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By John Helmer in Moscow

Russian boom creates beauty contest for European steel investors.

The rapid acceleration in iron-ore and coal costs can be camouflaged on the books of a vertically integrated steelmaker, who supplies his own raw materials to his own blast furnaces. But mineral cost inflation has begun to hurt, even in integrated steel industries fired by 7% annual GDP growth — that is to say, even in the Russian boom, the only one open in the developed economic world.

But the Russian boom isn’t open to foreign steelmakers.

To illustrate how the door can be shut against their expectation, Mineweb has been chronicling the pit and pratfalls of Lakshmi Mittal, whose ArcelorMittal, world’s biggest steelmaker, has stumbled from one promised Russian opportunity to the next, egged on by provincial governors, and Moscow touts. At last count, the Mittal group has closed its acquisition for $720 million of central Siberian coalfields; and it continues to pursue a scrap-fired mini-mill project in the Tver region, near Moscow.

Now comes the news that ArcelorMittal has found a prospective new way into the Russian steel sector, this time at the bottom of the vertical integration chain — the steel processing and distribution end.

Steel service centres (SSCs) are well-known in the developed metal industries of Europe and North America, because they provide steel consumers and users (housing, bridge and railroad builders; heavy engineering works; automobile plants) with the processing, batching, and delivery requirements, which the mills themselves cannot do at a profit. Up to 70% of the steel that is consumed in Europe passes through the SSC sector. Naturally, it has become an attractive target for consolidation by such companies as Kloeckner of Germany, BE of Sweden, and Ryerson, Reliance and Russel Metals of the US.

Even in a static to shrinking steel consumption market, like North America, these companies can grow by merger and acquisition, adding to their cash flow, and protecting their margins by immediately passing on their rising costs to their customers. When there is a downturn in steel demand, industry analysts believe the Ebitda performance (and the share price) of these companies is more resilient than the steelmills.

The Russian steel sector has evolved differently, without requiring the establishment of SSCs — until now. Because of the emphasis in the 1930s on integrating steelmaking with iron-ore and coking coal supplies, and then because of the 1941 attack by Hitler’s armies, Russia’s steel mills are monster combinations, located far to the east of the main steel-consuming centres, like Moscow, St. Petersburg and Yekaterinburg. Not only are they far from end-users, but they despatch such large lots of steel, intermediation is required to make this steel available and usable to those who want to buy it. There was no place in the Soviet planning system for the SSC sector. Now there is an increasing demand for the sector to process the steel, adding value to the product, before it is delivered to the end-user.

During the post-Soviet 1990s, hundreds of intermediaries sprang up to buy this steel, batch it, and trade it in the domestic Russian market. But not until there was a sustained revival of domestic steel demand has a group of traders evolved into steel processors, and the Russian SSC sector taken off. Now that this is happening, the big foreign steelmakers and steel investors see the largest of the Russian SSCs as an entry-point to Russian steel consumption — at a fraction of the cost of the major steel producers; the least of these has a current market cap of $20 billion.

Recent visits to Taganrog, in southwestern Russia, by steel investors have revealed this interest in the proposed initial placement offering (IPO) of Inprom, a leading Russian steel service centre company, headquartered in the heart of the Black Sea boom.

Inprom chief executive Igor Konovalov told Mineweb he is bound by confidentiality agreements to make no comment at this stage, but he said he may be in a position to make an announcement shortly. In the past, Konovalov has said he favours the IPO option, because it would potentially give existing shareholders better valuation in the future than a sale to a single strategic investor.

An investment banker in Moscow said that the two options are pitting two types of steel investor against each other, helping to lift the bid price for Russian assets.

There have been several recent rounds of negotiations with Inprom, an Inprom consultant acknowledged. He added that “different investors have different objectives. Thyssen Krupp of Germany has already tried to enter the SSC sector, but has been very limited in what it has been able to achieve so far.

“Portfolio investors see buying at the debut of steel service sector shares as offering higher initial upside than the mature vertically integrated steelmakers already listed internationally,” the source explains. “That’s because the steel service centre sector is directly exposed to the boom in steel demand. The listed steelmakers, which are trading at record highs, have begun increasing their risk by buying hedge assets abroad, in contracting markets like the US. They have limited upside.”

Raffeisen Bank of Vienna and Trust Investment Bank of Moscow are reportedly working as Inprom advisors. A source at Trust confirmed that “Inprom is ready for placement and portfolio investors are show increasing interest.”

On the Moscow RTS Exchange, shares of four of the five steel majors are currently trading at, or close to record highs for the year. Mechel has gained 55% since January 1, though largely on its coal, iron-ore and nickel mining assets; Evraz is up 37%; Novolipetsk, 21%; and Severstal, 16%. Magnitogorsk Metallurgical Combine, which lacks its own coal and iron-ore, is flat since the start of the year. Even if a foreign buyer had the cash, the closely held Russian majors aren’t for sale, not to foreign buyers.

At the same time, ArcelorMittal, according to a source in Luxembourg, is investigating its options for more than one move into Russia. Referring to its recent coal mine buy, a spokesman for ArcelorMittal said “this acquisition helps ArcelorMittal establish a presence in Russia, a fast-growing market for steel production.”

In December, the group sold its half-share in a hardware manufacturing joint venture, TrefilArbed Rus (TA Rus), to Severstal. The same month, ArcelorMittal announced an attempt to enter the Russian steelmaking market with an offer to invest $100 million in the Tver region. That proposal calls for an electric-arc furnace, and capacity to produce 1 million tonnes of annual crude steel capacity, and 600,000 tonnes per year of reinforcement bar for the domestic construction market.

An ArcelorMittal senior executive recently told Mineweb the group “acknowledges that it has made mistakes in its Russian approach.” The Luxembourg source said that before the merger with Mittal, Arcelor was well acquainted with Inprom.

Kloeckner and BE Group, the leading European steel service centre groups, say they want to break into the Russian market. Both are excluded for the time being, though they have made overtures to Inprom in the past, only to be turned down.

Kloeckner’s chief executive, Thomas Ludwig, told an industry conference in Budapest early in April that Kloeckner is planning to expand its presence in Central and Eastern Europe via greenfield projects and acquisitions. He explained his rationale: “end-users in the region are also starting to demand additional services to basic product supply, including material management, stock management and processing services, such as sawing and cutting.” Kloeckner owns units around Russia — in Poland, the Czech Republic, Romania, Bulgaria, Latvia, Lithuania and Estonia — but has so far been able to cross the border.

Kloeckner’s share price is currently at half its peak last July of Euro65; but its recovery from this year’s low of Euro19 in January has been unsteady, largely because of market uncertainty towards the future of steel demand in western Europe and the US. On April 4, Kloeckner announced its first acquisition of the year — the Taylor Equipment and Machine Tool Corporation of Mississippi, which reports annual turnover of about $350 million. Kloeckner’s current share price is Euro37.39; market capitalization, Euro1.7 billion.

The BE Group of Sweden has followed the same share price trajectory, peaking last July at 104 SEK ($17.68), and dropping to a low of 43.50 SEK ($7.40) in January. Recovery since then has been modest; the current price is 68.75 SEK ($11.69); market capitalization is 3.4 billion SEK ($585 million). One Swedish krona (SEK) is equal to 17 US cents.

Details of an Inprom investment memorandum have been circulating in London, Frankfurt, and Moscow for several weeks. These include the latest financial results (unaudited) of the Inprom group. Revenues for 2007 were $634.1 million; Ebitda $29.4 million.

“The market is coming back,” according to the Inprom memorandum, “especially in Russia where P/E and EV/EBITDA multiples are significantly higher compared to Europe and the US, because investors still consider the Russian market as hugely potential,”

Inprom’s turnover this year is growing at better than 30%, and should reach $850 million. Konovalov is projecting Ebitda of about $40 million. “The current prognosis is that by May of this year prices for almost all steel products will skyrocket to their historic record,” he said.

A report this month by Raffeisen on the prospects for M&A in the East European steel distribution sector commented that steel demand driving Kloeckner’s current operations would moderate this year, compared to 2007.

According to Raffeisen, “steel producers may begin to divest their in house steel distribution channels in order to concentrate on core activities.” This favours “large, consolidated service centres and distributors.” In pursuit of acquisitions, Raffeisen noted that “the emerging markets are still buoyant….Market conditions are still good — valuations will remain relatively high.CEE/CIS remains an attractive growth opportunity for Western European distributors, as Russia and Ukraine are still dominated by local players.”

A report on Inprom by Trust Bank of Moscow forecasts Inprom’s sales volume to grow from 706,000 tonnes in 2006 to over 1.7 million tonnes in 2012, with a 20% compound annual growth rate. The share of processing in Inprom’s turnover will rise from 7.7% (63,400 tonnes), according to Trust, to 30% (536,000 tonnes) by 2012. This should lift the estimated Ebitda margin from 5.3% at present to 7.8%

The 2007 production figures for Inprom show that the domestic construction boom, and growth in machine building, are the main drivers of demand for Inprom sales. An estimated 36% of Inprom’s shipments is flat steel; 30% structural shapes; and 19% rebar. Inprom’s throughput of steel products jumped 12% in 2007 to 830,000 tonnes, compared with the 2006 volume. Sales revenue grew at 37% year on year to Rb16.5 billion ($634.088 million). Inprom’s debt was reduced 5% over the year to $175 million

Inprom says it plans to invest Rb 1 billion ($42 million) for modernization and expansion projects this year.

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