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The service center sector is in the early stages of an uptick in consolidation that is likely to last another several years, according to Dan Sullivan, director of the industrial group for Chicago investment banking firm Houlihan Lokey. Sullivan delivered his thoughts on industry M&A during last month’s SBB Steel Markets North America Conference in Chicago. Sullivan appeared as part of a panel dealing with distribution issues. He was joined on the dais by Lourenço Gonçalves, chairman, president and CEO of Metals USA; Jeremy Flack, CEO of Flack Steel; and Mark Breckheimer, president of the heavy carbon group at Kloeckner Metals. Sullivan said the market for buying and selling service centers, like the metals industry itself, is a cyclical one, with each cycle typically lasting five to seven years. The current upswing is in its second or third year. “Our firm’s view is that there is a fair bit of ground to go in terms of M&A deals over the next few years. We’re really just getting started.” Most of the factors are in place for increased M&A activity. It starts with the need for growth, he said. While corporate profits have been high in recent years, the gains stem from curbing expenses, “and there’s a limited amount of profit you can wring out of cost cutting.” So companies seek out acquisitions, which become more attractive as distributors enjoy better results. “Companies are able to make strategic decisions on the buy side, and on the sell side you have 12-18 months of strong earnings behind you,” he noted. Other conditions working toward increased M&A include a high level of liquidity, better availability of credit, tax concerns for 2012, pent-up demand from the natural ownership turnover that was delayed by the recession, and simple psychology. “People like to do deals. M&A is a symptom of optimism. In an environment where economic growth will only get you so far, M&A is a way to make a splash and point to something concrete,” Sullivan said. There are some impediments to deal making, he noted, including end-market cyclicality, memories of overpaying in the last upcycle and a low barrier to entry that makes it difficult to truly eliminate competition. It’s likely that more foreign entities will buy into metals distribution in North America, including large, transformative mergers like the one that took place between Namasco and Macsteel in 2011. What Sullivan and other panelists consider unlikely is any trend toward greater mill ownership of service centers. “Mills would have to buy a lot of service center capacity to impact the end-user market,” Flack said. “I don’t see any difference between Nucor buying a service center and Kloeckner buying a service center. I don’t think it’s a huge event, unless mills start to commit billions of dollars to buy capacity.” Before the mills consider getting into the market, the service centers themselves will have to do the heavy lifting on consolidation, Sullivan said. Right now, to achieve the necessary scale, a mill would have to buy four of the largest service center companies “to make a difference and avoid the inherent channel conflicts they’d get into if they try to run a service center business.” Kloeckner’s Breckheimer, whose Roswell, Ga.-based service center company is one of the nation’s largest after last year’s combination of Macsteel and Namasco, said the only mill ownership he expects to see is a modest move into the automotive supply chain. That is close to the European model and the only area where such a strategy makes sense, he said. “The historical landscape is littered with examples of why steel mills should not own steel service centers, specifically in the United States,” Breckheimer said. “The steel producers should pay attention and not repeat the mistakes of the past. I don’t see much going on beyond integrated facilities investing in processing facilities for automotive applications.” Dealing with volatility The service center panel also discussed a number of other issues affecting distribution, starting with volatility and its impact on the market. Breckheimer said volatility is not just a matter of the vacillation of the price, but is an ongoing concern in other aspects of the industry, such as demand, financing capability and capacity. “It’s everywhere in this business.” One response to volatility is to reduce the amount of physical hedging that service centers do, he said. In the past, service centers routinely would buy long to make $40 to $50 per ton if they thought the market was on the verge of a shift. Today, it’s not a worthwhile gamble. “With a hypercyclical market, you can see steel prices change by 30-40 percent in 90 days, and even $100 per ton isn’t enough of a reward to take the risk.” Gonçalves, in contrast, said that while volatility exists, it’s often overstated. He blames misinformation, both intentional and unintentional, for artificially lifting the perception of price volatility. Intentional disinformation can be provided by anonymous sources cited in various publications who talk the price up or down. “If a person doesn’t have a name attached, it’s hard to tell what he’s trying to accomplish with that information.” An example of unintentional misinformation, Gonçalves said, is the ongoing complaints about overcapacity and how that will dampen prices. He said the United States has not been in a state of overcapacity at any point in the last 40 years, pointing to the unbroken string of U.S. steel consumption outpacing domestic supply every year. Citing another change, service center executives’ attitude toward inventory has changed, Breckheimer said. For the last 11 years, most distributors have been steadily cutting down their months on hand to reduce their price risk. Others in the industry, however, have not fully adjusted to this reality. “Every time we get down to 2.4 months supply, many of our suppliers think we’re going to add inventory as soon as we think business will get better. And they plan on that,” he said. “But our working capital models preclude that. We’ve worked very hard to turn stock much faster and create a more efficient financial engine. You’ll see spikes, but the long-term trend has been down and will remain at these levels going forward.” Future of futures In any meeting of steel executives, the subject will inevitably turn to futures trading. Or, as Gonçalves said, “For all the time we’ve spent talking about futures, if it was for real, we should be calling them ‘presents.’” The industry veteran, who spent time on the mill side before taking over the Fort Lauderdale-based service center company, remains opposed to futures trading. “This is just another way of people who have nothing to do with our business trying to grab a share.” But Flack and Breckheimer see otherwise. Flack’s company, which has no equipment, specializes in the transaction end of the business. “We see ourselves as structure, coming up with ways to help our customers grow their business through the way they buy steel.” And one of the ways they can do that is through the use of financial hedging in the futures market. He said companies can either learn how to use futures, or get left behind as customers seek out distributors who do. “The attitude in our industry is going to change, there’s no going back,” said Flack, who founded the Cleveland-based company in 2010. “If you’re involved with OEMs in this market, they’re going to want these products from us as an industry. The faster you get them to your customers in way that makes sense to them, the more business you’re going to capture.” He’s unconcerned about the presence of outside interests. “Do speculators get involved? Sure. But all they’re doing is providing liquidity to us.” Breckheimer had a similar assessment. “More and more of our customers are looking for certainty of supply and certainty of price. We expect that’s going to grow.” [callout] “People like to do deals. M&A is a symptom of optimism.” Dan Sullivan, Houlihan Lokey