Description

Summary

LONG MM Norilsk ADR (NILSY). MM Norilsk is the world’s largest nickel and palladium producer with significant copper, platinum, cobalt, and rhodium mining operations. Norilsk trades cheaply at 6x EBITDA, pays a consistently high dividend, and has low financial leverage. For investors willing to bear Russian equity risk, Norilsk presents an excellent opportunity to take advantage of the collapse of the ruble while avoiding a dollar squeeze induced debt default. Already the world’s lowest cost nickel producer before the ruble fell 43% over the past six months, Norilsk’s should preserve its high margins as its costs have fallen much faster than nickel prices.

Company

Norilsk sells its metals to predominantly industrial customers in Europe and Asia. Nickel constitutes approximately 40% of revenue, with copper and palladium each comprising a 20% share of sales. Norilsk had FY2013 sales of $11.5bn and 1H2014 sales of $5.7bn. The primary use for nickel is stainless steel, which is mostly used in consumer centric products such as appliances, cars, and construction. The Chinese have used nickel pig iron (NPI) as a cheaper substitute for nickel in stainless steel production. However, Chinese reliance on NPI is expected to fall as Chinese producers run down their nickel reserves built up before Indonesia enacted an export ban last year.  Demand typically tracks personal consumption spending and should follow trends in China and the US.

Norilsk is the lowest cash cost nickel producer in the world. Norilsk's low cash costs are evident in its margin profile, with EBIT margins ranging from 22-60% since 2006. Labor and consumables account for half of Norilsk’s cash operating costs and are mostly paid in rubles. Norilsk’s relative advantage on the cost curve has been enhanced as competitors’ cash costs have fallen less quickly, owing to more modest declines in other production currencies (e.g. AUD, CAD, BRL).

Under the management of Vladimir Potanin, Norilsk has been undergoing strategic restructuring emphasizing projects with large scale deposits, assets with EBITDA margins exceeding 40%, and reserve lives over 20 years. As part of this review, Norilsk has sold non-core assets in Australia, Africa, and Russia. These asset sales have increased Norilsk’s exposure to the ruble: leading to lower cash costs and provided capital for special dividends. Management has also focused on free cash flow generation by keeping costs low and managing working capital.

Corporate Governance

Norilsk was one of the Soviet era crown jewels that was privatized in the loan-for-shares program, and is partially owned by a coterie of oligarchs (30% owned by Potanin via Interros, 28% by Oleg Deripaska via Rusal, 6% by Roman Abramovich via Crispian Investments and Millhouse, and 3% by Alisher Usmanov via Metalloinvest). Except for Metalloinvest, these parties established a shareholder agreement in 2012 to resolve a power struggle between Potanin and Deripaska. The shareholder agreement installed Potanin as CEO, created lockups for each party, targeted leverage at no higher than 2x EBITDA, and limited capex spending through 2018. The agreement gave Abramovich enough voting power to create a blocking position between Interros and Rusal. There have been subsequent codicils to the 2012 agreement related to increasing dividend payout targets. The three major parties should continue to enjoy peace as long as the company performs well and is throwing off gobs of cash.

Capital Return

Norilsk has prioritized maintaining an investment grade rating and paying out regular and special dividends. Despite the turmoil in Russia and a sovereign downgrade to junk, Norilsk’s conservative balance sheet, with less than one turn of net debt, has kept its investment grade credit rating. The company has also adhered to its dividend policy, which is a 50% EBITDA sweep as a regular annual dividend. Norilsk also pays a special dividend conditional upon cash balances in excess of $1bn and asset sales. These dividends have been significant. Total payouts for FY2013 were $1.40 for the ADR. Norilsk paid a regular interim dividend and a special dividend of $1.33/ADR in January. These payouts should continue as long as Russian firms can make transactions through SWIFT.

Conclusion

Norilsk presents good value to investors comfortable with the sovereign risk. Norilsk’s position as the lowest cost nickel producer has been fortified by the weak ruble and has supported margin growth. A debt default is unlikely because of the low leverage (0.9x) and the company generates enough cash to meet its obligations. It also has dollar credit lines with Asian banks. Norilsk could generate between $5.5-6bn EBITDA in 2015, implying a minimum regular dividend of $1.75-$1.90/ADR. Norilsk should be relatively unaffected by Russia’s domestic economic problems (e.g. oil, inflation, or a potential banking crisis) and shares should appreciate as the market revisits the economic value of Norilsk’s mining assets and cost structure.

The company would be adversely affected by international sanctions in response to Russian foreign policy. The most severe sanction would be excluding Russian firms from the SWIFT payments system. Handicapping Putin is challenging and perhaps futile exercise, but Norilsk has performed well since the Crimean invasion and been good to shareholders.

Note

The ADR has 1/10 the value of the Russian shares

Catalyst

Low ruble, easing of tensions in Ukraine