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Move over, China, India:

here comes the Russian steel boom

With the Russian domestic economy expected to grow this year at 7% overall (GDP), and investment at 14%, the Russian steel sector is booming. But the super-sized steel mills are not able to deliver directly to satisfy consumption needs, thus opening up a lucrative market for steel processing unique to Russia. For the first time, it is becoming visible to foreign steel majors like ThyssenKrupp, and to the commodity investor market.

Russia's domestic demand for steel grew in 2006 by 16%, driven by the expansion of the construction and oil and gas industries, which are themselves growing now at an annual rate of around 15%; even faster for residential construction in some regions. This pace of demand growth is outstripping the availability of the domestic steelmills to supply; in 2006, rolled steel output grew by just 6.5% to 58.2 million tonnes.

Capacity limitations prevent some of the steelmaking groups from increasing output more than marginally. The best the steel producers can hope for is 5% to 6% growth in tonnage this year and next. Imports are rising, and so is the forecast for domestic prices.

"The domestic Russian steel market," reports Renaissance Capital, a Moscow investment bank, "can best be described as having been explosive over the past year - primarily due to strong demand and tight supply."

Sixty years ago, Stalin moved Russia's steelmills out of range of Hitler's tanks and artillery; today that leaves the mills producing enormous volumes of product far from their end-users. Insulation from global steel price volatility, the RenCap report suggests, is provided by "the huge distances that buffer the domestic heartland from imports, as well as the tariffs and quotas that are imposed on imported steel products."

Morever, it is the high concentration of mill ownership - 85% of crude steel output controlled by just four groups owned by four men - and their geographic location, far from the steel consuming centres, that puts a floor under domestic steel pricing. "What we have seen in the past," reports RenCap, "is that when export steel prices fall, domestic prices stabilize, but are unable to rally. When export prices recover, domestic prices recover in tandem. However, the spread between domestic prices and export prices was rarely as great as it was at the start of 1Q 2007."

For the first time since the end of the Soviet Union in 1991, more than 60% of the rolled steel produced by Russian steelmills will be sold and consumed this year on the domestic market. But since the great Soviet-era steelmills produce steel in a quantity and quality that cannot be directly consumed by the country's industrial end-users, a group of steel service-centre companies is developing rapidly to fill the widening gap between output at the factory gate, and on-time delivery to construction sites, machine engineering plants, and white goods manufacturers.

Inprom, based at Taganrog in southwestern Russia, and controlled by Igor Konovalov, is the first of the companies in the steel service-centre segment of the market, to capitalize on the demand for intermediation,  processing,  and delivery services to steel consumers by offering investors a shareholding stake in the hyper-growth of regional steel consumption. A recent company announcement said that an initial public offering of 30% of the company's shares will be made on the Moscow stock exchange at the end of June. Moscow-based Investment Bank Trust will organize the listing and sale of shares.

About half the money to be raised, Konovalov told, will be spent on an ambitious programme of regional expansion. Inprom already operates 25 centres, and will add 3 more this year. Expansion eastwards into the Urals and then Siberia is planned to make a total of 42 centres, with throughput of 1.7 million tonnes of steel products. Another third of the share sale funds will be committed to purchasing new equipment for steel processing, lifting the proportion of steel processed by Inprom before sale from 6% to about 33%.

The balance of the funds raised will be used to reduce Inprom's bank debts. Total debt is estimated at Rb5.7 billion (US$217 million), security for which includes freehold title to Inprom's plants and steel turnover. Lenders include the state savings bank Sberbank, and European banks - Raffeisen, Societe Generale, and BNP-Paribas.

In 2006, Inprom reports - audited to international financial reporting standards by Deloitte & Touche indicate that sales totaled Rb12.05 billion ($444 million). The other major Russian steel-service centres with sizeable turnover and market spread are the Steel Industrial Company (SPK) of Yekaterinburg; Comtech of Moscow; and Dipos of Moscow. SPK is privately held, issues no financial reports, and does not speak to industry media. Dipos is also reluctant to disclose its operating or financial details.

Gauging company size and market share is difficult, as a consequence. Estimates by steel industry monitor Rusmet indicate that in 2006,  SPK led with 816,000 tonnes of steel throughput. Dipos came second with 695,000 tonnes; and Inprom and Comtech equal with 538,000 tonnes. Inprom says its sale volume alone in 2006 totaled 706,000 tonnes.

The Metal.Com.Ru trade system ranks Inprom the second largest of Russia's steel service companies. Other sector estimates suggest that both SPK and Dipos are between 5% and 10% lower. Metallservice is another large service-centre contender in the top 5, with throughput of about 700,000 tonnes in 2006.

The two largest steel-service centre networks affiliated with the major Russian steelmakers are Severstal-Invest and Trading House Evraz Holding. Created as single-source distribution chains, both have been in trouble with their group managements. Severstal-Invest's chief executive was recently fired, while Evraz sold its unit to Swiss trading company, Carbofer - without official announcement. Severstal-Invest is estimated to distribute about 1.1 million tonnes annually, while Evraz's volume is between 600,000 and 900,000 tonnes. 

The intermediary steel market remains fragmented, however. Inprom estimates that it currently holds a 6% share of the steel sales market, while the top 5 independent steel service centre groups control about 23%.

The geographical dispersion of these companies, and their branches, is dictated by the logistics of steel consumption. About one tonne in four of Inprom's stock goes to the construction industry. For optimum application, sections must be cleaned with blasting equipment before delivery to building sites. Often, with under-capitalized stocklists and traders, it is not. Rebar distribution is widely dispersed through Russia. Inprom says that 19% of its sales go to the engineering sector. The service centres must be located close to the auto works and other plants. For products like welded mesh, the maximum distance between supply centre to consumption point, for cost efficiency, is within a range of 500 kilometres.

For the time being, much of the distribution chain remains oriented to trading, as large lots from the mill are broken down into smaller and smaller sized cargoes for customers.

This means that, compared to Western European or North American steel service-centres, where about 70% of steel throughput is reprocessed, less than 15% is the figure in Russia at present. In boom time, getting the steel to the end-user is a high-pressure business, with regions in northwestern Russia (St.Petersburg) and the southwest reporting current rates of steel demand rising at rates of 25% to 30% per annum.

Inprom reports that, overall, sales volume in 2006 grew 37%, but the proportion of steel traded on to small traders shrank.  Just three southwestern regions - Taganrog, Rostov, and Krasnodar -- accounted for almost half the tonnage sold.  Elsewhere in the market, SPK is concentrating its sales in the Urals, east of Moscow; while Comtech, based in Moscow, is focusing on the central region. According to Comtech, domestic Russian steel consumption is unbalanced, with about 45% of countrywide demand concentrated in the region around Moscow. That is changing.

With 21 branches at the moment, says Comtech chief executive Alexander Rubtsov, "our initial approach was to open in regions of the largest consumption. Another option we considered was to open in regions of lowest competitiveness. Now we are aiming at regions with the fastest tempo of growth - that means the northwest and the south. The growth in the central region is stabilizing." Comtech has also invested in new hot-dip galvanizing lines for supply to auto, refrigerator and other white goods plants.

According to Rubtsov, his group has started with relatively simple plants with warehousing, storage and trading operations. "Once you are on the ground," he said, "you assess the local demand for steel. Then you decide what processing equipment to install to meet the specific requirements of your regional customers. This is how service centres are evolving. And if the demand is sophisticated and sustainable, your plant develops into a full processing unit."  According to Rubtsov, his coated steel is produced far more swiftly than big mills like Magnitgorosk, Novolipetsk, or Severstal. "Surface quality is also superior," he claims.

Inprom's Konovalov told he sees that "the majority of Russia's regions is undergoing a combination of construction boom - both residential housing and commercial buildings - and mechanical engineering to supply investment goods and consumer goods. We expect, that if Sochi [on the Black Sea coast, in Krasnodar region] will win selection for the Winter Olympics of 2014, Inprom will have additional opportunities to increase its steel sales to meet the large-scale investment in construction of Olympic infrastructure. If that happens, we will have to adjust our business plan."

The federal government has earmarked $12 billion for investment in Sochi to support the Olympic bid. Salzburg, Austria, is the strongest rival for the Games with Sochi. The International Olympic Committee will vote on the selection in July. Construction of seaside hotels and holiday apartments for vacationers is being driven independently.

Comtech told it too will expand into the south. But Inprom's strength there is deterring, and so Rubtsov is focusing next on St.Petersburg, where the regional governor has provided a sote and other incentives. Comtech says it plans to invest $80 to $100 million in the region. Financing will come from retained earnings and bank loans for equipment purchase. 

According to Rubtsov, Inprom's bid for public listing of its shares, and for global investor interest, is an important test of the maturation of the Russian steel market in boom conditions. The steel service-centre segment "doesn't see big competition from the steelmills," he says. "The big steel plants cannot do the final processing, and in the Moscow region, the service companies which process small orders [from consumers] in huge quantities don't exist. Consumers cannot buy railcar-sized volumes that are the minimum lots, which the big steelmills sell. Everyone wants to establish a new stable distribution system."

Konovalov says "this is the optimum time to raise finance for expansion. We are going to become the largest company in the service-centre segment." 

Rubtsov acknowledge s that in this fast-moving market, it is difficult to agree on valuation of service-centre companies. "Everyone wants service centres to exist," Rubtsov says. "So the term exists, but there are not yet full service centres, in the European market sense of the term." In order to raise capital to catch the momentum of demand, Comtech says it is relying for the time being on secured lending. Konovalov says Inprom owns most of its plants, and has pledged less than a third of their asset value to secure current loans. Unlike Comtech, Inprom's business plan calls for expansion through acquisition.

Steel bankers and investors hold different views of how to value steel service-centre companies. Pure steel trading is considered too volatile, and thus its multiple to capitalization is usually discounted. However, steel processors in Europe like the BE Group of Stockholm have told they believe  steel companies of their type should enjoy higher multiples than the steelmill companies, because their revenues are spread over large client bases that can absorb price shocks more flexibly. BE, which is smaller than Inprom, recently made a merger bid for the Russian group, but Konovalov said no thanks.  Germany's ThyssenKrupp got the same response.

ThyssenKrupp is the leading the race among major European steelmakers to enter the Russian steel-service sector, but its precondition has been shareholding control. Corus is in negotiation with an unidentified Russian steel service company, along with Rautaruuki of Finland.

Vladimir Latishev, General Director of ThyssenKrupp Materials, based in Moscow, told that market demand is growing so fast, he expects the volume of his throughput to jump from 20,000 tonnes monthly at present to 40,000 tonnes within a year or two. "The Russian steel market is unique," he said -- "trailing behind the world tendency in the amount of processing the service centres do, but the potential is very high".

Latishev and a Russian partner hold 20% of the shares in ThyssenMaterials, while the German parent holds 80%. The company was started in mid-2004, adding stainless steel processing and distribution in April 2005. After selling five branches to Severstal-Invest,  Latishev and ThyssenKrupp are now concentrating on the Moscow, St.Petersburg and Nizhny Novgorod steel markets; on the Krasnodar region in southern Russia, which coasts on the Black Sea, in the second half of this year; and Yekaterinburg, in the Urals, next year.

For the most part, ThyssenKrupp is buying steel from Russian mills, and selling it to Russian end-users. This purely domestic operation imports no steel from Germany, and exports none to Germany, Latishev said.

He explained the slowness of the Russian steel service centres to invest in processing as due to lack of land ownership and capital shortage. Plants which lease or rent their premises in Russia cannot depend on the security of expensive equipment investments. "Now we are going to buy our own land, build our own plants, and processing will increase." The ThyssenKrupp service centres process about 3% of their steel before selling it.

Latishev told he expects that rapid growth rates will attract the investment required to drive consolidation of service centres into larger groups with nationwide ambitions like Inprom and Comtech.

Is the Russian steel service sector more exposed than the steelmills if prices drop,  and profit margins contract? Rubtsov says Comtech's performance shows it has grown rapidly and consistently in years when prices rose "like 2004; in 2005, when they fell; and in 2006 when they rose again."

Konovalov told the impact of price volatility is smaller on Inprom than on the steel producing companies. "During the period of price decline Inprom has the marketing flexibility to stimulate rapid turnover of stocks so as  to prevent sale prices from sinking below cost. Besides, prices on the Russian steel market will have strong support from the dynamic growth of the economy for the next 5 to 7 years. As our company annually expands the share of sales with higher added value, we expect to offset whatever volatility there may be in margins for the steel delivered from the mills." 

 

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