As we head into 2021, I am looking for some macro economic investments that may be produce solid returns in the up coming year. In the pandemic, lots of commodity businesses took a hit as the economy was put on hold. Cyclical industries such as steel took a hit and are starting to look like it may be setting up for a further recovery into the new year.
I used to work in the steel industry, so it is near and dear to my heart. It is quite a fascinating process from an operations standpoint and the industry is one that has had an interesting past. Over time, the industry has consolidated to a few big players. As with any commodity business it comes down to who will be the most efficient as margins tend to be lower and companies tend to compete on cost of production.
The other half to the business is the pricing of the commodity itself, and current pricing of your basic hot rolled steel (vanilla steel) is in the upper $800 range.
From my experience in the industry, I can tell you that in this price range and above is when these steel companies start to make some good profits if demand is there. The last time we were in this price range was back in 2018 which was a great year for the sector as a whole.
For the demand side 2020 has seen a contraction in the use of steel as industries like oil/gas have taken a hit. But the weakest part of the economy from Covid was around consumer/service sectors which are less steel reliant. As the economy re-opens and the recovery of industries like construction and oil/gas go up, steel will benefit as well.
My Play on the Industry Stabilization/Recovery
Nucor (NUE) is one of the largest steelmakers in the US. It operates in three segments: Steel Mills, Steel Products, and Raw Materials. What I like about Nucor is the fact they have mini mills and use electric arc furnaces for their production. The combination of these two factors allows the company to be more flexible than their competitors such as Cleveland-Cliffs (CLF) and US Steel (X) as those companies use blast furnaces. This flexibility allows the company to change production quickly as the supply chain adjusts and it has a lower fixed cost piece to produce. This is the reason I like to invest in Nucor for the steel industry recovery as they are also better fit fundamentally in any cycle (less reliant on pricing and timing).
Now the one advantage of blast furnaces is the pure capacity and volume in which they can produce steel slabs, so in times of a booming economy stocks like X/CLF will outperform. I see these two companies as boom and bust style of investing in this cyclical market. I see Nucor as the balanced play that actually performs well in most economic environments but will give you the upside in a steel recovery as well with less risk (as they manage the company financially sound).
Below you will see what I mean by stability of profits as their cost structure is highly variable meaning they make a margin spread regardless of the pricing.
Also the company is non-union and aligns performance with employees by providing incentives to become more efficient/profitable over time which I love to see! The other qualitative metric that translates to quantitative gains is their amazing safety culture.
To start off with, the company has a strong balance sheet. The company has the best credit rating amongst it’s peers which allows them to borrow debt at cheaper rates if needed for hard times or when there is an opportunity to expand.
You’ll also notice that they currently have a mountain of cash on the balance sheet at $3.4 billion dollars.
The company also has paid out dividends while growing them for 47 straight years. So the company has shown even in a cyclical sector, they know how to manage cashflows responsibly and return shareholder value at the same time while growing and sustaining the business. Nucor currently has a 3.1% yield at the current stock price.
For cyclical stocks, I prefer to hold a core holding and then add to the position when there may be upside and trim when we hit historically higher metric. As for the upside with Nucor, let’s take a look at historical metrics to conclude where potential upside remains on the stock that has recovered some already from the Covid downfall back in March.
One metric we can use is the price to sales ratio to come up with where it has historically peaked. As we compare to 2018, we can use that as an upside target as the industry recovers with solid pricing.
We can use 1 as a targeted P/S ratio that may show that the price has gotten ahead of itself.
With analyst estimate around 21.11 Billion into 2021 that creates a target price of around $70 (21.11 divided by .3019 which is shares outstanding). At a current price of around $52/share that leaves an upside of 35% and when looking at other stocks in the market as a whole this may provide some alpha to the portfolio.
From a EV-to- EBITDA standpoint, historically NUE has traded at a 9.5 multiple over the past 13 years. So if Nucor can return to a higher historical average EBITDA margin in 2021 similar to prior years of around 12%.
That also shows growth potentially from $18.08B EV to $24.05B or 33% with a $69 price target.
Something else to consider is how NUE has performed compared to others, lagging in the industry. So when finding value within the sector, Nucor seems like a good play.
In conclusion, if we see margin expansion along with revenue growth going into 2021, I believer there is around 33-35% upside in Nucor from current prices around $52. The company also has a 3.1% dividend to boot. So I think for someone trying to add specific cyclical names to their portfolio on a possible recovery, Nucor provides that upside while avoiding a company with high debt and more reliance on continued high pricing in the steel markets.