Raw material costs and price volatility have been two major threats dogging the global steel industry post the financial crisis. As a result many steel makers have attempted to bring in raw material mines into their supply chains.
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Ernst & Young research on the top 30 steelmakers by market capitalization over the last three years shows that there is a positive correlation between the integration of raw materials and increased profitability.The results are given below. (Global Steel 2013, © 2013 EYGM Limited.)
But there is still a question as to whether vertical integration creates enterprise value. For example, the differences between mining and steel making may create concerns regarding the allocation of risk. Mining is a high risk, high return business, whereas metals production carries moderate risk and moderate return.
This is evident when looking at the lack of increase in value when steelmakers integrate higher-risk mining businesses into their value chains. In addition to the risks associated with mining, vertically integrated steelmakers may not feel as pressured to implement radical cost management to protect margins if they are accessing raw material cash flows from their mines.
It is important to keep in mind that steelmakers have viable alternatives to legally owning the mining business for vertically integrating raw materials into their supply chains. They can adopt commodity price hedging to address raw material price volatility; hey can also enter into long-term contracts with suppliers at predetermined price.
With these considerations in mind, the Ernst & Young analysis of the enterprise value of the top 30 global steelmakers over the last three years shows that vertical integration has either no effect or a slightly negative effect on the valuations of steel manufacturing companies.