2 Steel Stocks That Have a Killer Advantage

Steel is a cyclical business driven largely by the economy's ups and downs. However, there are some important differences in the industry between companies like Nucor Corporation (NYSE: NUE) and Steel Dynamics, Inc. (NASDAQ: STLD) and iconic names like United States Steel Corporation (NYSE: X). Here's the big, killer advantage that Nucor and Steel Dynamics have in the steel industry.

Making steel vs. recycling steel

U.S. Steel's business is built on blast furnaces. This is an older technology that uses iron ore and metallurgical coal to make primary steel. These mills are generally very large and are costly to operate. They can be incredibly profitable operations when run at high capacity, but they tend to bleed red ink during downturns because capacity utilization can quickly fall to the point where the mills don't cover their operating costs. You will often see steel companies like U.S. Steel and peer AK Steel Corporation (NYSE: AKS), which is also heavily reliant on blast furnaces, idle mills in downturns to contain costs. Upturns often bring shuttered mills back online. But the key takeaway is that both U.S. Steel and AK Steel have high costs because of the way in which they make steel.

Nucor and Steel Dynamics, on the other hand, use electric arc furnaces. This is a newer technology that, as the name implies, uses electricity to make steel. These steel companies tend to operate smaller mills that are more efficient than blast furnaces at lower operating levels and, to simplify a complex process a little, are easier to turn on and off. This gives Nucor and Steel Dynamics an important edge when you take a through-the-cycle look at the steel industry. They may not be as profitable when the industry is peaking, but when the downturn hits, they tend to do much better.

To put a number on that, over the past decade, Nucor reported a net loss only once. Steel Dynamics did so twice. This span includes a deep steel industry downturn that started after the 2007 to 2009 recession and the upturn that started in early 2016. U.S. Steel lost money in seven of the last 10 years, while AK Steel posted losses in eight of those years. Using electric arc furnaces is a huge advantage for Nucor and Steel Dynamics, but there are other factors involved when you look at each individual company, too.

Digging a little more

With a technological head start, it would be easy to just call Nucor and Steel Dynamics better steel companies, but that would be too simplistic. As noted above, blast furnaces can be very profitable when run at high capacities. So, investors looking for a way to play a cyclical upturn in the steel industry will probably get more bang for their buck from investing in blast furnace owners like U.S. Steel and AK Steel. For example, these two stocks rocketed higher in 2016 when it became clear that an upturn was unfolding...leaving Nucor and Steel Dynamics in the dust.

However, if you are looking at a more fundamental level, there are reasons beyond the mill technology they use to like Nucor and Steel Dynamics. The first, as noted above, is that this pair of electric arc mills tend to be more consistently profitable. That's a huge benefit for investors who prefer to buy and hold.

However, Nucor and Steel Dynamics also have very solid balance sheets. That helps them weather downturns better financially. For example, following two good years in the steel industry, long-term debt makes up around 95% AK Steel's capital structure. That figure at U.S. Steel is about 40%. Just a few years ago, though, AK Steel's shareholder equity was negative, leaving debt at more than 100% of the capital structure. And U.S. Steel's debt peaked at around 57% in 2016. There were very real concerns about whether or not AK Steel and U.S. Steel would survive the deep steel industry downturn after the 2007 to 2009 recession.

By comparison, long-term debt at Steel Dynamics is currently around 37% of the capital structure. The highest level over the past decade was in 2008, when it peaked at 58%. That looks a lot like the highs and lows at U.S. Steel. The difference is that Steel Dynamics is a younger mill that's still growing its operating footprint, so it has been using leverage to opportunistically fund growth. When U.S. Steel's leverage peaked, it was looking to shed assets to bring debt levels down, a fundamentally different position.

Nucor, meanwhile, has the best balance sheet in the industry, with debt making up just 30% of the capital structure. The worst level in the past decade was 37% in 2015. That, interestingly enough, includes Nucor, one of the largest mills in North America, making a number of opportunistic investments through the downturn. Nucor, is by far, the U.S. steel mill with the strongest financial foundation.

Tied together

Using electric arc furnaces give Nucor and Steel Dynamics a valuable edge over companies like AK Steel and U.S. Steel, which make heavy use of blast furnaces. That's the big picture -- and one reason you might want to avoid AK Steel and U.S. Steel. However, Nucor and Steel Dynamics have also made very good use of their advantage by remaining financially disciplined and, at the same time, opportunistically growing their businesses during the downturn -- a period during which AK Steel and U.S. Steel were focused on survival. That's highlighted by the balance sheet trends of Steel Dynamics and U.S. Steel. Nucor, meanwhile, is solid as a rock in good times and bad.

Following an industry upturn, steel companies are doing pretty well today and aren't exactly cheap. If you are looking for a steel stock to buy right now, Nucor would likely be the best option. However, if you wait for the next cyclical downturn, and keep the electric arc versus blast furnace issue in mind, you can probably find two steel mills with a killer advantage trading on the sale rack even though they are industry standouts.

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Reuben Gregg Brewer owns shares of Nucor. The Motley Fool recommends Nucor. The Motley Fool has a disclosure policy.