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By John Helmer in Moscow

Sometimes it can happen that men of steel have a soft underbelly. It’s to protect that that they wear armour-plate.

The release this week of group financial results for Severstal, the third ranked Russian steelmaker owned by Alexei Mordashov, exposes the high cost, and poor judgement perhaps, of Mordashov’s purchases of US steelmaking and coal assets last year.

According to Uralsib Bank steel analyst Michael Kavanagh, “the consensus [is] that Mordashov bought the US assets as a hedge against losing the Russian assets. However, bear in mind that the Russian steel operations are subsidising all other assets. With hindsight, all acquisitions made in the last two years will look expensive. Acquisitions should be judged over time and through the cycle. However, it does look like they [Severstal] over-paid in the context of today’s market.”

According to Severstal’s financial report for 2008, issued last week with auditor’s notes by KPMG, a total of $1.54 billion has been written off against 2008 operating profits, slashing the pre-tax profit figure by almost 50%. The comparable writeoff loss for 2007 was $28.9 million; $57.8 million in 2006.

Mordashov is quoted in the company’s press release, accompanying the financial report, as claiming that a healthy 44% increase in the group’s 2008 revenues (to $22.4 billion) was “due to strong demand in the first nine months of the year, a favourable price environment and the consolidation of our assets in North America.” Mordashov was coy when it came to explaining the unprecedented loss of asset value. The public statement says: “There was an exceptional drop in the demand for steel in Q4 2008. This, combined with valuation adjustments of $411 million on inventories to NRV and a $1,540 million of impairment of non-current assets, contributed to a net loss of $1,208 million in the last quarter.”

Nowhere in Mordashov’s public statement is there any mention that most of this “impairment” was caused by the loss of value of the American assets Mordashov has recently purchased. All that he could find to say about the performance of these assets was how much better they are doing than before he paid premiums to take them over a year ago; and also how successful the company’s lawyers have been in claiming insurance and contract violation pay-outs.

Again, according to Mordashov, “at Severstal International, our North American operations showed $377 million of EBITDA in 2008 compared with negative $50 million in 2007. This includes a $156 million one-off gain relating to the buyout of a long-term electricity supply at Dearborn, a $267 million one-off gain relating to an award from A.T. Massey Coal Co. in connection with a breach of a contract with Wheeling-Pittsburgh Steel Corporation and a $152 million portion of insurance settlement proceeds (net of losses) related to an incident at the Blast furnace B in Dearborn.”

In the small print of the financial report, however, at auditor’s notes 8 and 23, it is revealed that Mordashov accepted a writedown or loss in value of PBS Coals, bought last October, of $361.1 million. The Wheeling steelmills, bought last August, were written down by $621.8 million. The Warren plant, purchased last July, lost another $382.6 million. Altogether, these three American losses amounted to $1.37 billion. By contrast, Mordashov lost just $29 million off the value of the one Russian asset impaired — the steel trader Neva Metall. The writedown at Severstal’s European mill group, Lucchini, was just $3.8 million.

Severstal claims to be the fourth largest steelmaker in the US, with annual crude steel production capacity of 3.2 million tonnes. It also owns coalmines, coke batteries, galvanizing and steel-coating production units. The company initially agreed to pay $1.3 billion in cash for PBS Coals, but between last August and October, it negotiated a discount, and ended up paying $998 million. After the writedown, Mordashov concedes his asset is now worth $637 million.

The Wheeling assets cost Severstal $775 million; they have now lost 80% of their value, and are worth just $153 million.

The Warren plant had been in bankruptcy before Severstal offered last July to pay $140 million in cash, and accept another $230 million in debt. The disclosure of a writeoff of $382.6 million is more than the deal cost; thus, in effect, doubling the financial burden minority shareholders were told they would have to carry, when Warren was bought. At the time, Greg Mason, the Severstal executive in charge of North American operations, claimed: “steel production in Warren has long contributed high-quality products to a region that is at the historical center of steelmaking in the US. Severstal is ready to carry that tradition forward in a way that is consistent with our strategy for growth and investment in North America; a strategy that views the experience and talent of the people at WCI Steel as a key part of Severstal’s continued success.”

The financial report for the year claims that, offsetting these losses, there have been profits since the takeovers took effect. Wheeling is reported to have earned $30 million in profit. Warren and PBS Coals have reported losses, however — $41.7 million and $6 million, respectively.

Severstal management was asked this week to clarify the terms of this “success”. However, they have refused several requests to clarify how Severstal’s US assets are legally owned within the group; or whether they are held outside the group by Mordashov. The available company documents indicate there are 14 companies owning the US assets, which are listed as subsidiaries of the Russian registered OAO Severstal. Two of these, Severstal US Holdings LLC and Barakom Ltd, are listed as 100% subsidiaries. The first is identified as a US corporation; the second as a Cyprus corporation. Baracom appears to have been privately owned by Mordashov, and was used as a vehicle to acquire US asset stakes for resale to the Severstal group. According to an auditor’s note, he sold Baracom’s 80% position in a North American joint venture called SeverCorr, a new flat-steel mill in Mississippi, to the parent company for $84.4 million.

Severstal was also asked to explain whether the substantial asset value writedowns reported for Severstal’s American operations may be interpreted as an admission of the strategic mistake in buying the assets in the first place. Mordashov’s spokesman, Olga Antonova, declined to respond to these emailed questions. She hung up the telephone when asked directly.

Troika Dialog steel analyst Sergei Donskoy was asked whether Mordashov would continue to control the US steel and coal assets unimpeded, if Severstal’s Russian assets were to be taken over by the state. “The US assets are owned by [Russian incorporation] OAO Severstal, but not directly. I think through daughter companies.” He declined to say if he believes the size of the writedowns suggests there was a misjudgement by Mordashov in buying them.

According to Kavanagh, “at the year end, accounting principles require assets to be tested for impairment. Hence, this was done now. We will likely see large write-downs from Evraz and Mechel, too.”

The new financial report from Severstal indicates that 40% of the group’s sales revenues were earned by deliveries inside Russia. At the back of the financial report, there is also a breakdown of sales, costs and profits by geographic division. It is disclosed that of aggregate group sales of $22.4 billion, the Russian steel division contributed $11.3 billion, or 50%. The American sales total was $5.3 billion, or 24%. The cost of these sales amounted to $5.8 billion in the US, or 35% of the aggregate, compared to the Russian cost of sales of $7 billion, or 42% of total. This is a clear sign that Mordashov’s US units were more costly in relation to their earnings than the Russian ones.

The current asset sheet for the group shows that Russian value dwarfs American — $9.3 billion to $1.5 billion.

On the bottom-line, the Severstal North America group is reported to have made an after-tax loss of $373 million. By contrast, the Russian steel division reported a profit of $1.9 billion. The Russian profit amounted to 90% of the entire group’s profitability. Without the Russian mills, Mordashov would not have had the cash or the borrowing capacity to buy his American mills and mines, nor to subsidize the extraordinary writeoffs his accountants have obliged him to disclose now. So what is the value of loss-making US steel assets to a Russian like Mordashov, if not as a safe haven for the future, when his balance-sheet might be scrutinized by the Kremlin more carefully than has happened to date?

“Diversifying country risk may prove to be a positive,” Kavanagh responds. “This will likely be highlighted by Evraz. They may be able to help their Russian operations maintain higher operating rates by sending semi-finished steel to their US mills. US assets also help to move the overall product offering up the value chain. The Evraz acquisition strategy [in North America] is easier to understand than Severstal’s, though.”

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