The ratings on the Russian vertically integrated steel group OAO Severstal are constrained by our view of the highly cyclical, capital-intensive, and competitive nature of the steel industry. Steel margins are relatively weak, and in our view, will continue to be pressured by global macroeconomic uncertainties. In addition, Severstal is exposed to the risk of operating in Russia where its key cash-generative assets are located.
The key factors supporting the ratings include Severstal's healthy credit metrics and moderate financial policy. Although steel margins are under pressure, Severstal benefits from full vertical integration into iron ore and coking coal mining, where margins remain robust and price declines are much less pronounced. Severstal's low-cost position in Russia and its solid share of the Russian steel market provide additional support for the rating.
S&P base-case operating scenario
We expect Severstal's 2012 EBITDA to be in the $2.2-2.4 billion range, compared with $1.8 billion generated for the nine months. This is well below the $3.6 billion in 2011 due to weaker steel, coking coal and iron ore prices. We expect 2013 EBITDA to be similar to the 2012 level, as we do not anticipate material improvements in the global steel markets. Severstal Resources and Severstal Russian Steel operations will continue to be responsible for 45%-50% and 40%-45% respectively, while Severstal International's contribution is likely to remain modest at 5-15% despite expansion and modernization investments that have been completed at Severstal's North American plants. In the longer term, we expect steel margins to improve somewhat but see mining margins gradually softening, which should translate into about $2.7-3.2 billion EBITDA on average through the cycle. Nevertheless, the steel industry is highly volatile and we therefore expect Severstal's profitability to fluctuate with the industry cycle.
S&P base-case cash flow and capital-structure scenario
In 2012, we expect FOCF to be positive, at about $0.4 billion, due to some working capital release and a relatively modest capital expenditure budget of $1.3 billion. We also believe that in the weak and uncertain steel industry environment in 2013 the company will not increase its capital expenditure (capex) materially in line with its moderate financial policy. We therefore anticipate that adjusted debt to EBITDA and FFO to debt will stay at around 2x and 40% respectively, which we see as commensurate with the current rating. In the longer term, as EBITDA improves to a mid-cycle $2.7-3.2 billion, we would also expect capex to increase. This would likely include mining greenfield projects, such as the Putu iron ore project in Liberia and the Usinskoye coking coal project in Russia.
Liquidity
We view Severstal's liquidity as adequate, with the ratio of liquidity sources to liquidity needs at more than 1.2x for the next 12 months, thanks to sizable cash reserves, robust FFO and our opinion about the company's flexibility in capital expenditure. At Sept. 30, 2012, key sources of liquidity included:
-- cash and short-term investments of $2.1 billion, of which we assume about $0.2 billion to be tied to operations;
-- committed lines of $0.6 billion; and
-- our expectation of $1.7 billion in FFO.
The liquidity cushion was further supported by the $750 million long-term bond issuance in October 2012.
Key liquidity needs in the next 12 months starting from Sept. 30, 2012 include:
-- $1.9 billion debt amortization;
-- $1.3 billion capex budget assumed in our scenario; and
-- $0.3 billion of expected dividends.
The company has considerable headroom under its Eurobond covenants, which limits net debt to EBITDA at 3.5x and net debt to net worth to 0.75x.
Outlook
The stable outlook reflects our expectation that Severstal will demonstrate relatively robust metrics even during the industry downturn in 2012-2013, with FFO to debt at about 40% and debt to EBITDA of about 2x. In our view, the ratio of net debt to EBITDA of about 1.5x (corresponding to about 1.7x with our adjustments for cash tied to operations, asset retirement obligations and others) on average through the cycle should be commensurate with the rating. At the current rating level, the near-term upside is limited, in our view, as the steel industry is very cyclical and is going through a difficult period. Over the longer term, an upgrade would require a sustainable improvement in the industry fundamentals (which is not our base-case scenario for the near term), positive free operating cash flow, strong liquidity and solid credit metrics.
If the steel, iron ore and coking coal markets deteriorate even more significantly and trigger persistently negative FOCF, or in the case of large debt-financed acquisitions or shareholder distributions, the rating could come under pressure.
