The signature steel deal of 2004 may well be the announcement last month of the impending sale of Wilbur Ross’s International Steel Group (ISG) to Lakshmi Mittal’s Mittal Steel, a newly formed combination of Ispat International and LNM Group. If and when consummated, the combined company will bolt to number one in the steel business with approximately 60 million tons of annual production. Of particular interest, though, is that ISG was not even a company two years ago – it is a conglomeration of steel assets that were assembled by Ross between 2002 – 2004 from the ashes of several U.S. steel bankruptcies (LTV, Bethlehem, Weirton, etc.). He only took the company public in December 2003.

What the Mittal/ISG deal really reflects is the economic opportunity that can be created in a cyclical industry like steel if you catch the cycle at the right point. Only a little more than one year ago, the steel industry was in the dumps, with the price of hot rolled band (HRB) at about $250 per ton. Fast forward one year later and the price of HRB was recently over $700 per ton. Steel companies that showed only red ink for the last several years are now coining money. EBITDA for the global steel industry in 2004 is expected to be $113 billion, or $117 per tonne shipped, versus $60 billion in 2003. Free cash flow (before dividends and equity infusions) is expected to increase to $31 billion in 2004 versus $12 billion in 2003. What happened?

First, remember that steel is a cyclical business. 2004 was the upslope on the Bell curve. Second, there are three key factors that are driving the steel business currently: China, metallics and consolidation.

China. Over the course of the last five years, China has become the biggest worldwide consumer of steel. Chinese steel demand grew at 20% per annum from 2000 – 2003, and at about 13% in 2004. Total Chinese production in 2004 is estimated to be 269 million tonnes (out of roughly 1 billion tonnes worldwide). Due to this enormous growth, a great deal of China’s steel requirements were imported. This in turn created an enormous selling opportunity for non-Chinese steel companies and forced up the price of HRB.

Metallics. At the same time that steel prices have reached new highs, a countervailing force has been the lack of availability, and increased cost, of the various raw materials necessary to steel making, including coking coal, pig iron and scrap. While these costs have not risen as fast as steel prices, we have nonetheless entered into the “Age of Metallics” according to Peter Marcus of World Steel Dynamics, noted industry expert. While previously the availability and pricing of these raw materials was relatively stable, over the past year or so the situation has completely turned around. Now, coke is in short supply worldwide, giving those steel makers that are internally coke sufficient a huge advantage over non-coke sufficient producers. Indeed, Peter Marcus speculates that continuing surging coking coal and iron ore prices in early 2005 will add about $35 per ton to integrated steel mill costs. Mini-mills, which require scrap, have similarly seen the cost of scrap soar, from $70 per ton in 2001 to over $200 per ton currently. High grade automotive scrap is now about $410 per ton. Peter Marcus notes that if China’s steel demand grows at just a 5.7% per annum compounded rate, and the rest of the world at 2.3% per annum compounded, global demand for steelmakers’ metallics would rise to 1.8 billion tons by 2015, or 500 million tons more than in 2004. Clearly, the availability and pricing of metallics will affect the steel industry for years to come.

Consolidation. Last, but certainly not least, there is now a clear worldwide trend towards consolidation in the steel business, an industry that has historically been extremely fragmented at the producer level. Indeed, if the Mittal/ISG deal goes through, the resulting company will only have about 6% of the worldwide steel market.

Upstream from the steel producers, at the raw materials level, significant consolidation has already occurred. For example, there are basically only three iron ore producers in the world. And downstream from the producers, at the customer end, significant consolidation has already occurred. For example, about 90% of the world’s automotive business belongs to about ten companies including the Big Three in the U.S. (GM, Ford and Daimler). This upstream and downstream consolidation allows for pricing discipline and efficiency, which is notably absent at the steel producer level – as witnessed by the 45 or so steel bankruptcies that occurred in the U.S. over the past five years. Those producers, each of which had only a tiny share of the domestic market, simply could not survive in the face of an inherently cyclical steel marketplace. Parenthetically, we note that among the hardest hit constituencies in this last bankruptcy shake-out were the workers, as companies went out of business, assets were sold and redeployed, and pensions were diminished.

Most analysts believe that brighter days likely await the reconfiguration of the old hub-and-spoke networks that Which brings us back to the ISG deal. A year ago, due to the then-down cycle of the steel market, this deal would not have occurred. A year later, due to the exuberance of the market, everyone involved looks like a genius. As they say, a rising tide lifts all boats. The question, though, is where is the steel business headed now? In 2005, Peter Marcus foresees a reduction in spot prices, higher raw materials costs, but relatively stable EBITDA due to higher prices in the one-year contract market. He estimates that EBITDA for the global industry will decline by 16% to about $95 billion, or $95 per tonne shipped.

What’s our View?
Our belief is that consolidation will continue to drive the steel business for the foreseeable future. Companies such as Mittal Steel and Russia’s OAO SeverStal have demonstrated the will and ability to deploy their considerable assets across a worldwide spectrum. This affords them the hedge of owning assets in lower cost, developing markets as well as in higher cost, more developed markets. Alexey Mordashov, SeverStal’s dynamic Chairman and 85% owner, has articulated a vision shared by many participants and observers in the steel industry, that there will be a small handful of mega-steel companies within the next five to ten years, each producing around 100 million tons of steel annually. For this vision to occur, a lot of M&A activity must take place on a worldwide basis over a relatively short period of time.

The following circumstances further support consolidation: (1) the price of most steel company stocks is up substantially, thereby enhancing the currency for acquisitions, (2) steel companies are flush with cash as a result of the resurgent market, (3) debt has been paid down, thereby improving balance sheets and enhancing borrowing power, (4) it is still cheaper to buy steel assets than to build new ones, and (5) the steelworker unions should be in favor of consolidation. This last point is particularly important, as we believe that the unions think they would fare better in the next (inevitable) industry downturn from the pricing discipline and efficiency created by consolidation.

Another key factor favoring consolidation is the ability under U.S. bankruptcy laws to jettison onerous legacy expenses (pension/OPEB). Wilbur Ross was able to turn ISG into a relatively low-cost producer overnight via the turnover of ISG component company pension liabilities to the PBGC. Effectively, this amounts to a Government-sanctioned subsidy, which will further facilitate the urge to merge and acquire.

With consolidation as a backdrop, every steel company in the world must – in real time - reassess whether they are a buyer, a seller, or will they attempt to hold their position. Tectonic plates are shifting in the steel business, and every company must quickly develop a vision of where they want to be when the plates stop shifting.

In 2004 this worldwide repositioning has already resulted in SeverStal’s successful acquisition of Rouge Steel (formerly U.S. #5), the ISG/Mittal announcement, and the current battle for Stelco, Canada’s largest steel maker, which pits SeverStal, U.S. Steel and other potential strategic and financial bidders*.

Stay tuned. We’re in for what looks like an interesting ride.

* The principals of Miller Mathis represented Rouge Steel, and the firm currently represents SeverStal in its proposed acquisition of Stelco.

New at Miller Mathis
Miller Mathis is pleased to announce the second member of its Advisory Board (as of January): Robert Rowe

Bob Rowe is the Chairman of the Montana Public Service Commission, with which he has served since 1993. During his tenure with the PSC Bob has been nationally recognized for his expertise in both telecommunications and energy matters. Rowe’s work emphasizes developing, building support for, and implementing constructive solutions to complex or intractable telecommunications and energy issues. When his term ends in January 2005 Bob will be joining a consulting practice, Balhoff & Rowe, focusing primarily on financial and policy issues affecting the telecommunications sector.

Bob has been President of the National Association of Regulatory Utility Commissioners (NARUC). He also served as Chairman of the NARUC Telecommunications Committee; Member and State Chairman of the Federal-State Joint Board on Universal Service; Member of the Federal-State Joint Conference on Access to Advanced Services; Chairman of the Regional Oversight Committee (ROC) for Qwest; Chairman of the thirteen state collaborative on Operations Support Services and Qwest’s compliance with Section 271 of the Federal Telecommunications Act; and, a member of NARUC’s Intercarrier Compensation Task Force.

In telecommunications, he proposed and led a unique thirteen-state effort that succeeded in achieving Qwest’s compliance with the market-opening provisions of the 1996 Federal Telecommunications Act. He proposed and helped implement a joint federal and state effort to promote broadband deployment and access. As a member of the Federal-State Joint Board on Universal Service he focused on developing sustainable approaches to building and maintaining the networks that serve much of America.

In energy, Bob led the NARUC effort to develop comprehensive positions on federal energy legislation, established a program of Congressional briefings, and led the early effort to understand and respond to the natural gas price rise in 2000. Bob led the Montana Public Service Commission’s efforts to ensure stable and reliable electric and natural gas supplies for residential and commercial customers in the wake of Montana’s 1997 energy restructuring. He has testified extensively on legislative matters, and led the Montana PSC’s successful effort to pass landmark state energy legislation. Bob organized and led the PSC’s successful participation in NorthWestern Energy’s Chapter 1l bankruptcy reorganization.

Bob has testified before Congress, including the Senate Commerce Committee, the Senate Energy Committee, and the House Commerce Committee. He has presented to international conferences including the International Telecommunications Union Development Symposia. He was co-chairman of the first World Forum on Energy Regulation (Montreal 2000), and led two NARUC-NECA National Summits on Broadband Deployment and Access.

Bob has served as a member of the Michigan State University Institute of Public Utilities Advisory Committee; the New Mexico State University Center for Public Utilities Advisory Council; the University of Florida Public Utility Research Center International Advisory Committee; the University of California at Berkeley Center for Research on Telecommunications Policy External Advisory Board; the Washington State University Center to Bridge the Digital Divide Advisory Council; and, the National Regulatory Research Institute Board of Directors.

Miller Mathis worked closely with Bob on the NorthWestern Corporation bankruptcy, which resulted in a consensual solution that balanced the interests of the company with those of its regulators who we represented. Bob will officially join the Miller Mathis Advisory Board in January, after his term as Chairman of the PSC has expired. As a member of the Miller Mathis Advisory Board, Bob will work together with the firm on all telecommunications and energy related matters.

A Word From Bob Rowe --

Are regulators from Mars and investors from Venus?

Regulators and investors in regulated industries are concerned with large and critical parts of the economy, industries that are “affected with a public interest” or occupy the economy’s “commanding heights.”

Regulators are charged with “balancing the interests” of shareholders and ratepayers; or achieving various rate and service objectives; or most broadly and also most vaguely, serving the “public interest.” They can’t get the job done without sufficient levels of investment, debt and equity, and without reasonably clear financial regimes in place.

Investors, and those who advise them, need to understand the rules that affect the flow of capital and risk within sectors, and that set the broad terms for many company-to-company and company-to-customer interactions. They also need to understand the offsetting benefits and costs of economic regulation. Good regulation may provide transparency, predictability, and confidence, and facilitate relatively smooth transactions. On the other hand, regulatory compliance often constitutes a significant business expense, regulation can raise the cost of or even block what would be beneficial transactions, and has the potential to create a deadweight economic loss.

What do regulators need to know about the financial community?
What do investors and analysts expect? Do investor expectations inevitably conflict with or, especially over the long-term, perhaps compliment consumer objectives? Is “back to basics” in energy still in fashion? Are all telecom sectors perceived as equally risky, and what regulatory policies most affect risk?

What does Wall Street need to know about economic regulation?
What value do regulators really assign to electric reliability, whatever happened to concerns about “gold plating,” and what policies might be adopted to achieve greater reliability? Is “restructuring” dead, or are competitive energy markets still on the march? How will telecom regulators treat “cross-platform” as opposed to on-platform (via unbundling) competition? How will the complicated web of intercarrier payments, implicit and explicit support mechanisms be changed, and will technology and market forces overtake efforts at regulatory reform?

Do regulators, and perhaps fixed income investors as well, expect certain basic rules and disciplines to be implemented?

Will Congress pass either comprehensive energy or telecommunications legislation in 2005?

Over the coming months, as part of Miller Mathis’s “Thoughts” pieces, I will attempt to sort through some of these issues. I’ll focus on areas where the arranged marriage between the financial community and regulators is most critical.

I’ve concluded twelve challenging and exciting years as a regulator, serving on the Montana Public Service Commission. During that time I’ve been deeply involved at the state and national level in efforts to restructure the energy and telecommunications industry, sometimes followed by attempts to undue the unintended consequences of the first round.

Miller Mathis is a boutique investment bank that provides its clients with sophisticated insights and creative solutions for complex business issues.

The views expressed herein are those of Miller Mathis only. Nothing contained herein should be considered as investment advice. Miller Mathis disclaims any and all responsibility.