We are upgrading our recommendation on Russian miner Mechel OAO (MTL) to Neutral factoring in the healthy prospects for its Elga mine. The company’s profit slipped 29.5% year over year to $218 million in first-quarter 2012. Revenues rose modestly to $3 billion.
Despite a weak pricing environment, revenues from the mining segment increased year over year in the quarter on the back of higher coal product sales volume and increased iron ore concentrate revenues. However, steel market dynamics were not favorable and Mechel had to deal with lower demand for steel products.
Mechel, which competes with ArcelorMittal (MT) and others, is a leading domestic steel and coal producer with a strong position in key businesses, including production of specialty steel and alloys. The company has the largest coal reserve base in Russia and is mainly focusing on growth and cost-cutting measures.
The company owns and controls essential infrastructure, including ports, rolling stock and power plants, which provide access to the export markets. It is capable of internally sourcing most of its raw materials.
We are encouraged by the incremental opportunities stemming from the Elga mine which is expected to reinforce Mechel’s position as a metallurgical coal producer through capacity expansion.
The company continues the development of the Elga mine. It has also constructed a seasonal washing plant at the site for accelerating the production and sales of coking coal concentrate. In addition, 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.
However, Mechel’s high debt load represents a serious concern. The company had total debt of $9.6 billion sitting on its books at the end of the first quarter, roughly four times of its market capitalization. Mechel could be handicapped because of its high leverage and interest burden and may not be able to keep up with its huge capital spending program.
In addition, Mechel’s cost advantage is in danger of being wiped out as the company has seen costs rising at a fast clip over the last three years. Increase in electricity costs, railway transportation, natural gas and labor coupled with effects of inflation could drive Mechel’s costs further north and diminish its earnings power.
There are several more established players in the steel and mining space who have more resources than Mechel. This could ignite a price war in emerging regions where Mechel has interests, forcing it to reduce price in order to compete and taking a hit on its margins in the process.
Our recommendation on the stock is backed by a Zacks #3 Rank, which translates into a short-term (1 to 3 months) Hold rating.
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