Interview

20 March 2017 NLMK Group

It’s clear that we’re going to grow. This is a strategic imperative

NLMK Group CEO Oleg Bagrin spoke to Russian business daily Vedomosti about the interim results and the development of the Group’s strategy, the new information technologies in the steel sector and the consolidation that is underway.

The new development strategy up to 2018, which you presented at the beginning of 2014 was a drastic turn for NLMK. It was the first time you dedicated this much attention to upstream. Fast forward to the present and with the launch of new plant at Stoilensky you will be entirely self-sufficient in iron ore. NLMK used to be proud of its agility and its ability to outperform competitors, even without captive resources. Why has your focus shifted?

We haven’t really shifted our focus. Vertical integration has always been a part of our strategy. There’s one condition though: it has to bring value, not just control over resources. It must deliver exactly what we need for steelmaking and at a lower cost than the market can offer. This rationale was the driving force for our acquisition and development of Stoilensky.

The reason our resource base is our focus today is that NLMK has almost doubled steel production, from 9 million tonnes in 2007 to 17 million tonnes now. Meanwhile, captive iron ore production has lagged. Our strategy has enabled us to bridge this gap. We added 2 million tonnes of iron ore to our production and built a new 6 million tonnes pelletizing plant. This has allowed us to finally close the Group’s production chain.

INTERIM RESULTS OF THE STRATEGY

You promised shareholders your strategy would deliver a $1 billion increase in EBITDA. Where do you stand today?

Over the past four years, we completed more than 100 investment projects and around 2500 operational efficiency initiatives. Our 2016 results show that the effect on EBITDA to date is about $550 million, of which efficiency projects have contributed around $400 million.

What share of EBITDA growth is due to ruble devaluation?

This $550 million is entirely the result of our efforts, net of any market factors. It’s widely believed that the industry benefits from currency devaluation, but if you look closely you’ll see that in 6-9 months the impact disappears entirely. Almost three quarters of our costs: iron ore, coal, ferroalloys, refractory and so forth are either dollar-based or tied to global prices. Russia is part of the global market, so after ruble devaluation the prices of these materials revert to export parity.

Some of your costs, like payroll, are in rubles. Have these increased much since 2014?

Around 25% of our costs are pegged to the ruble. However, energy and transport tariffs are indexed annually, and our payroll in recent years is indexed quarterly. This adds to costs. Keep in mind that 2016 kicked-off with steel prices at a 12-year low of around $200 per tonne and our average product prices have taken a $100-150 hit since the devaluation. Multiply this by our sales volume and you have a $2 billion negative top-line impact. That’s much greater than any gains from the devaluation.

So how did you deliver your highest profitability in years?

By streamlining costs and through gains coming from investment projects.

But you haven’t reduced your operating costs by much…

You’d be surprised how much we’ve tightened our belts on operating costs. And we’re not alone in our commitment to operational efficiency. Our peers have been moving in the same direction since the turbulence of 2013-14.

The ultimate goal of your strategy was $1 billion additional profit. Are you on track to deliver on this promise?

Let’s wait until the 2017 results are in. Investment projects that are nearing completion will bring in additional $200 million. Our operational efficiency initiatives will chip in too. I hope at the end of the day we’ll have hit our targets. Already now there’s results we can chalk up. When we broke ground on our strategy early in 2013, NLMK’s EBITDA margin was 11%. By Q3 2016, it had reached 30%. Putting aside the financials, when I joined, NLMK was a single site in Lipetsk. Today NLMK Group is a unified production environment integrating 20 major production facilities across Russia, Europe and the USA. We have created a well-diversified, international company, the largest in Russia, with production volume of almost 17 million tonnes. This is another outcome of our strategy.

What will the goals of your new strategy be?

This year we began a new strategic planning cycle, our fourth overall. We’re currently modelling various scenarios and development paths, which range from a fairly conservative increase in steel output of around 1 million tonnes, to a more ambitious increase of 3 to 4 million tonnes. We’ll increase iron ore production accordingly so we remain self-sufficient. We’re looking at a few possible scenarios, but it’s clear that we’re going to grow. This is our strategic imperative. If any steelmaker has earned the right to grow, it would be companies such as NLMK. In any case, if you fail to grow you’ll fade into obscurity sooner or later.

STAY FLEXIBLE

The focus of the market is shifting downstream. If you could step back in time, would you still throw your chips on upstream development?

I don’t fully subscribe to the downstream argument, as there was a sharp increase in raw material prices during H2 2016. The price of coal tripled and iron ore doubled in price. If something triples in price in three months, it’s out of the ordinary, even in our industry, which has seen it all. Regarding upstream, we are quite happy about our expansion but it’s never wise to place a one-way bet in steelmaking. The industry is inherently cyclical, the margin is always shifting between markets and production stages. This means we have to control costs throughout the production process and be in all markets. If the margin shifts upstream then we need a position on it. If it shifts downstream then we need to be there too. The same applies to markets: we need a presence in both developing markets, where there is growth; and developed markets, where there is stability. This means it is critical to be well-diversified.

Our strategy covered several objectives: developing captive resources, operational efficiency, and growth in high value added product sales on our home markets. These objectives have been linked to various metrics and projects. In terms of upstream, we have achieved close control over costs, while downstream growth has enabled us to diversify. The Russian market is narrow in terms of both consumption volume and product mix. The country produces twice as much steel as it consumes and demand is concentrated in the construction industry consuming commodity products. Given the lack of depth in the Russian market, we created a chain of rolling operations in Belgium, France, Italy, Denmark, and the USA to process our steel. We also set up a distribution network that stretches from Singapore to Peru. Our aim is to turn steel into high value added products close to consumers, preferably to order, rather than simply exporting it.

This allows you to control costs right at the end of the production chain?

Yes, but it’s mainly about mitigating risks, such as margin migration, market closure or a drop in the demand for a particular product. Downstream growth is therefore a counter-cyclical strategy. NLMK today is the only Russian steelmaker able to sign global supply agreements with automotive, machine-building and yellow goods manufacturers and to deliver from our plants in Russia, Europe and the USA.

GLOBALISATION x PROTECTIONISM

You are putting together a very close-knit production chain, but there has been a spate of protectionist measures introduced in your main sales markets. Europe has already introduced anti-dumping duties on your cold-rolled products and is planning to do so for your hot-rolled products. Are you concerned they will impose duties on other products too?

Anything can happen, as the steel industry knows only too well. Today we stand at the very peak of protectionism, heights that haven’t been reached since the late 90’s. We exist between the two pillars of globalisation and protectionism. Countries have introduced 46 protectionist measures against Russian steel, with 12 investigations initiated in 2016 and 7 more upcoming. This includes the Middle East, India and Europe. I’m afraid to say it’s a widespread trend. Geopolitics are to blame in part, but China shoulders much of the blame.

They control 50% of global production…

China is exporting almost 120 million tonnes of subsidized steel. That’s enough to supply the Russian market for three years. It’s like a bull in a china shop. It’s a headache in many regions, but then the anti-dumping investigations into China result in duties against Russia. This has a serious impact on our sales markets. The most disruptive is the duty introduced by the European Union on our cold-rolled products, with an investigation underway into hot-rolled products too.

Russian steel companies, NLMK included, feel aggrieved about the conduct of the European Commission’s representatives, whom are accused of not giving consideration to your argument and acting improperly. Do you think something provoked them?

I don’t want to speculate about their motives. We’ve filed a lawsuit against the European Commission in the European Court and I believe an appeal to the WTO is in the works. Our position is quite straightforward: if the dumping margin is negative then anti-dumping measures are simply out of order. It’s a sad state of affairs when the rule book goes out of the window and anti-dumping measures are used as a political stick.

Politics today is very closely linked to the economy and will have a greater impact on the economic process…

Nevertheless, it is essential to respect the rules of free trade.

How do you plan to develop your international facilities? Do you have plans to construct new mills?

Our international facilities have shown strong growth in production, ahead of the curve in the European and US markets. Naturally, we are thinking about how we can continue to grow. For example, we have a major project in the USA coming up. We are revamping our rolling facilities so we can reach a new level of productivity and quality. Our expectation is that we will launch the project this year and complete it within two years. Expansion of product mix is another way. Good examples are high-strength and abrasion-resistant steels, and the steels designed for the automotive industry and offshore structures that we produce in Belgium, France, and Denmark. We plan to focus on developing R&D expertise to support growth in these technologically complex niche markets. We’re considering setting up two R&D centres in Russia and Belgium.

HOMEWORK

Do you plan to expand your rolling operations at Novolipetsk?

We are the only Russian steelmaker with a bottleneck in rolling (Novolipetsk steel production volume is 13 million tonnes, whilst the hot-rolling mill has an output in excess of 6 million tonnes – Vedomosti). We’ve used captive overseas rolling facilities as a means to close this gap, but have always considered increasing our rolling output in Russia. This is a bet on the domestic steel consumption growth, because exports are less attractive. We are mulling over the construction of a continuous casting and rolling facility. This is a very ambitious project: an end-to-end production, from steel casting right through to the manufacture of rolled products. Such a facility may also focus on production of niche grades, such as transformer steel.

Taking into account the conditions in the Russian market, do you believe there will be demand for niche grades of steel?

Russia is our core market, it accounts for around 65% of our rolled products sales. There is no denying that the Russian market is going through tough times. For instance, over the past 2 years, demand from the construction industry dropped by 20%, and from the machine-building down by around 30%. This is the sad truth. Growth in Russian finished steel consumption has been less than 1% per year for a decade. Of course, there are bright spots also, such as large-diameter pipes production. We are working on unique projects there in partnership with pipe manufacturers. But overall, the Russian market is rather anemic.

Is this where the idea to step outside the Russian market and your international downstream strategy came from?

Yes. I think in future we’ll develop our rolling capacity in Russia and at our international facilities in parallel. It is a little known fact that we supply every plant in Russia and Turkey producing ‘white-goods’: fridges, washing machines, microwave ovens and so on. Turkey is the leading supplier of white goods to Europe, so European white goods are most likely to be made from our steel. Every automotive producer in Europe is a customer of NLMK. There’s a good chance that your fridge, microwave oven, or European car was made with NLMK’s steel. This is our downstream strategy in action.

REDUCING DEPENDENCE ON COAL

Because the price of coal has increased in recent months, is there a chance you might launch a captive coal source as part of your new strategy? Especially since you already hold licenses for ‘Zhernovsky-1’ in the Kuzbass and ‘Usinsky-3’ in the Komi Republic?

The price of coal is artificially high. It’s not a case of if, but rather when during the next year we will see an adjustment. When it comes to captive coal sources, you have to understand the structure of the market and the nature of our consumption. The Russian coal market has long had a surplus of semi-soft coal and a deficit of premium ‘K’ and ‘Zh’ grades. If there are no new extraction projects then this deficit will only widen. So if we are to begin coal mining then we need to focus on premium grades. Now onto the structure of our coal consumption. In the past 2-3 years, we’ve made massive changes to our blast furnace and coking technologies. Even though our steel output has increased, we’ve reduced how much coal we buy to the tune of one million tonnes each year. We’ve also managed to cut the amount of premium grades of coal we consume by almost 50%, without compromising quality. At times, we had to import from the USA. Today, we use around 2.5 million tonnes of premium grades of coal and in 2017 this will drop to 2 million tonnes when we roll-out pulverized coal-injection technology. In today’s conditions, launching a couple of greenfield projects just to get 2 million tons of coal would be overkill. We are taking all the necessary steps to reduce our dependence on coal, especially scarce grades, but naturally, we’re keeping an eye on the situation.

The deficit of premium grades of coal is the result of the accident at Severstal’s ‘Severnaya’ mine in Komi. Where are you buying your coal from now?

After the accident at ‘Severnaya’ we’ve been sourcing almost 100% of our coal from Kuzbass.

ENDURANCE TEST

You discuss strategy, where and how you’re going to expand production. But if we look at the bigger picture, traditional steel is being gradually squeezed out by the materials such as composites and aluminium. How can traditional metals & mining compete with new types of materials, if indeed it can compete?

Steel is the most widely used material in the world after cement; and the market for steel is second in size only to oil & gas. Global steel consumption is north of 1.5 billion tonnes. Aluminium consumption is less than 10% of this; composite is less than 1%. But we have to acknowledge that the threat exists, and the steel industry cannot turn a blind eye to it. R&D is one possible response. We can devise new types of steel for the applications that new materials are created for. The technology of steel processing is so tailored to our products that replacing it in the short-term will be tough. A new material could be the perfect solution to a very specific application, but there is an array of other functions it struggles with, like painting and welding. Finally, I challenge you to find another material as cost-effective as steel.

Oil prices are going to go up, followed by steel prices. The higher they get, the more profitable it will be to use an alternative.

What makes you think alternative materials would get any cheaper in the same scenario?          

Am I correct in thinking that R&D can help create new markets? For example, aluminium manufacturers are contesting Construction Rules and Regulations, and State Standards that greenlight the construction of bridges, tunnels and buildings.

Actually, we’re contesting State Standards in Russia to make it possible to use grades of steel in construction that have been used in Europe for over three decades. If you look at the new construction in any European capital, you will see it’s a world apart from here in Russia. The cities look entirely different as a result. Moscow is awash with concrete; in Europe it’s all glass and steel. As for the new markets, they are bound to emerge because the world is changing fast.

So the recipe for success in the steel sector is working with the market, hand in glove?

There’s no such thing as a universal recipe for corporate success, or a silver bullet for that matter. There are complex, multidimensional strategies that underpin a company’s success. Vertical integration, strong diversification and localization are the cornerstones of a successful strategy in steel. 10-15 years ago, around 40% of production was for export, while today this has dropped to 25%. Steel is going local: it’s manufactured and consumed straight away, on the spot. Operational efficiency is another cornerstone to success. This is what we have learned from our experience. It is my hope that each of these elements will be a part of NLMK’s Strategy 2025. Finally, to be successful, a company must know how to nurture new capabilities as they arise. Technologies and products emerge and evolve very quickly. This means we have to be prepared for change, ready to evolve and to create new technologies and processes. It is a tremendous advantage for a company to be able to embrace change. Companies that are all about hierarchy and red tape are dinosaurs, the head has no idea what the tail is doing so they don’t notice they’re going extinct until it’s too late. You can find very different ways of doing things within any sector, both forward thinking and retrograde.

STEELMAKING AND I.T.

What tasks will your R&D centres focus on? Understanding what new steel grades buyers might want? Or spearheading your approach to new materials?

Let me explain. Think about all the different industries that consume steel: construction, automotive, power engineering, wind energy… We can’t always be one step ahead on trends across every single one of them. Our R&D’s key goal is to be our eyes and ears in the market, to make sure our innovations are in synch with what our customers need. As for new materials, a number of steelmakers have tried their hand at all sorts of materials, which always ended in tears. Steel is such a universal material it’s no surprise steelmakers have been unable to reinvent the wheel. Steelmakers are better off sticking to what they know and focusing R&D on the new grades of steel, rather than new materials. The industry should leave this to other market players.

What we definitely need to focus on is an in-depth understanding of steelmaking processes. For instance, we plan on splitting I.T. into two areas: traditional I.T. that deals with platforms and systems, and I.T. that deals with data. We don’t just collect information about our customers and products like a bank or a telco, we gather a huge amount of data on the products we manufacture as they pass along the production line. We get terabytes of data on the properties of materials and how they come about. This is a unique competitive advantage, but we only use about 5% of this ocean of data. We will pave the way for technological breakthroughs by developing technologies for processing and analysing big data.

What do you plan to do with this data?

A simple example. To get the properties of steel right it takes over a dozen technological processes and dozens of chemical elements. A customer wants an end product with a certain composition, but they don’t need to hear exactly how this product came about. But for a steelmaker this information is essential because it has a massive impact on process cost. Data analysis and process modelling are a gateway to more efficient technologies.

Are you thinking about setting up I.T. Steelmaking?

Let’s wait and see what name catches on. It’s definitely the direction the sector is heading in.

How much do you plan to invest into it?

That depends on how far our ambition takes us. There is certainly huge potential here.

Have you discussed the possibility of joining forces with I.T. companies?

Yes, we already collaborate with Russian and international IT companies.

Are there any partnership agreements in the immediate pipeline?

Yes.

INVESTOR SENTIMENT

You keep close ties with investors. Has there been a change in the sentiment among international investors towards Russian companies?

I don’t think the attitude of international investors to NLMK has changed. This is mainly a question of reputation and whether you keep your promises. In a sense, the aim of strategic planning is to promote transparency on our targets and our progress towards them. A company must be tangible to its staff and shareholders and able to explain its goals clearly. This is how investor sentiment is formed.

Overall, there has been a seismic shift in sentiment towards the Russian market, which is now less attractive to investors. Today 90% of Russian market liquidity comes from index funds, for whom questions of trust are simply irrelevant.

Is the structure of NLMK Group shareholders changing?

The funds investing in NLMK are actively managed, because NLMK shares do not appear in the indexes as a result of low liquidity. Distribution is stable: 30-40% are from Europe, 20-30% from the USA and approaching 30% from Russia. The rest are held by investors from Asia and the Middle East.

Are shareholders considering increasing the free float?

I can’t really speak for our shareholders. Low share liquidity is a concern from a management point of view. It’s definitely a bottleneck in the Company’s investment appeal. We are considering our response, because NLMK shares trade with a discount mainly because they slipped out of the MSCI index due to low stock liquidity.

Are you considering a follow-on offering?

No.

Has it become more challenging to attract financing? You must be looking into options for refinancing, extending debt maturities, as low as yours might be.

We are in a rather unique situation. Firstly, we have low leverage (NLMK Net debt/EBITDA at the end of Q3 2016 stood at 0.4 – Vedomosti). Secondly, NLMK is one of the few Russian industrial companies with an investment grade rating. This means we have access to a wide range of financial instruments. Last year we placed Eurobonds cheaper than the sovereign debt, so I wouldn’t say there is much cause for concern. Our clients have been feeling the pinch, however, particularly those looking at ruble financing for their working capital. They really struggled with credit in 2015. We worked with them to find a solution on a case-by-case basis. They’re now accustomed to the new reality and rates have come down, which is a big relief.

You were considering issuing convertible bonds. Why did you give up on the idea?

We use vanilla instruments: Eurobonds, trade financing. These make more sense given the low price of our shares, stock dilutions and the option premium we give to the market. NLMK’s balance sheet capacity means it’s more efficient to use standard instruments for the time being.

CONSOLIDATION OF THE SECTOR

Are you considering making any acquisitions? In recent years, steelmaking companies have built up significant reserves, but nobody is making any acquisitions. Why is that?

M&A are not a goal by themselves, but a means by which to achieve other strategic objectives.

For example, in order to enter the Indian market you have to either make an acquisition or to invest in a stake in an entity.

That’s exactly what we did, we acquired a network of service centres to process electrical steel. We’ve been successful and have gained a significant market share (23% in 2015 - Vedomosti). Our current strategy doesn’t feature any M&A goals, but that doesn’t mean they won’t have a place in our forthcoming strategic phase beyond 2017.

So a downstream facility in Russia could be on the agenda?

Everything is possible, but opportunities are thin on the ground.

You could propose a merger with MMK, become the undisputed champion in one fell swoop.

That’s a new one on me <smiles>. We’ve already achieved leadership in steel output. Leadership in efficiency wouldn’t be a likely outcome from such a megamerger. We’d have to drop everything and spend the next three years simply processing the merger. Just imagine the challenge the two management teams would face to make sense of it.

In 2014 you said that the market was consolidating…

Look, NLMK’s output has expanded consistently over the past 5 years, during which there has been no overall growth in Russian steel production. This means someone else reduced their output or shut up shop entirely. This is consolidation in action. We could follow Japan, where there are only two steelmakers on the market, but I don’t think that would be very efficient.

HORIZONTAL COMMUNICATION

Did you have to radically rework the structure of the Company when you took the reins?

Yes. We did away with the old hierarchical model and introduced a number of horizontal lines of communication. Roles were reorganized. The most important outcome is far closer collaboration, which is crucial for a tightly vertically integrated player such as NLMK. Most of our sites serve one another; so interaction is vital. We had to break down a lot of barriers.

Was that difficult to do?

Some people took to the change like a duck to water; others less so. Many of those who were used to the hierarchy moved on. Those comfortable working in a network with horizontal communication stayed.

How are the relations between your Russian and international companies working out? The current context is not really conducive to international dialogue.

We put a lot of effort into building them using different tools. The simplest was setting transparent targets. Mind-sets change when people understand they’re working towards a common goal whether they’re based in Russia or Europe, rather than different goals for individual sites. It helps them see how the Group’s other sites are clients and that their fortunes are interconnected. Communication with colleagues becomes crucial, even more so than communication with the CEO.

Tell us about your management incentive scheme. Does NLMK have any plans for an option programme?

I don’t think Russian equities are a good incentive as there is no direct correlation between market volatility and company performance. We introduced a three-level scheme for motivation. On top of salaries, we award annual bonuses tied to individual KPIs. The third component is a 5-year incentive programme. This initiative is based on teamwork, rather than individual performance. Rewards are tied to our progress towards the strategic goals we’ve announced to our shareholders. It’s crystal clear: either the goals are achieved or they are not. Market or currency factors have no impact. This makes sure the interests of our team and our shareholders are perfectly aligned.

EMBRACING LEADERSHIP

How did you come to be on Mr. Lisin’s team? Was it a long time ago?

We met in 2002, before which I worked in finance. I brought this expertise to my new team, managing financial assets and investment funds. There was a solid deals pipeline right from the start, like the sale of a 5% stake in Norilsk Nickel in 2004 through a concurrent offering of GDR and exchangeable bonds. I went on to serve NLMK’s Board of Directors, supervising all M&A and capital market transactions, including our IPO. I had a role in devising our strategy; and in 2010 I headed up NLMK’s Strategic Planning Committee.

Do you find working with Mr. Lisin interesting? Did he ever tell you that one day you’d be the CEO, or that’s just how things turned out?

It’s just how things worked out. I never actually set the goal of becoming CEO. Do I find the work with Mr. Lisin interesting? Of course I do. How else would I have been able to hang in there for so long? I can remember my first impressions: a highly motivated team that had an impressive experience managing complex industrial systems. I also recall how extensive and constructive the agenda was, ambitions to drive forwards, investment programmes, industrial plans...

There were rumours that Mr. Lisin holds meetings that run past 3 a.m.; and then at 7 a.m. he sends out emails asking if draft resolutions were ready yet.

I guess our meetings were more efficient as we’d usually be done by midnight (smiles).

Is Mr. Lisin actively involved in life at NLMK?

Sure, he’s a Chairman of the Board. Everyone does their bit. The management team deals with operational management, and the Board of Directors looks after strategy, development, and large-scale projects. That’s exactly how it should be and it’s great we’ve got there.

What do you prefer: financial operations or strategic planning?

They are both an intellectual challenge. Markets in a reactive sense, with lots of fast data and analytics. Strategic planning is a more long-term challenge; though there is just as much data to sift through. I guess the key difference is that now I have to deal with major physical, organizational and social systems. Interaction and human relations play a huge part. The challenges and drive are unique.

Is it true that you climbed Mt. Everest?

No, but I’ve been to the base camp.

How long have you been mountain climbing?

Twelve years.

What’s the highest peak you’ve been to?

I’m more driven by the nature of the route. Plus I don’t really have the time for long, high-altitude expeditions. It’s always a joy to visit the Alps. You can get away for a weekend and climb a particular route, alpine style. The north walls are a personal favourite. Each one is legendary; and they all require special training. Maybe when I retire…

People say that mountain climbing nurtures a sense of balance.

Mountain climbing nurtures a lot of things. A completely different awareness of risk and safety, for one. You develop a unique rapport with your climbing partner, a deeper interaction and understanding of the people around you.

The interview was published in Vedomosti newspaper (#4243) on 18.01.2017. Authors: Alexandra Terentieva, Vitaly Petlevoy.