Russian Mechel Steel Roulette

| About: Mechel OAO (MTL)

Russian Roulette is a game of chance whereby the participants spin the revolver and hope the single round doesn't land on them. It is the element of risk-taking and the spinning of the chamber that is reminiscent of a roulette wheel.

Just as roulette is the spinning of the wheel so seems to be the recent volatility of the stock and steel markets. What once seemed to be a sure "bet" on growth has turned into casino like gambling coupled with extreme moves. In this article I will focus on Mechel Steel (NYSE:MTL)(NYSE:MTLPR), more specifically financial statement analysis and provide insight into their liquidity and debt ratios. I will also focus as to why this company is selling for a P/E of less than 5 and in the conclusion I will provide my fair valuation using a Discounted-Cash Flow Model.

First some background. According to their website, "Mechel is one of the leading Russian companies. Its business includes four segments: mining, steel, ferroalloy and power. Mechel unites producers of coal, iron ore concentrate, nickel, steel, ferrochrome, ferrosilicon, rolled products, hardware, heat and electric power." The company was started by Igor Zyuzin, now the CEO, who owns close to 70% of the Outstanding Shares. It is headquartered in Russia, with operations in Romania, Lithuania, Kazakhstan, Bulgaria, and the United States.

As a potential investor the first thing that strikes me is why does this company have $8.9B in Debt and only $356MM in cash? According to their balance sheet their Debt at the end of 2006 was $489MM, however, by the end of 2010 that number had grown to $7.3B. That's an increase of 1400%. On the contrary, their revenues also doubled in that same time period from $4.4B to $9.7B.

According to the financial statements ending 2007 their debt's increased due a series of "synergistic" acquisitions, "For the 2007 full year, Mechel spent $2.5B on acquisitions, including $281MM on Southern Kuzbass Power Plant OAO acquisition; $78MM on Kuzbass Power Sales Company OAO acquisition; $187MM on Bratsk Ferroalloy Plant OOO acquisition; $6MM on Temryuk-Sotra seaport acquisition; $1.9B on acquisition of 75% less one share of Yakutugol OJSHC and 68.86% of the shares of Elgaugol OAO; $73.5MM on acquisition of 49% of the shares of Toplofikatsia Rousse JSC as well as $2.4MM spent on acquisition of minority interest in other subsidiaries."

And in 2008, at the height of their stock price, the stock market, the commodity boom and oil prices, they did the following, "For the 2008 full year, Mechel spent $2.1B on acquisitions, including $198MM on Ductil Steel acquisition; $439MM on advances paid for Bluestone Industries Inc.; $1.4B Oriel Resources acquisition; $15MM on HBL Holdings as well as $51MM spent on acquisition of minority interest in other subsidiaries."

While their stock was hitting $50+, their myopic synergistic acquisitions later resulted in a SEVERE Liquidity Crisis in which there was a very high probability they would have been unable to meet their debt obligations (this was evidenced when their share price went under $4). Luckily, their creditors and banks gave them the proverbial "life-line" and extended them a line of credit and adjusted their debt covenants. The reason this stock has been beaten up recently is for the exact same reason, the possibility of another Liquidity Crisis.

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Financial markets tend to punish overextended firms at the start of a recession. The reason is simple: debt-leveraged companies have the hard task of paying their interest obligations out of a flat or declining level of income. Those firms that are unable to pay for their debt go bankrupt. Those that struggle to pay lose credit worthiness and face further financing troubles down the road. Shrinking profits make debts that are otherwise manageable look horribly burdensome.

As of May 24, 2010, Mechel has a stable corporate family rating of "B1" as well as a "B1" probability of default rating, both assigned by Moody's.

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Now why has this company been unable to grow even though its Annual Revenues have shown tremendous growth? It's because of their very large Interest Expense. See below.

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Now what does that mean for their Liquidity and Debt Ratios? I have attached a ratio analysis from 2006 to present.

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Anytime the Current or Quick Ratio's go below 1 that signals financial trouble to meet any short-term obligations. In this case, one can see that in 2008 and 2009 the company was facing a Liquidity Squeeze that almost put them out of business. They have recently recovered but they still face major headwinds if we head back into a recession.

The Debt Ratios signify that this company in 2007 started to over-leverage their assets due to the Debt. This is evidenced by the Debt/Equity & Debt/Total Assets Ratio. The lower the number the better.

The Time Interest Earned Ratio is a measure of how much Interest Expense they are paying for the Net Income coming in, its formula is EBIT/Interest Expense. The higher the number better, in this case they came dangerously low in 2009 to paying a majority of their Net Income in Interest, potentially causing bankruptcy.

Debt Profile - At the end of 2011 Mechel Steel had $1.3B in debt principal due, 2012 $1.3B, 2013 $960MM, 2014 $602MM, and thereafter $874MM for a total of $5B in debt due in the future. Where are they going to find the capital to pay off these debts? Will they have to change their debt covenants again or renegotiate with their creditors?

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Given this, one can see why this investment is risky and comes with a beta (volatility) level of 2.7 as the largest risks arises from the potential inability to pay off their creditors. Nonetheless, at these prices, this company is simply Under-Valued. If there demand remains stable across Europe and Asia, this stock has the potential to Double from here (early 2011 it was at $25+). As a speculative "risk-on" investment, they have over $6.6B in Property, Plant, and Equipment, this alone is LARGER than the current market cap of the company, ~$4B. In the future, the developing world looks poised to continue devouring steel, iron-ore, and nickel.

The company also pays an annual dividend on common shares but according to their 20-f Annual report the following exists, "Among other things, increased levels of indebtedness, and particularly increases in the level of secured indebtedness, could potentially: (1) limit our ability to obtain additional financing; (2) limit our flexibility in planning for, or reacting to, changes in the markets in which we compete; (3) disadvantage our group relative to our competitors with superior financial resources; (4) lead to a loss of collateral pledged as security; (5) render U.S. more vulnerable to general adverse economic and industry conditions; (6) require U.S. to dedicate all or a substantial part of our cash flow to service our debt; and (7) limit or eliminate our ability to pay dividends."

With a conservative forecast of 15% compounded annual growth I have a value of somewhere around $20+. Also, the PEG Ratio (Price to Earnings Growth) is 0.22, while its peers trade at 5.58. This shows a tremendous discount. Please keep in mind the below valuation is just a guide and the author bears no responsibility for investor loss. We wish to caution you that these statements are only predictions and that actual events or results may differ materially.

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Taken directly from the financial statements one should also be concerned about the Appreciation of the Ruble vs. U.S. dollar: "Our reporting currency is the U.S. dollar. Our products are typically priced in rubles for domestic sales and in U.S. dollars (and, to a lesser extent, euros) for export sales, whereas the majority of our direct costs are incurred in rubles and, to a lesser extent, in other local currencies
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where our operations are based. Appreciation in real terms of the ruble against the U.S. dollar results in an increase in our costs relative to our revenues, adversely affecting our results of operations. In 2003, the ruble appreciated in real terms against the U.S. dollar by 13.6% according to the Russian Central Bank, and further real appreciation of the ruble against the U.S. dollar may materially adversely affect our results of operations."

In conclusion, caveat emptor (buyer beware), this is a severely undervalued firm based on its non-current assets, growth prospects, PEG Ratio, Price/Book, Price/Earnings, and Price/Sales. On the contrary, their Debt Profile may severely hinder its long-term earnings prospects. In the case of a global collapse Mechel Steel will suffer tremendously from its weak financial position. If you are aware of the risks, the rewards will compensate you elegantly as this company can become one of the dominant steel players in our generation, given they manage their debt portfolio. As an added bonus they pay out an annual dividend on their common shares as a percentage of their Net Income.

I encourage all potential investors to read their end of 2010 annual report here.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MTL over the next 72 hours.

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Tagged: , Steel & Iron, Russia
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