White hot takeovers harden steel market

Steel has been hogging newspaper headlines across the world in recent weeks, thanks to soaring steel prices, booming emerging economies and feverish M&A activity. How can you play the M&A boom?

Steel has been hogging newspaper headlines across the world in recent weeks, thanks to soaring steel prices, booming emerging economies and feverish merger and acquisition (M&A) activity.

Steel sector M&A activity: Arcelor and Corus

The highest profile M&A in the sector recently has been the proposed purchase of French steelmaker Arcelor by Lakshmi Mittal's Mittal Steel. But after months of talks, Arcelor has now moved to buy little-known Russian steelmaker Severstal in the hope of blocking Mittal Steel's offer, says Peter Marsh in the FT. If it pulls off the Severstal deal, Arcelor will make the merged firm "the biggest in the world", with more than 20% market share in the global automotive steel industry. It will also give its main shareholder, Alexey Mordashov one of Russia's wealthiest men, with a personal fortune of £4.5bn a 38% stake in the merged entity.

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The deal would leave him with a minority stake in Corus and Evraz and give the British firm a foothold in the Russian steel sector an attractive proposition for them, since they currently have no access to the raw materials necessary for making steel and are forced to buy in iron ore at high prices.

But that's if someone else doesn't get there first. Speculation is "stalking" Corus as bid fever grips the sector, says Manfreda Cavazza in the Daily Mail. With Lakshmi Mittal's attempts to buy Arcelor hitting a wall, Corus is thought by some to be his latest target. But while shares in the firm were up strongly on hopes that Mittal might switch his attention to Corus, some analysts have sought to calm investors' excitement, reminding them that Mittal Steel's moves in the past have been in growing and emerging markets. But it certainly demonstrates that the steel sector is hot.

Steel sector M&A activity: consolidation

Why the lust for consolidation? Steel is a fragmented global industry, with the top ten firms accounting for just 30% of global production, say Mark Milner and David Gow in The Guardian. This highlights the industry's basic problem. Adapting to sharp swings in demand in this cyclical arena is not easy. Steel production can't be turned off and on "at the flick of a switch". Producers prefer to sell at any price rather than shut down, a stance that has been encouraged by governments, which value employment more than profits. The solution they think is bigger firms, which are more likely to be able to close capacity to align supply with demand and have more power in negotiations with raw-materials suppliers.

PriceWaterhouseCooper calculates that the steel sector saw 165 deals worth a combined $27.4bn last year. And now China is becoming a "focus for activity" too, as it encourages consolidation among its own steel firms, which could lead to overseas purchases. With this trend in place, the sector should remain a hotbed of M&A activity for the foreseeable future, making it a reasonable bet for investors.

The two best ways to play the M&A boom

Morgan Stanley analysts Charles Spencer and Scott Hudson believe investors should own European steel stocks, given the strong demand and pricing in the sector and the consolidation potential. The key is that after a "surprisingly strong" first half, producers are attempting a third-quarter price increase of €30-50/tonne of which they may be able to push through €20/tonne. Industry sources are indicating another price increase in the fourth quarter, and under-geared balance sheets are likely to be "put to work" via M&A.

Their top pick is Evraz (HK1q.L), which they rate overweight. It is the leading producer by volume in Russia and generates 60% of its sales there. It is cutting costs and has a very low-cost position, with 80% integration in iron ore and 100% in coal. Its p/e ratio is a low 6.3 times 2007 estimated earnings and it yields a hefty 8%.

ThyssenKrupp (TKAG.DE) was recently upgraded from neutral to overweight by HSBC Global Research. Its value-creating and restructuring measures should "offer results" by 2007. The automotive division is operating at "breakeven", and it is optimistic over pricing trends in stainless steel. Another positive is German corporate tax rates, which "should fall" by 2008. Its p/e ratio is nine times 2007 estimated earnings and it yields around 4%.

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