China's central government has battled for years to consolidate the country's fragmented steel sector by establishing a handful of giant high-quality producers.
Beijing wants the top 10 steelmakers to account for 60% of China's steel output, before consolidating further into perhaps three or four steel groups producing more than 80 million mt/year each by 2025.
At the moment, the top 10 account for just 37%. There is still a long way to go.
Successful merger and acquisition activity has proved elusive due to different ownership structures and disputes around how profits and taxes should be divided up between impacted companies. In some cases, mergers have been in name only, with the respective mills continuing to operate autonomously, before quietly going back their own ways. Square pegs have been forced into round holes.
But last month's announcement that Baowu Group - itself the result of a coming together of Baosteel and Wuhan Iron & Steel Group in late 2016 - will take a 51% stake in Maanshan Steel (Magang) indicates that the pace of consolidation could finally be speeding up.
Shanghai-based Baowu is China's largest and most sophisticated steel producer, and as such is expected to be the driving force behind ongoing steel industry consolidation.
"In our view, China Baowu acts as an important central state-owned enterprise that supports the Chinese government's plan to consolidate the steel sector," S&P Global Ratings said in response to the Baowu-Magang merger announcement.
Baowu Group chairman Chen Derong said on June 28 that Chongqing Iron & Steel, in China's southwest, will be the next company to be absorbed.
Chonggang will have 10 million mt/year of crude steel capacity by 2020, and will help Baowu achieve its 100 million mt/year capacity goal. With the absorption of Magang, Baowu's total crude steel capacity has risen from around 70 million mt/year to 90 million mt/year, moving it closer to Luxembourg-based ArcelorMittal, currently the world's largest steel producer with a nominal capacity of around 114 million mt/year.
OWNERSHIP CHALLENGE
One of the challenges in China has been trying to consolidate mills with different ownership models and cultures. State-owned mills are key revenue generators for local governments and M&A activity can provoke power struggles between rival provincial governments. Privately-owned companies are not beholden to the government - in principle - and are more flexible and market driven, but also naturally reluctant to get saddled with more cumbersome partners.
The Baowu-Magang merger has been more straightforward as both companies are under direct management of the state, albeit one by a provincial government and one by the central government.
Magang is 100% owned by Anhui provincial State-owned Assets Supervision and Administration Commission of the State Council, or SASAC. It will transfer a 51% stake to central SASAC-owned Baowu for free, while Anhui will retain a 49% stake.
Though Anhui's government will lose control of Magang, it will benefit from Baowu's investment, technology and expertize. Baowu is expected to help upgrade and expand Magang's product range and enhance its profitability.
The central government has been urging the manufacturing sector to upgrade, but most local governments - already highly leveraged - have not had the financial prowess to support their local enterprises.
For Baowu, the absorption of Magang will strengthen the group's market share and influence on China's flat steel market. Magang's high quality long steel products, such as railway wheel steel, will extend Baowu's product range.
Baowu has trimmed production from 80 million mt/year to around 70 million mt/year through closing outdated capacity, but will bring online a new 6 million-7 million mt/year capacity blast furnace in Guandong by 2021.
Two of its four major production bases are close to Magang at the mouth of the Yangtze River, so there will be some synergies in transportation and raw materials sourcing. Iron ore is transported by canal to the steelworks.
In terms of the potential impact of the takeover of Magang on Baowu's financials, S&P Global Ratings said the steelmaker had reduced its reported debt by Yuan 42 billion ($6 billion) in 2018 from the end of 2017 "thanks to robust cash flow generation during the recovery in steel prices over the past few years."
S&P Global Ratings said "on a pro rata basis, we expect China Baowu's debt-to-EBITDA ratio will remain below its downside trigger of 3x after the acquisition."
World's top steel producers
Rank Company Location 2018 output (mt)
1 ArcelorMittal EU 96.42
2 Baowu China 67.43
3 Nippon Steel Japan 49.22
4 HBIS Group China 46.8
5 PoscoS Korea 42.86
6 Shagang China 40.66
7 Ansteel China 37.36
8 JFE Steel Japan 29.15
9 Jianlong China 27.88
10 Shougang China 27.34
16 Maanshan China 19.64
Source: S&P Platts