Highly cyclical in nature, the steel industry has had long periods of lackluster performance that could devastate companies, so despite the Asian economic boom, how long steel prices will hold up is a different question. With all the new supply coming to the market, in 2005 lower prices reminded everyone that even prolonged cycles do not last forever.

The acceleration of Chinese demand for steel dropped in the second half of 2005 in comparison with the previous three years. China, producing more steel than everyone else, actually became a net exporter at the end of 2005. Consolidated or not, global steel companies may have to face the overcapacity of China and the related downturn sooner than expected.

China currently has about 5,000 steel plants, all of them built in last 50 years. Even though the Chinese government appears committed to slowing down economic expansion and tempering the steel business, production capacity continued to increase in 2005 amid lower steel prices in China.

As in every cycle, the exact timing is a guess. But any problem with the key source of growth, China, may fuel the next industry downturn. A slowdown in America or Europe, or the inability of the Chinese government to deal with overproduction could quickly alter the industry landscape.

The steel industry will face the next turnover with three major centers: Europe, including the capacities in both Western and Eastern Europe; North and South America; China, Japan and Korea in Asia. China is well positioned to dominate the low end of the market, while Japan and Korea are well positioned in the high-quality steel production segment. That's why the European industry needs to be well prepared for the next downturn, being not only consolidated, but also flexible to respond to changing market conditions.

Waiting for Worse but Better Times

Buying Arcelor now, despite the obvious benefits for the new company, carries substantial risks in the context of Mittal's debt and the possible downturn in the cyclical industry. While opinions on the longevity of this particular cycle vary, the important question is what is going to happen to the combined Mittal-Arcelor venture if indeed a downturn is near?

A larger steel company may avoid some of the effects of a slowdown, but it is definitely not immune to them. If in doubt, please refer to Bethlehem, U.S. Steel, GM, or Nissan. Facing a downturn with a debt-loaded and over-staffed giant may be isn't such a good idea.

Given Mittal's phenomenal growth in the last 10 years, this may be a better time to focus on internal improvement, cutting costs, decreasing the headcount, and paying down debt, rather than on making the largest acquisition in steel history.

One of Mittal's major advantages is that it is a low-cost producer and thus more resilient to weak market conditions. This was evident in the forth quarter results the company recently reported. Even though its operating margin fell to 12% from 28% in 2004 and EPS fell 62% as a result of the falling prices, Mittal beat consensus estimates by 20% and reported 22% return on equity in the second half of 2005. The company also led the industry in cutting production to avoid oversupplying the market, a very rare event in steelmaking.

On the other hand, unionized and government-controlled Arcelor lacks much flexibility and will have difficulties cutting costs quickly in a downturn; it will suffer like any other company. The big stake of European governments in Arcelor will make the decision of eliminating European jobs very difficult. The result could be losing money, cash flowing out of the company, lower debt rating, and cheaper stock price.

If the merger happens now, Mittal will have to do the dirty job of cost-cutting and laying off workers at Arcelor in less favorable times. A downturn, however, will force European politicians and unions to recognize the need for cost cutting and trimming the workforce or face dwindling cash flow. Even though the company is well-positioned in the high-end steel market, declining costs of steel will affect it just like any other steel company.

If the merger happens after the downturn, Mittal may avoid the political heat and the complications in labor relations and also enjoy being portrayed in more positive tone in the European press. He won't have to carry the burden of the rigidity of Arcelor and dealing with it in a hostile European environment during the next turn.

Mittal, the Man of Timing

So far Mittal has shown tremendously good feeling of timing when building his empire; he managed to buy cheaply the East European capacities when the West wasn't interested in them, when the post-communist governments didn't know how to manage them, and when unions feared losing the jobs. In the case of Arcelor, however, he seems to lack patience for the time when both the price, the shape of the company, and the political and social environment will not be hostile.

Currently, the two companies are relatively of the same size and strength; the difference is that the low-cost producer Mittal is better positioned for a downturn than the very political Arcelor.

Mittal will have to cut the capacity when exports from China begin to rise before Arcelor will have to cut it. The only difference is that if Mittal has to cut the capacity, he will cut it and cut it fast, Arcelor in that case will only bleed in the name of saving jobs. Arcelor believes that rising exports from China will not affect the company as it is focused on higher margin and better quality of steel product segments in which China does not compete. If South Korea and China target the global markets, Arcelor will have difficult time surviving the assault. In the end what China and South Korea does or does not do will determine the ultimate fate of the industry.

A bid during the lower part of the cycle, with stronger Mittal and weaker Arcelor, may bring the benefits of a cheaper acquisition price and more favorable political climate, two rather important factors in this heated merger. Mittal may be better-off in the long run focusing on improving production, investing in technology and cutting the cost and get ready for the coming downturn and China-Korea assault and wait for Arcelor to tumble, because it will. King of timing may have to wait for a while but not for a long, only if he is patient.