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By John Helmer, Moscow

When crisis strikes the global steel sector, sales revenues drop faster than costs, and earnings and profits shrink. The normal correction is for mill owners to cut their costs by reducing production, closing furnaces, furloughing workers, trimming supply of steel into the marketplace, cutting product prices to clear unsold inventories, and crossing fingers for an improvement of demand. If they can help it, the proprietors of steelmills don’t normally lift their interest expenses by raising debt loads.

In Russia, oligarch-owned steel companies do things a little differently. At Mechel, for instance, the owner Igor Zyuzin (with 67.4% of the outstanding shares) has been planning to cut out of the main company its coal-mining division and sell its stock at an initial public offering (IPO) on the London Stock Exchange. At the same time, he’s been piling on extra debt, guaranteed by the parent company, to finance new coalmines in the Sakha region of eastern Siberia, which he received from the federal government (instead of Lakshmi Mittal in 2007) on condition he invest and bring them swiftly into production.

As coal and iron-ore, the basic raw materials for steelmaking, have been growing in price globally, the mining division of Mechel has been a much bigger contributor to the Mechel group’s financial performance than its steel division. Mechel charts show that at present, 55% of the mine division’s sale revenues are earned from coking coal; 30% from other coal products; 9% from iron-ore; and 6% from other mine products. At the revenue line, according to the latest second-quarter figures, Mechel’s steel division generates 60% of sales, while mining accounts for 30%. But on the earnings (Ebitda) line, 86% is generated by the mine division; just 10% by steel.

Once again, as happened in the run-up to the crash of autumn 2008, the oligarch reflex appears to be the zoological one – increase debt, sell equity, and abandon the sinking ship with as much cash as you can carry away. Zyuzin’s plan, at least until very recently, was to capitalize on the rising value of the mining division by removing it from the steel company, and put the share sale proceeds in his pocket. However, when the IPO plan threatened to accelerate the collapse of the main Mechel shares, and the price for Mechel Mining, which the underwriters could raise from the market, was much smaller than Zyuzin’s expectation, he abandoned the idea.

Until the announcement by Bloomberg and “three people familiar with the matter”, Mechel shares had lost 47% of their value since the year began. Preserving the mining division within the main listed company hasn’t braked the 25% share price collapse over the past month. According to the Bloomberg release, “Mechel has notified the banks hired to manage the initial public offering, the people said, asking not to be identified as the information is private. The Moscow-based company cited unfavorable market conditions for its decision, they said….The company picked JPMorgan Chase & Co. (JPM), Morgan Stanley (MS) and UBS AG (UBSN) to manage the IPO, they said. The sale was intended to generate $1.5 billion to $2 billion, they said. ‘The company went half-way with this IPO and technically will be able to restart the process at any moment when the markets improve,’ George Buzhenitsa, a Deutsche Bank AG analyst, said.”

But according to Mechel’s financial reports for the second quarter, the writing was on the wall much earlier, where Zyuzin and the stock markets could see it. The new financial disclosures show that despite an increase in sales revenues for steel products to $2.1 billion, operating income for the steel division fell to $125.6 million, down 71% compared to the first quarter; earnings (Ebita) fell 56% to $149.8 million; and net income crashed almost sixfold to a bottom-line loss of $71.4 million. Falling steel volumes, rising costs, and falling steel prices caused the downturn. Andrei Deineko, head of Mechel’s steel division commented in a company release on Monday: “In the second quarter we managed to retain a high workload and used the period of rising prices for construction products to increase sales of our key products — rebar and hardware, by 46% and 12% respectively…Nevertheless, I must note that the situation in the steel market was not so favorable in the second quarter. We had to deal with growing prices for raw materials, which were not compensated by the growth of steel prices.”

In the consolidated group-wide report, Mechel’s coalmining operations lifted the results, generating a 33% increase in revenue, quarter on quarter, to $1.1 billion; a 63% increase in operating income to $474.5 million; and a 12% increase in net income to $126 million. Combining all business lines, including ferroalloys and power generation, Mechel reported first-half year revenues of $6.4 billion, a gain of 48% over the same period of 2010; operating income totaled $924.7 million, representing a year on year growth rate of 67%; and net income of $501 million, a threefold increase over last year. A rising tax bill, foreign exchange losses, and growing interest expenses contributed to the reduction in Mechel’s bottom-line.

Net debt of the group as of June 30 was $8.6 billion. The company has managed to convert short-term to longer-maturing loans, but total long-term debt is up 25% since last December at $6.5 billion. Half this debt is owed to Russian banks, and one-quarter to foreign banks, one-quarter to rouble-bond holders. As for how far off Mechel’s repayment obligations are – how long long-term really means – company releases indicate that repayments for this year amount to $746 million, and not until 2016 do they sink as low. But next year Zyuzin is going to have come up with a repayment balloon of $5.1 billion.

A website statement this week by Mechel’s chief executive, Yevgeny Mikhel, claims: “Despite a few difficulties we had to contend with early in the year, we concentrated on restoring production volumes in our mining segment while preserving high capacity utilization rates in steel and other segments. Our efforts were also directed to the implementation of the company’s ambitious investment program. As a result, in the second quarter we demonstrated a growth in mining volumes and sales of nearly all our products, which, when combined with fairly favorable market conditions, enabled us to improve the financial results of the previous period.”

“Ambitious investment program” – that’s election campaign talk.

Mechel is the virtual monopolist for stainless steel production in Russia. But the company reports provide no production figures for this, except to show that stainless product sales represent about 10% of the company’s aggregate. They were the target of a state steel company takeover move, led by Sergei Chemezov’s Russian Technologies, before the 2008 crash. That pressure in turn encouraged Zyuzin to use his steel asset collateral to run up debt for buying other non-steel assets in foreign havens, including ferroalloys and US coalmines. Asked for the current stainless volumes and sales figures, Mechel refuses without explanation.

The company isn’t issuing its prognosis for steel output and sales for the fourth quarter. ” In our view,” reported Uralsib bank steel analyst Dmitry Smolin, “the market could be disappointed by Mechel’s weak profitability in 2Q11, however, at the same time, the poor 2Q11 US GAAP results are already priced in by the market, as the stock In briefing sector analysts after the results release, Mechel claimed it currently does not see signs of crisis in the steel or coal markets, but is prepared for a downturn if it comes.

The remedy for that: Mechel says it is cutting capital expenditure by at least $500 million below the budget for this year. According to the company’s presentation, its capital expenditure and investment program for the first six months amounted to $818 million and was “financed entirely by long-term debt.” Slightly different capex figures are provided elsewhere in the latest financial report. “Capital expenditure [capex] on property, plant and equipment and acquisition of mineral licenses for the 1H 2011 amounted to $769.5 million, of which $562.4 million was invested in the mining segment, $174.6 million was invested in the steel segment, $18.7 million was invested in the ferroalloy segment and $13.8 million was invested in the power segment.”

During Mechel’s briefing for steel analysts, following the report release, the company claimed that it has reduced its 2011 capex plan from $2.3 billion to $1.8 billion due to “volatile markets”. If true, that ought to mean that Mechel intends to spend another billion dollars for capex before the year ends – and again pile on more debt. Either that, or borrow no more, spend no more.

Uralsib steel analyst Dmitry Smolin terms the results “weak”, well below the projections of Moscow’s investment banks. Alfa Bank steel analyst Barry Ehrlich has reported to clients that higher costs were the main culprit for the financial downturn in the second quarter, adding that Mechel’s management “did not provide the assurances and details we wanted, and we are therefore reluctant to conclude that coal production and cost performance will improve much in 2H11.”

Mechel also told its conference callers that its expanding debt and falling earnings have triggered a breach of loan covenants with its banking syndicate. According to the company, the banks have agreed to soften their covenant and loan terms to the end of this year, in the hope that Mechel will be able to lift revenues and earnings in the last quarter. Mechel’s share price fell 4% in Moscow and New York trading after the results report, but subsequently recovered. The covenants do not allow Zyuzin to pay himself dividends.

The particulars of this Mechel story may be exceptional, but Zyuzin’s pattern is not. Releasing its first-half financial report this week, Evraz, the Russian steelmaker owned by Roman Abramovich, Eugene Shvidler, Alexander Abramov and Alexander Frolov, announced that it will be paying a special dividend of $402 million, as well as an interim dividend of $89 million. Since the controlling shareholders own 71% of the issued shares, that means pocketing for Abramovich et al. of almost $350 million.

Frolov, the Evraz chief executive, explained in his report how hard and volatile times are affecting the company’s priorities. “The Group’s recent trading”, Frolov said, “has been impacted by scheduled repairs, lower production volumes, a weak market environment in the Czech Republic and a change in product mix in South Africa. In addition, in recent weeks, there have been some decreases in export prices. ..Going forward, [state owned] Russian Railroads remains a very strong buyer [of wheels and rails] and we expect it to maintain purchased volumes over the next several years. In addition we expect to improve our product mix and generate additional revenue through our rail mill and wheel shop modernisation. We continuously assess the market environment and have significant flexibility in our CAPEX plans.”

That last line is the giveaway. Evraz is notorious for proposing capital expenditure (capex) on production and job growth, pollution controls, mine safety, and the like, but then not spending the money. An example, which we report from time to time, is the court-ordered waste water treatment plant for Novokuznetsk city, to stop pollution from Evraz’s Novokuznetsk and Zapsib steelmills running into the Siberian city’s water catchment system. The court order, agreed also with the regional governor and the federal regulator in 2006, was for facilities costing about $92 million. Not a penny has been spent: link 1 and link 2.

According to the company’s presentation of October 11, the capex budget for this year totals $538 million. Actual spending reported as of June 30 is $133 million – just 25% of budget. It is difficult to contemplate how much more “significant flexibility in our CAPEX plans” Evraz has, unless it is to spend zero on capex in the remainder of the year, and put all the cash saved into the pockets of Abramovich et al.

This is not yet an election campaign issue in Novokuznetsk city. When a Moscow newspaper challenged Frolov for pocketing $61 million of dividend himself, he claimed he couldn’t see hard times at all. “We do not see anything that would be very different from the traditional seasonal fluctuations inherent in our industry,” he is quoted as replying.

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