Arcelor said on Friday it has agreed to buy Russia's Severstal to create the world's biggest steelmaker, in a move that threatens to block Mittal Steel's bid for the European group.

Arcelor said that the Severstal deal, announced just a week after Mittal improved its hostile cash and shares offer, would effectively value it at 44 euros per share, a premium of around 20 percent to Mittal's figure.

Arcelor Chief Executive Guy Dolle said the link-up with the Russian company had been over three years in the making although Mittal's unsolicited advances had been a catalyst.

Under the deal Severstal's Chairman Alexei Mordashov, who owns 89.6 percent of the group, is to provide 11.73 billion euros worth of assets and 1.25 billion euros in cash in exchange for Arcelor shares valued at 44 euros each.

Severstal was valued by the transaction at 13 billion euros, Mordashov told a conference call and its shares were up 12 percent by 0825 GMT at 369.77 roubles on Russia's MICEX exchange.

Dolle said the merger plan would be put to Arcelor shareholders in the coming weeks, adding that he expected a majority of them to vote in favor.

(This represents) a premium of 100 percent over Arcelor's closing price on January 26, 2006, the day before Mittal Steel announced its hostile offer, and 36.6 percent over Arcelor's closing price ex-dividend on May 25, 2006, Arcelor said in a statement.

Mittal Steel's existing bid values Arcelor at around 23 billion euros ($29.4 billion).

I think this is a deal-breaker for Mittal. It will be very difficult to match this, a Paris-based analyst said.

The deal makes industrial sense. With the deal, Arcelor will make some 40 percent of its EBITDA (earnings before interest, tax, depreciation and amortization) in Russia and Brazil, where there are high margins.

Another share dealer in London shared this view: It's unlikely Mittal will chase it at that price.

However, Arcelor shares were off 3.2 percent at 32.96 euros by 0828 GMT, while Mittal's were up 3.2 percent at 25.30 euros.

Shares in ThyssenKrupp, which is hoping to buy Arcelor's newly-acquired Canadian unit Dofasco if Mittal's takeover of Arcelor succeeds, were up 4.3 percent at 27.40 euros.

Mittal was not immediately available for comment.

GLOBAL STEEL LEADER

Arcelor, now the second largest steelmaker behind Mittal in terms of steel volumes, said the merger with the Russian group would create the world's most profitable steel group, targeting an annual core profit of 10 billion euros.

Arcelor's existing shareholders would have about 68 percent of the combined group, which would be the biggest steel producer in Europe, Russia and South America, it said.

Analysts said the Severstal deal could also trigger the long-awaited consolidation of Russia's steel industry, where powerful owners have been reluctant until now to share the spoils of their acquisitions made in Russia's economic turmoil of the 1990s.

It sends a message that Russian steel makers are in play, said Michael Kavanagh, metals and mining analyst at MDM Bank.

It sends a message that President Putin is prepared to allow at least one deal. There may be others.

Severstal can sell into some of the markets where maybe they didn't have access before. For Arcelor, it gives them exposure to the attractive, growing Russian market.

Arcelor and Mittal have been engaged in a war of words since Mittal made its first move to buy its rival in January. Arcelor had dismissed Mittal's initial bid as inadequate and also offered a 5-billion-euro share buyback.

Mittal then surprised the market by raising its cash-and-shares offer a week ago, only a day after the original offer was formally launched.

Arcelor said after the raised bid it was ready to evaluate Mittal's business plan, but investors and analysts said at the time that they suspected it was looking for an alternative, such as the one unveiled on Friday.

Under the agreement with Severstal, Mordashov will contribute all of his economic interests in Severstal and Italian steelmaker Lucchini in return for Arcelor shares.

The enlarged Arcelor would be the world's biggest steel company, with 46 billion euros in sales, 9 billion euros in earnings before interest, tax, depreciation and amortization (EBITDA), 70 million tonnes of production, based on 2005 numbers.

Arcelor said the combination would be accretive to earnings as early as 2006, before synergies, and create synergies of 590 million euros.

(Additional reporting by Marcel Michelson and Marie Maitre in Paris, Elif Kaban and Robin Paxton in Moscow, Mark Meadows and Louise Heavens in London)

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