The American steel industry has been in the downside of its cycle for several years. It's a product of both the economic downturn and slow recovery, as well as what leaders at Steel Dynamics (NASDAQ:STLD)Nucor (NYSE:NUE) and others claim is unfair competition from overseas rivals. The American Iron and Steel Institute takes a pretty clear stance on the matter, as evidenced by the text along the bottom of this screen capture from the organization's website:
This has kept domestic steel producers at a capacity utilization rate of close to 75% for the past several years. According to AISI's most recent data (through April 5, 2014), production capacity utilization this year stands at 76.3%, a 0.7% decrease from 76.9% in the same period of 2013. What does this mean for steelmakers? Let's take a closer look.
Fixed costs like a steel weight
When you make a heavy, high energy consumption product such as steel, you have major investments in mills and foundries, and a lot of this equipment can't be turned off, even when it's not being used. The weight of all these fixed costs is a big driver behind the "boom and bust" cycles that steel companies experience. Here's what the cycles look like over a 20-year period that includes a couple recessions:
As you can see, net income tends to plummet during and immediately after a recession. For years, steelmakers run at high capacity levels, often investing in more capacity (and the associated fixed costs), only to be blasted when the inevitable downturn arrives. As shown by the table above, both AK Steel and U.S. Steel have lost billions of dollars since 2010, and continue to bleed cash as they struggle to get operations to a level where they can operate profitably, but at lower levels to meet demand.
Nucor, however, has fared much better, only posting a loss one year since the recent recession, while continuing to invest in the business. Nucor has made efforts to reduce its input costs in recent years, including by investing in a direct reduced iron, or DRI, mill in Louisiana that will be powered by natural gas, while starting a joint venture with Encana to produce the natural gas that it will need and sell the excess.
According to Nucor CEO John Ferriola, a competitor that wanted to get into DRI would need at least two years before it could build the capacity, and probably even longer to refine the technology. That's before factoring in the cost advantage of Nucor's deal with Encana. Over the past decade, only much smaller competitor Steel Dynamics has managed to match Nucor and keep losses to a minimum during downturns, though its profitability has been significantly less due to its size.
Taking the long view
Nucor's stock has still underperformed the market over the past several years, even as the company has fared much better than its competitors. Legendary investor Peter Lynch has said that investing in a cyclical requires knowing when to get in (early in the upswing of the cycle), and when to get out (early in the downswing). And while some would call that trying to time the market, it's really not: These cycles last for years, and there are a number of economic indicators that can help investors know when it could be time to move on.
However, it still takes time, patience, and some solid understanding of the industry, which most people just don't have the time to invest. But Nucor and (maybe) Steel Dynamics have a track record of strong financial management and capital allocation that could make them good buy-and-hold candidates:
Sure, they both have their ups and downs. But over the long term, these two companies have vastly outperformed both their peers and the S&P 500. And it's not even close. Let's take a look at revenue over the same 20-year time frame:
While the past isn't a guarantee of what the future will bring, it does give us valuable insight. What can we see? As a start, only one company (Steel Dynamics, the fastest grower) has returned to its pre-recession sales levels. That indicates we are indeed still in the recovery phase of the cycle. It also tells us that there's a lot of room for Steel Dynamics to run.
Final thoughts: buying the best companies beats buying the cheapest
Warren Buffett has said that it's better to buy a great company at a fair price than a fair company at a great price. And when it comes to steelmaking, you're much better off with management that has proven itself in the bad times and the good. For that simple reason -- and the numbers are there to show it -- Nucor and Steel Dynamics are the clear leaders in the American steel industry. If you're willing to be patient, they could be great fits for your portfolio.
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Jason Hall has no position in any stocks mentioned. The Motley Fool recommends Nucor. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.