Markets & Finance

Nucor: This Minimill Could Be a Giant


By Leo Larkin Controlling costs is the key to profitability in the modern steel business, and Nucor Corp. (NUE) is Exhibit A. The Charlotte (N.C.)-based company is the largest "minimill" in the U.S. and the nation's second-largest steel producer behind USX Corp. Nucor manufactures the broadest range of products of any American steelmaker and is by far the most profitable. The stock carries Standard & Poor's highest investment ranking, 5 STARS (buy).

In contrast to the old-line integrated steel companies, Nucor makes raw steel by melting scrap in electric-arc furnaces, a far less costly and less capital-intensive method than integrated steelmaking, which requires mining of raw materials for conversion into liquid steel via blast furnaces and coke ovens.

Unlike many of its industry peers, Nucor employs a nonunion workforce whose level of compensation is tied directly to production and profits. In keeping its labor costs variable with production levels, Nucor has effectively limited its cost base in times of slack demand. And it isn't burdened by the contractual retiree and medical costs that have proved to be so debilitating to the integrated steel industry.

UP FROM ZERO. As a consequence of its overall lower cost structure and its aggressive pricing, Nucor and other minimills have driven their integrated rivals from a number of markets.

Perhaps no other minimill has been as successful as Nucor in capitalizing on its cost advantages. It has increased its output from virtually nil at its founding in 1966 to 12.2 million tons in 2001 -- accounting for 12.6% of total domestic output. Over that same period, sales have increased to $4.2 billion from $21 million, and net income has risen to $174 million from just over $1 million.

No other domestic minimill or integrated company comes even close to matching Nucor's profitability or potential for growth. And the market has recognized that, awarding Nucor a total capitalization of $4.4 billion, vs. $1.6 billion for USX, the nation's largest steelmaker.

IMPORT CHALLENGE. In 1989, Nucor gained a competitive edge by developing a new steelmaking technology that enabled it to crack the flat-roll carbon-sheet and strip-steel market -- the last bastion of the integrated steelmakers. Nucor's output in this category rose from 420,000 tons in 1990 to 5.1 million tons in 2001, and the company now accounts for approximately 10% of this market.

More recently, Nucor in 2001 began a new 1 million tons per year plate mill, which will serve as a vehicle for taking even more market share away from the integrated producers.

Since 1998, the U.S. steel industry has been challenged by a sharp increase in imports, which have severely depressed the domestic industry's prices and profits. This rise in imports, together with an already oversupplied domestic market, drove some 29 domestic steel companies to seek Chapter 11 bankruptcy from 1998 through 2001.

FINANCIALLY SOUND. Unlike past industry downturns, some of these bankrupt companies have been unable to generate enough cash flow to continue operations and have been forced to cease production. Recent examples were LTV, Northwest Steel & Wire, and Trico Steel. Although S&P anticipates an increase in steel demand in 2002 and expects that the Bush Administration will impose tariffs on imported steel, it's likely that several other major cash-starved steel companies will also halt operations during the year.

Nucor's finances, by contrast, are quite sound. Sporting a healthy debt-to-total-assets ratio of just 36%, with $471 million in cash, Nucor is perfectly situated to gain market share as customers of bankrupt competitors scurry to find a reliable, well-capitalized supplier. Additionally, with net income and depreciation expected to advance at about the same rate, and capital spending seen on the decline, Nucor is expected to generate substantial free cash flow in 2002 and 2003.

This financial strength should enable it to pick up some facilities of bankrupt rivals at depressed prices. We believe Nucor may be able to acquire as much as 4 million tons of capacity over the next 18 months with its excess cash and will account for at least 18% of the domestic steel market by 2004. One current strategic use of its internally generated funds is the development of a new steelmaking technology, the same sort of breakthrough process that enabled it to crack the carbon-sheet and strip market.

ROBUST EPS GROWTH. S&P expects Nucor, aided by declining imports, rebuilding of distributor inventories, and slightly firmer domestic demand, to post earnings per share of $2.40 in 2002. Assuming an economic recovery in 2003 and an increase in Nucor's market share, S&P believes the company can boost earnings per share to $3.60.

With its continued expansion via acquisitions, increased output at existing plants, and market-share gains at the expense of belly-up rivals, Nucor's EPS growth rate should expand at a mid-teen annual rate over the next four years, reaching $5 to $6 per share at the peak of the cycle. Using S&P's discounted earnings model, we have a 12-month price target of $68 -- a more than 15% rise from the current share price. Larkin is an equity analyst covering the steel industry for Standard & Poor's


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