Supply Chain Optimization to Restore Steel Company Profitability

Supply Chain Optimization to Restore Steel Company Profitability Speech delivered by John E. Lichtenstein Managing Director Accenture Metals China Iron and Steel Association s 7th China International Steel Conference 10 May, 2012 Beijing

Introduction I would like to thank Mr. Zhu Jimin, Chairman of CISA, and the other directors and officers of CISA for the opportunity to present Accenture s perspective on opportunities and strategies for supply chain optimization to help restore steel industry profitability. This topic is vitally important for steel company executives around the globe, and particularly executives here in China, because of the troubling profit outlook facing many companies. I greatly appreciate the chance to share some of Accenture s insights, lessons learned and leading practices from our more than 20 years work in the global steel industry.

Overview of the iron and steel industry supply chain A comprehensive view of the iron and steel supply chain recognizes three distinct stages: Upstream, consisting of the mining of raw materials, and the delivery of the raw materials to the steel mill. Midstream, incorporating the basic manufacturing activities of the steel company to convert raw materials into finished products and includes key processes such as planning and scheduling, internal movement of semifinished products, and inventory management. Downstream, consisting of the transfer of the finished steel product to the customer, and includes value-added processing such as cutting, slitting and blanking, and just-intime delivery. In recent years, a lot of attention has been paid to the upstream stage as dramatic shifts in pricing and market mechanisms for raw materials have had a profound impact on the global steel industry. While this attention and steel companies efforts to counteract these trends are certainly justified, we believe that steel company executives must pursue optimization strategies in all three stages to restore the industry to sustainable profitability. This will be the focus of my comments that follow. I will also address the topic of steel industry consolidation, as we believe that supply chain optimization can only be fully realized as part of a broader transformation that includes optimization of the industry structure through increased concentration. 3

Evolution of the steel industry supply chain over the past 10 years The fundamental trend in the steel industry supply chain over the past decade has been its value compression, measured as the reduction in the spread between the market price of steelmakers raw materials and the market price of steel mill products. As everyone here knows, the prices of raw materials have increased faster and more than the price of steel mill products. Everyone also understands the principle reasons for this include: growth in demand exceeding growth in supply; market power of the leading global raw material supplies; and significant excess of steel capacity. This trend can be seen in Figure 1, which tracks the spread between the export price of a hot roll coil and the prevailing market prices of the iron ore, coal and scrap consumed in producing that coil since 2000. In absolute dollar terms, the spread has ranged from a low of US$104 per ton in 2001 when the price of steel dipped below US$200, to a high of almost US$350 per ton in 2008 when the price of steel reached almost US$900 per ton. However, looking at the spread in relative terms as a percentage of the steel price, there has been a steady decline from a high in 2004 of almost 70 percent to less than 30 percent in 2011. Not surprising, the decline in the spread has been accompanied by a decline in overall industry profitability, measured as composite EBITDA margin of 50 global leading steel companies, including several Chinese producers. This measure peaked in 2005 at more than 20 percent, but by 2011, it was only 10 percent. While the depressed EBITDA values since 2008 reflect in part the impact of the global financial crisis and slow recovery, the compression trend is nonetheless apparent. However, while the industry as a whole has suffered from the supply chain value compression, some steel producers have performed well, overcoming the overall trend to generate strong returns. Figure 2 shows the three year financial performance of 50 major steel companies in Capital Efficiency (Revenues divided by Invested Capital) and EBITDA margin, which drive Return on Invested Capital (ROIC). While there are many factors that contribute to the strong performance of Vallourec, CSN, Tenaris, Posco, Severstal, Tata Steel and others, supply chain optimization is a key success factor for all of them, based on the following strategies: Expanding company-specific spread by investing in captive raw materials and by driving innovation in customer relationships: that is, by optimizing their upstream and downstream supply chains. Improving the efficiency of their conversion of raw materials to finished products to capture more of the available spread to their bottom line; that is, by optimizing their midstream supply chains. I will now discuss each of the three supply chain stages, focusing on opportunities, strategies and challenges for optimization. Figure 1: The spread between steel prices and raw material costs declined sharply over the past decade. Annual average steel producer spread, 2000-2011 1,000 80% Iron ore (US$/tons c&f) sinter 900 800 700 600 70% 60% 50% Steel producer spread (US$/tons) Coking coal (US$/tons c&f) Steel scrap (US$/tons) Spread as % of hot roll coil price (RHS) US$/tons 500 400 300 200 40% 30% 20% EBITDA margin (% RHS) Note: Spread calculated as hot roll coil price minus specific consumption of iron ore and coal at prevailing market prices. 100 10% 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 0% Source: Steel Business Briefing, World Steel Dynamics, Accenture Research. 4

Figure 2: Steel industry high profit leaders display high EBITDA margin and/or high levels of capital efficiency. Drivers of pre-tax return on invested capital (ROIC) 3 year average (2009-2011) 5 % 10 % 20 % Pre-Tax ROIC Threshold 3,3 Laiwu 2,9 Capital Efficiency (Revenue/Invested Capital) 2,5 Jinan Average 5.8 % 2,1 ThyssenKrupp Inner Mongolia Baotou Ak Steel Bluescope 1,7 One Steel US Steel Nucor Nippon Steel Tata Steel Hebei Salzgitter Kobe Steel Dynamics 1,3 Wuhan Rautaruukki Maanshan JFE Woestalpine SSAB Baosteel Posco Hunan Valin Angang ArcelorMittal Gerdau 0,9 Evraz Sumitomo China Steel Ternium Usiminas Severstal JSW Tenaris Vallourec Average 1.4 CSN -10 % -5 % 0 % 5 % 10 % 15 % 20 % 25 % 30 % 35 % 40 % Source: 2012 Capital IQ, Accenture Research. Operating Margin (EBITA/Revenue) percent 5

Upstream supply chain optimization: Iron ore There is a growing consensus that the global supply/demand balance for traded iron ore will start to improve by 2014, when new capacity additions will exceed slowing global demand growth. As Figure 3 shows, the global iron ore market could move from a balanced position in 2010 to a potential over-supplied position of between 200 and 450 metric tons by 2016. As a result, most analysts are expecting prices to be lower in the second half of the decade than in the first half. This good news, however, is tempered by realities that will constrain how far and fast prices can fall: More than 75 percent of the expected new capacity is controlled by the Big 3, who will be able to manage the rate at which this capacity enters the market to prevent major price disruptions. Much of the new capacity from new players is high cost due to ore quality, distance to markets, and/or large scale infrastructure investments, thus limiting the amelioration of price pressures. Even with growing availability of seaborne ore, China will still consume large volumes of domestic ore, whose low iron content and high costs will also help maintain a price floor for the global market. Despite these realities, efforts by Chinese steel producers to acquire stakes in overseas mines, and the Central Government s objective for 200 metric tons of total captive iron ore imports by 2020, are sound strategic moves. The advantages of ownership lie not only in the potential for lower delivered costs, but also in having a more stable, consistent supply, which can lead to both operational and commercial advantages. There are three notes of caution, however, that must be sounded: Figure 3: The apparent global supply of iron ore is expected to exceed demand in coming years, though market price impacts will be limited. Iron ore market surplus/deficit (Mt) 450 400 350 300 250 200 150 100 50 0 2010 2011 2012 2013 2014 2015 2016 Surplus/deficit (Mid case) Surplus/deficit (High case) Big 3 seaborne % (RHS) Source: UNCTAD, Accenture Research. Steel companies should avoid overpaying for mineral reserves or mining companies. Valuations reflect the quality and quantity of the underlying reserves, plus the market s expectation of the future prices, adjusted for the costs and risks of developing and maintaining output. Given the frenzied atmosphere surrounding any ore company or mine sale, there is a strong chance that companies will overpay. Even with low costs of capital overpaying can offset the supply chain benefits of ownership. Careful attention to establishing realistic valuations is essential. Developing a working mine is a difficult, costly and risky proposition: the experience of Chinese and other companies investing in mining operations abroad includes examples of significant cost overruns and project delays. As in the case with overpaying for a property, large scale delays or overruns can quickly offset the advantages of ownership. So establishing robust practices for monitoring, managing and optimizing overseas capital investment is required. 80% 75% 70% 65% 60% 55% 50% 45% 40% Seaborne share of Big 3 Slowing Chinese demand growth and increasing supply is expected to lead to an increasing surplus in the coming years. This trend, however, will not cause a major shift in the market because: -- The expected surplus is only around 10 percent of expected demand. -- Big 3 suppliers will still account for around 60 percent of seaborne supply. Prices may soften in the second half of the decade, but they will not collapse. -- Continued Big 3 leverage. -- Price floor established by costs of new capacity and large portion of existing Chinese capacity. Note: Positive value refers to market surplus, negative value refers to market deficit. Reaching 200 metric tons of captive imports will be an important achievement, but it will not fundamentally restructure the market nor will it substantially address the industry s profitability challenge since this amount will likely represent only 20 to 25 percent of the industry s expected future imports, the balance of which will be sourced at market prices. Nonetheless, steel companies that execute this strategy more effectively than others by not overpaying and by carefully controlling the development costs will achieve important competitive advantages. But in the absence of further industry consolidation, these advantages may be spread too thinly across multiple companies (who are in fact competing for the same mining assets), resulting in a sub-optimized upstream supply chain. Moreover, in the absence of further industry consolidation, even today s large steel companies acting alone lack the financial resources to pursue larger deals. 6

Downstream supply chain optimization Steel mills have traditionally viewed their supply chains as ending at their plant gate, once the product is loaded onto a truck for shipment. This perspective ignores the significant value that can be created by extending their reach to include the additional customer processing (cutting, slitting, blanking) and services that are sometimes provided by supply chain intermediaries. By focusing on their downstream supply chain, steel companies can realize higher margins, thus helping to recover some of the profits lost in the market spread compression. A major structural problem facing the Chinese steel industry in its pursuit of sustainable profitability is the large number of traders and other intermediaries operating in the downstream supply chain, together with the high percentage of the steel supply they control. Figure 4 compares the percentage of the steel market in different countries supplied by different channels: mill direct, mill-owned distributor, and independently-owned distributor or trader. For China as a whole, steel mills through direct shipments or captive distribution control a smaller percentage of the supply chain (around 35 percent) than their peers in other countries where the control ranges from 65 to 90 percent. Independent intermediaries control the largest portion of the downstream supply chain, often simply acting to buy and resell, and adding no value to the products or for the customers. The fact that so much of China s steel market is controlled by intermediaries has negative impacts at both the industry and individual steel company levels: For the industry as a whole, this control: --Increases market volatility, as intermediaries build or reduce inventories based on speculative expectations of future price movements rather than real demand trends. --Creates major inefficiencies in the overall physical and financial resource allocation due to the massive amount of redundant inventories held by competing ntermediaries and to excessive or indirect movement of material. Figure 4: The Chinese steel industry controls a smaller percentage of its market channels than it peers in other countries. Regional steel market channels, 2011 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Brazil China EU China top India Russia USA 40 steel mills Steel distribution by source Mill direct Mill owned distribution (including foreign owned) Independent distributor/traders Source: CISA, Eurometal, Meps, TSI, Accenture Research. For individual steel companies, this control: --Mutes real demand signals from the market, impeding efforts to optimize planning and scheduling. --Prevents direct interactions with customers, making it more difficult to understand their requirements and to see opportunities for new product development. --Reduces profitability based on pricing pressures from intermediaries and on the loss of potential margin on processing and services. Seen in this light, ownership of major distribution channels is both an essential strategy for steel producers and a necessary step in the optimization of the entire downstream supply chain. However, expanding downstream is not simply a matter of acquiring intermediary companies or building new distribution centers. To operate downstream successfully, steel companies need to implement new business models, capabilities and technologies. The following are some key lessons and leading practices based on our work with steel companies that operate downstream successfully: Using extended supply chains to get closer to the final customers, to better understand customer requirements and to develop new products and services that improve profits. Not using downstream warehouses as dumping grounds for excess mill production since inventory carrying costs would erode the margin benefits of higher value sales. Investing in advanced information technologies and tools to enable new operating model and capabilities, including: end-to-end order visibility; advanced planning and scheduling; logistics and network optimization; and customer profitability analytics. Companies that successfully execute downstream integration strategies leveraging both physical asset and technology investments can achieve higher market shares, margins and asset turnovers. However, the benefit that an individual steel company can realize through downstream integration will be limited if the overall industry downstream supply chain is not deeply restructured. Even though, as Figure 4 shows, the largest 40 Chinese steel mills control a higher percentage of their downstream supply chains (around 50 percent) than the industry as a whole, this has not been sufficient to deliver adequate profitability, due in part to the continued margin pressure from the independent intermediaries supplied by smaller steel companies. Optimization of individual downstream supply chains goes hand in hand with optimization of the overall industry supply chain, which also goes hand in hand with industry consolidation. 7

Midstream supply chain optimization There are two dimensions of midstream supply chain optimization that I would like to address. The first concerns the activities and processes that take place within an individual company where the goal is to optimize the use of a company s physical, financial and human resources to convert raw materials into finished products as efficiently as possible. The second is the organization of physical production units within an industry across companies to achieve industry-wide efficiency and sustainability, which I will address in the next section on Industry consolidation. Now, regarding the first concern about the individual companies midstream activities and processes, I have three points. First: Midstream supply chain processes provide the mechanism for a company to integrate the upstream and downstream supply stages and thereby optimize the entire enterprise. Centralized planning, scheduling and supply chain fulfillment processes link upstream (procurement) with downstream (sales and transportation management). The ability to operate the upstream, midstream and downstream as a single, integrated supply chain is a key characteristic that distinguishes high performing steel companies and allows them to achieve superior financial results. Second: Programs to optimize the midstream supply chain involving the implementation of new operating models, leading practices, and advanced systems and tools can often generate greater returns, in shorter periods of time, than either upstream or downstream investments. In our work with leading global steel companies, we have seen midstream supply chain transformation programs produce significant improvements in: order lead times (50 percent); work-in-process and finished inventories (25 percent); and overall plant yields (1-2 percent). Finally: Creating a strong supply chain organization is a critical success factor for effective midstream supply chain optimization, which is independent of both the production and commercial organizations. This represents a major shift from the traditional steel company operating model in which the supply chain function is a subservient department within either the commercial or production organizations. This independence is essential to confirm that the requirements of the different parts of the company are balanced, and planning, scheduling and resourcing decisions optimize the entire enterprise rather than individual production units or constituencies. Industry consolidation The need for further industry consolidation is widely recognized. The Central Government has set a target for the top 10 companies to produce 60 to 70 percent of industry output by 2020. Overall scale to assume global industry leadership positions in the areas of technology and global expansion. Financial scale to more effectively address upstream optimization: become financially stronger to pursue bigger targets and compete against other entities with deeper pockets. As Figure 5 shows, steel industry concentration in China currently lags far behind that of other regions, where Top 5 producer share is already 60 percent or higher. Based on the experience of the steel industry in other regions and of other industries, increased concentration can provide multiple benefits: Improved market discipline, helping to reduce volatility. Scale-driven operational cost efficiencies. Location-driven supply chain efficiencies. Capital investment efficiencies (more rational capital allocation, avoid excess capacity). Faster spread of leading practices, including in environmental, health and safety areas. Greater operational flexibility to quickly adjust to changing market conditions. Figure 5: The steel industry is less concentrated in China than in other countries. World steel industry consolidation: Top 5 market shares (2011) 100% 44mt 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 173mt Salzgitter Riva Tata Steel TKS Arcelor Mittal 108mt MMK Severstal NLMK Arcelor Mittal Evraz 111mt Gerdau Severstal Nucor US Steel Arcelor Mittal Gerdau Technit Usiminas AM CSN 271mt SAIL SMI JFE Nippon POSCO 683mt Next 5 Shangang Wuhan Anshan Benxi Baosteel Hebei EU CIS NA SA East Asia China Source: Company reports, World Steel Association, Accenture Research. mt = metric tons 8

While the benefits of increased industry concentration are clear, there are significant barriers to effective mergers and acquisitions that also must be acknowledged. For the Chinese steel industry, the social costs associated with shutdown of inefficient or redundant facilities are a major challenge, especially under local and provincial government ownership of the steel companies. This problem is further compounded when the proposed acquisition or merger crosses provincial boundaries, creating winner/loser tradeoffs. Another potential barrier is the potential for a merger or acquisition to decrease the raw material self-sufficiency of one of the entities: given the focus on upstream supply chain optimization, combinations that dilute this movement will be problematic. It is also important to recognize that size alone does not guarantee success. Figure 6 shows the three year average profitability (EBITDA margin) of the 50 global companies as a function of their 2011 production. You can see there is almost no correlation between size and profitability. This suggests that combinations that merely create larger entities but do not create value will not deliver value to shareholders or help the industry achieve its objectives. It is instructive to consider the examples of steel company mergers and acquisitions, which are generally viewed as being successful from the standpoint of delivering targeted synergies and creating a stronger combined company. Figure 7 lists some of these examples. The two things that are common to all of them are: Commercial synergies based on expanded product range, complimentary market channels, enlarged market presence, etc. Facility rationalization, based on the closure of least efficient facilities, preferential loading of the most efficient or better located facilities, avoidance of duplicative capital investments, etc. It should also be noted that several of these combinations were of companies operating within the same country or region: this greatly increases the opportunities to derive synergies based on facility rationalization. This is one of the major challenges facing cross-border M&A. Figure 6: There is little correlation between steel company production volume and profitability, suggesting that size alone does not guarantee success. Selected steel producers output versus EBITDA correlation EBITDA margin (2005-2011 average) 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% R² = 0.0049 However, even for combinations within the same country or province creating value is not easy. It requires a strong focus and commitment to merger integration as disciplined process and as a business activity that requires advanced capabilities and leading practices, like supply chain, sales, or mill operations. Selected steel producers output versus ROIC correlation 0% 0% 0 20 40 60 80 100 0 20 40 60 80 100 Steel production 2011 (metric) Steel production 2011 (metric) Source: CISA, Eurometal, Meps, TSI, Accenture Research. ROIC % (2005-2011 average) 30% 25% 20% 15% 10% 5% R² = 0.0032 Figure 7: Market synergies and facility rationalizations have played a major role in many of the global steel industry s successful mergers and acquisitions. Examples of successful steel industry mergers and acquisitions US Steel acquisition of Lone Star Technologies Ternium acquisition of Hylsa and Imsa Merger of Nippon Steel and Sumitomo Stainless business units Merger of NKK and Kawasaki Steel Gerdau (multiple acquisitions) Merger of Outokumpu and Avesta Sheffield Country Year Product Value Drivers USA 2007 Pipe & Tube Complimentary product lines, strengthen market position, feedstock synergies Mexico 2007 Flat Roll Complimentary products, facility rationalization, feedstock synergies Japan 2003 Stainless Facility rationalization, strengthen market position Japan 2002 Multiple Facility rationalization, strengthen market position Brazil, USA, Canada Finland, UK, Sweden 2002-2008 Long Products Merger of ThyssenKrupp Germany 1997 Flat Roll, other Source: Accenture Research. Create full-line, verticallyintegrated market leader; facility rationalization 2002 Stainless Facility rationalization, strengthen market position Facility rationalization, strengthen market position Accenture has more than 20 years of experience working on hundreds of merger integration projects with clients across the globe and in all industries, including the steel industry. Based on this experience, we have identified several critical success factors for merger integration. 9

As shown on the left side of Figure 8, these include: Conducting a thorough analysis of all potential synergies and risks before finalizing the merger. Identifying key stakeholder issues and negotiating resolution before merger. Focusing on organization and asset changes that will drive the greatest value. Putting the appropriate people in key roles. Developing a detailed merger integration plan with targets, work streams and timelines. Assigning clear responsibility for each work stream and synergy target. Closely monitoring progress of each work stream against targets, escalating problems for rapid executive decision making. By focusing on these critical success factors, steel companies can achieve significant synergy benefits from mergers and acquisitions as shown on the right side of Figure 8. These include: increased customer profitability (2 to 5 percent); lower purchasing costs (1 to 5 percent for direct Critical success factors Conduct a thorough analysis of all potential synergies and risks before finalizing the merger. Identify key stakeholder issues and negotiate resolution before merger. Focus on organization and asset changes that will drive the greatest value. Put the best people in key roles. Develop a detailed merger integration plan with targets, work streams, and timelines. Assign clear responsibility for each work stream and synergy target. Closely monitor progress of each work stream against targets: escalate problems for rapid executive decision making. supplies); reduced overhead costs (20 to 35 percent per ton); reduced working capital (10 to 25 percent); lower logistics costs (10 to 25 percent); and increased asset utilization (5 to 10 percent tons/hour). Figure 8: Focusing on merger integration critical success factors can help steel companies achieve significant benefits in all areas of their business. Achievable benefits Increase customer profitability Lower purchasing costs -- Direct materials -- Indirect supplies and materials Reduce overhead costs (per ton) Reduce working capital Reduce logistics costs Increase asset utilization (ton/hour) 2-5 % 1-5 % 5-20 % 20-35 % 10-25 % 10-25 % 5-10 % materials, 5 to 20 percent for indirect materials and 10

Conclusion The Chinese industry has made truly remarkable gains over the past decade, not only in its growth in size, but also in its advancements in product quality, process technology and development of people. As Figure 9 shows, however, the Chinese steel industry continues to lag the rest of the global industry in terms of profitability, a situation which is not sustainable. While the Chinese steel industry shares many of the same challenges facing the global industry as a whole, it also faces unique challenges that derive from speed and manner of its recent growth among other factors. To restore profitability and become sustainable, the Chinese steel industry faces three key imperatives: It must pursue upstream supply chain optimization through the appropriate acquisition and diligent development of mines. It must pursue downstream supply chain optimization through the restructuring of the trading and distribution sector to support greater mill control over the primary market channels. It must pursue midstream optimization through industry consolidation. Figure 9: The Chinese steel industry has underperformed financially relative to the rest of the global industry for most of the past decade. Annual average EBITDA margin, 2002-2011 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Asia except China China CIS Europe North America South America Source: 2012 Capital IQ, Accenture Research. These imperatives are interconnected and interdependent; the industry will not be able to achieve success in one area without significant progress in the other two. Companies that succeed in upstream or downstream optimization will attain competitive advantages, which will give them the stronger position in merger and acquisition negotiations. Yet without strong merger integration capabilities, they will not succeed in maintaining that leadership. And larger, financially stronger industry leaders are essential for the upstream and downstream supply chains to be optimized in the next few years. While optimization in all three supply chain stages is the goal for most steel companies, the reality is that not all companies will have the resources or skills to prevail in all three stages. Individual companies may be better suited to focus on either upstream, downstream or midstream optimization as the primary path for restoring profitability. From the overall perspective, identifying and promoting specific areas of capabilities among steel companies and guiding the consolidation process along these more natural paths will enable the Chinese steel industry to more rapidly reach its goal of an optimized, sustainable and global-leading industry. About the presenter John E. Lichtenstein is the managing director of the Accenture Metals industry group and leads the Accenture Natural Resources group (metals, mining, forest products and building materials) for the Asia Pacific region. Based in Beijing, Mr. Lichtenstein has more than 25 years of experience as an industry executive and consultant to the global metals and mining industries, including prior senior positions at Inland Steel, Arthur D. Little and Beddows & Co. He works with leading companies in the areas of strategy and organization, technology, mergers and acquisitions and business transformation. He is a recognized expert on global metals industry issues and has written numerous articles for industry publications and is frequently quoted in the financial press. He regularly appears as a featured speaker at events sponsored by the World Steel Association, the AISI, the Metals Service Center Institute, Metal Bulletin, World Steel Dynamics, the Brazilian Steel Institute, the China Iron and Steel Association and others. Mr. Lichtenstein holds a B.A. from Yale University and an M.B.A. from the Yale School of Organization and Management. john.e.lichtenstein@accenture.com

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