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January 1, 2007

A Growing Appetite

The still-fragmented steel industry is poised for a new phase of global consolidation.

U.S. Steel Corp. is far from being the world’s largest steel industry consolidator. That distinction, of course, goes to one of the dominant industrialists of our time, Lakshmi Mittal.

But U.S. Steel Chairman, President and CEO John Surma, who now chairs the International Iron and Steel Institute, understands economic imperatives. Early last year, Surma scanned eight major global industries and observed that the degree of concentration in the carbon steel industry—although high historically—remains low.

The iron ore, automotive, coking coal, glass, aluminum, copper and paper industries are much more concentrated. For example, the five largest companies in coking coal, auto and iron ore control 70% or more of global production. By comparison, the five largest steel producers combine to hold less than 20% of the output—small potatoes and, by Surma’s reckoning, a global opportunity for further major mergers.

That’s where Mittal comes in. The India-born consolidator burst onto the U.S. scene during the late 1990s, just before one of the industry’s worst downturns, with the resources, staying power and moxie to create the world’s first 100-million-metric-ton producer, now known as Arcelor Mittal. With its goal of almost doubling in size again by 2015, Mittal has raised the bar for the entire industry. Some predict there will be five to 10 mega-producers in less than four years.

“Mittal’s vision is right on because consolidation enables a more rational approach,” says Nick Sowar, global steel practice lead at Deloitte & Touche in Cincinnati. “He adjusts the supply rather than let the market adjust the price.”

Nationalism, high legacy costs and other factors long have stunted the merger and acquisition process that eliminated duplication, reduced overhead and added to efficiency in other industries such as aluminum and automotive. Consolidation does bring scale—and with it, pricing power on the sales side and negotiating power with sellers on the raw materials side. The emerging ability to control output to match demand and avoid the downward price spirals that have characterized the industry in the past has the potential to change the character of steel’s historic cyclicality.

Prices have remained higher on average since the bankrupt operations of Bethlehem Steel Corp. and LTV Corp. were combined, first under International Steel Group Inc., and then acquired by Mittal Steel Co., which already owned the former Inland Steel Co., data from Purchasing magazine shows.

Then there is the bandwagon effect. “Some of it is definitely ego-driven,” says Fariborz Ghadar, director of the Center for Global Business Studies at The Pennsylvania State University, State College, Pennsylvania. “If your competitors are becoming very big, there’s a lot of pressure to do it. And investment bankers play a role in convincing people that’s the way of doing it.”

Strong demand, high prices and strong earnings—which are spurring steel company valuations—are fueling the current level of activity. Buyers have money to spend and access to cheap debt. How quickly the current pace of cross-border mergers reconfigures the industry is not yet clear.

A NEW PLAYING FIELD

There’s no doubt that last year’s merger of Luxembourg-based Arcelor and Rotterdam-based Mittal raised the ante. Only six years ago, the world’s largest steel company had 30 million tons of production capacity. The new entity is now three times the size of the next largest company, and is No. 1 in North America, Western Europe and South America. Yet it has less than 10% of world production of around 1.1 billion tons.

World Steel Dynamics, an industry information service in Englewood Cliffs, New Jersey, predicts the merger will prompt another five to 10 companies to reach the 50- to 125-million-ton range by 2010.

With Mittal’s next largest competitor, Nippon Steel of Japan, at a distant second with 32 million tons, there is plenty of potential for partnerships. Before it’s all over, today’s 30-million-ton company could very well end up having the same quaint ring as 1995’s 4,000 Dow Jones Industrial Average.
At year’s end, the dance had begun, but it was as tentative and halting as a junior high mixer. U.K.-based Corus Group, No. 9 at 18.2 million metric tons, was the object of a bidding war between India’s Tata Steel, No. 56 at 4.4 million metric tons, and Brazil’s Companhia Siderurgica Nacional SA (No. 49). CSN countered Tata’s offer days after its takeover bid for Wheeling Pittsburgh Corp. was rejected in favor of Illinois steel distributor Esmark Inc.

The first steps toward creation of an Asian mega-mill also were reported as China’s Baosteel Group—the largest Chinese domestic consolidator—and Nippon Steel of Japan spoke publicly of joint equity ownership, with South Korea’s POSCO in the same mix. Other Japanese producers also hold small stakes in their domestic competitors, and Nippon, seeking alliances elsewhere, has agreed to buy a small stake in Usiminas of Brazil.

WHAT TOOK YOU SO LONG?

Steel has occupied a special position in the consciousness of industrialized countries. Few industries have been as aligned with national security as steel, whether in Europe, Asia or the United States. Long considered an arm of national defense, steel has played a vital role in building military power. Countries have feared being compromised by allowing a foreign nation to control its steel supply. But although steel is readily available, concerns about national security aren’t quickly shed.

“There’s still a sense that this is our patrimony,” says steel industry expert Paul Tiffany, a senior lecturer at University of California Haas School of Business in Berkeley and adjunct professor at the Wharton School of Business at the University of Pennsylvania in Philadelphia. Tiffany has written about the setbacks faced by the domestic steel industry.

If Arcelor’s strong resistance to the Mittal bid is any indication, overcoming that long-ingrained psychology against merging beyond national boundaries will be painful, no matter how compelling the benefits from increased reach, scale and negotiating power. Asian companies continue to consolidate among themselves, including the October 2006 strategic alliance between what was No. 3 Nippon Steel of Tokyo at 32 million metric tons and No. 4 South Korea’s POSCO, a 30.5-million-metric-ton producer.

“You’ve got companies in Asia taking cross-shareholdings in each other to provide some sort of defense against unwanted takeovers,” says Paul Scherzer, director, investment banking for Credit Suisse in New York.

Fear of losing high-paying jobs also slowed steel’s approach to globalization. As the dominant industry in industrializing nations, steel is prized in nearly every country for its jobs, which provide workers with a good quality of life. To protect domestic jobs and shore up prices, both the United States and EC nations have used tariffs and quotas to keep foreign products at bay. In China, state ownership of the industry enables job creation at a pace that reflects social priorities over economics.

Another brake on global consolidation was the high legacy costs—staggering retirement and health care obligations that made U.S. companies less attractive to domestic and foreign investors. When these obligations were shed during the bankruptcies of giants Bethlehem Steel Co. and LTV Corp. in the early 2000s, it paved the way for the combinations that followed. The big three U.S. producers—Mittal Steel USA, U.S.

Steel and Nucor—now control 57% of steel product shipments, calculations from consulting firm Accenture show.

BENEFITS OF GLOBAL CONCENTRATION

Globalization has speeded the worldwide consolidation in all markets, including steel. “Globalization and consolidation go hand in hand,” says Sowar of Deloitte & Touche. “As companies establish operations in the low-cost centers of India, China and Brazil, suppliers will follow. We’re going to see steel [companies] following their customers.”

That was the impetus for strategic partnerships between Arcelor and Nippon Steel, Tokyo, in 2001 and between ThyssenKrupp and JFE Steel Corp., Tokyo, in 2002. The driver for both alliances was the need to supply the highest-quality automotive sheet to global automotive companies.

“It’s clear that the big automotive companies expect to produce in each of their major markets, and they expect to be supplied in those markets,” says Ian Christmas, secretary-general for the International Iron and Steel Institute, based in Brussels.

On the purchasing side, steel has a lot to gain from global concentration, particularly in negotiating the soaring prices of iron ore and coking coal. “Companies are looking for scale, because with scale comes pricing power and negotiating power on supply contracts,” says Jeffrey Christian, managing director and president of consulting company CPM Group, New York.

Larger companies will have more negotiating leverage with the iron ore oligopoly that emerged following steel’s financial distress. In an ironic swing of the pendulum, as companies divested high fixed-cost mining assets to lighten their financial burdens, iron ore companies consolidated into a few global giants. Today, Brazil’s Cia Vale do Rio Doce (CVRD) and Australia’s Rio Tinto and BHP Billiton are the big three controlling 70% of seaborne iron ore. Arcelor-Mittal, through its acquisitions of mining properties and companies with iron ore assets in Mexico, the Ukraine, Liberia and the United States, is now No. 4.

Only recently a moribund industry, iron ore enjoys boom times. With strong demand, the industry has been able to command premium prices. Prices for seaborne iron ore rose 19% in 2006, the second highest price increase in 25 years. It was surpassed only by the 2005 price hike of 71.5%. The recent recovery of iron ore is attributed largely to increasing demand from China’s rapidly expanding economy. As alliances, agreements and outright mergers continue, pricing power is expected to shift toward the steel mills. The sharp rise in raw materials costs also could send steel companies back toward vertical integration, in another swing of the pendulum.

While negotiating power is one advantage of consolidation, even more important is pricing discipline. The ability to control output to match demand and avoid downward price spirals has the potential to change the character of steel’s historic cyclicality.

Steel producers in the bad old days did the opposite and maintained output to cover high fixed costs. The model was flawed and often drove prices to lows that at times couldn’t even cover the price of slabs. The shakeout in the number of producers results in a restraint that is an essential component of turning a profit, says Robert E. Powell, former vice president of sales for Inland Steel Co.

Powell notes that prices spiraled downward in the months leading up to the LTV and Bethlehem bankruptcies as the mills pushed output to raise cash. The average price for hot-rolled sheet in the Midwest fell to $235 per ton in December 2000, the month of the LTV filing—from $310 a year earlier—and to $215 in October 2001, the month of the Bethlehem filing, data from Purchasing magazine shows.

Market conditions in 2004 and 2005 may have marked a turning point. In 2004, a boom year for steel driven by Chinese demand, prices rose to a monthly high of $756 a ton. Then in 2005, orders fell by as much as 30%. In the past, that would have triggered a downward spiral.

But this time, it was different. With fewer companies on the price trigger when the market slowed down, companies refrained from the old pattern of producing more and instead reduced output to match demand.

“What you saw for the first time were the empirical benefits of consolidation in Europe and in the United States,” says John Lichtenstein, global metals industry lead at Accenture, based in Wellesley, Massachusetts. In response to the drastic reduction in order intake activity, Europe’s big three—Arcelor, Corus and ThyssenKrupp—reduced their output. In the United States, the three top companies did the same.

“That stopped the market price from going into a free fall,” he says. Although the average hot-rolled price fell to a low of $435 in August, that didn’t come close to previous lows.

The mills moved quickly to reduce production when inventories rose late last year. U.S. Steel curtailed output in the fourth quarter, reducing operations closer to the 71.9% of capacity of third quarter 2005 as compared to 89.1% in the third quarter of 2006. Mittal temporarily idled two of its 10 blast furnaces in North America and temporarily reduced output at its flat carbon steel mills in Dunkirk, France, and Avilés, Spain. At year’s end, prices had fallen from a high of $630, but were still at $565 for November, Purchasing magazine data shows.

Meanwhile, as acquirers grow and control more than one site, they have a better opportunity to adjust to the nuances of the market. This is what Mittal does with its multiple sites in North America—it can shutter a line in one location, pick up the slack in another and save on expending capital.

“You can better balance your lines if you have one facility that is better at construction-grade versus automotive. You’re not trying to do all things with one facility,” Scherzer says.

Of course, what a producer sees as discipline, a consumer might see as a too tightly controlled market. While the top three domestic producers represent about 57% of North American capacity, there is still a lot of competition on a global basis—which cheers steel users.

“Improved profitability is positive for the steel industry. However, the vehicle manufacturers and the steel mills are dependent on a healthy supply base, and vice versa,” says David Andrea, vice president for business development at the Original Equipment Suppliers Association in Troy, Michigan, which is geared to the auto industry. “Suppliers, as major steel consumers, want to ensure there is an efficient and competitive global market for steel.”

WHILE THE TOP THREE DOMESTIC PRODUCERS REPRESENT ABOUT 57% OF NORTH AMERICAN CAPACITY, THERE IS STILL A LOT OF COMPETITION ON A GLOBAL BASIS.

 

THE WILD CARDS

Not everyone believes that bigger companies are necessarily better, despite the advantages in purchasing power, price stability and operating synergies. Smaller companies have their own advantages, including their ability to respond more creatively to customers.

“Niche players will always have more flexibility to respond to unusual needs or technologies,” Ghadar says.

With scale comes bureaucracy. Will the largest companies have the managerial systems and processes required to manage massive scale? “Steel is an industry where efficiency is more at the plant level, not at the corporation level,” says Tiffany, adding that he doesn’t expect to see costs drop tremendously for Arcelor-Mittal or an acquired Corus. Relatively smaller companies that have reduced costs should be able to compete just as well in their markets against the largest companies.

CONSOLIDATION IN SELECTED INDUSTRIES

One of the toughest aspects of any merger is the post-merger integration, so the hard work of turning the global combinations into efficient and effective companies is yet to come. Steel’s historic underinvestment in information systems and business processes will add another layer of complexity to the challenges of managing exponentially larger companies.

Not all attempts to follow customers around the world have worked out. In pursuit of customers like Toyota, Honda and Nissan, two Japanese companies bought majority positions in U.S. companies. In 1984, NKK of Tokyo took a 50% ownership of National Steel, which slid into bankruptcy in 2002. Kawasaki Steel made a major joint-venture investment in Armco Steel, now AK Steel, Middletown, Ohio, in 1989, but after an IPO in 1994 found itself a minority shareholder.

“These deals happened awfully fast, and major challenges occurred in each of them,” Sowar says. “You have to understand what you’re buying and be able to measure the synergies that you expect.”

Looming in the background is near-universal concern over China’s fragmented and sprawling steel industry. The eastern giant accounts for more than 30% of world supply and demand for steel. In 2006, China swung from its position as the world’s largest steel importer to the largest exporter. Because of its potential for unbalancing world supply, the pace at which China continues to consolidate its steel companies is being watched closely. Christmas compares China’s fragmented industry to the landscape of North America and Western Europe some 20 or 30 years ago. “Few of these mills are world-class. Most are too small to be economically viable,” he says, but the political and social pressures for creating and maintaining employment are high.

THE NEXT WAVE

While the recent mergers have spurred speculation about who might be next, consolidation phases go on for decades. Even though Europe and North America have consolidated regionally among the largest companies, many smaller producers still dot the landscape. It’s at this level that merger activity continues unabated.

Acquisitions of U.S. targets in the metals arena actually declined slightly to 71 announced deals through the first 11 months of last year, compared with 75 in 2005, data compiled by investment banking firm Houlihan Lokey Howard & Zukin shows. But the deals were much bigger than last year. Based on transactions where the value was disclosed, the average deal rose to $971 million from $166 million the year before and the median price rose to $150 million from $91 million the year before. The 2006 average price was raised by the Freeport McMoRan Copper & Gold Inc. buyout of Phelps Dodge Corp.

Overseas, the number of deals through the first 11 months of 2006 was 190, compared with 230 the year before. Again, the average price was much higher: $1.5 billion, compared with $318 million the year before, driven by the Mittal takeover of Arcelor and other big mining deals. The median value rose to $37 million from $31 million.

Consolidation continues domestically among mid-size and smaller companies and within niches such as stainless and pipe. In September, for example, IPSCO Inc. of Lisle, Illinois, with big positions in plate, pipe and tube, agreed to buy tubular goods manufacturer NS Group, based in Newport, Kentucky, a $1.46 billion deal. So whether global consolidation has really begun—and while regional consolidation continues—the ultimate configuration of the industry is still decades away. For some, that’s not as crucial as what happens regionally in China. Other growth markets like Brazil and Russia could determine the future structure of the industry.

Steel companies in both countries are particularly interested in acquiring steel production assets in the United States, says Mark Parr, metals equity research analyst with KeyBanc Capital, Cleveland. For example, Russian steel and coal group Evraz Group SA agreed to buy U.S. pipe and tube maker Oregon Steel in November. In October, shortly after Missouri-based Maverick Tube agreed to a takeover from Luxembourg-based Tenaris, speculation circulated that Tenaris may be acquired by Gazprom, the Russian energy giant. Brazil’s Gerdau Group is on the prowl for more acquisitions (see “How Big is Big Enough,”).

Although balance sheets are recovering in the third year of unprecedented prosperity, Parr asserts that steel assets remain undervalued.

“What’s to keep a Brazilian or a Russian company from buying a big American company?” he says. “With these kinds of valuations, it’s a pretty good deal.”

Whether consolidation continues at its current heady pace or slows down as prices and demand adjust, as they ultimately will, the only certainty about the configuration of the industry is that it will not look like the past. What is to come will make history.