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Mechel Retained at Underperform

Zacks Equity Research

We are maintaining our Underperform recommendation on Mechel OAO (MTL). The company’s revenues jumped 28.7% year-over-year to $12.5 billion in 2011. Its consolidated net income also grew from $657.2 million in 2010 to $727.9 million in 2011, a roughly 11% surge.

However, there is more about Mechel than what meets the eye as the threats and weaknesses are substantial enough to hinder its progress in the long-term.

The company witnessed growth across the board in 2011, overcoming headwinds in the form of production issues, adverse market conditions and pricing pressures, among others. However, it might not be long before Mechel’s growth is severely affected due to stiff competition across its businesses.

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.

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 along with effects of inflation can drive Mechel’s costs further north and diminish its earnings power.

Mechel’s high debt load is a serious area of concern. The company had total debt of $9.9 billion sitting on its books at the end of 2011, way ahead of its market capitalization of around $2.4 billion. Mechel faces a greater challenge in pursuing its growth objectives. It had only $643.4 million in cash and cash equivalents at the end of 2011 as against its huge debt and high interest expenses.

Also, ratings agency Moody’s had cut Mechel’s rating outlook to negative from stable in December 2011 as the company went quite close to defaulting on its debt covenants. This might make it more difficult for the company to raise debt financing, hindering its expansionary plans and also puts a question mark on its ability to sustain operations properly in the long run.

Mechel 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. Mechel competes with ArcelorMittal (MT), among others.

The company owns and controls essential infrastructure, including ports, rolling stock and power plants, which provide access to the export markets. However, as mentioned earlier, Mechel could be handicapped because of its high debt and interest burden and might not be able to keep up with its huge capital spending program.

Our recommendation on the stock is backed by a Zacks #5 Rank, which translates into a short-term (1 to 3 months) Strong Sell rating.

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