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March 1, 2005

Capturea Capital

The best opportunity in decades for metals companies to raise capital begs the question: We can attract new investors and capital, but what do we do with them?

For metals service centers, the surprisingly favorable economic and market environment is good news—but also a problem. The good news is that the metals industry is in the midst of creating what will be known years hence as the “good old days.” Profits are robust and for the first time in many years, most metals companies are easily earning their cost of capital.

“This peak of the cycle has reached higher pricing levels and has lasted longer than could have been expected,” says Edward M. “Bud” Siegel, Jr., president and chief executive officer of Russel Metals of Mississauga, Ontario, Canada. “We aren't sure how much longer the good times can last,” he says.

The problem: What's the best way to benefit from this golden opportunity? Issue new debt, attract new equity or expand?

The answer is that faced with so many options, metals companies have been taking aggressive advantage of all of them. Some prudent companies have been paying down debt or securing new financing on more favorable terms. Others, with suddenly improved access to financial markets, have been taking on new debt to finance growth. IPO's have been announced by companies ready to attract new investors before the window of favorable opinions closes or investment companies who purchased metals service companies a few years ago decide to cash out and make a profit.

David H. Hannah, chief executive officer of Los Angeles-based Reliance Steel & Aluminum Co., agrees that the robust industry recovery affords metal companies options that they did not have in the lean years from 2001 to 2003: “Some firms were saved by the rebound and can now access much needed capital to resurrect their companies,” Hannah says. “Others that used the last few years to continue to build their businesses and pay down debt can use this period as a major building block for the future.”

The good times should continue for a while. Dieter Hoeppli, an executive director with UBS Securities and a senior member of UBS Investment Bank's global metals and mining team, says the window of equity opportunity should remain open to metals companies through the first half of 2005. In the latter part of the year, however, there could be some pressure on profit margins if production costs climb higher. That, in turn, may dampen Wall Street's enthusiasm for metal equity deals.

A “JUST RIGHT” ENVIRONMENT 

All of this is due to the fact that metals prices rose strongly in 2004, so that relatively small increases in tons shipped resulted in substantial revenue gains and improved margins.

Pricing, of course, rose like a rocket. Consultant CRU's North America's steel price index rose 69.9% in 2004. The average price of aluminum rose almost 14% in 2004, according to the BMO Financial Group's Commodity Price Report.

“Most service centers did significantly better in 2004, including small companies and privately held companies,” Hannah says. Like most others who follow the metals environment closely, Hannah expects metals prices to remain at elevated levels or even rise through 2005.

Results from Reliance and another industry leader, Olympic Steel of Bedford Heights, Ohio, demonstrate how far metals companies rose on this favorable tide.

In 2004, Reliance had its best-ever year with sales of $2.94 billion, a 56% increase over 2003. The company generated net income of $170 million in 2004, up from $34 million a year earlier. For the fourth quarter, year-over year sales jumped 53% to $743 million. Net income was $43 million in the period, versus $9.7 million in 2003. Likewise Olympic Steel turned in record results for 2004 and the fourth quarter. Annual sales rose 89.2% to $894.2 million; net income was $60.1 million, versus a net loss of $3.3 million in 2003. For the fourth quarter, year-over-sales climbed 87.1% to $240.2 million, while net income was $12.2 million. In 2003's fourth quarter, the company suffered a net loss of $2.1 million, or negative 22 cents per diluted share.

TAKING ADVANTAGE OF LOWER RATES

With such dramatic financial results, Wall Street bankers and private equity firms now are willing to provide financing for metals. Total debt issuance for U.S. metals companies in 2004 was $2.9 billion, as companies such as Ryerson Tull Inc., and others were responsible for 14 issues, says Bloomberg L.P. That's up from all of 2003 when nine debt offerings totaled $1.9 billion.

Investment bank Houlihan Lokey Howard & Zukin says the number and total dollar amount of metals-related bank financings rose during the third quarter of 2004. In the third quarter there were 71 announced financings, representing $9.9 billion, compared with 55 transactions and $12.4 billion of issued senior debt during the second quarter
of 2004.

Terms improved in 2004, too, with loan rates about 2% (200 basis points) to 3.5% lower than in 2003, says William G. Peluchiwski, a managing director at Houlihan Lokey. Peluchiwski adds that the interest on revolving lines and longer-range facilities now range between .35 to 8 percentage points over LIBOR (London Interbank Offered Rate), the interest rate offered by a specific group of London banks for U.S. dollar deposits of a stated maturity. LIBOR, recently at about 2.5%, is used as a base index for setting rates of some adjustable rate financial instruments. Interest rates charged by banks depend on the credit worthiness of the borrower—a large, financially sound company can command a lower interest rate. To wit, Ryerson Tull paid 2 percentage points over LIBOR for a $525 million one-year revolver borrowed in July 2004, while less credit-worthy International Wire Group, which declared Chapter 11 bankruptcy in March 2004, paid 8 percentage points over LIBOR for a $140 million term loan it borrowed that same month.

Several metals companies are taking advantage of lower rates to refinance or reduce older debt. For example, Louisville, Kentucky-based Steel Technologies Inc. issued $50 million of unsecured notes in October 2004 through a private placement arranged by SunTrust Robinson Humphrey. Company officials announced at the time that proceeds would be used to reduce outstanding debt under its unsecured revolving credit facility. Likewise Gibraltar Industries Inc. of Buffalo, New York, issued $75 million of debt in a private placement in June of last year with the Prudential Insurance Co. of America. Three months later, Gibraltar used $25 million from the note to pay a portion of its existing revolving credit facility.

TAPPING EQUITY 

As far as equity issuance, the total dollar amount slipped in 2004, but would have been higher had two companies not changed their minds after registering either initial or secondary public offerings. The joint owners of Integris Metals Inc., Alcoa Inc. and BHP Billiton, initially filed an IPO in August, but then pulled the IPO in October when Ryerson Tull stepped forward with a $644 million offer—$410 million in cash and assumption of Integris' debt, about $234 million. Olympic Steel withdrew a secondary equity offering in October 2004 after deciding that it had sufficient liquidity on hand to finance anticipated near-term growth and working capital requirements without the equity offering, Michael D. Siegal, chairman and CEO announced at the time.

Motivation to access equity markets varies from company to company. While some choose to reduce debt, others are cashing out old investments while still others are raising funds for acquisitions and growth.

Lynwood, California-based Earle M. Jorgensen Co. (EMJ) is an example of a company that filed an IPO this past October to allow its principal owner, private investment firm Kelso & Co, L.P., to cash out its ownership stake during the industry turnaround after owning the company for more than 14 years. Eighty-year-old EMJ is a $1.16 billion (revenues) company with 36 service and processing centers that distribute a broad mix of carbon steel, stainless steel, aluminum bar, tubular and plate products to 35,000 North American customers in numerous industries. Steel Technologies Inc. issued a secondary equity offering in March 2004 of $47.3 million to reduce debt, with some of the money earmarked for expansion.

GROWTH AND ACQUISITION 

Throughout last year, consolidation of metal processors, service centers and distributors increased (See Power Balance). The trend is occurring because these companies are attempting to “build enough footprint and substantial enough critical mass to gain leverage from large metals producers,” Peluchiwski says.

In fact, the number of mergers and acquisitions completed from December 2003 through the end of September 2004 was 76, compared with 68 from December 2002 through September 2003.

Companies choose to acquire others instead of employing the capital for internal growth because the industry has too much distribution capacity. “The service center industry has not gone through the significant consolidation that the producers have experienced. I believe that the service center industry will see consolidation in the years ahead,” says G. Thomas McKane, chairman and chief executive officer of A.M. Castle & Co. of Franklin Park, Illinois.

In the past five to eight years, durable goods manufacturing has shifted significantly to low-cost countries like Mexico and China. During that same period, there has not been a concurrent substantial reduction in the number of service centers, certainly not proportional to the exodus of manufacturing. “Therefore, one would conclude that if the industry were properly sized 10 years ago, it is probably overserved today. You can't prove it. It's just an observation,” concludes McKane.

Another factor driving consolidation is the fewer, but larger steel suppliers and mills today than a few years ago after a wave of M&A activity, Hoeppli says. Therefore, many smaller steel service centers are now interested in joining forces with larger companies so that they have sufficient clout to obtain steel shipments from mills in adequate capacity to stay in business, especially in a time of steel shortages or equilibrium.

Most observers agree that it is now extremely difficult to grow by expanding into a new region because of the potential for a costly price war with entrenched suppliers. Customers in any given market have existing metal suppliers, Hannah says. Most markets are saturated. Purchasing established companies with long-standing accounts, therefore, is a much better way to enter a new market.

Companies have been tapping both debt and equity to finance purchases. For example when Ryerson Tull Inc. purchased Integris Metals, it issued a private offering of senior notes. The financing included one private offering of $175 million in convertible senior notes and another $150 million in senior notes. Along with paying down debt, in contrast, Steel Technologies Inc. plans to use part of the $47.3 million it raised through its October 2004 secondary equity offering to expand, which includes possible acquisitions.

Nonetheless, with metals service centers operating either at the peak of the economic cycle or close to it, larger companies must guard against going on shopping binges as financing becomes more readily available. Companies that buy outside of disciplined financial hurdles may find themselves in the next down cycle with big debts and inadequate cash flow.

Many industry observers point to the over-ambitious acquisitions undertaken by Metals USA, of Houston, Texas, during the industry's last boom period in the mid- to late 1990s. Metals USA purchased 49 companies from 1998 to the end of 1999. But as the economy drastically slowed in the new millennium, the company began to lose money: $409 million in 2001 on sales of $1.56 billion. The company declared Chapter 11 bankruptcy in 2002. When it successfully emerged almost a year later, it was a third smaller after raising $120 million by selling off some of its specialty metals operations. Metals USA now has new management and is profitable.

Metals USA's troubles essentially were caused by bad timing, the price paid for the acquisitions and the large debt load generated by the transactions. All these factors were related, says metal industry analyst Lloyd O'Carroll, senior vice president and chief economist at Richmond, Virginia-based BB&T Capital Markets. Because the company tried to grow very quickly, it ended up bidding the price paid for assets to high levels. Because Metals USA used cash for some of these acquisitions, it incurred a substantial level of debt and thus became heavily leveraged, O'Carroll says. “Once the recession and 9/11 occurred, the company was left vulnerable to the downturn, liquidity issues and Chapter 11,” he says.

There was also the focus of the pre-Chapter 11 management on growth by “roll-up” or quick purchases, rather than operational improvement and integrating the acquisitions into an efficient organization, adds
O' Carroll.

The good news is that post-Chapter 11 Metals USA has learned from its past, says O'Carroll. “An important difference today is the new management team,” he says. The new team, led by CEO and President C. Lourenço Gonçalves, is focusing on integrating all subsidiaries, improving its operations and cleaning up the organizational chaos left over from the earlier era, he says. The operational and cultural changes underway “give optimism that the company's strategic strengths can be realized in a way that never happened in the earlier ‘grow at any cost' era,” adds O'Carroll.

DUE DILIGENCE

When scrutinizing potential purchases, Hannah usually looks for a 15% pretax return on investment (ROI) on normalized income, excluding Reliance's cost of capital. In addition to the minimum ROI expectations, Hannah says that all 30 of Reliance's acquisitions have also “addressed our goal of profitable growth while diversifying our customer base, products and geographic coverage.”

In other words, Reliance is not looking for companies that are simply cheap. “You get what you pay for,” Hannah says. “We would much rather buy a larger, more-successful company and in turn, pay more for it. We are not afraid of paying more as long as the company is worth the higher price.” In purchasing a company now, one must determine the likelihood that it will make as much money in a “normal” year as it did in 2004.

“We realize that in some years they will make more money and some less,” Hannah says, “but we try to value from an annual income number what the company can achieve in most years.”

The 2003 purchase of Minster, Ohio, Precision Strip Inc. (now operating as a wholly owned subsidiary of Reliance) is an example of a company that met Reliance's criteria. Hannah explains that Precision, which has eight facilities located in four states, gave his company significant exposure to the auto and appliance industries and a much larger Midwestern presence. The immediately accretive acquisition was funded with borrowings on Reliance's then $335 million syndicated bank line of credit and a new private placement of $135 million of senior secured notes. Although the purchase increased the company's debt load—at the purchase's completion in July 2003, the net-debt-to-total capital ratio was 46.2%—Reliance was able to pare down the debt in 2003 through its robust cash flow from operations. At the end of 2003, the company's net-
debt-to-total capital ratio was 43.1% and by the end of the third quarter of 2004 the debt was trimmed to 39.1%.

The bottom line on raising capital in today's market, says Hannah, is that even though metals service companies now have greater access to all types of financing, they should be mindful of the type of capital they raise. “Investors have different expectations,” he says. “You will be living with those investors in the future.”

“A debt investor is not as concerned about profitability,” Hannah says. “Certainly these investors would prefer it, but they might be willing to make an investment in a firm's debt instrument if they are confident of the company's cash flow, even with uncertain growth possibilities.” However, the mindset for an equity investor is much different. “Buyers of stock want the company to be profitable and improving the profitability year after year,” he adds, and that is why metal service centers are now successfully tapping equity markets. If market conditions change and profits shrink, however, equity investors will not be as forgiving as debt investors.