Description

Severstal is the world's most profitable steel company, able to produce boatloads of cash no matter what.

This idea is relatively straightforward, as I will try to quickly make apparent. It is an idea where no knowledge of how new tech advancements will change the world is required. Or hardly any skills to properly evaluate corporate culture or a business strategy in the light of competitor actions are necessary. It is an idea where bringing all the numbers together is almost enough. A serious day or two of studying a few transcripts and reports should do the rest. If one is keen to learn a lot about steel though, Vaclav Smill’s book Still the Iron Age is a great source to start (link). No matter the work a few unknowns/potential risks will remain, but this is the case with literally any investment. The margin of safety here seems so large that only expropriation by its country of operation or its controlling shareholder can reasonably kill the investment. I leave it up to you to put odds on those outcomes. 

Severstal is geographically based in Russia and more importantly, economically at the lowest end of the cost spectrum - the place where you want to find a commodity business. The business is fully vertically integrated with low-cost operations in each of the important production areas, iron ore mining, coal mining and steel making. The company produces close to 12mn tonnes of steel a year, which places it just in the top 40 global producers in terms of steel output. Here is a link from the world steel association that shows the largest 50 steel producers in the world (on page 9). There are other useful stats to find too. 

Apart from its steel production Severstal extracts over 6mn tonnes of iron ore, plus churns out an additional 11mn tonnes of iron ore pellets and mines close to 5mn tonnes of coking coal. These figures make Severstal more than self-sufficient on the iron ore side (130% of internal use) and close to self-sufficient on the coking coal input with a coverage of 75%. The graphs below provide a cash cost overview of the various areas. 

Taken together, these low product costs give Severstal its leading global cost position and lift their EBITDA margin above 30%.

Fortunately, the high EBITDA turns into real cash at a favourable ratio, and it is cash shareholders actually get. The company paid out ~7,8bn USD in dividends over the six years shown above, which is 78% of its current market cap of ~10bn USD ( $6bn came in just the last four years). The company has committed to payout 100% of its FCF as long as the Net-debt to EBITDA stays below 1. The current figure is at 0,6 which also means we can make an important check mark on the checklist: Leverage won’t kill this investment. 

Another one on the list, an economic crisis in its home market, won’t kill it either. The numbers in the graph above include the Russian crisis 2014/15. A time when Russia's GDP contracted, the price of Oil plummeted from over 100$ into the 30s, where major sanctions against Russia were implemented, and when the RUB lost half its value against the US Dollar. 

Part of the high resilience stems from the fact that up to 40% of Severstal’s steel is exported to other markets, a figure that can obviously move depending on the market conditions in Russia. It’s generally more profitable to sell it directly in Russia, but rather than destroying prices at home, you opt to export more when demand locally tanks. While currency devaluations can hurt investment returns a lot, they can also have the opposite effect for commodity producers. Their local costs go down, while revenues are linked to the global cost curve. With Severstal you don’t have to worry about a RUB devaluation, you get a margin boost. 

An additional stress test to the business and numbers shown above came with tanking global steel prices, which arrived roughly at a similar time frame as the Russian crisis. 

Tanking steel prices are obviously bad, but there is a good reason why they won't stay low for long. Other steelmakers don’t have the luxury of 30-plus % EBITDA margins. They simply don’t have room to absorb lower prices on a sustainable basis. As I write this and look at our excel (with over 40 companies) that includes most of the large steel companies in the world. The average EBITDA margin is a meager ~10% and they lose almost everything of that margin on the way to the bottom line. The average net margin for the group is ~1,3% and it doesn’t change much if you eliminate say the 10-15% worst and best performers. The industry as a whole barely gets by at current prices. Any price shock should therefore only be short-lived and resolve itself in relatively due course.  

The vertical integration with low-cost position on iron ore, coking coal and steel making means that you are also protected on price spikes from input materials that can’t be/aren't passed along and squeeze steel makers margins. It’s likely not a big issue for Severstal. The company can capture the margin in its resource division, especially on the iron ore front. 

The next snapshot shows the return on capital figures section of the steel comp excel. It is obvious how Severstal separates itself from the pack. Those are quite impressive numbers, especially for a steel company, prior to checking out the space I would not have guessed that such returns are possible. 

The next thing I want to talk about is capex, where looking at the difference between the last two columns is a good starting point. Severstal is currently obviously spending more on capex, than its peers. Capex runs at ~15% of tangible capital vs. ~6% for the industry. Severstal kicked off a number of expansion projects, starting last year, that more than doubled their capex from prior years. Peak capex will be this year with 2023 predicted to be below 800mn USD again. The capex is used to ramp up steel output, boost vertical integration and to lower costs further. In total they think they can boost baseline EBITDA (baseline = regardless of steel prices) by another 1,4bn USD from 2019 levels via those projects and other less capex heavy operational changes. 

Since their financial leverage is so low atm, they have also committed themselves to follow their 100% FCF dividend payout ratio, not on actual capex numbers in the investment phase but based on a maintenance capex of 800mn USD, at least until their 1 times net-debt/EBITDA level is reached. 

The new incremental EBITDA of 1,4bn USD (roughly a +50% boost to current EBITDA) should flow through to FCF at a slightly higher rate, but just assuming no change and not the full benefit should bring avg. cycle FCF to 2bn USD a year, which would produce a 20% dividend yield on the current market cap. An awful lot could go wrong and you should still come out ok. 

Since some of their earnings comes from mining operations, a sentence or two about that is warranted. You obviously don’t want them to run out of resources next year and watch those earnings evaporate. Fortunately that won’t be the case for Severstal. The three major iron ore mines together have billions of tonnes in resources. For example their Yakovlevskiy Mine that they currently work on to ramp up production to 5mn tonnes a year in 2023 has estimated resources of 9bn tonnes and they think they can lower the cash of that from the current 40$ to ~18$ a ton. The cash cost of the two other major iron ore mining complexes are 25$ for Oclon where they create iron ore pellets and 28$/ton for iron ore concentrate at their Karelsky mine complex. Selling prices in 2019 to external parties were 103$/ton for pellets and 79$ for concentrate. Around 6mn tonnes of pellets were sold.  

Severstal is majority-owned by Alexey Mordashov. The listing of the company on the London stock exchange took place in 2006 and there haven’t been any noteworthy changes to his holding since then. Usually, owner-operators are a welcome attribute but not so in Russia where there is a very dark stigma present, given the history of privatisations and other developments. The history is not pretty (yes, we have read Bill Browder's book red notice), but not all oligarchs are equal. We think Alexey Mordashov is ok, but everyone has to come to his/her own conclusion on that subject. 

The company also does not seem to be a dirty polluting and exploiting monster. A conclusion one could quickly reach given the prejudice involved with Russia and their extraordinary margins. However, they pay way above average salaries in their regions and more than the industry average in Russia. A surprisingly high 56% of engineers are female. They have fewer accidents than common in the industry. Environmentally they are in the top 15 in terms of Co2 pollution per ton of steel globally. With the lowest value of Co2 emissions at 1,81 tonnes of Co2 per ton of steel vs. their value at 2.06. The global max is at 3.34 and the average is at 2.33. Their ESG report reveals a few interesting lessons. Overall, the company seems to be quite transparent and corporate governance is decent enough for a position. Most importantly the dividends are real and destined to grow, potentially materially over the next three years. This is of course not our favourite idea or largest position, but we like it for its simplicity and low research maintenance requirements. Maybe another VIC member likes it as well

Finally, some current and historic trading ranges for the industry and Severstal.

Catalyst

no specific catalyst, rising EBITDA, FCF, Dividends over the next 3 years