For Russian steelmakers' credit ratings, until recently it has been all about low costs. This has been the companies' core strategic advantage. Although the forces putting upward pressure on costs have been persistent, these companies have been able to preserve margins via efficiency controls, production rationalization, and more value-added products in the sales mix. Standard & Poor's Ratings Services believes, however, that the key rating driver for the Russian steel industry in the medium term will be M&A activity: Most producers in the country have improved their vertical-integration capabilities through domestic acquisitions and now are increasingly looking at securing market access and diversifying the production base through foreign acquisitions.
Russian steelmakers are heading into what looks like a period of elevated M&A with good momentum from another year of favorable steel prices and high cash flow generation in 2006. The favorable cash flow environment contributed to improved credit quality for the four leading Russian steelmakers:
The resulting enhanced financial profiles contributed to all four companies being upgraded in 2006 (see table 1).
Table 1
Credit Quality Ranking Of The Four Leading Russian Steelmakers
Company
Corporate credit rating*
Credit ranking
Business risk profile
Financial risk profile
Rating actions in 2006
OJSC Novolipetsk Steel
BB+/Stable/--
1
Weak
Intermediate
Upgrade to BB+/Stable/-- from BB/Stable/-- on July 12, 2006, due to strong financial metrics.
OAO Magnitogorsk Metallurgical Kombinat
BB/Stable/--
2
Weak
Aggressive
Upgrade to BB/Stable/-- from BB-/Stable/-- on Oct. 2, 2006, due to sustainable favorable operating and financial metrics.
OAO Severstal
BB-/Stable/--
3
Weak
Aggressive
Outlook revision to positive from stable on Feb. 9, 2006, due to expected asset consolidation; CreditWatch placement with positive implications on May 26, 2006, due to a possible merger with Arcelor S.A. (BBB/Stable/A-2), which subsequently failed; Upgrade to BB-/Stable/-- from B+/Watch Pos/-- on July 26, 2006, due to completion of asset consolidation.
Evraz Group S.A.
BB-/Negative/--
4
Weak
Aggressive
Upgrade to BB-/Stable/-- from B+/Positive/-- on May 15, 2006, due to favourable operating and financial metrics; Outlook revision to negative from stable on Nov. 20, 2006, due to an expected acquisition of U.S.-based Oregon Steel Mills Inc.
*At Jan. 12, 2007.
We note that most of the companies used additional cash flows to upgrade their asset bases, which should strengthen their long-term competitiveness. Furthermore, some companies made efforts to streamline their corporate structures and consolidate assets (such as Severstal), or gain or enhance vertical integration (NLMK and Evraz).
While all of these factors should help improve credit quality, we believe M&A will play a greater role in future ratings because all four companies have shown an increased willingness to pursue domestic and, especially, overseas acquisitions.
Constraints On Business Risk Profiles Hamper Rating Improvements
We view the constraints on the business risks profiles of all four producers as the key challenges to overcome on the road to higher ratings. When analyzing each company's business risk profile, we evaluate the country risks and industry-specific risks (which are largely the same for these four producers). These are often beyond the control of each company's management. We also evaluate, however, the company's position, cost base, profitability, and strategic and operational management.
Operating in Russia is a double-edged sword for the four steelmakers. They benefit from the low costs of labor, energy, and raw materials, but are hampered by the country's weak political, legal, and economic institutions. All four steelmakers reviewed here enjoy the same benefits but face the same risks of operating in Russia.
NLMK's business risk profile is ranked the highest among the four peers, mostly due to its superior profitability, which is the best among global steelmakers. Although specific business risks and advantages might be different for Evraz, MMK, and Severstal, overall their business risk profiles are ranked at the same level. Lack of integration into raw materials for MMK is mitigated by improved quality of asset base and high operating efficiency. The good global diversity of Severstal's operations is offset by lower operating margins and cash flows of assets outside of Russia. Evraz benefits from diversified operations in Russia, but this comes with more complicated logistics, in addition to somewhat more dated production assets of some of its plants.
We acknowledge that all four producers have achieved positive results in upgrading, expanding, and modernizing their production assets. We also understand that all four companies are considering international expansion. It remains to been seen, however, how successfully this strategy will be executed and whether or not it would improve their business risk profiles.
Low costs bring benefits that are worth struggling for
Low costs are the key credit strength for all four rated Russian steelmakers. Their access to inexpensive labor, energy, and captive raw material sources offset any technological disadvantages, and allow the companies to post strong operating margins (see chart 1). These are above the margins of their international peers such as Arcelor-Mittal, which posts about a 20% operating margin, and Corus Group PLC (BB/Watch Dev/B), which posts less than 10%.
Chart 1
The margins for Russian players will be more volatile in the longer term, however, due to higher exposure to more variable spot sales and a higher share of less value-added products compared with global rivals. Sustaining low costs will also be a struggle given Russia's persistent cost inflation. So far the companies have been able to largely offset these challenges via vertical integration, investments in modernization, and efficiency controls.
Country risks temper benefits of low costs
All four producers are exposed to the high risks of operating in Russia: The country's political, legal, and economic institutions are weak due to a powerful bureaucracy. This exposes companies to regulatory, tax, and other risks and can create social liabilities. The expected liberalization of the Russian electricity market and gradual increases in the very low domestic gas price create the risk of increased energy costs. These risks largely outweigh many other advantages of operating in Russia in our credit assessment.
Although international diversification of assets is gradually increasing following overseas acquisitions, the Russia-based operations of all four companies are their key cash generators. Exposure to Russian country risks, therefore, remains significant. Severstal's production has the largest international component of the four peers. Six million metric tons (MT), representing 37.5% of the company's total 16 million MT, are produced outside of Russia in North America (at Severstal North America {SNA} and Italy {at Lucchini SpA}). These international operations are the least profitable and cash-generative: The operating margin of Russian operations was 38% in 2005 compared with 5% for SNA and 11% for Lucchini. The international operations generated a meager 15% of EBITDA. NLMK and Evraz have even smaller international diversification. NLMK's international operations are via a joint venture with Duferco Group and Dan Steel S/A. Evraz's international presence comes via Oregon Steel Mills Inc. (OSM), if its tender offer is successful, and earlier acquisitions of two small rolling mills in Italy and the Czech Republic, in addition to some vanadium operations outside of Russia. All of MMK's production is concentrated in Russia.
The younger the assets, the lower the expenditure needs
NLMK has the lowest cost position in liquid steel because it has the most modern production facilities, which increases the efficiency of its operations. Although modern facilities allowed for a comfortable period of lower capital expenditure needs, recently the company has accelerated its spending to maintain its competitive advantage. Although NLMK's profitability might exhibit slightly higher volatility compared with peers, its margins remain far higher even in a price downturn.
By contrast, MMK had the first steel mill constructed in the former Union of Soviet Socialist Republics and started its postprivatization history with an obsolete production base. In the late 1990s, however, it embarked on a large-scale capital expenditure program. As a result, its production assets are now of comparable or better quality than local industry peers.
Severstal's cost base in Russia is low. Its operating margins are affected by the consolidation of its U.S. and Italian operations, which have a much higher cost base.
Evraz's margins are somewhat affected by disadvantageous export logistics and older production assets of certain plants. Nevertheless, the company's margins are comparable with those of its peers.
Vertical integration can help offset raw-material prices swings
NLMK, Severstal, and Evraz are vertically integrated into raw-materials operations. This allows for better margins in the periods of high raw material prices, and ensures stability of supplies. Typically the self-sufficiency of these companies in raw materials reaches 70%-80%, and all three producers aim to reach full sufficiency via additional capital investments in existing resource operations.
MMK is the only one among the peers lacking such integration and in the past was exposed to supply disruption. The company's management, however, has been instrumental in resolving those issues: MMK has a significant leverage over its key supplier of iron ore, Sokolovsko-Sarbaisky, even if MMK does not own Sokolovsko-Sarbaisky, because MMK is the ore supplier's largest customer and also benefits from logistical advantages. Furthermore, MMK managed to obtain operating margins no worse than those of its peers due to good operating efficiency. MMK is considering vertical integration, however, as recently demonstrated by an acquisition of a license to operate an iron ore field.
Product mix affects profits and stability of demand
Different product mixes and geographical locations result in differences in profitability and stability of demand. All four rated Russian steelmakers are commodity players exposed to industry cycles, but their presence in various market segments differs (see chart 2).
Chart 2
NLMK has a product mix that is focused on the export of semifinished products (slabs) and sales of cold-rolled and high-value-added complicated flat products such as electrotechnical steels, demand for which is less volatile and for which prices are more stable. Slabs were traded at a premium in 2004 and 2005, although volatility and competition risks are higher in this segment.
MMK has the highest share of hot-rolled products, which are usually priced lower compared with cold-rolled and higher-value-added products. The company is gradually increasing its production of higher value products, however, such as galvanizing sheets and coating sheets.
Severstal's product mix is more diversified compared with its peers. The company's Italian operations produce specialty long products: SNA's production comprises equally hot-rolled-sheets and cold-rolled and coated products, but is heavily exposed to the U.S. automotive industry, where most producers experience difficulties. The product mix of Severstal's Russian operations is similar to that of MMK. Severstal is also focused on increasing its share of higher-value-added production and downstream operations, as exemplified by a recently commissioned large-diameter pipe mill with an annual capacity of 0.6 million MT.
Evraz produces semifinished products, which are mostly exported, and long steel, which is mainly sold domestically. It enjoys a near-monopoly position on the domestic market for rails and a strong position in construction steels. Evraz is benefiting from growing investments in the rail sector and from "marketing leverage" because rail is an important component of the company's own costs. This, however, results in high exposure to a single, albeit creditworthy, customer, Russian Railways (JSC) (BBB+/Stable/--).
The domestic market provides good growth and price stability…
All four producers have strong positions in the domestic market, and continue to capitalize from its good growth and relative price stability. After a plunge in the 1990s, demand has grown fast thanks to economic growth in the country, particularly in the pipe-making and construction sectors. Currently about 30 million MT is consumed domestically, compared with 18 million MT in 1998. Competition with international players is constrained by high logistics costs (due to large distances), while large domestic producers are well-spread across the country and, therefore, focus on different regional markets rather than competing with each other.
…but export markets allow for market diversification
Russian steelmaking capacity exceeds internal demand roughly by half, and therefore exports represent a significant share of sales for all producers. This increases the producers' diversity and allows them to fully utilize capacity. Foreign markets, however, also bring exposure to the risks of foreign protectionist measures. The end-markets for the steelmakers' exported products (see chart 3) can vary from year to year. Geographical proximity to certain markets (such as Europe for Severstal and NLMK and Asian countries for Evraz and MMK) is often a determining factor for foreign end markets. Generally, commodity-type, semifinished products face lower protectionist barriers, so product mix again plays an important role in this respect.
Chart 3
Severstal has the largest share of sales outside of Russia, about 70% of revenues, due to its overseas production. NLMK's exports represent some 60% of revenues, and until recently the company had been somewhat more exposed to price and regulatory risks of foreign countries, given that it did not have significant production assets in those counties. This could change, however, following its participation in joint ventures with Duferco, to which NLMK is expected to supply a significant part of its semifinished products. The sales share of exports of Evraz and MMK is lower, at about 40% of revenues for both.
Financial Risk Profiles Allow Flexibility For M&A Activity
Given that the four steelmakers reviewed here have somewhat comparable business profiles, the ratings are mostly differentiated by the companies' financial risk profiles. Of the four, NLMK has the highest free cash flow generation, lowest total debt, and highest net cash. MMK also has good credit metrics, but lower transparency and substandard corporate governance practices increase its financial risks. Severstal's strong financials were diluted by less-efficient and more-leveraged overseas operations. It also has a high and less-predictable growth appetite. Evraz's financial risk profile is the weakest among all four, both due to lower credit metrics and still somewhat aggressive strategies.
Although we expect cash flows to moderate when steel prices decline, resulting in lower credit metrics, the financial risk profiles of NLMK, MMK, and Severstal have sufficient flexibility for potential acquisitions and some higher debt. Evraz has largely used up this flexibility because of recent material debt-financed acquisitions. Evraz is in a position to recover, however, should it be willing to downsize its spending appetite and use cash flows for debt reduction.
Other factors that could affect a company's financial risk profile are capital expenditure levels, which are most likely at a historical high at the moment; distributions to shareholders; and corporate governance practices.
M&A in the air
The Russian steelmakers have already started to participate in domestic and international M&A activity that is consolidating the global steel industry. We expect this appetite to grow, with more focus on foreign markets: Despite long talks about domestic consolidation, little action has been seen so far, as Russian players look for international opportunities.
NLMK and Evraz were the largest acquirers in 2006 (see table 2). Severstal concentrated on consolidating steel and resource assets that were previously held by its shareholders. Nevertheless, we believe Severstal has the highest M&A ambitions, as demonstrated by its unsuccessful attempt to merge with Arcelor S.A. (BBB/Stable/A-2) in 2006 and acquisitions of distressed international steel producers before that. The company undertook an IPO in 2006, and proceeds of $1 billion are likely to be used for acquisitions. Given the company's track record of comparably large purchases, this amount is unlikely to be enough to satisfy its appetites.
Although NLMK spent a hefty $2.3 billion in 2006 on acquisitions, this was financed with existing cash holdings. Given the absence of debt and positive free operating cash flows through the cycle, NLMK's financial profile could sustain further cash outflows. MMK has paid high dividends over the last two years. After an undisclosed group of investors acquired its shares in late 2004 for $1.7 billion, we adjusted MMK's debt by this amount. This resulted from an absence of information about the deal's financing, and we believe the company indirectly financed this acquisition. By now, MMK's accumulated shareholder distributions are likely to cover this debt. We believe MMK could also have growth ambitions, particularly outside Russia, as demonstrated by an attempt to acquire Pakistan Steel Mills.
</para> <para> In our view Evraz's financial profile is the only one that could not sustain new debt, given that the company's growth strategy in recent years has been largely debt-financed. Evraz's credit metrics are already somewhat stretched factoring in the acquisition of OSM.
</para> <para> It is worth noting that Russian steel producers might also be acquisition targets for their international peers. Any such takeover would need some sort of approval from the Russian government, however, which could prove problematic.
</para> <para></para> <table>
<tablerow>
<tablenumber>
Table 2
</tablenumber>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tabletitle>
Acquisitions By Russian Steelmakers In 2006
</tabletitle>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tablecolhead align="left">
Target
</tablecolhead>
<tablecolhead align="left">
Description
</tablecolhead>
<tablecolhead align="left">
Cash price ($ mil.)
</tablecolhead>
<tablecolhead align="left">
Source of financing
</tablecolhead>
</tablerow>
<tablerow>
<tablesub>
Evraz Group S.A.
</tablesub>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Oregon Steel Mills
</tabletext>
<tabletext>
U.S.-based steel producer
</tabletext>
<tabletext>
2,300
</tabletext>
<tabletext>
Mostly debt
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Highveld Vanadium and Steel Corp.
</tabletext>
<tabletext>
South Africa-based vanadium producer
</tabletext>
<tabletext>
206 (for a 24.9% stake, with an option to increase the share to 79% for a total consideration of 678)
</tabletext>
<tabletext>
Debt and internal cash
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Stratcor
</tabletext>
<tabletext>
U.S.-based producer of vanadium alloys and chemicals for the steel and chemical industries
</tabletext>
<tabletext>
99
</tabletext>
<tabletext>
Internal cash and debt
</tabletext>
</tablerow>
<tablerow>
<tablesub>
OAO Magnitogorsk Metallurgical Kombinat
</tablesub>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Prioskolskoe Iron Ore Mine
</tabletext>
<tabletext>
Russian iron ore exploration and development company
</tabletext>
<tabletext>
24
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablesub>
OJSC Novolipetsk Steel
</tablesub>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
V Duferco Group
</tabletext>
<tabletext>
European producer of steel and rolling assets
</tabletext>
<tabletext>
805
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Altai Koks
</tabletext>
<tabletext>
Russian coke and coal producer
</tabletext>
<tabletext>
636
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Prokopievskugol
</tabletext>
<tabletext>
Russian coke and coal producer
</tabletext>
<tabletext>
188
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
VIZ-Stahl
</tabletext>
<tabletext>
Russian specialty steel producer
</tabletext>
<tabletext>
551
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Dan Steel
</tabletext>
<tabletext>
European steel producer
</tabletext>
<tabletext>
104
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablesub>
OAO Severstal
</tablesub>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Resource assets
</tabletext>
<tabletext>
Several large iron ore and coal producers previously owned by a Russian shareholder
</tabletext>
<tabletext>
0
</tabletext>
<tabletext>
Equity swap
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Carrington Wire Ltd.
</tabletext>
<tabletext>
U.K.-based wire and metal products producer
</tabletext>
<tabletext>
31
</tabletext>
<tabletext>
Internal cash
</tabletext>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tabletext>
Lucchini SpA
</tabletext>
<tabletext>
European steel producer
</tabletext>
<tabletext>
720.5
</tabletext>
<tabletext>
Internal cash and debt assumption (most of the cash was received back as shareholder debt repayments)
</tabletext>
</tablerow>
</table>
<object type="tsv" source="3377567" width="0" height="0"> </object>
<para></para> </section>
<section name="Corporate governance and transparency evolve in a positive direction">
<para>All four companies have a legacy of low transparency and corporate governance standards following their respective privatizations. Nevertheless, governance standards have been notably improving and are less of a concern than previously. In 2005 and 2006, Evraz, NLMK, and Severstal undertook IPOs and obtained listings with the London Stock Exchange. All four companies regularly publish their accounts under U.S. GAAP or IFRS. Their corporate structures have been streamlined and internal relationships have become more transparent.
</para> <para> MMK somewhat lags behind, mostly because it has not disclosed its shareholding structure or the structure and financing of the $1.7 billion acquisition of its shares in late 2004 by an unknown group of investors that were reported to be close to MMK's management. It remains to be seen if MMK will follow its peers and also undertake an IPO and, if so, what information would be disclosed as a result.
</para> <para></para> <table>
<tablerow>
<tablenumber>
Table 3
</tablenumber>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tabletitle>
Russian Steelmakers Key Statistics*
</tabletitle>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
<tablecell> </tablecell>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tablestraddle width="2">
Evraz Group S.A.**
</tablestraddle>
<tablestraddle width="2">
OAO Magnitogorsk Metallurgical Kombinat¶
</tablestraddle>
<tablestraddle width="2">
OJSC Novolipetsk Steel¶
</tablestraddle>
<tablestraddle width="2">
OAO Severstal§
</tablestraddle>
</tablerow>
<tablerow>
<tabletext>
Corporate credit rating at Sept. 27, 2006
</tabletext>
<tablestraddle width="2">
BB-/Negative/--
</tablestraddle>
<tablestraddle width="2">
BB/Stable/--
</tablestraddle>
<tablestraddle width="2">
BB+/Stable/--
</tablestraddle>
<tablestraddle width="2">
BB-/Stable/--
</tablestraddle>
</tablerow>
<tablerow>
<tabletext>
Business risk profile
</tabletext>
<tablestraddle width="2">
Weak
</tablestraddle>
<tablestraddle width="2">
Weak
</tablestraddle>
<tablestraddle width="2">
Weak
</tablestraddle>
<tablestraddle width="2">
Weak
</tablestraddle>
</tablerow>
<tablerow>
<tabletext>
Financial risk profile
</tabletext>
<tablestraddle width="2">
Aggressive
</tablestraddle>
<tablestraddle width="2">
Aggressive
</tablestraddle>
<tablestraddle width="2">
Intermediate
</tablestraddle>
<tablestraddle width="2">
Aggressive
</tablestraddle>
</tablerow>
<tablerow>
<tablecell> </tablecell>
<tablestraddle width="8">
--Year ended Dec. 31--
</tablestraddle>
</tablerow>
<tablerow>
<tablecolhead align="left">
(Mil. $)
</tablecolhead>
<tablecolhead align="right">
2005
</tablecolhead>
<tablecolhead align="right">
1H 2006
</tablecolhead>
<tablecolhead align="right">
2005
</tablecolhead>
<tablecolhead align="right">
1H 2006
</tablecolhead>
<tablecolhead align="right">
2005
</tablecolhead>
<tablecolhead align="right">
1H 2006
</tablecolhead>
<tablecolhead align="right">
2005
</tablecolhead>
<tablecolhead align="right">
1H 2006
</tablecolhead>
</tablerow>
<tablerow>
<tabletext>
Total revenues
</tabletext>
<tabledata>
6,508.1
</tabledata>
<tabledata>
3,825.0
</tabledata>
<tabledata>
5,380.0
</tabledata>
<tabledata>
2,780.0
</tabledata>
<tabledata>
4,468.7
</tabledata>
<tabledata>
2,601.7
</tabledata>
<tabledata>
8,624.3
</tabledata>
<tabledata>
4,376.7
</tabledata>
</tablerow>
<tablerow>
<tabletext>
EBITDA
</tabletext>
<tabledata>
1,899.5
</tabledata>
<tabledata>
1,098.5
</tabledata>
<tabledata>
1,511.0
</tabledata>
<tabledata>
779.0
</tabledata>
<tabledata>
2,144.8
</tabledata>
<tabledata>
1,083.8
</tabledata>
<tabledata>
2,744.5
</tabledata>
<tabledata>
1,114.4
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Operating income (after D&A)
</tabletext>
<tabledata>
1,640.1
</tabledata>
<tabledata>
951.5
</tabledata>
<tabledata>
1,323.0
</tabledata>
<tabledata>
690.0
</tabledata>
<tabledata>
1,860.0
</tabledata>
<tabledata>
925.3
</tabledata>
<tabledata>
2,328.2
</tabledata>
<tabledata>
720.0
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Net income from continuing operations
</tabletext>
<tabledata>
905.2
</tabledata>
<tabledata>
611.0
</tabledata>
<tabledata>
947.0
</tabledata>
<tabledata>
588.0
</tabledata>
<tabledata>
1,381.6
</tabledata>
<tabledata>
943.8
</tabledata>
<tabledata>
1,694.4
</tabledata>
<tabledata>
405.0
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Funds from operations (FFO)
</tabletext>
<tabledata>
1,370.2
</tabledata>
<tabledata>
728.0
</tabledata>
<tabledata>
1,134.0
</tabledata>
<tabledata>
682.0
</tabledata>
<tabledata>
1,653.2
</tabledata>
<tabledata>
739.5
</tabledata>
<tabledata>
1,947.6
</tabledata>
<tabledata>
806.4
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Cash flow from operations
</tabletext>
<tabledata>
1,404.8
</tabledata>
<tabledata>
825.0
</tabledata>
<tabledata>
1,255.0
</tabledata>
<tabledata>
660.0
</tabledata>
<tabledata>
1,514.7
</tabledata>
<tabledata>
527.3
</tabledata>
<tabledata>
1,986.5
</tabledata>
<tabledata>
736.7
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Capital expenditures
</tabletext>
<tabledata>
695.4
</tabledata>
<tabledata>
262.0
</tabledata>
<tabledata>
562.0
</tabledata>
<tabledata>
299.0
</tabledata>
<tabledata>
573.2
</tabledata>
<tabledata>
239.8
</tabledata>
<tabledata>
1,143.5
</tabledata>
<tabledata>
592.0
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Free operating cash flow
</tabletext>
<tabledata>
709.5
</tabledata>
<tabledata>
546.0
</tabledata>
<tabledata>
693.0
</tabledata>
<tabledata>
361.0
</tabledata>
<tabledata>
941.5
</tabledata>
<tabledata>
287.4
</tabledata>
<tabledata>
843.0
</tabledata>
<tabledata>
144.0
</tabledata>
</tablerow>
<tablerow>
<tabletext>
Discretionary cash flow
</tabletext>
<tabledata>
185.7
</tabledata>
<tabledata>
388.0
</tabledata>
<tabledata>
(254.0)
</tabledata>
<tabledata>
79.0
</tabledata>
<tabledata>
556.5
</tabledata>
<tabledata>
(48.7)
</tabledata>
's debt by this amount. This resulted from an absence of information about the deal's financing, and we believe the company indirectly financed this acquisition. By now, MMK's accumulated shareholder distributions are likely to cover this debt. We believe MMK could also have growth ambitions, particularly outside Russia, as demonstrated by an attempt to acquire Pakistan Steel Mills.
In our view Evraz's financial profile is the only one that could not sustain new debt, given that the company's growth strategy in recent years has been largely debt-financed. Evraz's credit metrics are already somewhat stretched factoring in the acquisition of OSM.
It is worth noting that Russian steel producers might also be acquisition targets for their international peers. Any such takeover would need some sort of approval from the Russian government, however, which could prove problematic.
Table 2
Acquisitions By Russian Steelmakers In 2006
Target
Description
Cash price ($ mil.)
Source of financing
Evraz Group S.A.
Oregon Steel Mills
U.S.-based steel producer
2,300
Mostly debt
Highveld Vanadium and Steel Corp.
South Africa-based vanadium producer
206 (for a 24.9% stake, with an option to increase the share to 79% for a total consideration of 678)
Debt and internal cash
Stratcor
U.S.-based producer of vanadium alloys and chemicals for the steel and chemical industries
99
Internal cash and debt
OAO Magnitogorsk Metallurgical Kombinat
Prioskolskoe Iron Ore Mine
Russian iron ore exploration and development company
24
Internal cash
OJSC Novolipetsk Steel
V Duferco Group
European producer of steel and rolling assets
805
Internal cash
Altai Koks
Russian coke and coal producer
636
Internal cash
Prokopievskugol
Russian coke and coal producer
188
Internal cash
VIZ-Stahl
Russian specialty steel producer
551
Internal cash
Dan Steel
European steel producer
104
Internal cash
OAO Severstal
Resource assets
Several large iron ore and coal producers previously owned by a Russian shareholder
0
Equity swap
Carrington Wire Ltd.
U.K.-based wire and metal products producer
31
Internal cash
Lucchini SpA
European steel producer
720.5
Internal cash and debt assumption (most of the cash was received back as shareholder debt repayments)
Corporate governance and transparency evolve in a positive direction
All four companies have a legacy of low transparency and corporate governance standards following their respective privatizations. Nevertheless, governance standards have been notably improving and are less of a concern than previously. In 2005 and 2006, Evraz, NLMK, and Severstal undertook IPOs and obtained listings with the London Stock Exchange. All four companies regularly publish their accounts under U.S. GAAP or IFRS. Their corporate structures have been streamlined and internal relationships have become more transparent.
MMK somewhat lags behind, mostly because it has not disclosed its shareholding structure or the structure and financing of the $1.7 billion acquisition of its shares in late 2004 by an unknown group of investors that were reported to be close to MMK's management. It remains to be seen if MMK will follow its peers and also undertake an IPO and, if so, what information would be disclosed as a result.
Table 3
Russian Steelmakers Key Statistics*
Evraz Group S.A.**
OAO Magnitogorsk Metallurgical Kombinat¶
OJSC Novolipetsk Steel¶
OAO Severstal§
Corporate credit rating at Sept. 27, 2006
BB-/Negative/--
BB/Stable/--
BB+/Stable/--
BB-/Stable/--
Business risk profile
Weak
Weak
Weak
Weak
Financial risk profile
Aggressive
Aggressive
Intermediate
Aggressive
--Year ended Dec. 31--
(Mil. $)
2005
1H 2006
2005
1H 2006
2005
1H 2006
2005
1H 2006
Total revenues
6,508.1
3,825.0
5,380.0
2,780.0
4,468.7
2,601.7
8,624.3
4,376.7
EBITDA
1,899.5
1,098.5
1,511.0
779.0
2,144.8
1,083.8
2,744.5
1,114.4
Operating income (after D&A)
1,640.1
951.5
1,323.0
690.0
1,860.0
925.3
2,328.2
720.0
Net income from continuing operations
905.2
611.0
947.0
588.0
1,381.6
943.8
1,694.4
405.0
Funds from operations (FFO)
1,370.2
728.0
1,134.0
682.0
1,653.2
739.5
1,947.6
806.4
Cash flow from operations
1,404.8
825.0
1,255.0
660.0
1,514.7
527.3
1,986.5
736.7
Capital expenditures
695.4
262.0
562.0
299.0
573.2
239.8
1,143.5
592.0
Free operating cash flow
709.5
546.0
693.0
361.0
941.5
287.4
843.0
144.0
Discretionary cash flow
185.7
388.0
(254.0)
79.0
556.5
(48.7)
565.3
65.9
Cash and investments
664.6
783.0
1,138.0
1,163.0
1,923.8
1,385.6
1,616.0
982.8
Adjusted debt
2,466.3
2,726.5
447.0
215.0
N.M.
N.M.
610.3
1,108.9
Common equity
2,694.9
3,373.0
3,688.0
3,848.0
5,054.2
5,847.6
7,794.7
8,971.5
Financial ratios
EBITDA/sales (%)
29.2
28.7
28.1
28.0
48.0
41.7
31.8
25.5
EBIT interest coverage (x)
11.4
8.7
21.6
25.6
127.3
87.0
15.3
7.6
EBITDA interest coverage (x)
13.0
10.1
23.6
28.9
142.1
101.9
16.9
11.8
Return on capital (%)
36.5
32.2
31.0
27.5
55.9
30.2
22.8
26.0
FFO/total debt (%)
55.6
53.4
253.7
634.4
N.M.
N.M.
319.1
145.4
Cash flow from operations/total debt (%)
57.0
60.5
280.8
614.0
N.M.
N.M.
325.5
106.8
Free operating cash flow/total debt (%)
28.8
40.1
155.0
335.8
N.M.
N.M.
138.1
26.0
Total debt/EBITDA (x)
1.3
1.2
0.3
0.1
N.M.
N.M.
0.2
0.5
*Fully adjusted. ¶Excess cash and investments netted against debt. §Pro forma for mining assets consolidation but Lucchini SpA is not included. **Before Oregon Steel Mills acquisition. N.M.--Not meaningful. 1H--First half of year ended June 30, 2006.
Appendix: Russian Steel Industry Overview
The global steel industry experiences large swings in prices. As the world's second-largest exporter of mainly commodity steel, Russia is affected by global cyclical trends as well as on going sector trends. For commodity exporters like Russia, cyclical fluctuations are exacerbated because, during cyclical troughs, governments tend to increase protectionist trade barriers, as happened in 2002, which makes life even more difficult for steel exporters. The key sector trends in the steel industry are consolidation, rising steel consumption in Asia, and increasing steel production capacity outside North America and Western Europe.
In addition, Russian steel companies are subject to a concentrated domestic steel industry. The four largest producers are responsible for about three-quarters of the country's steel production. The key customer industries, including construction, automotive, and pipe production, are fragmented. This improves the bargaining power of steel producers and, together with costly logistics caused by the country's large distances, has a stabilizing effect on domestic prices, which have been less volatile than global prices in recent years.
Compared with their North American and European peers, Russian steelmakers have the following key advantages:
Access to lower-cost labor and energy.
Geographical proximity to the sources of key raw materials (coking coal and iron ore). This is comparable with steelmakers in Latin America, although the quality of iron ore in Russia is generally lower than in Brazil.
Benefits from the gradual growth of the domestic steel market, on the back of the country's economic growth, and historically less volatile pricing in the domestic market.
Relatively favorable logistics for exports to China, the world's fastest-growing steel market, particularly for the Ural- and Siberia-based plants of MMK and Evraz, respectively.
Their key disadvantages are:
High capital expenditure needs to modernize their production bases.
A focus on commodity products, which increases exposure to cyclical fluctuations.
Land-locked locations, which increases logistic costs for exports to Europe.
Limited downstream integration, which limits a company's ability to compete. As a result, Russian companies are keen to acquire rolling mills in Europe and the U.S. to secure market access and circumvent import restrictions on value-added steel products.
Often complex corporate structures, a legacy of turbulent privatizations and the country's weak institutions.
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