Japan's smaller mills steeled for shakeout

TOKYO (Reuters) - Japan's $12 billion construction steel industry, facing overcapacity, a weak market outlook and the threat of a flood of Chinese imports, is set for a shakeout that could trim nearly three dozen players to fewer than 10.

Market leader Nippon Steel Corp (5401.T) is leading a drive to streamline a fragmented, low-valuation industry as it looks to cement its position by expanding capacity and tightening its grip on a highly volatile sector that can impact the upper-end market for automotive sheet and shipbuilding plate.

Japan's top steelmaker has snapped up or raised stakes in five small steel firms, including Nakayama Steel Works Ltd (5408.T), Chubu Steel Plate Co (5461.NG), Oji Steel Co and Hokkai Kogyo Co, as it seeks to raise its output of high-grade steel by shifting lower-end production to smaller affiliates.

Trading companies such as Mitsui & Co (8031.T) are also selling off minority stakes in the underperforming sector to improve their investment portfolios.

"There are too many small companies in the Japanese market, even smaller than those in Taiwan and South Korea," said Kenji Inokuma, president of Godo Steel Ltd (5410.T), a Nippon Steel affiliate. "A realignment is a must."

Japan's 10 million tonne market for steel bars is crowded by 30 small mills, which gather steel scraps from local building companies to melt down in electric furnaces, operating mostly at night to save on electricity costs.

The similar-sized South Korean steel bar market has fewer than 10 companies, a result of mergers and acquisitions in the late 1990s.

Top maker Hyundai Steel Co (004020.KS) has 40 percent of the local steel bar market, with output of 3.7 million tonnes, more than three times that of Japan's top steel bar maker Kyoei Steel Ltd (5440.T), which has 12 percent of the Japanese market.

Tokyo Steel Manufacturing Co (5423.T), Japan's biggest construction steel maker, has a market capitalization of $2 billion, less than a third of Hyundai Steel's, and a fraction of Nippon Steel's $45 billion.

BRACING FOR SHAKEOUT

Recent months have seen several operating alliances backed by minority cross-shareholdings, and industry officials expect the sector to be eventually consolidated into seven or eight groups.

Godo Steel in May entered a partnership with Kyoei, which is 34 percent-owned by Nippon Steel ally Sumitomo Metal Industries Ltd (5405.T). Kyoei did the same with unlisted Kishiwada Steel in March. Godo itself was consolidated into Nippon Steel in June.

"The market is strong, making a drastic change difficult," a source at Kyoei Steel said. "Our strategy is to start with soft alliances ... Eventually we hope to become one of the market's core companies."

Prices have stayed firm, but a shrinking construction market, higher raw material costs and a possible influx of Chinese steel cloud the long-term outlook, weighing on stock prices.

Most firms' price-to-book-value ratio is between 0.5 and 1.0.

Among Nippon Steel's group firms, Osaka Steel Co (5449.OS) trades at just over 8 times forecast earnings, against Godo Steel's 6, Chubu Plate's 4.5 and Topy Industries Ltd's (7231.T) 9.4. That compares with Hyundai of South Korea's 14 times and Dongkuk Steel Mill's (001230.KS) 18.5.

Japan's overall investment in housing, buildings and other engineering projects has plunged 30 percent in the past decade.

Most firms will book lower profits this business year. Tokyo Steel Manufacturing posted a 45 percent drop in April-September pretax profit to 12.33 billion yen ($107.4 million).

"It (the realignment) could be a gradual process centering on companies' operational alliances. But a big shock in the market, like a plunge in prices or a bursting of China's steel industry bubble, would trigger a drastic shakeout in Japan," said Atsushi Yamaguchi, analyst at UBS.

This possibility has attracted foreign funds.

Harbinger Capital Partners has taken a small stake in Tokyo Steel, and Owl Creek Overseas Fund has done the same with Yamato Kogyo Co (5444.T).

Japanese investment fund Ichigo Asset took a small stake in Mitsui affiliate Tokyo Kohtetsu Co (5448.Q) and vetoed its planned merger with Osaka Steel in a rare proxy fight this year, saying the deal undervalued Tokyo Kohtetsu.