Management discussion of financial performance

• Focus on maintaining financial strength in a loss-making year
• Actions taken in response to the weak stainless steel market
• Progress towards a more stable business model
• Excellence programmes
• Stainless steel market development in 2009
• Severe losses in historically poor market conditions
• Balance sheet remains relatively strong despite the heavy loss
• Dividend
• Economic value added
• Factors affecting Outokumpu's profitability
• Outokumpu and stainless steel markets going forward

Focus on maintaining financial strength in a loss-making year

In the wake of the global economic crisis and the resulting dramatic collapse of demand in the stainless steel market at the end of 2008, Outokumpu's focus at the beginning of 2009 was on cash generation, short-term cost-efficiency and maintaining the company's financial strength. In response to the weak demand that prevailed in 2009, painful actions to adjust capacity and costs were taken throughout the Group, resulting in both temporary and permanent layoffs and other cost-saving measures. At the same time, Outokumpu remained committed to its strategy of achieving a more stable and profitable business model by increasing the proportion of sales to end-user and project customers as well as building more stable relationships with key distributor customers. Other strategic objectives include maintaining cost leadership in standard grades and broadening the product portfolio, as well as increasing the share of special grades, value-added products and non-nickel containing grades. The ongoing recession limited progress towards these strategic targets in 2009.

The beginning of 2009 was marked by severe losses and very low demand from all major customer segments due to low levels of economic activity and heavy destocking throughout the value chain. Base prices were very low at the beginning of the year and the rapid decline in metal prices resulted in major raw material-related inventory losses. Market conditions improved slightly in the summer as increasing raw material prices triggered minor restocking by distributors and base prices started to recover. On the other hand, underlying demand for stainless steel remained extremely poor throughout the year and distributors' buying behaviour was cautious. Markets softened during the fourth quarter of 2009 and base prices declined again before stabilising at the end of the year. Even though Outokumpu's result improved gradually as the year-end approached, it remained disappointingly negative. In line with the company's 2009 focus, cash flow from operations was still positive and the balance sheet remained relatively strong. Cost-cutting measures implemented throughout 2009 had a positive impact of some EUR 185 million on the result.

At the beginning of 2010, market conditions remain difficult and challenging, but have stabilised from the total collapse witnessed at the end of 2008. Outokumpu's current focus is on restoring profitability while at the same time maintaining the balance sheet flexibility required to pursue strategic investments when market conditions improve.

Actions taken in response to the weak stainless steel market

In 2009, Outokumpu made a number of difficult decisions in order to prepare for a possible period of prolonged demand weakness and to ensure that cost-efficiency and financial strength are given the highest priority in extremely challenging market conditions. Cost-saving measures included temporary and permanent reductions in the numbers of personnel employed in several countries as well as Group-wide general cost-saving programmes. Actions taken included temporary layoffs affecting more than 2 000 people and some 900 permanent job reductions, with the result that Group fixed costs were reduced by some EUR 185 million in 2009. Approximately half of these savings are expected to be sustainable.

Progress towards a more stable business model

Outokumpu's objective is to develop and secure a more stable and profitable business model to balance out the effects of volatility in the market for stainless steel standard grades and products, and to address growth prospects related to the Group's size and geographical coverage. Despite the difficult market situation and the resulting limited progress towards its strategic goals, Outokumpu is committed to its chosen path towards a more stable business model. Read more about Outokumpu's strategy.

Increasing the proportion of value-added special products such as low-nickel duplex grades and growth in sales of ferritic (non-nickel-containing) grades will help reduce the earnings cyclicality driven by volatile nickel prices. Margins in special grades are higher and more stable than in standard grades. By offering special products, Outokumpu can serve end-customers better and offer tailor-made solutions which deliver higher value and higher performance as well as cost savings.

Supporting the aim of increasing the proportion of special grades, value-added products and non-nickel-containing grades, Outokumpu successfully completed replacement of one of the five annealing and pickling lines at the Group's Tornio Works in Finland during 2009. This investment improves Outokumpu's capabilities in brighter ferritic steel grades and enhances production flexibility. At Nyby in Sweden, the investment to double annual production capacity in special grades from 34 000 tonnes to more than 70 000 tonnes was completed. In order to shift the Nyby plant's product mix towards more value-added special grades, a new grinding line with automated intermediate storage and an entry section to the annealing and pickling line was taken into operation in October 2009. At New Castle (IN) in the US, an investment to upgrade and install equipment that will increase the plant's quarto plate capacity by some 20 000 tonnes to 70 000 tonnes has progressed well and completion is expected in the spring of 2010. With this investment, the Group's quarto plate product mix will shift increasingly towards value-added tailor-made plates and special grades, especially Outokumpu's proprietary lean duplex and other duplex grades.

The transformation towards increased end-user and project sales requires investment in the Group's service centre capabilities. In end-user and project sales, steps taken during 2009 include completion of the expansion in stock and processing capacity at the Outokumpu service centre in Willich, Germany. This investment improves and expands the Group's service offering to end-user and project customers in Germany, Europe's largest stainless steel market. The project consisted of expanding the site area, doubling the size of the service centre building and installing new cut-to-length and slitting lines. Annual capacity at the service centre has been increased from 60 000 tonnes to 125 000 tonnes. A new service centre being built in China near Shanghai will have the capacity to stock and process some 30 000 tonnes of mainly special grades when it becomes operational in mid-2010.

In December 2008, Outokumpu decided to postpone almost all elements of the Group's investment programme for at least 12 months. Continuation of any project is subject to a separate decision based on an updated feasibility study. In 2009, Outokumpu decided that the investment to expand melt-shop capacity from 500 000 tonnes to 750 000 tonnes at Avesta in Sweden will not proceed in the foreseeable future as there is no need for additional melting capacity in the medium term. Write-downs of EUR 15 million associated with this investment were booked in the 2009 third-quarter operating result. As originally planned, this investment would have totalled some EUR 200 million. Further decisions regarding other postponed investments will be made by the end of 2010.

Excellence programmes

The Operational Excellence programmes launched in 2005 and originally comprising Production and Commercial Excellence were expanded to include Supply Chain Excellence in 2007. While the targeted benefits were achieved in 2008, they were not reached in 2009 with the prime causes being very-low delivery volumes and raw material prices. The targets set for this programme were improving Group performance by EUR 80 million in 2008 and EUR 200 million in 2009 compared to 2005. In 2009, benefits delivered by the Operational Excellence programmes totalled some EUR 150 million (2006: EUR 25 million, 2007: EUR 45 million, 2008: EUR 86 million) compared to 2005. Examples of profitability-raising improvements achieved through the Operational Excellence programmes include utilising raw materials more efficiently, providing additional capacity to solve production bottlenecks, improved pricing discipline, the release of working capital through shorter payment terms and achieving profitable growth with key customers.

Due to the current weak market outlook for stainless steel, the original 2010 target of EUR 300 million in benefits from the Operational Excellence programmes will not be achieved. In the short term, these programmes will focus on working capital reduction, raw material usage and other cost-saving-related projects rather than capacity enhancement. The strong focus placed on Operational Excellence programmes within the Group will lead to the targeted benefits totalling EUR 300 million being achieved in the future.

Stainless steel market development in 2009

2009 began with both very low levels of demand and low base prices as inventories were being reduced throughout the value chain from mills to end-users of stainless steel. Significant production cuts were executed by producers, especially in Europe, and capacity utilisation was at the historically extremely-low levels of 50-55%. Triggered by higher raw material prices, purchasing activity among distributors improved somewhat in the second quarter, and base prices started to increase gradually as the autumn months approached. Towards the end of the fourth quarter, customers became hesitant about building stocks and delayed their purchases over the year-end. Base prices began to decline again during the fourth quarter but stabilised at the end of the year. Compared to 2008, estimates indicate that apparent consumption of stainless steel in 2009 was down by 29% in Europe and down by 8% globally. China, where year-on-year consumption is estimated to have increased by 13%, was the only region in which positive growth was recorded in 2009. Read more about the stainless steel market in 2009.

The average German base price for 2mm 304 cold rolled sheet in 2009 was 1 161 EUR/tonne, 2% lower than in 2008. After the collapse of the stainless steel market at the end of 2008, the base price was very low during the first quarter of 2009 at 925 EUR/tonne. The recovery that began in the second quarter lifted the base price to 1 307 EUR/tonne in the third quarter before it fell back to 1 297 EUR/tonne at the end of the year. The transaction price for stainless steel averaged 2 036 EUR/tonne in 2009, 27% lower than in the previous year because of the higher price of nickel in 2008 (CRU). Prices for special grades and project-related products were more stable but weakening demand had a negative impact.

Outokumpu's average base prices were somewhat lower than the CRU reference price in 2009.

The price of nickel increased from a very low level of 10 000 USD/tonne at the beginning of the year to some 20 000 USD/tonne after the summer and was at 17 500 USD/tonne at the year-end. The ferrochrome contract price increased gradually during the year, moving from 0.79 USD/lb in the first quarter and 0.69 USD/lb in the second quarter to 1.03 USD/tonne in the fourth quarter. Molybdenum, which is used to make stainless steel acid-resistant, surged from levels of 9 USD/lb at the beginning of the year to 18 USD/lb at the end of the summer, then declined to 11 USD/lb by the end of the year.

Severe losses in historically poor market conditions

Lower delivery volumes and lower transaction prices for stainless steel in 2009 resulted in Group sales for the year declining to EUR 2 611 million (2008: EUR 5 474 million). Stainless steel deliveries totalled 1 030 000 tonnes, a significant decline from the previous year (2008: 1 423 000 tonnes).

Operating loss in 2009 was EUR 438 million (2008: EUR 63 million), with net non-recurring costs of some EUR 20 million being included in this figure (EUR 15 million of write-downs resulting from the decision not to proceed with the melt-shop investment in Avesta in Sweden and EUR 5 million of restructuring provisions). In 2008, operating loss included net non-recurring costs of some EUR 83 million (EUR 66 million of provisions and write-downs related to the closure of the Thin Strip business in Sheffield and some EUR 17 million of provisions related to personnel reductions in Sweden). Raw material-related inventory losses constrained the Group's operating result in 2009 by EUR 78 million (2008: EUR 285 million losses). The underlying operational result for 2009 was EUR 340 million negative (2008: EUR 305 million positive), with the main reason for the decline in operating profit being significantly lower delivery volumes. Lower average base prices also had a negative effect on the result. On the cost side, financial benefits achieved through optimising raw material usage and pricing were reduced in 2009 because of lower metal prices. Cost saving actions implemented in 2009 resulted in EUR 185 million lower fixed costs compared to 2008. Approximately half of these savings are expected to be sustainable. The sharp decline from record-high ferrochrome prices in 2008 and lower delivery volumes due to closure of the Group's mine and ferrochrome production from April to October resulted in a negative year-on-year impact from Outokumpu's own ferrochrome operations in 2009.

Net financial income and expenses in 2009 was EUR 25 million negative (2008: EUR 47 million negative). Net financial expenses in 2009 do not include non-recurring items. In 2008, an impairment loss of EUR 21 million (EUR 12 million in the first quarter and EUR 9 million in the fourth quarter) was booked in other financial expenses due to the decline in the share price of Belvedere Resources Ltd, classified as an available-for-sale financial asset. Net interest expenses fell to EUR 22 million (2008: EUR 54 million). Profit before taxes was EUR 474 million negative (2008: EUR 134 million negative). Net profit in 2009 was EUR 336 million negative (2008: EUR 189 million negative) and the net profit from continuing operations was EUR 332 million negative (2008: EUR 110 million negative). Earnings per share was EUR -1.86 (2008: EUR -1.05) and earnings per share from continuing operations was EUR -1.83 (2008: EUR -0.61). The return on capital employed in 2009 was -11.7% (2008: -1.6%).

Balance sheet remains relatively strong despite the heavy loss

Due to the significant loss, Outokumpu's return on capital employed of -11.7% in 2009 was a long way from the target of 13.0%. Despite this disappointing result, gearing remained below the target level of 75%, and net cash generated from operating activities in 2009 was positive at EUR 198 million (2008: EUR 664 million positive). This figure includes a EUR 548 million positive effect from the release of working capital resulting mostly from declining inventory volumes, declining raw material prices and a reduction in accounts receivables. At the end of 2008, Outokumpu decided to postpone investments totalling some EUR 1.5 billion in order to maximise cash flow and maintain balance sheet flexibility in 2009 and afterwards. As a result, capital expenditure in 2009 totalled EUR 245 million compared to the planned level of EUR 850 million. Investments were limited to mandatory maintenance and expansion projects that were close to completion. Major investments in 2009 were the replacement of the No. 2 annealing and pickling line at Tornio Works, the expansion of stock and processing capacity at the Group's service centre in Willich, Germany, the building of a new dispatch hall for quarto plate in Degerfors, Sweden and the doubling of annual special grades production capacity in Nyby, Sweden. Construction of the Group's new service centre in China was also initiated. These investments totalled some EUR 98 million.

Outokumpu's financial and liquidity position remains relatively strong. At the end of 2009, the Group's equity-to-assets ratio stood at 50.6%. Net interest bearing debt at the end of 2009 totalled EUR 1 183 million (end of 2008: EUR 1 072 million) with most of the Group's debt maturities extending to the 2010–2013 period. Group cash and cash equivalents stood at EUR 112 million (2008: EUR 224 million) at the end of the year, and committed undrawn credit facilities totalled some EUR 1.1 billion. Committed credit facilities include a three-year EUR 900 million revolving credit facility signed in June 2009. Intended for general corporate purposes, this replaces the comparable five-year EUR 1 billion facility signed in June 2005. The loan agreement includes a financial covenant based on gearing. The facility was fully undrawn at the end of 2009.

Dividend

Group earnings per share in 2009 totalled EUR -1.86, with earnings per share from continuing operations EUR -1.83 and earnings per share from discontinued operations EUR -0.02. Total shareholder return (TSR) was 64.4% (2008: -58.6%). TSR is calculated as the annual change in share price plus the dividend, divided by the starting share price for the year. Outokumpu's share price was EUR 8.28 at the beginning of the year and fell to EUR 7.72 on January 23, 2009 before rebounding to EUR 13.26 by the end of the year (respective market capitalisation of EUR 2 400 million). Dividends for 2008 totalling EUR 90 million (EUR 0.50 per share) were paid in 2009.

In accordance with the Board of Directors' established dividend policy, the payout ratio over a business cycle should be at least one-third of the Group's profit for the period with the aim of making stable annual payments to shareholders. In its annual dividend proposal, the Board of Directors will, in addition to financial results, take into consideration the Group's investment and development needs. The Board of Directors is proposing to the Annual General Meeting to be held on March 30, 2010 that a dividend of EUR 0.35 per share be paid for 2009. The dividend yield is 2.6% and Outokumpu's average dividend payout ratio over the past five years has been approximately 91%.

Economic value added

Outokumpu's overall financial objective is to generate the maximum sustainable economic value added on capital invested by its shareholders. Outokumpu uses the weighted average cost of capital (WACC) in defining the capital charge for economic value added (EVA), and applies this when estimating the profitability of investment projects and defining the economic and commercial value of the Group's business operations. In 2009, Outokumpu's WACC after taxes was approximately 6%. This figure was obtained using a target capital structure in which the weight given to equity is 60% and the weight of debt is 40%. The cost of equity was 8.4% and the after-tax cost of debt was 3.3%. Economic value added by Outokumpu's continuing operations in 2009 totalled EUR -547 million (2008: EUR -293 million).

Factors affecting Outokumpu's profitability

The stainless steel business is cyclical. In addition to the company's own actions, Group profitability depends on the current stage in the global economic cycle and especially on levels of industrial investment activity. In the long term, demand for stainless steel has been growing at an annual rate of 5–6%. Changes in regional or global production capacity can sometimes have an adverse effect on stainless markets, resulting in temporary imbalances between supply and demand. Increasing stainless steel production capacity in China will continue to have an effect on the global supply situation in future years.

A key factor that has a direct effect on Outokumpu's profitability is developments in stainless steel base prices. The level of these prices is linked to both the economic cycle and to levels of industrial investment in the Group's main customer segments. Changes in base prices have also been attributable to strong fluctuations in demand from distributors who are either de-stocking or re-stocking their inventories. Outokumpu's current dependence on traditional nickel-containing standard austenitic grades exposes the Group to demand volatility caused by fluctuations in the nickel price. The distributor sector in particular has postponed placing orders for stainless steel when nickel – and thus stainless steel transaction prices – are expected to fall, resulting in unnecessary demand volatility without any changes in underlying demand.

Transaction prices for stainless steel comprise the base price plus an alloy surcharge. The alloy surcharge applied in Europe and North America includes the cost of alloying materials when the prices for these exceed predefined trigger-price levels. The cost of alloying materials for stainless steel – nickel, chrome, molybdenum, iron and titanium – is invoiced to customers by stainless steel producers through the alloy surcharge mechanism, reducing the producer price risk associated with alloying materials. Even so, the price paid for alloying materials feeds through into the amounts tied up in working capital. As Outokumpu's throughput time is longer than the time period applied in the alloy surcharge mechanism, changes in the price of alloying materials may lead to timing differences that have an impact on Group profitability. The alloy surcharge is based on a 30-day average of raw material prices calculated backwards from the 20th day of the preceding month.

Outokumpu's operating profit is affected not only by changes in base prices but also by delivery volumes, unit costs and the product mix. When manufacturing stainless steel, capacity utilisation rates also have a major impact on operating profit. Production volumes depend on the demand for stainless, and products are mostly produced to fulfil orders. The product mix also has an impact on profitability – products with higher value added are more profitable.

The Group's chromium mine near Tornio in Finland supplies Outokumpu with the majority of its ferrochrome needs at the cost of production. This has a direct positive impact on Group profitability. Read more about Outokumpu's ferrochrome operations.

Stainless steel is fully recyclable. Alloying materials can usually be purchased at a discount when sourced as recycled stainless steel and Outokumpu therefore always attempts to maximise the use of recycled steel in the Group's manufacturing processes. The extent of the discount depends on the prevailing market conditions. When prices for alloying materials are high, the financial benefits of using recycled material can be significant. Some 60% of raw materials used by the Group in production are sourced as recycled stainless steel.

As a general rule, currencies in which stainless steel products are priced are determined by the market area: euros in Europe and US dollars in the US and Asia. Price levels in Europe, the US and Asia can differ. Outokumpu is exposed to fluctuations in currency exchange rates primarily because of sales to the Asian and US markets and also because the Group's own ferrochrome production is priced in US dollars. Exchange rates may also impact the relative competitiveness of stainless steel producers on different continents. The majority of Outokumpu's production costs are incurred in euros, Swedish crowns and UK pounds. Prices for raw materials are determined primarily in US dollars, while the alloy surcharge mechanism transfers changes in exchange rates to the euro price in Europe.

The table below shows the approximate sensitivity of Outokumpu's operating profit in 2010 to changes in stainless steel base prices, changes in ferrochrome prices and changes in exchange rates between the euro and the main currencies used by the Group. These sensitivities have been calculated on the basis of the average exchange rates in 2009 and the highest achieved delivery volumes.

Outokumpu and stainless steel markets going forward

In 2009, the stainless steel industry was hit hard by the ongoing global recession, especially in Europe, and the dramatic decline in demand for stainless steel had a major negative impact on Outokumpu. At the beginning of 2010, although there are still no signs of major improvement in end-user demand for stainless, market conditions have stabilised and are clearly better than they were at the beginning of 2009. Although short-term demand remains depressed and visibility is still relatively poor, long-term prospects for stainless steel demand are robust. The long-term average annual rate of growth in global stainless steel consumption is forecast by SMR (Stainless Market Research) to be 5.5% (CAGR) in the period 2008–2020. Growth is expected to remain strong in Asian markets where capacity has also been increasing rapidly. These significant increases in capacity may cause periods of imbalance when supply exceeds demand, with a consequent impact on the global market and particularly in standard grades.

Despite the external uncertainties in the current operational environment, Outokumpu remains committed to its stated strategy and plans. The Operational Excellence programmes have delivered solid, well-proven results and Outokumpu is focusing strongly on building Operational Excellence in the future. Group-wide cost-cutting actions implemented in 2009 exceeded the original targets and resulted in clear sustainable savings. In the current market situation, Outokumpu's priority is to balance short-term cost and cash flow management with balance sheet flexibility and longer-term strategy implementation. Even though many related investments have been postponed, Outokumpu currently has adequate production capacity available to continue the Group's strategic drive towards a more stable and profitable business model. As a leading producer, Outokumpu is well positioned to capitalise on the world's growing demand for stainless steel.

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