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By John Helmer in Moscow

Alexei Mordashov (left figure) has a special thing for the Italians. He’s been rewarded for it in a number of ways.

Last July, he was awarded the Order of Merit from the Italian Ambasador to Russia. The order, according to a Severstal release, is the highest award in Italy. It had been presented to the chief executive and controlling shareholder of Severstal, “for considerable services to the [Italian] nation in the fields of literature, arts, and economics, as well as for social, philanthropic and humanitarian activities.” Owning steelmills in Italy can require the philanthropic and humanitarian impulse, not to mention literary and artistic panache.


In Mordashov’s case, he borrowed from Severstal to buy the Lucchini company in 2005. Then in October 2006, Mordashov sold Lucchini to Severstal, which paid him a premium of €182 million. This transaction sequence seemed too philanthropic for some of Severstal’s shareholders at the time, and at least one steel analyst told the market exactly what he thought was happening. That was Michael Kavanagh of Uralsib Bank.

The Lucchini family’s steel company, which operates 20 plants in Italy, France, Poland, Sweden and the UK, specializes in making long steel products, like rails. In 2005 it produced 3 million tonnes, with revenues of $2.99 billion, and net profit of $69.5 million.

When Mordashov began his takeover, much of the Lucchini production was by old blast-furnace technology in Italy, and part from more modern electric arc-furnace technology in France. A cost crunch to feed scrap, iron-ore and coking coal into the furnaces led to mounting losses by the family owner and operator in 2003 and 2004, while the family’s principal bankers, Banca Intesa and Unicredito Italiano, held 13% of the shareholding to secure their loans. At the time of the Severstal takeover between February and July of 2005, the Lucchini company was carrying $2.4 billion accumulated debt. That was more than Giuseppe Lucchini, the board chairman, could bear. The financial drain was even affecting his taste for car-racing.

Why Severstal wanted to take Lucchini off Giuseppe’s hands was another matter, and the transaction was discussed skeptically in Moscow when the first announcements were made in early 2005. “Unlocking real long-term synergies between Lucchini and Severstal will be a more complex issue,” Rob Edwards reported on behalf of Renaissance Capital in February 2005. “Complex” is the nearest an analyst at Renaissance Capital is allowed to write, when he means “lossmaking”. Edwards forecast erosion of the Severstal Group’s profit margins as a result of the Lucchini deal. In retrospect, Edwards erred on the small side.

At the time, there were two theories in Moscow of why Mordashov made the Lucchini deal at all. The humanitarian one was that Mordashov was thinking of giving his Russian steelmill the chance to supply semi-finished products for re-rolling within the European Union market, evading thereby the tight quota restrictions imposed by the EU on direct Russian imports.

The philanthropic theory was that Mordashov was using cash generated by Severstal that would otherwise be taxed in Russia, if it had remained there. Severstal’s tax rate was rising at the time. Notwithstanding its debts and losses, the Lucchini purchase was the most expensive asset purchase Severstal had made at the time, except for the domestic assets Mordashov had obliged his company to buy from himself.

Mordashov borrowed the money from his company to make the purchase for his own account of 50.82% of the Italian company. But neither he nor Severstal explained why the takeover of Lucchini was divided into two separate transactions – one, of 19.99%, to be paid for and bought directly by Severstal, and the other to be financed by Severstal, but owned by Mordashov.

Eighteen months later, in September of 2006, Severstal announced it was acquiring Mordashov’s 50.82% stake in Lucchini for €550m, comprising a cash component of €182 million and the assumption of debt as the balance. This implied an enterprise value of €1.7 billion and an acquisition multiple of 5.4 times 2005 earnings (Ebitda), based on Lucchini’s 2005 audited financial statements. According to these, Lucchini had reported sales and Ebitda of €2.42 million and €321million respectively for 2005. Severstal claimed that the valuation multiple applied to Mordashov’s re-sale was “in line with other European steel transactions.” Edwards found no fault. “This equates to 5.4x 2005 EV/Ebitda, full value in our view,” he said in a Renaissance Capital report to clients.

But Kavanagh charged in his client reports that the pricing had been inflated to Mordashov’s personal benefit, and was inequitable to minority shareholders in Severstal, which was footing the bill. According to Kavanagh, “the original stakes [in Lucchini] purchased by Severstal and Mordashov in April 2005 (61.9%), May/June 2005 (7.9%), and November 2005 (0.95%), took place at 2005 EV/Ebitda multiples of 4.2, 4.4., and 4.5, respectively.” Kavanagh wrote there was no justification for changing the multiple into cash for Mordashov’s pocket. “The total purchase price for the 70.81% interest [in Lucchini] in 2005 was €498.5m. Now Severstal will pay an additional €182m for something it essentially bought through the loan to Mordashov a year ago,” he said, adding: “One has to ask the question why the entire stake was not consolidated into Severstal from the beginning.” Mordashov and Severstal did not answer the question.

The latest report of Lucchini’s performance was issued by Severstal in November, and was for the nine months of the year to September 30. Lucchini’s sales revenues were reported at $1.2 billion; this was 64% less than for the same period of 2008. In proportional terms, this was the worst performance of any unit in Mordashov’s worldwide steel operations – worse even than his lossmaking North American mills. According to the Severstal financial report also, Lucchini had run up a loss of $344.8 million in the 9-month period, compared to a profit it had shown of $307.4 million the year before. Mordashov had had to write down Lucchini’s assets in the same interval from $4 billion, recorded at December 31, 2008, to $3.4 billion at September 30, 2009.

The last production and operation report issued by Severstal for the third quarter of 2009, shows that Lucchini had slashed its steel output to 251,507 tonnes, down 48% on the third quarter of 2008, and down 7% on the second quarter of 2009. Its rail production was cut to 28,049 tonnes, down 49% on 2008, and down 49% on the second quarter of 2009. The average sale price for Lucchini steel goods in the third quarter was $873 per tonne, down 43% on the year before; down 4% on the previous quarter. Brokerage reports issued this month in Moscow forecast that Lucchini will be lossmaking for most, if not all of this year.

Yet, all of a sudden on January 23 — normally a football Saturday in Italy — the news leaked to Interfax that Mordashov has found a buyer for Lucchini. There is no source for the claim; no hint of the buyer’s name; no report of a transaction price; and no confirmation from Severstal itself.

The Moscow brokerage and bank response was generally positive, for the simple reason that if true, the deal would mean less lossmaking to pull down Severstal’s financial results, and more earnings to be converted into stock price gains. But Alfa Bank steel analyst Barry Ehrlich is suspicious of a ploy to pump up Severstal’s share price : “we believe it will be difficult to find a buyer for Lucchini in the current environment. We also highlight that throughout 2009 there were discussions and rumours of a possible sale or restructuring of North American assets; however nothing happened, and these rumours have now completely died down. Nonetheless, such rumours tend to be sentiment-positive for the stock in the short term.” In Monday trading in Moscow the share price dropped 1.3%.

Kavanagh also reports the silver lining for Mordashov’s stock value, if the sale leak turns out to be true. “While we do not expect Severstal to be able to recoup its investments in Lucchini – the deal price will be much less than the acquisition price – the change in Severstal’s strategy with more focus on its Russian operations may result in support for the stock.”

No word has reached Moscow of what the Italians have been thinking – either those who work for Lucchini, or used to; and those who are Mordashov’s fellow Commanders of the Order of Merit, Third Class – all 13,973 of them.
 

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