Arcelor agrees to Mittal takeover

By James Kanter, Heather Timmons and Anand Giridharadas Published: Sunday, June 25, 2006

LUXEMBOURG A new steel giant is to be created out of a bitter battle, after Arcelor formally agreed on Sunday to a 26.5 billion takeover by rival Mittal Steel. The deal combines Arcelor - a symbol of successful, pan-European cooperation and economic revival, with operations that span Luxembourg, Belgium, France and Spain - with a fast- growing conglomerate founded by the India-born Lakshmi Mittal, who built a fortune turning around sick steel plants in rapidly expanding markets from Trinidad to Kazakhstan. The deal, valued at $33.1 billion, is the latest sign that shareholder activism is marching through the once staid and sleepy boardrooms of Europe. The agreement to pair with Mittal caps a wrenching turnaround for Arcelor's management, which once dismissed Mittal as a "company of Indians" but were forced to backtrack after shareholders threatened to revolt. Politicians in Europe who once criticized Mittal have remained mum in recent days, and the merger brings hope that protectionist barriers against such deals may be eroding in Europe. Mittal is paying 40.37 a share for Arcelor, nearly double what the company was trading at when Mittal first made an offer in January. The new company will be named Arcelor-Mittal and will be headquartered in Luxembourg. Joseph Kinsch, chairman of Arcelor, will be chairman of the new company, and will be succeeded by Mittal when Kinsch retires next year. It was unclear what role Guy Doll, Arcelor's chief executive, will have. Mittal will be president until Kinsch's departure. "It's been a long struggle," said Wilbur Ross Jr., a U.S. billionaire investor and Mittal board member. "Now that we have had an opportunity to be inside, with management, we believe there will be even more synergies than we thought." Kinsch, speaking in the courtyard of the Arcelor headquarters, said that the deal would create "global leadership in steel" not just by ton but by value. Getting to this point has involved a bruising fight for both sides. Mittal first made an unexpected 18.6 billion offer for Arcelor in January, and was swiftly and harshly rebuked by Arcelor management and a chorus of European politicians who criticized everything from his grammar to his Indian origins to the quality of his company's steel. Arcelor's bare-knuckled defense strategy included refusing to meet with Mittal until a string of demands were met, and simultaneously orchestrating a 13 billion deal with Severstal of Russia to keep him away.

Arcelor's choice of Severstal as a white knight was problematic from the beginning. An unconventional vote on the deal, which was scheduled for Friday, was immediately criticized by shareholders. It allowed the deal to be approved unless the meeting was attended by an unprecedented number of Arcelor shareholders and they voted it down. After Arcelor executives and Severstal's chief executive, Aleksei Mordashov, appeared at a triumphant news conference to announce the deal, they were rarely seen together again. Instead, Mordashov embarked alone on a global tour to win Arcelor's investors to his side. He found shareholders were willing to listen to him, but angry with Arcelor's top executives, according to one of his advisers who spoke on the condition of anonymity. "They had managed to alienate everyone," the adviser said. Management had "taken their shareholders for granted." In fact, Arcelor's shareholders, including institutional investors and a growing number of hedge funds, were angry enough about the way the last- minute deal with Severstal was being pushed that they had started to talk about trying to oust Arcelor's management, and suing its board members. Such shareholder revolts have been successful in the past.Last year, for example, the chief executive of Deutsche Brse, Werner Siefert, was forced out after shareholders opposed his plans to buy the London Stock Exchange. Support eroded for Arcelor's plans behind the scenes, too. Representatives from the Luxembourg government, which is one of Arcelor's largest and most influential shareholders, spoke out strongly against the Mittal deal at first. Luxembourg regulators approved the Severstal deal, even though it had a few quirks. But as shareholder wrath grew over the Severstal agreement, the government began to privately question it. One representative claimed that Arcelor management had tried to "bully" the government into writing a takeover law that shut Mittal out. The real turning point, according to several people involved in the negotiations, came when Arcelor's board and management realized that a share buyback connected to the deal with Severstal might be voted down. The vote on the buyback, scheduled for last Wednesday, was canceled, in order to concentrate on negotiations with Mittal. "If the shareholders and if the regulators in charge are going to accept what was concluded today, then I think this will be a truly extraordinary situation for Luxembourg, to have by far the biggest steel maker here and to have its headquarters and decision-making center here," said Luxembourg's economy minister, Jeannot Kreck. "It's a great victory." On the other hand, Arcelor's foot- dragging has also wrung expensive concessions from Mittal. The agreed offer is nearly 40 percent higher than his initial offer in January, which was 27 percent higher than Arcelor's stock price at the time. Mittal also was expected to concede some management control andfamily voting rights. The sale price represents a hefty premium to Mittal's last offer of about 36 a share, and to Arcelor's last trading price of 35.02 a share. Arcelor board members unanimously approved the deal, after a nine-hour meeting at the company's palatial headquarters in Luxembourg. Many board members arrived in chauffeurdriven luxury cars, though Prince Guillaume of Luxembourg, who is also an Arcelor director, drove his own car, a blue Volkswagen Passat. It may be too early to rule Mordashov out completely. He still has a contractual deal with Arcelor, and the vote Friday on the Severstal deal will still be held. It will be unwound when shareholders tender their shares to Mittal. At the very least, Arcelor will be forced to pay 140 million in a breakup fee to Mordashov.

"According to the law, Mr. Mordashov could always through Severstal make another offer," Kreck said. "That's not on the table for the moment." Mordashov was also in Luxembourg over the weekend, though he declined to disclose what he might do next.Kreck said he had met with Mordashov on Saturday, and executives from Mittal and Arcelor. "We have a legal, binding merger agreement that the board of Arcelor entered into," Mordashov said Sunday. That accord had been unanimously supported by Arcelor until now. "We are very surprised that the board did not invite us to discuss our revised proposal nor offer us an opportunity to respond as we had requested," Mordashov said in his statement. Mordashov said his company was reviewing all of its options. Business leaders have watched the Mittal-Arcelor deal closely as a bellwether for emergingmarket businesses seeking to acquire their slower-growing Western counterparts. Once completed, analysts expect a surge of acquisitions attempts by multinationals rooted in the developing world. The situation also spotlighted changing standards of corporate governance in Europe, where boards and management are being forced to pay attention to a growing number of activist shareholders, after decades of running companies as they pleased. Ross, the Mittal board member, said the deal will "make a very powerful statement that no matter what the games, shenanigans and interventions at the end of the day if you're determined enough, the best price will prevail." He added, "That is a message that has not always been clear" in European deal-making. The merger is a milestone in the consolidation of the global steel industry, creating a behemoth with three times the capacity of its nearest rival, Nippon Steel, and 10 percent of global market share. With 320,000 employees and an estimated $70 billion in revenue, the combined company will be the firststeel maker with more than 100 milliontons of annual capacity - enough fortwice as many automobiles as the worldmakes every year. Months of acrimony during the takeover battle has raised concerns that Arcelor and Mittal will have difficulty integrating their operations. "The differences of mentality, plus all the energy which has been put into the fight over the last several months, would make it very difficult for the current people to work together," said Patrick du Bois, a former executive vice president of Arcelor who left the company late in 2005, just before the Mittal bid was announced. "If I was on the current board," he added, "I would probably put new CEOsand managers in the new group, because otherwise you will still have remnant battles inside." Anand Giridharadas reported from Mumbai, India, and Heather Timmons of The New York Times reported from London. The merger plan between Luxembourg-based steelmaker Arcelor, which operates in Brazil, and Rotterdam-based Mittal Steel (NYSE: MT) is positive for the steelmaking industry, BES Securities said in a report. "It is positive for the sector because it strengthens the steel companies by creating a greater discipline in production and enhancing their relations with suppliers," the report said. Furthermore, the merger plan is also positive for Arcelor's South American subsidiary Arcelor Brasil, which is expected to remain competitive after the merger, the report added. Post-merger, Arcelor and Mittal Steel shareholders would hold 50.5% and 49.5% respectively of a new company to be called Arcelor-Mittal.

In addition to Arcelor Brasil the Luxembourg-based company has a 55.7% stake in Brazilian specialty steel producer Acesita, while Mittal operates the 3.8Mt/y Lzaro Crdenas steel plant in Mexico and a 2.7Mt/y DRI plant in Trinidad & Tobago.

The Merger Process

2006 was a very exciting and challenging year for ArcelorMittal. The new company was at the forefront of the consolidation process, leading the industry through mergers and acquisitions.

January 2006 Historic moment for the Global Steel Industry

The year started with the historic launch of the Mittal Steel offer to the shareholders of Arcelor to create the world's first 100 million tonne plus steel producer. The aim of increasing globalisation and consolidation, necessary in the steel industry, defines the deal kussand sets the pace for the industry.

February 2006 - Expansion and strong results

Mittal Canada completes the acquisition of three Stelco subsidiaries, the Norambar and Stelfil plants, located in Quebec, and the Stelwire plant in Ontario. Stelfil and Stelwire will add 250,000 tonnes of steel wire to the company's annual production capacity, providing a wider product mix to better meet customers' needs. Arcelor acquires a 38.41% stake in Laiwu Steel Corporation, in China. Laiwu Steel Corporation is China's largest producer of sections and beams, and will further boost its operational excellence thanks to this partnership. It is still awaiting approval with the Beijing authorities.

April 2006 - Renewal after Hurricane Katrina and new galvanised line
Out of the devastation of Hurricane Katrina, arose a revitalised Mississippi youth baseball field, rebuilt with the help of Mittal Steel USA and Arcelor. The company provides money towards the purchase of lighting fixtures and steel cross bar support. It also arranges for and donates the labour costs for their installation. Mittal Steel USA places a new line into operation in Cleveland to provide top-quality galvanised sheet steel to automakers and other demanding customers. The new line is designed to produce in excess of 630,000 tonnes of corrosion-resistant sheet annually, using the hot-dip galvanising process.

May 2006 - US clears the way for bid

Mittal Steel announces US antitrust clearance for Arcelor bid and the approval of the offer documents by European regulators. The acceptance period starts in Luxembourg, Belgium and France on 18 May 2006 (some days later for Spain and the United States) and lasts until 29 June 2006.

Arcelor contributes to the first anti-seismic school building in Izmit (Turkey), where a school building had been destroyed by an earthquake in 1999.

June 2006 - Historic agreement to create the No.1 Global Steel Company
Creating the world's largest steel company, Mittal Steel and Arcelor reach an agreement to combine the two companies in a merger of equals. The terms of the transaction were reviewed by the Boards of Arcelor and Mittal Steel which each recommended the transaction to their shareholders. The combined group, domiciled and headquartered in Luxembourg, is named Arcelor Mittal. Demonstrating the commitment to extend markets in developing nations, a strategic partnership between Arcelor Mittal and SNI (Socit Nationale d'Investissement) is concluded concerning the development of Sonasid. This consolidates and develops the position of Sonasid on the Moroccan market, allowing the company to benefit from the transfer of Arcelor Mittal's technologies and skills in the long carbon steel product sector.

September 2006 - New dividend policy

Arcelor Mittal announces new dividend policy, under which it will pay out 30% of net income annually. 93.7% of Arcelor shareholders tender their shares to Mittal Steel. Arcelor Mittal confirms Value Plan up to 2008.

December 2006 - Deals, deals, deals!

Arcelor Mittal sells Thringen long carbon steel plant to Grupo Alfonso Gallardo for 591 million euros, as part of Mittal Steel's commitments to the European Commission. Arcelor Mittal and the Government of Liberia conclude the review of the Mining Development Agreement. With this agreement giving access to iron ore mining, with capacity of 15 million tonnes a year, the Liberian Government and Arcelor Mittal will be partners in jumpstarting economic recovery and development for Liberia. The USUS$1 billion investment will bring around 3,500 direct jobs and 15,000 to 20,000 indirect jobs. Arcelor Mittal sells the Italian long carbon steel production Travi e Profilati di Pallanzeno and San Zeno Acciai to Duferco for 117 million, as part of Mittal Steel's commitment to the European Commission. Arcelor Mittal acquires Sicartsa, the leading Mexican long steel producer. Sicartsa is a fully integrated producer of long steel with an annual production capacity of about 2.7 million tonnes, and with production facilities in Mexico and Texas. This combination of Sicartsa with Mittal Steel Lzaro Crdenas leads to the creation of Mexico's largest steel producer with an annual capacity of 6.7 million tonnes. Arcelor Mittal signs a Memorandum of Understanding for the Greenfield project in Orissa, India. The aim is to set up steelmaking operations in the Keonijhar District. The integrated steel plant should have a total annual capacity of 12 million tonnes. This would include captive mining facilities, captive power supply, water supply infrastructure and other facilities including setting up townships for employees. The first slab in the new continuous caster in Dabrova has been produced and represents a key step of the successful restructuring of Arcelor Mittal Poland. Other projects had been achieved earlier, such as the relining of a blast furnace in September 2006, the commissioning of the new colour coating line in Huta Florina. The start-up of a new hot strip mill in Krakow is foreseen in the first half of 2007.

Arcelor Mittal says EBITDA will be higher in 2007 than in 2006.

History of Arcelor Mittal

ArcelorMittal was formed from the acquisition of Arcelor by Mittal Steel. Mittal Steel was in turn formed from the merger of ISPAT International and LNM Holdings. The timeline below covers the history of these firms. Notes 1989: Lease deal with Iron & Steel Company of Trinidad & Tobago. 1992: Acquisition of Sibalsa in Mexico. 1994: Acquisition by Ispat of Sidbec-Dosco in Canada. 1995: Acquisition of Karmet Works in Kazakhstan. 1995: Acquisition of Hamburger Stahlwerke in Germany. 1997: Ispat International floats in NY & Amsterdam. 1997: Takeover of Thyssen Duisberg, Germany. 1998: Acquisition of Inland Steel Company, USA. 1999: Ispat purchase of Unimetal, France. 2001: Purchase of Sidex Galati in Romania. 2001: Purchase of Alfasid [renamed Mittal Steel Annaba] in Algeria. 2001: Equity partnership deal with Iscor, South Africa. 2003: Acquisition of Nova Hut in Ostrava, Czech Republic. 2004: Acquisition of Skopje plant from Balkan Steel, Macedonia. 2004: LNM Holdings & ISPAT International merged into Mittal Steel. 2005: Purchase of PHS - Polskie Huty Stali in Poland. 2005: Mittal Steel takeover of the International Steel Group, USA. 2005: Acquisition of Kryvorizhstal, Kryvyi Rih in Ukraine. 2005: Purchase of small stake in Hunan Valin, China. 2005: Iron ore mining agreement with government of Liberia. 2005: Unsuccessful bid for Erdemir Group, Turkey. 2006: Acquisition of Arcelor and creation of ArcelorMittal. 2007: ArcelorMittal purchase of 100% stake in Galvex, Estonia. 2007: Arcelor Mittal finalises acquisition of Sicartsa. 2008: Increase of stake in Macarthur Coal Australia to ~20%. 2008: Sale of Sparrow's Point to Russia's Severstal. 2008: Purchase of three coal mining assets in Russia. 2009: Dispute in South Africa over iron ore supply from Kumba. 2009: Divestment of minority interest in Wabush Mines, Canada. 2010: Spin-off of stainless & specialty steels business into Aperam. 2011: ArcelorMittal wins control of Baffinland iron ore mine, Canada.

1995 purchase: Karmet also known as the Karaganda Metallurgical Kombinat. The facility is now known as ArcelorMittal Temirtau. 1997 flotation of Ispat International - at this point the Company controlled group steelmaking operations in Trinidad & Tobago, Mexico, Canada and Germany. The stock exchange debut involved a $776 million initial public offering. In December 2004 Ispat International acquired LNM Holdings NV. The merged companys name was then changed to Mittal Steel Company NV. 2005 purchase of PHS comprised Huta Katowice, Huta Sendzimira, Huta Florian and Huta Cedler. 2005 deal with International Steel Group (ISG) involved acquisition of the former Inland Steel's East Chicago Works, ex-LTV Corporation's Indiana Harbor Works and the Burns Harbor Works that had previously been owned by Bethlehem Steel. 2005 bid for the Erdemir Group was won by OYAK, the Turkish army pension fund. 2007 Sicartsa deal involved acquisition of long product capacity of ~2.7 million tonnes on facilities in Mexico (Lazaro Cardenas) and in Texas, USA (Border Steel). It included purchase of Sicartsa's wholly owned mine with iron ore reserves of ~160 million tonnes. 2008 purchase in Russia was of Beryozovskaya and Pervomayskaya coal mines and of the Zhernovskaya coal deposit. In the 2009 Kumba dispute, the Sishen Iron Ore Company [a subsidiary of Kumba Iron Ore Ltd] informed ArcelorMittal South Africa (AMSA) in early 2010 that the steelmaker was no longer entitled to receive 6.25 mt per annum of iron ore mined by Sishen at cost plus 3%, as AMSA had failed to convert its old order mining rights in May 2009. Adding to the complexity of this dispute, the 21.4% mining rights not converted by AMSA were sold in early 2010 to Imperial Crown Trading 289 (Pty) Ltd (ICT), a step that was later challenged by Sishen. As at mid-2011, both cases are the subject of separate legal proceedings. 2011 purchase of Baffinland was a combined venture involving ArcelorMittal (70% ownership) and Nunavut Iron Ore Acquisition Inc (30% stake) of the Canadian iron ore mining assets.

An account as to how the impossible Arcelor-Mittal merger became possible.

With a large number of parties involved, with different cultures in play, and a lot at stake, this deal promises to give many insights into the negotiation techniques used. Background Mr. Lakshmi Mittal founded Mittal Steel in 1976 in India. After a few years, Mr. Mittal found that it would take him long to grow to a significant size and wanted a way to grow fast. He found that there were various steel companies around the world, which had been performing badly, due to cyclical nature of the industry and poor management of the companies. He started acquiring these companies and turning them around through better management and economies of scale. In 2005, when Mittal Steel acquired the American steel company, ISG, it overtook Arcelor as the worlds largest steel maker, in terms of output. Towards the end of 2005, it made up its mind to acquire Arcelor, the second largest steel producer by output and the largest by turnover. Mittal Steel was headquartered in Netherlands. Arcelor was created in 2002 through merger of three major European steel companies, Arbed (Luxembourg), Aceralia (Spain) and Usinor (France). The idea was to leverage their technical, industrial, and commercial resources in order to create a global leader in the steel industry. It was headquartered in Luxembourg and Mr. Guy Doll was the CEO. Arcelor employed thousands of people across 60 countries. Most of the employees were from Western Europe and in countries with a traditionally strong labor union. Arcelor were still in the process of integrating the business and were neither expecting nor ready for any deal, let alone a takeover offer. It is important to understand where the main people stood when the deal was proposed. This is because, finally it is after all these individuals who would consider and negotiate the deal. The personal interests would play a critical role in the entire process. Mr. Mittal, aged 55 and Mr. Doll, aged 63 shared the same vision. They believed that the steel industry was too fragmented (top 5 companies controlled just 20% business) and was being exploited by the raw material / commodity producers (top 3 iron ore companies controlled 70% business) as well as consumer companies (top 5 automobile companies control 70% business). Consolidation was required and both wanted to emerge as the leader once it gets achieved. Both had contributed their fair share to this process of consolidation in the industry. Their aim was to do things in a way that, before they retire, the companies reach a dominating position in the industry. And that they are considered responsible for that leading position of their companies. The Offer On January 27, 2006, Mittal Steel unveiled an unsolicited $22.7 billion bid for Luxembourg-based Arcelor. As we have already seen, that both companies had been acquiring others in the industry. Both thought that it was a competition against each other. They had been part of various bidding fights for acquisitions of steel companies. But at least one side was not thinking of both going hand in hand against all others. In one such typical bidding, the steel company, Kryvorizhstal of Ukraine was on the block. Many companies entered the fray and the price kept on increasing. Mittal Steel and Arcelor were the last two remaining in the tussle, and the price increased from $3.5bn (when the last company left leaving these two) to $4.8bn where Mittal Steel won the bid.

There was clear scope for saving money in such context. Mr. Aditya Mittal, son of Lakshmi Mittal, was of the view that there were a large number of synergies between the two companies not to mention getting better valuations while buying different companies. There were complementary strengths that could be leveraged. After intense internal discussions, they decided to take the leap, and find ways to make this acquisition possible. The Process of the Initial Offer Generally, in such acquisitions, the acquirer company would like to have a cooperative discussion and settlement. After acquiring, the acquirer is dependent on the target firm for collaboration from executives, employees etc. In addition, the acquirer would like to be seen not as a predator but someone who would make the company achieve greater heights and also help the employees improve their standard of living something which makes it preferable to go for a co-operative process. As we know that, they finally had to resort to go towards a competitive process but they did that when it became a necessity. I believe one has to be ready for this as well for the other sides rationale might be very different and sometimes there might be seemingly irrational behavior as well that would necessitate such a process. Whom to approach The best foot forward One important issue is how the discussion with the target should get started. Research suggests that extroversion, agreeableness and cognitive ability of the negotiators play a major role in the negotiation. So, a person on the other side with these attributes should be preferred, especially when it comes to the initial stages. This particular person is the potential harbinger of the proposed deal in the target. The Mittals found such a person at Arcelor Mr. Alain Davezac, Senior VicePresident, International Business Development, Arcelor (Cognitive Ability). He had been dealing with the extended Mittal family before (Agreeableness) and was an outgoing person (Extroversion). He was enchanted with Buddhism and had dealt with Indians & Indian Companies extensively before in his career. Mr. Aditya thought that it was important to make Mr. Alain up to terms with what has been going on at the Mittals side, and show him the benefits of the collaboration between the two companies. In addition, if everything goes on well, it is Aditya and Alain that would have to do bulk of the work during integration, and so it was best that they became acquainted with each other at the earliest. Where to discuss and the occasion? Issues such as where do the meetings take place; who all are part of the meeting; how are they treated etc, though they might seem trivial, play a very important role. After discussions with Alain for some time and a couple of meets, the Mittals thought that it was now time to involve the CEO of Arcelor, Mr. Doll. Instead of having a formal meeting at some office or hotel, Mr. Doll and Mr. Alain were invited to a dinner meeting on 13th January, 2006 at the grand Mittals home in London (the worlds most expensive house at that time). We believe that it was a way to show the other party that they would be dealing with someone who is not less equal in any possible way. It was also to settle any apprehensions regarding the Mittals ability to handle the large company, that might arise once they come to know about their proposal. The Mittals might also be looking to gain an upper hand (through the venue and the fact that they are the hosts) before the start of the formal negotiations. The negotiations before the negotiation The notorious dinner

When the dinner was planned, little did anyone know that it would become such a quoted event in the future. The Mittals did not want to indicate on an outright basis that there would be a deal coming. They wanted to explore the possibility and see the reaction of the other side. As per Mittal Steels prospectus for the Arcelor offer, the issue of the merger was brought up at the dinner meeting but Mr. Dolls reaction was non-committal and that he pointed out the issues that would arise and the risks involved. The part of the conversation related to the merger was only for 4-5 minutes. Mr Doll later said that the conversation was friendly but did not give any details. A week after the dinner, both sides decided to meet again to discuss about the merger specifically, but the meeting could not take place as Mr Doll had to follow-up on their proposed acquisition of the Canadian company, Dofasco. Now or Never This was an inflection point in the whole deal. The Mittals knew that if Arcelor went ahead with the Dofasco deal, it would get tougher to merge, possibly due to anti-trust conditions and due to Arcelor becoming a larger company. So that Dofasco can be done away with, they needed to find an alternate for Dofasco in case they are successful in going ahead with merging with Arcelor. They signed a binding agreement with ThyssenKrupp AG (that was also involved previously in bidding for Dofasco) about selling Dofasco to them, after the merger. Without wasting any more time, the Mittals informed Mr. Doll (who reportedly hung up on hearing about the Offer announcement) and Mr. Alain on 26th January, 2006 (after markets closed) about their plans to announce an Offer on 27th January. The Mittals had gotten the sense that management at Arcelor, specifically Mr. Doll would not be too keen on such a proposal. However, they wanted to do as much as possible that would make them look as if the were on the right side; and it was their counterparts that did not co-operate. The offer was announced the next day.

Integrating steel giants: An interview with the ArcelorMittal postmerger managers

The merger of two large, complementary companies presented an unusual challenge: sustaining growth as well as focusing on integration and cost savings. FEBRUARY 2008 Seraf De Smedt and Michel Van Hoey

In This Article Exhibit: Biographies of ArcelorMittal's Jrme Granboulan and William A. Scotting About the authors Comments

Few industrial mergers in recent years have captured the business worlds imagination quite like the combination of giants Arcelor and Mittal Steel. The two were brought together in June 2006 to form the worlds biggest steel company, ArcelorMittal. It now has 320,000 employees in more than 60 countries and is a global leader in all its major customer markets, including automotive, construction, household appliances, and packaging. In 2007, the company earned revenues of more than $105 billion, while its steel production accounts for roughly 10 percent of the worlds output. Behind the headlines, the primary challenge of any industrial merger is to integrate the separate management teams, sales and product groups, operating assets, and procurement divisions. At ArcelorMittal, the responsibility for driving this effort fell to Bill Scotting and Jrme Granboulan, two experienced steel men and veterans of earlier mergers at Mittal Steel and Arcelor, respectively. The London-based Scotting, an executive vice president responsible for strategy at the combined group, and Granboulan, CEO of ArcelorMittals tubular-products division headquartered in Rotterdam, recently met McKinsey associate principals Seraf De Smedt and Michel Van Hoey to analyze the lessons of the integration and to review the progress to date. The Quarterly: In what ways did this merger differ from previous ones you have been involved with? Jrme Granboulan: Besides the huge size of ArcelorMittalwhich was a new experience a big difference this time was that we did not face the sort of difficult, sometimes terrible, problems that arise when capacity has to be rationalized. In this case, there was limited overlap between the two entities. Two other key features have been the speed with which the integration has been achieved and the balance of the objectives. In many mergers the integration process seems so delicate that the sole objective set by senior management is to succeed in merging; the other issues are considered at a later stage. In our case, top management decided to set three clear objectives right from the outset: first, to achieve an efficient and rapid integrationaligning people, delivering synergies, creating the appropriate organization; second, to secure and manage the day-to-day business; and third, to drive continued growth. The first two are fairly common objectives in any merger, though generally with more emphasis on integration than on managing the business. The third one was more unusual. Bill Scotting: The scale of what we were doing and the history of both companies gave us greater visibility than in most mergers. Many more people inside and outside the company were following our activities to see how things would progress. This was quite different from being involved in a local acquisition in a single national market. As Jrme has noted, the fact that the merger was strategically driven by growth rather than by restructuring objectives is particularly significant. The aim has been to combine two complementary businesses with a wide range of capabilities in order to create a more complete entity. In contrast, many of our earlier acquisitions at Mittal Steel were turnarounds focused on cost and productivity improvements.

JRME GRANBOULAN Vital statistics Born July 1953 Married, with 3 children Education Graduated with degrees in engineering from cole Polytechnique (1977) and civil engineering from cole Nationale des Ponts et Chausses (1979) Alumnus of AVIRA (INSEAD) Career highlights ArcelorMittal (2007present) Usinor Executive vice president and CEO of packaging steel business (19982002) Vice president of planning and strategy and head of sales packaging steels (1998) Head of management control (199298) Sollac (Usinor) Vice president and CEO of tubular products Executive vice president of substainable development (200506) Executive vice president of innovation research and development (200205) Arcelor

Fast facts Chairman of boards of ArcelorMittal Tubular Products holding and companies The creation of ArcelorMittal was significant for several reasons, not least of which was the mergers sheer scale. While unambiguously shaped and driven by the vision of President and CEO Lakshmi Mittal, the two parts were of roughly equal proportions, so in that sense the deal constituted a merger of equals. Both Mittal Steel and Arcelor were relatively young companies: the former resulted from a string of international acquisitions, while the latter was the product of three primarily European steel companies (Arbed, Aceralia, and Usinor). Unusually, the deal involved two corporations whose geographic and market strengths were remarkably complementary, though Mittal Steels vertically integrated business model (it owned iron ore mines around the globe) contrasted with Arcelors greater downstream concentration.

WILLIAM A. SCOTTING Vital statistics Born October 1958, in Newcastle, NSW, Australia Married, with 2 children Education Graduated with BS in metallurgy in 1982 from University of Newcastle, NSW, Australia Earned MBA in 1992 from Warwick Business School, UK

Career highlights ArcelorMittal Executive vice president, member of management committee and head of strategy (2007present) Executive vice president, member of management committee and head of performance enhancement (200607) Director of Continuous Improvement Associate principal

Mittal Steel (200206) McKinsey & Company (19952002) Fast facts Member of board of directors of ArcelorMittal Kryviy Rih, ArcelorMittal Temirtau JSC, ArcelorMittal Galati, and ArcelorMittal Liberia; formerly member of supervisory board of Mittal Steel Hamburg (200507) Awarded Australasian Institute of Metals Prize (1980) in metallurgy at the University of Newcastle The Quarterly: Has the experience taught you things that would be useful in more conventional mergers, or is the approach always dictated by individual circumstance? Bill Scotting: I believe we would always seek to integrate quickly, as we have here. It is also always critical to be aware of internal perceptions. In this merger, we conducted interviews and surveys with employees to gain a better understanding of their views about the two companies, a process that culminated in an entire rebranding exercise. We questioned people about the companys strengths and weaknesses and what they thought ArcelorMittal should stand for. I had not done this sort of thing in the past, but based on our recent experience it is something I would definitely apply in the future to any type of merger. Having ones antennae up with respect to what people are thinking is extremely useful. The Quarterly: What were the main issues at the outset of the merger? Jrme Granboulan: One of the greatest challenges was to get line managers involved and to sell the merger to the operating teams. This was time consuming. Our initial communication efforts, including the launch of a top-management road show, were extremely successful. We established a Web site and introduced Web TV, which as far as I know represented the first large-scale application of this tool. Top executives recorded two- to three-minute interviews on various topics, and everyone with access to a PC was able to watch them onscreen. The launch of our new brand and the employee convention at which we gathered the companys top 500 executives, in spring 2007, provided a great boost and put an end to the formal integration process. So far as communication is concerned, the theory of integration and how it is managed does not interest people particularly. When cascading information throughout the organization, focus on concrete messages rather than general ones. The Quarterly: Did the challenge lie with the line managers themselves, the employees at large, or merely the ability of the line managers to translate your vision? Bill Scotting: It could have been a number of things. In the early days of the merger, inevitably everyone was wondering what impact this process would have on them, and the uncertainty level was quite high. Managers need to have a well-structured message about the significance of the merger and the direction the company is going in, and we learned that this

should be done very clearly and as a matter of urgency. With relatively few operational overlaps, initially the merger only directly affected employees working in procurement, sales and marketing, and the corporate centerbesides those operating managers involved in benchmarking and the integration task forces, of course. So a lot of time may have elapsed before it had a direct impact on the activities of many other employees. That time lag may have contributed to the uncertainty. Agreeing on the medium-term value plan for the new group was also an intense effort. Fortunately, the budgeting cyclethe integration effort started in August 2006, and budgets for 2007 had to be finalized in Novemberworked in our favor and added impetus to the process. The Quarterly: Youve mentioned speed as a critical factor. How did you generate it? Jrme Granboulan: Our goal at the beginning was to complete the formal phase of integration within the first six months. It was therefore critical to agree quickly the role of the integration office; the essential characteristics of the integration process, including how decisions would be made; and what problem-solving mechanisms might be needed. In large mergers such as this, progress is often reviewed on a monthly basis, but in our case the cycle was weekly. The group-management board,1 essentially the top-executive team, met every Monday, and the integration office, which Bill and I headed up, met every Wednesday. This allowed us to review the progress of the 20 to 25 decentralized task forces in the middle of every week, identify roadblocks, and bring them to the management board meeting a few days later, where decisions could be made. This cycle continued throughout the integration effort. I believe this was an extremely efficient way to maintain tension and momentum within the organization, and this fast-beating pulse was a key to the success of the integration. It was also critical at the beginning to work in parallel, instead of in sequence. In many mergers, teams from the two merging entities are nominated. These teams then propose a draft organization to the management board. The profiles of the people who will occupy the senior positions are defined and committees established to select them. Once these senior managers are nominated, they build their own teams to identify the synergies and build action plans. In our case, all these different tasks were conducted in parallel. Teams were formed before the organization had been fully announced; the implementation of certain actions was started before the detailed plans had been developed. The Quarterly: Can you say more about how you structured the new organization and the integration team? Jrme Granboulan: Everything was initially divided 5050 between the two companies. There were 6 members on the new group-management board, for example3 from each side. The integration office comprised 10 to 12 people, again evenly split. In many mergers this team is much larger, but I believe that 10 to 12 was an optimal size and contributed to the speed at which we moved. Typically, the larger the team, the more complicated the process becomes. The role of the integration office is not to lead the company, nor is it a body located in a remote corporate office to manage processes. Although its an instrument of the management board, it must establish its credibility with the managers of the large units separately. The managers must feel that they can receive assistance and facilitation from the integration office. Bill Scotting: It was clear from the first day that the CEO and the group-management board were effectively the integration board. They were the ones who laid out the expectations.

They decided what actions should be taken, and at what speed. They also outlined the core principles and guidelines and the weekly cycle. The small size of the integration team, which as Jrme says was deliberate, raises a second key design element of the mergerin addition to speedwhich we termed integrating integration. When we established the task forces, the people leading them came from the business units. Thus, commercial integration issues were handled by the commercial business units; technical-benchmarking issues were handled by the operations experts. The role of the integration team was to coordinate all these efforts. Each integration coordinator was responsible for three or four task forces and maintained contact with them on a daily basis. The Quarterly: Did these task forces achieve the targets they had identified? Bill Scotting: At the outset there was a high-level, top-down target of $1.6 billion of synergies, based on earlier acquisitionsfor example, ISG2 in the United Statesknowledge sharing, and the use of benchmarks. The role of the task forces was first to validate this number from the bottom up and then to tell us how the synergies could be achieved. As the merger progressed, it was necessary to get the business units to assume ownership of the process and to formulate the action plans for delivering the synergies. We pushed hard to obtain the plans, details of the initiatives, timetables, and, where possible, key performance indicators that we could use to track the delivery of objectives. We were able to obtain this information for some areas, but not all. In some cases we discovered the scope for savings was larger than we thought, in others smaller. Overall, we managed to validate our target of $1.6 billion to be achieved by mid-2009. The realization of these synergies, incidentally, is well ahead of schedule, with more than $1.4 billion of annualized savings captured by the end of the fourth quarter 2007. Jrme Granboulan: Within a month we had refined the $1.6 billion savings target, which is an annualized figure, divided it into four main chapterspurchasing, sales, operations, and miscellaneousand assigned parts of it to the business units and task forces. Each task force had about five weeks to confirm that the figures seemed correct and to present their action plan. As Bill mentioned, the timing worked in our favor, as the integration objectives could be incorporated into our 2007 budget plans, which were being finalized at the time. Without this, people might have tried to suggest that the environment had changed. Some of the task forces were named after large business entities, such as Flat Carbon Europe (FCE) operations and Long Carbon Europe operations. Others, such as purchasing or sales, were functional. However, all were staffed by people from the business and deeply rooted in the business. The key point is that the task forces did not operate independently of the business operations. The Quarterly: What was your approach to stakeholders such as customers, communities, and suppliers? Bill Scotting: The external communication was conducted in several ways. In the early days, members of the group-management board traveled to all the major cities and sites of operationsthe road show we referred to earliertalking to local management and employees in these environments. Typically, media interviews were also conducted around these visits, providing an opportunity to convey our message to local communities through the press. Because of the size of the merger, it has generated ongoing interest from the financial and business press. We organized a media day in Brussels in March 2007, offering presentations on the status of the merger and the results and inviting journalists to go to the different businesses and review the progress themselves.

Jrme Granboulan: With respect to investors and other stakeholders, I believe the fact that group-management board members came from both companies was significant. A key objective of the commercial task force during the integration phase was to create, and quickly, a single face to the market, rather than two separate propositions. Besides the synergies this task force was asked to deliver, it was instructed to set up the appropriate organization for communicating with customers in this waysomething that was achieved by the end of the first three months. Customers were informed about the advantages of the merger for them, such as enhanced R&D capabilities and wider global coverage. The Quarterly: What characteristics or key skills are required to run an integration office? Bill Scotting: The leader of an integration office must be collaborativein the ArcelorMittal case, the office played a facilitating roleand at the same time possess a degree of process orientation: for instance, to manage the weekly cycle and obtain all the mandates. In addition, I believe the role requires a thorough understanding of the business. For example, we held some intense debates on the changes that could, or could not, be made in the value plans. The leader must possess an understanding of such matters. Jrme Granboulan: I would also say that key qualities are cultural openness, the capacity to understand people, and the ability to see how they can fit together. However, its also important not to accept any diversions and to adhere to the schedule and the key objectives of the organization. The integration leader should also be able to form a close, trusting relationship with the senior management of the group. The integration offices credibility and authority, which are essential for the tougher aspects of a merger, rely on the support of the CEO and senior management. The Quarterly: From your perspectives, what is the appropriate role of the CEO in a merger? Jrme Granboulan: Clearly, the CEO sets the tone, the speed, the direction, the key principles, and the requirements. In this case, he insisted that the business units should be fully involved and take the reins as soon as possible. The CEO also plays a critical role with respect to communication and developing the personality of the new company. A merger is like a river flowing into the sea. When the tide is changing, the boats do not know exactly how to align. Then, progressively, they manage to do so. The role of the CEO is quickly to set everybody on the same axis and to reassure people. At the same time, though, he is responsible for what in French we call exigencethat is to say, being demanding. Bill Scotting: Id stress that the river needs to be flowing; it cannot be a stretch of still water. There is also the accountability aspect. CEOs should not merely announce that the merger is important; they should demonstrate its importance by ensuring that it is placed on the agenda every week. The CEO plays an extremely important role in communication, both internal and external, but in our model it is vital that the whole top-executive team should be visible, cohesive, and that it should provide leadership. We could not afford its members to be pulling in different directions. It is the CEOs role to ensure that the top team is aligned and speaking with a single voice. The Quarterly: Some people talk about merging or combining cultures, while others seek to create a new culture that is separate from those of the legacy companies. What was your approach? Jrme Granboulan: We are not in the position of groups that have existed for, say, 50 years, and therefore it may be more useful to speak of company cultures. Our approach has been to take the best genes of the two groups, in order to create the DNA of the new entity, but that process takes time. The formal integration was completed when the new organization, the brand, the one face to the customer requirement, and the synergies were finalized, two and

a half quarters after the start. But it will take more time to fully integrateincluding all the cultural aspectstwo entities such as Arcelor and Mittal Steel. The passion in the industry is remarkable, and there is always an immediate common ground when steelmakers meet. The first time we got the senior management from the two sides together some may have had apprehensions, but they were discussing steel and exchanging ideas after a few minutes. We are progressively building a common culture combining the best of both entities. We are combining the speed and vision that characterized the genes of Mittal Steel with the steady, long-term, step-by-step approach that characterized the genes of some of the ex-Arcelor entities. In areas like health and safety, quality, and performance, we are conveying the message that this group has high standards and that if some parts of the group do not meet these standards it is possible for them to obtain help from other parts. Id particularly single out our health and safety day, which was a highly effective way of aligning people during the integration phase. It did not merely convey a direct message, in this case relating to health and safety. By involving all operations in the same activities, it subliminally reinforced the notion that ArcelorMittal is now a worldwide organization. Bill Scotting: I would say that the cultural differences within the two legacy groups are more significant, as a result of their history. In effect, neither company was overly homogenous, at least from a cultural perspective. One of the beauties of mergers is that the less homogenous the two merging entities, the greater the opportunity to learn new ideas, combine existing ones, and gain fresh perspectives. The Quarterly: Whats the next big challenge? Bill Scotting: In mid 2007, we held a strategic seminar and subsequently published an addendum to our growth plan, extending it beyond 2012 and focusing on internal opportunities. We used the same approach to develop this plan as we did to formulate the initial strategy. The main agenda and direction were set at the top, and many internal opportunities were identified. Then, a bottom-up process conducted at the business unit level led to the development of specific growth initiatives. Meeting these objectives is one of our priorities going forward. Beyond this we have the challenge of fulfilling our aspirations and truly achieving the potential from the merger. It has created a clear leader in the industry in terms of scale and scope. Such a position brings responsibilities and an opportunity to shape the development of the steel industry and make it truly sustainable. To accomplish this goal, we must continue to expand, particularly in the faster-growing emerging markets. In addition to looking for further consolidation opportunities, we have the new challenge of managing greenfield expansion in these geographiesfor example, in India and West Africa. Innovation will be important to make our steelmaking processes more energy efficient and environmentally sound and to improve our product capabilities: lighter, stronger steels can meet the evolving needs of our customers, for example. Success in these areas will help make steel a material of choice in many applications. We also face the organizational challenge of managing this large, diverse group: capitalizing on the benefits of our scale and scope, such as product and market capabilities, technical knowledge, and so forth, while at the same time meeting the needs of local customers and local communities. The merger and the integration process unleashed a lot of goodwill and energy. Its always important to look for new ways to maintain energy levels.

About the Authors Seraf De Smedt is an associate principal in McKinseys Brussels office, and Michel Van Hoey is an associate principal in the Luxembourg office. 1ArcelorMittal, as with many European companies, has a two-tier board structure: a board of directors, responsible for oversight, and a group-management board, responsible for day-today operations. The president and CEO is a member of both boards. 2Mittal Steel completed its merger with International Steel Group (ISG) in April 2005.
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OCTOB E R 2 0 0 9

Risk: Seeing around the corners

Risk-assessment processes typically expose only the most direct threats facing a company and neglect indirect ones that can have an equal or greater impact.
Eric Lamarre and Martin Pergler
riskpractice

The financial crisis has reminded us of the valuable lesson that risks gone bad in one part of the economy can set off chain reactions in areas that may seem completely unrelated. In fact, risk managers and other executives fail to anticipate the effects, both negative and positive, of events that occur routinely throughout the business cycle. Their impact can be substantialoften, much more substantial than it seems initially. At first glance, for instance, a thunderstorm in a distant place wouldnt seem like cause for alarm. Yet in 2000, when a lightning strike from such a storm set off a fire at a microchip plant in New Mexico, it damaged millions of chips slated for use in mobile phones from a number of manufacturers. Some of them quickly shifted their sourcing to different US and Japanese suppliers, but others couldnt and lost hundreds of millions of dollars in sales. More recently, though few companies felt threatened by severe acute respiratory syndrome (SARS), its combined effects are reported to have decreased the GDPs of East Asian nations by 2 percent in the second quarter of 2003. And in early 2009, the expansion of a European public-transport system temporarily ground to a halt when crucial component providers faced unexpected difficulties as a result of credit exposure to ailing North American automotive OEMs. What can companies do to prepare themselves? True, theres no easy formula for anticipating the way risk cascades through a company or an economy. But weve found that executives who systematically examine the way risks propagate across the whole value chainincluding competitors, suppliers, distribution channels, and customerscan foresee and prepare for second-order effects more successfully. Risk along the value chain Most companies have some sort of process to identify and rank risks, often as part of an enterprise risk-management program. While such processes can be helpful, our experience suggests that they often examine only the most direct risks facing a company and typically neglect indirect ones that can have an equal or even greater impact. Consider, for example, the effect on manufacturers in Canada of a 30 percent appreciation in the value of that countrys dollar versus the US dollar in 200708. These companies did understand the impact of the currency change on their products cost competitiveness in the US market. Yet few if any had thought through how it would influence the buying behavior of Canadians, 75 percent of whom live within 100 miles of the US border. As they started purchasing big-ticket items (such as cars, motorcycles, and snowmobiles) in the United States, Canadian OEMs had to lower prices in the domestic market. The combined effect of the profit compression in both the United States and Canada did much greater damage to these manufacturers than they had initially anticipated. Hedging programs designed to cover their exposure to the loss of cost competitiveness in the United States utterly failed to protect them from the consumer-driven price squeeze at home.
3

Clearly, companies must look beyond immediate, obvious risks and learn to evaluate aftereffects that could destabilize whole value chains, including all direct and indirect

business relationships with stakeholders. A thorough analysis of direct threats is always necessarybut never sufficient (Exhibit 1). Competitors. Often the most important area to investigate is the way risks might change a companys cost position versus its competitors or substitute products. Companies are particularly vulnerable to this type of risk cascade when their currency exposures, supply bases, or cost structures differ from those of their rivals. In fact, all differences in business models create the potential for a competitive risk exposure, favorable or unfavorable. The Exhibit 1

Cascading risks
Competition Distribution Geopolitical events Foreignexchange rates Economic growth Public policy/ regulation Commodity prices Financial Demographics markets Technology Environment Pandemics Inflation Hazards

MoF 2009 Risk cascades Exhibit 1 of 2 Glance: Companies are susceptible to interconnected cascades of risk. Exhibit title: Cascading risks
Company Impact of risk on: Productivity Product/service performance Cost structure Financing Changes in ability/ willingness to buy Price sensitivity Credit availability Shift in buying patterns Changes in health or performance of distribution channels Financial strength Value vs alternative channels Changes in competitive position vs competitors or substitutes Cost difference Relative product performance Changes in input costs Security of supply Suppliers cost structures Logistics costs Tariffs Supply chain Customers Risk triggers 4

point isnt that a company should imitate its competitors but rather that it should think about the risks it implicitly assumes when its strategy departs from theirs. Consider the impact of fuel price hedging on fares in the highly competitive airline industry. If the airlines covering a certain route dont hedge, changes in fuel costs tend to

percolate quickly through to customerseither directly, as higher fares, or indirectly, as fuel surcharges. If all major companies covering that route are fully hedged, however, that would offset changes in fuel prices, so fares probably wouldnt move. But if some players hedge and others dont, fuel price increases force the nonhedgers to take a significant hit in margins or market share while the hedgers make windfall profits. Companies must often extend the competitive analysis to substitute products or services, since a change in the market environment can make them either more or less attractive. In our airline example, high fuel prices indirectly heighten the appeal of video-conferencing technologies, which would drive down demand for business travel. Supply chains. Classic cascading effects linked to supply chains include disruptions in the availability of parts or raw materials, changes in the cost structures of suppliers, and shifts in logistics costs. When the price of oil reached $150 a barrel in 2008, for example, many offshore suppliers became substantially less cost competitive in the US market. Consider the case of steel. Since Chinese imports were the marginal price setters in the United States, prices for steel rose 20 percent there as the cost of shipping it from China rose by nearly $100 a ton. The fact that logistics costs depend significantly on oil prices is hardly surprising, but few companies that buy substantial amounts of steel considered their second-order oil price exposure through the supply chain. Risk analysis far too frequently focused only on direct threatsin this case, the price of steel itselfand oil prices didnt seem significant, even to companies for which fluctuating costs may well have been one of the biggest risk factors. Distribution channels. Indirect risks can also lurk in distribution channels: typical cascading effects may include an inability to reach end customers, changed distribution costs, or even radically redefined business models, such as those recently engendered in the music-recording industry by the rise of broadband Internet access. Likewise, the bankruptcy and liquidation of the major US big-box consumer electronics retailer Circuit City, in 2008, had a cascading impact on the industry. Most directly, electronics manufacturers held some $600 million in unpaid receivables that were suddenly at risk. The bankruptcy also created important indirect risks for these companies, in the form of price pressures and bargain-hunting behavior as liquidators sold off discounted merchandise right in the middle of the peak Christmas buying season. Customer response. Often, the most complex knock-on effects are the responses from customers, because those responses may be so diverse and so many factors are involved. One typical cascading effect is a shift in buying patterns, as in the case of the Canadians
5

who went shopping in the United States with their stronger currency. Another is changed demand levels, such as the impact of higher fuel prices on the auto market: as the price of gasoline increased in recent years, there was a clear shift from large sport utility vehicles to compact cars, with hybrids rapidly becoming serious contenders. Consider too how the current recession has shrunk the available customer pool in many product categories: demand for durable goods plummeted among consumers holding subprime mortgages as their access to credit shrank, and demand for certain luxury goods fell as even financially stable consumers turned away from conspicuous consumption. Effects on a companys risk profile Risk cascades are particularly useful to help assess the full impact of a major risk on a companys economics. Exploring how that risk propagates through the value chain can help management think throughimperfectly, of coursewhat might change fundamentally when some element in the business environment does. To illustrate, lets examine how the risk posed by new carbon regulations might affect the aluminum industry. Aluminum producers would be directly exposed to such regulations because the electrolysis used to extract aluminum from ore generates carbon. Theyre also indirectly exposed to risk from carbon because the suppliers of the electrical power needed for electrolysis generate it too. The carbon footprint can be calculated easily and its economic cost penalty determined by extrapolation from different regulatory scenarios and the underlying carbon price assumptions. This cost penalty would of course depend on the carbon efficiency of the production process and the fuel used to generate power (hydropower, for instance, is more carbon efficient than power from coal). In general, large industrial companies believe they are carbon short in the financial sensetheir profits get squeezed when carbon prices increase. Is that always true? A different story emerges from a closer look at the supply chain, which stiffer carbon regulations would change in many different ways. The cost of key raw materials, such as

calcined petroleum coke and caustic soda, would increase, along with logistics costs and therefore geographic premiums. The US Midwest market premium, for example, reflects the cost of delivering a ton of aluminum to the region, where demand vastly exceeds local supply. Not all competitors in the industry would be affected alike: this effect favors smelters located close to the US Midwest, because they could then pocket the higher premium. Some suppliers might even benefit from their geographic position. Moreover, in a carbon-constrained, tightly regulated world, aluminum becomes a material of choice to build lighter, more fuel-efficient cars. Since automobile manufacturing is one of the largest end markets for aluminum, carbon regulation could substantially accelerate demand, thus helping to support healthy margins and attractive new development projects. Clearly, a high carbon price would enhance aluminums value propositionpositive news for the industry.
6

Finally, carbon regulations would affect not only a particular company but also its competitors, changing the economics of the business. For commodity industries, the cash cost of marginal producers sets a floor price. In a world where carbon output has a price, the cost structure of different smelters would depend on their carbon intensity (such as the amount of carbon emitted per ton of aluminum produced) and local carbon regulations. Its possible to show how any regulatory scenario could influence the aluminum cost curve (Exhibit 2). In nearly all the plausible scenarios, the curve steepens and the floor price of aluminum therefore increases. For most industry participants, especially very carbonefficient ones (such as those producing aluminum with hydropower), a meaningful margin expansion could be expected. A simple risk analysis suggested that one of our clients would be carbon short and that its profits would therefore decrease under new carbon regulations. But a more extensive Exhibit 2

Shifting advantage
High (>$3,000 per ton1) Aluminum industry cost curve after factoring in cost of carbon regulation Production cost Low (~$1,000 per ton) Capacity in tons

MoF 2009 Risk cascades Exhibit 2 of 2 Glance: Carbon regulation would reshuffle the aluminum industrys cost curve. Exhibit title: Shifting advantage
The cost of carbon shifts up the cost curve and lifts the commodity price Low-cost players that also have low carbon costs see margins expand Some previously low-cost players are marginalized
1Dependent

on regulatory scenario.

Some previously high-cost players are advantaged

Baseline production cost Cost of carbon

view of the way carbon risk cascades through the industry value chain shows that this company would actually be carbon long: as carbon prices increase, the company benefits economically thanks to its high carbon efficiency, its desirable geographic location (proximity to the US Midwest), and the potential added demand for aluminum.
7

Unknown and unforeseeable risks will always be with us, and not even the best riskassessment approach can identify all of them. Even so, greater insight into the way they might play out can provide a more comprehensive picture of an industrys competitive dynamics and help shape a better corporate strategy. Thinking about your risk cascades is a concrete approach to gaining that insight.

Eric Lamarre is a director in McKinseys Montral office, where Martin Pergler is a consultant. Copyright 2009 McKinsey & Company. All rights reserved.

Risk: Seeing around the corners

Risk-assessment processes typically expose only the most direct threats facing a company and neglect indirect ones that can have an equal or greater impact. OCTOBER 2009 Eric Lamarre and Martin Pergler Source: Risk Practice

In This Article Exhibit 1: Companies are susceptible to interconnected cascades of risk. Exhibit 2: Carbon regulation would reshufe the aluminum industrys cost curve. About the authors Comments

The financial crisis has reminded us of the valuable lesson that risks gone bad in one part of the economy can set off chain reactions in areas that may seem completely unrelated. In fact, risk managers and other executives fail to anticipate the effects, both negative and positive, of events that occur routinely throughout the business cycle. Their impact can be substantial often, much more substantial than it seems initially. At first glance, for instance, a thunderstorm in a distant place wouldnt seem like cause for alarm. Yet in 2000, when a lightning strike from such a storm set off a fire at a microchip plant in New Mexico, it damaged millions of chips slated for use in mobile phones from a number of manufacturers. Some of them quickly shifted their sourcing to different US and Japanese suppliers, but others couldnt and lost hundreds of millions of dollars in sales. More recently, though few companies felt threatened by severe acute respiratory syndrome (SARS), its combined effects are reported to have decreased the GDPs of East Asian nations by 2 percent in the second quarter of 2003. And in early 2009, the expansion of a European public-transport system temporarily ground to a halt when crucial component providers faced unexpected difficulties as a result of credit exposure to ailing North American automotive OEMs. What can companies do to prepare themselves? True, theres no easy formula for anticipating the way risk cascades through a company or an economy. But weve found that executives who systematically examine the way risks propagate across the whole value chainincluding competitors, suppliers, distribution channels, and customerscan foresee and prepare for second-order effects more successfully. Risk along the value chain Most companies have some sort of process to identify and rank risks, often as part of an enterprise risk-management program. While such processes can be helpful, our experience suggests that they often examine only the most direct risks facing a company and typically neglect indirect ones that can have an equal or even greater impact. Consider, for example, the effect on manufacturers in Canada of a 30 percent appreciation in the value of that countrys dollar versus the US dollar in 200708. These companies did understand the impact of the currency change on their products cost competitiveness in the US market. Yet few if any had thought through how it would influence the buying behavior of Canadians, 75 percent of whom live within 100 miles of the US border. As they started purchasing big-ticket items (such as cars, motorcycles, and snowmobiles) in the United

States, Canadian OEMs had to lower prices in the domestic market. The combined effect of the profit compression in both the United States and Canada did much greater damage to these manufacturers than they had initially anticipated. Hedging programs designed to cover their exposure to the loss of cost competitiveness in the United States utterly failed to protect them from the consumer-driven price squeeze at home. Clearly, companies must look beyond immediate, obvious risks and learn to evaluate aftereffects that could destabilize whole value chains, including all direct and indirect business relationships with stakeholders. A thorough analysis of direct threats is always necessarybut never sufficient (Exhibit 1).

Competitors Often the most important area to investigate is the way risks might change a companys cost position versus its competitors or substitute products. Companies are particularly vulnerable to this type of risk cascade when their currency exposures, supply bases, or cost structures differ from those of their rivals. In fact, all differences in business models create the potential for a competitive risk exposure, favorable or unfavorable. The point isnt that a company should imitate its competitors but rather that it should think about the risks it implicitly assumes when its strategy departs from theirs. Consider the impact of fuel price hedging on fares in the highly competitive airline industry. If the airlines covering a certain route dont hedge, changes in fuel costs tend to percolate quickly through to customerseither directly, as higher fares, or indirectly, as fuel surcharges. If all major companies covering that route are fully hedged, however, that would offset changes in fuel prices, so fares probably wouldnt move. But if some players hedge and others dont, fuel price increases force the nonhedgers to take a significant hit in margins or market share while the hedgers make windfall profits. Companies must often extend the competitive analysis to substitute products or services, since a change in the market environment can make them either more or less attractive. In our airline example, high fuel prices indirectly heighten the appeal of video-conferencing technologies, which would drive down demand for business travel. Supply chains Classic cascading effects linked to supply chains include disruptions in the availability of parts or raw materials, changes in the cost structures of suppliers, and shifts in logistics costs. When the price of oil reached $150 a barrel in 2008, for example, many offshore suppliers became substantially less cost competitive in the US market. Consider the case of steel. Since Chinese imports were the marginal price setters in the United States, prices for steel rose 20 percent there as the cost of shipping it from China rose by nearly $100 a ton. The fact that logistics costs depend significantly on oil prices is hardly surprising, but few companies that buy substantial amounts of steel considered their second-order oil price exposure through the supply chain. Risk analysis far too frequently focused only on direct threatsin this case, the price of steel itselfand oil prices didnt seem significant, even to companies for which fluctuating costs may well have been one of the biggest risk factors. Distribution channels Indirect risks can also lurk in distribution channels: typical cascading effects may include an inability to reach end customers, changed distribution costs, or even radically redefined business models, such as those recently engendered in the music-recording industry by the rise of broadband Internet access. Likewise, the bankruptcy and liquidation of the major US big-box consumer electronics retailer Circuit City, in 2008, had a cascading impact on the industry. Most directly, electronics manufacturers held some $600 million in unpaid receivables that were suddenly at risk. The bankruptcy also created important indirect risks for these companies, in the form of price pressures and bargain-hunting behavior as liquidators sold off discounted merchandise right in the middle of the peak Christmas buying season. Customer response Often, the most complex knock-on effects are the responses from customers, because those responses may be so diverse and so many factors are involved. One typical cascading effect is a shift in buying patterns, as in the case of the Canadians who went shopping in the United States with their stronger currency. Another is changed demand levels, such as the impact of

higher fuel prices on the auto market: as the price of gasoline increased in recent years, there was a clear shift from large sport utility vehicles to compact cars, with hybrids rapidly becoming serious contenders. Consider too how the current recession has shrunk the available customer pool in many product categories: demand for durable goods plummeted among consumers holding subprime mortgages as their access to credit shrank, and demand for certain luxury goods fell as even financially stable consumers turned away from conspicuous consumption. Effects on a companys risk profile Risk cascades are particularly useful to help assess the full impact of a major risk on a companys economics. Exploring how that risk propagates through the value chain can help management think throughimperfectly, of coursewhat might change fundamentally when some element in the business environment does. To illustrate, lets examine how the risk posed by new carbon regulations might affect the aluminum industry. Aluminum producers would be directly exposed to such regulations because the electrolysis used to extract aluminum from ore generates carbon. They're also indirectly exposed to risk from carbon because the suppliers of the electrical power needed for electrolysis generate it too. The carbon footprint can be calculated easily and its economic cost penalty determined by extrapolation from different regulatory scenarios and the underlying carbon price assumptions. This cost penalty would of course depend on the carbon efficiency of the production process and the fuel used to generate power (hydropower, for instance, is more carbon efficient than power from coal). In general, large industrial companies believe they are carbon short in the financial sense their profits get squeezed when carbon prices increase. Is that always true? A different story emerges from a closer look at the supply chain, which stiffer carbon regulations would change in many different ways. The cost of key raw materials, such as calcined petroleum coke and caustic soda, would increase, along with logistics costs and therefore geographic premiums. The US Midwest market premium, for example, reflects the cost of delivering a ton of aluminum to the region, where demand vastly exceeds local supply. Not all competitors in the industry would be affected alike: this effect favors smelters located close to the US Midwest, because they could then pocket the higher premium. Some suppliers might even benefit from their geographic position. Moreover, in a carbon-constrained, tightly regulated world, aluminum becomes a material of choice to build lighter, more fuel-efficient cars. Since automobile manufacturing is one of the largest end markets for aluminum, carbon regulation could substantially accelerate demand, thus helping to support healthy margins and attractive new development projects. Clearly, a high carbon price would enhance aluminums value propositionpositive news for the industry. Finally, carbon regulations would affect not only a particular company but also its competitors, changing the economics of the business. For commodity industries, the cash cost of marginal producers sets a floor price. In a world where carbon output has a price, the cost structure of different smelters would depend on their carbon intensity (such as the amount of carbon emitted per ton of aluminum produced) and local carbon regulations. Its possible to show how any regulatory scenario could influence the aluminum cost curve (Exhibit 2). In nearly all the plausible scenarios, the curve steepens and the floor price of aluminum therefore increases. For most industry participants, especially very carbon-efficient ones (such as those producing aluminum with hydropower), a meaningful margin expansion could be expected.

A simple risk analysis suggested that one of our clients would be carbon short and that its profits would therefore decrease under new carbon regulations. But a more extensive view of the way carbon risk cascades through the industry value chain shows that this company would actually be carbon long: as carbon prices increase, the company benefits economically thanks to its high carbon efficiency, its desirable geographic location (proximity to the US Midwest), and the potential added demand for aluminum. Unknown and unforeseeable risks will always be with us, and not even the best riskassessment approach can identify all of them. Even so, greater insight into the way they might play out can provide a more comprehensive picture of an industrys competitive dynamics and help shape a better corporate strategy. Thinking about your risk cascades is a concrete approach to gaining that insight. About the Authors Eric Lamarre is a director in McKinseys Montral office, where Martin Pergler is a consultant.