Such A Deal: Mittal and Arcelor

By Kathryn M. Welling
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Such A Deal
Mittal, A Heavy Metal Triumph Of Globalization, Or Something Less?

Globalization = Good.
Xenophobia = Bad.
The French = Snooty sissies.
The people of India = Developing dynamos.
The steel industry = a Balkanized, rusting cyclical hulk of a business burdened with insuperable legacy labor and environmental costs—until, that is, it surrenders to the liberating embrace of Lakshmi Mittal and Wilbur Ross’s vision of global consolidation under the corporate banner of Mittal Steel Co. N.V.

That, in a nutshell, is what passes for conventional wisdom in a lot of Wall Street watering holes and even in more sober precincts hereabouts on Rotterdam-based-but-globe-spanning Mittal’s $23 billion hostile bid to takeover Arcelor SA. An offer that the big Luxembourg-domiciled steelmaker, created in 2002 via a merger of formerly state-owned French, Luxembourg, Belgian and Spanish steel interests, has rather haughtily rejected out of hand, comparing its steel to perfume and Mittal's to (sniff) mere eau de cologne.

Indeed, Arcelor CEO Guy Dolle reportedly told a roomful of reporters and analysts at an industry meeting in Chicago last Monday that his company—the world’s largest steel maker, based on its 2005 sales of 32.6 billion euros—couldn’t be bothered with tactics such as swallowing a major acquisition to act as a poison pill against Mittal’s offer. And he went on to evince certainty that the deal “will never succeed,” assurance grounded, the aristocratic Dolle maintained, on the feedback he’s been getting as he meets with Arcelor shareholders.

For his part, India-born tycoon Lakshmi Mittal, who calls a $128 million London manse (inevitably described as palatial) “home,” has largely contented himself with complaining on Indian television that the deal’s European critics were setting back globalization, all the while shuttling around Europe, conferring with regulators and politicians. The 55-year old industrialist now ranks as the World’s third richest man, right behind Bill Gates and Warren Buffett, according to Forbes’ latest compilation. A serial acquirer who has patched together down-at-the-heels hulks of formerly government owned steel plants in places as disparate as Kazakhstan and Trinidad, South Africa and Poland to create the world’s largest steel producer in terms of tonnage shipped, Mittal inked his biggest previous deal just as 2004 was coming to a close.

That was the purchase of Ohio-based International Steel Group, or ISG, the corporate successor to bankrupts Bethlehem, Weirton and LTV. ISG itself was pieced together by another serial acquirer, the U.S.’s premier vulture investor, Wilbur Ross, who now graces Mittal’s board. Control of Mittal, however, rests squarely with the Mittal family. Despite all its deal-making (some 20 acquisitions over the past five years), Lakshmi Mittal and his wife still control 88% of Mittal Steel, and both their daughter and their son, the company’s CFO, sit on its board with the founder. As much as he wants to acquire Arcelor, moreover, the mega-mogul has said he is determined not to let his control of the steel conglomerate slip below 50.1%. Control, even a Reader’s Digest condensed version of Mittal’s biography would make clear, is not something he take lightly. The scion of an Indian mining family, Lakshmi Mittal in 1976 persuaded his father to back his initial foray into the international steel business, in Indonesia. But he was soon expanding those interests against his father’s advice and later severed Mittal Steel’s ties to the Indian branch of the family’s interests.

Mr. Mittal has been widely quoted proclaiming that a combined Mittal-Arcelor would mean “a better future” for the steel industry, better because consolidation would bring discipline, making prices more predictable. "If you look at our customers, they are consolidating," he told the Wall Street Journal. "There are three or five major car companies in the world. If you look at our iron suppliers, there are only three iron suppliers. It is a very natural process. It is more so in the steel industry, which has been very fragmented.”

No doubt there’s a compelling logic to steel industry consolidation. Mittal is scarcely the only company that has seen that particular light, and M&A activity in the business has picked up steam (generally, along with steel prices) in the last several years. No doubt, either, that Mittal is dreaming big. Arcelor itself triumphed in a contested battle for Canadian specialty steel producer Dofasco just the day before Mittal sprang its surprise bid for Arcelor’s shares.

The Mittal proposal, announced on Jan. 27, would join the world's No. 1 and No. 2 steelmakers, creating a behemoth with roughly a 10% share of global steel production. The combined company would produce more than 100 million metric tons of steel a year, boast a market value being estimated these days at around $40 billion and would employ something on the order of 320,000 workers in more than a dozen countries. That sort of scale would be nothing short of daunting in an industry traditionally highly fragmented and regionalized, largely along national lines. Its nearest competitors—companies the likes of Japan's Nippon Steel Corp. and JFE Holdings Inc., Korea's Posco, China's Shanghai Baosteel Group, and U.S. Steel Corp.—each make only between 20 million and 35 million metric tons of steel annually. Yet Mittal has brashly proclaimed recently that its goal is actually to achieve twice that scale, churning out 200 mmt a year by a decade from now.

The shares of Arcelor (5786.FR), which are traded on Euronext, have soared above the implied offering price since Mittal’s very-much-unsolicited cash and shares offer was announced, suggesting that at least some investors are anticipating the appearance of still-higher bids.

Official offering documents have yet to emerge from the European regulatory labyrinth, but Mittal’s (MT) primary offer, which it has insisted repeatedly that it does not intend to sweeten, is comprised of four new Mittal shares and 35.25 euros in cash for every five Arcelor shares tendered. The bid represented a 25% premium to Arcelor’s closing stock price on the day of the announcement, but Arcelor shares in short order shot well ahead of the offer price. They closed Thursday at 31.72 euros, giving the European company a market cap of 20.3 billion euros, and putting Mittal’s bid at an implicit 7.2% discount. (Mittal’s Dutch and NYSE-listed shares closed at 28 euros, which translates into a current bid of 29.45 euros a share for Arcelor.)

For all the theatricality in the clash of Old World and New that Mittal’s bid for Arcelor neatly encapsulates, the key question for investors is really quite straightforward: Whether Mittal’s bid is a fair or good deal for Arcelor’s shareholders. But on that question, alas, analysis that probes beyond the propaganda packets and conference call bromides from the opposing camps has been conspicuous most for its absence.

Non, le plus certainement pas! is the answer, according to former French President Valery Giscard d'Estaing, who has made headlines warning against giving into economic "laws of the jungle." Nor is it fair according to Arcelor boss Dolle, who, a WSJ editor has reported, publicly complained: “Rotterdam-based Mittal Steel is a ‘company full of Indians’ that wants to buy his with ‘monnaie de singe.’ The expression means ‘monopoly money’— Mittal's offer is mostly shares—but the literal translation is ‘monkey money.’ That double-entendre wasn't lost on people.”

A perhaps more dispassionate view is that Mittal’s bid, which at current stock prices values Arcelor’s production capacity at somewhere in the neighborhood of $450-$475 a ton, may be a little light, considering that steel-making assets have changed hands in deals in the last year for as much as $500 to $800 a ton produced—a far cry from the $80-$100 a ton bankrupt mills fetched as recently as 2000-2003.

Arcelor, to be sure, insists that Mittal’s unwelcome bid substantially undervalues its assets (what else would it say?) and that Mittal’s hodgepodge of “opportunistically acquired” commodity production assets would be a very bad fit with its “state-of-the-art and best-in- class” manufacturing business.

Then again, the Luxembourg-based company recently announced a snappy 67% earnings increase for 2005, on an 8% rise in revenues, results which were bolstered by cost-cutting, restructuring and strong business in Brazil. That sparkling performance doesn’t hurt its defense, particularly since it was achieved against a backdrop of growing industry overcapacity and weakening prices last year. Nor, presumably, did Arcelor’s recent 85% dividend increase ruffle the feathers of many of its investors, especially since plentiful cashflow also permitted the company to slash its debt by 50%, to just 1.3 billion euros, over the course of the year.

Mittal, by contrast, didn’t advance its case much at all with its own release of 2005 results. While its steel shipments climbed almost 17% and its sales surged 27% for the year, Mittal’s reported operating income slid 23% and its per share net sank 33%. Even worse were trends visible in the company’s fourth quarter numbers, where sales climbed 14% year-over-year but were virtually flat, sequentially, and where operating income plunged 50% and per share net, 62%, y-o-y. This, even though Mittal’s tonnage shipped in the fourth quarter grew by a hefty 35% y-o-y. One clear gauge of pain: Mittal’s average realization per metric ton was $520 in the fourth quarter, down from the year earlier’s $610.

Mittal’s problem, simply put, is that 2005 was the year that China switched from being a net importer to a net exporter of steel on a full year basis, and so prices plunged. Especially for the lower-quality and semi-finished grades of commodity steel sold on the spot market that make up a large portion of Mittal’s output. Arcelor, conversely, sells more of its high-grade and specialty steels under long-term contracts, and so was impacted to a far lesser extent by Chinese competition. Which probably begins to explain why Mittal suddenly finds Arcelor irresistibly attractive.

Just a few figures from the International Iron and Steel Institute bring Mittal’s dilemma into focus: Output from the three nations that dominate international steelmaking climbed just shy of 13% last year, but all of that increase—and then some—came out of China. Specifically, Chinese output surged 25%, to 349 million metric tons, from 281, in 2005, while Japanese production came in just on the negative side of flat, at 112.5 mmt, vs. 2004’s 112.7mmt. U.S. output, meanwhile, slid about 5%, to 93.9 mmt, from 99.7 mmt. Indeed, China, which produced just 20% of the world’s steel as recently as 2002, has virtually doubled its output in the last two years, cranking out roughly one-third of all the world’s steel in 2005. In fact, it came within a rounding error of accounting for every scrap of last year’s 72 mmt, or 7% increase in global steel production.

China’s ascendancy as not just a consumer, but a producer and exporter of steel potentially has profoundly destabilizing implications for the global steel market, particularly because it was Chinese demand that lifted the business, and steel prices, out of the doldrums and created the industry’s good times in the last couple of years.

As Steve Mackrell, the operations director at the Iron and Steel Statistics Bureau (www.issb.co.uk), the leading producer of steel industry statistics in the U.K., wrote in an ominously headlined piece, “Steel, the ‘new textiles’ for China,” published in Asia Times last November:
“Looking at Chinese steel consumption trends, it appears that while consumption has continued to grow, the rate of growth has been slowing, following macroeconomic cooling measures by the central government. As a result, the level of steel imports entering China has fallen significantly... Inevitably, the combination of rampant production and dampened domestic demand has caused more and more Chinese steel to find its way onto the export market.”

Mackrell continued: “If current Chinese trends of increased self-sufficiency in steel continue to develop, then the impact on the rest of the world could be dramatic...the global equilibrium of steel supply and demand could once again be upset. The past 12 months [2004] have seen unprecedented price increases for steel. Supplies of basic steelmaking materials have remained tight, pushing up their price, and adding to the costs of steelmaking. Steel supply, in turn, also became tight in a period when demand was rising, which meant that, on this occasion, the higher steel prices were sustained. For once, steel supply and steel demand were broadly in balance.

“There is now the specter that this new and delicate balance of steel supply and demand could be disrupted. Firstly, Chinese steelmakers appear to be successfully finding new markets outside of China which are vital if they are to sustain their high production levels. Second, exporting countries with a hitherto large foothold in the Chinese market are, with domestic Chinese consumption dampened, having to look elsewhere and find alternative markets.
“This additional "floating" steel, when combined with production from new steelmaking capacity destined to come on-stream, could upset the current balance of steel supply and demand, tilting it back in favor of oversupply. And that would bring the world back to the old story of steel being in oversupply, consequently depressing prices.”

Nothing in the statistics the ISSB has produced since alter that view: For all of 2005, China’s steel imports, which peaked at 43 million tonnes in 2003, fell 18% to 27.3 million tonnes from 33.2 million tonnes in 2004. That nation’s exports, meanwhile, grew 36% last year to hit a record 27 million tonnes. In January moreover, (the most recent statistics available) China’s steel output continued to grow, while the rest of the world’s contracted. The IISI put total world crude steel production that month at 94.4 million tonnes, a rise of 4.6% on January 2005, but said that if China were excluded, the rest of the world’s output fell 1.6%.

Trees don’t grow the sky, to be sure, and there are forces acting to brake the Chinese steel industry’s torrid growth, most notably raw materials costs. Especially with some estimates saying as many as 50% of China’s steel plants operate in the red. Iron ore prices rose sharply last year and this year’s negotiations with the three companies that essentially control the world’s ore exports have been unusually drawn-out and tense. China’s Shanghai Baosteel Group has taken a lead role in trying to beat back the exporters, who are attempting to push through a 20% price increase. The steelmakers’ argument: recent price weakness in various steel products augers an oversupply. When the dust settles, most industry observers expect steelmakers’ ore costs to rise in the range of 7-15% this year. Again, that’s not great news for any steelmaker, but especially unhappy for a company like Mittal, whose output skews to commodity side of the business.

Which brings us to the nub of the question before Arcelor shareholders: Whether the value of what Mittal is offering in its bid of 4 shares of Mittal plus 35 euros for 5 shares of Arcelor is sufficient compensation for their equity.
It’s a fundamental question, as noted, on which oddly little has been published in the six weeks since the bid surfaced, and about which Arcelor, at least so far, has said remarkably little beyond sniffing at the quality of Mittal’s assets and noting that Mittal shares, even after a successful deal, would scarcely be liquid because of the Mittal family’s overwhelming control. In fact, Arcelor’s reticence is more than passingly odd because even a casual perusal of Mittal’s most recent form 20-F (annual report of a foreign filer to the SEC), would seem to provide ample ammunition for calling Mittal’s value into question.

Or maybe it’s not so odd. Perhaps it reflects a lingering at Arcelor of an attitude once widespread in Europe, an attitude in which financial disclosure was considered more outre than de rigeur. As a now-retired investment banker with decades of experience on the Continent puts it, “Europeans are not really good at looking at footnotes in annual reports. Basically, their attitude is, that’s an accounting thing that has nothing to do with business.” Indeed, that particular banker wouldn’t be in the least surprised to discover that Arcelor hasn’t even ordered up a forensic analysis of Mittal’s accounts.

Even so, however, the dearth of fundamental reporting on Mittal seems to this writer another sad commentary on the dearth of quality financial analysis in today’s global markets. There once was a time when reading the fine print in Mittal’s latest 20-F [for 2004], which is what this writer (who is by no means either an account or an expert on the steel industry) has done, was Financial Analysis 101, for both journalists and analysts, at least on this side of the pond.

Not that, at 235 pages, 112 of which were required for the footnotes, Mittal’s 2004 20-F is exactly light reading. It is, in fact, the opposite: One of those densely packed exercises in disclosure that seems to list everything but the kitchen sink but reveal as little as possible, except perhaps to a forensic accountant.

Nor I am about to launch into a line-by-line analysis of a financial document covering a period that’s almost ancient history, now that Mittal has closed the books on another full year of operations. But the exercise proved quite useful in flagging some issues at Mittal that anyone considering acquiring the company’s shares might well find germane.

No. 1, clearly, is that Mittal’s 20-F miserably fails the heft test, a personal favorite of mine in the annals of financial analysis. The heft test simply says the quality of a company is often inversely proportional to the number of pages, and footnotes, in its financial disclosure documents. Then there was the little matter that hit me as I flipped to the back of the book to start reading the footnotes (there’s no better place to begin this sort of thing): Where most companies reproduce the audit letter from their accounting firm, Mittal’s 20-F didn’t contain one auditors’ letter—it contains no fewer than six, from geographically widely dispersed offices of three international accounting firms, all of them carefully laying out that they limited their auditing services to mere pieces of the Mittal empire. Even the letter from Deloitte Accountants B.V.’s Rotterdam office, covering Mittal’s consolidated 2004 financials, notes that the auditors did not actually audit results from operations that contributed roughly half of the company’s sales that year. They relied instead on the reports of other auditors. Nor was that the only tidbit in the accountants’ letter: The scope of their engagement did not include auditing the company’s internal controls and thus they expressed no opinion on their adequacy. Mittal won’t fall under section 404 of Sarbanes-Oxley, which requires such reporting, until it files its 20-F for the current year. However, portents are not good: One its subsidiaries, ISG, has already reported finding three material weaknesses in its internal controls. And the 20-F warns that it may require “significant expenditures and management time” to bring the holding company’s internal controls up to U.S. reporting snuff.

Turning to note 1, I quickly discovered that the flurry of mergers among the Mittal family’s publicly held (then known as Ispat International) and privately owned steel operations, the transactions that created Mittal Steel in the closing weeks of December, 2004—because of the companies’ common control—was accounted for “on the basis of common control accounting, which is similar to a previously permitted method of accounting known as a “pooling-of-interests”. [Italics added.]

Interesting piece of financial legalese, that. Someone obviously thought it sounded better than admitting that pooling of interests accounting is now verboten under GAAP. My point isn’t so much that Mittal’s accountants found a loophole that permitted it use of a methodology akin to an outlawed one dubbed “dirty pooling,” years ago in Barron’s by accounting guru Prof. Abraham Briloff. My point, instead, is what that “dirty pooling” does to the quality of the numbers in Mittal’s financials. The essence of the problem with pooling was that it permitted companies to put the assets and liabilities of acquired operations on their books, not at cost, but at book value. By doing so, they avoided a step-up in depreciation and amortization charges—and burnished reported earnings to a high sheen.

Mittal can’t use common control accounting, however, to book its myriad of non-affiliated acquisitions. For those, it uses GAAP-standard purchase accounting—but with a twist. Since Mittal has historically bought under-performing steel assets, usually plants being privatized by a former member of the Soviet bloc, it has typically picked up said assets for a song. Or, at the least, for something considerably less than their historical costs. Which leaves Mittal with what’s known as negative goodwill on its books. In a simpler world, I suppose, a business would write down the value of such crummy acquired assets to what it paid for them. But we surely don’t live in a simple world. While Mittal’s disclosures on the topic are convoluted and darn near opaque, as near as I can figure out, Mittal essentially carries that negative goodwill on its books and then recognizes a portion of it every year—as a fillip to earnings. This much is clear, at least: Purchase accounting has enough impact on its financial statements that Mittal management feels constrained to list it as one of its “critical accounting policies” in the management’s discussion and analysis section of its financials.

Beyond the question of accounting for all of its rapid-fire acquisitions, there’s the question of operating them to generate profits. One thing that Mittal’s 20-K does make clear is that what the holding company is running is a loose agglomeration of assets; that very little, if any, headway has been made so far in rationalizing or reorganizing them.

In acquiring its various assets, moreover, Mittal has committed itself to hefty future expenditures for things like capital improvements, environmental remediation and labor benefits in various jurisdictions. Promises to pay that could severely hamper Mittal management’s financial flexibility. It’s on the hook for something over $2 billion in such outlays over the next decade (mostly, in fact, in the next five years), according to the back-of-the-envelope notes I made while reading its commitments and contingencies footnotes. That’s in addition to roughly $1 billion in uncovered pension obligations.

One more thing potential Mittal shareholders may want to consider before surrendering their Arcelor stakes for a share in Lakshmi Mittal’s expansive vision of global steel dominance: Mittal Steel, as a holding company, has no manufacturing operations of its own, and can only pay dividends to the extent that it can arrange cash distributions from its heavily encumbered operating subsidiaries.

Now, to be sure, Mittal’s various predecessor companies were not so constrained in years past, and did find ways to pay dividends: In 2000, an $18 million dividend was paid to Mittal’s sole shareholder. In 2003, the dividend was $164 million. But it was in 2004 that Lakshmi Mittal enjoyed a real payday: a dividend of $2.386 billion, paid out in part that year and in part last year.

Despite all his rhetoric about creating a strong, value-increasing company with global reach, Mr. Mittal, in other words, has taken an awful lot of skin out of the game.