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Analysts see a lot more upside upstream of distribution


If there's a cheering section for mills interested in buying service centers, it's not on Wall Street.

While some distributors continue to look over their shoulder at the possibility of mills moving into their home turf, securities analysts who follow steel and other metal producers don't see much support for such a move in the equity markets.

"I guess anything is possible, but I'm not hearing an awful lot about it," said Leo Larkin, equity analyst for the Standard & Poor's division of the McGraw-Hill Cos. Inc., New York. Like others, Larkin pointed out that producers such as Nucor Corp., Charlotte, N.C., and Steel Dynamics Inc. (SDI), Fort Wayne, Ind., have instead been either going upstream to secure in-house supplies of scrap and metallics or, when they travel downstream, look for fabrication or processing operations. While he's aware of the theory that mills could turn to distribution once "there's nothing left for them to buy," Larkin still thinks there's going to be more opportunities upstream.

Another analyst who isn't a fan of producers getting into distribution is Charles Bradford, who follows the metals industry for Soleil Securities/Bradford Research Inc., New York. "I think they have better things to spend their money on," he said, arguing that a mill could "antagonize its customers" by buying a service center.

Bradford pointed out that, unlike in Europe, U.S. producers have their own fully staffed marketing teams and "wouldn't gain anything by having another sales force downstream." In fact, he said, in certain cases it actually "might make sense" for a distributor to acquire a mill if it perceived a shortage of a crucial product. But in that case it would probably be a relatively small mill to satisfy a specific requirement. Moreover, as producers' share prices have escalated, this proposition is probably "too expensive" for a distributor to swing.

In Portland, John Rogers, who follows the steel industry for D.A. Davidson & Co., noted that each era of consolidation usually carries its own theme, with the most recent cycle marked by "back-end" combinations rather than downstream mergers.

Does that necessarily mean a return one day to downstream consolidation? "I think it's certainly possible, but I would guess the priority will be more on the product side than on the distribution side," Rogers said, citing such sectors as reinforcing bar, pipe and plate fabrication.

One group that's already taken a hard look at the likelihood of mills scooping up distributors is Moody's Investors Service, whose analysts determined in June 2007 that while there are "potential benefits" to a producer-distributor merger, "the benefits of implementing the model in North America would be outweighed by the likely challenges." Among other likely drawbacks, Moody's saw little chance for achieving substantial synergies and distributors' "thin margins" could undercut mills' stronger results during a market up-cycle.

More recently, Steve Oman, a Moody's analyst and senior vice president, described as "still relevant" the study's conclusions that mills acquiring service centers "didn't make a lot of sense." Distribution, he believes, is outside the mills' "core competence." And as steel prices rose to $1,000 per ton, mills enjoyed a bigger upside than service centers, Oman pointed out.

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