Severstal and MMK - High Dividend Yields in Focus; Upgrading to BUY

Yesterday, Severstal and MMK reported strong, above-consensus IFRS results for 3Q20. The positive earnings momentum may continue into 4Q20 given the guided solid sales volumes. The domestic steel price premium over the export netback remains at record-low levels, though we believe it should rise toward a more normal level next year. At spot steel export and bulk prices and the current USD/RUB rate, and assuming a $50/tonne average domestic premium next year, Severstal and MMK trade at almost 15% yields on dividends for 2021. We upgrade both stocks to BUY.> Severstal and MMK's 3Q20 IFRS results were above-consensus, with both companies demonstrating very strong FCF generation, with respective FCF yields of 3.5% and 6.4%, thanks to increased earnings and a working capital release. While in 4Q20 both companies' FCF will be pressured by rising capex and likely a working capital buildup, we believe that their positive earnings momentum will continue. Steel export prices grew sharply in the second half of August, and this effect will be fully reflected in the financials for 4Q20 given the lag of 1-2 months between spot prices and actual shipment. Meanwhile, domestic steel consumption remains unusually high for the late autumn because of pent-up demand following the lockdown. In addition, the government's mortgage subsidy program continues to support mortgage issuance and is leading to increased demand for steel from the construction sector. > The sharp ruble depreciation in 3Q20 caused domestic flat product prices to underperform export benchmarks. As for HRC, the domestic premium over the export netback remains close to zero, well below the historical average of $50/tonne and far below the $100-150/tonne seen in 2019. On the 3Q20 earnings calls, all of the Russian flat producers expressed a positive outlook for the domestic steel market, anticipating a rebound in the domestic premium in the near term. MMK was the most optimistic, expecting this to happen in 1-3 months, while Severstal and NLMK gave a time frame of 3-6 months. The differences in opinion probably owe not only to the companies' varying levels of optimism over the prospects for the domestic market, but perhaps also to their differing regional mixes and transport legs. MMK is more focused on Russia's Urals region, while NLMK and Severstal sell mostly to the Central region and have shorter transport legs to FOB. All in all, we think an increase in the domestic premium for HRC to $50/tonne in 1Q21 is highly likely.> We increase our 2020-21 EBITDA forecasts for both stocks, noting that our estimate for Severstal for next year is around 10% above the Bloomberg consensus. At spot commodity prices and the current USD/RUB, Severstal and MMK are trading at respective 12% and 10% yields on dividends for 2021. However, if we plug in a $50/tonne average domestic premium for next year, the yields rise to 15% for both companies. We consider these valuations an attractive entry point and upgrade our target prices to $15.80/GDR for Severstal and $6.70/GDR for MMK. We upgrade both to a BUY.