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By John Helmer in Moscow

In cockfighting there is a hard and fast rule – if your bird won’t fight, no matter how hard you push it, you forfeit the contest, and bets on the other bird must be paid.

When it comes to fighting and hiding, Alexei Mordashov, the Russian steelmaker, appears to have been outwitted by the Ukrainians. The more he hides, the more the Ukrainians push him, the more he loses. This is the first time since the presidential election of January that the new Ukrainian government has beaten off a major Russian business figure, who has the backing of Prime Minister Vladimir Putin.

Last Friday, the Ukrainian government announced it is blocking the sale of the Zaporizhstal steel, iron-ore and coke combine to the Russian state banking group Vnesheconombank (VEB). At the same time it was disclosed in Kiev that VEB is understood to be fronting for Mordashov’s Severstal group in its bid to buy Zaporizhstal for $1.7 billion. The secret financial operation which Mordashov apparently discussed with Putin, when they met on December 4, last year, is out.

Zaporizhstal is owned by five companies representing the two controlling shareholders of the Canada-based Midland Group, ex-Ukrainians Alex Shnaider and Eduard Shifrin; and three, possibly four other individuals.

The Ukrainian mill can produce between 3 and and 4 million tonnes of rolled steel per annum, but the production technology is out-dated and should be replaced. The assets for sale in the holding also include stakes in a coke plant, an iron-ore mine and processing combine, two pipe-making plants, and a refractory unit which supplies the open-hearth furnaces.

According to the official transcript from Kiev last Friday, President Viktor Yanukovich said that press reports of a $1.7 billion sale by the Zaporizhstal shareholders to a group of Russian investors represented by VEB are mistaken, and that no sale will occur for the foreseeable future. “There is a legal process now over Zaporizhstal, and it is examined in court,” Yanukovich said. “The proceeding is over the dispute between two Ukrainian companies for the company’s stake. By the ruling of the London court the stake has been frozen, and it cannot be sold for about a year,” the president added.

Independently, Andrei Kliuyev, the Ukraine’s First Deputy Prime Minister, was reported as saying at Zaporizhye, where the mill is located, that Severstal is the buyer behind VEB, and that the court action bars Severstal from going ahead with the purchase. “As regards the future or current owners, as far as I know all the cases are with the courts. Once the courts have delivered their verdicts, you will probably find out who the plant’s owners,” Kliuyev put in the record.

Severstal was asked to clarify Kliuyev’s remarks, but did not respond to questions from CRU Steel News. Interfax Moscow has published a report claiming Severstal denies its involvement in the Zaporizhstal transaction, but the claim lacks a source. The wording leaves open that not Severstal, but one of Mordashov’s personal companies is involved in the deal.

That has been Mordashov’s modus operandi before, and a personally lucrative one. For example, Severstal bought the Italy-based Lucchini steel assets in 2006 from Mordashov’s private companies, which had acquired them in 2005, using funds borrowed from Severstal. An estimated €182m went to Mordashov in profit, drawing criticism for self-dealing from Moscow institutions.

Last week Ukrainian industry sources indicated that the court to which Yanukovich and Kliuyev were referring to is the UK High Court in London. According to the Ukrainian media, proceedings have been brought in the High Court by a company associated with Rinat Akhmetov (right image) and his System Capital Management Group (SCM).

The defendants are reported to be companies controlled by Eduard Shifrin (left) and Alex Shnaider (right), but until the court documents are disclosed the full list of the defendants is unknown.

The lawsuit claim is reported to be that a purchase offer of $1.2 billion Akhmetov made for Zaporizhstal was binding on the sellers, and should not have been rejected in favour of a reportedly higher offer by the Severstal group, represented by VEB. It has also been reported in Ukraine that SCM has paid a deposit of $50 million, confirming the purchase, last month. However, Akhmetov and SCM issued yesterday this carefully worded statement to CRU Steel News: “Currently SCM is not a shareholder of Zaporizhstal and has not signed any agreements with its owners to purchase shares of the company. In addition, neither Akhmetov R.L. personally nor SCM group has filed any claims against the owners of Zaporizhstal on this matter.”

What this denial leaves open for Akhmetov to be suing Shifrin and Shnaider for in London is anyone’s guess. The latter aren’t saying any more than the former. Midland is a private holding. Its Moscow office requested questions in writing, but then declined to answer them. The receptionist at the group’s Toronto headquarters refused even to identify the chief executive, much less put the call through to him. A Manchester, UK, number for Midland, listed on the Midland website, is no longer in working order. A Midland director, identified as Derek Rowe, who works at Midland’s small registry office on the Channel Island of Guernsey, promised to return a call, but did not do so.

In April, Severstal confirmed to the Russian industry press, without making an official statement, that it was undertaking due diligence and valuation in preparation for a bid for Zaporizhstal. Others also reported to be engaged in parallel preparation were much bigger and financially more powerful rivals — Posco and ArcelorMittal. With Zaporizhstal estimated to be worth between $1.5 billion and $2 billion, and with an upgrade investment requirement projected for the same amount, the asset had appeared to be too expensive for Severstal group owner Mordashov. Since steel prices crashed in autumn of 2008, Mordashov has been trying to sell his US and Italian steelmills to reduce the huge bank debt he rolled up buying them in the first place, and cut their operating losses which have been eating into the much more profitable Russian operations.

In this situation, who benefits from a replay of the same highly leveraged, risky offshore game? Why Mordashov would want Zaporizhstal is a question he is too shy to answer in public. He almost certainly disclosed his answer privately to Putin, although the latter is also shy about admitting it. Perhaps it was the Christmas spirit that suffused their December 4 meeting.

According to the Russian prime minister’s website, Mordashov met that day with Putin to answer the question Putin posed: “how is your company finishing the year?” Mordashov replied: “the situation is somewhat difficult as the company, like many others, has been affected by current events. Still, there are some positive trends. We can clearly see that the market is recovering.” Putin wanted to know “is demand slowly increasing? To which Mordashov replied: “It is, no doubt. The main thing is that we are raising the company’s competitiveness through restructuring and optimisation, which will enable us to take a greater market share.” If Putin and Mordashov knew that by market share, Mordashov was talking, not about Russia, but about the Ukraine, the public record provides no hint.

Putin appeared to be asking about Severstal’s efforts at home, to which Mordashov replied: “We have obviously adjusted our production schedule to current demand. We are optimising by closing inefficient facilities and making pinpoint investments in the facilities with the best opportunities to increase our productivity. We have initiated the operation of a blast furnace this year and plan to re-fire another one now standing idle.”

In retrospect, the speculation has followed the December meeting that the real reason for Mordashov’s conversation with the prime minister was to ask for Putin’s approval for a high-priced bid for the Ukrainian steel and iron-ore complex at Zaporizhe. Putin is also chairman of the VEB board of directors, and his approval of Severstal’s bid, and special state financing by VEB, would have been required before Severstal started its negotiations for Zaporizhstal.

Once before, it is known that Mordashov had met with Putin to get advance approval of a bid to buy steel assets outside Russia. That occasion was on May 16, 2006, when the official Kremlin transcript made it appear the two men were talking about the dynamics of the steel pipe market. In fact, Mordashov was asking then President Putin for permission to attempt a takeover for Europe’s largest steelmaker, Luxembourg-based Arcelor. The permission was granted; a $2.7 billion bid was made; and it was soundly defeated. Arcelor went to Lakshmi Mittal instead.

This time round, Mordashov has also been begging for state money. When he said, according to the official transcript, that he was “making pinpoint investments”, he and Putin were apparently not revealing that the pin was pointed across the border. And when Mordashov made a show of expressing gratitude for “assistance from government agencies, we make every effort to provide people with retraining,” the real meaning was to thank Putin for agreeing to lend $1.7 billion of state funds to help employment of Ukrainian steelworkers, not Russians.

“Good. Let’s go into more detail,” said Putin. And that’s where the official transcript of the meeting stops. Last Friday, it seems that President Yanukovich told Putin where the buck stops.

Following the Putin meeting, the Fitch ratings agency reported in detail what a bad idea it was for Mordashov to take on more debt for Severstal, and why Severstal’s existing debt agreements with creditors made new spending or new borrowing unwise and unlikely. In its release on January 20, Fitch said that with about $8 billion in total debt, Severstal’s non-Russian operations “may remain dilutive in 2010, with a negative EBITDAR margin of 6%-9%. Fitch expects Severstal’s FY10 gross leverage to improve to 3.3x-3.5x compared with expected gross leverage of 8.0x-9.0x in FY09, and for net leverage to improve to 3.0x-3.2x compared with expected net leverage of 5.0x-6.0x in FY09…. Fitch nonetheless notes that incurrence covenants for eurobonds remain at the existing level (debt/EBITDAR less than 3.5x) which limits Severstal’s ability to access new debt, except for specifically permitted instances including debt refinancing, until it complies with these covenants. The Negative Outlook reflects Severstal’s high dependence on the speed of recovery in demand and prices for steel products in various markets, high expected leverage in FY09 above ‘B+’-rated peers, uncertainties on finalizing restructuring plans for North American and European operations, and the risks in executing these restructuring plans.”

As Fitch notes, for Severstal to compete for Zaporizhstal against Posco and ArcelorMittal would also require the approval of Severstal’s international bankers, whose debt refinancing and loan servicing agreements carry covenants restricting the value of new transactions by Mordashov, and subjecting them to a special credit review process by his bankers.

What happened next appears to have been off Severstal’s beleaguered balance-sheet. For it appears to have been a Mordashov private company that made the pact with VEB for the reported $1.7 billion offer for Zaporizhstal. Legally, according to Severstal’s current loan agreements, nothing Mordashov offered VEB to secure such a loan could already have been pledged to secure Severstal’s debts. Mordashov’s private companies were also busy on other deals at the same time, spending about $200 million on shares of two junior goldmining companies, Crew Gold and High River Gold.

VEB was asked to explain the rationale for its readiness to lend $1.7 billion for the Zaporizhstal purchase, and to clarify the identity of the borrower. It has not responded.

Marat Gabitov of Unicredit Moscow reports the consensus of investment bank thinking on the deal, which the VEB appears to be over-riding. “Should [Severstal] acquire Zaporizhstal, we doubt that it would be positive news for the stock: Zaporizhstal is a non-integrated producer with out-of-date and hence low-margin facilities. Even in 2008 with record-high steel prices, the company’s EBITDA margin was only 2.2%, suggesting that even in the post-crisis 2010E EBITDA may be negative. Moreover, we believe that the reported target valuation of the sellers of USD 2bn is not justified by any multiples.”

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