Fitch Affirms Evraz Group S.A. at 'BB-'; Assigns Prospective Eurobond Issue 'BB-(exp)'

April 11, 2012 Fitch Ratings
Fitch Ratings-London/Moscow-10 April 2012: Fitch Ratings has affirmed Evraz Group S.A.'s (Evraz) Long-term foreign currency Issuer Default Rating (IDR) at 'BB-', with a Stable Outlook, Short-term foreign currency IDR at 'B', senior unsecured rating at 'BB-' and has assigned an expected 'BB-(exp)' rating to Evraz's prospective Eurobond issue.

Evraz plans to use net proceeds from the notes for refinancing purposes. Fitch will assign the notes a final rating upon closure and receipt of final documentation materially conforming to the information reviewed.

Evraz, having 100% self-sufficiency in iron ore and 56% in coking coal (without OAO Raspadskaya, 'B+'/Stable), is better placed to control the cost base of its upstream operations than steelmakers with a lower level of vertical integration. The cash cost of slab production at Evraz's Russian steel mills is approximately 25% lower than the global average. This resulted in the full capacity utilization rate of the company's steelmaking facilities in Russia.

Russia continues to be the largest regional market for Evraz (40% of revenues in 2011), where the company is focusing mainly on long products' sales. Fitch views demand driving factors for steel products in Russia, including long products, as strong. In 2011, after two years of stagnation, the intensification of construction activity was noted - 62.3m sq.m. of residential houses were built, 6.7% higher yoy, and the apparent demand for long products increased by more than 20% vs. 2010 yoy.

Taking into account the continuing increase of real disposable income of Russian households (by more than 50% in 2011 vs. 2005), the quite poor quality of existing housing and the development of mortgage lending along with the lowest mortgage loans to GDP ratio in Europe (in 2011 approximately RUB713bn of new mortgage loans were issued, 88% higher vs. 2010), the agency expects demand for new housing to continue to grow in 2012. This will stimulate demand for long steel products.

Evraz, controlling more than 30% of long products production capacity in Russia, is the main beneficiary of the expected demand growth. In 2011 Evraz sold 4.9m tons of construction steel products in Commonwealth of Independent States (CIS, a grouping of former soviet republics), 12% higher compared with 2010 yoy. This also contributed to the improvement of the product mix of Evraz's CIS mills - the portion of semi-finished products in revenue has decreased to 26% compared with 34% in 2010.

Evraz is the only Russian producer of rails and is the second largest supplier of wheels with 30% of domestic market share. Taking into account that the main portion of rail products is directed for maintenance, the demand is quite stable through the cycle.

The company's liquidity position is healthy, with USD626m of short-term loans compared with USD803m of cash on hand, USD562m of unutilized committed bank loans and an expected positive free cash flow margin in 2012.

During 2011 the company continued deleveraging. Funds from operations (FFO) adjusted gross leverage decreased to 2.3x at end-2011 compared with 3.0x at end-2010. The conversion of USD650m convertible notes into equity and the improvement of working capital management were among the contributing factors for deleveraging. Fitch expects the increase of FFO adjusted gross leverage to 3.3x-3.5x by end-2012 with it deleveraging to 2.0x-2.2x by end-2014.

Fitch notes the progress in the company's corporate governance practices. A new holding company of the group incorporated under UK law, EVRAZ plc, received admittance to the London Stock Exchange plc (LSE) in Q411, which means that the company complies with the LSE's admission and disclosure standards. Also the independent directors have a majority in all of EVRAZ plc's board committees.

The ratings are supported by Fitch's expectations of positive free cash flow generation over the medium term. Evraz's ratings remain constrained by its large Russian operational base, which exposes it to higher than average political, business and regulatory risks.

The deterioration of its financial and operational profile resulting in an EBITDAR margin below 15% and FFO adjusted gross leverage above 3.5x on a sustained basis would put negative pressure on the ratings. Conversely, further deleveraging to FFO adjusted gross leverage below 2.0x with an EBITDAR margin above 20% on a sustained basis would put positive pressure on the ratings.