ANNUAL REPORT 2016

Strategy and Business Review

Dear Shareholders,
Severstal is a focused, world-class business with a mission to be a leader in value creation.
I was very pleased to be appointed CEO of the Company in December 2016 and to join our extremely talented and experienced Management Board and work closely with our respected Chairman and Independent Directors.
Over the course of 2016, the Company has made further progress on its strategy to maximise shareholder value. This has involved a continued focus on cost and efficiency leadership, improving customer care, a prudent approach to capital expenditure and a commitment to sustainability and improvements in the area of health and safety.
Again this year Severstal delivered high shareholder returns through the generation of strong free cash flow, with higher than market average earnings. The strong performance across the business continues to be underpinned by Severstal’s low cost business model and supported by its dedication to developing its people and its corporate culture.
Despite the industry backdrop which remains challenging, the Company is strongly positioned to maintain its leadership in profitability and I look forward to helping the Company to move to the next level.

 

Alexander Shevelev
Chief Executive Officer

Severstal’s Business Model

Severstal is a vertically integrated steel and steel-related mining company with its major assets located in Russia.

Our business model is based on producing basic steel in a single location from iron ore and coking coal largely supplied from our own resources. Our current level of vertical integration is set out on page 22.

Our highly skilled, dedicated workforce, which is committed to incremental cost improvement enabled us, when combined with our low indebtedness to produce steel slab at one of the lowest costs compared with both local and global competitors.

Severstal is predominantly focused on supplying steel to the Russian domestic market. However, the Company’s assets are strategically located near to export markets. In times of changing currency dynamics or weaker domestic demand, the Company is well-positioned to switch sales volumes between its domestic and export markets to take advantage of higher margin demand given the favourable location of its assets.

We aim increasingly to produce value-added steel and we continuously seek to improve the quality of our products, supply discipline and service quality to build long-term customer partnerships.

Capital expenditure is planned over a long-term period and each investment must meet the strict internal rate of return (20%) or quality enhancing metrics, ensuring a disciplined and effective capital expenditure programme.

The business model allows Severstal to focus on maximising free cash flow and generate higher than market average earnings throughout the economic cycle enabling regular and strong dividends for shareholders from Severstal’s transparent dividend policy.

Strategy – focus on efficiency leadership, prudent investments and customer care

Severstal’s strategy is aimed at maximising shareholder value by ensuring that the Company remains one of the global industry leaders in terms of profitability, generating sustainably higher than market average earnings throughout the economic cycle. This translates into strong free cash flow and results in the Company’s ability to pay attractive dividends to our shareholders.

Severstal has developed a variety of competitive strengths and a clear growth strategy which it believes provides a greater resilience to the cyclical nature of the steel and steel related raw materials industries than many competitors and a basis on which to strengthen its position as a global industry leader. The five key elements of Severstal’s strategy are:

1. Cost and efficiency leadership

Severstal’s strategy is focused on enhancing product quality rather than increasing scale of production, underpinning the ability to generate higher earnings per tonne of product.

By creating incremental value through further efficiency improvements and cost control projects, Severstal maintains a leading competitive position against peers and offsets market risks. Severstal has already achieved a position on the left of the cost curve and aims to keep this favourable position by delivering continuous improvement.

Severstal’s Business System ensures that the Company is constantly innovating to achieve greater efficiency across its operations.

Global HRC production cash cost, $/t

What we delivered in 2016 – cost and efficiency leadership:

Initiatives within the Business System of Severstal continued to drive operational and organisational excellence along its entire value chain, improve customer satisfaction and promote a safety-conscious culture.

Since 2010, the Business System has primarily focused on culture change within the Group’s production departments in order to achieve cost reductions, improve working conditions and industrial safety, and enhance product quality.

The Company believes that the implementation of the Business System achieved these targets by fostering an ambitious and collegiate working environment which is more receptive to change and the adoption of new best-in-class business-processes.

Severstal’s internal Expert Network continues to focus on improving operational processes at ground level throughout the whole Company structure. Since the programme’s launch in mid-2015, 300 experts have been working on more than 600 small scale initiatives. Severstal is working to expand this network to 1,500 specialists by 2018. Specifically in 2016 the main focus of these initiatives in 2016 were:

  • Electric-arc furnace processing;
  • Underground coal mining, beneficiation process and open pit mining at Severstal Resources.

Although the majority of the “quick wins” from Severstal’s efficiency improvement mechanisms have already been realised, we delivered a further US$80 million contribution to EBITDA in 2016.

In the Company’s iron ore operations, Severstal has a consistent track record over recent years for maintaining a low cash cost for raw material production. Since 2012, in rouble terms, the cash cost of iron ore and iron ore pellets has remained relatively flat.

Cash cost dynamics, RUB*

During 2016, Severstal implemented several measures to improve costs and efficiency at its coking coal operations. These included:

– Stabilisation of production volumes. The majority of costs at Severstal Resources are fixed and therefore a stabilisation of production volumes results in a minimisation of fluctuations in cash costs per tonne.
– Partial substitution of outsourced personnel at Vorkutaugol with employees from the Severnaya mine.
– Control and reduction of production overheads.
– Mini-transformation programme at the Vorkutinskaya mine aimed at cost reduction (reduced by 13%) which will continue in 2017.

Across our steel operations, in 2016 cost reduction was supported by prudent capex initiatives and implementation of the project “Factory of ideas”.

The project “Factory of ideas” is Severstal’s internal system of collection and realisation of new ideas within the Company aimed at business processes optimisation, labour conditions and product quality improvement, as well as health and safety enhancement.

In 2016, Severstal continued to develop the following energy efficiency initiatives:

2. Customer care

Severstal’s success is built on long-term customer partnerships and a key pillar of the Company’s strategy is delivering improvements in customer care. Good customer care involves being responsive and flexible to clients’ changing needs. This includes ensuring we deliver consistent quality products; disciplined delivery; fast processing of orders; and additional services that meet our customers’ requirements. Severstal continues to be one of the leaders in customer care for the level of service and quality it provides and we strive to be the company of choice when it comes to purchasing steel.

When assessing customer care enhancement, the Company employs Net Promoter Score (NPS) metrics, whilst benchmarking results against previous performance.

NPS is an index which defines devotion of customers to a product or a company which they can recommend/promote.

Is widely used for estimation of iterative purchasing. NPS is calculated as the share of promoters less the share of detractors.

NPS

Severstal’s key customer care projects fall into three key groups:

1. Product quality;
2. Supply discipline;
3. Service quality.

What we delivered in 2016 – customer care:

Severstal has continued to make significant progress in its customer quality satisfaction indicator since the end of 2015, which is a measure of product quality.

Quality satisfaction

This was supported by the effectiveness of the Company’s Quality Assessment System. Severstal is changing its approach to product quality assessment and today Severstal evaluates product quality from the consumer’s perspective. Improvement initiatives in this area are focused on:

Severstal is also focused on supporting product quality through smart capex. In 2016, major product quality investment projects included:

– The construction of a second ladle furnace complex for steel production at Cherepovets Steel Mill.
– The upgrade of the 4-stand cold-rolled mill.
– Upgrade of the #1 edger of the hot-rolling mill 2000’s main drive and HAGC (hydraulic automatic gauge control).

The Company has plans for further blast furnaces and basic oxygen furnaces modernisation programmes.

In terms of supply discipline, during 2016 we continued to improve our planning tools. Our integrated IT-system now effectively covers all processes from receiving orders to production planning and supply chain control. Effective Product Portfolio management enables the Company to differentiate specific market segments and define optimal sales, production, planning and logistic strategy to fully address customer expectations.

Supply satisfaction

For Severstal’s commodity products, which have a diversified customer base and numerous purchases every month, Severstal employs simple forecasts in planning its production cycle to improve lead-times without building up inventories. For clients in the automotive segment, who demand considerably lower volumes of specific higher value-added steel products, the Company’s production planning method is more complex.

Even though our financial investments in customer care projects are relatively low at the moment, it is a key element in evolving our internal processes and culture, which allows us to better respond to a changing macro environment. Severstal is shifting from a B2B focus to a more customer centric model.

In terms of service quality, in 2016 we continued to develop our IT-related customer tools, including our mobile service and online orders. In 2016, Severstal relaunched its online shopping platform and online customer accounts. This helps to support proactive and regular engagement with customers, which is key to ensuring Severstal continues to meet their evolving needs by better understanding the balance between price and non-price factors affecting customer decisions. Another aim is to make communications between Severstal and its customers ever easier and more transparent from product order to delivery and aftersales service. Ongoing client feedback enables Severstal to enhance and adapt its customer service tools to satisfy our customers’ requirements.

Service expectations satisfaction

3. Smart capital expenditure

Our focus on delivering cost and efficiency improvements and developing our market leading customer focus are supported by a prudent and smart approach to investments that is flexible to market conditions.

What we achieved in 2016 – smart capital expenditure:

One of our key developments in 2016 was the development of the ‘investment direction’ foundation within Severstal, which manages capital expenditure projects across key areas including:

– Project management;
– Project institute;
– Building and repairs teams.

In 2017, Severstal plans to invest approximately 43 billion roubles across the business. This investment will primarily focus on developing key areas of the company’s strategy including cost control, increasing production of high value-added products and enhancing safety and customer care.

Approximately 17 billion roubles will be invested into the Severstal Resources division in 2017. 8.4 billion roubles of this will be invested in development of the assets. One of the most significant projects at the division is the implementation of a new multi-functional safety system at the Vorkutaugol mines. This will enable the company to locate staff and equipment across the mines in real-time and improve the monitoring and control of gas emissions. The company will also continue to invest in improving the stripping works.

Approximately 26 billion roubles will be invested into the Severstal Russian Steel division in 2017. 12.1 billion roubles of this will be invested in development projects including the construction of a new coating line and second ladle furnace at the Cherepovets Steel Mill. 1.7 billion roubles of this will be invested in IT and digital projects aimed at further operational and customer service improvements. 13.9 billion roubles will be invested in maintenance, environmental and health and safety projects.

In 2017, Severstal will concentrate on the following capital expenditure projects, which will not exceed US$ 700 million of investment.

4. Health & safety and people

One of the Company’s key objectives is to eliminate all fatalities across the business with health and safety continuing to be a key priority and focus of investment, as we strive to ensure tragedies such as at Severnaya in February 2016 will not be repeated.

Progress in health and safety is supervised directly by the Board of Directors’ HSE Committee which continues to ensure that the Company benchmarks its performance against global peers. Severstal has implemented a single set of health and safety policies across all assets to reduce lost time injury frequency rate (LTIFR). The Company remains committed to continuously improving health and safety procedures and equipment.

Severstal’s driving force is its dedicated workforce, united by a strong corporate culture and shared values. We value each and every one of our employees and aim to provide equal opportunities to all, from when they first begin their careers at Severstal, through the ongoing development of their professional skills. Many employees begin their careers at Severstal on either practical training courses or internships, which includes professional training, working with a mentor and other activities to help people develop their understanding of the production processes.

What we achieved in 2016 – health & safety and people:

In 2016 the average headcount at Severstal Resources was 12,914 employees, compared with 13,025 in the prior year. In 2016 the average headcount at Severstal Russian Steel was 37,115 employees, compared with 37,543 in the prior year.

In 2016, Severstal employees were participating in training programmes including Severstal’s Young Resources programme. This programme, which works actively with undergraduate university and high-school students, is aimed at developing future talent.

Read more about our industrial safety initiatives and processes and talent in the chapter “Responsibility”.

5. Sustainability

Part of Severstal’s strategic progress involves the reduction of its environmental footprint and promoting the efficient use and conservation of energy and natural resources.

What we achieved in 2016 – sustainability:

In 2016, Severstal continued to reduce air emissions through installing filters at its basic oxygen furnaces (BOF) and upgrading its aspiration units in sinter production and reducing dust emissions at its tailings facilities.

A number of further energy generator upgrades enabled the Company to increase its energy generation self-sufficiency to 78%.

In September 2016, Severstal and Rutgers Group launched Russia’s first top class coal-tar distillation facility for producing vacuum pitch which will reduce waste in line with European environmental standards.

Severstal remains committed to actively restoring the environment and improving water recycling, fast-track soil recultivation and planting new trees.

You can read more about our approach to sustainability and what we delivered in 2016 on page 34.

Outlook

Our focused business model and clear growth strategy continues to position Severstal to deliver outperformance throughout the economic cycle.

Looking ahead, steel producers globally still face the challenges of increasing protectionism across the world. This distorts global free trade principles and negatively impacts customers. Whilst Severstal complies with international trade rules, we continue to take initiatives to mitigate the impact of these restrictions on our performance by reducing costs, raising quality and service, increasing the share of high value-added products in the sales portfolio and diversifying our export markets. We believe that our strategy combined with our strong financial position will enable the Company to continue to deliver long-term shareholder value.

Severstal continues to deliver a steady performance driven by the strength of our operations and the management’s ongoing focus on enhancing efficiency. Following the contraction of Russia’s GDP in 2016, domestic steel demand softened during first the nine months of the year. However, many experts are forecasting the economy to strengthen during 2017, which should boost steel demand. Domestic sales have been impacted by reduced activity from local traders and domestic steel demand softening after a seasonal improvement in previous periods. In response to these conditions, the Company has increased sales to its export markets. Severstal’s proximity to both main export and domestic consumers allows it to shift flexibly between export and domestic deliveries each quarter, depending on the market environment. In addition, the Company increased its stock levels and replenished some steel inventories.

The Company’s vertically integrated business model, high quality and cost competitive operations, low debt level, and sizeable share of high value-added products in the portfolio, means that Severstal continues to be well positioned relative to both local and global peers.

Integrated Business Model

Positive impact of vertical integration on production cash cost of slab at Cherepovets Steel Mill, US$/t

Cherepovets Steel Mill production cash cost of slab, $/t