M2M Strategy Tuesday, July 2, 2013 Metals & Mining Spot based valuation Vol. 4 The names and trades below comprise our monthly M2M strategy: Most and least preferred stocks Most preferred Least preferred Norilsk Nickel Mechel TMK Polyus Polymetal Uralkali Pair trade summary Long Short TMK Tenaris Polymetal Polyus Evraz Severstal Norilsk Nickel Uralkali M2M valuation summary 12MF M2M Company EV / EBITDA P/E Norilsk 6.5 11.0 UC Rusal neg. neg. Severstal 7.0 22.1 7.5 16.2 MMK 6.4 neg. EVRAZ 5.5 neg. Mechel neg. neg. TMK 6.1 9.4 Uralkali 10.3 14.5 Phosagro 6.1 8.1 Acron 4.9 5.7 Polyus 10.0 18.7 Polymetal 6.2 14.4 Nordgold 3.9 20.1 Most favored stocks: Norilsk Nickel, TMK and Polymetal Least favored stocks: Mechel, Polyus Gold and Uralkali Pair trades: o TMK vs Tenaris o Polymetal vs Polyus o Evraz vs Severstal o Norilsk vs Uralkali Base metals (Norilsk) is our top pick, Avoid steels BCS M2M strategy: Spot based valuations used to create short term valuation calls. The BCS Mark to Market (M2M) strategy is geared to isolating equity value in an investment environment characterized by high volatility. To this end, we apply a sector valuation based on spot commodity prices and the exchange rate. To be more precise, our analysis takes into account the current market environment (e.g., commodities, exchange rates) to deliver a spot based valuation, which we use to decide our short term valuation calls in both pair trade and long only territory. Most Favored/Trade ideas: Norilsk Nickel, TMK, Polymetal. There were no changes since last month in either of our portfolios. In particular, our Most Favored stocks are still Norilsk Nickel (dividends were fully in line with guidance, confirming improving corporate governance), TMK (collapsed recently contrary to market and pipe peers, should benefit from high oil prices and declining steel prices) and Polymetal (a valuation call, never traded so low, a higher beta play on gold/silver price recovery). Least Favored: Mechel, Polyus, Uralkali. Similarly, the same names remain among our Least Favored: Mechel (coking coal prices under pressure, renewing record lows since 2008/09 crisis), Polyus Gold (outperformed the market heavily, looks overpriced on fundamentals) and Uralkali (lacking short term upside drivers, while the buyback appears set to end in 6 weeks). Pair trades: TMK vs Tenaris, Polymetal vs Polyus, Evraz vs Severstal, Norilsk vs Uralkali. We added one pair trade Norilsk vs Uralkali to our latest portfolio of three, i.e., TMK vs Tenaris, Polymetal vs Polyus and Evraz vs Severstal. The TMK vs Tenaris trade: TMK underperformed its key peers dramatically, which we see as unjustified, fundamental risks are overvalued by the market. The Polymetal vs Polyus trade: unjustified heavy underperformance of the former vs the latter should partially reverse. The Evraz vs Severstal trade: long steel prices should outperform flat steel, benefitting the trade. The Norilsk vs Uralkali trade: we are long in Norilsk and shorting Uralkali nickel prices are seen to rebound in the very short term due to supply cuts, while Uralkali will lose support from the buy back and potash prices have no risks to the upside. Research Department + 7 (495) 785 53 36 www.bcs.ru Kirill Chuyko, +7 (495) 785 5336 (4733), kchuyko@msk.bcs.ru Oleg Petropavlovskiy, +7 (495) 785 5336 (4680), opetropavlovskiy@msk.bcs.ru
Table of Contents Most favored / trading ideas... 3 Least favored... 3 Pair trades... 4 Mark to Market summary... 5 Key inputs for M2M EBITDA estimate... 6 M2M EBITDA v BCS and Consensus... 7 Sensitivity to input changes... 8 Debt is a growing major concern... 9 2
Most favored / trading ideas Norilsk Nickel Dividends are coming, corporate governance improvement The Buy call on Norilsk Nickel is the safest in our universe at this stage: Downside is limited by the valuation safety net (low multiples) Profits highly unlikely to fall more: globally nickel price is below cash costs Norilsk s M2M EV/EBITDA is 6.5x, a discount to historic averages; single digit P/E Stock to re rate as corporate governance set to improve FY12 dividends are in line with guidance, should confirm governance improvement We see no risks to financial gearing, CapEx should be controlled Finally, all shareholders are interested in a higher NN share price TMK Unjustified collapse, gap to global peers: attractive entry point TMK should benefit from weakening steel prices, reducing cost pressures The stock is suffering from share overhang, that should ease Thus, the stock s recent decline offers a good buying opportunity M2M EV/EBITDA is 6.1x, below historical averages Underperformance to global peers Tenaris, Vallourec is strong and unjustified Polymetal A valuation call, never traded this low Polymetal shares have fallen 4 ytd, heavily underperforming peers Risk #1 operational, but valuations more than fully discount the worst case scenario Risk #2 M&A, but Polymetal s core shareholders will not accept merger at the current market valuation, we believe M2M EV/EBITDA is now 6.2x, below historical averages Least favored Mechel Coking coal prices under pressure, new capacity in long steel is a risk Coking coal prices are under further pressure, renewing lows since 2008/09 crisis Risks for coking coal are high China is almost self sufficient High financial gearing is a concern, M2M net debt/ebitda ratio is 38x On multiples the stock is expensive, with M2M EV/EBITDA is negative The only hope is a strong rebound in coking coal prices of c3+ Highest beta play on China s industrial cycle in Russia Polyus Outperformed the market, fundamentals look overpriced Stock outperformed EM gold peers being flat ytd Market overestimates the M&A premium, assuming Polymetal merger Operational issues remain, including Natalka project commissioning M2M EV/EBITDA is 10.0x, at a premium to key peer Polymetal Uralkali No drivers to the upside, buyback set to end in just 6 weeks Potash industry and Uralkali have no upside risk Negotiations with Chinese buyers are difficult due to high inventories Price news only in November and we believe news may be negative Uralkali already spent c$1bn for buyback, just $0.65bn left We estimate buy back to continue at $100mn/week rate; buyback will end in 6 weeks Based on our estimates, continuing buy back unlikely would threaten leverage metrics M2M EV/EBITDA is high at almost 11 3
Pair trades Long TMK, Short Tenaris A great hedged play on TMK s collapse The recent Russian market correction presents strong bottom fishing opportunities: Underperformance to its global peers Tenaris and Vallourec is strong Historically TMK was highly correlated with global peers Steel price declines should ensure limited financial risks for the stock The stock s recent decline offers a good buying opportunity M2M EV/EBITDA is 6.1x, somewhat below averages Tenaris is a source of hedged funding, not a standalone short Long Polymetal, Short Polyus Polymetal s underperformance should partially reverse Polymetal was among the worst performing stocks in the gold equity space ytd Polyus, on the other hand, was among the key outperformers in EM Fundamentally, Polymetal has always traded at least in line with Polyus, sometimes at a 1 premium on EV/EBITDA now there is a 38% discount A merger with Polyus is unlikely to go through at current valuations The spread is unjustified; the trend should reverse once market recovers Long Evraz, Short Severstal A bet on the ongoing rebar prices growth Long steel prices (Evraz) are clearly much better positioned than flat steel (Severstal) Performance gap between stocks is only partially justified, fundamentally excessive Evraz s M2M EV/EBITDA multiple was at par with Severstal s, vs 21% discount now Construction season pick up may help long steel stocks (i.e. Evraz) in the short term Financial risks are not strong for Evraz, state should back the company This is a higher risk trade though; competition risks for Evraz will increase in 2014 Long Norilsk, Short Uralkali Nickel prices to rebound, potash industry has risks to the downside Current nickel prices are loss making for up to 4 of global producers We expect supply cuts in the very short term Norilsk s CapEx and OpEx are seen to be under control and we see no big threat to the dividend story Negotiations with China on potash supplies are expected only for November due to high inventories, otherwise price may be reduced Uralkali s buyback set to end in 6 weeks and support will be gone from the stock 4
Mark to Market summary Below you can see the M2M summary valuation table for the M&M space in Russia. Russian metals and mining equities mark to market valuation summary Share MCAP, EV, 12MF M2M Company price Crncy $ mn $ mn EV/EBITDA P/E Comment Norilsk Nickel 13.6 $ 21 520 23 857 6.5 11.0 Trades at a mid cycle multiple, but we are in a trough market inefficiency UC Rusal 3.0 HK$ 5 819 9 810 neg neg. M2M multiples discounts the best case scenario, an expensive option on Al Severstal 6.3 $ 5 166 9 512 7.0 22.1 Trading at a premium to peers not fully justified 12.5 $ 7 504 10 987 7.5 16.2 Premium to peers has recovered, no major triggers seen MMK 2.9 $ 2 519 5 711 6.4 neg. Lack of vertical integration partially offset by high financial gearing Evraz 103 GBp 2 395 9 185 5.5 neg. Cheapest stock in the sector thanks to construction season pick up Mechel 2.8 $ 1 303 10 684 neg neg. An expensive option on coking coal prices, which are at new lows since crisis TMK 11.0 $ 2 383 5 923 6.1 9.4 Gap to pipe peers is unjustified, benefits from weak steel and strong oil Uralkali 33.6 $ 19 708 21 307 10.3 14.5 Trades high and lacks short term drivers, buyback to end in less than 2M Phosagro 12.4 $ 4 631 5 250 6.1 8.1 Stock trades unfairly low, re rating expected as liquidity improved, potential MCSI inclusion Acron 3.9 $ 1 565 2 254 4.9 5.7 Fairly valued Polyus 493 GBp 9 278 8 697 10.0 18.7 Trades at an unfairly high premium to global peers Polymetal 199 GBp 2 908 3 098 6.2 14.4 At a discount to historic multiples, weak performance is still unjustified Nordgold 2.0 $ 755 1 175 3.9 20.1 The stock that is always cheap, lacking triggers Note that the discount to historical averages may be due to one of the following: The market believes that the stock s M2M EBITDA will deteriorate usually due to expectations of lower commodity prices. Other reasons include expected growth in production costs or lower sales volumes. The stock has fundamentally de rated on risks (i.e., corporate governance concerns, financial leverage risks, de rated growth outlook) Our methodology provides a relatively short term analysis of the expected share price performance of the stocks covered in this report If none of these is true, then the stock is underpriced. The reverse logic applies for the explanation behind a potential premium to historic multiples. Methodology The M2M valuation assumes spot commodity prices in real terms as well as a spot exchange rate (in real terms as well), resulting in an implied spot based 12 Month Forward (12MF) profit estimate (EBITDA and net income) and, consecutively, EV/EBITDA and P/E multiples, which are then compared to historical averages for each stock. This approach gives a relatively short term analysis of the expected share price performance of the stocks covered in this report. We note that these recommendations may conflict with BCS official ratings, which are more long term. 5
Track record The charts and tables below show the track record for our key portfolios. Note that our performance is based on the following: Pricing is defined as a trading average in 30 60 mins after the report release; If the stock is not trading, we take the first 30 mins average at the opening; If the number of stocks/pairs in a portfolio is less than 3, we assume the remaining being cash (i.e. with 2 trade ideas, cash is a third of the portfolio). 15% 1 5% 1 15% 2 Pair trade portfolio Pair trade portfolio summary Long Short Launched Performance Share in portfolio Active TMK Tenaris 25 Apr 5.5% 25% Polymetal Polyus 2 Apr 39.6% 25% Evraz Severstal 7 May 0.4% 25% Norilsk Uralkali 20 Jun 1.8% 25% Pair trade portfolio return since April 2nd 12.4% 1 Apr 15 Apr 29 Apr 13 May 27 May 10 Jun 24 Jun 15% 1 5% 1 15% 2 Most/Least preferred portfolios Most Least RTS RTS M&M 25% 1 Apr 1 May 1 Jun 1 Jul Most/Least preferred portfolios summary Stock Open Return Share in portfolio Most preferred Norilsk 2 Apr 5.7% 25% TMK 2 Apr 6.5% 25% Polymetal 2 Apr 40.8% 25% Least preferred Polyus 2 Apr 1.9% 33% Mechel 2 Apr 40. 33% Uralkali 20 Jun 0.4% 33% Return since April 2nd: Most preferred 15. Least preferred 17.9% RTS index 11.9% RTS M&M index 19.6% Key inputs for M2M EBITDA estimate The table below summarizes the inputs used in the current M2M strategy. Key inputs summary (as of Monday s close) Ruble exchange rate 32.74 Nickel, $/ton 13 562 Copper, $/ton 6 638 Aluminium, $/ton 1 726 Platinum, $/oz 1 360 Palladium, $/oz 669 Gold, $/oz 1 287 Silver, $/oz 20 Steel (HRC dom/exp average), $/ton 496 Steel rebar (domestic), $/ton 554 Coking coal (Newcastle FOB), FCA, $/ton 130 Coking coal (Russia, mix), FCA, $/ton 105 Potash, China domestic, $/ton 424 DAP, Tampa FOB, $/ton 459 Urea, FOB Black Sea, $/ton 320 Source: Datastream 6
M2M BCS EBITDA changes M2M Strategy The table below summarizes the key changes to BCS EBITDA estimates for the stocks that we cover with a short justification. Vol. 2 Vol. 3 Chng., Comment Data as of 7 May 4 Jun % Norilsk Nickel 4 226 3 660 (13%) Lower commodity prices UC Rusal 546 neg. n/m Al prices slumped to loss making level Severstal 1 566 1 356 (13%) Steel slumped, ruble depreciation not enough 1 617 1 461 (1) Steel slumped, ruble depreciation not enough MMK 1 007 896 (11%) Steel slumped, ruble depreciation not enough Evraz 1 677 1 664 (1%) Rebar prices still stronger vs HRC Mechel 259 neg n/m Coking coal prices slumped to loss making level TMK 1 017 966 (5%) Slightly weaker market environment Uralkali 2 361 2 068 (12%) Weak 1Q13 force to revise optimistic estimates Phosagro 982 863 (12%) DAP price declined, ruble helped a bit Acron 378 462 22% Weaker N fertilizer prices Polyus 1 050 866 (18%) Weaker gold Polymetal 625 499 (2) Weaker gold/silver Nordgold 394 303 (23%) Weaker gold M2M EBITDA v BCS and Consensus The chart below compares M2M EBITDA v the 12MF BCS and consensus forecasts. This is a good indication of potential dynamics of revisions to consensus estimates. BCS/Consensus EBITDA upside/(downside) to M2M levels 2 4 6 8 10 12 14 Rusal * not yet officially covered by BCS Comparison of M2M EBITDA v BCS and Consensus estimates 12MF Mark tomarket BCS forecast Consensus forecast Company name EBITDA 2013E 2014E Implied 12MF 2013E 2014E Implied 12MF Norilsk Nickel 3 660 5 602 5 902 5 752 4 627 5 062 4 844 UC Rusal neg. 1 024 1 244 1 134 1 019 1 204 1 111 Severstal 1 356 2 238 2 631 2 434 1 854 2 033 1 943 1 461 1 843 2 041 1 942 1 811 2 050 1 930 MMK 896 1 196 1 304 1 250 1 256 1 349 1 302 EVRAZ 1 664 2 112 2 347 2 229 1 944 2 150 2 046 Mechel neg. 1 624 2 065 1 844 1 347 1 614 1 480 Uralkali 2 068 2 223 2 425 2 324 2 275 2 627 2 450 Phosagro 863 1 083 1 168 1 125 1 033 1 080 1 057 Acron 462 572 541 557 501 513 507 Polyus 866 1 052 1 327 1 189 Polymetal 499 734 888 811 Nordgold 303 457 518 487 MMK EVR MTL * vs. BCSe vs. Cons. * * 7
The table below shows the changes in consensus forecasts over the past month. 12MF Consensus EBITDA change over month M2M Strategy 1% 2% 3% 4% 6% 7% 8% 9% 3% 4% 6% 6% 6% 4% 4% 1% 7% 8% Rusal MMK EVR MTL Sensitivity to input changes The analysis below shows the sensitivity of each company s EBITDA and net income to commodity price changes (1 increase in all commodities). UC Rusal and Mechel are the most geared to commodity prices due to low profitability and integration into mining. Sensitivity to a 1 increase in all commodity prices M2M EBITDA M2M Net income 20 16 12 8 4 155% 21% 3 26% 47% 35% 23% 17% 29% 26% 19% 22%23% 8 6 4 2 28% 7 43% 2 36% 29% 24% 31% 46% Rusal EVR MMK MTL Rusal * EVR * MMK * MTL * * n/m We also show how sensitive Russian stocks are to ruble exchange rate changes (we consider a 1 appreciation). This sensitivity is highly important, given that the Russian currency is highly correlated to the oil prices and Russian stocks suffer from any ruble appreciation. Similarly, the most sensitive stocks here are UC Rusal and Mechel, also for the same reasons being low profitability and high mining exposure. Gold stocks, Norilsk and Uralkali are least levered to ruble exchange rates due to high margins. Sensitivity to 1 ruble appreciation M2M EBITDA M2M Net income 2 4 6 8 10 Rusal 7% 81% EVR MMK MTL 11% 19% 16% 28% 22% 17% 16% 7% 8% 1 15% 2 25% 3 35% 4 45% 5 Rusal * 9% EVR * MMK * MTL * 44% 22% 6% 22% 19% 8% 11% 11% * n/m 8
The chart on the left below illustrates the exact correlation between oil prices and the ruble exchange rate. This high correlation is a strong risk for many Russian miners, whose costs rise in USD terms on appreciation, but that growth is no longer compensated by higher commodity prices see the chart on the right below showing the de coupling of oil from metals and mining commodities. US$ exchange rate 50 45 40 35 30 Ruble exchange rate vs oil price (real current terms) Historical Current y = 139,09x 0,311 R² = 0,8408 25 30 50 70 90 110 130 Brent oil price, $/bbl Oil vs CRB commodity price index clear de coupling 650 CRB Index Brent oil price 600 550 500 450 400 350 300 250 Jan 09 Jan 10 Jan 11 Jan 12 Jan 13 140 120 100 80 60 40 20 This de coupling is fully in line with our view, as we expected that consumption stories (i.e. oil) will outperform investment ones (i.e. steel, other metals) given the risks of global overinvestment. This is also the major reason why the Russian mining companies are showing deteriorating profitability over time (see chart below). Debt is a growing major concern In this section, we provide some analysis of the Russian metals and mining space in terms of financial gearing. Below you can see a summary of Russian stocks net debt/ebitda ratio based on mark to market estimates. M2M 12MF net debt/ebitda ratio 40,0 38,0 35,0 30,0 25,0 20,0 15,0 9,4 10,0 4,2 2,8 3,5 3,5 4,0 5,0 2,0 0,5 0,7 0,6 0,3 0,0 0,5 1,1 5,0 Rusal * EVR MMK MTL TMK * EBITDA includes 28% of UC Rusal s share in Norilsk Nickel s earnings 9
Institutional Sales & Trading Moscow: +7 (495) 785 5336 (ext. 4702) London: +44 (207) 065 2022 Research Department +7 (495) 785 5336 (ext. 7822) Head of Equity Research Head of Fixed Income Research Head of Private Client Research Head of Production Kirill Chuyko kchuyko@msk.bcs.ru Leonid Ignatyev lignatyev@msk.bcs.ru Vladislav Metnev vmetnev@msk.bcs.ru Mark S Bradford mbradford@msk.bcs.ru Head of Russian Product Olga Sibiricheva osibiricheva@msk.bcs.ru Equity Research Fixed Income Research Editing/Translation Equity Strategy Kirill Chuyko (ext. 4733) kchuyko@msk.bcs.ru Oil & Gas Timur Salikhov, CFA (ext. 4631) tsalikhov@msk.bcs.ru Electric Utilities Igor Goncharov (ext. 4622) igoncharov@msk.bcs.ru Consumer / Retail / Real Estate Tatyana Bobrovskaya (ext. 4666) tbobrovskaya@msk.bcs.ru Financial Services Olga Naydenova (ext. 4734) onaydenova@msk.bcs.ru Metals Kirill Chuyko (ext. 4733) kchuyko@msk.bcs.ru Oleg Petropavlovskiy (ext. 4680) opetropavlovskiy@msk.bcs.ru TMT Anna Kurbatova (ext. 4735) akurbatova@msk.bcs.ru Market Analysis Mark S Bradford (ext. 4681) mbradford@msk.bcs.ru Leonid Ignatyev lignatyev@msk.bcs.ru Dmitry Dorofeev ddorofeev@msk.bcs.ru Maria Radchenko mgradchenko@msk.bcs.ru Yulia Safarbakova ysafarbakova@msk.bcs.ru Artem Usmanov ausmanov@msk.bcs.ru Mitch Mitchell mmitchell@msk.bcs.ru Nikolay Porokhov nporokhov@msk.bcs.ru Elena Kosovskaya ekosovskaya@msk.bcs.ru Vladlen Garazha vgarazha@msk.bcs.ru Technical specialist Svetlana Fedorovykh sfedorovykh@msk.bcs.ru Industrials / Transportation Igor Kraevskiy (ext. 7564) ikraevskiy@msk.bcs.ru Quantitative Strategy Shan Jiang (+44 207 0652024) sjiang@bcsprime.com Private Client Service +7 (495) 785 7475 (ext. 2123) This research report is prepared by the Research Department of BrokerCreditService Ltd (hereinafter referred to as the Company) for information purposes only. Neither the information nor any opinion is intended to be, or should be construed as an offer, a recommendation or an invitation to make an offer, to buy or sell any financial instrument. This research constitutes neither investment advice nor tax advice and it does not take into account the specific investment objectives, risk appetite and financial situation of anyone who may receive this report. Investors should seek their own advice regarding the appropriateness of investing in any financial instrument or investment strategy discussed or recommended in this report. Investors should note that any income derived from investments in financial instruments may fluctuate and that the price or value of securities and investments may rise or fall. Accordingly, investors may lose their investment or receive back less than originally invested. Past performance is not a guide to future performance. Foreign currency exchange rates may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, there may be currency risk if investing in securities such as ADRs or GDRs. Investing in the Russian economy and Russian securities involves a high degree of risk and requires appropriate knowledge and experience. The information and opinions have been obtained from public sources that are believed to be reliable, but no representation or warranty is made by the Company with regard to accuracy. The opinions contained herein reflect the current judgments of research analysts and are subject to change without prior notice. All of the above considered, this report should not be viewed as the only source of information, and the Company, nor its affiliates or employees accept any responsibility or liability whatsoever for any direct or indirect damage arising out of or in any way connected with the use of information contained herein, nor for its authenticity. Investors should note that the Company and/or its affiliates may have or have had positions or derivative positions in the securities or other instruments referred to herein or make or have made a market or otherwise act or have acted as principal in transactions in any of these securities or instruments or may provide or have provided investment banking or consulting services to or serve or have served as a director or a supervisory board member of a company being reported on herein. The Company operates in the Russian Federation. This report can be used by investors on the territory of the Russian Federation subject to Russian law. The use of the report outside the Russian Federation is subject to the laws of the respective country. For distribution within the UK, this research report is intended only for eligible counterparties or professional clients (as defined in the FSA Rules) and should not be communicated to retail clients. This report may not be distributed, copied, reproduced or changed without prior written consent from the Company. Further information may be obtained from the Company upon request. 2013 BrokerCreditService Ltd. All rights protected and reserved.