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Valuation: A DCF valuation of Mechel (MTL) yields a price of $29/ADR, an upside potential of 52% to current price of $19. We have arrived at this valuation after using extremely conservative sustainable cost of equity of 14.2% and a low short-term revenue growth rate of 20.1%; MTL’s TTM revenue growth rate is 62% while it’s at 22.5% in the last three years. In the last three years, MTL’s net margin has been in the 11-13% range and we have used the lower end for sustainable net profit margin in the model. In the last five years, MTL has traded in a PE range of 2.1 to 14.8 and at an expected 2008 EPS of $5.68 the stock should trade in the range of $12-$84.

Scenario Analysis: A scenario analysis shows that MTL’s current stock price reflects low short term revenue growth at 12% or a low sustainable net profit margin of 7%; either one of which has a low probability. The margin of safety built-in the current price of $19 is quite large to sustain the current uncertain market conditions and we have used a higher discount rate to account for the political risks associated with this stock.

Steel & Mining Sector Analysis: It is increasingly difficult for smaller steel mills to compete without owning iron-ore and coking-coal mines. Coking-coal accounts for 20% while iron-ore accounts for 80% of total variable steel production expenses. A surge in raw material prices has pushed labor expenses to a small portion of the total cost and hence steel mills in China don’t have a significant cost advantage vis-à-vis MTL. Labor is 11% of the cost while energy and raw materials comprise 84% of the total cost of steel production for MTL.

China forbids foreign controlling stakes in steel producers since steel is a strategically important industry, leading to smaller inefficient steel mills which could change in the near future. Since 2005, China has been increasing steel export-taxes as part of its efforts to curb smokestack industries. In January 2008, China raised export-taxes on coke, pig-iron and steel-billet to 25% from 15% and on rebar-rod from 10% to 15%. Chinese steel mills source iron-ore from global miners; increases in raw material prices since 2006 has led to margin deterioration. Owing to all of the above, fears about China dumping low-cost steel in the markets have subsided in 2008.

India imports almost all of its coking coal requirement while China depends on iron ore from global miners in Australia and Brazil. Since 2006, Asian-European central banks have been battling inflation by reducing liquidity.

However, the mood of late has been changing from battling inflation to supporting modest growth. China’s politburo emphasized the importance of growth and omitted previous mentions of worries about inflation in its June statement. Vice premier Li Keqiang said on Aug 19 that China needed to increase domestic spending to keep growth on track as the global economy weakened. India’s Prime-Minister emphasized growth in his Aug 15 speech and avoided the inflation rhetoric.

The ECB and the Bank of England left interest rates unchanged in August, after multiple rate increases in the last one year, as signs of slowing economic growth left little room for rate increases. Russia hasn’t tried to control inflation in 2007-2008 and supports growth centric economic policies. Even though we might not see the jump in commodity prices we saw last year, the demand could be sufficient to stabilize prices or increase at a moderate pace. Moreover, some of the recent pullback in commodity prices is also due to a 10% surge in the Dollar’s value against the Euro since July 2008 rather than a decline in demand.

Overall, in the short-term we might see some softness in commodity stocks but in the long-run this pullback could be a good opportunity to buy in this sector.

Growth Catalysts: The top-15 steel companies account for 35% of global capacity, while the top-3 miners control 70% of total iron-ore trade. We like MTL’s unique three pronged growth model of vertical integration of mining with steel and power generation. MTL has 100% raw material self-sufficiency and unlike its Chinese or European competitors, it is not dependant on contracts with Rio/BHP for iron ore and coking coal.

In the last week, steel producers have lost 15-20% of their market value since the analysts expect global steel prices to decline. In such a scenario, MTL will have a competitive advantage in steel production since it doesn’t have long term raw material supply contracts with global miners and could easily adjust costs to reflect the reduced iron-ore and coking-coal prices. On the other hand, Chinese and European steel producers could be caught between high raw material cost and low steel prices.

With 65% of its steel sales from Russia-CIS countries and less than 5% of sales from US, MTL’s growth is dependent on Russia and is unlikely to be affected by a slowdown in the US economy. Russia’s GDP is expected to grow by 7.5 percent in 2008; while that is lower than 8.1 percent in 2007, it is still a growth rate that a lot of countries strive to achieve. CIS countries and Russia have a low per capita consumption of steel so the steel industry is poised to grow with the economy. Russian growth is fueled by oil and other commodity exports, a sector the government is unlikely to strangle with drastic changes in regulation.

MTL is well diversified with 45% of the revenues from mining and power segment. Power is a high growth segment in Russia and quite a few regions lack adequate power supply. MTL is buying power plants in Russia and Eastern Europe to utilize the extra coal produced from its mines. Mechel ventured into power business in 2007 and increased revenues from power by 917% on a y-o-y basis in Q1-2008. Moreover, the forthcoming deregulation in the Russian power sector should benefit independent power producers like MTL.

MTL’s Steel product mix comprised high value products with 25% of revenues from Stainless flat, an increase of 2 percentage points on a y-o-y basis.

Risk Factors: In a rather unusual style, on July 23 2008, Putin made some very angry comments directed at MTL reminiscent of the YUKOS saga. YUKOS, once Russia's biggest oil company, was divided up and sold by the Russian state after massive back tax claims. Former YUKOS CEO Mikhail Khodorkovsky was sent to prison for tax evasion and fraud. MTL was in Kremlin’s good books until last year when it was awarded the world’s largest coal mine in Elga, Siberia, while ArcelorMittal (MT) was prevented from bidding.

Government scrutiny in new mining contracts and a demand to sell coal at lower price to local steel producers is a concern for investors. If MTL could avoid getting on the wrong side of the government in the future, it is an extremely undervalued stock with limited downside. In August, Russian FAS ordered a light fine and a 15% price cut on coking coal and so for now it seems that MTL will not follow YUKOS. Russian stocks also took a beating due to the Georgia crisis but it is unlikely to last longer owing to the military supremacy of Russia and US being busy with Iraq and the election season.

Overall, investing in MTL does involve the some political risk but this risk is factored to quite an extent in the higher discount rates that we apply to value such companies.

Financials: MTL has increased margins over the past five years and shown reduction in COGS, SG&A and other expenses. A reversal in interest income is due to the addition of debt to its balance sheet since 2007. An increase in debt combined with an increase in net margins has improved ROE from 18% in 2005 to a TTM ROE of 35%.

The latest global steel consumption forecast predicts 6.77% y-o-y increase in steel consumption in the current year. The additions in capacity are likely to be around 90 million tonnes which is just enough to meet the consumption without any spare capacity. Any delay in bringing new production online will result in a shortage of steel in 2008. The sector has seen a massive sell-off since July due to macroeconomic concerns, but the existing supply-demand gap would shield it from short-term macro issues and owing to its unique position in Russia, MTL should continue to grow above the industry average.

Disclosure: The analyst or his firm doesn’t hold any position in this stock. The views expressed here are of the analyst and doesn’t reflect the position of any firm associated with the analyst.

Source: Mechel: The Strength of Russian Steel