China now dominates the global steel industry, producing about 500 million tons of steel, or roughly 40% of the world's steel supply. China's steel industry is growing at about a 10% annual rate, which is nearly five times the growth rate of steel in the rest of the world. While only five years ago China was a relatively small blip on the global steel radar screen, now it is the driving force behind the current steel supercycle.

Much of China's steel is going into infrastructure development, including roads, bridges, and office buildings. Indeed, if you travel around China today by car, you will likely be driving on some highways that were not in existence only a few years ago. These roads are so new, in many instances, they do not yet have any roadside amenities such as gas stations and restaurants. Overall, the effect of observing China at this time, particularly as the country prepares for the 2008 Olympics, is probably much the same as if one were living 150 years ago and observing America's Industrial Revolution.

Two forces are shaping China's steel industry. The first is internal consolidation, as China attempts to eliminate many smaller, inefficient steel mills and to concentrate its growth in the larger, mainly state-owned mills. The second is China's need to upgrade the quality of its steel. Indeed, one of the major complaints in the past about China's steel has been that it was primarily commodity-grade. But now, to compete on a global basis, Chinese steel companies generally realize they must upgrade their product quality to world-class levels.

Tantalized by Prospects for Growth

While the Chinese might eventually be able to do this on their own, it would undoubtedly take much time and effort. The better and quicker solution-particularly for the smaller, non-state-owned Chinese companies-is to partner with a global, non-Chinese steel company, whose know-how, technology, and skills can help the Chinese to quickly upgrade their steel production.

And of course, the global steel companies all want to do business in China, as they are extremely attracted to China's remarkable growth story. For example, in regard to the automotive industry, fewer than 50 in 1,000 people in China now own a car, while in the U.S. it is closer to 8 in 10. Steel companies that make automotive steel covet this growth potential.

China is the centerpiece of the global steel consolidation story led by Arcelor Mittal (MT), the industry leader with about 130 million tons of production, or roughly 11% of the world's steel market. The major steel companies are all seeking to develop a balanced portfolio of developed- and emerging-market assets, the former due to their stability and high value-added products and customers, and the latter due to their lower costs and higher growth rates. China and India are the big prizes among the emerging-market countries.

The Last Market for Relative Bargains

One big advantage of cross-border Chinese steel deals is in valuation. Because of all the hurdles to these deals, the Chinese steel M&A market is not nearly as efficient as the non-Chinese steel M&A market. In fact, China is probably the last market where Western steel companies can obtain relative bargains. Most Chinese steel companies are not public companies, and therefore have no fiduciary requirements to conduct auctions.

So, given the desire and need of the Chinese steel companies to upgrade their product quality through relationships with the large, successful non-Chinese steel companies, and the desire of the non-Chinese steel companies to participate in China's phenomenal growth profile, one would guess there have been a great number of cross-border M&A transactions.

However, to date, there has been only one completed cross-border transaction: Arcelor Mittal's 2006 minority investment in Hunan Valin. Indeed, the second announced proposed transaction, in which Arcelor Mittal hopes to acquire a minority stake in Laiwu Steel, has not yet received the requisite Chinese approvals.

An Arduous Approval Process

Why the dearth of steel transactions? There are three primary reasons. First, China has declared steel to be a protected industry. This means all steel transactions must obtain governmental approval. There are usually three levels of approval that are required: local, provincial, and, finally, the central government. This approval process can sometimes be long and arduous. BR> Second, as of now, foreign steel companies are limited to owning a minority interest in Chinese steelmakers. This raises several issues, including that large Western steel companies, which are used to calling the shots with respect to their investments, can neither have absolute control nor majority vote. This makes foreign companies much more dependent upon the honesty, good faith, and fair dealing of their Chinese partners. In addition, it puts non-Chinese companies in the somewhat precarious position of being asked to transfer their technology and know-how to a company that they do not control, and that operates within a country which has not always recognized the sanctity of intellectual-property rights.

Third, there are still significant cultural and business obstacles to overcome. China is new to capitalism. Many steel mills and other businesses were not run for profit in the past, but rather as a means for employment. Chinese accounting standards differ from international standards. Language differences can be an obstacle, too.

Having a Team on the Ground Helps

However, the M&A pendulum is beginning to swing in the other direction. Smaller Chinese companies, particularly those that are privately owned, do not draw as much attention from the Chinese political machine as the larger, state-owned companies. Recently, for example, the opportunity to invest in a privately owned Chinese specialty steel company has attracted a great deal of interest from a number of large, multinational steel companies. This transaction is far less likely to draw the kind of political scrutiny and attention as those involving a larger, state-owned company.

What are the elements for success in China steel transactions? First, having a team on the ground in China, composed of experienced Chinese steel professionals, is critical to the transaction process. A team is important in virtually every respect, from identifying good Chinese prospects, to facilitating communications, to the nuts and bolts of a transaction including plant visits, due diligence, and deal negotiations. Every venture takes preparation, and matching Chinese and non-Chinese companies requires extreme sensitivity to each side's business, cultural, and political hot buttons.

Second, personal relations are critical. Because of the political, cultural, and business disparities between the Chinese and non-Chinese, business relations will grow and flourish only if a bond of trust is developed between the parties. To do so, communication and relationships at the highest level of each organization must be facilitated.

State-Owned Companies Draw Scrutiny

Third, flexibility is essential. Doing business generally in China is still much like being a stranger in a strange land. If global companies approach Chinese companies with rigid expectations, they will be sorely disappointed. Chinese steel transactions are much more art than science, as the parameters of control and other required business terms are defined on a case-by-case basis.

Fourth, patience is required. As noted above, all steel transactions in China must receive governmental approval. This is a somewhat arbitrary part of the deal process, as there is no set time frame and no fixed set of rules. Connections obviously help.

Fifth, look for smaller, private companies. The larger, state-owned companies draw the most scrutiny. In contrast, smaller companies, and privately owned companies, are either off the radar screen or much less significant, thereby enhancing the ability to close the transaction. And many smaller-company opportunities exist today.

Global Consolidation Will Come to China

I believe it is only a matter of time before the Chinese government loosens its rule against foreign majority ownership in the steel industry. China's governmental policies are evolving. The needs of Chinese steel mills for foreign investment, know-how, and technology are too significant for the ownership policy to remain stagnant. Within a few years' time, I predict, the Chinese government will allow foreign majority ownership. When that occurs, those foreign companies that are already doing business in China as minority partners, that have shown themselves to be good corporate citizens and valuable partners, will in essence be grandfathered under the new system. They will have greater opportunities than nonparticipants.

China remains a country of great industrial opportunity. The needs of the Chinese and foreign steel companies are complementary. Global steel consolidation will eventually come to China. The industrial, sales, marketing, and distribution power of the larger, global steel companies is too significant to be denied to the nation with the greatest needs and growth profile.

Robert M. Miller is senior managing director of Miller Mathis & Co., an independent investment bank whose industry focus is steel, metals, and mining.

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