Steel Industry at a Crossroads

The global financial crisis has had a dramatic effect on those sectors that consume steel. Both the construction and automotive sectors were hit by the lack of demand: with mortgages and credit becoming less available, people are not rushing to make purchases that can be put off.

The Russian steel industry was hit even harder. While, for example, the construction and automotive sectors were affected in Russia as they have been in the U.S., exports of Russian semi-finished products are also in somewhat dire straits.

Despite their high profitability, Russian companies (along with the Ukrainian steel industry) have had to make some of the biggest production cuts of any steel companies in the world in an attempt to eliminate stocks and adjust to the new demand realities.

We use the following steel market development scenario for Russian producers in the remainder of 2008 and 2009:

Current situation:

Companies in Russia are operating at 50% of capacity.

Prices are down 30-50%, depending on the product.

Steel companies use up their own raw materials stocks, which at current production levels are good for 2-3 months, meaning that the steel companies are barely profitable (or even unprofitable), but as they buy no raw materials and sell their steel it frees up some cash.

Simultaneously, it allows companies to negotiate the prices for raw materials down.

Going into 2009:

Raw materials prices negotiated down to a much greater degree than steel prices. We see coking coal back below $100 per ton and a similar move for iron ore.

On the other hand, stocks of both raw materials and steel will be used up by February-March 2009.

Simultaneously, a bit of a seasonal pick up in steel consumption begins.

Capacity utilization improves to an average of about 70%, from 50% at present.

Russian steel companies return to profitability.

Fixed costs are helped by ruble weakness.

Our dream steel company for 2009 has high profitability, low debt and low integration In the current environment, we are setting Buy ratings for NLMK and MMK. Novolipetsk Metallurgical Factory (NLMK) scores points in terms of profitability (it was, after all, one of the three most profitable steel companies in the world) and low debt. Its lack of full integration on the coking coal side might also help the company as we could see a lot of supply on the Russian coking coal market. The spoiler, in NLMK's case, is the cancellation of the John Maneely deal, which could result in a large break-up fee after court proceedings (we currently factor in $1 billion, just in case).

Magnitogorsk Iron and Steel Works (MMK) also has little debt. It will fight for lower iron ore and coking coal prices, as well as utilize its electric-arc furnace capacity in the meantime using low scrap prices. The spoiler, in MMK's case, is the high level of non-payments from pipe makers (possibly originating in Gazprom) and the automotive industry.

The sector has already lost 90% of its peak value, but 2009 EPS forecasts corrected comparably. Russian steel stocks retreated in a quite unorganized manner and have lost between 82% and 94% of their Mcap since the peaks. The decline is very much in line with how we forecast earnings to drop, except for NLMK and MMK.

We see earnings driven by three major factors:

production cuts,

drop in steel prices,

interest expenses.

Given that interest expenses are going to increase, especially for those companies that will require refinancing (it is not a variable cost), the earnings of those companies that have a significant amount of debt will show a more rapid decline. We therefore see two outliers — NLMK and MMK — that are being oversold compared with their peers, because they have a lower level of debt and their interest expenses are smaller compared with earnings.

Next year, all the flaws in the previous strategies, all the weaknesses and inefficiencies will be more visible than ever. Furthermore, they will be accorded greater significance than the advantages. Among them we see:

Severstal's US steel business and domestic coal mining, both of which are low margin;

Mechel's high cost nickel production and low efficiency steel operation;

Evraz's very high debt burden, which overshadows its great assets.

The sensitivity of these companies' earnings to any external factors makes them very risky — though potentially regarding — investment opportunities. The fact that the Russian Government and the Bank for Development (VEB) have so far been helping most of those who applied for help (Evraz, in our case) tells us that the risks are possibly more on the upside. With that in mind, and provided the companies do not go bust, we believe that the steel market will recover and pull the share prices up. Severstal, Mechel and Evraz have already lost 90-94% but still we set Hold ratings.

One of the important factors is low costs, which are based on strong fundamental factors such as the availability of domestic raw materials, integration and lower comparable energy prices. While steel prices can go up and down, the cost advantage always remains. The crisis could possibly make the sector even stronger. Severstal's Vorkuta coal assets, where the cost of production is over $50 per ton, are clearly not competitive and need to be restructured or shut down. Mechel's nickel business, where costs are close to $20,000 per ton (although they will also come down, of course) could also be shut down if nickel prices remain where they are for much longer.

Productivity is very low and we have heard that some companies are asking all levels of local and federal government to start helping with retraining the workforce. The reality is that companies can cut their labor force in half and still be more productive than foreign peers. This will be a long and painful process, but everybody knows it has to be done and the crisis might force companies to speed up the process.

The further consolidation which the market so desired could become a real agenda now that the situation is not as strong as it was just a couple of months ago (when each of the companies was developing on its own).

And while it is not so fundamental, ruble weakness is also on the side of the steelmakers, especially integrated ones.