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November 1, 2006

Together Again?

U.S. steel producers, flush with cash, could get back into the distribution business.

U.S. steel producers spent decades divesting service centers. Mills worried about keeping the plants running efficiently, while service centers monitored the pulse of a fragmented and diverse customer base. Given those diverging imperatives, divorce seemed reasonable.

Yet less than a decade after the breakup of Ryerson Tull Inc. and Inland Steel Co.—the last and most successful of the mill/distributor pairs—there is speculation that mills and service centers could get together again.

Mittal Steel Co.’s acquisition of Arcelor SA earlier this year shows that steel industry consolidation is far from over and that the industry is awash in cash to make deals. Could forward integration be the next step? Such a combination would mark a return to the integrated model that has been the norm in Europe (See “Distribution, Euro Style”).

Second marriages and a re-integration of the industry could have its benefits. It could help tame the sometimes undisciplined metals supply chain and give mills a better view of demand. But it also could reignite old problems that plagued the industry before. Would a mill sell to a service center owned by a rival producer? Would customers be better served?

“I don’t want to see it happen,” says Parke McConnaha, senior buyer at BT Prime Mover, a maker of forklift trucks in Muscatine, Iowa. “The service centers are generally more attentive; they are customer-driven. The mills say you’ll get it when you get it.”

McConnaha says the issue seems mostly theoretical at this point, yet it has resurfaced because there is so much money available to do deals. The subject comes up continually: “What [else] are they going to do with the cash?” says J. Michael Marks, managing partner at the Indian River Consulting Group in Melbourne, Florida, which focuses on distributors.

Edward M. “Bud” Siegel, Jr., president and CEO of Russel Metals Inc. in Mississauga, Ontario, observes that once all the low-hanging fruit has been picked in terms of the mills acquiring other mills, the service center industry is the next logical place for acquisitions. There’s a concern, he notes, that if the mills keep generating cash at the same level and don’t spend it on further acquisitions, “some hedge fund will tell them how to spend their cash.”

Already, there are some modest signs of a new generation of mill/service center combinations. Acquisition-minded distributor Esmark Inc., of Chicago Heights, Illinois, hopes to create an integrated but regional niche player if it wins control of Wheeling-Pittsburgh Corp., for example.

Germany’s ThyssenKrupp AG is seeking a mill in North America to supply its service centers and has said it may build a greenfield mill in the Southeast if it doesn’t win control of Canadian producer Dofasco Inc. Mittal, during its takeover battle for Arcelor SA, struck a deal with Thyssen to sell Dofasco, which previously had been acquired by Arcelor. The Dofasco shares are now in a trust and can’t be sold, Arcelor maintains. Mittal says it is committed to completing the deal with Thyssen.

These initiatives suggest that the idea of forward integration could take a different form than in the past—perhaps alliances driven by service centers intent on nailing down secure supplies, says Gregory R. Eck, senior vice president for General Electric Co.’s Corporate Lending Group. Alternatively, a service center company could be acquired by a foreign mill interested in further penetrating the U.S. market.

“Service centers are more focused on supply and may be open to a strategic alliance,” Eck says.

NOT SO FAST

The wave of North American service center divestitures ended in 1998 when Ryerson Tull, now known as Ryerson Inc., emerged as an independent company at the time the steelmaking operation of parent Inland Steel Industries was acquired by Ispat International N.V., now Mittal.

Ryerson, then and now the largest single service center operator in North America, had been owned by Inland since 1935 and had been successful, in part, because it was given resources to grow, says Robert E. Powell, former vice president of sales for Inland.

But when the steel industry in the 1970s and 1980s came under pressure from imports and scrap-fed mini mills, the producers were forced to divest service centers and focus on their core business.

For example, Jones & Laughlin Steel Corp. sold its steel service center operation to Tulsa, Oklahoma-based Williams Co. in the early 1980s, prior to parent LTV Corp.’s acquisition of Republic Steel. Bethlehem Steel Corp. sold J.M. Tull to Ryerson in 1986 after owning the distributor for only a year.

United States Steel Corp. sold U.S. Steel Supply Co. in 1986 at the time it reorganized as USX Corp. In 2001, it launched an online distribution service, Straightline Source, which competed with its service center customers, but it closed the operation in 2003 after it ran up losses.

When the mills owned their own service centers, “the reality was that the people running the steel companies were often manufacturing and research engineers and cost managers,” Powell says. “Distribution was a different kind of animal, dominated by commercial people and entrepreneurs who were used to turning inventories and caring for customers.”

Often, the two sides of the business were not on the same page, he says. When business was slow, some mill managers demanded that service centers buy their product. During peak demand, service centers expected more product than the producers wished to direct to them. Pricing often was in dispute.

“There was little effort on top management’s part to really understand the distribution business,” he says.

Another perennial problem is the risk of alienating suppliers and customers once alliances are formed. Mills risk angering distributor customers if they team up with one of their competitors. Would a producer sell to the service center owned by a competitor, especially when steel is in short supply? Would a service center owned by a mill be able to get enough supply from other mills?

Any mill that buys a service center still would be dependent on other service centers to buy its products. Any gain in sales could, and probably would, be offset somewhat by a loss of business from its other service center customers, says David H. Hannah, CEO of Los Angeles-based Reliance Steel and Aluminum Co., the industry’s second-largest service center operator.

Then there is the consideration of whether any service center can provide enough market penetration.

“There are no U.S. service centers that are large enough to make a big difference to a mill,” Hannah says.

Indeed, big mill takeovers of service centers won’t happen until there is a lot more consolidation in the distribution sector, says William G. Peluchiwski, managing director of Houlihan Lokey Howard & Zukin in Chicago. Even Ryerson isn’t large enough for a mill on the scale of Mittal. “If it was three times larger, that would change the equation,” he says. “The time will come, but I don’t know if the time is quite yet.”

UNCONVENTIONAL ARRANGEMENTS

While no one expects big service center acquisitions by giants Mittal, U.S. Steel Corp. or Nucor Corp., mills and service centers could get together in unconventional ways, perhaps in smaller regional alliances or with a foreign partner as a way to achieve global expansion.


A ROUND OF PARTNERSHIPS COULD BE DRIVEN MORE BY SERVICE CENTERS CONCERNED ABOUT SECURING SOURCES OF SUPPLY, ESPECIALLY AS MILLS CONSOLIDATE AND BECOME MORE DISCIPLINED ABOUT CUTTING PRODUCTION DURING DOWNTURNS IN DEMAND.

—Gregory R. Eck, senior vice president, General Electric Co.’s
Corporate Lending Group

If mills do return to distribution, it is likely to be as part of a global expansion, says Nick Sowar, global steel industry lead at Deloitte & Touche LLP in Cincinnati. In an increasingly globalized market, he suggests that the U.S. mill that supplies a factory in China or an auto plant in Eastern Europe might want to control the downstream end to help finalize that transaction, or to bend or warehouse the steel.

Eck says a round of partnerships could be driven more by service centers concerned about securing sources of supply, especially as mills consolidate and become more disciplined about managing production.

An example is Esmark’s bid for Wheeling-Pittsburgh, which would create a regional, niche company, says Esmark CEO James P. Bouchard. If successful, Esmark plans to double its network of service centers to 20 from 10 in the area that’s roughly between Pittsburgh and Chicago with “just-in-time delivery in 48 hours,” he says. “We want to have the most efficient supply chain to keep costs down for the customer.”

But the formula won’t be for everyone. Bouchard agrees that the largest mills are unlikely to adopt the European model because it would be difficult to fashion a mill/service center strategy on a national scale.

“They’re just too big,” Bouchard says.

A SYMBIOTIC RELATIONSHIP

A wave of mergers between producers and service centers in the United States could have some beneficial effects in combating inefficiencies of the inventory cycle. Mill ownership of distributors would give them a better understanding of shifts in demand and enable them to adjust their own production, says Michelle Applebaum, a steel analyst and managing director of research firm Steel Market Intelligence in Chicago.

Forward integration would help resolve “one of the remaining industry issues: the destructive inventory cycle that results in overbuilding at the peak, and then over-liquidation at the trough,” Applebaum says.

She cites the recent roller-coaster ride in the price of commodity-grade hot-rolled coil, which was more than $700 a ton in September 2004, but dropped to $400 a ton in July 2005. In June 2006, it was back to $550 a ton and was hovering at $600 earlier this fall.

“It was not a business cycle in the traditional sense; it was an inventory cycle. Prices doubling and halving from one period to another is not a healthy phenomenon,” she says. “It speaks of an inefficient market.” An improved flow of information between the two ends of the business would align production more closely with demand and contain volatility, she says.

If the mills could avoid the mistakes of the past and run service centers by staying hands-off, they’d have a beautiful barometer of what was happening at the customer level and a related but diversified cash flow stream, Applebaum says. “It would make for a very symbiotic relationship.”

Others say mills with cash to invest could buy service centers because it is a logical way to expand sales, earnings and market share.

Acquiring service centers would give mills a way to sustain growth and, for public companies, satisfy the demands of Wall Street, says Nicholas D. Tolerico, who retired as president of ThyssenKrupp Steel Services of Richburg, South Carolina, at the end of last year. Acquiring a service center, he notes, can give a steel mill “an immediate pop to sales and earnings.”

He estimates that there currently are about 16 major U.S. flat-rolled service center operators that are large enough to be of interest to a mill, he says. The publicly traded companies and larger privately held concerns may not cover the country, but they have dozens of locations with a broad line of products.

Also, the sale of service centers to mills could be an attractive exit strategy for private equity firms that only recently have bought into metals distribution.

So far, only a handful of firms have made deals. Among the most high profile, Apollo Management LP of New York purchased Metals USA Inc. of Houston last year, and Platinum Equity of Los Angeles acquired PNA Group Inc. in May. But Peluchiwski points out that many more have tested the waters, either by responding to solicitations or bidding unsuccessfully.

Tolerico predicts that private equity firms will buy more service centers, which have “all the good characteristics that the private equity guys like—they’re highly liquid, with relatively constant cash flow, and easy to finance through asset-backed loans,” he says.

But private equity firms usually have a three- to five-year time frame for generating high returns on the investment, so a distributor owned by a financial buyer is destined to come onto the market sooner or later.

Will mills and service centers learn from the mistakes of the past and try it again? It comes down to whether there is a perceived competitive advantage. If service centers felt they could gain security of supply and mills believed they could lower distribution costs or get a view of the market shifts sooner, it just might happen. Or does the bad memory of turmoil and estranged relationships still linger?