Severstal: Higher dividends, but still expensive (stays SELL)

Following the capital markets day, we expect Severstal to pay out 100% of its FCF as dividends after a change in the dividend policy. We believe this merits a higher target EV/EBITDA multiple (5.8x, in line with our target for NLMK, vs. 5.1x previously – its five-year average valuation). Combined with our updated macro forecasts, including higher short-term coking coal, iron ore and steel prices, a stronger rouble, as well as other modelling changes, we have increased our 2016/17E EBITDAs by 6% and 13%, respectively, and increase our price target (PT) by 21% to USD 12.7/GDR. This implies 8% downside from the current levels (zero total return when accounting for dividends). We reiterate our SELL, however, as it trades at unjustified 17-29% premiums in 2016-18E EV/EBITDA vs. NLMK, which has more organic growth, a similar dividend (and the potential to pay more with FCF yields over 10% p.a.). We expect the raw materials prices to fall faster than steel prices next year relative to current spot, resulting in an expansion of the steelmaking margin, which should favour NLMK over Severstal. We would advocate a long NLMK/short Severstal trade as this hedges out most of the steel price risk, plays the trend of the narrowing valuation discount and effectively takes a short position in coking coal, which seems reasonable, given that the spot price of USD 250/tonne is double the marginal cost of production. SVST’s current valuation seems to price in sustainable spot market steel prices vs. our lower 2017E price assumptions but, if this scenario holds, NLMK would be worth more than our USD 19/GDR PT.