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March 1, 2005

Power Balance

The Chinese economy is devouring the world—commodities as well as finished goods. But when the dragon is full, what becomes of global markets? And what if this dragon is, in fact, insatiable?

The big are getting much, much bigger in the metals industry these days. Ryerson Tull, already the nation's largest metals service center operator, with sales of more than $2.2 billion, buys Integris Metals, with sales of more than $1.5 billion a year. Global steel magnate Lakshmi Mittal buys International Steel Group—itself the creation of recent consolidation—and merges his holdings into a new Mittal Steel, the world's largest steel maker with shipments of about 57 million tons annually.

Consolidation is not a new phenomenon in the metals industry, but these recent mega-deals, and others of lesser magnitude, promise to alter significantly the balance of power in the business. Just a few years ago, service centers and other metals buyers had the upper hand as they shopped for the best possible deals among mills, many of them in Chapter 11 or otherwise ailing, all of them fighting for share in a saturated marketplace. “Advantage, customer,” and to lock in desperately needed volume, mills and service centers often signed long-term supply contracts at low prices and meager margins.

“Remember, for the last several decades the steel mills have slowly been committing suicide, destroying their capital base and earning far less than the cost of capital,” says Lloyd O'Carroll, senior vice president and chief economist for the Scott & Stringfellow Inc. division of BB&T Capital Markets. “Pricing has not been adequate, largely due to the structure of the industry, and that's one reason why consolidation needs to continue. You either earn your cost of capital or you die.”

Then, only 18 months ago, everything changed. Beginning in the fourth quarter of 2003, the metals oversupply evaporated. Increased demand from rapidly growing China was one reason (Forward, January/February 2005), but in addition, the generally healthy world economy consumed metal and raw materials at an unprecedented rate. Global steel shipments exceeded 1 billion metric tonnes for the first time, the International Iron & Steel Institute reported. With prices for all metals, scrap and related materials soaring, the metals business became profitable once again, attracting previously scarce capital that facilitated this new round of consolidation. (See Capture Capital)

In 2000, the three largest steelmakers in the world—Nippon Steel, Posco Steel Works and Usinor Steel—shipped between 20 million and 30 million tons each. This year, however, the equation has changed, with the pro forma Mittal and Arcelor (created in 2001 with the merger of Aceralia, Arbed and Usinor) expected to ship more than 40 million tons each, and U.S. Steel, Posco, Nippon and JFE Steel Corp. each shipping more than 30 million tons. With the completion of its ISG acquisition, Mittal's North American output will approach 30% of the total market—not quite a stranglehold, but a significant reduction in alternative resources for steel, and an equally significant shift of resources to financially secure hands. “Advantage, producer.

A RISING TIDE

The rising tide has lifted all boats, and with few exceptions, everyone in the metals business did very well in 2004.

“It has been very good for all of us,” says David H. Hannah, chief executive officer of one of the industry's most active consolidators, Reliance Steel & Aluminum Company of Los Angeles (See MAP). “If you didn't have your best year or darn near your best in 2004, you ought not be in this business.”

Clearly, consolidation is good for consolidators, who build economies of scale, market power and negotiating strength with suppliers and customers.

“Larger and more established companies like EMJ have certain advantages over smaller companies, such as obtaining higher discounts associated with large volume purchases, the ability to service customers with operations in multiple locations, the use of more sophisticated information systems, and the availability of sufficient working capital to expand product lines, facilities and/or processing capabilities,” Earle M. Jorgensen Company told the Securities and Exchange Commission in a candid assessment of why size matters.

Consolidation is also usually good for the consolidated, who although acquired, gain the clout, scope and resources for growth intrinsic to being part of a larger and theoretically more prosperous company.

ANY SINKERS?

Mills and distributors that choose to go it alone, doing business the same old way, counting on existing relationships for supply, sales and growth are the potential losers in the current environment.

Consolidation, says Tim Doherty, sales and marketing vice president for Wixom, Michigan-based Almetals Co., a specialty metals supplier, will create “a small number of very large players offering an extensive variety of plain vanilla products at competitive prices. At the other end of the spectrum will be a large number of very specialized suppliers, or boutiques. I believe that mid-sized companies that try to be all things to all people will disappear.”

Observers identify a number of important likely consequences of industry consolidation.

First of all, because there are fewer yet stronger domestic sources of supply, pricing in most market environments will emphasize profits and not just cash flow. Put another way, there is no incentive for mills to resume the pricing death spiral when they are financially healthy and metal is in short supply, or even in supply-demand equilibrium. This could change very quickly if Chinese growth slows and the substantial new metals production capacity there needs to find additional markets for bargain-basement steel.

Second, there is every reason to believe that to counter the growing power of fewer mills, consolidation will continue among distributors. “Our industry still has room for consolidation, and we have an appetite to continue it,” says Hannah of Reliance. Since 1994, when Reliance completed an initial public offering, it has purchased 30 companies to diversify and to improve its customer base, product breadth and geographic coverage. Revenue during that period rose from $371 million in 1993 to nearly $3 billion last year.

“Since there are fewer suppliers, you want to have a number of service centers that have significant size and can stand up to suppliers and be important to them,” says Dieter Hoeppli, an executive director at UBS Securities and a senior member of the UBS Investment Bank's global metals and mining team. William G. Peluchuwski, a managing director at Houlihan Lokey Howard & Zukin, the Los Angeles-based investment bank, estimates that consolidation among metals producers has created a distribution overcapacity of 10% to 20%, adding further pressure for additional distribution mergers.

Third, consolidation forces more companies to investigate new business models, such as additional product lines, new services and improved customer relationships.

For example, C d'A Metals of Spokane, Washington, added aluminum to its product mix when steel revenue plunged 30% as Northwest aluminum smelters shut down in response to rising prices for electricity. Aluminum alone restored revenue to previous levels in less than 12 months, and a new, real-time inventory control system has added additional efficiency while improving customer service.

“Now with the new computerized tracking system, we have a totally accurate picture of where all our orders and inventory are in the plant and the state they're in,” says Larry Coulson, chief operating officer. “Before when people went out on the shop floor they were trying to expedite orders. Now they do it just to get some exercise. We have been earning a bigger share of a shrinking market and the new system has played a big part in it.”

Almetals moved into foil-gauged metals, of less than 0.005 of an inch thickness, after examining the needs of customers for its clad products, used for bearings, gaskets, battery cells, heat exchangers, transition joints and other products. “After doing our due diligence on [foil's] market potential, we realized it was a business opportunity that could deliver double-digit profit margins,” says Doherty.

Almetals has worked harder to be part of its customers' design processes. Two such design initiatives led to $10 million of annual sales with auto parts makers.

Similarly, Eaton Steel Bar Co. of Oak Park, Michigan, has built a significant business based on its cold drawn technology, says Gary Goodman, its president. But relying so heavily on that product isn't enough, Goodman says. So he sent eight of his top executives to spend two days each week for a month on a thorough product and service analysis.

From this, Eaton has developed four strategic alternatives, including product diversification, expanded geographic coverage, creation of a new product development team and creation of a new customer development team. Eaton has also established an accredited metallurgical laboratory and delivers metal using its own trucking fleet.

“In 2004, base trucking rates jumped 3% to 10%,” Goodman says. “Even more important, industry overcapacity disappeared as public carriers had no spare equipment, so by using our own private fleet, we still could almost always find a way to make emergency deliveries to regular customers.”

These and other changes have produced solid results. “It looks like 2005 will be our second-best year ever—after 2004,” Goodman says.

Fourth, consolidation forces all distributors to manage and solidify their supply base. In some cases, that will mean finding better sources of offshore supply. That move has already begun. Net U.S. and Canadian imports of aluminum more than doubled in 2004, while U.S. steel imports rose more than 50%.

Fifth, consolidation feeds on itself and creates an environment in which selling a family held enterprise becomes more attractive. For example, service center membership in the Metals Service Center Institute fell by more than 100 companies from 1996 to 2004, with 70% of the decline due to consolidation.

“The issues that caused owners to consider selling to us were either personal in nature or for liquidity, estate planning or succession issues,” says Hannah of Reliance, which has found its share of owner-operator companies to buy. “All the companies we've taken on since 1994 are viable, successful businesses.”

Finally, consolidation coupled with the substantially higher prices that end users pay for metals adds to pressure among some manufacturers to find alternative materials. “Automotive manufacturers are developing new components that reduce or alter their use of metals,” says James Gillette, an analyst for CSM Worldwide Inc., in Farmington Hills, Michigan. “There is demand for composites, including lighter weight aluminum and magnesium. It's just the start, because many auto component suppliers don't have the margins to hold on and are not in a position to charge the end customer for increased steel prices.”

The key, says Bert Tenenbaum, president, Chatham Steel Corp. of Savannah, Georgia, (part of Reliance Steel & Aluminum Inc.) is to find a niche, assess the customer base and your market position, adjust products and service offerings to fit real needs – and then repeat the whole process.

“Ultimately, service centers need to understand the value they bring to the market, and charge accordingly,” Tenenbaum says.

SUCCESS LIES IN THE SUM OF ITS PARTS

In the past decade, Reliance Steel & Aluminum Co. has acquired companies in 27 states in the United States and three countries outside of North America (Belgium, Korea, France) to diversify and to improve its customer base, product breadth and geographic coverage. This map shows the number of acquired operations per state across the United States.