production by use of pig iron.

Conversely, metallurgical coal prices would have to fall to levels around $50 per ton before pig iron production would allow for lower iron unit costs than DRI production. We view both of these scenarios as highly unlikely and therefore maintain a high conviction that Nucor's DRI production will allow for a sustainable cost advantage over the pig iron that the firm would otherwise import.

To lock in the advantage provided by the use of natural gas rather than metallurgical coal as a reducing agent, Nucor has engaged in a 20-year natural gas drilling joint venture with Encana Oil & Gas. A clause in the agreement allows Nucor to suspend drilling if natural gas prices remain below a predetermined threshold. Indeed, in late 2013, low natural gas prices motivated Nucor to activate this clause and suspend drilling. This decision is expected to save Nucor roughly $400 million of capital expenditures in 2014, although if natural gas prices were to rise, the joint venture could quickly resume drilling operations. Rather than using this natural gas for DRI production, the joint venture serves solely as a hedge against rising natural gas prices. Nucor intends to sell the entirety of its share of the gas produced to third parties, offsetting the toll that elevated natural gas prices would take on its steelmaking operations.

Because we think natural gas prices will remain well below the threshold at which the St. James operation would become uneconomical, and given that early results at the first facility have been overwhelmingly positive, we expect that Nucor will construct the second DRI module at some point in the next few years. If so, Nucor will ultimately offer a total production capacity of 7 million mtpy of DRI. This would amount to a significant portion of global DRI production, which totaled roughly 73 million metric tons in 2013.

DRI production volume in the United States and in Trinidad and Tobago is exclusively associated with Nucor's operations. Although management has been unwilling to provide specifics on the iron unit cost differentials between its Trinidad and Louisiana operations, we believe the Trinidad operation enjoys modestly lower unit costs, largely because Nucor was able to secure favorable natural gas procurement prices from the Trinidadian government in return for its large foreign investment. Nucor signed a 22-year contract before initiating production in 2007, by which it purchases natural gas in Trinidad at $2 per MMBtu to manufacture DRI.

We calculate that Nucor's DRI project will allow the company to generate significant savings per ton of steel produced relative to its unit costs for steel production solely via the use of high-quality ferrous scrap metal. We assume that Nucor will be able to pair DRI with ferrous scrap to produce steel at a cost of $359 per ton in a midcycle environment. Relative to steel produced by use of high-quality scrap in an EAF without DRI, this would result in a cost savings of $17 per ton, or an average cost savings of roughly $20 per ton over our explicit forecast period.

On an absolute basis, given our forecasts for sheet, plate, and special bar quality production volume, Nucor's incremental DRI tonnage produced in Louisiana will save the company an estimated $136 million in 2018, which represents a midcycle environment for raw material prices, thereby driving margin expansion for the company's steel mill business. Additionally, our calculations point to cumulative savings of $762 million over our five-year forecast period, implying a shorter payback period relative to the $750 million project cost than one might normally expect for such a capital-intensive project.

Our projections do not account for the possibility that Nucor will pursue the next phase of its DRI project, which would allow for the production of an additional 2.5 million mtpy, because the timing and capital requirements involved are uncertain at this point. Even so, given our shipment volume forecasts for sheet, plate, and SBQ, Nucor's DRI needs would exceed its current production capacity of 4.5 mtpy at some point in 2018. It appears unlikely that the company will produce enough excess DRI to explore third-party DRI sales unless it proceeds with the construction of a second Louisiana DRI facility.

Nucor's incremental DRI production will allow for an additional benefit that is more difficult to quantify and is not included in our project-related forecasts: It will provide the company with a much greater degree of operational flexibility in determining the appropriate raw material mix in its EAFs.

Because DRI serves as both a substitute for scrap metal and a complement to it, Nucor can change the mix of its raw material charge to arbitrage price fluctuations of varying ferrous scrap grades. In other words, Nucor will be able to adjust to input cost volatility by selecting the most cost-effective feedstock basket available at any given time.

Nucor uses software by which it is able to optimize the costs associated with its steelmaking raw material charges on a heat-to-heat basis. Additionally, it is comfortable loading its furnaces with anywhere between a 0% and 50% share of DRI relative to the total raw material charge, so the degree to which it can vary its mix of feedstocks is substantial.

Additionally, Nucor has access to a multitude of steelmaking raw-material pricing data thanks to its ownership of David J. Joseph, the fourth-largest scrap metal recycling company in the U.S. David J. Joseph's trading arm is able to provide Nucor's furnace operators with detailed pricing information for prime scrap, obsolete scrap, pig iron, DRI, and HBI, so they can actively and almost instantaneously optimize input costs.

Market Underappreciates Benefits of Nucor's DRI Project
Nucor's shares are trading at a 14% discount to our assessment of the company's intrinsic value. We believe the stock is mispriced because of a few key considerations.

First and most important, we do not believe that the benefits of Nucor's DRI project are fully priced into the current share value. The most visible attempt a U.S. steelmaker has ever made to build out in-house production of a high-iron-content feedstock is Steel Dynamics' Mesabi Nugget Project. Thus far, the project has flopped, and, although initially advertised as a $235 million initiative, the total capital outlay required has exceeded $300 million and is probably closer to $500 million. The project continues to require incremental capital expenditures as management holds out hope that it will ultimately be value accretive.

We believe that the Mesabi Nugget Project is still fresh in investors' minds and has damped enthusiasm for Nucor's DRI initiative. In our view, Steel Dynamics' struggles have caused investors to hold out for a clear indication that Nucor's DRI production is having a meaningful impact on input costs before they establish a position in Nucor. This is especially true since the total estimated capital requirement of Nucor's Louisiana DRI project could exceed the magnitude of the Mesabi Nugget Project at its outset by a factor of 4 and also because Steel Dynamics is the closest comparable to Nucor.

We maintain a high degree of confidence, however, that Nucor's Louisiana DRI project will yield the results advertised at its outset. Nucor employees have a wealth of relevant experience from operating the highly successful DRI production operation in Trinidad, and this will be helpful as the company ramps up the Louisiana facility. Early results have been encouraging, as product quality and yield have exceeded management's own expectations.

In its first full quarter of operation, the facility produced 455,000 tons of DRI at peak operating rates above 90%. The DRI pellets produced exceeded quality expectations, offering a metallization rate of 96% (relative to a target of 95.5%), and met carbon content expectations of 4%. These targets were higher than those associated with the Trinidad startup seven years earlier (93.5% and 2.5%), so the Louisiana plant is actually producing a higher-quality product. Furthermore, the Louisiana plant achieved its quality targets in only one week of operation versus a total of five weeks for the Trinidad project. For further comparison, the Louisiana operation reached its daily production nameplate target in 11 weeks versus 26 weeks for the Trinidad operation. Even though the ramp-up process has been costly and is not yet complete, management still expects the project to yield net savings in 2014, its first full year of operation.

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Another driver leading to the mispricing of Nucor shares is the widely accepted view that steel prices in the U.S. are likely to decline significantly over the remainder of calendar 2014, owing to three factors: (1) Higher steel prices in recent months have resulted from supply chain disruptions rather than an organic improvement in market dynamics. (2) Steel prices in the U.S. have diverged from global steel prices, which have declined steadily year to date. This increases the risk that low-price imports will take market share and weigh on domestic average selling prices. (3) Our forecast is that lower steelmaking raw material prices will prohibit steel prices from holding steady and instead remain depressed over the medium term.

The consensus view that steel prices in the U.S. will decline is weighing on share values across all major U.S. steelmakers and is probably keeping potential investors on the sidelines for now. Although the realization of lower steel prices could lead to a better entry point for Nucor--or any U.S. steelmaker, for that matter--we believe that share values already reflect this outcome.

Nucor's Moat Is Only Getting Wider
Nucor is likely to improve on its already enviable positioning on the industry cost curve in the years to come. Incremental DRI application will allow for considerable cost savings, as we estimate that the company can produce DRI at an estimated 15% discount to the cost of imported pig iron.

Although natural-gas-fueled iron ore reduction also takes place in Mexico and the Middle East, Nucor is the only U.S.-domiciled steelmaker that is actively building out DRI production capacity. Some competitors have indicated that they are interested in pursuing DRI production, but Nucor is uniquely positioned to benefit from DRI use.

Nucor's excellent financial health has provided management with the financial flexibility to make the necessary capital investments to allow for the implementation of a DRI-based production process. By and large, Nucor's major competitors in the U.S. steel market exhibit a high degree financial leverage on both a relative and absolute basis, thereby reducing the likelihood that they would pursue a capital project of this magnitude.

Also, Nucor's portfolio of EAFs is well suited for a large-scale application of DRI. DRI is not as economically viable for use with blast furnaces as it is for use with EAFs because blast furnaces are already capable of producing high-quality, low-residual steel. Given that 70% of global steel production relies on the use of blast furnaces, only about 30% of global steelmaking capacity can be paired with EAF in an economically sensible manner.

In addition, relative to the majority of its peers, Nucor has advantaged access to low-cost natural gas. Nucor's ability to source natural gas in Trinidad at $2 per MMBtu via a favorable long-term contract and its access to natural gas near its Louisiana DRI facility set it apart from many of its foreign competitors, whose inability to secure low-cost natural gas prevents them from producing DRI economically.

Nucor Is a Best-in-Class Steelmaker
Nucor's financial health is strong relative to its peers in the highly cyclical steel industry. Although reduced EBITDA generation over the past three years has increased the company's total debt/EBITDA ratio to nearly 3.0 times, we believe Nucor's ability to generate free cash flow, combined with a reduction in capital spending, will materially reduce total leverage to around 1.0 times by the end of our explicit forecast period. This ratio would be consistent with levels enjoyed by the company before the onset of the global financial crisis.

Nucor's financial health is also supported by ample liquidity, including $1.2 billion of cash on the balance sheet and a $1.5 billion undrawn revolver facility. The company further benefits from having no near-term debt maturities and no pension or retirement obligations. Nucor's strong liquidity and manageable debt burden have historically provided the company with financial flexibility that helps it absorb the high degree of market volatility inherent to the steel industry.

Nucor has committed more than $1 billion to build out its DRI production capacity in Trinidad and Louisiana while its competitors have been slow to embrace DRI as a more cost-effective substitute for pig iron. Its DRI-related investments will further entrench the company as a low-cost steelmaker, increasing the likelihood that it will be able to generate outsize returns on invested capital in the coming years.

Nucor's management team has made consistent progress toward reducing raw material costs and increasing the production share of high-margin steel products. Given that Nucor's balance sheet has remained healthy as the company has progressed toward these objectives, we assign the firm an Exemplary Stewardship Rating.

Management also has historically been very shareholder-friendly. Having been profitable in all but one year, 1966, Nucor has consistently delivered a solid dividend that has grown with earnings while also investing in key strategic capital projects that have supported ongoing profitability. John Ferriola, who began his career at Nucor in 1992, was appointed as CEO in January 2013 and is the company's fifth chief executive over the past 45 years. Given Ferriola's industry expertise and experience working under Nucor's well-respected previous CEOs, we anticipate that he will be able to perpetuate Nucor's tradition of strong, capable leadership.

Finally, Nucor currently offers a 3% dividend yield, which compares favorably with competitors. Since the beginning of 2009, as its peers have licked their wounds after entering the global financial crisis with too much financial leverage, Nucor has steadily increased its dividend while a comparative group composed of ArcelorMittal (MT), Steel Dynamics (STLD), and U.S. Steel (X) has, on average, cut its dividend 50%. Although the payout ratio is high, we anticipate that Nucor's free cash flow generation will improve significantly by the end of our explicit forecast period, supporting our conviction that the current dividend is safe and likely to be increased further. Therefore, investors will be paid to wait as our investment thesis plays out.

Risks to Our Thesis
The share of imports as a percentage of total U.S. steel consumption, which is near an all-time high above 30%, could remain elevated and impair Nucor's returns on invested capital. Also, if natural gas prices rise significantly or metallurgical coal prices fall precipitously, the cost advantage engendered by Nucor's DRI project will be marginalized or eliminated. In addition, execution risk remains as the Louisiana DRI facility is still in its initial ramp-up phase and management is considering the construction of a second DRI production facility. Finally, the previous downcycle for steel prices lasted 16 months. Another extended downcycle for steel prices could nullify the positive impact of Nucor's efforts to reduce input costs.