May 1, 2011

An Accelerating Urge to Merge

Conditions are right for a period of rapid consolidation in the metals business, with the prospect of cross-border M&A also an increasing likelihood.

Gisbert Rühl, Chairman of the management board, CEO and CFO of Europe's largest metals service center company, with $7.36 billion in 2010 global sales, is wearing his white gloves.

His company, Klöckner & Co. SE of Germany, is currently carrying out the due diligence of the 30 Macsteel USA service centers in North America that Klöckner plans to acquire to become, by its calculation, the third-largest North American metals distributor, behind Reliance Steel and Aluminum Co. and Ryerson, Inc.

“What surprised us a bit on the positive side [are the] warehouses of the service centers, which are in very good shape,” Rühl told largely European security analysts in a March conference call. “Service centers could look a bit ugly, but that is not the case with Macsteel.”

With the upbeat global outlook for metals companies, there are plenty of reasons for a little dress-up. After going into hiding during the recession, shoppers have returned once again to the metals industry acquisition market. Moreover, the outlook for the North American metals industry must be viewed through a global lens. Executives of the major metal companies rarely speak of borders anymore.

“We want to grow in developed markets and also expand our footprint in emerging markets,” Rühll told Forward. “We do not intend to end our acquisition strategy in North America post-closing with Macsteel.”

Klöckner & Co., via its Namasco subsidiary, posted $1.2 billion in North American sales last year. “The North American metals distribution and service center market continues to be very fragmented. We intend to continue to be a consolidator in this field,” says Rühl.

He added that the company has a “war chest” of about $1 billion for acquisitions around the world. “I believe everybody is looking at everybody. There is a lot of tire-kicking and discussions going on right now,” Rühl says.

Chicago-based Ryerson, Inc., the only North American service center company with significant operations in China, is taking a similar view under its new president and CEO, Michael Arnold.

“While it remains the largest market, the United States isn't any longer the center of economic development,” says Arnold, who in January joined Ryerson from The Timken Company, a global manufacturer of bearings and alloy steel based in Canton, Ohio. “I spent a lot of the last 10 years developing markets in Asia. I don't see a lot of borders. There are customers who have needs spread out across the world. Competing supply chains will attempt to satisfy those needs.”

From producers to service centers, two factors are reshaping the metals landscape.

First, the world's biggest mill operators need to bulk up to secure better access to raw materials and technology innovation. Such consolidation and integration will ripple throughout the metals supply chain (see “Steel Consolidation,” left).

The first post-recession acquisition by Luxembourg-based ArcelorMittal, by far the world's leading steel producer with 2010 sales of $78 billion, was an iron ore mining company in Canada, Baffinland Iron Mines Corp.

“ArcelorMittal has always believed in the benefits of vertical integration,” Chairman and CEO Lakshmi Mittal told shareholders in the company's 2010 annual report. “The size of our mining activity is sometimes overlooked.”

Late last year, German steelmaker and distributor ThyssenKrupp AG began making carbon flat-rolled steel for North American automakers and other customers at a new $5 billion plant in Calvert, Alabama, and will be using an estimated 3 million tons per year of steel slabs produced at the company's mill in Santa Cruz, Rio de Janeiro, Brazil, a rich source of iron ore.

Dr.-Ing Ekkehard Schulz, ThyssenKrupp's CEO, called the Calvert operation, which includes a stainless steel plant, “the cornerstone of our trans- Atlantic growth strategy.”

Second, unprecedented volatility in metal prices makes metals companies vulnerable up and down the supply chain if they rely too heavily on traditional commodity price arbitrage instead of more profitable and stable value-added services.

“Especially in developed markets, we focus on value-added services and products,” Rühl says. “The more products and services we can offer our customers at a competitive price, the more important we become to supply chain decisions. I believe that in the current environment of volatile raw material prices, exchange rate uncertainties, reduced mill operating rates and volatile steel prices, our customers will have a greater reliance on our ability to supply the products they need, in a manner in which they need them, and on a timely basis, more so now than ever before.”

To be sure, the outlook for North American metals industry mergers and acquisitions also relies on domestic factors, especially among the highly fragmented service center segment. As 2011 opened, share prices of publicly traded U.S. service centers outperformed the S&P 500 index and an index of public metals company share prices compiled by investment bank Houlihan Lokey in Chicago (see “Service Centers at a Premium,” below). The public stock market is sending signals to privately held companies and private equity investors.

“We're going to see a lot more deals in the distribution business,” says William Peluchiwski, co-head of the industrials unit and senior managing director at Houlihan Lokey.

“People are feeling better about the [metals] segment and the industrial economy in general,” says Peter Matt, head of the New York-based global industrials investment banking group and managing director at Credit Suisse. “That always augurs a period of increased consolidation. Most of the industry is still very unconsolidated.”

A number of M&A deals in the works in 2008 fell out of bed by the end of that year, right along with the world financial sector. PricewaterhouseCoopers (PwC) count of global metals industry deals worth $50 million or more dropped to 17 in the second quarter of 2009 from 44 in the second quarter of 2008. At the end of last year, the count had risen to 26 (see “Merger Trends,” in Datapoints, page 12).

“There was a lot of M&A momentum in 2008 that got put on hold because of the collapse of the global credit markets,” says Mark Parr, managing director and steel industry equity analyst at KeyBanc Capital Markets in Cleveland. “Some of the backlog might create the illusion of a much stronger year than it really is.”

An additional factor behind the urge to merge in metals is the unprecedented shock felt by virtually the entire industry in the last three years.

“There are a lot of scared puppies in the metal industry and they were dumping inventory to keep their banks and their boards happy,” says Stephen Schober, chief executive of Metal Supermarkets Ltd. in Toronto, a franchising organization for small service centers. “There is a group of people who look at this recession and say, 'I just made it through this with the skin of my teeth. If I can ride this recovery for two or three years, I won't be so proud about the price I take to get my chips off the table.'”

The Global View

Such instincts are natural for any entrepreneur with money at risk, especially at small service centers. What's different this year is the overarching global scope of the drama. The business footprint imagined by ArcelorMittal, Klöckner & Co., ThyssenKrupp, Nippon Steel and a dozen Chinese steelmakers is quite different than the viewpoint of the typical North American service center owner and his or her investment banker and business broker.

“The Macsteel acquisition allows us to expand both our geographic footprint and product offering to both existing and new customers with a minimal amount of overlap,” Rühl told Forward. “So far, I have not seen U.S.-based service centers having a strategy to globalize their footprint, but that could change, of course.”

More than ever before, the consolidation process will be top-down.

Bob McCutcheon, leader of the U.S. metals industry group at consultant PwC in Pittsburgh, points to a critical fact: Crude steel output, as compiled by the World Steel Association in Brussels, has grown by 68.4% in the last 10 years, to 1.41 billion metric tons. But the share of the 10 largest producers has held constant, at about 26% (see “Top 10 Steel Producers' Share of Global Production,” page 26). During the recession of 2009, the most recent year for which the association provides top 10 production numbers, the share slipped to 23.5%.

“Consolidation has taken place, but that consolidation has only kept pace with the growth of demand,” McCutcheon says.

The proposed merger of Japanese steelmaking giants Nippon Steel Corp. and Sumitomo Metal Industries Ltd., announced in February, was characterized as an effort by Japanese steelmakers to gain leverage over raw material suppliers and compete against their Chinese competitors. But the official rationale issued by the two companies had a much larger scope: “The companies would, through the business combination, accelerate their global strategies and realize a level of competitiveness which is globally outstanding in all aspects, . which would cover Japan, the United States, ASEAN member states, India, Central and South American countries, Middle and Near East countries, and African countries where economic growth is expected.”

Adjusting for possible hyperbole in the official statement, the strategic talk of the would-be Japanese steel merger partners is worth noting.

“There's every chance that we'll see further consolidation in the steel industry, not only in Japan, but worldwide,” says Gavin Wendt, a veteran mining analyst in Australia and founding director and senior resource analyst of MineLife Pty Ltd., which hosts MineLife.com.au.

“Outbound” metals sector M&A deals, in which an acquirer from one of five major regions (North America, South America, Europe, Asia, Africa) merges with a target company in another region, are far more prevalent coming from Europe and Asia than from North America, with cross-region acquisitions increasing most rapidly in Asia, according to M&A transaction data compiled by PwC (see “Mergers and Acquisitions by Region,” page 30).

“Look at how many steel producers exist in China,” says McCutcheon. Nine of the 25 top steel producers listed by the World Steel Association for 2009, the most recent ranking, were Chinese. “There's a strong case for consolidation in China alone.”

“The key driver of these mergers is operating margins,” Wendt says. “Most steel companies have felt their margins coming under increasing pressure from rising input costs, mainly iron ore and metallurgical coal, which have hit record levels recently. Steel companies have not been able to increase prices at the same rate as their costs have been rising.”

The Service Center View

It's less clear how the distribution side of the metals supply chain will evolve as the big mills grow bigger. The history of metal distribution outside North America suggests that the independence of service centers is by no means guaranteed. Still, Rühl doesn't believe service center ownership is high on the mills' agenda.

“I believe they are currently more concerned about acquisitions on the raw materials side versus acquisitions in distribution or service center assets,” he told Forward. As for his company, “we see clear advantages for non-mill tied companies. As a nonmill owned company, we are not constrained on our choice of supplier base and can offer them the relative comfort of purchase quantity agreements and complete confidentiality.”

“North America is almost unique in the world in the sense that there is not a combination of steel production and distribution,” says Richard McLaughlin, a Pittsburgh-based steel industry strategy consultant and director of iron and steel consulting at Hatch Associates. “If you look everywhere else in the world, steel producers control a substantial amount of the distribution.”

Particularly in the United States, mill ownership of service centers has been regarded as the “third rail” of the metals industry, McLaughlin says.

“The obvious reason why steel companies haven't been more aggressive in pursuing [service center acquisitions in North America] is that if you were to make an acquisition of a service center, you would make an enemy of all the other service centers who are very important to your business,” says Hatch's McLaughlin. “Everyone walks around trying not to discuss that topic.”

Still, after it was formed in 2006, ArcelorMittal of Luxembourg's first acquisition was Mexican steel mill Sicartsa. ArcelorMittal established a 50-50 joint venture partnership with Grupo Villacero, a unit of Sicartsa and Mexico's largest steel distributor, selling long steel products in Mexico and the southwestern United States.

“I do not see the role of the traditional steel distributor or service center in North America changing much in the next few years, but the trend of further consolidation will continue,” Rühl says.

CEOs of public service centers in America, speaking during fourth-quarter conference calls with stock analysts, uniformly reported renewed selling interest in the industry.

Commenting on the Klöckner & Co. acquisition of Macsteel USA, David Hannah, Reliance chairman and CEO, said in February, “I think we will continue to see more. It's not boiling over at this point in terms of people all of a sudden wanting to sell their businesses. But I still expect as we go through the year we're going to see more and more opportunities. . When the owners are seeking to sell, that's when we can get transactions done. What we do is stay close to those folks, so that when they're ready, hopefully we get the call.”

Reliance has acquired 47 companies since it went public in 1994, Hannah added.

The phone calls with would-be sellers are no sure thing, C. Lourenco Goncalves, CEO of Metals USA Holdings Corp., told analysts in February. “Some companies we were unable to acquire [during slow times in the business] because the owners — no matter how much we explained about our ability to value owners' companies over the cycle, — would always believe if they could wait until things are more normal, they would be able to command a higher price. As things go more normal, we are going to see people believing that now is not a good time to sell their company because they can make money again.”


The Outlook

The North American metals M&A market was a mixed bag as 2011 began. In addition to the Klöckner& Co./Macsteel USA deal, private equity firm Renco Group Inc. of New York bought three steel plants in Maryland, Ohio and West Virginia formerly owned by Russia's OAO Severstal. The transaction, valued at $1.2 billion, makes the new company, RG Steel LLC, the fourth largest flat-rolled steelmaker in the United States, Renco says. Renco also acquired a 50% stake in Severstal's West Virginia coke plant, Mountain State Carbon LLC.

In March, Metals USA, with $1.29 billion in sales last year, completed its acquisition of oil field service center The Richardson Trident Co. of Dallas, its third service center acquisition since private equity investor Apollo Group of New York took Metals USA public in April 2010. Ryerson has made four acquisitions in the last 14 months.

Last year's shift by Metals USA from private equity ownership to public ownership gave the metals industry a look at the value of metal distribution operations. Analysts say they may get another look this year if Platinum Equity LLC of Beverly Hills, California, renews its proposed initial public offering of Chicago-based Ryerson. Platinum acquired Ryerson in 2007 and filed in early 2010 to sell public shares. Platinum withdrew the proposal last May, citing weak stock market conditions.

“I think there's a good chance it comes back,” says Peter Matt of Credit Suisse. “If they get things done, it will signal to the market that you can get these companies public, and that might cause other people to come to the market following suit.” Ryerson CEO Arnold referred questions about an IPO to Platinum Equity. A spokesman there did not respond to an inquiry.


On the Lookout

Meanwhile, private equity investors are scouting for companies. “Finding a good management team, hard assets and natural resources is a good place to be,” says Hunter Carpenter, managing director of The Stephens Group LLC, a family investment management company in Little Rock, Arkansas.

Carpenter says that in the wake of the recession, manufacturers are reconsidering their supply chains. “The value of having a supply chain that is buttoned down has grown,” he says. “We are in steel, driving to those that provide the best value-added, not just price. Some baby boomer companies really don't have an exit [in the public stock market]. Come hitch your wagon on our bus.”

The Stephens “bus” for metals acquisitions is Chicago-based Shale-Inland LLC, headed by private investor Craig Bouchard, who, with his brother, James, organized a steel service center acquisition company, Esmark Inc. (the same name as a defunct diversified holding company that included meat packer Swift & Co.) in 2003. In their biggest acquisition, they strayed from their service center core to acquire steelmaker Wheeling Pittsburgh Corp. Esmark sold its steel operations to Severstal in 2008 but has since reentered the service center and processing arena. Shale-Inland is unconnected to Esmark or to James Bouchard, Craig Bouchard says.

Bouchard plans to aggregate companies in the production and distribution of steel products, as he did once before in forming Esmark. In March, Shale- Inland acquired Main Steel Polishing Co., a premier metal processing operation based in Tinton Falls, New Jersey, and installed metals industry veteran Keith Medick, former president of Metal Processing Corp. of Gary, Indiana, to run the company.

“The market is different today than when consolidation started to speed up prior to the recession,” Bouchard says. “Scale in the steel business is extremely important. So we will continue to have consolidation as people try to achieve scale and collect larger customer bases. I have an interest in building a large customer base and offering a variety of products across stamping and fabrication, stainless and carbon. I am interested in being back in the service center business. It's close to the customer.”

For small, independent service centers, the outlook could be difficult. “As raw material prices become more volatile and [sales] contract lengths shorten, steel producers like to pass that volatility to their customers,” says Richard McLaughlin of Canada-based consultancy Hatch Ltd. “Inventory valuations rise and fall very rapidly. Companies find it harder to get credit for their inventories.”

Franchising, not consolidating, may be one way for small metals wholesalers running a spot order business to survive, says Stephen Scober of Metal Supermarkets. His company comprises 56 franchises in the United States, Canada, the United Kingdom and Austria, along with 18 corporate stores being converted to franchises.

“We believe as time goes on we'll attract some of the folks who are already in the business but who recognize that with better marketing, better support, better software they could be more successful. While that's not pure consolidation, they're looking to some of the benefits you get from consolidation.”

Meanwhile, there are few indications North American service centers are planting their footprints overseas, says KeyBanc's Mark Parr. He described the typical view of North America service centers this way: “If I know how to grow oranges, there are a lot more orange groves to buy. Why would I want to get into the banana business?”

Investment banker Peter Matt of Credit Suisse agreed, “The service center business is a regional business; so it's questionable what the synergies are when you go across regions. It's more profitable for a Metals USA to consolidate within the U.S. market, and there are plenty of consolidations to be done, than it is for them to buy a Brazilian service center, where they don't have any connectivity.”

Clearly, that view isn't shared by Klöckner & Co., with its Macsteel USA agreement, and ThyssenKrupp, the German steelmaker, with manufacturing facilities on four continents, and with more than 75 service centers in the United States, Canada and Mexico, among many other places around the world. Both companies follow a multi-hub strategy. ThyssenKrupp, for example, operates manufacturing and distribution facilities in China. This year, Klöckner & Co. plans to establish a greenfield service center to become, as Rühl put it, an “insider” in China. “We will start . in China with European customers as our core account base, to get a sense for the market and to work out further expansion opportunities while already being an insider in the market,” Rühl says.

Such strategic thinking is slowly finding its way to North American service center executives. Last year, Reliance Steel, through its Earle M. Jorgensen subsidiary, opened a 65,000-square-foot warehouse in Malaysia, with plans for locations in China, India and Vietnam.

In 2001, service center Samuel, Son & Co. of Mississauga, Ontario, acquired Airport Metals, a metals distributor to the aircraft industry in Australia.

“I find the rest of the world to be extremely exciting,” says Ryerson's Arnold. Last summer, Ryerson acquired full ownership of a metal processing service center operation in China from its Chinese joint venture partners.

“Going into brand new markets gives you the opportunity to think of what your business should be like,” Arnold says. Foreign participation in emerging markets is educational for indigenous business as well, he says. “They are learning opportunities for the countries as well as the companies. History does repeat itself.”

At the moment, access to raw materials is a greater force for globe-hopping consolidation among steel companies than control of distribution.

Investment banker Peluchiwski of Houlihan Lokey says the skills of U.S. service center operators aren't yet in high demand in emerging economies. Steel mills have proliferated in China alongside manufacturers

“The steel mill in China doesn't need a service center,” he says. “One of the values that service centers offer is reducing the capital needs of the customer. That is less so in China. Capital in China is pretty cheap. That's not to say they aren't worried about inventory turns, but it's a focus on growth and net income rather than chewing up working capital by having inventory on the ground. Companies are measured on growing assets and net income and employment.”

Ryerson's Arnold describes the service center business in Asia as “immature,” but adds that circumstances could change rapidly for mills and metal customers. “There are 700 million tons of metal produced in China, a lot of material being moved across that country,” he says. “One of the real challenges has been distribution infrastructure.”

Business structures evolve rapidly, a process known as “China speed,” Arnold says. No sooner does an idea such as tight inventory management emerge than multiple companies pop up to compete for customers. “As emerging economies, there are clear inefficiencies in their business model. But China moves at significantly greater speed than any of the economies I've seen. If you are going into emerging economies, there are going to be emerging players who are strong players.”

It may not be long before the Chinese players are dealt into the North American game, particular after Chinese mills consolidate, as is widely expected.

“China, with its increased influence and financial strength, is looking outside its borders for M&A opportunities,” says PwC metals consultant McCutcheon. “They are buying assets outside of China and looking for joint ventures and minority stakes.”

The white gloves inspecting North American metal companies could fit many new hands.