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Shagang the Integrator

02-25 13:17 Caijing Magazine

Shagang Group Co. Ltd., China’s largest private steel enterprise, is now the pride of Jiangsu Province and a fitting symbol of the rise of private steelmaking in a country traditionally dominated by state-owned operators.

By staff reporter Gong Jing

Government officials were on hand January 16 when Jiangsu Municipal Party Secretary Wang Rong congratulated Shagang founder and majority stockholder Shen Wenrong at a company ceremony. A few weeks earlier, Jiangsu Provincial Party Secretary Liang Baohua visited Shagang to wish the company well in its bid to create a world-class enterprise.

Shagang last year became the province’s first company to report an annual pre-tax profit topping 14 billion yuan and sales of more than 115 billion yuan -- about doubling its 2006 earnings and revenues. The steelmaker called 2007 one of its best years ever, with output of 22.89 million tons of steel -- up from 10 million tons the year before.

Shagang’s outstanding progress has been led by four, major acquisitions since the second half of 2006: Jiangsu Huai Steel Co. Ltd. (Huai Steel), Henan Yongxing Steel Co. Ltd. (Yongxing), Xinrui Special Steel Co. Ltd. (Xinrui), and Jiangsu Yonggang Group Co. Ltd. (Yonggang). These buyouts increased capacity by 10 million tons to 25 million tons, allowing it to surpass Tang Steel Co. Ltd. and Anshan Steel Co. Ltd. to become China’s second largest steel enterprise by output, behind only industry leader Baosteel Co. Ltd.

Considering Shagang’s sudden rise as a sign of an industry trend, China’s private steel enterprises appear to be emerging from the shadows cast by the industry’s so-called Tieben Incident six years ago and restoring their lofty ambitions. Even in the tough environment of China’s steel industry, survival for private companies is getting easier.

Shagang’s Thaw

Huai Steel was Shagang’s first purchase supported by Jiangsu. The buyer won controlling rights from the city of Huaian’s Municipal State-owned Assets Department in June 2006, contributing 3.4 billion yuan to transform Huai Steel through major construction projects and corporate integration with Shagang’s system, covering upstream iron ore imports as well as downstream product sales. By 2007, Huai Steel’s sales revenue had increased 21 percent to 10.3 billion yuan and pre-tax profits jumped nearly 90 percent to 1.15 billion yuan.

Jiangsu’s high-level officials weren’t always as supportive of Shagang. Before the Tieben Incident in 2002, the provincial government gave a public stock listing quota originally intended for Shagang to Nanjing Steel Co. Ltd.

Attitude shift in Jiangsu’s political circles started in March 2004, after the State Council investigated and prosecuted Jiangsu Tieben Cast Iron Steel Co. Ltd. (Tieben), a steel company that planned to build a huge, new complex. After securing nearly 1,667 acres of land, Tieben started building the factory with a capacity of 8.4 million tons and an investment of about 10.59 billion yuan.

The project crashed after investigators said farmland had been illegally obtained for the factory, leading to several dismissals in Jiangsu’s political and business spheres. Government’s tighter macroeconomic policies also contributed to the decision to scrap the project, even though 4 billion yuan already had been invested.

After Tieben, fears silenced Shagang’s ambitions for some time and locked the nation’s private steel enterprises in a doldrums for two years. One senior steel industry insider observed that, before the Tieben Incident, all private steelmakers had undergone 10 years of development and had achieved power equal to state-run enterprises. After the incident, a good deal of small- to mid-size private steel enterprises slumped or went bankrupt, the state-owned enterprises recovered large amounts of land.

The situation did not significantly change until the second half of 2006. First, Shagang broke its silence, launching its first buyout since the Tieben Incident. The sector’s turnaround seemed assured after September 2007, when the private Fosun Group acquired Hainan Steel. Insiders said the Fosun deal was a clear signal of a thaw for private steel.

Caijing learned that, in addition to Jiangsu’s change of mind in Shagang’s favor, the National Development and Reform Commission and other relevant departments in Beijing had also basically approved the steelmakers recent course of development. Furthermore, the acquisition moves by Shagang, Fosun and other private enterprises are thought to conform to the state’s latest steel industry policies.

Series of Acquisitions

Shagang was dormant for two years. It also seemed the government didn’t care. Shagang received little attention and none of the usual government kudos when it started annual production of 6.5 million tons of thermal coils in August 2004, even though a similar project by Baosteel generated considerable buzz.

Beijing announced a National Steel Industry Policy in July 2005, stipulating that foreign capital could not hold a majority share of any Chinese steel enterprise. This scuttled Shagang’s plans for a tie-up with South Korea’s Pohang Iron and Steel (see Shagang Besieged City in the October 2007 edition of Caijing). Barred from floating stock, Shagang’s future development prospects grew dim.

Nevertheless, rising prices for steel helped Shagang post revenues of 40 billion yuan in 2005, making it China’s largest producer of electrical stove and specialty steel products.

And although the National Steel Industry Policy blocked one road for Shagang, it opened another -- through acquisitions.

"The National Steel Industry Policy demanded no construction of new factories, no enlargement of production capacity,” Shen Wenrong said, “[But] at the same time, the policy was encouraging mergers between steel enterprises to consolidate the industry. This was Shagang’s new opportunity." 

Jiangsu Province is a home to no fewer than several dozen steel enterprises with a combined production capacity of more than 46 million tons. Shagang had ample room for a cooperative base with Jiangsu provincial government.

2006 marked the beginning of a series of acquisitions made by Shagang. In June, Shagang bought 90.5 percent of Huai Steel for 20 billion yuan, adding three million tons to its steel production capacity.

The depleted capital did not pose a problem for Shagang, which subsequently took out a bank loan and soon began looking for other targets.

In September 2007, Shagang paid 2 billion yuan in cash to acquire 80 percent of Yongxing, Henan Province’s largest private steel enterprise with one million tons of production capacity. However, Caijing learned that what really interested Shagang was the 2.5 million ton technology transformation project that Yongxing was developing.

Before the year passed, Shagang made another move, purchasing 25 percent of Yonggang from the Yonglian village committee in the town of Nanfeng. The purchase price for Yonggang is unknown, but it is believed that Shagang offered approximately one billion yuan for the acquisition.

The deal caused a stir in the steel industry. Yonggang – located just 10 kilometers from Shagang – had nearly 10 billion yuan in assets and a production capacity of five million tons per annum. In comparison, Bayi Iron and Steel Co. Ltd., acquired by the industry leader Baosteel, had a production capacity of just 3 million tons.

Shagang also took control of Changzhong’s Xinrui, acquiring 51 percent of the company at a cost that “wasn’t much” according to Shen Wenrong.

With just 0.3 million tons of annual production, the Xinrui deal seems unremarkable. However, Xinrui has held a control over Tieben’s old factory – which had a production capacity of 1.2 million ton in 2004 – since August 2004, when the local Changzhou government assigned Xinrui to rent and manage the factory after the arrest of Tieben’s Chairman.

The Tieben incident is coming to a close, with the fate of its factories soon to be decided. Industry sources say Shagang’s reason for the Xinrui purchase is Tieben’s old factory. In fact, Shagang’s 25 million tons of production capacity already includes both Xinrui’s 2007 steel output and that of Tieben’s old factory, and Shen Wenrong said that Shagang would spare no efforts to support Xinrui’s development in 2008.

When asked about Tieben’s factory, Shen Wenrong remained coy, saying "Tieben’s affairs are sensitive and very complicated." But, he expressed confidence about the future of Tieben’s factory.

Are there more acquisition targets on Shagang’s radar screen? "We are certainly negotiating simultaneously with many potential acquisition targets,” one senior official at Shagang said, “It’s just that unsuccessful talks are not good to announce."

Potential Partnership with Baosteel

One reason for Shagang’s emboldened moves in 2007 is its improved relationship with Baosteel.

China’s state-owned steel enterprises have not always been on good terms with their private counterparts. Private steel enterprises, with their high efficiency, crowded out numerous state-run steel factories, earning wary suspicions from state-owned competitors such as Baosteel and Angang.

However, the appointment of Xu Lejiang as Chairman of Baosteel in January 2007 provided an impetus for a change. An insider told Caijing that both Xu Lejiang and Shagang’s standing vice president and chief engineer, Liu Jian have been close friends since their years at Juangxi Metallurgy Institute. This relationship served as an ice-breaker in the cooperation between the two enterprises.

In August 2007, Beijing’s "China Times" reported Baosteel would purchase shares of Shagang in the future, becoming Shagang’s largest shareholder. Caijing learned that Shen Wenrong and Xu Lejiang already held several talks to explore various possibilities for a bilateral cooperation that could prove to be mutually beneficial.

Xu Lejiang wants to achieve Baosteel’s goal of reaching a 80 million ton production capacity by 2012 through acquisitions rather than the past strategy of building new factories. However, Baosteel’s current standalone capacity is just 23 million tons, and even after the addition of Bayi Steel in 2007, the total capacity rises to just 43 million tons, still far short of its projected target. An alliance with Shagang, whose production capacity is second only to Baosteel, will go a long way in meeting the objective.

Shagang hopes the cooperation with Baosteel can bring greater flexibility and bargaining power in negotiations with authorities. Despite its size and market position, Shagang has continuously failed in its attempt to go public in China’s current political and economic systems.

Caijing learned that Shagang would object to excessive interference by Baosteel in Shagang’s production management. Provided this condition is satisfied, however, Shagang will consent to joining hands with Baosteel to establish a new company through which Baosteel will hold the majority of the Shagang Group.

The negotiation is still ongoing, and both sides remain cautious. Both Xu Lejiang and Shen Wenrong know from their past acquisition experience that many difficulties lie ahead before the deal comes to fruition. The immense sizes of the two enterprises, the presence of their factories all over China, and their place in the local economy all could potentially pose a problem and derail the talk. In addition, regional politics will also likely play a role, introducing further complications.

Shagang at Crossroads

Whether it be going public, making acquisitions or forming a partnership, difficult decisions lie ahead of Shagang. But, Shen Wenrong is willing to take on the challenge himself and shape Shagang’s future. He said, "If you can’t strengthen yourself, who will cooperate with you?"

Shagang’s 2008 acquisition restructuring strategy has two main goals. The first is to transform recently-purchased enterprises through reform and restructuring. The second is to diversify its acquisitions into upstream iron ore, coke or similar businesses, in addition to the main steel business.

Shagang’s M&A strategy is captured well in its phrase "First close then far, first easy then difficult, first internal then external." Responding to the possibility of making “far, difficult, external” acquisitions in 2008, Shen Wenrong said Shagang has major targets but refused to elaborate further.

However, the industry is not optimistic about Shagang’s ambitious moves in 2008, citing Shagang’s weak financing platform and its past acquisitions, which were all paid either in cash or through bank loans. Moreover, many of the companies Shagang bought are heavily in debt, requiring Shagang to inject additional capital to turn them around.

Shen Wenrong dismisses these concerns, saying all the deals in the past were within the scope of Shagang’s ability. Shen noted that Shagang had managed to maintain its debt ratio stable at 57 to 58 percent through the four acquisitions.

However, Shen’s response does little to ease the industry-wide skepticism. Based on Shagang’s assets and debt ratio, Shagang is expected to accrue approximately 2 billion yuan in financial costs. In addition, as of April 2008, Shagang had 1.25 billion yuan in short-term financing bills due. Industry experts argue a decline in steel price, a market recession or unsuccessful integration of past acquisitions all could trigger liquidity problems for Shagang.

One thing seems certain. If Shagang is to make additional acquisitions in 2008, it will need to rely on bank loans given its current tight liquidity.

On January 14, 2008, Shagang held a banquet in Zhangjiagang for high-level bank managers from the entire province. There were more than 240 people in total. This shows that Shagang still receives considerable support from the banks. At the same time, it demonstrates Shagang’s need for bank financing.

Acquisition aside, Shagang’s top priority is still to go public. In October 2007, Shen Wenrong revealed that Shagang had already begun to promote the idea of going public and had been negotiating with potential strategic partners like Goldman Sachs.

Caijing learned that Shagang and Goldman Sachs agreed on a deal that would give Goldman Sachs a stake of Shagang. But the transaction did not complete because they failed to receive approval from administrative departments. At present, negotiations between the two parties are still progressing, but the process of going public seems to have stalled.

Because of Shagang’s immense size and unclear shareholding structure, the listing process is fraught with difficulties. Inside sources told Caijing that Shagang is most likely to try reverse listing. In fact, around Spring Festival in 2007, Shagang seemed interested in the acquisition of Ling Steel (Shanghai Stock Exchange code: 600231), which was eventually purchased by Angang owned by local Liaoning Province.

Split listing is another possible alternative. However, it is more difficult for the China Securities Regulatory Commission to approve split listing because of industry competition and other problems.

The third means is to attract foreign capital and aim for overseas listing, a part of Shagang’s original plan. But because drawing investment from Goldman Sachs has been disrupted, Shagang has to temporarily put this plan on hold.

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