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July 1, 2006

What’s Your Worth?

There are plenty of sellers who would like to cash out at the top of the market, but not all will land their dream deal. A panel of six investment bankers explores the pressures and pitfalls of the acquisitions game.

The dramatic upturn of the metals market during the past two years opened a new round of merger and acquisition activity. Mittal Steel Co.’s brash bid for No. 2 steelmaker Arcelor S.A. foreshadows another round of mill consolidation that could lead to a mere handful of producers, each with the capacity to produce more than 100 million tons of steel a year.

Major acquisitions, such as the Ryerson Inc. takeover of Integris Metals Corp. and the Reliance Steel & Aluminum acquisition of Earle M. Jorgensen Co., have paced the action on the distributor side of the business, where an estimated 2,000 individual companies operate—75% of them privately held. Private equity firms, with large amounts of cash to invest, have entered the metals arena in deals such as Apollo Advisors’ acquisition of Metals USA and Platinum Equity’s purchase of PNA Group.

Forward recently convened a panel of investment bankers active in the metals industry to explore the consolidation trend and what it means for industry valuations. Their general conclusion: In today’s marketplace for metals companies, there are far more sellers who want to catch the top of the market than there are buyers, with plenty of pitfalls awaiting incautious buyers and family sellers. Financial buyers prefer to purchase large operations that can serve as platforms for expansion. Public companies provide a measure of confidence because their financial statements have been audited and are considered transparent. With liquidity in the market, it’s a good time to sell, but sellers must consider their own motivation. Do they want to stay involved or ensure that their management team is retained? How attractive is their company to buyers? Will their financial statements hold up to detailed, Sarbanes-Oxley-style scrutiny?

Another important valuation question: How long will this consolidation phase last? Takeovers continue in good times and in bad. Savvy buyers may prefer not to dole out top dollar now, but wait to pick up distressed companies on the cheap in the next down cycle.

FORWARD: We are in the midst of major industry consolidation. Have the large producer and service center mergers of the past year altered valuations for the metals industry? By how much?

Gregory Eck: It’s clear the industry is in a consolidation phase. This is very apparent for the mills. The service centers still are in the early stages. Either way, consolidation tends to raise valuations, in part through the positive effects on the industry, such as higher and significantly less volatile steel pricing. To get a sense of how positive the effects have been, there was a time when Wilbur Ross [the New York investor who consolidated distressed steel mill assets, then cashed out with great profits in the sale of International Steel Group to Mittal Steel] was able to purchase assets at $80 to $150 per ton. Today, Techint Group [the multinational based in Argentina with interests in steel, oil and gas, and engineering] is paying $800 per ton.

Is this shift permanent? I believe it is, as the consolidation we have seen to date is fundamentally changing the business.

Jonathan E. Rose: I don’t think the deals in and of themselves necessarily increase valuation. I think the market has changed, which has increased profitability and stability of the long-term outlook. These deals crystallize that everyone has a more optimistic view. I don’t think the multiples, per se, of the service center deals have gone up that much. Maybe they will over time.

JONATHAN E. ROSE, executive director in the investment banking department (metals and mining group) of UBS Securities LLC, joined the firm in 2002. He worked in a similar capacity at J.P. Morgan & Co. for five years. Prior to that, Rose worked for three years on behalf of the Harvard Institute of International Development in Poland. He holds a master’s degree in international affairs and a certificate from the Institute of East Central Europe of Columbia University, and a bachelor’s degree in economics from the University of Virginia.

FORWARD: How do you determine what a company is worth? By how much have valuations increased?

Sulian M. Tay: There’s been an increase in public equity market valuations for both producers and service centers. The drivers of this are increased profitability and confidence in the outlook for future profitability, coupled with an increase in the valuation multiples that investors are willing to pay for this higher profitability.

For instance, in August last year, Nucor was trading at about $55 per share. This resulted in a levered enterprise value of 5.3 times the consensus EBITDA estimate for 2006 of about $1.7 billion.

Today, Nucor is at $110 per share, which results in a levered enterprise value of 6.6 times the consensus EBITDA estimate for 2006 of about $2.5 billion. So profitability estimates have increased in the case of Nucor by almost 50%, and the valuation multiple has increased by about 25%, which work together to double the share price.

It’s not just that producer and service center profitability has improved.

There is confidence in the sustainability of that profitability improvement. This is what has caused valuation multiples to expand and what gives companies the confidence to pay more for acquisitions. They are more confident of earning an attractive return.

In addition, valuations in the merger arena are supported by access to less-expensive capital for the buyers. Companies in the sector have built cash surpluses and now have better access to debt financing on better terms than in the past. They have better terms on equity and equity-linked products, given their higher stock prices.

William G. Peluchiwski: We had swings in the price of raw materials and the price of steel, and as a result, we had a lot of gains in the value of inventory. Recognition of that has made the multiples come down. I think this upcoming year is probably the first year you will be able to see clean numbers, based on an understanding of what everybody can really do under more traditional market conditions.

MORTEN G. JORGENSEN, director in CIT’s Chicago-based mergers & acquisitions advisory group, was a vice president in the global industrial and services group at Credit Suisse First Boston, specializing in the capital goods sector. He then founded MGJ Advisory Group, an advisory firm focusing on corporate divestures. He began his career as an investment banking analyst in the mergers and acquisitions department of Morgan Stanley & Co. in London. Jorgensen received his master’s degree and bachelor of science degree in economics and business administration from Copenhagen Business School in his native Denmark.

FORWARD: How much further do we have to go in the consolidation on the producer side?

Rose: Whether [the Mittal-Arcelor] deal happens or another deal happens, the consolidation is here to stay, and within a few years, you will probably have five or so 100-plus million ton producers.

Eck: It depends on the end game. There’s quite a way to go if that means four or five operators producing 100 million tons each. For service centers, those numbers aren’t likely. However, there will be significant consolidation required to try to maintain some degree of equilibrium with consolidated producers. A softer metals market could drive additional consolidation by tempering seller expectations and facilitating more deals. However, too much of a slowdown would obviously hinder the market as a whole. In the end, consolidation is inevitable for both mills and service centers.

FORWARD: Won’t we see more action in the service center arena because it’s still so fragmented?

Morten G. Jorgensen: Given the fragmented nature of service centers, you’re going to see a lot more activity. Steel manufacturers are consolidated, and there is continued consolidation of steel users such as parts manufacturers. Steel distributors become a little piece of lunch meat in the sandwich, and in order for them to supply more demanding customers and even larger volumes, they really have to [become larger].

FORWARD: What can we look for in the aluminum industry?

Rose: It’s more consolidated now, and I think you’ll see different aluminum companies with different strategies—some having upstream and downstream vertical integration like Alcoa. Then there’s Alcan, which spun off [rolled products maker] Novelis Inc. to focus on primary aluminum. The verdict is still out on whether the Alcoa strategy or the Alcan strategy is the right one. Clearly, aluminum is more stable than the steel industry or certainly the service centers.

Jorgensen: The users of aluminum are consolidated. The aluminum beverage can industry is consolidated, as is aerospace. So that means equilibrium in the industry is much easier to maintain than it is in the steel industry.

WILLIAM G. PELUCHIWSKI, managing director in the Chicago office of Houlihan Lokey Howard & Zukin, leads the firm’s basic industrial group, in particular its efforts in the metals sector (manufacturing and distribution), transportation parts, chemicals, plastics, packaging and diversified manufacturing. Previously, he traded derivative equity securities on the Chicago Board Options Exchange and futures on the Chicago Board of Trade. Peluchiwski received a bachelor of science degree in finance and accounting from the University of Illinois and an MBA in finance and marketing from The University of Chicago. He is a certified public accountant and a chartered financial analyst, and is licensed with the NASD as a general securities registered representative.

FORWARD: Are there more sellers than buyers?

Rose: Right now, there probably are more sellers than buyers. I think there are more deals that are trying to get done than are getting done. The windfall profits of 2004, due to the rapidly rising steel prices, got owners thinking, “Oh gee, now is the time to get out. Even if I get a lower multiple, I’ll still make more money than I was expecting.” But the strategic buyers [those already in the industry] have been pretty disciplined, and they look for targets that either give them increased market share or maybe another geographical leg. It will be interesting to see if sellers’ expectations have moderated enough so that they will be willing to sell to the buyers that are out there. I don’t think there has been a crazy frenzy of buyers that are willing to overpay for assets right now.

Steven P. Anderson: I agree that today there are more sellers than buyers. On the other hand, it’s a very good environment. Deals can get done. There have been points in the cycle where, if you wanted to sell, there just was nothing out there. You couldn’t find interest on the equity side; you couldn’t get the debt financing. At least today we are in a pretty favorable financing environment, so it really comes down to a question of price. As a seller, am I going to be able to get the price that I want?

If you take a property to market, you will get bids. It’s a reasonably constructive environment for transactions, and I think as normalized earnings start to shake out through this year, it could disburse some additional activity.

Tay: Unlike in the recent past, strategic buyers have the resources to do deals. Capital for mergers comes from balance sheet cash that has built up over the last few years, as well as proceeds from debt or equity issuances. Debt financing is less expensive today for companies in the sector than in the past, and that is allowing more capital to be raised for mergers and acquisitions. With higher stock prices, companies have a more valuable currency to use in acquiring other firms.

In addition, you have to consider the synergies that can be driven through merger transactions. These also help pay for the deals. And because costs in the industry also are higher than they were a few years ago, synergy opportunities are more valuable.

FORWARD: What is the mix between private equity and the operating companies usually referred to as strategic buyers?

Peluchiwski: For all mergers and acquisitions, I would say 75% of our business is strategic; 25% is financial. Maybe that number in two years is 90% strategic and 10% financial.

Rose: I think if you look at a number of deals, more strategic deals are getting done, and those are the smaller ones. The only large deals done by strategic buyers were Integris and Jorgensen. Some strategics buy other companies to consolidate or shut them down. But Reliance, when it bought Jorgensen, said that other than the CEO moving on, the rest of the company was going to stay intact. And that’s what Reliance does with most other acquisitions.

Anderson: There are more strategics, but private equity firms certainly have been playing, and there are other firms that haven’t yet made an investment that are looking. One option that is off the table that maybe 10 years ago was much more realistic is going public. It’s very unlikely for a mid-sized company to view that as an attractive alternative. You have all the issues around the Sarbanes-Oxley requirements, director liability, and you have the lack of research coverage. Research analysts aren’t covering mid-cap stocks the way they used to, so valuations have suffered. The IPO option has been replaced by private equity or supplanted because these private equity firms have grown dramatically. The amount of capital they have under management is substantial, and what they can do with a business and with management can be very helpful and very significant.

STEVEN P. ANDERSON, director in the investment banking department of Credit Suisse, joined the firm in 1985. He went to Morgan Stanley’s corporate finance department in 1994 and ran its private wealth management practice in the Midwest from 2002 to 2004. Anderson rejoined Credit Suisse in 2004 and is based in Chicago. He received his A.B., magna cum laude, from Dartmouth College and his MBA with honors from The University of Chicago.

FORWARD: For a service center, is it better to be acquired by a strategic buyer or a private equity firm?

Eck: Strategic buyers in general are likely to pay a higher price for an asset because they can generate synergies from their existing platforms that a private equity group cannot. In some instances, customers can become concerned when their supplier is owned by a private equity group, with a potential short-term view. On the other hand, private equity will likely leave senior staff intact, which, for many family businesses, is an important point. In addition, leverage can be a key component, as service centers historically generate their greatest cash flow in a down cycle. Some equity players might be concerned about closing a leveraged deal in a working capital-intensive business during an up cycle.

Tay: Strategic buyers expect synergies such as overhead and operational improvement, and that can be painful for management and employees. Private equity buyers don’t have the expectations, but they do expect to generate value from the business. And this often comes from operational improvement, as well as from debt paid down over time. There is the risk that, in a down cycle, the company may endure hardship if little of the debt has been paid off. Typically, private equity firms set demanding goals for financial performance and will be diligent in monitoring progress toward them. Finally, a private equity firm may not view the company as a long-term holding, but instead, it may plan to sell it within a three- to five-year timeframe, either to a strategic buyer or in the public equity markets, or it may become more of a strategic acquirer itself.

Jorgensen: If a seller wants to stay invested in the sector, then a private equity buyer is viable because he may let the family take part of the proceeds and be long-term involved in the business. Also, you may be better able to take care of employees—the people that helped you build up.

Rose: Financial sponsors typically require more diligence. They spend a lot more time pulling apart all the numbers, and they hire accountants and consultants. They are not industry experts, so they usually hire an army of people to run through the company. It’s typically more of a process than it would be if you were selling to a strategic buyer that probably has been following the company for 20 years and, therefore, would require a little bit less diligence.

FORWARD: Is it easier for public companies or private companies to do deals?

Anderson: From a buyer’s perspective, it’s fundamentally more difficult to buy a private company. If I’m going make an offer on a public company, I know exactly where the stock price has been every day for the last number of years since it went public. I can pull all the public fillings, read about exactly what it’s done and know that the accountants had very consistent rules about how it’s all been reported. When you’re dealing with a private company—even with the best private company—there is a lack of transparency and a lack of experience.

FORWARD: Is it an advantage to be large or small?

Rose: I think it’s easier for larger companies to sell than smaller companies. There are a lot of really small service centers, and those are tougher to finance in the public capital markets. And there are more financial buyers interested in larger companies because they typically want to buy a platform they can use to grow and expand the business, and then sell out later at a much higher valuation. If you’re looking at some of these small guys with $20 million or $30 million in sales, it’s just very tough to use that as a platform acquisition.

Jorgensen: The question is whether a family has the resources and the desire to manage through the next down cycle. There will be privately owned companies that will see the opportunity to buy out competitors and relocate them or take them out to improve the pricing in the market.

Rose: O’Neal Steel has made several acquisitions recently, such as TW Metals. Macsteel is another privately owned service center that made small disciplined acquisitions. It’s more difficult for them to buy [a big operation] because then you would want to go to the public capital markets. But right now, their acquisition targets are within the realm of the things they can finance with bank debt and cash on hand.

GREGORY ECK, senior vice president and industry leader for steel and diversified metals at GE Commercial Finance’s corporate lending business, joined GE in 2002. He held various positions in risk and sales in the metals sector before being named to his current position in 2005, based in Chicago. Prior to joining GE, Eck held positions in the business credit group at Bank of America, where he worked for 14 years. He holds a bachelor’s degree from Northern Illinois University and an MBA from The University of Chicago.

FORWARD: What should a family know about positioning its business for sale?

Eck: A surplus of sellers raises the importance of capitalizing on a market niche to attract a buyer. That niche can be size, geographic footprint or product offering, just to name a few. Being a generalist without a market niche makes for a very difficult value proposition as a seller.

Rose: It can be difficult for public service centers to buy private ones because, if they buy a company that doesn’t have good audits and good accounting statements, they can’t necessarily get it onto their system when they have to. I’ve worked on deals where the reason a company couldn’t be bought was that the financial and accounting controls weren’t up to standard. If I were giving advice, I’d say get a good accountant and start doing your numbers now because that is what you’re going to need before you sell to anybody. You have a much higher valuation if you have transparent numbers that everyone trusts.

Anderson: For an entrepreneur to sell a company, it’s very significant, it’s very difficult, it’s very emotional. It’s still a change in control. There is a new boss. It can be collegial, it can be collaborative, it can be very positive, but it’s different. People should know that. It can be either a pleasant or unpleasant surprise. It’s a two-sided interview as to what the buyer wants and what the seller wants, and how everyone decides what is the best fit. While price is certainly important in any transaction, other qualitative issues will be pretty important.

If someone is contemplating a sale, he needs to be realistic about what the future prospects are if he goes it alone in the face of the consolidation. There is a tougher industry environment that we’ll all face at some point.

You need good accountants. Having someone that gives good advice with respect to estate planning and investments also is critical. I have seen so much value lost or even destroyed by having a poor infrastructure in terms of how the business is owned, how the family ownership has evolved over time. Taxes can absolutely kill somebody in a sale. We have all seen sales not go through because, at the end of the day, the seller decides, “Oh my gosh, I didn’t really fully focus on the fact that it’s not just a headline price. It’s what I net after all these other issues are taken care of.”

The entrepreneur is thinking about future generations and how they are taken care of. He is thinking about philanthropic interests and how that gets satisfied. He’s got his life tied up in this. These are fundamentals that can cause a fairly significant gap between what a buyer is willing to pay and what a seller really thinks he needs to make it worthwhile.

FORWARD: After a sale, how well do the previous owners adapt to the new structure?

Peluchiwski: With a change in control, there is a revised set of rules and revised set of demands from the new owners, whether it be a private equity owner who expects immediate financial feedback in terms of flash reports three days after the month closes—something they never even cared about before—or a strategic buyer that wants to know how we are going to grow market share. As a large organization, we now have more resources, but how do we use those resources?

Jorgensen: The major change is from a family-owned business that has been run very conservatively to a new owner. The new owner most likely is going to look for an angle to grow the business, offer more services, get more customers, take this business to the next level and achieve the economic return he needs. Some entrepreneurs do very well with this; for others, it’s hard.

SULIAN M. TAY is vice president in the industrials group at Goldman Sachs & Co., where she covers steel and steel-related companies. She moved to Goldman’s Chicago office two years ago after having been previously based in New York. She graduated with a bachelor’s degree from Harvard University and has an MBA from Stanford University.

FORWARD: Is it fair to predict that some service centers won’t be able to sell and will just go out of business?

Peluchiwski: A lot of people got into the automotive sector after World War II, and now some will go out of business because they’ve made enough, they’re just done and they don’t want to deal with it anymore. Also, there still is an industrial shakeout going on, with a lot of [manufacturers] going overseas. There still are too many [service centers] for the likely amount of business available.

Anderson: We have seen consolidation at [similar] points that was relatively favorable, and people exited voluntarily because they saw attractive valuations. We also have seen consolidation come at down cycles where people were forced to get out or were in a bankruptcy reorganization position and someone else was making a decision for them. Today, conditions are good and favorable, but there will be a time when there is consolidation activity not in the way everybody would want it to play out.

FORWARD: Each of you at some point have used the phrase, “When it gets bad”—not “If it gets bad.” When is it going to get bad?

Anderson: We have all been around long enough. We know these businesses are economically sensitive, and it’s hard to predict economic cycles—close to impossible to predict. But we have seen the cycles, and it hasn’t been cured. The continuing rise in energy prices certainly could put a wrench in the works.

FORWARD: What is the near-term outlook for North American metals and manufacturing?

Eck: It’s a good time for the industry. Global demand is up. Consolidation on a global scale [will] maintain a better supply/demand ratio, and buyers are accepting a new pricing paradigm that allows the industry to more efficiently pass through significant raw material/energy costs. In North America, the mills have generated significant cash flow for the last several years and are reinvesting in their quality locations, although there still are high-cost steelmaking assets in North America that will eventually go away. A significant core of low-cost, high-quality production is receiving the investment it needs.

The roundtable on valuation took place in early April and was moderated by Rebecca Rolfes, executive vice president of Imagination, which produces Forward for MSCI, and Judith Crown, senior editor of Forward magazine. Participants were Steven P. Anderson, Morten G. Jorgensen, William G. Peluchiwski and Jonathan E. Rose. Gregory Eck and Sulian M. Tay submitted written answers to questions.