Plans by Nippon Steel Corp <5401.T> and Sumitomo Metal Industries <5405.T> to create the world's No. 2 steelmaker fanned expectations of further consolidation in the fragmented industry, sending Japanese steelmakers shares surging on Friday.

Over-capacity has long been a problem for the global steel industry, but big deals have been few and far between since the merger that created top steel company ArcelorMittal in 2006.

There was little expectation of any more consolidation among Japanese steelmakers but they showed this is not the case, said Norihide Tsuji, senior analyst at Mizuho Securities. I expect overseas rivals will feel an increased threat.

Shares in Nippon Steel ended 9.1 percent higher and Sumitomo Metal Industries surged 16.1 percent in Tokyo, adding almost $4 billion in combined market value.

The Tokyo iron and steel subindex <.ISTEL.T> rose 6.1 percent, suggesting that investors could be expecting more realignment in the crowded Japanese steel industry.

I think the whole Japanese steel industry has to restructure anyway somewhere down the line and these two companies are at the forefront of that restructuring process, said Goldman Sachs analyst Rajeev Das. What we saw yesterday is the start of a very long one or two decade restructuring of the whole industry.

China, the world's largest steel producer, is aiming to bring more than 60 percent of national steel capacity under the control of its top ten producers by 2015, so more mergers are expected there too.

OVERSEAS EXPANSION

Japan's No.1 and No.3 steelmakers are hoping to merge under a holding company in October 2012, in a deal that would be worth about $13 billion at Sumitomo Metal's current share price.

Analysts shared the companies' view that greater leverage over heavyweight suppliers of iron ore and coking coal was unlikely at a combined market share of just 3 percent.

Japan's top three steelmakers have all cut their outlooks for the year to March in recent days, blaming soaring raw material costs.

The new group could, however, achieve higher margins, better pricing from customers and a more global reach to fend off growing competition from Asian competitors such as South Korea's POSCO <005490.KS>, China's Baoshan Iron and Steel <600019.SS> and India's Tata Steel .

The merged entity would have a very good combination of flat-steel and tubular products, and exposure to growth markets like Brazil and India, Goldman's Das wrote in a note to clients.

With a projected 45 percent share of the domestic steel business, it may also be able to get better pricing/margins at home.

But with management discounting plans to cut their domestic capacity despite a shrinking market, analysts said it was still unclear how much cost saving the yet-to-be-named group would be able to achieve.

If they don't consider (plant closures at home), then they won't get any real benefit from joining, said Keiju Kurosaka, senior analyst at Mitsubishi UFJ Morgan Stanley.

Nippon Steel for example operates nine sites; that is inefficient. It's a cost factor and something they will have to think about.

REGULATORY APPROVAL NEEDED

What conditions the Fair Trade Commission places on approving the deal could also determine the strength of the new entity.

I don't think we can expect smooth sailing (in the approval process), said Polina Diyachkina, Tokyo-based steel analyst at Macquarie Research. It's definitely a concern but the hope is that global market share rather than domestic market share will be taken as a benchmark.

Margins at Japanese steelmakers have been especially hard hit as domestic automakers such as Toyota Motor <7203.T> and Nissan Motor <7201.T> build fewer cars at home and expand in emerging markets such as India, using products from local steelmakers.

Compared with other overseas rivals like POSCO, the two companies have low margins, so that's a challenge, said Mitsushige Akino, a fund manager at Ichiyoshi Investment Management.

Still, supportive comments from Japanese policymakers kept the market's focus on the positive aspects of the planned merger, which is expected to help the companies expand overseas more efficiently.

The main reason for the merger is overseas expansion rather than streamlining domestic operations, although that will also gradually come through, said Macquarie's Diyachkina.

A union between Nippon Steel and Sumitomo Metal would be the first major consolidation in the Japanese steel industry since 2002, when JFE Steel was formed through the merger of Kawasaki Steel and NKK.

Shares of JFE Holdings <5411.T>, Japan's second-largest steelmaker, rose 2.1 percent, while Kobe Steel Ltd <5406.T>, which has capital ties with Nippon Steel and Sumitomo Metal Industries, put on 2.8 percent.