Certain Factors Affecting TMK’s Results from Operations

TMK’s results from operations were affected by a number of factors, including, among others, global and Russian macroeconomic trends, oil and gas industry dynamics, TMK’s development and leverage level.

The Recent and Current Economic Environment

In 2010, global markets demonstrated strong improvement after a recent financial and economic crisis of late 2008 indicating demand recovery for consumer and industrial products. The Russian economy emerged from recession in the third quarter of 2009.

TMK is a company with global presence and geographically diversified production facilities, although most of its operations are based in Russia and 62% of its revenue is generated from Russian customers. Consequently, TMK is exposed to both macroeconomic trends in global as well as Russian economy.

Throughout 2010, global financial markets, though generally improving, remained uncertain. After the stock market crash in the second half of 2008, stock indexes have recovered worldwide and, particularly, in Russia, but still are highly volatile.

The implementation of anti-crisis policies by the Russian government helped the economy to survive the financial and economic crisis of late 2008. Stable economic growth resumed in the second half of 2009. However, the economic activity in Russia in 2010 was impacted by severe summer drought and wrecked harvests. The Gross Domestic Product (“GDP”) in Russia increased by 4.0% in 2010 compared to a 7.9% decrease in 2009.

Other markets of TMK presence have also been seriously affected by the recent financial and economic crisis. In 2010, the European economy showed a gradual GDP recovery by 1.8% in comparison with a negative growth rate of 4.2% in 2009. The U.S. GDP rose by 2.8% in 2010 as compared to a decline by 2.6% in 2009.

In addition, recent and continuing political crisis in North Africa and Middle East where a substantial proportion of the world’s oil reserves is located, press up the price of oil which may negatively impact worldwide economic conditions. The risks of worsening of economic conditions may influence TMK’s operating results.

Global and Russian Oil and Gas Industry

Sales to oil and gas companies in Russia and worldwide represent the lion’s share of TMK’s total sales of pipe products. Pipe demand from the global oil and gas industry significantly affects both sales volumes and pipe prices. Global prices for crude oil are rather volatile and reached a peak in July 2008, U.S.$147/bbl, then fell significantly after the onset of the global economic slowdown in late 2008 reaching an average monthly price for crude oil of U.S.$40/bbl in December 2008. Crude oil prices strengthened in 2010 and in January 2011 stood at around U.S.$96/bbl. Since the start of political crisis in the Middle East region in January-February 2011, the crude oil price has surged over U.S.$115/bbl. Market analysts forecast further growth in prices for crude oil. Henry Hub prices for natural gas have also fallen sharply since their peak price of U.S.$13.31 per million British thermal units (“mmBtu”) in July 2008 and, in December 2010, natural gas prices were approximately U.S.$4.1-4.4 mmBtu. The increase of shale gas production has contributed to the general price weakness in the U.S. market as production (or supply) has outpaced recent demand growth.

TMK 2010 Development Highlights

As part of its strategy to enhance its position as one of the leading producers of steel pipes, TMK continued to extend its production capacity and achieve technological improvements:

  • The intensive development of U.S. shale plays made it necessary to increase ULTRA production volumes at TMK IPSCO facilities. In May 2010, TMK IPSCO opened a new ULTRATM Premium Connections facility in Ohio, USA, close to the Marcellus Shale Region, one of the U.S. largest shale gas deposits. This new manufacturing facility will help TMK to meet the growing demand from gas shale developments.
  • In 2010, TMK modernised the continuous casting machine and seamless rolling mill at Volzhsky plant and installed the ancillary equipment needed for the plant’s full ramp-up for the production of pipes. As a result, production capacity of seamless pipe at the Volzhsky plant increased by 210,000 tonnes.
  • TMK and RUSNANO established a strategic venture, TMK-INOX, for the production of precision stainless steel and alloy tubes. The joint project aims to create modern high-tech production of pipes for special applications.

TMK sold a non-core asset:

  • At the end of 2010, TMK entered into a contractual agreement to sell a 100% ownership interest in TMK Hydroenergy Power S.R.L. (“TMK-Hydro”) whose assets consists of four hydropower generating units located in Romania and previously owned by TMK-Resita.

TMK continued to expand its global presence:

  • TMK IPSCO opened a new sales office, TMK IPSCO Canada, in Calgary in August 2010, which functions as a head office for sales in Canada and supports conventional and unconventional hydrocarbon exploration and development programs in the country. TMK believes the success of ULTRA premium connections will serve as a platform for the supply of tubular goods to Canadian oil sands development.
  • In June 2010, TMK established TMK Africa Tubulars, a trading subsidiary incorporated in Cape Town, South Africa, to strengthen its commercial presence in sub-Saharan oil and gas markets.

Leverage Level and Liquidity Profile

Following the recovery in economies and through refinancing of short-term debt on a long-term basis, the Company improved its financial performance and liquidity position. The following table sets forth certain information regarding TMK’s indebtedness, working capital, leverage and certain key related financial measures as of and for the dates/periods indicated:

  December 31, 2010 June 30, 2010 December 31, 2009 June 30, 2009 December 31, 2008
  in millions of U.S. dollars
5 Net debt calculation — See “Selected financial data”. 6 Calculated on a rolling twelvemonth basis. Adjusted EBITDA — See “Selected financial data”. 7Net-Debt-to-EBITDA ratio is defined as Net Debt at the end of the given measurement date to Adjusted EBITDA for the 12 months immediately preceding the given measurement date. 8Share of short-term loans and borrowings is calculated as based on the information presented in the Consolidated Statement of Financial Position. 9 Working capital is calculated as current assets at the end of the given measurement date net of current liabilities.
Net debt5 3,711 3,555 3,504 3,561 3,064
Adjusted EBITDA6 942 597 328 776 1,047
Net-debt-to-EBITDA ratio7 3.9 6.0 10.7 4.6 2.9
Share of short-term loans and borrowings8 18% 23% 41% 54% 69%
Working capital excess/(deficit)9 595 147 (645) (952) (1,446)

Since late 2008, a combination of factors related to the global financial and economic crisis has adversely affected TMK’s operating performance. As a result, the Company’s Adjusted EBITDA decreased from U.S.$1,047 million in 2008 to U.S.$328 million in 2009.

On the other hand, TMK’s net debt increased significantly primarily as a result of: (a) borrowings undertaken in connection with the Company’s acquisition of TMK IPSCO, which comprised IPSCO Tubulars, Inc. and NS Group, Inc., in 2008 and the further exercise of an option to purchase the remaining 49% interest in NS Group, Inc.; and (b) the continued capital investment programme. The Net-Debt-to-EBITDA ratio reached an historic high of 10.7 as of 31 December 2009.

Prior to getting the access to international capital markets TMK has relied on cash provided by operations and short-term debt to finance its working capital and other capital requirements. In addition, a bridge financing attained for acquisition of U.S. operations coincided with the global economic crisis and the Company’s financial position worsened. Since the onset of the global economic downturn, TMK has been actively implementing certain cost-optimising measures as part of its programme to manage the consequences of the financial crisis, and concentrated on cuts in its operating costs and optimising its working capital and operating performance. At the same time, TMK has been negotiating extensions of credit terms and refinancing its short-term indebtedness. As a result of refinancing TMK’s debt on a long-term basis, the share of TMK’s long-term debt increased from 59% at the end of 2009 to 82% at the end of 2010. TMK has also successfully negotiated lower interest rates on certain borrowings. Consequently, its weighted average nominal interest rate as of 31 December 2010 decreased to 7.86% as compared to 10.72% as of 31 December 2009.

However, as the increase in operating activity in 2010 required additional working capital, total TMK’s debt increased from U.S.$3,752 million as of 31 December 2009 to U.S.$3,872 million as of 31 December 2010. Implemented investment projects also required financing.

Restructuring of TMK’s loan portfolio and cost optimisation programs over the last two years have enabled the Company to significantly improve its working capital position and reduce its leverage ratio. Thus, as of 31 December 2010, TMK total current assets exceeded its total current liabilities by U.S.$595 million. Its Net- Debt-to-EBITDA ratio decreased to 3.9 as of 31 December 2010 from a historical high of 10.7 as of 31 December 2009. Its debt maturity profile has improved substantially as TMK has refinanced its short-term debt and increased the share of long-term facilities in its credit portfolio. Adjusted EBITDA for the twelve-month period ended 31 December 2010 almost tripled to U.S.$942 million from U.S.$328 million for the twelve-month period ended 31 December 2009.

TMK is continuing to carry out a series of measures to maintain sufficient liquidity and improve its loan portfolio structure.

Issuance of Convertible Eurobonds

In February 2010, TMK, through TMK Bonds S.A., issued U.S.$413 million 5.25% bonds due 2015 convertible into TMK Global Depository Receipts. The bonds are convertible at the option of bondholders on any date starting from 24 March 2010 until 2 February 2015, or, if earlier, on the seventh London business day prior to any earlier date fixed for redemption of the Convertible Bonds. The bonds are convertible into GDRs at a conversion price of U.S.$23.075 per GDR.

TMK, through TMK Bonds, can make an early redemption of all outstanding bonds, in whole but not in part, at any time on or after 4 March 2013 at their principal amount plus accrued interest, if the volume weighted average price of TMK GDRs traded on the London Stock Exchange during 30 consecutive dealing days exceeds 130 per cent of the conversion price (the “Issuer Call”). In addition, TMK has the option to redeem the bonds at the principal amount plus accrued interest if 15% or less of the bonds remain outstanding. Bondholders also have the right to request redemption of the bonds on the third anniversary following the issue date at the principal amount plus accrued interest.

As disclosed in Note 25 of TMK Consolidated Financial Statements, TMK determined that the convertible bonds represent a combined financial instrument containing two components: (i) a bond liability and (ii) an embedded derivative representing a conversion option in foreign currency combined with an issuer call (“embedded conversion option”). Generally, conversion options are recognised as a part of equity, however, IFRS requires that in the specific case when the conversion option is denominated in currency other than issuing entity’s functional currency, no equity component can be recognised prior the conversion of the bond. As a result, in accordance with IFRS, TMK recognised a bond liability of U.S.$368 million (net of transaction costs of U.S.$9 million) and the liability under embedded conversion option of U.S.$35 million at the initial recognition date.

The liability component is subsequently carried at amortised cost using the effective interest rate method. The derivative component is subsequently remeasured at fair value at each reporting date. As of 31 December 2010, the bond liability and the liability under the embedded conversion option were U.S.$378 million and U.S.$48 million, respectively. TMK recorded a loss on changes in the fair value of the derivative financial instrument in the twelve months of 2010 of U.S.$12 million.

Nevertheless TMK’s management believes that IFRS accounting treatment of the conversion option of the bond does not reflect the expected outflow of resources under the conversion rights. The conversion option, whether exercised or expired, will not result in cash outflows from the Company. In the event of the bond not being converted, the liability under the conversion option will be recognised as a gain in TMK’s income statement. In the event of the exercise of the option, the liability will be transferred to equity (together with the carrying value of the converted bonds); no gain or loss will be recognised on the transaction. Additionally, the accounting treatment of the conversion option requires TMK to recognise changes in the fair value of the embedded instrument in the income statement. The price and volatility of TMK’s GDRs have significant impact on fair value of the embedded derivative. In the event the GDRs perform well, the Company’s liability under the conversion option will increase and result in losses in the income statement. The changes in fair value may be material in comparison to TMK’s net profit and may cause distortions in the income statement. As such, for management discussion and analysis purposes, in addition to net profit (loss) as reflected in the 31 December 2010 consolidated income statement, TMK has decided to present in this management’s discussion and analysis, adjusted net profit (loss) so that it does not reflect gains or losses on the changes in fair value with respect to the embedded derivative component of the convertible bond. Such adjusted net profit (loss) figure is an alternative performance measure that is not reflected in TMK’s consolidated financial statements and has not been audited or reviewed in accordance with ISA.

Issuance of Capital

On 5 February 2010, the Company’s Board of Directors authorised an increase of share capital. In June 2010, TMK received RUB 8,590 million or U.S.$279 million from its shareholders as consideration for the issuance of 64,585,094 shares, representing approximately 7% of its issued and fully paid share capital before the additional issue. In November 2010, the increase of share capital was finalised by means of an open subscription at the price of RUB 133 per share. After completion of the share capital increase, the total number of TMK’s issued and fully paid shares amounts to 937,586,094. Furthermore, during the six months ended 30 June 2010, TMK purchased 64,478,432 of its shares from TMK Steel for U.S.$281 million to guarantee the fulfillment of the Company’s obligation to bondholders in respect of its convertible bonds. The net effect of these two transactions has not materially altered TMK’s total equity.

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