Having fallen from its high point in 2000, mergers and acquisition activity within the steel industry has slowed in both volume and value of transactions.
According to Brian Grant, managing director at Conway MacKenzie Inc., an international consulting and financial advisory firm, merger and acquisition (M&A) activity in the steel industry has been down for a few years now.
“Despite the need for further consolidation in the industry and relatively low valuations, the continued uncertainty in the outlook for steel and financial challenges of would-be acquirers has contributed to low M&A activity,” Grant said. “However, the mini-mills have fared much better than the integrated steel mills have over the past several years and are starting to use their cash and relatively strong balance sheets to vertically integrate.”
Nucor’s acquisition of Chicago-based Independence Tube Corp. and Steel Dynamics’ acquisition of Vulcan Threaded Products are two notable transactions that demonstrate this trend whereby steel makers are buying higher-margin downstream businesses, effectively shoring up captive demand for the steel produced from their mills.
In October 2016, St. Louis based Alter Trading Corp acquired “substantially all of the operating assets” of Rockford based Behr Iron & Metal, which owned the vast recycling facility on the far southern edge of Peoria, Illinois. The acquisition includes nine of Behr’s metal processing facilities in Illinois, Iowa and Wisconsin, including three shredding operations and a specialty metals operation, according to a release.
“It is certainly an interesting time in the steel industry now,” said Aaron Witalec, managing director at UHY Advisors Corporate Finance, LLC. “On one hand, you see industry players who are focused on growing their companies through strategic acquisitions in the industry. Their reasons can vary from a desire to expand into adjacent geographic markets, realize synergies, or better position their organization for the next market up-trend. As in many industries, business owners in the steel market are starting to sense stronger headwinds and, because of this, may be leaning more toward an exit than they were just a year ago.”
It’s vital to understand that the global steel demand has increased at 4.2 percent annually over the past decade, however, world steelmaking capacity has expanded at a rate of 6.2 percent annually and has been higher than demand since mid-2014.
“In 2015 China produced 50 percent of global crude steel while also fulfilling slightly over 51 percent of demand,” said Jeffrey Zappone, senior managing director at Conway MacKenzie, Zappone is a certified turnaround professional and a member of the Turnaround Management Association, American Bankruptcy Institute and the Association for Corporate Growth. “In recent years, China has scaled back real estate and infrastructure investments, reducing their demand for steel. Falling demand coupled with falling prices, partially due to oversupply in the market, has the country’s steel industry poised for further consolidation.”
The metals deals market remained relatively slow in the third quarter of 2016. Zappone said that while the average deal size increased slightly during the quarter, this was largely driven by two transactions, which accounted for 78 percent of total value. “Overall, the value and number of deals continues to trend well behind historic levels. Depressed metal prices, global demand and economic uncertainty continue to plague the relevant deal markets,” Zappone said.
While global M&A activity in the metals industry continues to fall, the average deal size appears to increasingly signal that industry consolidation is maturing. The acquisitions of Wuhan Iron & Steel Co. ($4.2B) and Aleris Corp. ($2.3B) in Q3 2016 accounted for 58 percent of the quarter’s total deal value.
“Consolidation and vertical integration have become the solution for many companies as larger and more diversified operations can recognize cost savings through economies of scale and are able to mitigate the risk of negative product or market segment conditions,” Zappone said.
Grant agrees. “The steel industry is consolidating,” Grant said. “Steel has always been a highly cyclical industry with periods of excess production capacity, but the present state of the industry is different than previous downturns.”
Grant said that there is far too much under-utilized global capacity and the industry needs to adjust; by consolidating, costs can be lowered and production can be distributed to the most efficient assets. Unfortunately, because many companies in the industry are financially suffering, this means that a number of them won’t make it through this consolidation process.
Continued M&A in the steel industry will lead to fewer players in the market; those that remain, will be larger and better equipped to handle market challenges. “Consolidation lends itself to vertical integration as companies look to cut costs and boost sales via expanded product offerings and customer bases,” Zappone said. “The number of U.S. enterprises in the steel industry is expected to decrease at an annualized rate of 1.1 percent through 2021.”
Challenging markets and infrequent deal flow have also led to lower exit valuations impacting investors (PE and other shareholders) as they try to monetize their investments.
“Steel producers and metal service centers have had their EV/EBITDA multiples drop 16 percent and 9 percent respectively since the beginning of 2016,” Zappone said. “Within the U.S., multiples are down because cheap scrap has given electric arc furnaces a cost edge versus integrated producers using blast furnaces which suffer higher variable and fixed costs from labor and raw materials.”
That said, integrated steelmakers have looked to defensible markets with high grade products or specialized inputs such as automotive high strength steel and the petroleum sector.
“However these markets have struggled with their own issues – auto sales slowing and aluminum substitution and declining oil prices,” Zappone said. “Current steel prices would indicate that many steel producers are cash flow negative. Declining revenues and pricing have also negatively impacted the steel industry.”
Indeed. As Witalec noted, the volatility of commodity prices has further pushed the private business owners towards considering a potential exit, especially as many borrowers have an asset-based lending (ABL) arrangement with their financing source.
“Any swift decline in commodity prices can cause a borrower in the steel industry to easily fall out of compliance with their loan covenants,” Witalec said. “In these circumstances, a sale may be a viable option.”
As the steel industry continues to consolidate, industry players, particularly metal recycling operators, which operate in a highly fragmented network with low market concentration, will be reliant on fewer customers.
According to Zappone, due to high transportation costs, industry operators position themselves to be as close to clients as possible. As such, scrap metal recyclers tend to be located in manufacturing regions as well as highly populated urban areas. For example the Great Lakes region accounts for 31 percent of iron and steel manufacturing in the U.S. with the largest share of that region in Ohio (11 percent) with 27.4 percent of all scrap recyclers located within the Great Lakes region.
Despite high transportation costs, the export of scrap metals still accounted for approximately 30.2 percent of 2015 revenue. However, this number is down from the nearly 50 percent export generated in 2011 primarily due to slowing demand in emerging markets such as China and a stronger U.S. dollar.
As noted, most of the trends in the M&A activity within the steel industry relate to vertical integration. Grant noted that the strongest steelmakers will continue to look at higher-margin downstream acquisition targets.
“On the upstream side, there will likely be consolidation amongst recyclers,” Grant said. “Industry players should pay attention to the larger competitive dynamics within their markets to assess what level of consolidation is likely and where they fit into that process.”
Remember, global steel demand has increased at 4.2 percent annually over the past decade, however world steelmaking capacity has expanded at a rate of 6.2 percent annually and has been higher than demand since mid-2014. In 2015 China produced 50 percent of global crude steel while also fulfilling slightly over 51 percent of demand.
“In recent years, China has scaled back real estate and infrastructure investments, reducing their demand for steel. Falling demand coupled with falling prices, partially due to oversupply in the market, has the country’s steel industry poised for further consolidation,” Zappone said. “Globally, the metals industry has experienced a decline of 17 percent while the average deal value has seen a 143 percent increase over the same period.”
Over the last three years, M&A in the metals industry was led by industry participants. However, activity is shifting from industry participants to financial investors, which accounted for almost half of the activity in Q3’16.
As Zappone explained, financial investors are entering into the industry as prices remain at their lowest levels in a decade and domestic demand is expected to grow approximately 13 percent to 102.9B tons by 2021.
In Q3’16 a trend towards local, in-country (not cross-border transactions) deals accounted for 89 percent of total deal volume and 92 percent of total deal value. North America accounted for approximately 24 percent of deal value while the Asia & Oceania region continued to lead in M&A representing 60 percent of value for the quarter.
“While U.S. M&A activity has slowed down compared to the considerable activity earlier in the past decade, the total number of operators has declined at an annualized rate of 4.5 percent to 365 companies over the last 5 years,” Zappone said. “Through 2021 the number of steel companies in the U.S. is expected to decline at an annualized rate of 1.1 percent to 353 facilities due to consolidation and closures.”
Despite the current high level of excess steelmaking capacity and weak market conditions, capacity is projected to grow further in 2017 as current projects come online.
“Asia will account for 71.3 percent of the 2017 100.3 million tpy capacity increase,” Zappone said. “North American capacity is expected to remain the same with a 3.2 million tpy increase expected in electric arc furnace capacity offset by closures of 2.2 million tpy capacity in blast furnace operations. There are no capacity additions underway in the EU, LA, Israel or Australia.”
According to Witalec, currently, valuation multiples in the metals sector are under competing pressures. The need for acquisition-driven growth among public buyers is keeping M&A multiples healthy.
“Conversely, downward pressure is being created from distressed deals in the market that are trading at asset value,” Witalec said. “Buyers are weighing the relative value of acquiring a distressed asset versus a healthy business that will not require as much management time. In addition, financial buyers, especially at the lower end of the middle-market, are beginning to drive-up deal multiples.”
Industry experts agree that the industry is largely looking towards 2017 for a recovery after a disappointing 2015-16. Positives include many U.S. and European industry players accumulating large cash balances available for acquiring new businesses. In order to compete more effectively with foreign steel producers, large domestic manufacturers may look to acquire smaller steel mills.
“Financial sponsors also have the potential to boost global transactions and deal values, with U.S. private equity firms sitting on a record $1.31 trillion in unvested capital according to Prequin,” Zappone said. “However, private equity dry powder hit a record number of $1.1 trillion in 2013 – the prior record was 2008 – and has only grown in the last 2 years. These companies have been patiently waiting for the right time to invest. However, volatile but generally rebounding steel prices, stronger downstream demand and increased product differentiation are all possible to revitalize industry revenue in the coming years.”
Published in the December 2016 Edition of American Recycler News