Let's Get Greedy with Mechel Steel

Jul.31.08 | About: Mechel OAO (MTL)

One of my favorite investment axioms is “try to be fearful when others are greedy, and greedy when others are fearful.” Today you would be hard pressed to find a stock with more fear surrounding it than Russian Steelmaker Mechel (NYSE:MTL).

The Fear

Mechel was obliterated when Putin suggested last Thursday that the Russian Anti Monopoly Committee look into the prices at which Mechel has been selling its products domestically and internationally. There was another panic selloff on Monday when Putin insinuated that Mechel had been evading taxes. Now the stock, which had traded for 46 dollars on July 16th, is trading for about 21 dollars. A lot of fear came from investors' memories of YUKOS, which was Russia’s biggest oil company before Putin bankrupted it with back taxes and sent billionaire owner Mikhail Khodorkovsky to a Siberian prison.

Why Putin Did it

While I cannot be sure how the mind of an autocrat works – Putin probably has many motivations for his attacks on Mechel. Firstly, Russia is experiencing Latin Americanese double digit inflation (10.6% and heating up). Putin feels that higher raw material costs are contributing to this rise in inflation and that by lowering Mechel’s domestic raw material prices he will curb inflation. In addition to that, Putin wants to remind the billionaires of Russia, like Mechel owner Igor Zyuzin, that he is in charge and cannot be crossed. Furthermore, Putin wants more control over “strategic” industries like steelmaking, mining and oil – so that he can get Russia’s military industrial machine going strong again.

The Reality

The fine – if Mechel is convicted of foul play – is, at most, 2% of revenue. Moreover, the rampant fear that Mechel is the next YUKOS is unwarranted. Deputy Prime Minister Igor Shuvalov said that the chances of Mechel becoming the next YUKOS are “a most unlikely scenario,” and that,” the most likely scenario is that the company will co-operate with the state authorities. We are intent on there not being any more stress.” Moreover, Mechel has already said that the company will cooperate fully with Russian authorities – which should speed up this process.
And finally, Russia still needs foreigners’ money. The Russian economy is not yet in a place where it can afford to shut out foreign investors. In fact, the Russian government needs to encourage foreign investors if it hopes to keep oil production at current levels, and Russian officials realize this.

The Plan

We will have the ruling from the Russian Anti Monopoly committee by August 26th, but I think it will come sooner as the authorities seek to soothe the recently volatile market for Russian securities. So I suggest buying the September or October out of the money calls. Depending on how you want to frame your risk/reward – I think the 25, 30 or 35’s are all a good way to play the August 26th ruling.

Simple Calculation

The way I see it, Mechel has two possible states in the next year – either the stock will go to zero or it will go back to its pre-drama fair value of about 60 dollars per share (see Deutsche Bank equity valuation report). Therefore, the risk neutral probability of insolvency is 63.25% using the current market value of equity, a discount rate of 5%, and the above future states. 63.5% even though the Deputy Prime minister said the chances of bankruptcy were very unlikely! That is fear for you!

Disclosure - Long MTL.