Nucor (NUE): A Dividend Aristocrat Yielding 4.3%

Nucor (NUE) has increased its dividend for 43 consecutive years – every year since it first began paying dividends in 1973. For a company operating in the often-challenging steel market, such consistency is remarkable.

 

The stock also offers the fifth highest dividend yield (4.3%) out of all the dividend aristocrats, perhaps making it an interesting candidate for investors living off dividends in retirement to consider.

 

While the stock is not in our Top 20 Dividend Stocks portfolio today, the company possesses several competitive advantages that dividend growth investors should be aware of.

 

Business Overview

NUE manufactures steel products in the U.S. and Canada and began operating its first mini mill in the late 1960s. With production capacity that exceeds 27 million tons, NUE is the largest manufacturer of steel products in North America.

 

Some of the main products NUE produces are carbon and alloy steel (used in bars, beams, sheets, and plates); steel piling; steel joists; steel deck; concrete reinforcing steel; cold finished steel; and steel fasteners. Steel is sold into a variety of end markets, but non-residential construction and automotive markets are the biggest drivers for NUE.

 

2014 sales by product type: sheet (32%), bar (22%), raw materials (15%), downstream products (11%), structural (10%), plate (10%).

 

Business Analysis

NUE is in a tough business. The price of steel is extremely volatile, demand trends are unpredictable, raw material costs can significantly fluctuate, and many overseas competitors are happy to irrationally flood the market with supply.

 

So, how has NUE not only survived these challenges but also managed to raise its dividend with such consistency over the last 40+ years?

 

In a commodity business such as steel, it’s all about cost. NUE runs an extremely lean business model that has made it one of the lowest-cost producers in the world.

 

Steel is generally manufactured in one of two ways. Traditional steel mills rely on iron ore, blast furnaces, and unionized labor. Mini mills such as NUE take a different approach, using recycled metal, steel scrap, and electricity to manufacture steel. These raw materials are usually cheaper than iron ore and require less labor and capital in their manufacturing process. Scrap prices also tend to move with steel prices, providing a bit of a hedge throughout the steel cycle (e.g. if demand for steel falls, NUE’s primary input cost will also likely fall in price, helping protect gross profit to an extent).

 

As a result, mini mills have more variable cost structures and production schedules that can be quickly adjusted up or down in response to market conditions. NUE also has a nonunion workforce that receives over 60% of its pay in the form of incentive bonuses, which protect the company’s profits during periods of depressed demand.

 

While the majority of steel manufacturers in the U.S. have transitioned to mini mills, one of the biggest players still uses blast furnaces – U.S. Steel. However, the company is now transitioning to use more mini mills, recognizing their relative effectiveness and superior profitability.

 

As seen below, U.S. Steel (X) burned through substantial cash during the financial crisis and was forced to cut its dividend.

 

 

On the other hand, NUE’s low-cost, capital-light, labor union-free, and flexible mini mill model kept generating free cash flow throughout the entire period:

 

 

NUE also reduces its cost structure and volatility by vertically integrating (it is the largest steel recycler in the country). The company has primarily used recycled metal and steel scrap to manufacture steel, but it has increased its use of direct-reduced iron (DRI) as a raw material, recently building a DRI plant in Louisiana.

 

DRI allows the company to create higher-quality products that are more profitable and less subject to import competition. These products are typically required to meet certain specifications, often need just-in-time delivery, and have less margin of error (i.e. it would be costly for customers to return these products to China if they aren’t made right the first time).

 

NUE is also the most diversified steel producer in North America, which reduces the company’s dependence on any one end market. Its large size also provides economies of scale to further reduce costs. Essentially, NUE is the best house in a bad neighborhood.

 

Key Risks

Steel is a commodity, and commodities are priced based on supply and demand. Companies that produce commodities are typically subjected to the market’s ups and downs unless they can somehow constrain supply.

 

Unfortunately, the market for steel is global, and China is the biggest producer. According to World Steel, China produced about 50% of crude steel worldwide in 2014.

 

While NUE has one of the lowest cost profiles in the U.S., there is little it can do to combat the Chinese producers that receive subsidies from China’s government and have lower labor costs. Government subsidies allow them to dump steel in the U.S. at extremely competitive prices. When the U.S. market is seeing strong demand for steel, it is a magnet for foreign imports, which account for about one-third of the U.S. market.

 

The Wall Street Journal published an article in June 2015 that did a nice job covering the challenges faced by the two major remaining steel manufacturers in the U.S. (NUE and U.S. Steel). It noted that surging Chinese steel production had pushed steel prices down by 23% since January 2015, causing NUE and U.S. Steel to ask the government for protective import tariffs on steel from China and four other countries.

 

Most recently, NUE noted during its third quarter 2015 conference call that China’s global steel exports surged by 27% in the first eight months of the year. They are on track to exceed 100 million tons, which is greater than the total U.S. steel production in 2014. Many steel markets around the world are suffering from overcapacity, causing steel products from low-cost countries such as China to flood the U.S. and pressure profitability. Companies like NUE are crying for more import tariffs and greater government protection from illegally dumped imports, but these processes move very slowly.

 

The chart below shows the price of hot-rolled band (HRB) steel over the last 15 years across several different regions. It highlights the cyclicality of steel prices and their current weakness as a result of import competition and soft demand trends. The dark blue line shows prices in the U.S. and currently hovers around levels last seen during the financial crisis.

 

Source: SteelBenchmarker

 

Beyond international supply concerns, the automotive industry is one of the two largest markets for steel in the United States. Lighter-weight materials such as hard plastics and aluminum are increasingly posing as threats to steel because they help with fuel efficiency and can be cheaper to use.

 

Of course, near term demand trends can also be volatile in major end markets such as construction and energy. As you can hopefully tell by now, investing in the steel industry can be quite the rollercoaster ride and is not for the faint of heart.

 

Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. NUE’s long-term dividend and fundamental data charts can all be seen by clicking here.

 

Dividend Safety Score

Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Despite some of the drawbacks of the steel industry, NUE’s dividend appears to be quite secure and has a nice Safety Score of 74.

 

Over the last four quarters, NUE’s dividend has consumed 76% of its earnings and 26% of its free cash flow. As seen below, the company’s payout ratios have been volatile over the last decade but increased meaningfully from about 15% in 2005 to around 60% last fiscal year. NUE grew its dividend faster than its earnings over this period. For a cyclical company, its payout ratios are getting to be on the higher side of what we prefer, but we will see that it’s less of a concern with NUE’s business model, which generates reliable cash flow in most environments.

 

 

As we have noted, NUE is a cyclical business. We can see that the company’s sales and earnings fell more than 50% in fiscal year 2009 as global steel markets collapsed. They also rebounded strongly in 2010 and 2011, underscoring the violent swings the steel market can take.

 

 

Despite the swings in steel prices and demand, NUE’s low-cost operating model and variable cost structure has enabled it to respond extremely well to periods of low demand. As seen below, NUE has generated free cash flow in nine of its last 10 fiscal years.

 

Importantly, NUE’s annual dividend payments total $1.50 today. We can see that the company’s current dividend would be covered by the company’s free cash flow generation in each of the years during the financial crisis ($2.52 in 2009; $1.75 in 2010). While industry conditions could always surprise to the downside, NUE seems to be in good shape to keep paying its dividend under most worst-case scenarios for the steel industry.

 

 

Companies with strong competitive advantages typically earn high returns on their invested capital. We can see that NUE enjoyed excellent returns from 2005 through 2008 when steel prices were higher and its customers were healthier. Since then, the market has mostly remained oversupplied and caused NUE’s returns to fall to a more reasonable level that suggests an average moat.

 

 

Given the cyclicality of NUE’s business model, paying attention to its balance sheet is realty important. If steel markets drop even further and credit markets tighten, NUE could be forced to reduce its dividend to make principal and interest payments on its debt.

 

NUE’s balance sheet looks alright. The company has about $2 billion in cash on hand compared to $4.4 billion in debt. Even with earnings looking depressed, the company could cover its entire debt with cash on hand and two years of earnings before interest and taxes (EBIT). Morningstar has also given NUE an “A-” credit rating.

 

 

NUE’s dividend looks reasonably secure, especially for a cyclical steel company. Its payout ratios don’t provide as much flexibility as other companies, but these figures are currently being calculated during a time of extremely depressed steel prices. Importantly, the company’s low-cost business model has helped it generate free cash flow in practically all macro environments, and its balance sheet is reasonably healthy.

 

Dividend Growth Score

Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

NUE’s dividend Growth Score of 7 suggests that the company’s dividend growth potential is very weak. While the company has increased its dividend every year since it started paying dividends in 1973 (43 straight years), its dividend growth over the last five years has been very underwhelming.

 

As seen below, NUE’s dividend has grown less than 1% per year during its last five fiscal years. For a dividend aristocrat, this is disappointing and reflects the challenging steel markets that NUE has dealt with over this time period.

 

 

Going forward, we expect NUE’s dividend growth to remain very low until steel markets recover (assuming they eventually do). Thereafter, we still wouldn’t expect dividend growth to exceed 3-5% per year, which is also the growth rate we expect the company’s earnings could experience longer term.

 

Valuation

NUE trades at about 16x forward earnings and has a dividend yield of 4.3%, which is meaningfully higher than its five year average dividend yield of 3.2%. Cyclical stocks like NUE typically look cheap when their earnings are peaking and expensive when their earnings are nearing a trough (investors are pricing in higher earnings in the coming years).

 

With steel prices near their 2008-09 low, investors are hopeful that macro conditions are about as bad as they can get for NUE. If they are right and steel prices rally sharply by 30%, the stock will likely do quite well.

 

Longer-term, however, it seems unlikely that NUE will grow its earnings by more than 3-4% per year. The steel market is too saturated and competitive, and NUE is already the largest player in North America. Under those earnings growth assumptions, the stock’s total return potential appears to be about 7-9% per year.

 

It’s very important to keep in mind that cyclical stocks are usually volatile. While NUE’s long-term earnings growth might be 3-4% per year, growth will not be linear. Earnings could fall 35% one year, double the next, and contract by 15% in the third year. The stock will whip around as well. For these reasons, we view most mature commodity stocks like NUE as “trading stocks” that do not fit as well with our buy-and-hold investment philosophy.

 

Conclusion

NUE has the fifth highest yield (4.3%) of all the dividend aristocrats. While the dividend payment looks reasonably safe, the steel market has become increasingly challenged. There are numerous global competitors (e.g. China) with deep, government-subsidized pockets that can ship cheaper steel to the U.S. and pressure industry pricing. While NUE’s operations are very efficient and management is doing all of the right things, it ultimately has no control over the headwinds facing its business.

 

Steel prices do appear unusually depressed at the moment and could unexpectedly rebound to drive the stock higher in the near term, but that is not the game we try to play with our dividend growth investing. We will stick with some of our favorite blue chip dividend stocks instead.