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By John Helmer in Moscow

Severstal, the third-ranked Russian steelmaker, continues to suffer from owner and chief executive Alexei Mordashov’s past ambitions to be the world’s largest steelmaker, with safe-haven production lines in the United States. What has already happened to other Russian oligarchs has arrived for Mordashov: caught in the ring with his bankers, the debts he ran up to buy stakes beyond the Kremlin’s reach have now now turned into liabilities giving the foreign creditors power to dictate terms. Until now, the small print in Mordashov’s loan agreements, which give the bankers this punching power, has not been disclosed.

On May 15, Severstal headquarters reported in Moscow that in the first quarter ended March 31, the company sustained a negative earnings (Ebitda) figure of $158 million, and a foreign exchange loss from ruble devaluation of $381 million. On revenues for the quarter totaling $2,796 million, Severstal reported an after-tax loss of $644 million. This was well below industry analyst estimates, prior to the disclosure. Revenue was down 30% on the fourth quarter of 2008, and down 35% on Q1 2008.
The results were, according to Troika Dialog steel analyst Sergey Donskoy, “the lowest point in the company’s history since its London IPO.”

Mordashov claimed, in a statement attached to the financial report, “we continue to act decisively to reduce fixed costs and improve working capital management, with benefits already coming through in the first quarter…. Despite current difficulties we are well-positioned to weather the challenging year ahead given our robust financial position and competitive cost structure.”

The plummeting Ebitda, according to Michael Kavanagh, steel analyst for Uralsib Bank, was “driven mainly by the weaker operating performance of Russian steel operations (EBITDA margin of just 8%)…The biggest disappointment came from the company’s Russian steel operations, as EBITDA for the segment fell by 69% QoQ to $88 mln in 1Q09, implying a weak EBITDA margin of 7.6% (down from 16.2% in 4Q08). We view the deterioration in the operating performance of Russian operation as a very negative sign, which shows the very thin margins on export sales and high costs at Severstal’s coal assets, which were essentially subsidized by the profitable Russian steel segment.”

The Russian performance was mixed, however, as the main Severstal mill at Cherepovets was reported to be turning out slab at a competitive cash cost of $250 per tonne, falling to $200/t. Its positive contribution to the financial aggregate was “diluted”, according to a Renaissance Capital report, by “close to break-even figures of Severstal Metalware and a moderate performance of Izhora pipe-mill.” Last week, the chief executive of the metalware division, Olga Naumova, resigned for a job elsewhere.

George Buzhenitsa, steel analyst at Unicredit Securities in Moscow, said “the poor performance of the North American segment did surprise us, as we expected smaller losses; however, we note that lay-offs and asset shutdowns did not result in any major provisions.” Ebitda for the Severstal North America division was a loss-making $243 million.

The company report indicates that Severstal’s European Union assets — the Lucchini plants in Italy (Piombino) and France (Ascometal) — were also loss-making, with an Ebitda loss of $43 million.

Severstal’s mining segment was hurt by the coal-producing unit, Vorkutaugol. In the first quarter, the company says that Vorkutaugol was mining coal at a cash cost of up to $75/t, well above the domestic Russian coal supply price of around $50/t (concentrate ex works) during the period. The negative cost impact from coal-mining cut the positive Ebitda contributions to the mining division result of the gold and iron-ore operations.

Severstal is reporting gross debt of $7.5 billion, and $2.7 billion of cash. Short-term debt repayment this year is estimated by management and industry analysts at $2 billion. Management told analysts at a briefing after the financial report was released that it will cut capital expenditure for this year to $1 billion, and suspend dividend payments to conserve cash. Layoffs and reductions of capacity are expected to continue, but the company is not explicit on where in the group it plans to do this.

At this point in time, the management said it is impossible to forecast production, sales and demand trends. But executives said that there may be an improvement in steel prices in June in export markets, such as China. Currently, two-thirds of the Cherepovets steel production is being exported, mostly to China, and management thinks that this will be sustained through the second quarter. The company claims it does not expect a sizeable reduction in its US sales volumes, and despite problems with the American car producers, unpaid or overdue receivables from bankrupt GM and Chrysler are reportedly insignificant.

Now comes the rub.

In a statement to the Wall Street Journal on Monday, Severstal North America (SNA) chief executive Greg Mason insisted that SNA will remain in business. The assurance was cold comfort to the London stockmarket, which has traded Severstal shares down 18% over the past week; 3% down in Monday’s trading.

The Wall Street Journal reported Mason as saying: “We are here for good. Severstal will continue to make steel in America. As for our actions, like many others, we are making critical decisions and we are positioning ourselves for the long term sustainability of our U.S. operations.” According to the newspaper, Mason has been meeting US shareholders in order to “quash concerns that the steelmaker is planning to pull out of the country after announcing last week that it was idling operations in West Virginia and Ohio because of dropping demand.”

Severstal’s company website and spokesmen in Moscow make no reference to the widespread speculation that Mordashov is considering the sale of mills which are either currently idled, or on reduced production regimes. The Warren mill in Ohio, formerly known as WCI, was bought by Severstal for $370 million (including debt) in July of 2008; the Wheeling plants in Pennsylvania were acquired, also in 2008, for $775 million from Esmark. Operations at both SNA properties are currently halted. The Rouge plant in Michigan — the first of Mordashov’s offshore acquisitions — is reportedly working at 70% capacity, while the Sparrows Point mill in Maryland, bought a year ago, is at 75%.

Mason’s remarks stop short of a denial that some US asset sales may be forced on Mordashov below the full reimbursement level of his purchase price, which — it was implied a few days ago — he might accept. The extent of the pressure he is under was disclosed in Moscow on May 18 by a report to clients from Alfa Bank. This reveals that Severstal’s loan agreements for Eurobonds, due for repayment in 2013 and 2014, carry covenants which seriously restrict Severstal borrowings right now. The upshot is that if Severstal’s lenders agree, they are now in a position to force the group to lower its debt, and reduce its losses by selling assets. Without lender agreement, Mordashov doesn’t have the legal right to make deals himself.

One of the covenants, according to the report by analysts Barry Ehrlich and Dmitry Vodnev, requires Severstal to maintain a Gross Debt to Ebitda ratio of 3.5 to 1. The text of the covenant in the loan agreement, disclosed exclusively to CRU Steel News, says: “on the date of such Incurrence and after giving effect thereto on a pro forma basis, the Consolidated Leverage Ratio does not exceed 3.5 to 1.”

In a following section, Severstal agrees it “will not Incur any Indebtedness pursuant to Clause 10.10 if the proceeds thereof are used, directly or indirectly, to Refinance any Subordinated Obligations of Severstal unless such Indebtedness shall be subordinated to the Loan to at least the same extent as such Subordinated Obligations.”
In addition, Severstal may not reorganize its businesses, or sell off core assets, such as the SNA mills, if the deal value exceeds $150 million, if the company is in violation of covenants, and if the creditors do not give permission. “Severstal shall not and shall ensure that its Material Subsidiaries do not (in each case disregarding sales of stock in trade on an arm’s-length basis in the ordinary course of business and assignments of or other arrangements over the rights or revenues arising from any Steel or Ferrous Metal Contract) sell, lease, transfer or otherwise dispose of, to a person other than a Subsidiary or Severstal, as the case may be, by one or more transactions or series of transactions (whether related or not), the whole or any part of its revenues or its assets which have the aggregate value in excess of U.S.$150,000,000 or the equivalent thereof in any 12 month period, if such sale, lease, transfer or disposal has a Material Adverse Effect.”

A further covenant, attached to the loan agreement for 2014, provides that “Severstal shall not, at any time, permit Consolidated Net Indebtedness to exceed 75 per cent of Consolidated Net Worth.”
This is the first time restrictive loan obligations incurred by Russian steelmakers have been publicly revealed. The 2013 Eurobond was issued on July 29, 2008, for $1.25 billion. The 2014 Eurobond was issued on April 9, 2004, for $375 million.
Since the reporting of the required ratios is limited to a period “within three months after the end of the first half-year of each of its financial years”, the company may not be in technical default until September. However, the release of first-quarter financial results on May 15 may trigger another provision in the loan agreements: “Severstal shall from time to time, on the request of the Lender and without undue delay, furnish the Lender with such information about the business and financial condition of Severstal and its Subsidiaries as the Lender may reasonably request for regulatory compliance purposes.” If a lender issues a request to Severstal, the company would then have 20 days to reply, and another 30 days to negotiate compliance.
Alfa analyst Barry Ehrlich reports that Severstal “can no longer undertake any borrowings at any level…this makes it very difficult to undertake normal business operations.” He adds that Severstal may be forced into “tough restructuring measures”.

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