Severstal - the time- hardened business · PDF fileSeverstal - the time-hardened business...

Company note

April 2, 2012

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Author of the report: Morin Aleksandr, analyst, [email protected]

Severstal - the time-hardened business model

HOLD

Target price: $15,02 Upside: 11%

CHMF - As part of our analysis of the metallurgical industry, we have begun to cover shares of "Severstal". As a result of the study, our estimate of fair value of the shares is $ 15.02 at the end of 2012 with a recommendation "Hold". - In February and March 2012 a number of Russian steel producers (Severstal, MMK, NLMK) began to increase the prices of steel products: domestic prices for hot-rolled steel grew by about 2%. In addition, domestic prices of products were adjusted upwards in anticipation of seasonal demand, however, in our opinion, there are no fundamental reasons for product price increases such as the increase in production costs (raw materials) and an increase in demand. Prices for raw materials (coking coal concentrate and iron ore) are currently quite strongly depressed (the current coking coal concentrate prices are lower by 16.8% compared with the January prices, fall of the iron ore price amounted to 1.6%). In the evaluation of global demand for steel the growth dynamics of industrial production and GDP in China are indicative as it is a major producer and consumer of steel products. The head of the Ministry of Industry and Information Technology of China Miao Wei said that China expects the slowdown in industrial production in 2012 to 11% from the actual 13.84% in 2011. We believe that the slowdown in industrial production has a negative impact both on the domestic market of China in the sectors of metallurgy, construction and engineering industries, and on international markets. - Severstal is the 2nd largest company in terms of steel production in Russia. The company has a fairly high level of transparency, the availability of financial statements under IFRS, good indicators of profitability, diversification of the sales structure (by the assortment and markets), as well as the prospects of increasing the volume of steel production in 2015. Also there are other positive moments, such as news that Severstal will supply steel for German cars of Russian assembly (Volkswagen), thus the company begins a planned strategy to increase sales of metal products for the automotive industry on the domestic market.

- One of the competitive advantages of Severstal is it’s vertically-integrated business structure, through which the company has high profitability and self-sufficiency of raw materials. Severstal has an extensive product range that sells in both domestic and foreign markets (the share of sales attributable to the Russian market for 9M2011 is 48%). In addition, the company carries out the majority of investment projects at the expense of its operating cash flows, due to this the level of Net debt / Ebitda is one of the lowest in the industry.

- In our opinion, the upside of the business value is associated with the possible increase in share of high value added steel products sales and

Stock data Ticker CHMF M.Cap, $ mln 13616,52 Shares Ords 1007701000 Freе Float, % 17,60 Shares Pref 0 Free Float, $

mln 2396,51

Bid Ords, $ 13,48 Offer Ords, $ 13,51

Market performance 1 month 6 months Absolute Ords -10% 28% Relative to RTSI Ords -5% 5% High Ords 15,38 15,41 Low Ords 13,49 9,60

Financials, 2012Е Revenue, $ mln 15345 EV/S 1,22 EBITDA, $ mln 3889 P/E 11,77 Net income, $ mln 1219 EV/EBITDA 6,55

Stock prices dynamics

Source: Bloomberg, Sovlink

* market prices as of April 2, 2012

0.4

0.6

0.8

1

1.2

1.4

01.01.2011 01.07.2011 01.01.2012

CHMF RX EQUITY RTSI$ Index

Company note

April 2, 2012


potential M&A deals in the steel sector in the domestic market (low debt burden creates opportunities for the acquisition of core assets). An additional factor in the growth of the company's value can be an improvement of financial performance of North American assets of Severstal.

- Weaknesses of Severstal are mainly related to the industry's dependence on the cyclical state of the economy. The deterioration of the financial performance of Severstal will occur due to lower prices and demand for products and raw materials sold by the company. We expect that in 2012 year priсes for commodities will decline more rapidly than prices for steel products, thus companies, which purchase raw materials, will be in a better position than companies producing and selling raw materials, which adversely affect the profitability of their business. Severstal also carries additional risks associated with the activity in different regions of the world (different anti-trust legislation and the anti-monopoly regulation of steel companies).

According to the forecast indicator, EV / EBITDA (consensus of Bloomberg) for 2012, Severstal is the cheapest among the Russian sector peers.

According to our estimates, based on the method of DCF, the target price by the end of 2012 is $ 15.02 per share, which is by 11% above the current market price ($ 13.49). Recommendation 'Hold'.

Company note

April 2, 2012


Dynamics of operating profitability by years in the context of Russian companies

Operating profitability, % Company 2008 2009 2010 9M2011 2011E

ММК 11% 6% 8% 6% 6%

НLМК 36% 15% 22% 16% 13%

Меchel 26% 5% 16% 15% 15%

Еvraz 20% 1% 10% - 11%

Severstal 26% 9% 19% 20% 20%

Average 23% 7% 14% 12% 13%

Source: Bloomberg, Sovlink estimates

Dynamics of average annual prices for products, $ per tonne

Average annual

prices for products, $

per ton

2008 2009 2010 2011 2012Е

Hot-rolled steel

811,1 447,5 579,1 683,1 655,8

Large diameter

pipes 2676,6 1476,6 1911,1 2254,3 2164,2

Cold-rolled steel

934,8 546,7 661,8 833,8 774,9

Metalware products 1364,9 798,2 966,2 1217,3 1131,4

Long products

762,4 420,6 544,4 642,1 616,5

Colour-coated sheet 1529,1 1070,6 1197,7 1232,3 987,5

Source: Metal Expert, Sovlink forecasts

World steel consumption in the context of major consumers, mln tonnes

2010 2011E 2012E

European Union (27) 144,8 151,8 157,5

Other Europe 29,6 32,8 35,2

CIS 48,5 52,1 56,7

NAFTA 110,3 122,3 130

Central & South America 45,8 48,8 52,8

Africa 25,9 25,1 27,4

Middle East 45,3 46,5 49,9

Asia & Oceania 833,6 879,9 931,1

China 576 604,8 635 World 1283,8 1359,3 1440,6

Growth Rates % 15.1 6.5 5.4 Source: WSA World steel production in the context of major consumers, mln tonnes

2010 2011E European Union (27) 172,6 177,4

Other Europe 33,6 46,2

CIS 108,2 112,6

North & South America 155,3 167,3

Africa 16,6 14,3

Middle East 19,6 20,9

Asia & Oceania 911,4 988,2

China 626,7 695,5 World 1417,3 1526,9

Source: WSA

Development of the steel industry The metallurgical sector is extremely sensitive to changes in the global economy and serves as an indicator of its development. If the economy grows, the steel sector is also developing positively, and vice versa. Currently, a number of world economies (e.g. China) are experiencing growth, which puts pressure on the construction and metallurgical sector. If we compare the average prices for steel products in the past few years, we see that after 2008, prices for steel products fell sharply and gradually restored in 2011. This period was the most difficult for Russian steel companies, profitability declined sharply (to an average of 7% in 2009), debt burden increased, some companies have reduced their production volumes. In 2011, prices for steel products in general improved the financial performance of metallurgy, however, with the weak demand and slowdown of the growth of some economies, this growth has been restrained. In February and March 2012 a number of Russian steel producers (Severstal, MMK, NLMK) began to gradually increase the prices of steel products: domestic prices for hot-rolled steel grew by about 2%. In addition, domestic prices of products adjusted upwards in anticipation of seasonal demand. However, in our opinion, there are no fundamental reasons for product price increases such as the increase in production costs (raw materials) and an increase in demand. Prices for raw materials (coking coal concentrate and iron ore) are currently quite depressed (the current prices of coking coal concentrate are lower by 16.8% compared with the January prices, reduction of the price of iron ore amounted to 1.6%). In the evaluation of global demand for steel the growth dynamics of industrial production and GDP in China are indicative as it is a major producer and consumer of steel products. So the head of the Ministry of Industry and Information Technology Miao Wei told China that China expects the slowdown in industrial production in 2012 to 11% from the actual 13.84% in 2011. We believe that the slowdown in industrial production will have a negative impact on both the domestic market of China in the sectors of metallurgy, construction and engineering industries, and on international markets. We expect that in 2012 the reduction of the average annual price of the hot-rolled steel will happen (-4% compared to 2011 year) and at c/r rental (-7% compared to 2011 year), which will adversely affect the financial performance of a number of steel companies. At the same time reduction of the volume of steel production is possible with a background of a slowdown in demand (growth in demand for steel, according to the WSA in 2011 was 6.5% year on year, the forecast value for 2012 - 5.4% year on year). In this regard, we assume that the most secure and resilient to adverse changes in market conditions will be companies with the following characteristics: 1) With a low debt burden. High levels of debt prevents the

development of the company, because with the deterioration in external conditions it will be difficult to respect the covenants and to refinance existing debt, which could lead to a substantial reduction in investment;

2) Sales of products in the domestic market. Export-oriented companies are more sensitive to changes in metal prices and decrease in sales volumes because of deteriorating global

Company note

April 2, 2012


Self-Sufficiency in the context of Russian metallurgical companies

Source: company data, Sovlink estimates

Dynamics of raw material prices, $ per ton

Source: Metal Expert, Bloomberg,Sovlink estimates

Actual and forecast values of steel production of Severstal, mln tonnes

Period 2011 2012F 2013F 2014F 2015F Steel, mln tonnes

15,29 14,53 15,75 16,71 18,10


Steel production (2010) in the context of major steel producers, mln tonnes

World rank Company Steel production

(2010), mln tonnes 1 ArcelorMittal 98,2

2 Baosteel 37

3 POSCO 35,4

4 Nippon Steel 35

5 JFE 31,1

6 Jiangsu Shagang 23,2

7 Tata Steel 23,2

8 U. S. Steel 22,3

9 Ansteel 22,1

10 Gerdau 18,7

11 Nucor 18,3

12 Severstal 18,2 Source: WSA

conditions. At the same time, manufacturers focused on the domestic market, can smooth the impact of deteriorating market conditions on the financial results because of the presence of a certain lag in the change between domestic and export prices;

3) Companies with low production costs. Vertically-integrated steel companies are the most protected from sharp increases in the cost of raw materials for production, while at the same time are able to gain additional revenues from the sale of surplus materials. However, given current market conditions, the fall in commodity prices could adversely affect the company's operations. In October 2011 the export price of coking coal concentrate (based on the DFA), one of the main raw materials used in steel production fell sharply (by 13% compared to September 2011). We assume that in 2012 the average prices for raw materials will be lower than in 2011, with the decline in commodity prices outpacing the decline in steel prices, which will give certain advantages to companies purchasing raw materials to companies that have their production assets.

4) The range of products. A wide range of products allows the company to quickly reflect changes in the demand for each type of products and adapt to changing market needs.

In our opinion, among the companies that meet the above criteria, the most promising is "Severstal". The company has a fairly high level of transparency, the availability of financial statements under IFRS, good indicators of profitability, diversification of the structure of sales (by the range and markets), as well as the prospects of increasing the volume of steel production in 2015.

280%

40%

113%

56%81%

100%

30%

89%102%

0%

50%

100%

150%

200%

250%

300%

Mechel NLMK MMK Severstal Evraz

Coking coal concentrate Iron ore

297

258 253 245 236219

177.23150.43

135.54 136.46 140.35 140.4

0

50

100

150

200

250

300

350

Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12

Coking coal concentrate Iron Ore Fines 62%

Company note

April 2, 2012


Volumes of production in the context of metallurgical companies in Russia in 2011, %

Source: WSA,company data, Sovlink estimates

Severstal Brief description of the company and industry Severstal - metallurgical company with a full production cycle, including coke, sinter, blast furnace, steelmaking and rolling production. The company is one of the world's largest producers of steel (in 2010 the company ranked 12th in the world in terms of production1). "Severstal" business consists of three divisions: "Severstal Resource", "Severstal Russian Steel" and "Severstal International", which includes North American companies. Due to its own resource base, a diverse range of sales and marketing (31% of revenue in 2010 the company received from exports), the company has a high value of the operating margin (19.8% based on data for 9M2011, which is higher than the industry average of Russian counterparts).

The structure of the assets of Severstal in the context of individual enterprises

Location An asset of Severstal Type of asset The main product Production volume / capacity

Russia «Karelskiy Okatysh» Raw materials iron ore pellets 9,8 mln tonnes Russia Cherepovets Output Steel 11,1 mln tonnes

Russia «Vorkutaugol» Raw materials Coking and thermal coal

concentrate 8,5 mln tonnes

Russia «Olkon» Raw materials iron ore concentrate 4,0 mln tonnes

USA Dearborn Output Steel 2,1 mln tonnes

USA PBS Coals Raw materials Coking and thermal coal

concentrate 3,4 mln tonnes

USA Columbus Output Steel 3,1 mln tonnes Source: company data

The dynamics of the production in the major Russian producers, mln tonnes

Steel production, mln tonnes Company 2008 2009 2010 2011

ММК 12,0 9,6 11,4 12,2

НLМК 11,3 10,9 11,9 12,0

Мechel 5,9 5,5 6,1 6,1

Еvraz 17,7 15,3 16,3 16,8

Severstal 19,2 16,7 18,22 15,3 Source: company data, Sovlink estimates

Revenue for 9М2011 and 9М2010 in the context of divisions of Severstal

Division 9М2011 9М2010 Change Severstal Resource 2825 1893 49%

including Nord Gold 797 485 64% Severstal Russian

Steel 8206 6342 29% Severstal North

America 2531 2301 10% Source: company data, Sovlink estimates

Financial and industrial performance Sales. One of the key roles to ensure high profitability of Severstal is done by the mining division of the company - Severstal Resources. Using their own sources of raw materials helps to minimize the production costs in the steel division of Severstal and provides additional business value in the whole company. In the production of steel Severstal consumes huge amounts of raw materials (coke and iron ore concentrate), and at the same time sells the surplus with the additional margin. For 9M2011 the company consumed 3.6 million tonnes of coking coal concentrate for production (47.4% of total sales), and 9.19 million tonnes of iron ore (62% of total sales). The total contribution of Severstal Resource to the consolidated revenue for the 9M2011 amounted to 21.9%. Financial results for 9M2011 of Severstal in the context of divisions

Index Severstal Resource

Severstal Russian Steel

Severstal North America

Severstal (total)

Revenues, $ mln 2824,94 8205,53 2530,59 12881,95 Operating income, $

mln 1105,00 1115,00 79 2548,957 EBITDA, $ mln 1258,00 1369,00 163 3173

Operating margin, % 39,1% 13,6% 3,1% 19,8% EBITDA margin, % 44,5% 16,7% 6,4% 24,6%


1Including Lucchini steel production 2Including Lucchini steel production.

24%

22%

18%

18%

9%

9%

Evraz Severstal MMK NLMK Mechel Other

Company note

April 2, 2012


EBITDA for 9M2011 9M2010, and in the context of division of Severstal

Division 9М2011 9М2010 Change Sevestral Resource 1258 791 59%

Including Nord Gold 379 250 52% Severstal Russian

Steel 1369 1271 8% Sevestral North

America 163 84 94% Source: company data, Sovlink estimates

Itemized revenue in the context of selected products for 9M2011,%


Itemized revenue in the context of product markets for 9M2011,%


Dynamics of the EBITDA margin by years in the context of Russian companies

EBITDA margin Company 2008 2009 2010 2011E

ММК 20% 20% 19% 16%

НLМК 40% 23% 28% 20%

Меchel 30% 12% 21% 18%

Еvraz 26% 11% 16% 18%

Severstal 31% 17% 25% 24%

The mean 29% 17% 22% 19%


But the main share of the company's revenue (63.7% of consolidated revenue) is formed by companies belonging to the steel division - Severstal Russian Steel, which accounts for 44% of operating income of Severstal. At the same time 65% of the total revenue of the division accounts for the domestic market, which ensures a stable financial performance in the periods when the demand for steel products in foreign markets declines. One of the key positions of Severstal's strategy is to increase the volume of sales on the Russian market. At the same time a wide range of products allows the company to effectively reallocate production priorities, adapting to current market needs for a particular type of product. However, the details of revenue of Russian Steel in monetary terms by product type shows that the large proportion (44%) is formed at the expense of products with low added value, such as hot-rolled sheet, etc. As for the investment and development capacity, the company will increase its production of higher added value - with a corresponding increase in demand. Considering the operational efficiency of North American companies that make up the division Severstal North America, it is clear that the profitability of this division is at a low level. Low operating margin is primarily associated with higher production costs, particularly costs for materials. Severstal aims to optimize the structure of its subsidiaries, increase of production efficiency, in accordance with the plan of development of the enterprises of Severstal North America. It may well be that part of the existing assets of Severstal North America will eventually be sold. The main items of cost, which have a significant impact on the profitability of the company, are related to compensation of employees, purchase of materials and high depreciation costs. Together, these articles form 72.4% of the total cost (based on data for 2010). Analyzing statements for the first nine months of 2011, we can conclude that the company has achieved significant financial growth in the divisions of Severstal Resources and Severstal Russian Steel. The increase in revenue was due to higher market prices for raw materials (coking coal concentrate, etc.), gold, and the increase in sales (adjusted for the sale Lucchini). Operating profitability was 19.4% (for the same period last year figure was 18.2%). However, in late 2011, management has decided to separate Severstal Nord Gold from the general structure of the business, which had a moderately negative impact on the overall profitability of Severstal. According to our estimates, the total operating margin is 20%, which is slightly higher than in 2010. We assume that the company's operating margin in the light of weak demand for steel and falling commodity prices will decline because of the rapid growth of cost of sales of the company. However, the company has some "leverage" cost containment, such as: 1) Optimizing the number of staff (in a long-term the company will

strive to reduce the number of employees to 70 thousand people from the current number of 85 thousand);

2) Sale of unprofitable assets; 3) Slowdown of depreciation growth by the stabilization of the rate of

growth of the company.

29%

12%

10%6%6%

4%

33%

Hot-rolled steel Colour-coated sheetCold-rolled steel Large diameter pipesMetalware products Long productsOther prodaucts

48%

22%

19%

3%3% 2% 2% 1%

Russia North America

Europe China and Central America

Middle East Central and South America

South-East Asia Africa

Company note

April 2, 2012


Itemized revenue for Severstal Russian Steel division by consumers,%

Source: company data

Itemized revenue for Severstal North America in the context of customers,%

Source: company data

ND / EBITDA in the context of the major Russian steel companies over the years

ND/EBITDA Company+ 2007 2008 2009 2010 2011Е

ММК -0,27 0,23 1,69 1,98 2,35

НLМК 0,09 0,18 0,56 0,63 1,19

Меchel 1,96 1,71 8,42 3,48 3,92

Еvraz 1,49 1,71 6,93 3,26 2,32

Severstal 0,39 0,94 2,65 1,22 1,0

The mean 0,73 0,95 4,05 2,11 2,16 Source: Bloomberg, Sovlink estimates

The plan for the production of crude steel, tonnes


Debt and capital investments For 9M2011, the company's total debt amounted to 6.207 billion dollars. If we compare the dynamics of ND / EBITDA of Russia's largest metals companies, it is evident that the Severstal indicators of debt burden are much better than the industry average values, what indicates a certain stability of the risks of changes in the cost of new borrowing, as well as the availability of investment projects, even in deteriorating market conditions. We expect that in 2011 the ratio of net debt to EBITDA will not exceed 1,1 x, and in the long-term average annual will amount to 0,99 x, which will fully meet the company's strategy to maintain the target value covenants on the level of 1,5 x. In addition to low levels of debt, it is important that a company spends almost all of their investment projects from its own operating cash flows. To maintain the production the company spends 700-800 million dollars, the rest of the capital investment is used to further development of the existing business structure. In 2012, the company plans to invest 905 million dollars into the development of Severstal Russian Steel division (of which more than 600 million dollars will be spent on completion of the mini-plant in Balakovo, and the production of long products), 659 million dollars for the modernization of production facilities for Severstal Resource and 104 million dollars to support the production for Severstal North America.

The company's strategy Severstal as a vertically-integrated company seeks to improve production efficiency and increase the volume of steel and raw materials production. The strategic objectives of the company: 1) Increase in capacity of sales of steel products in the domestic

market; 2) Improving the efficiency and cost reduction of metallurgical assets; 3) Development of the product mix and distribution, increase in sales

for further added value; 4) The acquisition of new production assets in order to further expand

the volume of steel production and maintain high availability of raw materials;

5) Entering new markets with the prospect of significant growth in consumption of steel products.

To fulfill the goals the company plans to initiate a number of projects in the mining sector.

Projects of the company

Start of production

The main product Production

volume/ capacity

Putu deposit (Liberia)

2017-2018 Iron ore 20-30 mln tonnes

Amapa deposit (Brazil)

2019-2020 Iron ore 20-30 mln tonnes

Tuva deposit (Russia)

2017-2018 Coking coal concentrate

7,5 mln tonnes

By 2020, Severstal plans to increase steel production by 28%, coking coal concentrate by 136%, iron ore by 158% from current levels. In parallel,

55%

7%

9%

6%

12%

11%

Construction and processing Machine building

Tubes and pipes Auto

Other Oil & gas pipes

20%

18%

16%

29%

17%

Construction and processing Machine building

Tubes and pipes Distribution

Other

15.2918.1

19.6

0.00

5.00

10.00

15.00

20.00

25.00

2011 2015Е 2020Е

Company note

April 2, 2012


The plan for the production of coking coal, million tonnes

Source: sompany data, Sovlink estimates

The plan for the production of iron ore, million tonnes


the company by 2016 plans to increase sales of products with high value added by 8%, reduce the proportion of export sales to 23% and increase the production of steel products (cold rolled sheet, etc.) used in the automotive industry. The company believes that by 2016 the volume of steel consumption in Russia will grow by 31% due to an expected rise in demand from the construction and automotive sectors. The company places high hopes on future growth in demand from India (projected CAGR of 10%), in which steel consumption per capita is 52 kg (figures for the United States - 258 kg, Russia - 257 kg, Brazil - 132 kg per capita).3 The increase in consumption growth will be contributed to by population growth, expansion of consumer markets, a significant infrastructure development. In addition to developing new markets, the company will optimize the industrial structure of North American assets. By 2016 the company plans to increase the proportion of sales for the American auto industry up to 42% (actual value - 28%) in connection with the prospects for sustainable development of the American automotive industry. At the same time it will lead to an increase in the proportion of products with high value added from 49% to 64%. Also, due to ongoing modernization of the production company costs will be reduced in some of its North American operations and thereby increase the overall profitability. In our opinion, Severstal has set itself quite achievable goals that can be implemented in the long run. The gradual change in sales mix towards sales of products with high value added will lead to improved financial performance, and is one of the key growth drivers of shares of Severstal. In general, by 2015-2016, the company will seek to enter the planned volume of production and "prepare a basis" for future capacity expansion in countries with high growth potential of consumption of steel products.

3 2010 data

7.59

10.4

17.9

0.00

5.00

10.00

15.00

20.00

2011 2015Е 2020Е

14.82 15.4

38.2

0.00

10.00

20.00

30.00

40.00

50.00

2011 2015Е 2020Е

Company note

April 2, 2012


SWOT-analysis

Strengths Weaknesses 1) Diversified sales structure of the company's business (in markets and product types); 2) Having its own resource base provides a high return on the whole business of Severstal (self-sufficiency in coking concentrate 113%, iron ore - 89%); 3) Maintaining the low value of debt, project financing mainly at their own expense; 4) The geographical proximity of raw materials, production facilities and major customers.

1) The relatively high level of production costs in North American assets of Severstal and as a consequence, low operating margins;

Opportunities Risks 1) Changes in the structure of production in favor of products with higher added value (from 40% in 2010 to 48% by 2016). 2) Access to markets of developing economies with high growth potential of steel consumption (India). According to the forecast of the company, the average annual growth in steel consumption in India will be 10% due to increase in population and development of the automotive industry. In this region, the company plans to build a vertically-integrated business model based on local sources of raw materials. 3) The significant growth of the resource base, including the deposits of coal and iron ore in Brazil, India and Russia (by 2020 increase of production of coking coal concentrate will be 145%, iron ore - 177%). 4) A significant decline in the share of exports in favor of the domestic market (a more stable demand, support for investment by the state in infrastructure projects). The share of exports will be reduced to 23% by 2016 compared to 46% in 2010. 5) Optimization of costs, increase of capacity utilization in the North American assets and, consequently, the increase of operational efficiency. 6) The possibilities of mergers and the subsequent development of productive assets.

1) High dependence of the financial performance of Severstal on prices and demand for raw materials and steel products; 2) The implementation of projects requiring large amounts of money, and as a consequence of an increase in debt of the company; 3) A high proportion of export sales in total revenue may adversely affect the financial performance of the company in case of reduction in demand in foreign markets; 4) Companies operating in developed markets, carry additional costs associated with higher labor costs of employees, etc. The activities of these companies are also subject to the laws of these countries, in particular taxation and antitrust regulations; 5) Under progressive rates of reduction of the cost of raw materials for production in comparison with the prices of steel products, companies that purchase raw materials will "save" at cost, and companies with their own production assets, on the contrary.

Distribution of net income per share before the spin off Nord Gold and after the separation of gold mining company based on the data for 9M2011

Division Before spin

off After spin off Net profit

Nord Gold, $ mln 173,782 Net profit (other divisions), $

mln 1376,218 1376,218

Severstal's net income, $ mln 1550 1376,218

The number of ordinary shares of Severstal, mln.

1007,7 837,7

Net income per share, $ 1,54 1,64


Capital structure As of November 15, 2011 the main shareholders of the company were: 1) Severstal CEO Alexei Mordashov - 82.4%; The estimated level of free-float is about 17.6% or 177.355 million shares.

Corporate Events Spin off of Nord Gold. November 30, 2011 Severstal announced the proposal of separating (spin off) Nord Gold from the general structure of the company through the exchange of their shares for the GDR Nord Gold (at the time the shares of the company had no listing). In the background of the news Severstal shares instantly fell in price by 7% compared with the level of quotations for the last day. A certain number of investors have been disappointed by a separation of the asset because of the expected deteriorating financial performance of Severstal after the separation of the gold mining company. However, the separation of Nord Gold sooner or later, was a predictable step, since in general the activity is non-core for the steel companies, subject to other regulations, has a completely different cost structure and its own development strategy. We assume that overall the separation of the gold mining company from Severstal mining division will be neutral, however, the spin off of Nord Gold means the loss of a potential trigger for the growth of shares of Severstal. Actually in 2011 the presence of gold mining business in the holding structure was seen by many investors as a stabilizing factor, as a result Severstal shares were more resistant to the fall in prices

Company note

April 2, 2012


Itemized cost of forecasted cost in the context of particular types of expenditure for 2011


compared to other steel companies. Redemption of shares of Severstal. During the separation of Nord Gold from Severstal structure, shareholders were invited to exchange the shares of the parent company for shares of gold mining company (exchange ratio was 1.86). As a result Severstal has received 170 million shares to be redeemed within the public offer at a price of 390 rubles, which is below the current market price of shares by 9.3%. Isolation of the gold mining company from Severstal has been already incorporated in the prices of shares and should not have a significant impact on the price of the shares of Severstal.

Valuation We estimate the fair value of the company based on the income approach (DCF). Evaluation method of DCF Production of crude steel. Severstal aims to increase steel production to 18.1 million tonnes by 2015 (CAGR is of 4.3%). We believe that the goals set by the company are achievable, however, we estimate that the production of steel in 2012 compared to 2011 decreased by 5%, given the weak demand and a slowdown in emerging economies. The reduction in production will lead to a decrease in financial performance and poor operating margins. From 2013, we assume that the company will gradually restore production. Revenue. In predicting a fair valuation of Severstal's share price, we use a conservative model. In our opinion, in 2012 there will be a continued decline in prices for steel products and raw materials (the average price per h / r sheet will fall by 4%, per c / r sheet - by 7%, for coking concentrate - 14%), which will have a negative impact on company's financial performance (Operating margin will drop to 14.2% from the expected in 2011 18,5%, EBITDA margin in 2012 will amount to 18.6% against 24% a year earlier). We expect that in the absence of significant demand from the construction sector in the domestic market, as well as reduction of the demand on foreign markets, companies will also have to reduce the volume of steel production (down by 5% compared to 2011 year). The total revenue of the company in 2012 could reach $ 15.3 billion (-5,7% yoy).

The main items of expenditure and the cost of production. In our model, forecast production cost depends on the following factors:

Producer Price Index (PPI). It is used to forecast costs of the company (materials, third-party payment services, etc.).

Tariffs for electricity. Forecast of electricity tariffs up to 2014 is based on the basic scenario, the forecast MEDT (rates for the industry), then - on forecasts of "Sovlink" taking into account changes in the exchange rate.

The dollar against the ruble.

Wages. Forecast of a nominal wage growth is tied to the expected rate of inflation and exchange rate changes.

The main items that make up the cost of the company, can be divided into the following types: materials, energy, labor costs, depreciation and other expenses. The largest share in the cost is taken by the cost of materials (49%), which are mainly related to the level of production, thus, consist of variable costs. Depreciation and amortization expenses

49%

9%

10%

12%

10%

1%9%

MaterialsEnergyStaff costsDepreciation and amortisationServicesOtherCosts of Severstal North America

Company note

April 2, 2012


also constitute a significant proportion (12%), but their level is directly related to the cost of fixed assets, including the ongoing capital investment in the company upgrade of production facilities. It is important to note that the labor costs of employees constitute 10% of the total cost. In our opinion, this expenditure will most significantly affect the profitability of the company, because, by assumption, these expenses primarily consist of fixed costs, that is, cannot be reduced by reducing output. Severstal, is likely to reduce these costs by reducing the number of employees (current 85 thousand people, the best for the company - 70 thousand employees). The level of debt and capital investment (CAPEX). The values of the debt ratio is projected based on the company's debt to the estimated level of capital. A unique feature of Severstal is funding nearly all capital investments with its operating cash flows, thereby providing a low debt burden on the company's business and servicing current debt. The level of covenants (ND / EBITDA) by 2015 will be on average at the level of 0.99. We expect that the effective interest rate on the debt will amount to 9.4% (now, according to the company for 9M2011, involves loans at rates of 8.2%). The annual capital expenditure to maintain the level of production is $ 700-800 million, while the rest goes to the construction of new enterprises and the acquisition of new assets. The planned volume of capital investments in 2012 will be about $ 1.7 billion, while in subsequent periods, we expect that the annual rate will be $ 1.2 billion Dividends. According to the dividend policy of Severstal, the company pays out dividends per share of 25% of net profit under IFRS. We estimate the total volume of dividend payments for 2011 will be $ 0.53 per share, while the company has paid out dividends for 9 months of 2011 of $ 0.40 per share, calculated at the current rate.

Assumptions and conditions of the DCF model:

1) The final growth rate. We assume that in the long term the company will grow at a growth rate of 3%.

2) the tax rate. Income tax rate is 20%. 3) Return on risk-free asset. Accepted at the level of 5.7% (tied to

long-term profitability of Russian Eurobonds). 4) The risk premium of investing in stocks for the Russian

market. It is determined based on the Damodaran methodology and his data for the Russian market:

Country

The risk premium

of investing in shares

(U.S.)

Spread in the Russian market

The coefficient of volatility in

emerging markets

The risk premium

of investing in shares (Russia)

Russia 5% 200 1,5 8%

5) Unlevered beta. Beta of Severstal shares equal to 1.15. 6) Levered beta. Based on the ratio of debt to total debt and equity

(42%), as well as the beta coefficient (excluding debt), the value of beta is 1.53.

7) The cost of debt. In our model, the cost of debt is assumed to be 9.4%, which corresponds to the expected value of the effective interest rate on debt service (2011).

Company note

April 2, 2012


As a result, the fair price of the shares of the company "Severstal", calculated by taking into account the DCF with WACC, equal to 13.6%, is $ 15.02 per share at the end of 2012, recommendation "HOLD".

DCF model and the calculation of target prices

Cash flow forecast 1 1 2 3$ mln 2008 2009 2010 2011E 2012E 2013E 2014E 2015ERevenue 16 066 9 594 13 573 16 264 15 345 16 666 17 495 19 073Growth rate (%) -40% 41% 20% -6% 9% 5% 9%EBITDA 4 685 1 238 3 217 3 889 2 849 3 667 3 639 4 472Profitability (%) 29% 13% 24% 24% 19% 22% 21% 23%EBIT 3 847 541 2 504 3 262 2 172 2 909 2 904 3 714Profitability (%) 24% 6% 18% 20% 14% 17% 17% 19%- Income Taxes 517 18 487 535 305 434 415 556NOPAT 3 329 523 2 017 2 727 1 868 2 476 2 489 3 158+ Amortization 838 698 713 627 677 758 734 757- Capex 2 154 983 1 499 1 500 1 668 1 200 1 200 1 200- Increase (decrease) in working capital 0 -1 129 -141 938 -52 287 301 360- Share of minority 0 0 62 93 53 75 72 97Net cash flow 2 013 1 367 1 310 822 875 1 671 1 650 2 258

The basic assumption Assessment of DCFThe discount rate (WACC) 13,6% The discounted cash flow 4 288Terminal rate 3,0% Terminal value 21 889Tax rate 20% NPV of terminal value 14 921

Fair EV 19 209WACC calculation Net debt 4 075Risk-free rate 5,7%Spread across Russia, pp 200 Fair Mcap 15 134Premium for investing in stocks 8,00% Shares outstanding (mln) 1 007,7Specific issure risk 0,00% Target for the end of 2012, $ 15,02D / (D+E) 0,42

The sensitivity analysisBeta (unlevered) 1,15Beta (levered) 1,53 10,6% 11,6% 12,6% 13,6% 14,6% 15,6% 16,6%Risk-free rate 5,7% 4,5% 28,68 23,99 20,46 17,70 15,49 13,68 12,17Cost of equity 18,0% 4,0% 26,43 22,34 19,20 16,71 14,70 13,03 11,63Cost of debt 9,4% 3,5% 24,49 20,89 18,08 15,82 13,98 12,44 11,13Income tax rate 20,0% 3,0% 22,80 19,60 17,07 15,02 13,32 11,89 10,67Cost of debt after taxes 7,5% 2,5% 21,33 18,46 16,17 14,28 12,71 11,38 10,24WACC 13,6% 2,0% 20,02 17,44 15,34 13,61 12,16 10,92 9,85

1,5% 18,86 16,52 14,60 13,00 11,64 10,48 9,47

The discount rate (WACC)

Term

inal

gro

wth

rate

(%)

Company note

April 2, 2012


According to the forecast indicator, EV / EBITDA (consensus of Bloomberg) for 2012, Severstal is the cheapest among the Russian sector peers.

Comparison with peers

Projections of the target firm Evaluated company Price, $ Mcap, $ mln P/E EV/S EV/EBITDA

SEVERSTAL 13,52 13625,60 7,23 0,99 4,40 Source – Bloomberg,consensus-forecast for 2012 The sample of the Russian metallurgical companies

Russian companies Price, $ Mcap, $ mln P/E EV/S EV/EBITDA MAGNITOGORSK IRON&STEEL 0,47 5208,30 12,67 0,80 5,16

NOVOLIPETSK STEEL (NLMK OAO) 2,11 12674,32 8,54 1,16 5,66 MECHEL 9,45 3933,49 4,13 0,96 5,32

EVRAZ PLC 5,73 7671,76 8,09 0,88 4,81 Average (median) 8,31 0,92 5,42

Source – Bloomberg, consensus-forecast for 2012

The sample of foreign metallurgical companies in emerging markets Emerging markets Price, $ Mcap, $ mln P/E EV/S EV/EBITDA

POSCO 331,28 28883,28 9,70 1,05 6,23 TATA STEEL LTD 8,82 8562,70 10,10 0,73 7,16

BAOSHAN IRON & STEEL CO-A 0,76 13351,98 8,16 0,48 4,02 GERDAU SA-PREF 9,73 15732,27 12,29 0,96 6,80

NANJING IRON & STEEL CO-A 0,42 1646,47 13,29 0,52 6,91 CHINA STEEL CORP 1,01 15181,18 23,18 2,31 15,86 Average (median) 11,20 0,85 6,86


The sample of foreign iron and steel companies in developed markets Developed markets Price, $ Mcap, $ mln P/E EV/S EV/EBITDA

NUCOR CORP 42,55 13490,02 15,67 0,74 6,98 ARCELORMITTAL 18,89 29479,97 9,05 0,55 4,99

NIPPON STEEL CORP 2,76 18773,90 - 0,73 8,17 UNITED STATES STEEL CORP 28,81 4348,18 11,22 0,40 5,31

SSAB AB-A SHARES 9,26 2897,54 11,00 0,81 6,75 THYSSENKRUPP AG 24,79 12756,75 27,08 0,34 5,46 Average (median) 11,22 0,64 6,11


Severstal - the time-hardened business model April 2, 2012


Stock recommendations

STRONG BUY: Upside over 25%; confidence level – high / upside over 100%; confidence level - low

BUY: Upside between 15 and 25%; confidence level – high / upside between 25% and 100%; confidence level – low

HOLD: Upside of less than 15%; confidence level – high / upside of less than 25%; confidence level – low

SELL: Target price at or below current price levels

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www.sovlink.ru [email protected]

©2012, SOVLINK LLC. The information in the enclosed Report (the "Information") is not an advertisement for any security or particular issuer and should not be interpreted as such. The Information is intended solely for the personal use of SOVLINK LLC's clients or other parties pre-agreed to with SOVLINK LLC. The Information is not intended for use by citizens of the USA or legal entities registered in the USA. Nothing contained in the Information is, or should be interpreted as being information intended for an undetermined audience. The Information is exclusively of an informational/analytical nature, and should not be interpreted as a recommendation to take any particular investment action. The Information should not be relied upon as a justification for the execution of any transactions, and should not be referred to as such. SOVLINK LLC takes no responsibility for any actions taken on the basis of the Information. The enclosed Report does not contain an offer or an invitation to make an offer to buy or sell any securities or any options, futures or other derivatives related to such securities. This Report does not have regard to any specific investment objectives, financial situation and the particular needs of any specific person who may receive this Information. Investors should seek financial advice from SOVLINK LLC, regarding the appropriateness of investing in any securities mentioned and should understand that statements regarding future prospects of the issuers may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may earn less than originally invested. Past performance is not necessarily a guide for future performance. Foreign currency exchange rates may adversely affect the value, price or income of any security mentioned in the Report. Please bear in mind that investment activity in emerging markets is very risky, and investors should conduct their own due-diligence prior to making an investment decision. The individual(s) responsible for the preparation of this Report (the Author(s)), or SOVLINK LLC may hold short- and long-term positions in any of the securities mentioned in the Report, and may take part in investment activities with companies mentioned in the Report. In preparing this Report, the Author(s) assumed that the issuers mentioned in the Report disclose information in the amount and under the procedure stipulated by the securities legislation of the Russian Federation for issuers who publicly place securities. This Report and the Information is based exclusively on publicly-available information. which is deemed to be reliable. however SOVLINK LLC makes no representation that this Information is accurate or comprehensive. and it should not be relied upon as such. SOVLINK LLC makes no representation that this Report has been released to all readers simultaneously. nor that SOVLINK LLC will update this material on a regular basis. or that it will correct inaccuracies contained in this Report.

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