OREANDA-NEWS. Fitch Ratings has affirmed Russia-based OJSC Novolipetsk Steel's (NLMK) Long-term Issuer Default Rating (IDR) at 'BBB-'. The Outlook is Negative.

The ratings reflect NLMK's strong vertical integration, low production costs, a robust product mix, geographical diversification as well as above-average corporate governance in Russia. The Negative Outlook reflects NLMK's still high leverage, which is inconsistent with Fitch's guidelines for current ratings.

KEY RATING DRIVERS
Leverage to Decline
Total debt (including the USD791m of NBH's debt guaranteed by NLMK and off-balance sheet amounts calculated by Fitch) increased to USD5.1bn at end-2013 from USD4.9bn at end-2012. Cash and cash equivalents balance increased to USD1.5bn at end-2013 from USD1.1bn at end-2012. Funds from operations (FFO) adjusted gross leverage increased to 4.11x in 2013 (3.03x in 2012). However, Fitch expects FFO adjusted gross leverage to fall to 2.68x by end-2014, due to positive free cash flow (FCF) generation resulting from a more conservative investment spending programme (compared with previous years).

Partial Vertical Integration
Although NLMK is only a partly vertically integrated steel company (due to the absence of an in-house coking coal supplier), the availability of low-cost iron ore from subsidiary Stoilensky GOK and ownership of Russia's largest scrap collecting network, coke-making facilities and state-of-the art steelmaking facilities located in Russia make NLMK one of the most efficient steel producers globally.

The company aims to strengthen its mining division by expanding an open-pit mine and constructing beneficiation (5mtpa iron ore concentrate capacity) and pelletising (6mtpa pellet capacity with expansion potential to 7.2mtpa) plants at Stoilensky GOK. As a result, the iron ore requirements of the company's steel operations will be fully covered internally from 2018. Given current weak pricing on coking coal, development of NLMK's coking coal green fields (Zhernovsky-1, Usinsky-3) has been postponed.

Restructuring of European Assets
Since 2009 NLMK has been actively restructuring its European mills by completely switching to a re-rolling model (steel-making capacities have been divested), consistently cutting costs and implementing technical upgrades (at NLMK Dansteel and at NLMK Clabecq). As a result of these initiatives NLMK Europe's fixed costs were reduced to EUR161m in 2013 from EUR233m in 2009.

Despite a continuing weak market environment in Europe, NLMK managed to significantly improve the operating performance of its international (including European) operations. In 2013 NLMK Europe generated an operating loss of USD257m in 2013 (versus loss of USD347m in 2012). In September 2013 NLMK sold 20.5% of NLMK Belgium Holdings (NBH) to SOGEPA for EUR91.1m and deconsolidated it from its balance sheet. NBH holds the rolling mills of NLMK in Europe with a total production capacity of 0.47m tonnes. Deconsolidation of NBH has already brought positive results with the international division reporting its first ever positive EBITDA of USD30m in 4Q13.

New Strategy
In February 2014 NLMK revealed its new strategy targeting operational efficiency, improvement in its resource base, market share gains and sustainability of its operations. NLMK would implement a number of projects on operational and management levels to attain better efficiency with the aim of achieving USD330m of sustainable annual net gains over a five-year period (with over USD200m expected in 2014). NLMK is also targeting 100% self-sufficiency in iron ore pellets by constructing a 6mtpy pelletising plant by 2017-18, and by introducing PCI technology (which will cover 50% of Russian blast furnace operations in 2014 with the option to expand to 100%). This will require USD1.4bn of investments during 2014-17 but is expected to generate USD480m of annual net gains by 2018. NLMK also targets to strengthen its market position in Russia and to remain visible in EU and the US, which will require minimal capital expenditure (USD50m in 2014-2017). This should result in annual net gains of USD190m.

Above-average Corporate Governance
Fitch assesses NLMK's corporate governance as above-average compared with other Russian corporates but the country's overall poor standards of governance and lack of legal safeguards are constraints on the ratings. As a result, the ratings are notched down only one notch for corporate governance compared to the more common two for Russian issuers with similar standalone ratings.
Profitability to Recover

The weak market environment in 2013 negatively affected NLMK's performance, as revenue declined 10% to USD11bn while EBITDA margin slipped to 13.8% from 15.6%. Fitch expects NLMK's EBITDA margin in 2014 to improve to 17%-18%, due to NBH deconsolidation, cost cutting initiatives and further sales growth as the company ramps up its newly launched facilities.

LIQUIDITY AND DEBT STRUCTURE
NLMK's liquidity position is strong with USD1.5bn of cash and short-term investments in hand and USD3bn of unutilised committed bank loans compared with USD1.1bn of short-term borrowings at end-2013.

RATING SENSITIVIES
Positive: Future developments that could lead to positive rating actions include:
-Evidence of deleveraging with FFO adjusted gross leverage falling towards 2x by end-2015, which would lead to the Outlook being revised to Stable. Leverage below 1.5x would result in an upgrade
- Improvement in the Russian business environment
- Positive FCF on a sustained basis

Negative: Future developments that could lead to negative rating action include:
- EBITDAR margin below 16% on a sustained basis
- Failure of NLMK to deleverage in line with Fitch's expectations with FFO leverage above 2.5x.