Although the rally in steel stocks has cooled in February, investors are still generally optimistic on the outlook for domestic names like Steel Dynamics (STLD) and Nucor (NUE), as well as global plays like ArcelorMittal (MT). That enthusiasm has not extended out to Russia's Mechel (MTL) to the same degree, as analysts are concerned not only about the company's higher-cost steel operations, but also its over-leveraged balance sheet and its unimpressive history of organic growth.
Can Integration Pay Off?
As the largest producer of coking coal in Russia (with well over 20% share), and a large iron ore miner as well, Mechel is well-covered for its own steel needs, and it's the second-largest long steel maker in Russia (behind Evraz). Unfortunately, this level of internal integration hasn't necessarily always paid off for shareholders.
Management has had a disappointing record of meeting its own internal coal and steel production targets in recent times. What's more, the company has not enjoyed an especially robust premium for its various construction-related steel outputs. Unlike ArcelorMittal, then, which enjoys not only internal supply integration but also solid specialty pricing, Mechel is floundering and the recent single-digit returns on invested capital reflect that.
A Relatively Local Market
Russian steel is not often a major player in markets like the U.S. or China, though a few companies like Severstal do perform relatively better in this regard. That leaves Mechel more exposed to local Russian demand. Although Russia has been seeing some residential construction growth and growth in its energy sector, the overall performance of the Russian steel sector hasn't been dramatically better than that in markets in North America or Europe.
At the same time, while Mechel's mining business is relatively more profitable than its steel operations, these markets have been cooler of late as well. Vale (VALE) reported a 20% sequential decrease in iron prices that broadly correlates with recent price movements in the Russian market.
Thermal coal has likewise been weaker (to much the same extent) as utilization in the steel industry has been fairly soft. It also has not been helping matters for Mechel that they've been producing more of the lower-value thermal coal of late.
Beaten Down To Outperformance?
Relative to large integrated steel companies like Arcelor, U.S. Steel (X), and POSCO (PKX), Mechel produces pretty solid EBITDA margins. On the flip side, relative to miners like Vale, Rio Tinto (RIO), and Peabody Energy (BTU), Mechel's margins are relatively poor. Moreover, it's inability to drive better mining production absent M&A is a serious consideration when it comes to assessing just how much shareholder value the company can produce.
All of that said, perhaps the company has been pounded far enough. Yes, the company's debt has reached a level where the company is likely to feel pressure from the market to be better about its cash generation and allocation. And yes, the markets for iron, thermal coal, and steel are still touch-and-go.
Even with relatively pessimistic expectations for 2012, Mechel is trading well below its normal long-term forward EV/EBITDA multiple. Were the company to trade in line with the multiple, the stock would trade in the mid-teens. Moreover, there's a bit of scarcity value here as it's one of the few liquid Russian stocks on an American exchange and it is leveraged to further growth in Russia (particularly the construction and energy markets).
It's difficult to advocate for owning Mechel when better-run companies like Steel Dynamics, Nucor, and ArcelorMittal all also offer discounts to long-run forward multiples. It's also difficult to look past the unimpressive recent trend in ROIC, though the company has done better before and arguably could return to better performance. Much as I like contrarian plays that go against sell-side skepticism, Mechel needs to start delivering signs of better performance before I'd take the plunge.