September 1, 2007

Great Expectations

Metals industry CFOs weigh in with forecasts for the market and share their thoughts on such heated topics as private equity and Sarbanes-Oxley.

As a rule, chief financial officers are a conservative bunch, very much at home counting corporate winnings, less at ease making positive projections about the future.

Yet in a discussion convened by Forward magazine, a group of metals industry CFOs was remarkably upbeat about how long the current positive cycle might last. The consensus: With occasional short-term exceptions in some product or geographic markets, the good times should last another two or three years. One imponderable, the CFOs say, is the extent to which Chinese overproduction will flood the world with excess steel.

The CFOs were also largely negative about the impact of private equity on the metals industry, warning that some companies acquired by financial buyers— as opposed to strategic buyers already in the metals business—might find themselves in a precarious financial condition during the next down cycle.

FORWARD: Metals companies are enjoying a fourth consecutive year of good financial results. How much longer can this last?
RICHARD T. MARABITO: For the next two to three years, worldwide steel consumption still looks to be very good. There may be certain pockets that are up or down or certain geographies that are up or down. We could have some little mini down cycles like we’ve had during the last three or four years. But for the industry as a whole, we’re pretty bullish that we’re still in the middle part of a good cycle.

MARY VALENTA: While there may be some industries that slow down, there will also be other industries that will continue to grow. For example, we’re seeing a lot of growth in the alternative energy industry. Globally, there’s so much growth that I agree [with Marabito]. For the medium term— the next two or three years—it should be pretty strong, still.

BRIAN HEDGES: We’re struggling a little bit up here with the Canadian dollar that’s heading for par [with the U.S. dollar]. I’m hoping that our dollar will go back to where it belongs.

VICKI AVRIL: A lot of the outlook depends on how effectively China manages its growth. Whenever you have a developing country, you could get some violent swings in their consumption. So there is some concern that while we might continue to have a strong market with some modest growth, on a global basis, you could have supply growth actually outpace demand. That would cause some weakening of the sector.

With China, we’re seeing a lot of imports of processed steel products, and not just the steel itself. China has been clear: They’re down-streaming it and bringing the downstream products in. So we will see some of the finished consumption moved to China to displace the finishing that’s been done domestically.

KARLA R. LEWIS: We’re definitely on the good end of the cycle right now. The only thing I can add is that some of the industries that were very cyclical in the ’80s and ’90s, such as semiconductors and aerospace, are still cyclical. But the peaks aren’t as high or the troughs as low as they used to be; they are more stable.

FORWARD: What has the availability of so much private equity capital meant for the metals industry?
HEDGES: We certainly see financial players more often now. Their formula is levering the company up with relatively attractive payouts to the owners. We [as strategic buyers] don’t tend to do that.

MARABITO: Private equity has been driving up the valuations for steel companies. Depending on where you are, that could be perceived as a good thing. It also seems that the equity players have certainly levered up the assets that they’ve purchased much more than the normal debt levels that you would see. That’s the only concern I would have, because you wouldn’t want to see the industry get too leveraged again. That’s a concern even for those companies that aren’t highly leveraged, because you don’t want capital in the future to begin to flow away from the industry because of some of the leverage ratios.

VALENTA: The concern I have is that the financial buyers may make operational decisions based more on the immediate financial impact, rather than making good operational decisions. Their decisions can impact the industry as a whole.

FORWARD: What kinds of decisions?
VALENTA: Leveraging up the business. Borrowing to pay dividends. Not wanting to reduce inventory to certain levels. And maybe not being responsible or caring as much about pricing levels in the industry as much as meeting certain financial indicators.

AVRIL: With the cost of debt being so much lower than the cost of equity, it places a certain floor on how you operate. It means that if you were somebody that’s been underleveraged in the past, it puts an awful lot of pressure on you to raise your leverage to be competitive with the [leveraged buyout] firms. It can potentially drive you to shortertime decisions that are cash-flow sensitive, as opposed to long-term, strategictype decisions that you had the luxury in the past to consider more thoroughly.

LEWIS: While there is a lot of private equity money out there, and there is a lot of talk about increased valuation expectations by sellers, we have not really been impacted by that. We think that we can still get deals done, kind of ignoring some of these private-equity valuations. The most significant example was the Earle M. Jorgensen Co., which we acquired a little over a year ago. They had been owned by a private equity firm for more than 15 years. They definitely had some conflicts in how to commit capital for things that would be good for the growth and profitability of the business, because the private equity owners prioritized cash distributions to the owners.

AVRIL: I think a strategic buyer can generally outbid a private equity buyer. One, because they can use debt just as well if they choose to, and two, because there will be synergies from the acquisition. The synergies can always boost the potential of the acquisition.

FORWARD: Are valuations now in excess of what might be sustainable over the long term?
LEWIS: Reliance has continued to use a consistent valuation methodology. We do try to look at what we call a normalized number, so we’re not playing off of forecasts and we’re not playing off just the last one or two years.

Our methodology has remained consistent, but our idea of a normalized number has typically increased because of the positive things that have happened in the industry, especially at the supplier level.

MARABITO: I don’t think that the multiples or valuations have in and of themselves risen to a level that’s not sustainable. The private equity money has brought some assets in the industry and outbid strategic buyers. But then, you’ve seen them take enormous sums of money out in the first 18 months, leaving those companies levered.

The difference is that the strategics are taking the strong earnings and pumping them back into the business, where some of the private equity is pulling it all out. Over time, if you’re pulling all the money out and not reinvesting in the company, those companies are going to fall behind the competition.

AVRIL: One way to say it is that as people have leveraged up more with some of these acquisitions, and consolidation has continued in the industry, the industry will be less cyclical and there will be less volatility within the cycle. People can’t afford to go into price wars the way they have in the past.

FORWARD: So have prices reached a new plateau?
HEDGES: We’ve had three companies up here that went for pretty dear money. All of them went for premiums that would have been unheard of two or three years ago. I think that if you’re paying good will at these levels, that’s automatically dropping the returns in the industry. If we’re making returns in the high teens at this point in the cycle, I don’t think that’s probably a good and viable structure for the industry in the long-term.

A lot of companies being bought today are making 30% to 45% return on assets. They are being bought at premiums that drive that return down into the teens. Assuming this remains a cyclical business, we will return to numbers in the teens, the way it was before all the leverage was put on. Plus, interest rates may go up. So, I guess we’re the Chicken Little of the group, because we just don’t believe that this is going to change as permanently as everybody else is thinking.

FORWARD: Now that we’ve all lived with Sarbanes- Oxley for a couple of years, what’s your view of it—a net positive or a net negative?
VALENTA: O’Neal is a private company. We’ve been able to take our time and select the most valuable parts of SOX to implement. We have downstreamed all of the signoffs for the controls down to a clerical level, so pretty much everybody in the company is much more aware of what they’re doing and what control issues there are around it. It has enlightened a lot of people as to the impact of their operations on the financials of the company as a whole.

MARABITO: The most painful time was the first year of trying to implement it. I think that certainly, the corporate governance and transparency aspects of the legislation have been good things. But I also think that initially, the public accounting firms went way overboard. It was almost a bit ridiculous.

It got down to minutiae. If there’s not an initial on some page, that’s a control weakness. That’s away from the bigger scope of what you’re trying to accomplish.

LEWIS: For Reliance, it has been a net negative. We didn’t have to change much internally at the company. But most negative to me are the audit fees. Although there have been changes in the regulations [since Sarbanes-Oxley went into effect], we have not seen our auditors adjust their approach. Somehow, they always keep coming up with just about the same number of hours every year. When I got the quote for this year and saw the total hours, it was the equivalent of almost my whole corporate accounting staff.

FORWARD: Do you still find yourself required to hire outside consultants and advisors?
GENERAL RESPONSE: Absolutely. Yes. Oh, yes.

LEWIS: Heaven forbid that your auditors sign off on anything if you haven’t contracted 20 other attorneys or someone to talk about it with them.

MARABITO: The public accounting firms really did not care what the costs to clients were. They did not care about common sense. They just said, ‘We’re going to cover our butts. Whatever we have to do and however much time we have to spend, we’re going to bill you for it. We’re going to run it through 88 layers of management.’ I think it got a little bit ridiculous.

LEWIS: We’re also covering all of their insurance and exposure and everything else. So we’re paying a brand-new staff person who can’t even tie their shoe for less than $200 an hour.

MICHAEL S. DINANNO: I think hours are stabilizing, but that’s being offset by the rising cost per hour of audit time. Pay scales have escalated. It’s extraordinary what has happened to young people going into the public accounting industry … and for what we’re being charged for a first-year staff auditor who is just learning the ropes.

HEDGES: We’re like the others. We have increased costs. You’ve mentioned the relationship with your audit partner. Well, they’re no longer audit partners because they can’t make any decisions. They can’t say yes or no to anything.

The financial statements we are producing … I guarantee you, the average investor has no idea what’s in the notes. For example, we have five pages of notes on our pension liability. We have 11/2 lines on our $600 million inventory. My audit chairman asked me about one of our notes, ‘Do you understand it?’ I had to say no. If the professionals can’t understand what’s in these things, I’m not sure what we’re doing for investors.

FORWARD: Do you think investors care about these issues?
HEDGES: A lot more of our bonds now have clauses that don’t require the debt holder to file in the United States. It only costs us 50 basis points to get that, one time. All we do is file in Canada. So, how much do those bondholders care?

We’ve got nearly 90% of the bondholders. They voted as basically they don’t care.

LEWIS: When SOX first came out, people thought that if a company has a material weakness or deficiency, there would be a significant negative impact on their stock price. That didn’t happen. It appeared that people for the most part didn’t really care.

MARABITO: I think the market’s response is kind of a big yawn on all this stuff. On the flip side, my opinion is that it’s had to have had a negative impact on capital formation and smaller companies deciding whether to become public. It adds another level of complexity and costs that in other parts of the world you don’t have.

HEDGES: I hate to tell you guys, but I think there are frauds out there now that are being missed by Sarbanes-Oxley. If we have a downturn, we’re going to find out about them.

MARABITO: Crooks are going to be crooks. We don’t need legislation to do things the right way. Ninety-nine percent of the companies do it all right, and we’re the ones bearing the brunt of the cost and effort.