Investments are investments, but dividends take priority!

• The weakening of the Russian ruble in early 2020 due to the fall in oil prices may have a positive effect on the profitability of Russian metallurgy companies. This is because about 80% of their costs are ruble denominated, while most of their revenue is denominated in dollars or pegged to the US currency. This factor, when combined with the vertical integration of the business, will enhance the competitive advantages of Russian producers compared to their foreign peers.
• ACRA forecasts moderate average annual growth of steel consumption in Russia in 2020–2023 (2%). The implementation of the transport infrastructure national projects will create additional demand for steel products. However, ACRA assesses that the effect of this will not be felt until at least 2021.
• The main vertically integrated Russian steel producers have entered the next stage of the investment cycle, during which they plan to upgrade and modernize existing facilities and broaden their product offerings. In 2019, the aggregate capital expenditures of the four leading Russian steel producers (PJSC “Severstal”, PJSC “NLMK”, PJSC “MMK”, and EVRAZ Group) amounted to USD 4.2 bln, a 53% increase compared to 2018. In 2019–2023, the average annual investment expenses of these companies will equal USD 3.8 bln, which is 65% higher than the indicator for the preceding five years.
• Dividends will continue to take priority. The increased volume of investments in forthcoming years should not have a significant impact on the cash flow that the companies under review allocate for dividend payments. High dividends, especially those paid on a quarterly basis, are an important factor in the investment appeal of Russian steel producers. According to ACRA’s assessments, their average annual total dividend flow in 2020–2023 may amount to USD 5.2 bln.
• Leverage is expected to stay moderate. The average ratio of net debt to operating cash flow prior to changes in working capital (FFO) of the four leading Russian steel companies was 0.79x in 2019 versus 0.52x in 2018 due to these companies entering a new investment cycle. ACRA assumes that the average net debt to FFO ratio will grow to 1.06x by 2021 and then remain unchanged until 2023, given the companies’ increased capital expenditures and desire to avoid lowering dividend payments. The net debt to EBITDA ratio, which industry companies use as a guideline for leverage, will remain within 1.0x.

Implementation of the national projects will support demand for steel in Russia

The volume of Russian steel production fell by 0.7% in 2019 (to 71.6 mln tons), while global production grew by 3.4% (to 1.9 bln tons). The Russian trend was primarily due to maintenance and repair works carried out on blast furnaces (at PJSC “NLMK”), as well as the need to reduce steelmaking operations due to the repair of rolling capacity (at PJSC “MMK”). Nevertheless, the consolidated volume of steel products sold by PJSC “Severstal”, PJSC “NLMK”, PJSC “MMK” and EVRAZ Group increased by 0.7% to just over 53 mln tons, and the lion’s share of these products were sold in the Russian market.

Steel consumption increased by 4% in Russia in 2019 (to 46.5 mln tons), despite the results for the first half of the year pointing to considerably lower growth. The situation picked up in the second half of the year amid increased purchases of steel for construction purposes, which in turn was caused by changes in construction industry regulation and the introduction of escrow accounts from July 1, 2019. ACRA assesses that these changes created deferred demand for steel products because construction companies attempted to create maximum project portfolios prior to their introduction (in 2020 there is a risk of falling demand for steel for construction purposes as construction project portfolios shrink).

Figure 1. Production and consumption of steel in Russia, mln tons

Source: ACRA

ACRA assumes that Russia will experience moderate average annual growth in steel consumption in 2020–2023 of around 2%. At the same time, the effect produced by the transport infrastructure national projects will be felt no earlier than 2021 due to delays in the implementation measures that are part of the projects “Comprehensive Plan for Modernization and Expansion of Trunk Infrastructure”, “Safe and High Quality Roads”, and “International Cooperation and Exports”. The budgets of these projects are valued at 6.35, 4.78, and 0.96 trillion rubles, respectively, however, the percentage of execution of allocated budget funds is considerably behind schedule, according to a report published by the Accounts Chamber.

The Russian Federation’s housing development strategy envisages growth in the volume of new housing of up to 120 mln sq. m per year by 2025 (average annual growth of around 7% compared to 2019); this is a rather ambitious target.

According to ACRA’s calculations, faster implementation of the housing construction national projects, increased volumes of transportation along the Northern Sea Route, development of high-speed rail, and the expansion of Russia’s motorway network will contribute to growth in demand for steel products. Consumption of steel for construction purposes may grow, given the possible increase in construction of new housing in Russia in the medium term against the backdrop of lower interest rates on mortgages. ACRA assumes that the average annual growth in the commissioning of new housing until 2025 should amount to 3–4% (in 2020 it is possible that construction volumes may fall year-on-year due to a reduction in the size of construction companies’ project portfolios).

A new stage of the investment cycle in the Russian metallurgy sector

In 2019, the leading Russian steel producers presented updated strategies for the period until 2023, thereby marking the start of a new investment cycle. In particular, the companies anticipate an increase in capital expenditures for the expansion and modernization of steelmaking facilities, as well as an increase in the range of rolled products.

PJSC “NLMK”: The 2020–2023 investment program is valued at USD 3.5 bln. Its primary goal is to boost iron ore concentrate and pellet production output to 20 mln and 8 mln tons, respectively, and hike steel production capacity to 14.2 mln tons. Blast furnace no. 6 and converter no. 2 were modernized and underwent production capacity increases in 2019 for these purposes. The company will optimize its production facilities in order to increase efficiency, including via the construction of a 300 MW power unit that runs on by-product gases from steelmaking operations and will cover almost 100% of NLMK’s energy needs at its Lipetsk site. In addition, expanded use of coal charge ramming technology at subsidiary Altai-Koks will help reduce the cost of coke, as it will be possible to use cheaper grades of coking coal.

PJSC “Severstal”: The 2023 investment program may amount to around USD 3.5 bln, while the impact of modernizing and optimizing metals production alone may increase EBITDA by almost USD 200 mln by 2023 (if the macroeconomic situation is stable). The company plans to achieve greater vertical integration by increasing extraction at its resource assets: by 2023 it is planned to increase the production of coking coal concentrate by 2.4 mln tons (to 5.6 mln tons) and iron ore pellets by 1 mln tons (to 12 mln tons). Higher extraction of iron ore at the Yakovlevskaya mine (from the current 1.2 mln tons to 5 mln tons by 2023) will lower the cost of extraction from USD 41 to 18 per ton. The company also plans to build blast furnace no. 3, with an annual capacity of around 3 mln tons of pig iron. This new furnace should replace retired obsolete furnaces and ensure that by 2023, installed pig iron production capacity is maintained at around 10 mln tons (capacity may be further increased to 12 mln tons, taking into account the modernization of furnaces no. 1 and 2). As a result, PJSC “Severstal” plans to increase steel output to 13 mln tons per year by 2023.

PJSC “MMK” is the leader in terms of the range of products and the share of products with high added value because in the past it actively invested in rolling facilities and equipment for the production of rolled steel of various assortments.

PJSC “MMK” (has a smaller supply of raw materials than the other companies, especially iron ore): At around USD 3.6 bln, the size of the company’s 2020–2023 investment program is similar to that of its competitors. A significant share of these funds will be used to replace three obsolete blast furnaces, construct a new coke oven, and build a new oxygen workshop for use in the converter process. In 2019, the company launched a new sintering plant with an output of 1 mln tons, thereby bringing the total sintering capacity to 11.5 mln tons per year. Thanks to its production of sinter, PJSC “MMK” can buy lower quality ore at reduced prices and then use sintering to increase the ore’s iron content to the required level, which reduces the cost of smelting pig iron. The company’s situation in terms of coking coal is more positive, and the upgrade of enrichment capacity to 3.2 mln tons of concentrate by 2023 will allow it to reduce purchases of this material from third parties.

EVRAZ Group (has the largest supplies of its own materials and is the most diversified in terms of geographical presence): The 2023 investment program amounts to around USD 4 bln. Around half of these funds will go toward the primary and accompanying development programs. These include the construction of a mill in the United States (worth more than USD 500 mln) for production of long (100m) rails, the modernization of rail and beam production at the Nizhny Tagil plant, and the construction of an integrated complex at the West Siberian plant (worth around USD 650 mln) with a capacity of 2.5 mln tons of flat-rolled products. Given the Group’s focus on production of steel for construction purposes and railway products, the latter project is especially important and seeks to increase the share of products with high added value.

Figure 4. Total capital expenditures of Russia’s four leading steel producers, USD mln

Source: ACRA

Dividend payments will remain a priority

Russian steel producers entering a new investment cycle will try to maintain a balance between dividend payments and leverage. Dividends will be a priority, despite a moderate increase in debt.

Over the past five years, Russia’s four leading steel producers have managed to maintain a steady cash flow due to market conditions, reduced capital expenditures, and the sale of foreign assets. The size of these cash flows has allowed the companies to reduce debt and make sufficient dividend payments, making it possible to start a new investment cycle with low leverage.
In 2019, the total cash dividends of these companies decreased slightly in annual terms due to a drop in sales prices. However, the dynamics of the dividend reduction was not comparable to the scale of the decline in operating profit. This suggests that the priority for these companies is to pay dividends to shareholders and to maintain the amount of dividends, despite periods of weak price conditions.

Figure 5. Total dividends of Russia’s four leading steel producers, USD mln

Source: ACRA

In 2019, the combined FCF of PJSC “Severstal”, PJSC “NLMK”, PJSC “MMK”, and EVRAZ Group turned negative for the first time since 2011, partly due to a sharp increase in their capital expenditures as they entered the new investment cycle. To finance this negative FCF, the companies had to increase their leverage.

The dividend payments of Russia’s four leading steel producers have grown consistently since 2013. According to ACRA, this has created a certain paradigm in the industry in which companies will continue to pay high dividends, despite the need to allocate significant funds for investment programs. This is evidenced by the terms of the dividend policies these companies presented in new versions for 2019.

PJSC “NLMK”, under the terms of its dividend policy, directs at least 100% of FCF to pay dividends, with a net debt to EBITDA ratio of less than 1.0x (or at least 50% of FCF if the ratio exceeds 1.0x). The company also supplemented its policy in 2019 with an FCF calculation condition: the normalized flow of USD 700 mln per year is used as the investment flow, and therefore, additional capital expenditures within the new investment cycle (about USD 200 mln per year) will not be taken into account when calculating FCF. This means that the company will allocate an additional USD 200 mln for dividends if the net debt to EBITDA ratio remains within 1.0x.

Figure 8. PJSC “NLMK”: capital expenditures, dividends, leverage

Sources: PJSC “NLMK”, ACRA

PJSC “Severstal” has a similar dividend policy to PJSC “NLMK”, but uses normalized capital expenditures of USD 800 mln per year to calculate FCF. At the same time, the company indicates that given the updated investment program and dividend policy, net debt to EBITDA will remain below 1.5x in 2019–2023. ACRA maintains a more conservative assessment and believes that the company will try to maintain leverage below 1.0x. Otherwise, there is a risk of exceeding the rating covenants based on the debt to FFO ratio. According to ACRA, in 2020–2023, the compromise dividend amount will be 110% of adjusted FCF, which will maintain a balance between leverage requirements and the amount of dividend payments.

Figure 9. PJSC “Severstal”: capital expenditures, dividends, leverage

Sources: PJSC “Severstal”, ACRA

PJSC “MMK” presented an updated dividend policy in 2019 for the next few years, one based on capital expenditure requirements. The policy is similar to those of PJSC “NLMK” and PJSC “Severstal”, and PJSC “MMK” will use a normalized investment flow of USD 700 mln per year to calculate the adjusted FCF when determining the amount of dividends. In recent years, PJSC “MMK” has followed the most conservative policy regarding leverage, resulting in a net debt to EBITDA ratio of -0.14x at the end of 2019, the lowest value among the companies under review. In this regard, ACRA believes that PJSC “MMK” has the most room to maneuver in determining the amount of dividend payments. However, taking into account the company’s conservative approach to this issue, we can expect that PJSC “MMK” will continue to adhere to its previous dividend policy in the future and allocate 100% of its FCF to paying dividends.

Figure 10. PJSC “MMK”: capital expenditures, dividends, leverage

Sources: PJSC “MMK”, ACRA

EVRAZ Group is less specific about its dividend policy, possibly due to a higher level of leverage compared to the other three companies analyzed. EVRAZ Group plans to pay shareholders at least USD 300 mln per year while maintaining a net debt to EBITDA ratio below 3.0x. At the end of 2019, this ratio was 1.29x, and cash dividend payments for the year slightly exceeded USD 1 bln, almost 65% of FCF. According to ACRA, given the average value of the company’s capital expenditures in 2020–2023 at USD 1 bln, EVRAZ Group can afford to pay dividends in the specified period at an average level of 110% of FCF without exceeding rating covenants. An additional incentive for paying high dividends may be the acquisition of new assets by EVRAZ Group’s shareholders, which will require additional funds to service debt. According to media reports, the main owners of EVRAZ Group are beginning the process of purchasing the Sibuglemet coal mining holding company, one of the largest producers of coking coal in Russia, from VEB.RF. The transaction amount may be small (about RUB 4 bln), but the new owners will have to service a large of Sibuglemet’s debt to VEB.RF (about USD 3.5 bln). ACRA estimates that in the future, as Sibuglemet’s leverage decreases to a level comparable to the current level of EVRAZ Group, this asset can be successfully integrated into EVRAZ Group’s perimeter.

Figure 11. EVRAZ Group: capital expenditures, dividends, leverage

Sources: EVRAZ Group, ACRA

Turbulence in world markets caused by the spread of COVID-19, as well as the breakdown of the OPEC+ agreement, creates uncertainty in terms of the growth rates of both the world economy in general and the Russian economy in particular. The rapid fall in oil prices has triggered a sharp depreciation of the Russian ruble, which may lead to an increase in inflationary dynamics and a decrease in investment activity. ACRA believes that the situation with COVID-19 will be brought under control, and oil prices will gradually recover thanks to a compromise between OPEC+ members (the current situation is disastrous for all OPEC+ participants as well as the US shale industry).

If markets recover from the effects of COVID-19 as soon as possible in 2020 and there are no global shocks in 2021 or in the following years, Russia’s leading steel producers will be able to generate stable operating cash flow, enough to implement new investment programs and maintain high dividends.

The depreciation of the Russian ruble in early 2020 may have a positive impact on the profitability of Russian steel companies. About 80% of the cost of companies in the industry is in rubles, while most of the revenue is in dollars or pegged to the dollar. This factor, combined with the vertical integration of the business, will help to increase the competitive advantages of Russian manufacturers relative to foreign ones.

ACRA assumes that domestic steel consumption in Russia will grow by an average of 2% annually in 2020–2023, while steel prices will remain low in 2020–2021 (followed by a moderate recovery of 2% annually in 2022–2023).

The combination of increased capital expenditures and the desire of the analyzed companies to maintain the level of their dividend payments will contribute to a moderate increase in their leverage. However, this will not create a risk of exceeding rating covenants.

Table 1. Summarized cash flow data for Russia’s four leading steel producers, USD mln

Source: ACRA

Russian steel companies look noticeably better than comparable foreign producers

Russian steel producers differ significantly from comparable foreign companies in their high production profitability. This advantage comes from a high degree of vertical integration, strong market positions in both the domestic and export markets, and significant product line diversification. High profitability and moderate capital expenditures in previous years have afforded Russian companies significant FCF, enough to both pay dividends and reduce leverage.

As a result, Russia’s leading steel companies have achieved the lowest net debt to EBITDA ratios among global producers in this industry. This provides PJSC “Severstal”, PJSC “NLMK”, PJSC “MMK”, and EVRAZ Group with greater flexibility compared to international competitors in terms of the ability to pay dividends even in the event of lower prices for steel products and, as a result, operating profit.