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Maxim Semenovykh
Analyst, Moscow (+7 495) 795-3725
Russian Steel
China Slowdown Outweighs Japan Reconstruction Opportunity
Japanese reconstruction efforts add 22mt, or 1.5%, to global steel demand in FY12, according to our preliminary estimate. This unanticipated volume expansion is dwarfed by slowing growth in China, where PMI and domestic steel prices are lead indicators, and both have fallen in recent months. We expect global steel demand to slow considerably in FY11. Therefore, despite considerable theoretical upside for steel producers on spot steel prices, we believe risk outweighs opportunity and move U/W the subsector, reducing our rating on MMK to E/W, on NLMK and SVST to U/W, and reiterating our U/W rating on EVR. Upside to peak cycle valuation: Investors who believe spot is the best indicator of future prices should be long the subsector. We introduce our peak-cycle valuation methodology, which identifies peak stock price potential under the assumption that current spot prices are sustainable. Evraz offers the most upside of 35%. Reconstruction generates 22mt incremental steel demand: We estimate reconstruction efforts in Japan add 22mt, or 1.5%, to global demand in 2012 relative to pre-earthquake forecasted growth. but we see prices falling on China PMI, domestic discount: China consumes almost 9x the steel that Japan does, so our view on a slowdown in China takes precedence. Chinas PMI has declined in the past two months, and there is a strong relationship between PMI and steel prices four months later. Furthermore, Chinas domestic steel price has moved to a discount to Black Sea, a rare development that typically signals declining global steel prices. Subsector to U/W: Slowing demand growth will likely cause steel prices to begin declining in 2Q11 as shortages in raw materials are relieved. We lower NLMK, SVST and MMK one notch each and leave EVR at U/W. Taking into account our February 22 downgrade of FXPO to E/W, we are now U/W Russian ferrous and steel. Valuation: We value steel on sum-of-the-parts, utilizing DCF for currently or soon-to-be operating assets, risked NPV for long-dated mining assets, and market value for non-controlling stakes. FY12 multiples unattractive: We view the subsector as unattractive on average FY12 EV/EBITDA and P/E of 5.9x and 10.5x, respectively. Risk to top-down forecast is high: We are aware that this top-down call 1) conflicts with valuations implied by spot prices; 2) carries greater forecast risk than usual due to macroeconomic uncertainties; and 3) may play out only after a rally to peak valuation levels.
Summary
Bloomberg ticker Rating Closing Price* Target Price Return to TP Bloomberg ticker Rating Closing Price* Target Price Return to TP Bloomberg ticker Rating Closing Price* Target Price Return to TP Bloomberg ticker Rating Closing Price* Target Price Return to TP
EVR LI U/W 36.4 29.6 -19% MMK LI E/W 13.3 14.2 7% NLMK LI U/W 44.1 41.6 -6% SVST LI U/W 18.3 17.3 -5%
Investment Case
Source: Bloomberg
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TABLE OF CONTENTS:
Investment Summary ......................................................................................................3 Valuation, Forecasts, Multiples ......................................................................................5 Upside on Peak Cycle .....................................................................................................8 Japan Reconstruction: +1.5% to Global Steel Demand .............................................10 Scrap use reduces raw material inputs.........................................................................10 Steel demand growth slows despite Japan...................................................................10 Lifting our steel price forecast on higher raw material prices ........................................11 China Slowdown Key Driver for Steel to Decline........................................................12 Economy and steel demand slowed in 2H10................................................................12 China steel demand declined in 2H10 ..........................................................................14 Tightening measures to continue..................................................................................15 Testing the PMI/global steel price relationship .............................................................18 Possible explanations for break in relationship.............................................................19 Chinese metals premiums shrinking often a leading indicator ...................................21 Stock Specific Issues and Risks ..................................................................................24 Financial Statements.....................................................................................................25
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Investment Summary
While we believe that steel volume growth will slow, causing steel prices to peak in 2011 and decline thereafter, we recognize that this is a minority view and that investors require valuation guidance for other commodity price scenarios.
China PMI has weakened. There is a strong correlation between Chinese PMI with a four-month lead and global steel prices. Steel prices have risen sharply over the past few months, contrary to what this relationship would suggest. We attribute this to supply-side shocks in iron ore and coking coal, as well as a restocking cycle. Our view is that steel prices are most likely to decline in coming quarters as this relationship is reestablished.
China domestic steel discount to Black Sea is often a lead indicator of declining prices
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Our revised target prices indicate downside for most steel names. Figure 1: Target prices, upsides and recommendations
Price, $ New 12-month target price, $ Previous target price, December 2, $ New rating Previous rating Return to 12-month TP Source: Alfa Research, Bloomberg Evraz 36.4 29.6 28.8 U/W U/W -19% MMK 13.3 14.2 16.1 E/W O/W 7% NLMK 44.1 41.6 40.0 U/W E/W -6% Severstal 18.3 17.3 15.9 U/W E/W -5%
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We adjust our company forecasts as follows. Figure 3: Changes to company forecast, $ mln
2010E New Evraz Domestic steel finished, mln t International steel finished, mln t Revenues, $ mln EBITDA, $ mln Net income, $ mln match MMK Finished steel, mln t International steel finished, mln t Revenues, $ mln EBITDA, $ mln Net income, $ mln match NLMK Finished steel, mln t Revenues, $ mln EBITDA, $ mln Net income, $ mln match Severstal Domestic steel finished, mln t International steel finished, mln t Revenues, $ mln EBITDA, $ mln Net income, $ mln 11.7 4.1 14,023 2,371 137 Old 11.7 4.1 14,023 2,371 168 2011E New Old 12.5 4.2 17,515 3,694 1,311 12.5 4.2 17,051 3,287 1,062 2012E New Old 12.4 4.4 17,323 3,354 1,284 Sep'09 12.6 2.1 12,460 2,578 1,143 Sep'09 16.0 12,946 3,882 2,366 Sep'09 10.8 4.7 18,260 4,070 2,031 12.4 4.4 17,600 3,516 1,454 Sep'09 12.6 2.3 12,042 2,783 1,344 Sep'09 15.5 12,483 3,998 2,452 Sep'09 10.8 7.2 25,008 3,958 1,951
Source: Alfa Research, *SVST 2010 financial results are actual not expected
On FY11 and FY12 multiples, the subsector does not look attractively valued on an absolute basis. The sector trades inline with global peers on FY11 multiples and at a premium on Alfa below-consensus forecasts on FY12 multiples.
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Country South Korea China Brazil Brazil India China Taiwan India Turkey South Korea China
MCap $ mln 34 901 18 830 23 020 18 167 14 260 5 483 15 280 12 457 4 891 9 362 4 266
2010E 0.8 0.8 3.1 1.3 1.3 0.7 1.5 1.2 1.7 1.5 0.6 1.1
2012E 0.7 0.6 2.3 1.0 1.4 0.5 1.1 0.8 1.1 0.8 0.6 0.9
2010E 8.9 9.8 12.2 14.5 10.0 20.4 12.5 neg 10.9 11.2 21.2 12.2
2012E 6.4 7.3 7.4 8.7 9.1 10.1 10.9 7.6 9.1 7.7 11.5 7.9
Country Netherlands Japan Germany Japan USA USA Austria Germany USA USA USA
Mcap $ mln 52 870 22 918 19 978 18 419 14 238 7 583 7 449 4 495 6 027 3 890 1 612
2010E 0.9 1.0 0.5 1.0 1.0 0.6 1.2 0.3 1.6 0.9 0.3 0.8
2012E 0.7 0.7 0.4 0.8 0.8 0.5 0.7 0.3 1.2 0.7 0.3 0.6
2010E 14.4 neg 20.8 57.3 nm neg 63.2 97.4 62.5 25.0 neg 32.1
2012E 8.4 12.1 8.9 11.9 11.7 8.0 8.4 11.0 12.6 7.8 10.0 9.6
Our target prices move down slightly for EVR and MMK, and move up slightly for NLMK and SVST. We downgrade MMK, NLMK and SVST We downgrade MMK to E/W and NLMK and SVST to U/W. We reiterate our U/W rating on EVR.
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Following the downgrade of FXPO from O/W on 22 February, we have no O/W recommendations in the subsector.
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The peak cycle approach involves two steps: 1) Apply spot prices to estimate FY12 earnings; 2) Apply forward earnings multiples at the peak of the last cycle to estimate the peak stock price potential, assuming this cycles valuations reach the same peak level as the last cycles. Relies on the previous cycles peak forward earnings multiple We note that the multiple was above the mid-cycle multiple, representing a higher-than-normal multiple during a period of rising prices and bullish sentiment, similar to the current period. Peak cycle commodity prices utilized are shown in the left-hand column and for comparison purposes we show our actual forecasts to the right. Figure 8: Peak cycle commodity scenario and Alfa forecast, $/t
Peak cycle (2Q11E) Iron ore FOB Australia Iron ore domestic Coking coal FOB Australia Coking coal domestic HRC FOB Black Sea 170 160 300 235 800 2011E Alfa forecast 155 145 255 200 730 2012E Alfa forecast 135 125 240 175 710 2013E Alfa forecast 125 115 230 168 700
Source: Alfa Research Note: Under the peak scenario, domestic prices are theoretical netbacks not actual/forecasted 2Q11 figures
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98.9 390.4 38,611 3,700 1,858 40,452 4,000 9.7 7,000 5.8
17.1 859.6 14,699 1,000 947 14,752 1,800 8.2 2,800 5.3
35.9 437.9 15,721 3,400 2,075 17,046 2,285 4,771 8.4 19,287 5.3 23,929 21,608 36.4 49.3 35%
13.2 859.6 11,347 1,800 681 12,465 1,628 3,173 8.4 13,741 5.3 15,678 14,710 13.3 17.1 30%
42.9 599.3 25,710 600 26,310 3,090 4,849 8.4 26,081 5.3 25,068 25,575 44.1 42.7 -4%
18.1 1007.7 18,239 2,400 20,639 2,315 5,545 8.4 19,540 5.3 26,952 23,246 18.3 23.1 26%
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Source: Japan Iron and Steel Federation, Ministry of Finance, Bloomberg, Alfa Research estimates
We sanity check this estimate by assuming the construction of 1m homes providing 65m m2 of living area and 100m m2 of total construction area and an equivalent volume of commercial and infrastructure building. Then we assume 0.22mt of crude steel (~200kg steel product) per m2 of total construction area. Total volume of reconstruction work may require 40-45mt This generates a total volume of 40mt, which is not far from the incremental volumes anticipated through 2013 of 45mt (8mt, 22mt and 15mt per year in 2011 through 2013). It represents about 1.5% incremental global steel demand in 2012.
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Figure 11: Global steel and pig iron production forecast, mmt
2006 Steel Global production growth, % Chinese production growth, % Global ex-China growth, % Global capacity Capacity utilization note: China % of global Pig iron Global production/consumption growth, % 1 251 423 828 1470 85% 34% 869 875 2007 1 351 8% 495 17% 856 3% 1546 87% 37% 949 950 9% 2008 1 350 0% 500 1% 850 -1% 1626 83% 37% 933 930 -2% 2009 1 220 -10% 568 14% 652 -23% 1686 72% 47% 891 891 -4% 2010E 1 413 16% 627 10% 786 21% 1736 81% 44% 1023 1 023 15% 2011E 1 480 5% 664 6% 816 4% 1804 82% 45% 1074 1 074 5% 2012E 1 564 6% 714 8% 849 4% 1872 84% 46% 1138 1 138 6%
Source: World Steel Association for historical data, Alfa Research forecasts
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Source: World Steel Association for global and Chinese production, Customs General Administration of China for exports and imports, apparent demand calculated as production minus net exports.
Source: China Economic Information Network, Ministry of Finance of Japan, steel demand sources cited above
Chinas area of buildings under construction totaled 7.5bn m2 at the end of 2009, and areas of buildings completed was 834m m2 in 2010. China reported 931m m2 of real estate sales during 2010, which assuming an average apartment size of 80 m2 is about 11.6m units. This compares to 0.8m units started in Japan during the same period.
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Source: China Federal of Logistics and Purchasing, China Economic Information Network, three-month moving average of y/y change in PMI and electricity consumption
PMI
Source: China Federal of Logistics and Purchasing
3mo MA
The growth rate in Chinese steel apparent demand moved slightly negative in August-September, 2010, and has since rebounded, albeit to levels below the 2009-1Q10 peak growth rates.
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Figure 17: China steel apparent demand, change y/y and 3-month MA, %
50% 40% 30% 20% 10% 0%
May 09 Mar 09 Jan 09 Nov 08 Sep 08 Jul-07 May -07 Mar- 07 Jan-07 Jul 08 May 08 Mar 08 Nov -09 Sep -09 Jul 09 Jan 08 Nov-07 Sep-07 May -10 Mar -10 Jan-10 Jan-11 Nov -10 Sep -10 Jul-10
Consumption, yoy
3mo MA
Source: World Steel Association for global and Chinese production, Customs General Administration of China for exports and imports, consumption calculated as production minus net exports
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Source: World Steel Association for global and Chinese production, Customs General Administration of China for exports and imports, apparent demand calculated as production minus net exports
Lending
Interbank
Deposit reserve/2
Source: PBOC, National Interbank Funding Center, Deposit reserve requirement ratio is the announced ratio for major banks, dividend by two for easy display (current level is 19.5%)
Tightening is required after massive loan and monetary aggregates growth over the past two years.
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30%
20%
10% 3/31/06 6/30/06 9/30/06 12/31/06 3/31/07 6/30/07 9/30/07 12/31/07 3/31/08 6/30/08 9/30/08 12/31/08 3/31/09 6/30/09 9/30/09 12/31/09 3/31/10 6/30/10 9/30/10 12/31/10
3mo MA
Source: China Economic Information Network, February data is taken from press sources, as not yet officially released
The official growth rates understate real growth due to the use of off-balancesheet and non-bank-lending financing sources. Based on the estimates provided in a recent PBOC press release, it appears that net loans to the system expanded at about $1.6-1.7bn p.a. over the past two years, at a compound annual growth rate of 34%. Chinas loans-to-GDP ratio is about 150%.
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We do not display here the inflationary impact on house prices and other goods and assets in the Chinese market, but the impact has been significant. Chinese headline CPI of an average of 4.9% over the past three months is widely believed to understate the real level of price inflation in the economy.
30%
20%
10%
0% Dec-10 Sep-10 Jun-10 Mar-10 Dec-09 Sep-09 Jun-09 Mar-09 Dec-08 Sep-08 Jun-08 Mar-08 Dec-07 Sep-07 Jun-07 Mar-07 Dec-06 Sep-06 Jun-06 Mar-06 Dec-05 Sep-05 Jun-05 Mar-05 Dec-04 Sep-04 Jun-04 Mar-04 China US Europe
17
-10%
-20%
Source: y/y change of cumulative year to date China residential and commercial floor space under construction (China Economic Information Network), three month moving average of y/y change in US housing starts (US Census Bureau), and European construction volumes (Eurostat).
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Source: Three-month moving average of monthly change in Chinese PMI, with a four-month lead, vs. three month moving average of monthly change in Black Sea HRC, China Federation of Logistics and Purchasing, Metal Bulletin. Slope is Black Sea sensitivity to change in Chinese PMI.
The relationship is evident in the scatter plots below. Figure 24: PMI+4 months vs. Black Sea HRC since 2005, 3-mo MA %
10% 8% 6% 4% PMI+4m o 2% 0% -30% -20% -10% -2%0% -4% -6% -8% -10% Black Sea 10% 20%
Source: Three month moving average of monthly change in Chinese PMI, with a four-month lead, vs. threemonth moving average of monthly change in Black Sea HRC, China Federation of Logistics and Purchasing, Metal Bulletin
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Figure 25: PMI+4 months vs. Black Sea HRC since Mar 2008, 3-mo MA %
10% 8% 6% 4% PMI+4mo 2% 0% -20% -10% -2% -4% -6% -8% Black Sea -10%
Source: Three month moving average of monthly change in Chinese PMI, with a four-month lead, vs. threemonth moving average of monthly change in Black Sea HRC, China Federation of Logistics and Purchasing, Metal Bulletin
-30%
0%
10%
20%
Over the past four months, PMI has moved 2%, 1%, -2% and -2%. HRC rose 22% over this period. As a result, the steel price probably overshot its natural level.
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China steel
Source: Steelhome, Metals Service Center Institute
US steel
While coking coal prices are settling sharply up in 2Q10, iron ore prices have begun to ease. Figure 27: First month swap, 62% iron ore fines, CFR China, $/ton
200 180 160 140 120 100 80 60 Oct-09 Nov-09 Dec-09 May-10 Oct-10 Nov-10 Dec-10 Feb-10 Feb-11 Mar-10 Aug-10 Sep-10 Mar-11 Jan-10 Jun-10 Jul-10 Apr-10 Jan-11
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30%
20%
10%
0% May-05 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 Feb-07 May-07 Aug-07 Nov-07 Feb-08 May-08 Aug-08 Nov-08 Feb-09 May-09 Aug-09 Nov-09 Feb-10 May-10 Aug-10 Nov-10 Feb-11
-10%
-20% Steel Cu Al
Source: Four-week moving average of difference between Chinese domestic and global benchmark prices for steel, Cu and Al, Shanghai Futures Exchange, LME, Metal Bulletin for China domestic HRC and Black Sea HRC
The Chinese relative price is important because China is often a lead indicator for global pricing. This makes sense because of its substantial weight in global consumption. This chart shows the absolute levels instead of the discount. HRC Black Sea has moved above Chinese rebar (and HRC as shown in the chart above). During the April/May 2010 period, we experienced a similar development and this preceded a significant drop in global steel prices.
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3/27/09
5/27/09
7/27/09
9/27/09
1/27/10
3/27/10
5/27/10
7/27/10
9/27/10
LME billet
Source: World Steel Association for historical data, Alfa Research forecasts
22
1/27/11
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Financial Statements
Figure 32: Evraz income statement, $ mln
Revenues Operating Profit EBITDA Interest expense Other non-operating items EBT Tax Net income Minority interest Net income to shareholders EPS Margins Operating Net EBITDA Source: Company data, Alfa Research 2006 8,292 2,298 2,601 -229 -22 2,087 -637 1,450 -73 1,377 3.33 2007 12,808 3,523 4,380 -409 -1 3,051 -984 2,179 -76 2,103 5.08 2008 20,380 3,632 6,286 -599 0 3,051 -1,192 1,859 -62 1,797 4.34 2009 9,772 -1,047 1,237 -730 0 -1,600 339 -1,261 10 -1,251 -3.02 2010E 14,023 821 2,371 -717 0 233 -65 168 -6 162 0.37 2011E 17,515 2,194 3,694 -585 0 1,881 -526 1,354 -45 1,309 2.99 2012E 17,323 1,904 3,354 -398 0 1,865 -522 1,343 -45 1,298 2.96
18% 9% 31%
6% 1% 17%
13% 8% 21%
11% 8% 19%
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6% 4% 22%
11% 7% 21%
14% 9% 21%
15% 9% 21%
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15% 2% 24%
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10% 0% 17%
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Contact Information
Alfa Bank (Moscow)
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