STEEL INDUSTRY UPDATE
(With thanks to Peter Marcus of World Steel Dynamics)

• The steel pricing outlook has sharply declined in the last several weeks
  • Hot-rolled band ("HRB") prices are under pressure across the world, including in the U.S., EU, and China
    • U.S. HRB prices have declined below $550 per ton with some estimates as low as $520 per ton
    • European Union HRB prices are approximately $590-610 per tonne, down from over $650 per tonne in March 2005
    • China HRB prices are approximately $515-525 per tonne, down from over $545 per tonne in March 200
  • Major mills are experiencing a prolonged slump in new orders as steel buyers are still paring inventories that were built up in the fourth quarter of 2004
  • Steel price reductions to date have not had a positive effect on demand as many buyers face no immediate supply needs and believe that prices can fall further
• As steel prices decline and raw materials costs remain high, steelmakers may reduce production levels to establish a more favorable price/cost balance
  • In the U.S. and EU, Mittal, Arcelor, Thyssen Krupp, U.S. Steel, and Corus have already initiated production cutbacks
  • Japanese steelmakers may be the next to decrease their production levels since they face many of the high costs that plague the U.S. and EU producers
  • Chinese steelmakers could reduce their production levels in response to already falling prices and the Chinese government’s attempts to combat inflation in the raw materials segment
    • The Chinese Ministry of Finance has eliminated export tax credits for semi-finished steel and has cut the export tax credit for finished steel products from 13% to 11%
    • If the Chinese RMB is revalued this would push up Chinese steelmakers’ costs even higher
• However, the current market correction may result in a steel price rally later in the year
  • World Steel Dynamics puts the odds at 65% that HRB prices will rally in the fourth quarter of 2005
  • Steel prices may fall to levels that are perceived as bargains by buyers
  • Steel buyers are clearly paring inventory at the present time – the liquidation may run its course in the third quarter

STEEL INDUSTRY Outlook

A Word From Mike Locker —

The following was prepared by Michael D. Locker, President of Locker Associates, Inc., a New York-based consulting firm that specializes in providing advisory services to the steel industry. Mr. Locker is a new member of the Miller Mathis Advisory Board.

• For the first time in years, recently consolidated steelmakers are using pricing power to minimize the current decline in prices. However, with soaring raw material costs, hot-rolled band tags must stay above $500/ton for most integrated mills to make a profit. But minimills, which have lower operating costs, will remain profitable even if hot-rolled band prices drop to $450/ton.
• In the past two years, the steel market has become far more concentrated. In 2004 (adjusted to reflect the ISG-Mittal merger), the top five U.S. players sold 61% of all domestic steel shipped versus 39% in 1995, while the top three alone controlled nearly 50% of the market (compared to 28% in 1995).
• In Locker Associates’ opinion, U.S. steel demand and producer pricing power will hold hot-rolled band prices above $500/ton in 2005. However, unpredictable import levels could sink domestic steel pricing. China’s steel production and demand will remain the “tipping point” – if its economy weakens, then the world’s excess steel, now absorbed by China, will end up in the U.S., thereby pushing down prices. In our opinion, this is not likely to happen.
• A hidden pricing flaw continues to undermine steel producers. Hobbled by the antiquated per-ton pricing system, steelmakers are unable to generate adequate value for the lighter, stronger steels demanded by customers. If they fail to get out from under this burdensome system, their long-term financial stability will remain in jeopardy. The best solution: gradually shift to length or application-based measures instead of weight.
• Soaring Chinese demand has created a revolutionary rise in raw material pricing, especially for iron ore, coking coal, coke, alloys and, to a lesser extent, scrap. The price surge in the past 18 months has forced steel mills, raw material producers and Wall Street to reassess the strategic value of these inputs. Higher prices now justify substantial capital investments in raw materials -- even those with much higher production costs.
• One aspect of last year’s unprecedented price spike was particularly unexpected. Commodity hot-rolled band, not finished products like cold-rolled or galvanized coils, saw the greatest increase in prices. As a result, high quality commodity hot-rolled producers, like Algoma Steel in Canada, became investor favorites. Whether this shortage in commodity hot-rolled band is temporary or not, it caught many steel watchers by surprise.
• For a brief period in 2004, minimill production costs exceeded those of integrated mills. But the recent plunge in scrap prices (from $450/ton in late 2004 to $215/ton in recent weeks) has changed the equation. Minimill costs have dropped, while integrated raw material costs have remained high, shifting the cost advantage back to minimills.
• The number one factor determining the value of steel companies is legacy liabilities. While in many cases management and labor have reduced these costs to preserve viability, mills that have not yet restructured will be caught in a margin squeeze as prices decline. Legacy-burdened mills have a $30 - $40/ton disadvantage to restructured competitors.
• Although the North American steel industry has already undergone a major round of consolidation, much of it has occurred in the integrated sheet world. There is more consolidation coming for minimills, particularly long product producers. Remaining integrated “orphans” will not find a new home until lower prices again threaten their viability.
• In the long product minimill world, likely candidates for consolidation include Kentucky Electric Steel, Roanoke Steel, Connecticut Steel, Keystone Steel and Bayou Steel. The biggest minimill consolidator, Nucor, will not acquire any of these companies, because it does not buy unionized plants. This leaves an opening for other potential consolidators such as Gerdau Ameristeel or Commercial Metals to grow their capacity.
• Some pipe and tube producers, including NS Group, Maverick Tube, Lone Star Steel and other smaller mills are also potential acquisition candidates, particularly for Ipsco. Again, Nucor’s aversion to union operations will keep it away from this group.

HIGH YIELD UPDATE

A Word From Ed Altman —

The following was prepared by Dr. Edward I. Altman, Max L. Heine Professor of Finance and Director of the Credit and Debt Markets Program, NYU Salomon Center at the Stern School of Business. Prof. Altman is a member of the Miller Mathis Advisory Board.

• High-yield bond defaults were just $1.7 billion in the first quarter of 2005, thus continuing the trend of extremely low quarterly defaults that began six quarters ago in the fourth quarter of 2003. The dollar-denominated default rate was down to 0.18% from 0.32% in the fourth quarter of 2004. In 2004, high-yield bond defaults were $11.7 billion and the default rate was 1.25%.
• The default loss rate for the first quarter of 2005 declined to just 0.09% based on a weighted average recovery rate of 65.8%. In 2004, the default loss rate was 0.61% with a weighted average recovery rate of 57.7%.
• High-yield bond spreads vs. U.S. Treasuries are still quite low relative to historical averages. Spreads increased by 45bp during the first quarter of 2005, representing the first increase since the first quarter of 2004. However, the 359bp spread at the end of the first quarter was still about 130bp below the historical average. By April 19, 2005, the spread had increased to 395bp.
• In the first quarter of 2005, the proportion of new issues that were rated “B-“ or lower was a record 49.0%, thus continuing a trend that had started at the end of 2002. In 2004, this “bad cohort” represented 42.5% of all new issues. In the first quarter of 2005, the proportion of new issue dollars from firms rated “B-“ or lower was approximately 35%. The high proportion of poor credits among new issues is one of the main reasons for our forecast for higher default rates in the near future.
• After two exceptionally good years for high-yield and distressed investors in 2003 and 2004, returns in the first quarter of 2005 were relatively low. High yield bonds were down 1.48% for the first three months of 2005. The Altman-NYU Salomon Center Index of Defaulted Bonds was down 1.67% for the first three months of 2005, and the Index of Defaulted Bank Loans was up slightly by 0.86%.
• The distressed ratio increased from just 3.9% of the high yield market at year-end 2004 to over 5.0% at the end of the first quarter of 2005. The size of the combined face and market values of defaulted and distressed debt increased in the first quarter for the first time in over two years.
• New high-yield bond issues totaled $29.4 billion, down from the record quarterly average of $36.8 billion in 2004, but still indicating a solid market for new issues. The high-yield market’s total size increased by approximately 1.5%, to $952 billion.

If you would like to receive a free copy of Dr. Altman’s Report, “Defaults and Returns on the High Yield Bonds: First Quarter 2005 Update”, please call us.

UTILITIES UPDATE

A Word From Bob Rowe —

The following was prepared by Robert C. Rowe, former Chairman of the Montana Public Service Commission and a founding partner of Balhoff & Rowe, LLC, an advisory firm focused on the telecommunications industry. Mr. Rowe is a member of the Miller Mathis Advisory Board.

• The power transmission segment could be the next dynamic growth arena within utilities
  • There is strong demand for new transmission infrastructure
    • The development of the merchant generation sector and the adoption of competitive access models in the majority of the U.S. have exposed the current transmission systems as inadequate in meeting the needs of today’s complex universe of power produce
      • Most of the current transmission infrastructure was constructed by vertically integrated utilities for their own use – it was not designed to meet the needs of the multitude of merchant generators that are operating today
      • The proliferation of merchant generators and the adoption of competitive access models in many states have created a need for a transmission infrastructure that can handle increasingly complex functions that cannot be performed by the existing systems
    • Investment in transmission infrastructure has traditionally been highly cyclical and the industry has experienced a long lag since the last peak in the cycle
      • The last major investment cycle is now approximately 20 years old with investment peaking at $5 billion (2003 dollars) in 1975 and dropping to $2 billion (2003 dollars) in 1998
      • The ratio of dollars invested in new generation facilities to those invested in new transmission facilities is considered to be out of balance by many industry watchers
      • Most of the recent transmission infrastructure investments have focused on serving current customers and not on growth opportunities
    • Many utilities have successfully restructured their operations and now have the wherewithal to make investments that were previously impossible
      • Companies have streamlined their operations and divested non-core assets
      • A series of financial restructurings has allowed companies to deleverage their balance sheets

Our next issue will discuss the major issues facing investors in the transmission sector and the various strategies for successfully overcoming these hurdles.

NEW AT MILLER MATHIS —

Miller Mathis is pleased to announce the newest member of its Advisory Board: Michael D. Locker

Michael D. Locker is President of Locker Associates, Inc., a New York-based consulting firm that specializes in providing advisory services to the steel industry. Over the last 20 years, Michael has advised numerous companies, employee unions, and investors regarding steel company operations. Michael has been involved in restructuring efforts at AK Steel, Wheeling Pittsburgh, Stelco, Algoma, and LTV among others. He has also advised on the sale of numerous steel and forging plants throughout the United States. Recently, he has been an advisor to Stelco’s Lake Erie Local during the company’s CCAA proceedings, and also served as the Chief Restructuring Officer for J&L Structural during its Chapter 11 proceedings.

Locker Associates’ services include operational efficiency studies, industry analyses, and financial advisory. Michael often facilitates restructuring efforts and labor contract negotiations by providing an independent analysis of company and plant performance, including benchmarking and an evaluation of cost reduction and capital investment plans. These efforts typically include a comprehensive operational and financial analysis that is performed in conjunction with joint labor-management teams. Throughout his career, Michael has authored and directed over 100 such strategic and operational studies for the steel industry.

For the last 20 years, Michael has also edited and published Steel Industry Update, a monthly steel industry newsletter that is widely subscribed by top executives, union officers, and financial experts. Michael is a member of the Iron & Steel Society and has made numerous presentations to the Steel Success Strategies Conference, Institute of Scrap Recycling Industries, Canadian Steel Trade & Employment Congress, U.S. International Trade Commission, United Auto Workers, UNITE-HERE, and Teamsters. He has conducted training sessions at Wheeling-Pittsburgh Steel, Republic Engineered Steel, Stelco, AK Steel, IPSCO, Algoma, WCI, Bethlehem Steel, LTV Steel, Rouge, National Steel, USS/KOBE, Inland Steel, Co-Steel Lasco, Northwestern Steel & Wire, and Acme Steel. Michael currently serves on the Board of Directors of Special Metals, Meta Software, Boxingranks.com and MediaTEK Consulting.

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.