Magic Formula Stock Review: Nucor (NUE)
It's hard to imagine a less attractive business than the production of steel. Steel is a commodity - that is, there is no differentiating feature of the product amongst competitors, other than price. A steel beam is a steel beam is a steal beam, regardless if it comes from Nucor (NUE), US Steel (X), or Arcelor Mittal (MT). Like most commodities, the price of steel has been quite erratic over history due to the extreme fragmentation of providers. Commodity production is usually a business with low barriers to entry, and when you have a lot of competitors, it's very likely that a few will price product irrationally, destroying profits for all players. Add to the commodity aspect of steel the fact that it takes a lot of heavy and expensive equipment to run the mills. This leads to high capital expenditures to both maintain existing operations and to increase capacity. Foreign competition, with it's low labor costs, is a major threat. At first blush, this does not look like an industry that meets many of the criteria that leads to competitive advantages, and by extension the MagicDiligence Top Buys list.
However, Nucor has long been a company that has flourished in a difficult market. The company has not reported a quarterly loss in over 40 years, despite numerous large and small competitors disappearing from the scene (Bethlehem Steel being the most visible example). Nucor has averaged nearly 45% MFI return on capital over the past 5 years, excellent for any large firm. Free cash flow margin is a very respectable 9%. Growth in sales, profits, and dividends has also been great over the past 10 years, rising at a compound annual rate of 17%, 23%, and 20%, respectively. If the proof is in the pudding, Nucor's numbers seem to indicate that this is indeed a firm with some durable competitive advantages in a tough industry. So how have they achieved this?
Predictably, Nucor's formula for success in a tough industry mirrors that of Dell (DELL), Southwest Airlines (LUV), and Wal-Mart (WMT) in similarly difficult markets - by consistently being the low cost provider. In Nucor's case, the low cost advantage has been achieved through consistently doing things better than competitors. Nucor uses scrap steel from automobiles and demolitions which is then recycled in what are known as "mini-mills". This is in contrast to the historical method of making steel by extracting iron from ore and alloying steel in integrated mills. The mini-mill method is much more efficient in energy, labor, and raw material cost. Nucor has a culture of technological advancement that has consistently allowed the company to price steel cheaper than both integrated and competing mini-mill operations.
Another reason Nucor has thrived is because of outstanding management and company culture. Management matters a lot in competitive industries and Nucor earns an A+ here. The company has very little hierarchy - only 2 management levels separate the CEO from a floor worker. The majority of compensation for all employees is based on performance, up to 3 times base salary. This encourages constant improvement to stay ahead of the competition. Also, all of Nucor's 12,000 employees are independent of unions, which prevents disruptive work stoppages and expensive labor negotiations that plague several of the older steelmakers.
Nucor is a great company, and has continued to expand their competitive advantages. David J. Joseph, a scrap metal broker, was acquired earlier this year to strengthen Nucor's raw material acquisition ability. Other acquisitions have led to the company acquiring over 20% market share in the U.S. Industry trends are favorable too. Steel production is no longer a highly fragmented industry, as the "big 3" of Nucor, U.S., and Arcelor account for over 70% of the domestic market. This leads to more rational pricing. The weak dollar has helped too, as U.S. sales are less attractive to foreign steelmakers when this is the case. Emerging economies, where steel skyscrapers are sprouting like weeds and more and more cars hit the road, is a long term growth driver for steel demand.
I'll be keeping an eye on Nucor as a potential Top Buy, and this is a fine pick for Magic Formula investors today. For now, though, there are other Magic Formula companies with more sustainable competitive advantages and less volatile industries to choose from. The near term could be difficult. The domestic automobile industry is at least 15% of Nucor's customer base (possibly higher), and the future for this industry is up in the air right now. The dollar is strengthening, making foreign steelmakers more competitive. Still, Nucor has a track record of great results, and this record is likely to continue into the future.