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Russian steelmakers set to reap rewards of infrastructure spending boost

Russia's top steelmakers could reap the rewards of Kremlin plans to inject US$170 billion into infrastructure from 2019 to 2025 to the tune of US$1.6 billion per annum on a conservative EBITDA basis, according to VTB Capital research.

The country will need nearly 40 million additional tonnes of steel over the next seven years, compared to consumption of 44 Mt in 2018, as it seeks to fulfill ambitious national projects decreed by President Vladimir Putin in May 2018, the state-owned investment bank said in a May 20 research note.

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Moscow wants to spend about US$400 billion — equivalent to 25% of 2018 GDP — on 12 national projects designed to reinvigorate the economy, raise standards of living and improve infrastructure. The initiative will also see US$17 billion invested in real estate, another steel-intensive area, with about US$15 billion earmarked for an industrial export stimulus.

However, questions remain over funding and which projects will actually get the go-ahead.

VTB projected that steel consumption will grow at an average compound annual growth rate of 5% to meet the additional demand over the coming years. It said PAO Severstal, PJSC Magnitogorsk Iron & Steel Works and Evraz PLC are best placed to benefit from the spending boom due to their larger shares of the domestic market and high-value-added products.

However, VTB's top pick, Severstal, anticipates steel demand growth of between 2% and 3% per annum by 2025, according to CEO Alexander Shevelev, Kommersant reported May 28. Commenting on the VTB report, Shevelev said the national projects require "serious funding," which depends on the macroeconomic situation and the ability to attract private capital. Magnitogorsk agreed with Severstal's stance.

Russia's largest steelmaker, PJSC Novolipetsk Steel, will benefit too, but to a lesser extent, VTB's analysts said. The company, known as NLMK, produced almost 17.5 Mt of crude steel in 2018, a third more than second-largest producer Evraz, but still ranked behind the other three in terms of domestic market share, with only 34% of its revenue coming from Russia.

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Nevertheless, NLMK plans to grow domestic sales by 1.2 Mt by 2023, equivalent to a 22% rise over total 2018 volumes, the company's head of external communications, Maria Simonova, said in an interview. The company could cater to a significant part of the steel demand growth if the infrastructure initiative is implemented in the amounts predicted by VTB analysts, Simonova added.

Evraz does not have any specific numbers related to the infrastructure initiative but believes that it will retain its position in the Russian railway and construction markets, Senior Manager of Media Communications Anatoly Dzhumaylo said in an interview. The company has an 81% share of the Russian market for rails and further increased supplies to Russian Railways over rival Mechel PAO in 2018.

Most of the steelmakers are expecting annual demand growth of between 1% and 3% over the next five years, investment bank Wood & Co. metals and mining analyst Andrew Jones said in an interview. "There may be some upside to these forecasts, but it is hard to estimate. However, the Russian producers are suffering from tariffs and quotas in several export markets, notably the EU and the U.S. as well as seeing demand weakness in other markets such as Turkey."

"They will need domestic market growth to offset these factors, in my view, especially if they want to add additional volumes," Jones concluded.

Challenges

Severstal recently estimated steel demand growth in Russia at 1.1% in 2018 and forecast just 0.3% for 2019, citing three challenges: trade restrictions, a global economic slowdown due to trade wars, and excess capacity. Nonetheless, the London- and Moscow-listed company plans to bring its steel output up to 12.7 Mt by 2023 while increasing its vertical integration.

Fitch Ratings upgraded Severstal's credit rating, as well as NLMK's and Magnitogorsk's, at the beginning of April, highlighting their low operating costs, but warned of geopolitical headwinds and sluggish Russian steel demand in 2019 as GDP growth slows to an expected 1.5%.

The four top steelmakers are not fazed, though. They hope to lift EBITDA 25% by 2023 to US$3.2 billion through US$10 billion of expansion capital expenditure between 2019 and 2023, according to VTB. Severstal, Evraz and Magnitogorsk are targeting higher raw material integration, Severstal and NLMK aim to raise output, and all four companies want more efficiency.

However, VTB believes that some of the anticipated EBITDA gains are still to be proven, and it models US$1.6 billion higher EBITDA by 2023 compared to 2018 as "a more conservative but still substantial figure." The bank sees the potential for material upside to its estimates for Severstal and NLMK.

While the capex upswing would increase the steelmakers' debt, albeit from a low base, through 2021 and weigh on dividends, VTB expects earnings growth to start bringing debt down again by the end of the capex cycle in 2023 to 0.7x EBITDA, while dividends would yield more than 15% on average the same year.

Slow to saddle, fast to ride

The national projects were supposed to kick off with spending of US$22 billion this year, but less than 10% of that has been spent so far. Pressure is mounting from the Kremlin to speed up the process, but VTB thinks that the US$22 billion is "unachievable."

The analysts characterized the situation in terms of a Russian proverb that translates roughly as "slow to saddle, fast to ride."

"There's always the chance that some of these national projects will lose steam and money will be reallocated," political risk consultancy GPW principal analyst Christopher Tooke said in an interview. "Projects could also be scaled down — case in point: there were plans to build a high-speed rail link from Moscow to Kazan, but this was scrapped in favor of a shorter express rail route to [Saint] Petersburg because of costs."

"But there'll always be money for politically important projects such as the World Cup stadium and the Crimean Bridge," Tooke added.

The Russian Ministry of Finance plans to use the National Wealth Fund to help bankroll the 12 national projects, but the International Monetary Fund recently advised it against doing so, suggesting that the national fund continue investing in high-quality foreign assets "to save resources for future generations and avoid procyclicality."

VTB sees a failure to deliver on the national projects, as well as exchange rate, steel and raw material price volatility, as the main risks to its investment cases for the top four steelmakers.

"One cannot exclude certain skepticism regarding the development of large projects," Deloitte CIS head of research projects Dmitry Kasatkin said in an interview. "In many respects, the development of the Russian economy, and even more so of its key industries, depends on external economic factors, among which the sanctions imposed by the West and trade conflicts have had a negative impact."

Russia's GDP grew just 0.5% in the first quarter, Finance Minister Anton Siluanov said May 30, according to Interfax. He expects the rollout of the national projects to help make up the ministry's projected annual figure of 1.3%.

"The plans have ambitious targets and deadlines but lack details about how these will be achieved and how exactly they'll boost the economy in the long run," GPW senior analyst Florence Cahill said in an interview. "Even if they are implemented well, they will still struggle to reach the high benchmarks set by the president."