High-Quality Steelmaker Steals
We think Nucor and Commercial Metals are undervalued.
Nucor (NUE) and Commercial Metals (CMC) are trading at the most compelling valuations across the U.S. steelmaking space. With considerable leverage to the production of long-rolled steel used in construction, Nucor and CMC are positioned to benefit from an upturn in U.S. nonresidential construction activity, which has lagged the recovery in other steel-intensive sectors. We expect robust construction spending growth across the most steel-intensive nonresidential project categories, such as infrastructure and manufacturing. Combining this view with our assertion that the U.S. steel industry is gradually emerging from a cyclical trough, we expect Nucor and CMC to generate attractive returns over the long run.
Nucor Remains Our Top Global Steelmaker Pick
The only investment-grade steelmaker under our coverage, Nucor offers the most attractive risk-adjusted return potential across our steel coverage universe. Our outlook for improving nonresidential construction spending supports our thesis for Nucor, as we think the company will be one of the biggest beneficiaries of this trend. Although Nucor manufactures nearly all major steel product lines via its fleet of minimills, the company offers a considerably higher degree of exposure to construction-related steel demand than its blast furnace-operating peers. The shares are currently trading at a significant discount to our $62 fair value estimate.
Via its flagship steel mills segment, Nucor derives roughly 45% of its external sales via shipments of bars and structural products, most of which are sold into the construction end market. The sale of these products predominantly takes place in the spot market at prevailing market prices.
Nucor's steel products segment is almost exclusively exposed to the construction end market. This division largely generates revenue via firm, fixed-price contracts that are competitively bid against other suppliers. Customers include general contractors and fabricators. These products are used to construct highways, bridges, reservoirs, utilities, hospitals, schools, airports, stadiums, and high-rise buildings.
Although the steel products business endured four consecutive years of losses on an earnings before taxes basis from 2009 to 2012, it returned to profitability in 2013. Earnings before taxes then doubled to $166 million in 2014 as margins expanded as a result of lower steel input costs, steady average selling prices, and a 13% full-year increase in shipment volumes. We anticipate incremental gains in 2015 and beyond as improving nonresidential construction demand leads to higher shipment volumes which, in turn, will drive further margin expansion via the benefits of operating leverage. After accounting for only 10% of companywide segment earnings before taxes in 2014, we think this figure will rise to 20% over our explicit forecast period. For the purposes of comparison, we forecast that earnings before taxes will increase at a 14% compound annual growth rate for the steel mills division through 2019 from 2014 levels and a 33% CAGR for the steel products segment (from a low base).
Nucor's Louisiana DRI Project Will Turn From Burden to Boost
We are encouraged that the key factor that has weighed on Nucor's recent returns should turn from a negative to a positive by the end of 2015. Nucor's Louisiana direct-reduced iron facility, which is now fully operational, has detracted materially from companywide earnings in recent quarters because of a lengthy, unplanned outage and the ongoing digestion of high-cost iron ore inventory that resulted from the outage. In accordance with Nucor's management team, we expect the facility to be cash-positive by the end of 2015. We anticipate that it will provide inroads to margin expansion by reducing the company's iron unit costs. Per our analysis, the project will provide roughly $20 per ton of cost savings for the steel mills segment relative to 2014 unit costs by replacing imported pig iron with direct-reduced iron manufactured in-house. Removing the impact of this project in our model, Nucor's midcycle operating margin would decline from 15% to 12% and our fair value estimate would fall to $52 per share, still higher than the current market price. Both scenarios assume that steel prices will be effectively flat, in real terms, from our full-year 2015 forecast through the end of the decade.
We think the Louisiana DRI project will improve upon Nucor's already enviable positioning on the industry cost curve by providing lower iron unit costs. As a result, it should strengthen the company's low-cost moat source, a consideration that underpins our positive moat trend rating for Nucor. The competitive advantage engendered by the project will not be easily replicated by Nucor's peers for four key reasons.
CMC Highly Exposed to Nonresidential Construction Activity
Commercial Metals has more exposure to U.S. nonresidential construction activity than any other steelmaker under our coverage. The company's steelmaking facilities procure iron units via ferrous scrap metal that is melted down and converted into products that are sold into the construction industry.
CMC's Americas mills division manufactures steel via five minimills located in Alabama, Arizona, Arkansas, South Carolina, and Texas. Key product types include rebar, angles, flats, round, small beams, fence post sections, and other shapes. The Americas fabrication segment bends, welds, and cuts rebar and other steel products for more specific applications. CMC operates the fabrication business via 46 locations across the U.S. Sun Belt. The company's fabricated steel products are used in the construction of commercial and noncommercial buildings, hospitals, convention centers, industrial plants, power plants, highways, bridges, arenas, stadiums, and dams. CMC typically generates fabricated steel sales via bidding processes with construction contractors and project owners.
CMC also operates a steelmaking business in Poland and an international marketing and distribution segment. The operations in Poland manufacture rebar, merchant bar, and wire rod. Sales are predominantly generated via shipments to customers in Poland, the Czech Republic, Germany, and Slovakia. The marketing and distribution business purchases and resells steel products and steelmaking raw materials via a global network of distribution offices and processing facilities. Combined, these two international business segments accounted for roughly 40% of companywide segment sales in fiscal 2014 but only 16% of adjusted segment operating income. Over the past eight years, both of these divisions generated an average operating margin between 1% and 2%, although in a midcycle environment, we'd expect the steelmaking operations and marketing and distribution operations to generate operating margins of 6% and 3.5%, respectively. For the international mill division, we expect the benefits of operating leverage to be the main driver of margin expansion as utilization improves. Our 6% midcycle operating margin forecast sits well below the 14.5% high-water mark achieved in 2007, just before the onset of the global financial crisis. For the international marketing and distribution segment, we assume no incremental margin expansion, as operating margins came in at 3.4% in each of the first two quarters of fiscal 2015.
In recent years, CMC's Americas mills operations have generated the vast majority of the company's adjusted operating income. Manufacturing steel products mainly sold into the construction end market, this business has generated an average adjusted operating margin just shy of 12% over the past eight years, with margins averaging 19% through the first three quarters of the company's fiscal 2015). Our $21 fair value estimate assumes only a 15% midcycle operating margin for this business, implying a wide margin of safety relative to current profitability levels. If we were to assume that the Americas mills business maintains a 19% operating margin over our entire explicit forecast period, our fair value estimate would jump to $25 per share. Although elevated operating margins are likely to remain in place in the near term given the sudden $100 per ton decline in U.S. ferrous scrap prices witnessed in February, we think the company's metal margins will gradually contract from current levels as pricing for certain key product lines moderates in the coming months and scrap prices appreciate gradually. This factor alone drives our expectation for margin contraction.
Although the Americas mills business generates attractive returns on invested capital, the other four reporting segments detract from companywide returns, leading to a no-moat rating for the company as a whole. CMC generated returns on invested capital of 7.6% and 7.7% in 2013 and 2014, respectively, shy of the 9.1% weighted average cost of capital that we assume.
The Americas mills division performs well on an EBITDA-per-ton basis relative to its peers, having generated $107 per ton in fiscal 2014. This result sits just behind Steel Dynamics (STLD) ($111 per ton) and just ahead of Nucor ($90 per ton), two companies that operate on the low end of the steelmaking cost curve. By this metric, minimill operators outperformed blast furnace operators last year because utilization rates were low and minimills are subject to a lower proportion of fixed costs. Although we don't expect utilization rates to approach 80% until later this decade, blast furnace operators should enjoy improved profitability per ton when operating rates improve.
Sun Belt Presence Holds Promise
CMC's geographic footprint across the U.S. Sun Belt points to attractive growth prospects. The Sun Belt stretches across the southern portion of the country, from Florida to California. In recent decades, population growth in the Sun Belt states has outpaced population growth across all other U.S. states by nearly 1% each year. This demographic shift supports our view that nonresidential construction starts will grow more rapidly in the Sun Belt than other regions over the long run.
Additionally, according to the regional breakdown of the Architecture Billings Index, project activity has been particularly strong in the Southeastern U.S., a region where four of CMC's five minimills are located and from which CMC derives a considerable portion of its sales. For this reason, regional ABI data portends improving shipments volumes for CMC over the balance of 2015 and into next year. The ABI is a diffusion index obtained via survey responses of more than 700 architectural firms in the U.S.
The index measures whether project billings in the previous month significantly increased, remained the same, or significantly decreased relative to the prior month. A reading above 50 indicates growing billing activity and a reading below 50 indicates declining billing activity. Given that architectural planning takes place before the construction process, the ABI tends to lead construction activity by 9-12 months.
CMC represents a great way to capitalize on our outlook for improving nonresidential construction activity across steel-intensive project categories. The company also offers a 3.4% dividend yield, meaning that investors can be paid to wait if nonresidential construction activity were to take off more slowly than we anticipate.
Andrew Lane does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.