For those of you who don’t know me, I’d like to briefly introduce myself. I’m a triple threat guy – an investment banker, a lawyer, and a jazz musician. The latter may be my most important attribute, since it allows me to improvise when the stuff hits the fan, as it always does in deals. I run an independent investment bank based here in New York that specializes in the steel industry. This gives me an excellent perch from which to observe and comment on the current M&A environment in the steel industry.

As we all know, 2004 was a watershed year for the global steel industry, as profits soared, primarily as a result of dramatic growth in China. So far, 2005 has been a watershed year as well, but for very different reasons. The steel market has softened dramatically, with buyers sitting on inventories and prices decreasing. China is a big question mark. This is further evidence of the cyclicality of the steel industry.

The questions that I want to discuss today are: what are the most important factors that will influence the long-term growth and prosperity of the steel industry? And, how can steel makers best protect themselves against the dark forces while taking advantage of industry opportunities?

The first thing we must realize is that, in the words of my friend Peter Marcus, the steel industry has entered the “Age of Discontinuity”. This means that many of the old rules are out, forcing a new way of thinking. Going forward, I believe that the three major watchwords of the industry will be consolidation, metallics, and technology. I will discuss each of them briefly.

Consolidation: The steel industry must consolidate if it is to soften, if not avoid, the periodic pricing death spirals and shakeouts that occur in a completely fragmented industry. The last several years have witnessed a great deal of consolidation, especially in North America through the bankruptcies of over 50 steel companies, but this is still an industry where the top 5 producers account for just 20% of total world production. In contrast, looking upstream, the top 3 iron ore companies control nearly 70% of the market, and, looking downstream, the top 5 automakers control 55% of their market.

Two important bullet points under global consolidation:

1. Each steelmaker must decide whether they are a buyer or a seller, or do they try to hold their position. The latter strategy is problematic, however, as it ignores the fact that many small competitors will disappear and will be replaced by larger and stronger rivals who will only get bigger and stronger. Soon, it is widely expected that the steel industry will feature several mega-steelmakers, each with 100+ million tons of capacity, and each with a stable and predictable supply of raw materials. These steelmakers will have the wherewithal to service any multinational client in any location within the shortest of time frames, and they will have the price leverage with their suppliers and their customers to avoid the debacles of the past. How will the non-consolidators keep pace with these Goliaths? Will the growing disparity between the larger and smaller companies neutralize the smaller companies or energize them? These are serious questions that every steelmaker must consider.
2. If the steel world is moving towards a handful of mega-companies, where is the additional capacity for these companies to come from? The world’s largest steel company is currently at 70 million tons. The second and third largest steel companies are at 50 million and 35 million tons, respectively. For these three companies each to be at the 100 million ton mark they will need to acquire more than 150 million tons of capacity. Where will this new capacity come from? Given that most state-owned steelmakers will not be for sale and that many companies are too small to affect the consolidation equation, the competition for attractive, mid-sized assets could be fierce. This may explain the recent bidding war for Mexico’s Hylsamex, which traded at a premium to market expectations. Clearly, quality mid-sized independent steel makers will benefit from this “urge to merge” mentality.

Metallics: The global steel industry is so large now that even marginal increases in production spur large increases in the demand for raw materials. Peter Marcus refers to this phenomenon as the “Tyranny of Large Numbers”. With the global demand for steel expected to grow at more than 3% per year over the next 10 years, the industry will be scrambling to find the raw materials to fill that new demand. This growth will likely create a need for more than 500 million tons of new metallics by 2015. This situation will further skew the competitive balance between steelmakers that have metallics and those that don’t, and between steelmakers and raw materials providers. The 71% price increase for iron ore that was pushed through in early 2005 gave a grim preview of what may develop if this latter imbalance is not corrected. This is why so many steelmakers have made it a strategic priority to ensure a predictable supply of iron ore at reasonable prices. Every steel company that we know is looking for a hedge and a wedge in iron ore. The most successful steel companies will succeed in balancing their raw materials needs.

Technology: The “X” factor in any industry, including steel, involves technological innovation that shakes up and alters the status quo. New technologies that will make it cheaper and more efficient to produce steel, with less emphasis on metallics, could change the competitive equation going forward and alter the fundamental economics of the industry. For example, Kobe Steel’s Mesabi Nugget project and other liquid pig iron production processes such as HIsmelt, Corex, and Finex may open a new frontier in innovative steelmaking technology. Those companies that proactively embrace new technological changes and implement them into their processes will be successful; those that do not will find it more difficult to keep up.

To summarize, I anticipate the following movements in the industry:
For the larger steel companies:

1. They will continue to move forward in their quest to reach the 100 million ton level, which will help to rationalize the industry and create operating and pricing efficiencies.
2. The focus of consolidation for the large companies will be (a) the desire for geographic and economic diversity, as they seek to balance low cost emerging markets assets with assets from higher cost developed markets, and (b) the need to own and control their raw materials.
3. Those larger players with the strongest currencies – cash, liquid stock and debt capacity – will have a big advantage over those that do not have one or more of these attributes.
4. Perhaps the most important factor of all will be the majors’ ability to act boldly – to make quick, decisive, informed decisions in a highly competitive environment.

For the smaller and mid-level steel companies:

1. The better run companies that put themselves up for sale could be the big beneficiaries of the consolidation era. The relative scarcity of superior companies will create a highly competitive environment and lead to significant valuation premiums.
2. On the other hand, those smaller and mid-level companies that choose to stand pat will have a more problematic situation, since they will come under severe and increasing pressure as they attempt to compete against ever more formidable larger, integrated companies.

For all steel companies:

1. Control of metallics, and adapting to technological advances, will be the defining characteristics of successful steel makers.
2. Those steelmakers that lead the way in consolidation, metallics and technology will increasingly widen the gap between the haves and the have nots in the industry.

I thank you for your attention, I wish you all the best of luck in meeting these challenges, and I hope to meet more of you as you steer your companies through this brave new world.

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