Mechel OAO ADS

/ Equity Research / MTL | Page 1

Mechel OAO – ADS

/ (MTL-NYSE)
/ Equity Research / MTL | Page 1
Current Recommendation / NEUTRAL
Prior Recommendation / Underperform
Date of Last Change / 08/30/2012
Current Price (12/31/14) / $0.68
Target Price / $0.75

SUMMARY

We are retaining our Neutral recommendation on Mechel OAO.The company posted wider loss in the third quarter of 2014, hurt by lower iron ore and coal pricing. Revenues fell by double-digits year over year on declines across all segments.Mechel’s high debt and substantial interest burden are matters of concern. The company is also faced with weak demand from Europe and pricing pressure. However, we are encouraged by the incremental opportunities stemming from the Elga mine, which is expected to reinforce the company’s position as a metallurgical coal producer through capacity expansion.
/ Equity Research / MTL | Page 1

SUMMARY DATA

52-Week High / $2.58
52-Week Low / $0.43
One-Year Return (%) / -73.29
Beta / 2.49
Average Daily Volume (sh) / 722,206
Shares Outstanding (mil) / 416
Market Capitalization ($mil) / $283
Short Interest Ratio (days) / 25.60
Institutional Ownership (%) / 10
Insider Ownership (%) / N/A
Annual Cash Dividend / $0.00
Dividend Yield (%) / 0.00
5-Yr. Historical Growth Rates
Sales (%) / N/A
Earnings Per Share (%) / N/A
Dividend (%) / 62.6
P/E using TTM EPS / N/A
P/E using 2014 Estimate / N/A
P/E using 2015 Estimate / N/A
Zacks Rank*: Short Term
1–3 months outlook / 2 - Buy
* Definition / Disclosure on last page
Risk Level * / High,
Type of Stock / N/A
Industry / Steel-Producers
Zacks Industry Rank * / 230 out of 267

OVERVIEW

Mechel OAO (MTL) is one of Russia’s leading mining and metallurgical companies, producing coal, iron ore, nickel steel, rolled steel products and hardware. Headquartered in Moscow, the company conducts business through a number of subsidiaries. Besides Russia, Mechel operates facilities in Romania and Lithuania. The company has 4 operating segments – Mining, Steel, Ferroalloy and Power.

Mechel’s Steel segment comprises the production and sale of semi-finished steel products, carbon and specialty long products, carbon and stainless flat products, besides value-added downstream metal products including hardware, stampings and forgings. It also produces significant amounts of coke, both for internal use and for sale to third parties. Mechel has integrated backwards into mining and is feeding its steel mills with raw materials from the mines. The company’s steel and steel-related production facilities in Russia include two integrated steel mills, a coke plant, a hardware plant, a forging and stamping mill, and a scrap-processing facility in the southern Ural Mountains, a ferrosilicon plant in eastern Siberia, a hardware plant in northwestern Russia near the Finland border, and a coke and coal gas plant near Moscow. Outside Russia, Mechel has steel facilities in the European Union, including a hardware plant in Lithuania and 4 steel mills in Romania. Mechel is the smallest company among Russian integrated steelmakers, but is the most diversified in the Steel and the Mining segments. It is the largest and most comprehensive producer of specialty steels and alloys in Russia, producing 39% of total Russian specialty steel output. Chelyabinsk Steel is Mechel’s core steel mill and one of the 10 biggest Russian steel plants, with around 30% share of the national output of stainless and of special steel as well as large-scale production of rebar.

Mechel’s Mining segment consists of coal and iron ore mines in Russia. The company’s subsidiary Southern Kuzbass Coal Company operates coal mines located in southwestern Siberia. Mechel has four open pit coal mines— Krasnogorsk, Tomusinsk, Olzherassk and Sibirginsk— and three underground coal mines— Lenin, Sibirginsk and New-Olzherassk. In the SakhaRepublic in eastern Siberia, Mechel’s subsidiary Yakutugol operates the Nerungrinsk and Kangalassk open pit mines and the Dzhebariki-Khaya underground mine. The company’s subsidiary Korshunov Mining Plant operates three open pit iron ore mines— Korshunovsk, Rudnogorsk and Tatianinsk, all located in central Siberia.

The Ferroalloy segment was formed at the beginning of 2008, following the acquisition of U.K.-based chrome and nickel mining and processing company Oriel Resources.

Mechel’s Power segment is the newest of its three segments. The Power segment, comprising power generating facilities, supplies energy to the Mining and Steel segments and sells a portion of the power to third parties and a power distribution company. The company expects its Power business to help increase the electric power self-sufficiency of its Mining and Steel segments. The Bulgarian Rousse power planthas an installed electric power capacity of400MWand ithas total heat capacity of35Gcal/h. The Southern Kuzbass Power Plant has atotal installed capacity of554MWand an installed heat capacity of560Gcal/h.

Mechel produced roughly 27.5 million tons of coal, 3.7 million tons of pig iron and 4.7 million tons of steel in 2013.

Mechel, in January 2013, acquired a controlling stake in Vanino Sea Trade Port OAO for about RUB15.5 billion ($512.5 million). The Government of the Russian Federation, in December 2012, issued a decree related to the sale of federally owned shares of Vanino Sea Trade Port OAO and Mechel was declared the buyer. The company purchased 55% of share capital (or 73.33% of common shares) of Vanino.Port Vanino is one of Russia's ten largest ports. According to Mechel, Port Vanino’s coal transhipment capacity can be increased to 7 million tons in 2013 without incurring any significant costs.

However, Mechel subsequently sold a part of its 73.3% stake (55% of share capital) in Vanino Sea Trade Port OAO. As such, the company now retains a small portion of the enterprise's common shares.

Mechel, in February 2013, announced that its logistics subsidiary Mecheltrans OOO acquired a 21.64% stake at Port Vanino for 4.57 billion rubles (around $152 million) from one of the port's minor shareholders, a subsidiary of the company En+.According to the agreement signed between the two parties, Mecheltrans got hold of the port's shares immediately.

Mechel, in February 2013, announced the sale of its Romanian steel assets to Romania's Invest Nikarom SRL for a small amount of 230 Romanian lei (about $70). Invest Nikarom SRL bought Mechel’s five assets, namely, Ductil Steel Mechel, Campia Turzii S.A., Mechel Targoviste S.A., Mechel East Europe Metallurgical Division SRL, and Laminorul S.A.The decision to sell these assets was in response to weak pricing for steel products in Europe and weak demand for finished products. Earlier, in November 2012, Mechel temporarily halted Romanian steel manufacturing facilities because of poor economic conditions.

Mechel, in June 2013, signed an agreement with BelAZ OAO to form a Russo-Belarusian joint venture that will be responsible for technical maintenance and repairs of BelAZ mining dump trucks in the Republic of Sakha (Yakutia), Russia. The joint venture will be called ElgaBelAvto OAO.Mechel and BelAZ have decided to utilize Yakutugol Holding Company’s production area for setting up ElgaBelAvto’s plants and they also plan to create a subsidiary at the Elga Open Pit. ElgaBelAvto will provide services to meet the maintenance requirements of Yakutugol Holding Company's two biggest coal open pits — Neryungrinsky and Elga — which include more than 140 mining truck units in the medium run.

The company, in August 2013, entered into an agreement to sell its ferroalloys assets to Turkey-based ferroalloys company Yildirim Group for $425 million.The divestmentcompleted in December 2013.Mechel disposed Voskhod Mining Plant in Khromtau, Kazakhstan and Tikhvin Ferroalloy Plant in Tikhvin, Leningrad Region, Russia.

REASONS TO BUY

Mechel is Russia’s second largest producer of specialty steel and long steel products. It has a wide range of offerings as compared to other Russian producers, thereby giving it an extra edge in its addressable market. Also, Mechel has established itself as one of the largest producers of coking coal in the world by fully acquiring the U.S. entities Bluestone Industries Inc., Dynamic Energy Inc., and JCJ Coal Group LLC in West Virginia. Mechel is also focusing on expanding its customer base. The company, in April 2013, signed a contract with Baosteel Resources Int. Co., under which, it will supply the latter with up to 960,000 tons of coking coal annually. Moreover, the company’s mining unit’s trading subsidiary, Mechel Carbon (Singapore), signed a three-year coking coal supply agreement, in May 2013, with South Korean steel maker POSCO Corporation. Under the contract, Mechel Carbon will be supplying 500,000 tons of coking coal per year to POSCO for three years. Mechel Carbon has also signed another one-year contract with POSCO, wherein, it will supply 200,000 tons of PCI coal in 2013. More recently, Mechelinked a coking coal supply deal with China’s Shasteel Group, under which, Mechel Carbon will supply 40,000 to 80,000 tons of coking coal a month from Russian Far East ports to Shasteel.

Mechel benefits from backward integration as the only specialty steel manufacturer in the world capable of internally sourcing most of its raw materials. The company is capable of internally sourcing 100% of coking coal, 30% of iron ore and 89% of nickel requirements of its Steel segment. The company intends to selectively expand internal logistics capabilities, currently centered on railway freight, enhanced by the acquisitions of Port Posiet located on the Sea of Japan, and Port Kambarka – one of Russia's largest river ports – to help optimize transportation expenses. The company has successfully tested a new coal export terminal at Port Posiet.Its exports to Asia-Pacific countries will increase once the port's facilities are modernized.Mechelrecently announced that the Port Posiet has attained 5 million tons of annual cargo volume of coal products. The company now expects the port to achieve a capacity of 7 million tons of coal by 2015.

Mechel continued to develop its production assets and key strategic projects at all mining subsidiaries in 2011. Its largest achievement was the launch of the first stage of Elga open pit, the significance of which is hard to estimate. With Elga reaching full capacity, Mechel will substantially reinforce its positions among leading world metallurgical coal producers. Mechel has received the industrial washing results confirming the high quality of Elga's coking coal. The company further plans to develop the mining segment's resource base, creating a solid platform for increased production of high-value coal.The company has completed the construction of the Elga Coal Complex. It also signed a long-term deal with RAO Energy Systems of East OAO, which offers gradual increase in coal supplies up to a total of 60 million tons over 15 years, thus ensuring a long-term off-take for Elga’s steam coal. Mechelhas also constructed a seasonal washing plant at the site for accelerating the production and sales of coking coal concentrate. The plant has reached a capacity of 2.7 million tons of coal.The launch of the washing plant enables the company to mine and process coking coal at Elga on production scale. The company, in Oct 2013, entered into an agreement with Vnesheconombank for the allocation of the first tranche (worth $150 million) of the project financing for Elga Coal Complex's first stage aggregating $2.5 billion. Mechel has also signed agreements for the second and third credit lines of project financing amounting $2.085 billion and $418.7 million, respectively. Mechel expects that products from the Elga deposit will make their first major contribution to the Mining division's operational results in 2014. The company has also installed new coal washing and dewatering technology at Elga Coal Complex's seasonal washing plant. With the technology in place, the washing plant's end-product capacity will increase by 10% (from 2 million tons to 2.3 million tons annually) and cut the facility's consumption of process water by 2.5-3 times. Roughly 1.3 million tons of coal are expected to be mined at the Elga deposit in 2014, increasing to 3-3.5 million tons in 2015. In addition to Elga, Mechel is also making progress in building a second line at the Sibirginskaya mine in the Southern Kuzbass, which is expected to double its production capacity to 2.4 million tons of coking coal a year.

Mechel’s mining and logistical assets are strategically located to help it expand its sales in Atlantic and Asia-Pacific seaborne markets. The Yakutugol and its Elga mines are expected to increase the company’s footprint in key Asian markets. The presence of its mines near emerging regions gives Mechel the much needed leverage it requires to grow its sales.

REASONS TO SELL

Mechel’sposition is still precarious as far as debt is concerned, since total debt on its books (roughly $7.9 billion at the end of the most recent quarter) is nearly thirtytimes of its market capitalization. Higher debt results in a greater interest charge. Moreover, a high leverage restricts the company’s ability to raise new debt for further financing.

The company is facing stiff competition in its steel, mining and ferroalloys businesses. The steel and mining industry has several bigger players who are more resourceful than Mechel. The company expects to face competitive pricing from established producers in emerging markets such as Ukraine and Kazakhstan. Increased competition could lead to a pricing war and throttle Mechel’s margins in the process.

Although Mechel’s operations are mostly low cost in nature, such as those in Russia and other former Eastern Bloc countries, it has seen its costs escalate over the past few years. Higher costs of electricity, railway transportation, natural gas and labor along with inflation might decrease Mechel’s competitive lead by moving it higher on the cost curve. This would result in lower operating margins as well, and therefore, diminish the company’s earnings power.

The company is contending with lower coking coal sale prices stemming from low demand from key customers. Mechel, in April 2014, temporarily suspended mining at Bluestone in the U.S. (a part of the company’s Mining division) due to weak spot prices for coking coal. Average coke and coal prices fell 33% year-over-year in 2013. The company’s steel business is also facing weak demand from Europe and pricing pressure, and its Ferroalloy division remains affected by lower nickel pricing. Considering the unfavorable nickel market trends, the company has halted production at its South Urals nickel plant.