Stainless Steel SECTOR FORECAST. Source: Credit Suisse research

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1 Europe / Belgium & Finland & Spain Equity Research Steel Research Analysts Michael Shillaker michael.shillaker@credit-suisse.com James Hanford james.hanford@credit-suisse.com James Gurry james.gurry@credit-suisse.com Specialist Sales: James Brady james.brady@credit-suisse.com Stainless Steel SECTOR FORECAST Favourable fundamentals vs. carbon We think stainless steel's fundamentals are stronger than carbon steel's at this point in the cycle. We upgrade Outokumpu to Outperform from Underperform (new TP 0.26 from 0.15). We downgrade Aperam to Neutral from Outperform (new TP 21 from 16) and Acerinox to Underperform from Neutral (new TP 7.30 from 7.76). (1) Rising nickel prices: The Indonesian export ban on unprocessed nickel ore has helped reverse the two-year decline in the nickel price. Chinese Nickel Pig Iron producers need Indonesian ore to produce via the cheapest RKEF method, and are likely to see their cost position move from positive to negative, pushing the nickel price and stainless price higher. Stainless benefits (and suffers) from volatile restock (destock) cycles, driven in part by nickel pricing. (2) Improving end demand: European stainless producers have passed on two rounds of base price increases since Sept. 2013, and our channel checks suggest end demand is stronger for stainless than carbon steel at this point. (3) Material supply reductions in Europe: Outokumpu is scheduled to remove c.1mt of capacity over the next two years, allowing European producers to price at the top end of the natural corridor vs. the Asian export price. Outokumpu has materially underperformed over the past two years with good reason, making deep losses following the problematic Inoxum merger. However, post-rights issue and with Terni/VDM divested, Outo is left with a solid asset base and manageable balance sheet. We think the share price will eventually reflect this and believe investors should start considering Outokumpu again. Acerinox has a market-leading position in the US. However despite Acerinox's solid core we see a lack of opportunity for earnings growth. We also show why we think proceeding with Phases 3 and 4 of the Bahru project may not maximise shareholder value. Aperam's monopoly position in the structurally tight and import-protected Brazilian market remains a great advantage vs. peers. However, the stock's recent rally means potential upside looks more limited. We also note the risk of the anti-dumping duties in Brazil being removed by a new government, which would hurt earnings. Figure 1: Summary of ratings changes Stock New rating Old rating New TP Old TP Outokumpu OUTPERFORM UNDERPERFORM Aperam NEUTRAL OUTPERFORM Acerinox UNDERPERFORM NEUTRAL Source: Credit Suisse research DISCLOSURE APPENDIX AT THE BACK OF THIS REPORT CONTAINS IMPORTANT DISCLOSURES, ANALYST CERTIFICATIONS, AND THE STATUS OF NON-US ANALYSTS. US Disclosure: Credit Suisse does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. CREDIT SUISSE SECURITIES RESEARCH & ANALYTICS BEYOND INFORMATION Client-Driven Solutions, Insights, and Access

2 2011 Q Q Q Q Q Q Q Q Q Q Q Q Q1 24 March 2014 Key charts Figure 2: European stainless producers vs nickel YoY 80% 60% 40% 20% 0% -20% -40% -60% -80% 04/03/ /06/ /09/ /12/ /03/2014 Figure 3: European stainless producers vs nickel rebased /03/ /06/ /09/ /12/ /03/2014 LME-Nickel Cash U$/MT APERAM LME-Nickel Cash U$/MT APERAM OUTOKUMPU 'A' ACERINOX 'R' OUTOKUMPU 'A' ACERINOX 'R' Source: Thomson Reuters Source: Thomson Reuters Figure 4: German and US 304 conversion margins ( ) German conversion margin ( /t) 430 German conversion margin ( /t) Source: CRU Figure 6: LME nickel vs. world stainless production 250% 80% Figure 5: US distributor months of supply on hand Jan-90 Oct-92 Jul-95 Apr-98 Jan-01 Oct-03 Jul-06 Apr-09 Jan-12 Carbon steel Stainless steel Source: MSCI Figure 7: Global stainless vs. carbon steel production (kt) 160, % 60% 140, % 100% 40% 20% 120, ,000 80, % 0% 60, % Jan-96 Apr-98 Jul-00 Oct-02 Jan-05 Apr-07 Jul-09 Oct-11-50% -20% -40% 40,000 20, % -60% 0 Jan-95 Jun-97 Nov-99 Apr-02 Sep-04 Feb-07 Jul-09 Dec-11 0 LME Nickel cash Global stainless prodn Global carbon Global Stainles Source: Thomson Reuters, CRU Source: WSA Stainless Steel 2

3 Table of contents Ratings changes 5 Stainless: favourable fundamentals 7 1) Nickel 8 Rising surcharge = better distributor demand 8 The importance of the Indonesian ban 11 Will the ban stay in place? The key question 12 2) Demand and base prices 14 Underlying demand improving 14 permitting base price increases 16 but only to the top of the global price corridor 17 3) Supply 19 Europe: Supply tightening with Inoxum closures and Outo streamlining 19 Anti-dumping measures in Europe? We assume no for prudence despite Eurofer intention 20 4) The broader macro picture: Continuing to cast a shadow 21 Outokumpu (OUT1V.HE): Hurdles overcome, ready to run 22 Summary 24 Following Nirosta closures, Outo will be left with a solid asset base 25 1) Tornio 25 2) Calvert 26 and balance sheet has improved 27 Earnings road map 28 Aperam (APAM.AS): Shares now pricing in the strength 32 Brazil monopoly the key advantage 34 Strategic cost-reduction programme continuing to produce visible savings 35 Valuation 37 Acerinox (ACX.MC): Exploring the strategic options 39 Summary: Is shareholder value maximised if Bahru Phases 3 and 4 are undertaken? 41 Solid business in recovering market 42 but lack of catalysts 43 Bahru at a crossroads 43 Option 1: Proceed with Phase 3 and 4 of the Bahru expansion 47 We use a WACC of 9.2% 47 First phases self-financed, 3 and 4 likely through the bond markets 48 What would the balance sheet look like? 48 Key assumptions 48 The result 49 Option 2: Forgo phases 3 and 4, continue using Columbus 50 Key assumptions 50 The result 51 Valuation 52 Stainless Steel 3

4 Summary Figure 8: The circular nature of demand Indonesian export ban Price of nickel ores Price of nickel pig iron 24 March 2014 Price of nickel metal European supply reduction Stainless prices Distributor demand Alloy surcharge Source: Credit Suisse research End demand Low stainless inventories In this report we discuss the favourable sector-specific fundamentals of the European stainless industry vs. carbon steel, and provide company updates for Acerinox, Aperam and Outokumpu. We upgrade Outokumpu to Outperform from Underperform (TP 0.26 from 0.15), downgrade Acerinox to Underperform from Neutral (TP 7.3 from 7.76), and downgrade Aperam to Neutral from Outperform (TP 21 from 16). At a time when we have turned cautious on carbon steel owing to poor China and US data with our channel checks suggesting that Italian HRC prices are rolling over, we believe stainless steel looks to have considerably better fundamentals for the following reasons. As shown in the above table, the demand improvement for stainless can be considered circular with a positive feedback mechanism. Commodity cycles are driven by inflationary expectations of that commodity, and we think the combination of this with the factors discussed in this report gives the stainless market favourable fundamentals at this stage. 1) Rising nickel and an increasing surcharge. The Indonesian export ban on unprocessed nickel ores and the possibility of sanctions against Russia have helped reverse the consistent two-year decline in nickel. Chinese NPI producers are likely to see their position on the cost curve move from positive to negative and nickel demand rise (pushing the nickel price and stainless transaction prices higher. Stainless benefits (and suffers) from volatile restock (destock) cycles, driven in part by nickel pricing. 2) Improving end demand and base price increases. European stainless producers have passed on two rounds of base price increases since September 2013, and our channel checks suggest demand is strong in the stainless end markets compared with carbon, while inventories remain very low. 3) Tightening European supply. Outokumpu is scheduled to remove c.1mt of capacity over the next two years, bringing supply in line with demand and allowing European producers to price at the top end of the natural corridor vs, the Asian export price (which is likely to see rise driven by cost curve changes). 4) Self-fulfilling cycle. As such we have the real possibility of a self-fulfilling cycle driven by better demand, inflationary expectations and tighter supply (of nickel and stainless steel). This is shown in Figure 8. The broader macro, however, continues to cast a blanket of risk over the stainlessspecific fundamentals. We discuss in detail each of the points above, and then in the final section discuss the reason for our caution on the broader macro situation. We do not address the macro issue in detail in this report as we have discussed it extensively in our recent industry notes such as Demand: Mixed messages (18 February) and Slowdown but not (yet) out (21 February); however, the broader macro picture does continue to lend to uncertainty at this stage, despite the sector-specific fundamentals in stainless being superior to those for carbon in our view. Stainless Steel 4

5 2013E underlying EBITDA P150 impact Inoxum synergies EMEA restructuring measures FeCr ramp up impact 10/t underlying base price increase Calvert ramp up impact 2014 EBITDA P150 program impact Inoxum synergies EMEA restructuring measures Ferrochrome ramp up impact 10/t underlying base price increase Calvert ramp up impact 2015E EBITDA EMEA restructuring measures 10/t underlying base price increase 2016E EBITDA 24 March 2014 Ratings changes Outokumpu: upgrade to Outperform, TP 0.26 Figure 9: European stainless companies vs. nickel YoY 80% 60% 40% 20% 0% -20% -40% -60% -80% 04/03/ /06/ /09/ /12/ /03/2014 Figure 10: European stainless companies vs. nickel rebased /03/ /06/ /09/ /12/ /03/2014 LME-Nickel Cash U$/MT APERAM LME-Nickel Cash U$/MT APERAM OUTOKUMPU 'A' ACERINOX 'R' OUTOKUMPU 'A' ACERINOX 'R' Source: Thomson Reuters Source: Thomson Reuters We upgrade Outokumpu to Outperform (from Underperform), and increase our target price to 0.26/sh from 0.15/sh. The above charts show the material underperformance of Outokumpu vs. its European peers and nickel over the past two years. This is with due reason in our view. Prior to the Thyssen transaction and rights issue, the company was in an unfavourable position, with weak share price performance. Figure 11: Outokumpu EBITDA bridge to 2016E Source: Credit Suisse estimates Stainless Steel 5

6 Now, however, we think that the necessary hurdles have been crossed, and Outokumpu will be left with a strong asset base that management should be able to make profitable. We think the share price will eventually reflect this and we recommend that investors start considering Outokumpu again. The above bridge shows how we think Outokumpu's EBITDA will progress from 32m underlying in 2013 to our estimate of 568m in Tornio will be 100% self-sufficient in Ferrochrome by 2015E. Tornio is the second-lowestcost FeCr producer globally as a result of the captive ore at Kemi, which we think gives Tornio a significant cost advantage vs. its European peers. Acerinox: downgrade to Underperform, TP 7.3 Acerinox has historically been the most constant of the stainless names, enjoying a market-leading position in the US with its highly efficient NAS mill in Kentucky, and retaining its sole European mill at Gibraltar, while the rest of the industry saw heavy consolidation. However, with Outokumpu ramping up its world-class Calvert mill, we think there is a risk that some of NAS's market share for high-value clients will be taken. We also note the significant capex to proceed with phases 3 and 4 of its Bahru expansion programme in Malaysia. Hence we downgrade Acerinox to Underperform (from Neutral) and reduce our TP to 7.3 (from 7.76). In this report, we discuss whether Acerinox's shareholders would be better off if phase 3 and 4 are not approved, and if the c.$700m capex on those phases is saved and instead black coils continue to be shipped from Columbus to be finished at Bahru. To do this we look at what the NPV would be to shareholders under each path by discounting the free cash flow to equity under each path based on several important assumptions. Under this set of assumptions we find the final two phases to have negative NPV, while proceeding with shipping band from Columbus would be value accretive. In light of this analysis, we conclude that it could make more sense for Acerinox to not go ahead with the meltshop expansion of Bahru, and instead continue to ship the hot band from Columbus and Spain to be cold rolled at Bahru. Aperam: downgrade to Neutral, TP 21 Aperam has remained our preferred name within the European stainless space for the past year. However, owing to risks relating to anti-dumping duties in Brazil, we downgrade Aperam to Neutral (from Outperform); although we still like the company's profile, specifically its monopoly position in Brazil where margins are far higher than in Europe as a result of the Brazilian government's protectionist policies on stainless and electrical steel. We increase our TP to 21, from 16, however, as potential upside looks limited. We note the risk here of the anti-dumping duties that are currently in place being removed, which would have severe consequences for earnings. Stainless Steel 6

7 Stainless: favourable fundamentals Figure 12: Summary of stainless fundamentals Availability of saproilitic ore for Indonesian export ban RKEF-derived NPI # Nickel price 1 Alloy surcharge 1 Source: Credit Suisse research Improving end demand 1 Distributor demand 1 Base prices 1 Outokumpu capacity closures # European supply 0 Utilisation rates 1 At a time when we have turned cautious on carbon steel given poor China and US data, with our channel checks suggesting that European steel prices are rolling over, we think stainless steel looks to have better fundamentals for the reasons discussed in this section. (1) The importance of nickel in determining stainless steel demand. We think nickel has stabilised at these levels, and that there is potential upside to prices given the Indonesian export ban on saprolitic ore which is used in the cheapest production process for producing NPI, the rotary kiln route. Key will be whether the surcharge remains in place with the presidential elections in July. Around half of the European and US stainless steel transaction price is the alloy surcharge, which is primarily determined by nickel. In a rising nickel price environment, this encourages distributors to restock. After two years of decline, the nickel price now appears to have stabilised and is indeed rising, with consensus for it to rise further. (2) Better base price outlook. Since September, European producers have passed on two rounds of base price increases. This is partly because of improving end demand in the stainless market, and partly because according to our channel checks Outokumpu is now taking on the responsibility of being the price leader. Historically, Inoxum had been the price leader, but following the merger Outokumpu had not been adequately taking on the responsibility. (3) Tightening European supply. Outokumpu has c.1mt of capacity closures scheduled over the next 18 months, which should see the European demand and supply brought into balance. Although European producers need to be careful that they do not raise prices above the natural corridor vs. the export price, the closures mean they should be able to price at the top of this corridor. Figure 13: Credit Suisse European stainless supply forecasts Europa Genk Chatelet Guegnon Isbergues Imphy Tornio Krefeld Dillenburg Bochum Sheffield Avesta Kloster Nyby Degerfors Terni Others Source: Company data, Credit Suisse estimates Stainless Steel 7

8 1) Nickel Figure 14: How nickel fits into the circular nature of demand Indonesian export ban Price of nickel ores Price of nickel pig iron Price of nickel metal European supply reduction Stainless prices Distributor demand Alloy surcharge Source: Credit Suisse estimates End demand Rising surcharge = better distributor demand Low stainless inventories Figure 15: LME nickel (LHS) and 304 surcharge (RHS) 50,000 3,500 45,000 3,000 40,000 35,000 2,500 30,000 2,000 25,000 20,000 1,500 15,000 1,000 10,000 5, Jun-05 Jun-07 Jun-09 Jun-11 Jun-13 LME-Nickel Cash U$/MT Alloy surcharge ( /t) Figure 16: LME nickel standard deviation Oct-05 Oct-06 Oct-07 Oct-08 Oct-09 Oct-10 Oct-11 Oct-12 Oct-13 Source: Thomson Reuters Source: Thomson Reuters The first point to make is on nickel. In the stainless market, transaction prices of each grade consist of: (1) The base price (2) An alloy surcharge to reflect the movement in the cost of alloying elements, partly the likes of chrome and for more advanced grades other elements as well, but in standard austenitic (i.e. high Ni content stainless) grades the surcharge mostly reflects the price of nickel. As a result of the export ban on Indonesian unprocessed ore and the possibility of sanctions against Russia, it seems that we have started to see a flattening in the nickel price and hence the surcharges of key nickel-based grades. The standard deviation of the LME nickel price has reduced sharply versus the volatility in the nickel price in , as shown in Figure 16 and in February the surcharge increased. Nickel is a crucial determinant of distributor demand This is a welcome change. The virtually constant decline in the nickel price has been a problem for stainless demand over the past two years, as the alloy surcharge makes up around half of austenitic transaction prices (and austenitic is around 60% of stainless, Figure 17). Stainless Steel 8

9 1999 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q4 24 March 2014 The reason for this is that in a declining nickel price environment, distributors will hold off because the nickel price makes up so much of the transaction price of austenitic (around half) therefore, if there is a constantly declining nickel price, as we have seen for the past two years, distributors would typically be reluctant to stock up if they are going to sell that material at a potentially lower price three months later. Bloomberg consensus $15,500/t in 2015E Our Credit Suisse commodities analysts, who are significantly below consensus, forecast a nickel price of $13,875/t in 2014, $14,250/t in 2015 and $16,000/t in 2016 (see supply and demand model output in Figure 24). Bloomberg consensus estimates for nickel are $15,500/t in 2014 and $16,400/t in Figure 17: Stainless consumption by grade 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5, Austenitic Ferritic Chomium manganese austentitic (200 series) Duplex Figure 18: Stainless consumption by end market Others Source: CRU Source: CRU Over the past two years, the alloy surcharge has decreased almost every month with just a handful of exceptions, owing to the constant decline in the nickel price. LME nickel stocks have increased sharply over the past two years (Figure 19, Figure 20) and now stand at over 250kt; we believe global nickel stocks are closer to 500kt. Figure 15 shows the German surcharge for 304, but the surcharge for higher grades such as 316 has had the same pattern, just with a higher (i.e vs ) absolute value. Therefore, end demand aside, because the surcharge is such a large component of austenitic transaction prices, it has a significant effect on the propensity of stainless distributors to buy austenitic grades. Stainless Steel 9

10 2011 Q Q Q Q Q Q Q Q Q Q Q Q Q1 24 March 2014 Figure 19: LME nickel stocks since 2005 Figure 20: LME nickel stocks since Jan /01/ /01/ /01/ /01/ /01/2013 Source: LME /01/ /04/ /07/ /10/ /01/2014 Source: LME Conversion margins and inventories coming off lows Figure 21: Conversion margins in Germany and US Figure 22: US distributor months of supply German conversion margin ( /t) 430 German conversion margin ( /t) 0.0 Jan-90 Oct-92 Jul-95 Apr-98 Jan-01 Oct-03 Jul-06 Apr-09 Jan-12 Carbon steel Stainless steel Source: CRU Source: MSCI As a result of the reversal in nickel price momentum, conversion margins (i.e. the transaction price minus the lagged price of nickel, ferrochrome and ferrous scrap used as raw materials) are beginning to come off the lows in Germany and the US as the nickel price starts to increase, for standard 304 and 430 grades in Germany (Figure 21). For the same reason, inventories are starting to follow suit. As discussed above, the stabilisation of the nickel price is crucial for a restocking to take place because in a declining nickel price environment, distributors will hold off because the nickel price makes up so much of the transaction price of austenitic grades. Stainless Steel 10

11 The importance of the Indonesian ban Figure 23: Nickel cost curve with location range of RKEF, EAF and BF NPI capacity Source: Wood Mackenzie, Dataset Q On 12 January, Indonesia's President, Susilo Bambang Yudhoyono, put in place an expected ban on Indonesia's unprocessed ore exports. The ban was put in place to promote domestic processing of ores Indonesia is a significant exporter of unprocessed nickel and tin ores and has the biggest nickel resources in the world, but it hardly processes any. While in the short term it affects Indonesia's trade balance and domestic miners, in the long term the ban's aim is to make Indonesia profit more from its natural resources by miners processing ores prior to exporting and therefore making a higher margin. Indonesia the main ore exporter to China Indonesia has the largest nickel resources in the world, at around 35Mt nickel content vs. 18Mt for Russia and Canada. However, Indonesian ore is all laterite, which is lower quality than the sulphide ores of Russia and Canada, and is more expensive to refine. While China imports most of its refined nickel (c.50%) from Russia, it imports the vast majority of its unprocessed nickel ore from Indonesia. In 2013, China imported 70mt of nickel ore, of which 40mt was from Indonesia and 30mt was from the Philippines. and the ore is used in the cheapest NPI production method. Importantly, Indonesia supplies saprolitic ore (1.8-2% Ni content), which is higher grade and is the ore that is generally used by in Chinese NPI producers' rotary kilns to produce high grade (10-15% Ni content) NPI. The Philippines liminite ore is generally lower grade (i.e. <1.7% Ni content) and is instead used in the blast furnace route of producing NPI. We estimate that NPI produced via the RKEF method has a cash cost of c.$14,000/t vs. $16,000/t for pure EAF and $18,000/t for BOF, as a result of the lower power and coal costs more than offsetting the higher cost of the higher grade ore. which now produces half of China's NPI This is very important given that (a) Nickel Pig Iron production in China has considerably increased in the past two years, and (b) the vast majority of the growth of NPI has been via the RKEF method. While virtually no NPI was produced via the RKEF route in 2010, RKEFs now currently account for around half of China's NPI production, which in turn represents half of China's nickel (vs. under 1% in 2005). Stainless Steel 11

12 and would become $ /t more expensive if the ban remains in place Therefore, if the ban remains in place, this would both limit the output of half of China's NPI industry until the Indonesian domestic smelters are constructed, and increase the cash cost for the RKEF producers which represents around 14% of the cost curve. If the 10% price increases of Indonesian ore that we have seen in February remain, on our estimates this would add $600-$800/t to the cost of production for RKEF plants, which as shown by Figure 23 sit just below current nickel market prices and represent around 20% of world nickel supply. Will the ban stay in place? The key question The key issue therefore is whether the ban stays in place. Presidential elections are in July, and given how tough the ban is on Indonesia's economy in the short term it is possible it is reversed or relaxed. In 2013, in anticipation of the Indonesian ban, Chinese NPI producers built up stockpiles of around 20mt of Indonesian ore. We believe this stockpile should last for around six months, as if we assume a 2% nickel content for saprolite ore this would imply 400kt of nickel content from the 20mt. Once these are worked through, this is where serious pressure would be put on the prices of Indonesian ore i.e. Q3 and Q4 and in turn, where the cost curve is raised by $ /t around current prices on a very flat portion of the curve. Stainless Steel 12

13 Stainless Steel 13 Figure 24: Credit Suisse nickel supply and demand model World Nickel Supply and Demand Balance (kt nickel) E 2014F 2015F E 2014F 2015F Mine Production 1,600 1,451 1,658 1,995 2,181 2,292 2,356 2,458 Stainless Production by Country (kt stainless steel) Disruption Allowance 0 (118) (123) Europe 8,079 6,064 7,558 7,659 7,559 7,210 7,705 7,730 Mine Output 1,600 1,451 1,658 1,995 2,181 2,292 2,238 2,335 % change -4% -25% 25% 1% -1% -5% 7% 0% REFINED Ni AND FeNi PRODUCTION China 7,200 9,400 12,600 14,500 15,500 17,600 19,400 20,952 Canada % change -8% 31% 34% 15% 7% 14% 10% 8% Western Europe Japan 3,566 2,607 3,427 3,256 3,132 3,126 3,165 3,197 CIS % change -8% -27% 31% -5% -4% 0% 1% 1% Japan South Korea 1,743 1,644 2,022 2,116 2,131 2,040 2,130 2,151 China % change -21% -6% 23% 5% 1% -4% 4% 1% Australia Taiwan 1,313 1,468 1,523 1,203 1,106 1,019 1,100 1,078 Other % change -12% 12% 4% -21% -8% -8% 8% -2% Highly Probable Growth 5 8 India 1,550 1,690 2,170 2,105 2,950 3,300 3,700 3,996 Disruption Allowance (61) (65) % change -13% 9% 28% -3% 40% 12% 12% 8% Required Adjustment 0-30 USA 1,925 1,618 2,201 2,074 1,978 1,990 2,280 2,212 Total Production 1,390 1,339 1,465 1,655 1,766 1,912 1,979 2,068 % change -11% -16% 36% -6% -5% 1% 15% -3% % change -1.7% -3.7% 9.4% 13.0% 6.7% 8.3% 3.5% 4.5% Brazil Capacity Utilisation % 73% 66.1% 65.7% 61.6% 60.0% 62.1% 62.8% 65.6% % change -8% -17% 24% -7% -3% 13% 11% 5% NPI (Ni Content) Other CONSUMPTION Total World 26,635 25,499 32,669 33,987 35,471 37,505 40,849 42,600 Nth America % change -8% -4% 28% 4% 4% 6% 9% 4% Europe Austenitic ratio 70.7% 72.5% 71.6% 71.1% 73.2% 73.4% 73.8% 74.0% China ,028 Scrap ratio 46.1% 40.3% 40.9% 37.6% 37.6% 36.5% 36.3% 36.1% Japan India Nickel Production (bars) versus Consumption (kt Ni) Other Asia ,000 Other World Total consumption 1,289 1,325 1,529 1,643 1,718 1,819 1,965 2,059 1,500 % change (World) -6.1% 2.8% 15.4% 7.5% 4.5% 5.9% 8.0% 4.8% % change (China) -11.1% 62.0% 20.3% 22.6% 7.0% 12.4% 11.1% 8.0% For Stainless ,010 1,103 1,175 1,256 1,381 1,452 1,000 % change -10.6% 7.2% 21.0% 9.2% 6.6% 6.9% 10.0% 5.1% For Non-Stainless % change 1.7% -4.0% 5.8% 4.3% 0.3% 3.8% 3.8% 3.9% 500 SURPLUS/(DEFICIT) LME stocks Estimated Total Stocks E Weeks Consumption Nth America Europe China Japan India Price (US$/t) 21,204 14,651 21,806 22,843 17,548 15,143 13,875 14,250 Other Asia Other World Canada Western Europe CIS Price (US$/lb) Japan China Australia Other Source: Company data, Credit Suisse estimates

14 2) Demand and base prices Figure 25: How end demand improvement and base price increases fit in to the circular nature of demand Indonesian export ban Price of nickel ores Price of nickel pig iron Price of nickel metal European supply reduction Stainless prices Distributor demand Alloy surcharge Source: Credit Suisse research End demand Underlying demand improving Figure 26: Europe stainless production vs. IFO Low stainless inventories Jan-92 Aug-93 Mar-95 Oct-96 May-98 Dec-99 Jul-01 Feb-03 Sep-04 Apr-06 Nov-07 Jun-09 Jan-11 Aug W.Europe production IFO Source: Thomson Reuters, CRU While we are cautious at this stage on the carbon steel cycle given poor China and US data and our channel checks suggesting that Italian HRC prices are rolling over, European stainless producers have passed on two rounds of base price increases since September 2013, and our channel checks suggest that demand is stronger in the stainless end markets. The above chart shows a divergence between the IFO and European stainless production in recent months. The below chart splits out Euro area (EA18) industrial production growth YoY into the key segments for stainless steel. Stainless Steel 14

15 Figure 27: Euro IP split by segment Figure 28: Stainless demand by end market (2012) 35% 25% Consumer durables Cap Goods Energy Autos Construction Transportation 12% Chemical, Petro, and Energy 11% Other 3% Catering and Appliances 38% 15% 5% -5% -15% 01/03/ /11/ /07/ /03/ /11/ /07/2013 Architectural, Building and Construction 17% Process and Resources 19% Source: Eurostat Source: Company data, Credit Suisse estimates The above chart splits out Euro area (EA18) industrial production growth YoY into key segments for stainless steel. Since the second half of 2013 there has been a significant pick-up in the autos and cap goods sectors, while other segments such as consumer durables have lagged. Construction, however, the most important segment, shown by the red line, has continued to lag. However, this is now also starting to pick up tentatively, following up the US with a 6-9-month lag as per usual. Figure 29: Auto registration Credit Suisse forecasts in W. Europe, China and US E 2015E Source: AEAA, Credit Suisse estimates China W. Europe (EU15+EFTA) N. America In the Q4 results presentation Outokumpu provided the following demand forecasts in Europe and Americas in It forecast a greater improvement in the second half of 2014, especially in the Americas. Stainless Steel 15

16 Figure 30: Outokumpu forecasts stainless real demand in EMEA (LHS) and Americas (RHS) Source: Outokumpu Q results presentation, SMR permitting base price increases Figure 31: German 304 2mm base + surcharge 1600 Figure 32: USA 304 2mm base + surcharge Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Base Alloy Base $/cwt 11 Alloy /lb Source: CRU Source: CRU European stainless producers have passed on two rounds of base price increases since September 2013, and our channel checks suggest that demand is strong in the stainless end markets. The US has not seen base price increases since July 2013, with prices actually lower than Europe despite a tighter market. However, according to industry reports such as the CRU Stainless Steel Monitor, industry participants are saying that base price hikes early in the second quarter are "highly likely" in the US. Seasonality is also on side as we enter the spring months, the key months for stainless between winter and the Q3 maintenance shutdowns, which generally last for three weeks of August in Europe and two weeks in the US. While past trends cannot be treated as a guarantee of future trends, base prices have increased through March and April in each of the past five years with the notable exception of 2013, which in our view was largely explained by (a) the rapidly deteriorating nickel price and (b) the poor management of volumes by Outokumpu and Inoxum, as both pushed out too much volume into the market. Stainless Steel 16

17 1998 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q1 24 March 2014 but only to the top of the global price corridor Figure 33: China stainless HR and CR exports and imports Figure 34: German China 304 price differential CR Exports HR Imports HR Exports - Jan-06 Dec-06 Nov-07 Oct-08 Sep-09 Aug-10 Jul-11 Jun-12 May-13 Source: CRU Source: CRU We want to highlight, however, that although European base price hikes are sticking, the ability of European producers such as ACX to raise prices is limited naturally by the fact that the European market is not protected and that the cost of freight is such a low percentage of stainless prices. The above and below charts tell a clear story. Since mid-2004, Chinese stainless exports, both for HRC and CRC, have risen sharply, and the country has gone from a net importer to net exporter, importing around 500kt of material a quarter prior to 2005, and now exporting about the same amount. In terms of production, the below chart is clear. Production in Western Europe, Japan and the US has remained broadly unchanged for the past decade, whereas China has gone from producing c.50kt of stainless a month in 2000, to 1600kt a month in 2013, a significant portion of which is exported. Figure 35: Monthly stainless steel production in the key stainless regions Jan Jul Jan Jul Jan Jul Jan July Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Source: CRU W. Europe USA China Japan Stainless Steel 17

18 Therefore, a constant threat of Chinese imports remains if prices get raised too much relative to where demand is, distributors will just accept a longer lead time and take the Chinese material. This is why the European stainless price has had to pretty much follow a constant margin over the Chinese price. However, as mentioned in the Nickel section of this note, if the Indonesian ban stays in place and the higher cost of Indonesian ore feeds through into more expensive NPI, Chinese costs of production will rise and the pricing corridor should widen as a result. Stainless Steel 18

19 3) Supply Figure 36: How supply reductions fit in to the circular nature of demand Indonesian export ban Price of nickel ores Price of nickel pig iron Price of nickel metal European supply reduction Stainless prices Distributor demand Alloy surcharge Source: Credit Suisse research End demand Low stainless inventories Europe: Supply tightening with Inoxum closures and Outo streamlining Figure 37: Estimated EU stainless capacity by company Figure 38: Estimated EU stainless capacity by mill Acerinox Aperam Outokumpu Terni Other Europa Genk Chatelet Guegnon Isbergues Imphy Tornio Krefeld Dillenburg Bochum Sheffield Avesta Kloster Nyby Degerfors Terni Others Source: Company data, Credit Suisse estimates for 2014/15 Source: Company data, Credit Suisse estimates for 2014/15 Further to improving end demand and hence a good base-price outlook and stabilising nickel and alloy surcharges, 2014E and 2015E should also see supply in Europe being reduced to better match demand with Outokumpu owing to some important capacity reductions, particularly in the upstream, although rationalisation is also planned in the downstream. The balance is still relatively loose despite some good progress in consolidation in Europe, with c.6.5mt of annual demand vs. 8mt of capacity for all grades. Outokumpu's reductions, when completed in 2015, should see CR capacity reduced by c.600kt and meltshop capacity reduced by c.1400kt (i.e. c.20%). Therefore, given the reduction in supply that is due to take place over the next two years, we emphasise that although the European producers need to be careful that they do not raise prices above the natural corridor vs. the Chinese price, they should be able to price at the top end of this corridor. The road map of closures in Europe for Outo between now and 2015 is as follows. (1) Closure of the 800kt Bochum meltshop in late 2014 (vs. original plan of 2016) (3) Closure of Benrath in 2015 Stainless Steel 19

20 (4) Reduction of 200kt of A&P capacity in Tornio, bringing Tornio's CR capacity from 1100kt to 900kt (5) Reduction of Dillenburg CR capacity from 230kt to 160kt (6) Reduction of Krefeld CR capacity from 640kt to 340kt Figure 39: Outokumpu European footprint now vs. planned state at end-2015 EUROPE Current state Stainless coil HPSA Finland Nirosta Sweden UK Tornio Krefeld Dillenburg Bochum Benrath Avesta Kloster Nyby Degerfors Sheffield Melting Hot rolling Finished Flat cold rolled Flat cold rolled, slabs for quarto plate Flat cold rolled Quarto plate + longs Longs Planned state at end of 2015E Stainless coil HPSA Finland Tornio Krefeld Dillenburg Bochum Benrath Avesta Kloster Nyby Degerfors Sheffield Melting Hot rolling 1450 Nirosta Finished Source: Outokumpu, Credit Suisse estimates Flat cold rolled 900 Flat cold rolled, slabs for quarto plate Sweden Flat cold rolled Quarto plate + longs UK Longs Anti-dumping measures in Europe? We assume no for prudence despite Eurofer intention An issue that is brought up quite regularly is the potential for anti-dumping in Europe against the Chinese, Russians and Taiwanese, given that Eurofer is planning to file an anti-dumping case with the European Commission this year (Eurofer director general Gordon Moffat accorded an interview on this to Reuters on 13 February). If the EC accepts the claim, the investigation must be completed within 15 months. Taiwan recently successfully put in place anti-dumping (AD) duties against China and South Korea, which has allowed YUSCO to increase base prices. This would be good news for the European stainless industry as currently producers are forced to price in reference to China. However, we assume that there will be no antidumping duties in the interest of prudence while some AD duties do exist on certain steel products it has been difficult for European industries to get the EU to apply AD duties compared with the US, largely because of Germany not wanting to lose its exports. If they were put in place this would therefore be an added bonus to the supply situation, but we do not think this likely. Stainless Steel 20

21 4) The broader macro picture Continuing to cast a shadow Figure 40: Stainless vs. carbon steel monthly prodn (YoY) Figure 41: Stainless vs. carbon steel monthly prodn (kt) 80% 60% 40% 20% 0% Jan-96 Feb-98 Mar-00 Apr-02 May-04 Jun-06 Jul-08 Aug-10 Sep-12-20% -40% -60% 160, , , ,000 80,000 60,000 40,000 20,000 0 Jan-95 Jun-97 Nov-99 Apr-02 Sep-04 Feb-07 Jul-09 Dec Global Stainles Global carbon Global carbon Global Stainles Source: Thomson Reuters Source: Thomson Reuters In our view, because of the scheduled reduction in European stainless supply and what looks to be improving demand and a better outlook for the surcharge, the stainless market is in a better situation than the carbon market, on which we have become increasingly cautious in the past month or so. However, the broader macro still casts a cloud over the stainless market as an overlaying factor on the strong sector-specific fundamentals. We discuss the macro in detail in recent industry notes such as Demand: Mixed messages (18 February) and Slowdown but not (yet) out (21 February). Following the past few weeks of currency turmoil in the emerging markets, we also continue to cautiously flag the risk of EM currencies deteriorating further, with what we think is the potential for a further deterioration to send the broader market into a downturn, as we discuss in our 4 February report Steel and Mining: How real are EMG currency risks. Our base case for the broader macro picture does remain an OECD-led restock in 2014; however, as we discussed in our 4 February report, we cannot ignore the risks that the emerging currencies pose at this point. In our view, either the OECD drags up the emerging markets as in the early to mid-2000s, or, like 1997/98, the emerging markets bring down the commodity cycle in the OECD. We note the historical correlation of the stainless cycle with the carbon cycle as shown by Figure 7and hence how a derailment of the carbon cycle would therefore very likely correspond to a derailment of the stainless cycle. Therefore, we emphasise emerging currency risk as a key caveat. Stainless Steel 21

22 Europe / Finland Steel Rating (from Underperform) OUTPERFORM* [V] Price (20 Mar 14, Eu) 0.18 Target price (Eu) (from 0.15) 0.26¹ Market cap. (Eu m) 1, Enterprise value (Eu m) 3,654.4 *Stock ratings are relative to the coverage universe in each analyst's or each team's respective sector. ¹Target price is for 12 months. [V] = Stock considered volatile (see Disclosure Appendix). Research Analysts Michael Shillaker michael.shillaker@credit-suisse.com James Hanford james.hanford@credit-suisse.com Outokumpu (OUT1V.HE) Hurdles overcome, ready to run We upgrade Outokumpu to Outperform from Underperform. Our target price moves to 0.26 from We increase our 2014E EBITDA estimate to 349m, from 196m previously, on a better earnings outlook. Investment case: Outokumpu has materially underperformed over the past two years, with an extremely stretched gearing ratio of >150% and negative earnings following the poorly managed Inoxum merger. Now with Terni and VDM divested to Thyssen, however, and the rights issue approved, Outo is left with a solid asset base and a manageable balance sheet. We think the share price will eventually reflect this and believe investors should start considering Outokumpu again. Catalysts: The key catalysts will be updates with regards to the (a) Calvert ramp-up, (b) Ferrochrome ramp-up, and (c) progress on European restructuring measures. The first restructuring measure on the agenda is the Bochum meltshop closure (800kt capacity), which is scheduled for the end of 2014 but could potentially be pushed back to Q in our view. Valuation: Our earnings bridge shows Outo going from an operating loss in 2013 to profitability in 2014E and to 573m EBITDA in 2015E. Applying an 8x multiple to account for the growth potential we arrive at a value per share of Share price performance Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Price Price relative The price relative chart measures performance against the HEX25 INDEX. which closed at on 20/03/14 On 20/03/14 the spot exchange rate was 1./Eu 1. - Eu.73/US$1 Performance Over 1M 3M 12M Absolute (%) Relative (%) Financial and valuation metrics Year 12/13A 12/14E 12/15E 12/16E Revenue (Eu m) 6, , , ,755.8 EBITDA (Eu m) Adjusted Net Income (Eu m) CS adj. EPS (Eu) Prev. EPS (Eu) ROIC (%) P/E (adj., x) P/E rel. (%) EV/EBITDA Dividend (12/14E, Eu) IC (12/14E, Eu m) 4, Dividend yield (%) 1.0 EV/IC 0.91 Net debt (12/14E, Eu m) 1,547.8 Current WACC 11.0 Net debt/equity (12/14E, %) 62.5 Free float (%) 61.0 BV/share (12/14E, Eu) 0.24 Number of shares (m) 10, Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates. Stainless Steel 22

23 Outokumpu OUT1V.HE Price (20 Mar 14): Eu0.18, Rating: (from Underperform) OUTPERFORM*, Target Price: Eu(from 0.15) 0.26 Income statement (Eu m) 12/13A 12/14E 12/15E 12/16E Revenue (Eu m) 6,745 7,478 7,628 7,756 EBITDA (165) Depr. & amort. (346) (351) (351) (351) EBIT (Eu) (511) (2) Net interest exp. (197) (87) (87) (57) Associates (2) Other adj, (113) PBT (Eu) (823) (89) Income taxes (11) 25 (27) (76) Profit after tax (834) (64) Minorities 6 Preferred dividends Associates & other (170) Net profit (Eu) (998) (64) Other NPAT adjustments Reported net income (998) (64) Cash flow (Eu) 12/13A 12/14E 12/15E 12/16E EBIT (511) (2) Net interest (197) (87) (87) (57) Cash taxes paid Change in working capital 296 (109) (51) (41) Other cash & non-cash items Cash flow from operations CAPEX (285) (190) (190) (190) Free cash flow to the firm (252) (12) Acquisitions Divestments 72 Other investment/(outflows) 105 Cash flow from investments (108) (190) (190) (190) Net share issue/(repurchase) 650 Dividends paid (19) (32) Issuance (retirement) of debt 458 Other (509) 1,370 Cash flow from financing (51) 2,020 (19) (32) activities Effect of exchange rates 1 Changes in Net Cash/Debt (125) 2, Net debt at start 3,431 3,556 1,548 1,349 Change in net debt 125 (2,008) (199) (282) Net debt at end 3,556 1,548 1,349 1,067 Balance sheet (Eu m) 12/13A 12/14E 12/15E 12/16E Assets Cash and cash equivalents 607 1,245 1,444 1,726 Accounts receivable Inventory 1,216 1,346 1,388 1,419 Other current assets 2, Total current assets 4,879 3,547 3,814 4,143 Total fixed assets 3,254 3,093 2,932 2,771 Intangible assets and goodwill Investment securities Other assets Total assets 8,823 7,330 7,436 7,604 Liabilities Accounts payable 1,136 1,256 1,274 1,280 Short-term debt Other short term liabilities 1, Total current liabilities 3,141 2,344 2,362 2,368 Long-term debt 3,270 1,987 1,987 1,987 Other liabilities Total liabilities 6,932 4,852 4,870 4,876 Shareholders' equity 1,887 2,473 2,562 2,724 Minority interest Total equity & liabilities 8,823 7,330 7,436 7,604 Net debt (Eu m) 3,556 1,548 1,349 1,067 Per share data 12/13A 12/14E 12/15E 12/16E No. of shares (wtd avg) 2,077 10,387 10,387 10,387 CS adj. EPS (Eu) (0.48) (0.01) Prev. EPS (Eu) (0.03) Dividend (Eu) Div yield Dividend payout ratio (30.00) Free cash flow per share (Eu) (0.12) (0.00) Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Price Price relative The price relative chart measures performance against the HEX25 INDEX. which closed at on 20/03/14 On 20/03/14 the spot exchange rate was 1./Eu 1. - Eu.73/US$1 Stainless Steel 23

24 Summary We upgrade Outokumpu to Outperform from Underperform, and increase our target price to 0.26/sh from 0.15/sh on what we think is a materially better growth outlook. We think Outokumpu is worth 0.26 per share based on our 2015E EBITDA estimate of 573m and an 8x multiple to account for the better growth outlook. See our earnings bridge in Figure 49. Figure 42: Valuation of 0.26/sh based on 2015E earnings and 7x EV:EBITDA multiple 2015E EBITDA 573 Multiple 8 EV 4,585 Less net debt 1,349 Less pension 300 Less minority interest 4 Add back investment in associates 66 Equity value 2,999 # of shares post rights issue (m) 10,387 Nominal value per share ( ) 0.29 Discounted back at 10% ( /sh) 0.26 Source: Credit Suisse estimates The below charts show the material underperformance of Outokumpu vs. its European peers and nickel over the past two years. This is with due reason in our view. Prior to the Thyssen transaction and rights issue the company was in an unfavourable position, with a share price that performed accordingly. Figure 43: Stainless producers vs. nickel YoY 80% 60% 40% 20% 0% -20% -40% -60% -80% 04/03/ /06/ /09/ /12/ /03/2014 Figure 44: Stainless producers vs. nickel rebased /03/ /06/ /09/ /12/ /03/2014 LME-Nickel Cash U$/MT APERAM LME-Nickel Cash U$/MT APERAM OUTOKUMPU 'A' ACERINOX 'R' OUTOKUMPU 'A' ACERINOX 'R' Source: Thomson Reuters Source: Thomson Reuters Now, however, we believe the necessary hurdles have been crossed, and Outokumpu will be left with a strong asset base that its management should be able to make profitable. We think the share price will eventually reflect this and investors should start considering Outokumpu again. Stainless Steel 24

25 Following Nirosta closures, Outo will be left with a solid asset base Following the Thyssen transaction and rights issue, Outokumpu is left with a solid asset base, with the balance sheet no longer posing the serious problems of November 2013, when it looked like gearing was over 150% with Terni looking to be sold at a low price. Figure 50 shows what we expect the Outokumpu asset base should look like from 2015 once the Nirosta streamlining has taken place. 1) Tornio The workhorse mill, Tornio in Finland, is the lowest-cost mill on the European stainless cost curve as a result of having Ferrochrome works on site and the integrated chromite mine. All of the FeCr is used internally, and gives Outo a cost advantage as it does not need to re-melt FeCr, which gives material cost savings on power costs. Outo is expanding the chromite mine and Ferrochrome works at Tornio, which will make Outokumpu 100% self-sufficient in Ferrochrome. The Ferrochrome will have a 54% chrome content i.e. once the Ferrochrome operations are ramped to 530kt, it will deliver 286kt of annual primary chrome production, the majority of which will be used internally. Adding the scrap stainless to that at a 50-60% scrap ratio means scrap makes up the rest of the chrome requirement (recall standard grades such as 304 have an 18% chrome content). We estimate c 60m savings over next two years from the Ferrochrome ramp-up Figure 45: Estimated cost savings from the Ferrochrome ramp up overall and in 2014/15 Overall FeCr savings 2014E 2015E 230 FeCr in 2012 (mt) Additional tonnes (t) 530 FeCr in 2015E (mt) Production cost ($/kg) Additional tonnes (t) FeCr price ($/kg) 0.88 Production cost ($/kg) 54% 54% Chrome content 2.3 FeCr price ($/kg) Saving per kg ($) 54% Chrome content Saving per tonne ($) 0.8 Saving per kg ($) Savings per tonne ( ) Saving per tonne ($) 590 Savings per tonne ( ) 177 Saving ( m) Saving ( m) Source: Credit Suisse estimates Outokumpu will not provide the exact amount of the cost advantage it has in Europe as a result of being integrated in liquid Ferrochrome; however, we estimate the advantage to be in the region of 590 per tonne of Ferrochrome consumed. What we do know is that Tornio is the second-lowest cost Ferrochrome operation worldwide, after ENRC's operation in Kazakhstan, as a result of the captive ore at Kemi. We estimate the Tornio work's average cost of production per lb of contained ferrochrome to be $0.40/lb or $0.88/kg. This compares with a Ferrochrome contract price on the open market of c.$2.30/kg. As 304 stainless has an 18% chrome content, then per tonne of stainless on a $2.30/kg FeCr price (on an apples for apples basis), we estimate Outokumpu would save $0.80/t x 100kg = 590 per tonne of FeCr. Stainless Steel 25

26 For higher-chrome grades such as 2205 (22% Cr) or 904 (25% Cr), the cost advantage in chrome would be higher; however Tornio produces mainly 304 grades in the big #2 meltshop. Figure 46: Chrome flow diagram Source: Company data We visited the Ferrochrome works and Kemi mine in September, and were impressed by the quality of the assets. The mine produces 2.7mt of ore a year (26% chromium oxide), 850kt of fine concentrate (45% chromium oxide) and 400kt lumpy ore (36% chromium oxide). All of the lumpy ore and concentrate is for internal use at the ferrochrome works. 2) Calvert Calvert is the other important factor for Outo following the Inoxum merger. Calvert was inherited from Thyssen, and is the most expensive and advanced stainless mill in the world. The earnings bridge in Figure 48 shows how important the Calvert ramp up will be in getting Outo back to profitability. However, the problem has been that because of the EC remedy package for the Inoxum merger, Outokumpu has been obliged by the EC to continue shipping slab from Terni to Calvert for rolling, instead of producing its own melt. The margin comes from using your own melt. As of Q Calvert will be able to produce its own slab, for rolling at Calvert and Mexinox (as a reminder, meltshop capacity will be 900kt when ramped, CR capacity will be 350kt which will couple up with the 250kt at Mexinox to give 600kt for Stainless Americas as a whole). Given Calvert's location in the south and the high quality of the products it will produce, we think Outo will be able to take market share from Acerinox. Management is aiming for Stainless Coil Americas to reach breakeven on an EBITDA basis by the end of We have it slightly negative, at 35m for 2014, albeit rising to 113m to 2015, by which time Calvert's meltshop and rolling shop should be fully ramped. We expect that any logistic issues with the Mittal/Sumitomo JV sharing the hot rolling shop with Outokumpu should also be fully ironed out by that stage. All hiring at Calvert is almost over and staff are being trained; by 2015 we expect the rolling shop to be fully ramped. Stainless Steel 26

27 and balance sheet has improved Figure 47: Gearing bridge following TK transaction and rights issue ( m) 188% 120% 64% Net debt reported Equity reported TK loan note Net debt post loan note Equity Rights issue Net debt post loan note & Rights issue Equity post rights issue Source: Company data, Credit Suisse estimates The balance sheet is no longer the cause for concern that it was until the end of November 2013, when the Thyssen deal and rights issue were announced. The above bridge shows how those two transactions serve to reduce the gearing ratio by over 100 percentage points. The initial deadline for selling Terni set by the EC was May 2013, which was then approved to be extended when bids were unsatisfactory as a result of low demand. According to articles from Reuters such as Reuters's 22 nd October 2013 article "Outokumpu asks EU to let it keep Italian Steel plant" the quoted bids for Terni were only in the region of m, which is exceptionally low for a 1mt stainless mill. The mill was then divested back to Thyssen along with VDM in exchange for cancellation of the 1,269m loan note, which was created in the Inoxum transaction. The asset sales of VDM and Terni to Thyssen were advantageous, persuading Thyssen to take back assets that it had sold already and that Outokumpu wanted to sell (or had to in order to comply with the EC remedy package). Outokumpu appeared to have scant interest from buyers for the sale of these assets in the open market, thus to get the kind of price that Thyssen paid was a smart move in our view. Rights issue timeline Wednesday 19 March: Rights stop trading Wednesday 26 March: Subscription deadline for new shares. The rights issue is fully underwritten by the banking syndicate and 53% of shareholders have agreed irrevocably to take up the rights. However, it is only the largest shareholder Solidium (owned by the Finnish state) that has a lock-up agreement. All other shareholders that have agreed to take up the rights, and the banking syndicate that has underwritten the issue, have the right to sell the shares on the day if they so wish. Stainless Steel 27

28 2013E underlying EBITDA P150 impact Inoxum synergies EMEA restructuring measures FeCr ramp up impact 10/t underlying base price increase Calvert ramp up impact 2014 EBITDA P150 program impact Inoxum synergies EMEA restructuring measures Ferrochrome ramp up impact 10/t underlying base price increase Calvert ramp up impact 2015E EBITDA EMEA restructuring measures 10/t underlying base price increase 2016E EBITDA 24 March 2014 Earnings road map Figure 48: Outokumpu earnings bridge to 2016E ( m) Source: Company data, Credit Suisse estimates We think Outo faces four important steps to return to profitability, which we show in the earnings bridge in Figure 48. The full bridge calculation with notes on why we reach these assumptions is presented in Figure 49. Note the earnings forecast does not assume a material cyclical recovery, as we incorporate only 10 base price increases each year. 1. Finish the P150 working capital programme. We think another 50m should be freed up in 2014, largely through closures, and then another 5m in 2015 (Figure 49). 2. Ramp Calvert and make Americas profitable. Now that Terni will no longer be supplying the slabs to Calvert as of Q1 2014, Outo will be able to start ramping Calvert and increasing its exposure to the US market, which is structurally stronger than Europe. Currently, Acerinox's NAS is the market leader, although given Calvert's location in the south and the high quality of the products it will produce we think Outo will be able to take market share from Acerinox. Management is aiming for Stainless Coil Americas to reach breakeven on an EBITDA basis by the end of We have it slightly EBITDA negative on a 2014E basis, at -66m, and 112m EBITDA in 2015E when Calvert is ramped. We can see from the earnings bridge in Figure 48 how important the Calvert ramp-up will be for getting Outo back to profitability, with a 160m EBITDA impact in 2014E. 3. Finish the Ferrochrome ramp-up, which should further enhance Tornio's position as the lowest-cost European mill among European stainless producers. Tornio already has a best-in-class cost position as a result of not needing to re-melt its ferrochrome, having the ferrochrome works onsite in Tornio. Ramping FeCr to 530kt should enhance this and deliver a better margin in EMEA. We estimate the ferrochrome expansion will give Outokumpu a 177m cost advantage vs Realise the Inoxum synergies. Rationalising the upstream will result in recurring cost savings through fixed cost removal and reduced capex requirements. 5. Carry out the EMEA restructuring measures, namely: Stainless Steel 28

29 o o o o o o Closure of the Bochum meltshop in 2014 (the original plan was to close it in 2016). Re-route 130kt of production from Krefeld to Tornio. Meltshop #2 at Tornio will continue to be the workhorse, doing high volumes of standard austenitic grades primarily 304 and 316. Rerouting 130kt to Tornio will allow Outo to take full advantage of Tornio's low-cost position on the European cost curve (lowest-cost mill among European stainless producers, not least because of the integrated chromite mine and selfsufficiency in ferrochrome). Meltshop #1 will continue to produce ferritics and low-volume standard-grade steels. Investment of 100m at Krefeld to enable the transfer of production from Benrath to Krefeld and close down Benrath. Nirosta will therefore be streamlined with Bochum and Benrath no longer part of it in 2015, with Dillenburg and a smaller Krefeld representing Nirosta. The structure can be easily streamlined given the proximity of all the Nirosta facilities in the Ruhr metropolitan area. Reduce annealing and pickling capacity by 200kt in Tornio by closing one line. Therefore Tornio's total cold-rolling capacity will come down from 1100kt to 900kt, with the 200kt loss all in A&P. Reduction of CR capacity by 300kt-350kt in Krefeld. Therefore rolling capacity will come down from 640kt to 340kt, with Krefeld continuing to roll bright annealed ferritic, unstabilised ferritic and marstenitic steels. Closure of two service centres one in Langenhagen, Germany, and one in Birmingham, in addition to the transferral of the Tours, Terninox, Gebze and Barcelona centres to Thyssen. Stainless Steel 29

30 Stainless Steel 30 Figure 49: Outokumpu earnings bridge to 2016E ( m) Outokumpu EBITDA bridge ( m) 2013A 2014E 2015E 2016E Notes 2013A Reported 2013A EBITDA -165 One-offs -133 Underlying 2013A EBITDA E P150 program impact 50 Raw materials, IT, SG&A reduction as per management guidance. Inoxum synergies 75 EMEA restructuring measures 20 Closure of 800kt Bochum meltshop Ferrochrome ramp up impact 35 Target 490kt FeCr vs. 430kt in Underlying base price & volume increase 38 Calvert ramp up impact 160 Terni slab deliveries terminating, using own melt. Expect ship 200kt of CR sheet at Calvert, 250kt at Mexinox. 2014E EBITDA E P150 program impact 5 Inoxum synergies 20 EMEA restructuring measures 45 Reduce CR capacity by 300kt in Krefled (reducing capacity from 640kt to 340kt). Ferrochrome ramp up impact 24 Target 530kt FeCr vs. 490kt in Underlying base price & volume increase 38 Calvert ramp up impact 95 Expect ship 350kt CR sheet at Calvert, 250kt at Mexinox, margin improvement to 10% at Calvert 2015E EBITDA E EMEA restructuring measures 50 Reduce A&P by 200kt in Tornio. Close Benrath, reroute 130kt from Krefeld to Tornio Underlying base price & volume increase E EBITDA 662 Source: Company data, Credit Suisse estimates

31 Stainless Steel 31 Figure 50: Outokumpu current and planned footprint post 2015 Current state Finland Nirosta Sweden UK Mexico USA China Tornio Krefeld Dillenburg Bochum Benrath Avesta Kloster Nyby Degerfors Sheffield St Louis Calvert New castle Wildwood Richburg Shanghai Melting Hot rolling Finished Updated planned state at end of 2015E Finland Nirosta Sweden UK Mexico USA China Tornio Krefeld Dillenburg Bochum Benrath Avesta Kloster Nyby Degerfors Sheffield St Louis Calvert New castle Wildwood Richburg Shanghai Quarto plate + longs Longs Flat cold rolled Melting Hot rolling Finished Source: Company data Stainless coil Flat cold rolled Stainless coil Flat cold rolled EUROPE Flat cold rolled, slabs for quarto plate Flat cold rolled, slabs for quarto plate HPSA Flat cold rolled HPSA Flat cold rolled Quarto plate + longs Longs Stainless coil Flat cold rolled Flat cold rolled Stainless coil Flat cold rolled AMERICAS Quarto plate Quarto plate HPSA Tubular HPSA Tubular Bar Bar APAC Stainless coil Flat cold rolled Stainless coil Flat cold rolled

32 Europe / Luxembourg Diversified Metals & Mining Rating (from Outperform) NEUTRAL* Price (20 Mar 14, Eu) Target price (Eu) (from 16.00) 21.00¹ Market cap. (Eu m) 1, Enterprise value (US$ m) 2,558.5 *Stock ratings are relative to the coverage universe in each analyst's or each team's respective sector. ¹Target price is for 12 months. Share price performance Research Analysts Michael Shillaker michael.shillaker@credit-suisse.com James Hanford james.hanford@credit-suisse.com 7 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Price Price relative The price relative chart measures performance against the AMSTERDAM EXCHANGE INDEX which closed at on 20/03/14 On 20/03/14 the spot exchange rate was 1./Eu 1. - Eu.73/US$1 Performance Over 1M 3M 12M Absolute (%) Relative (%) Aperam (APAM.AS) Shares now pricing in the strength We downgrade Aperam to Neutral from Outperform, but increase our target price to 21 from 16 as we increase our 2015 EBITDA estimate to 435m from 399m. Investment case: Aperam's monopoly position in the structurally tight and import-protected Brazilian market remains a great advantage vs. peers. However, since the stock recent rise, upside potential looks more limited. We also note the risk of the anti-dumping duties in Brazil being removed by a new government, which would have an adverse impact on earnings if this bear-case scenario were to play out. Catalysts: With few company-specific catalysts on the horizon, the keys as for Acerinox and Outokumpu are the developments in the broader stainless cycle such as nickel pricing and whether any further base price increases in Europe are passed on. Potentially the major risk is that the current antidumping duties are removed by a new government in a Brazilian election year. Valuation: We think Aperam is worth 21 per share based on our 2015 EBITDA estimate of 435m. Financial and valuation metrics Year 12/13A 12/14E 12/15E 12/16E Revenue (US$ m) 5, , , ,762.2 EBITDA (US$ m) Adjusted Net Income (US$ m) CS adj. EPS (US$) Prev. EPS (US$) ROIC (%) P/E (adj., x) P/E rel. (%) NM EV/EBITDA Dividend (12/14E, US$) 0.75 IC (12/14E, US$ m) 3, Dividend yield (%) 3.0 EV/IC 0.72 Net debt (12/14E, US$ m) Current WACC Net debt/equity (12/14E, %) 21.0 Free float (%) 57.0 BV/share (12/14E, US$) 37.8 Number of shares (m) Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates. Stainless Steel 32

33 Aperam APAM.AS Price (20 Mar 14): Eu18.03, Rating: (from Outperform) NEUTRAL*, Target Price: Eu(from 16.00) Income statement (US$ m) 12/13A 12/14E 12/15E 12/16E Revenue (US$ m) 5,120 6,071 6,367 6,762 EBITDA Depr. & amort. (303) (310) (312) (321) EBIT (US$) (11) Net interest exp. (131) (74) (76) (76) Associates Other adj, (1) (1) (1) (1) PBT (US$) (143) (6) Income taxes 44 1 (9) (22) Profit after tax (99) (5) Minorities (1) Preferred dividends Associates & other Net profit (US$) (100) (5) Other NPAT adjustments Reported net income (100) (5) Cash flow (US$) 12/13A 12/14E 12/15E 12/16E EBIT (11) Net interest (131) (74) (76) (76) Cash taxes paid Change in working capital (18) (105) (33) (43) Other cash & non-cash items Cash flow from operations CAPEX (125) (130) (150) (150) Free cash flow to the firm Acquisitions Divestments Other investment/(outflows) 6 Cash flow from investments (119) (130) (150) (150) Net share issue/(repurchase) Dividends paid (59) (59) Issuance (retirement) of debt (6) Other 53 Cash flow from financing 47 (59) (59) activities Effect of exchange rates (6) Changes in Net Cash/Debt Net debt at start Change in net debt (126) (71) (107) (156) Net debt at end Per share data 12/13A 12/14E 12/15E 12/16E No. of shares (wtd avg) CS adj. EPS (US$) (1.28) (0.06) Prev. EPS (US$) (0.40) 0.18 Dividend (US$) Div yield Dividend payout ratio (1, Free cash flow per share ) (US$) Key ratios and valuation 12/13A 12/14E 12/15E 12/16E Growth(%) Sales (2.7) EBIT (89.3) (729.3) Net profit (9.9) (95.3) (877.3) EPS Margins (%) EBITDA margin EBIT margin (0.2) Pretax margin (2.8) (0.1) Net margin (2.0) (0.1) Valuation metrics (x) EV/sales EV/EBITDA EV/EBIT (239.1) P/E (19.4) (412.6) P/B Asset turnover ROE analysis (%) ROE stated-return on (3.3) (0.2) equity ROIC (0.2) Interest burden 13.0 (0.1) Tax rate Financial leverage Credit ratios (%) Net debt/equity Net debt/ebitda Interest coverage ratio (0.1) Source: FTI, Company data, Thomson Reuters, Credit Suisse Securities (EUROPE) LTD. Estimates. Balance sheet (US$ m) 12/13A 12/14E 12/15E 12/16E Assets Cash and cash equivalents Accounts receivable Inventory Other current assets Total current assets 984 1,161 1,302 1,501 Total fixed assets 2,388 2,208 2,046 1,874 Intangible assets and goodwill Investment securities Other assets Total assets 4,693 4,689 4,668 4,696 Liabilities Accounts payable Short-term debt Other short term liabilities Total current liabilities Long-term debt Other liabilities Total liabilities 1,735 1,736 1,737 1,737 Shareholders' equity 2,953 2,948 2,926 2,954 Minority interest Total equity & liabilities 4,693 4,689 4,668 4,696 Net debt (US$ m) Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Price Price relative The price relative chart measures performance against the AMSTERDAM EXCHANGE INDEX which closed at on 20/03/14 On 20/03/14 the spot exchange rate was 1./Eu 1. - Eu.73/US$1 Stainless Steel 33

34 Brazil monopoly the key advantage Figure 51: European stainless producers by geographic exposure (2012 sales) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Aperam Outokumpu Acerinox Europe N.America S.America Other Figure 52: Europe and Brazil EBITDA/tonne E 2015E -200 Europe Brazil Source: Company data, Credit Suisse research Source: Company data, Credit Suisse estimates ( ) Aperam's monopoly position in Brazil has always been an advantage (a) because the market is structurally tight, (b) stainless consumption per capita in Brazil is very low, c.3kg vs. 15kg for Germany and 25kg for Taiwan, giving good long-term growth opportunity, and (c) crucially because the Brazilian electrical and stainless markets are protected by stringent government anti-dumping duties for the next five years. There had previously been a tariff of 25% on imports, which reduced to 14% in October however the duties listed in Figure 53 below were applied instead. These most recent antidumping measures on stainless steel flat products add to the existing anti-dumping duties on stainless welded tubes that are already in place for the next five years against China and Taiwan, signed on 29 July, and the anti-dumping duties on GO & NGO electrical steel against China, Korea and Taiwan that are also in place for the next five years. As a result of this, EBITDA/t in Brazil is not comparable to that in Europe (Figure 52) as Aperam does not need to compete with the constant threat of Chinese imports unlike in Europe. We estimate that without the protectionist policies in place, Aperam's profits in Brazil would be the same as in Europe. This of course creates the risk that if the tariffs are removed, profitability would suffer greatly as a result. This is why we use a lower earnings multiple for Aperam than Acerinox. The Brazilian mill at Timoteo therefore is the major driver of Aperam's profitability, purely because of greater pricing power. Underlying profitability excluding the protectionist policies that are in place is in our view the same as for Europe. However, the below duties remain in place for the next five years and the Brazilian government appears committed to the goal of protecting the domestic Brazilian industry. Stainless Steel 34

35 Figure 53: Brazilian anti-dumping duties applied to stainless cold rolled imports on 7 October 2013 Country Exporter $ / mt Germany All China Lianzhong Stainless Steel Corp Shanxi Taigang Stainless Steel Co Others Korea Posco Pohang Steel Works Hyundai BNG Steel Others Taiwan All Vietnam All Finland Outokumpu 1, Source: Steel Business Briefing Others 1, This is all on top of the already strong fundamental growth outlook for the Brazilian market. Stainless steel apparent consumption and end demand are closely determined by broader economic and industrial activity. Not only is the Brazilian economy growing much faster than the main European markets to which Aperam is exposed (most notably Germany, France, Italy and Spain), but stainless steel is also structurally later cycle than carbon steel particularly ferritic and duplex grades, which are more geared towards autos/ white goods/ cap goods rather than construction, which is the case for austenitic. As such, stainless steel consumption per capita remains low in Brazil at c.3kg according to the ISSF, and we think this should grow significantly over the long (and medium) term as the country continues to develop. Strategic cost-reduction programme continuing to produce visible savings Figure 54: Leadership Journey: European downstream rationalisation in Stainless & Electrical division from 29 tools to 17 tools Source: Company data, Credit Suisse research Aperam has also undergone a well-planned and executed programme of cost cutting that has produced visible cost savings of over $350m recurring since the beginning of Q through regular cost-saving measures such as yield and quality improvement but also fixed cost removal through strategically shutting down lines. The above table shows what lines have been either suspended or mothballed. Stainless Steel 35

36 Note that this is also strategically wise as well as producing cost savings. Most of the capacity removal has been in the standard ferritics, particularly the suspension of the independent cold-rolling lines at Isbergues and the mothballing of cold rolling and annealing and pickling lines at Genk and Gueugnon. This reorganisation is allowing Aperam to reroute ferritic production away from Isbergues and improve utilisation rates which is also a ferritics-focused plant and of a similar size (400kt cold-rolling capacity for Gueugnon vs. 350kt for Isbergues). Further, Isbergues's location in Northern France near the Belgian border means Gueugnon is more strategically placed in our view given Aperam's existing presence in Northern Europe with Genk and Chatelet. Figure 55: EBITDA margins 15% 10% 5% Figure 56: Cumulative gains from Leadership Journey ($m) % % % Aperam Acerinox Outokumpu 0 Q Q Q Q Q Q Q Q Q Q Q Source: Company data, Credit Suisse estimates (2014) Source: Company data Other stainless peers have also embarked on similar cost-saving programmes which will cause a parallel downward shift in the cost curve, but we think Aperam has credibility and could potentially improve the company's relative position on the curve, especially relative to Acerinox. The above charts show the visible effect of this both relative to Aperam's European stainless peers and in terms of the visible cost savings already achieved. Note that at the investor day in Genk in November 2011 the cost savings target for the Leadership Journey was increased to $450m. Stainless Steel 36

37 Valuation Figure 57: Earnings road map: bridge to 2014E EBITDA EBITDA LJ cost savings Europe base price impact Brazil base price impact Brazil volume impact Europe volume impact Speciality impact 2014E EBITDA Source: Company data, Credit Suisse estimates Despite Aperam's advantageous position in Brazil and the relatively high profits it earns there relative to Europe, we downgrade the stock to Neutral from Outperform as we think the shares are now pricing in the company's strengths and it is Outokumpu that is likely to see the re-rating. The shares have rallied significantly from 10 in July. We now move our target price to 21 per share (from 16) based on 2014E earnings. We arrive at our target price via the calculation in the below table. The target price increases due to our higher 2014E EBITDA estimate of 435m. The surface diagram overleaf shows the sensitivity of this calculation to the 2015E EBITDA estimate and our chosen multiple. Note we use an EV:EBITDA multiple of 7x for Aperam vs. 8x for Outokumpu for its growth and 9x for Acerinox for its premium configuration and stability, because the supernormal earnings in Brazil cannot be priced into perpetuity. The duties in Brazil are intended to be in place for five years, but the risk remains that they are removed early in which case Brazilian earnings would move into line with Europe in our view. Figure 58: Target price calculation Number of shares in millions; other values in euro millions unless otherwise stated 2015E EBITDA 435 Multiple 7 EV 3, E Net debt E Pension E Minorities 5 Implied Market cap 2,307 # No of shares 78 Implied share price ($) 30 Implied share price ( ) 23 Discount at 10% 21 Source: Credit Suisse estimates Stainless Steel 37

38 The surface diagram below shows the sensitivity of this calculation to the 2015E EBITDA estimate and the chosen multiple. Figure 59: Sensitivity of per share valuation to 2014E EBITDA and chosen multiple E EBITDA Source: Credit Suisse estimates Stainless Steel 38