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Why Japan’s EF contingent is in no rush to consolidate

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The announcement that Kyoei Steel Ltd. and Tokyo Tekko Co. Ltd. are set to merge in October may not herald the long-awaited consolidation of Japan's electric-arc furnace (EF) sector despite its pressing need to do so, analysts and market players warn.

Under the deal, the two companies will both de-list and replace their shares with a new holding company on Oct. 1.

Kyoei Steel is 25.8-percent owned by Sumitomo Metal Industries Ltd. With annual sales of 149 billion yen ($1.52 billion) last year and an annual production capacity of over 2.5 million tonnes, Kyoei ranks as Japan's second-largest EF operator, after Tokyo Steel Manufacturing Co Ltd., and the country's leading rebar producer. With a production capacity of around 700,000 tonnes, Tokyo Tekko is Japan's largest producer of steel screws and rivets, last year posting sales of 61 billion yen ($623.2 million).

Japan's electric furnace sector mainly produces commodity-grade steel, principally for the nation's $12-billion construction steel industry, and is rife with overcrowding.

While the United States has three major mini-mill operators and South Korea has about six following a bout of mergers and acquisitions in the late 1990s, Japan counts 30 of them.

Many of the EFs in Japan are so small and inefficient that they are forced to operate mostly at night to save on electricity costs, and even the biggest players cannot compare with their counterparts in Korea.

South Korea's top EF operator, Hyundai Steel Co., for example, has 40 percent of the local steel bar market, with output of around 10 million tonnes, more than three times that of Japan's top steel bar maker, Kyoei Steel, which has 12-percent share of the Japanese market.

Tokyo Steel Manufacturing, Japan's largest producer of construction steel, has a market capitalization of $2 billion, less than a third of Hyundai Steel's and a fraction of Nippon Steel Corp.'s $45-billion market cap.

"This is a sector that is in desperate need of serious consolidation, given the long-term demand outlook for commodity-grade steel—especially from the construction sector—yet I am not sure it will happen anytime soon," an executive at Kyoei Steel said.

The past couple of years have seen a flurry of activity as steelmakers seek to strengthen their ties with each other. Kyoei Steel, for example, has share cross-holdings with Godo Steel Ltd. and Kishiwada Steel Co. Ltd., while Japan's top steelmaker, Nippon Steel Corp., has snapped up or increased its stake in several small steel firms as it seeks to raise its output of high-grade steel by shifting lower-end production to smaller affiliates such as Nakayama Steel Works Ltd., Chubu Steel Plate Co. Ltd., Oji Steel Co. Ltd., Hokkai Kogyo Co., Suzuki Metal Industry Co. Ltd. and Sanyo Special Steel Co. Ltd.

JFE Steel Corp., meanwhile, has boosted its stake in Maruichi Steel Tube Ltd., while Nippon Steel and Sumikin Stainless Steel Corp. increased their share in Takasago Tekko KK.

But all these moves have done little to spur any real restructuring, particularly in terms of capacity reduction. "Rather, they are holding it back by preventing companies from simply going under," says one industry analyst who asked not to be named,

The problem is that many of these alliances are no more than just cross-shareholdings undertaken to thwart unwanted take-over bids.

Despite his protestations that the Japanese electric furnace sector is in dire need of consolidation, even Kyoei Steel's executive acknowledged that its ties with Godo Steel and Kishiwada Steel are unlikely to develop, at least anytime soon, into full-blown alliances. "We have no intention of seeking full business integration with either of these companies," he said. "We don't believe that we need any further consolidation for the time being."

For a while, the sector seemed to be able to cope with the situation, particularly with demand for Japanese steel soaring and the major integrated steelmakers finding it hard to keep pace with customer orders. By acquiring stakes in EF operations, they could shift the production of commodity-grade products to their partners while focusing on producing higher-grade steel products such as auto sheet and shipbuilding plate.

But the collapse in global steel demand in the past year has shown the short-sightedness of this tactic as demand for steel from sectors such as the construction industry has totally collapsed.

Yet, ironically, Nippon Steel, in particular, is likely to see considerable financial benefit from its EF acquisitions. While the parent company has had to struggle in a highly depressed market with raw material costs set in April last year at record-high levels, its EF subsidiaries have reaped the rewards of the sharp collapse in ferrous scrap prices and are expecting bumper profits this year as a result.

But raw material costs have not been universally welcomed by EF operators. "Obviously, lower scrap costs reduce our production costs. But they also prevent us from increasing our sales prices," a Tokyo Steel executive said. "We would much rather have higher scrap prices and higher sales prices than low scrap prices and low sales prices."

Another difficulty slowing EF consolidation is the frequent lack of truly effective synergies. The Kyoei Steel executive admitted as much when arguing that the scope for it to push for additional business alliances was limited. "Tokyo Tekko fits in very well with us, not only because it is strong in eastern Japan and we are strong in western Japan, but its position as Japan's largest steel screw and rivet manufacturer and ours as the number two player gives our combined operations domination of this segment of the market," he said. "But its hard to find similar synergies with other companies."


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