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By John Helmer in Moscow

Confirmation this week by Mechel of its takeover of the West Virginia coal producer, Bluestone, has drawn fire from Moscow bank and brokerage analysts, who claim the price paid exceeds the value of the deal.

The Mechel announcement was issued on April 22, confirming details of a transaction which first commenced late in 2008, when Mechel made a cash down-payment, first reported at $425 million. An issue of about 80 million preferential shares, completed in March, was the second payment stage of the transaction. Although undisclosed to shareholders or to the US Secutiries and Exchange Commission, which regulates US-listed Mechel, the early reports indicated a valuation of Bluestone, owned by James Justice, of about $870 million. The share issue, it was speculated before this week, would amount to a 19% dilution for current shareholders.

Negotiations to finalize the deal appear to have continued between Justice of Bluestone and Igor Zyuzin, Mechel’s controlling shareholder and chief executive. According to the new release of the “definitive agreement”, Mechel says “”the aggregate merger consideration is $436 million paid in cash (including $36 million interest paid), approximately 83.3 million preferred shares, plus the assumption of approximately $132 million of net debt”.

Additional terms disclosed set out a more complex valuation of Bluestone, and substantially more to be paid for its acquisition by Mechel over the next five years. An analysis of the transaction by Uralsib Bank indicates that “if the value of the market value plus dividends paid in the next five years is less than $1585 million in five years’ time, Mechel will make a top up cash payment on the fifth anniversary of the deal. Finally, Mechel will pay an additional $3.04/ton for every ton of proven coal reserves in excess of 458 mln tons. Mechel’s expectation is that reserves could be 730 mln tons, implying that an additional $828 mln will be paid when the reserves are proven.”

Zyuzin had planned last year a spinoff of Mechel’s coal assets and their independent listing in Frankfurt or London. He is cited in the new release as saying: “The addition of Bluestone’s production assets and large, high-quality coking coal reserves and resources establishes Mechel as one of the largest producers of coking coal in the world and provides us with additional scale that will drive added efficiencies through our business. Following the closing, we expect to have up to an estimated 725 million tonnes of coal reserves and resources in the U.S. (JORC Guidelines, subject to confirmation during a planned drilling program) and a more diversified asset base, including a strong foothold in North America and enhanced European, American and Asian sales channels.”

Bluestone sold 2.8 million tonnes of coking coal in 2008 and generated total sales of approximately $327 million. According to Mechel, “the transaction is expected to be accretive to Mechel OAO 2009 earnings.”

At a newly estimated deal value for Bluestone of $1.14 billion, counting both the cash component and the preferential shares, the numbers are significantly more expensive than the market had been led to expect, and Zyuzin’s bargain substantially more costly than he had been anticipating. Uralsib Bank analyst Michael Kavanagh reports. “Adding the $135 mln in net debt that Mechel will assume, the EV [enterprise value] of the transaction is $1274 mln. This implies a 2008E EV/EBITDA multiple of 13.6. Thus the acquisition looks expensive to us. The EV/production multiple is a staggering $455/ton.”

Kavanagh adds a calculation of the 5-year value of the preferential share issue in Justice’s favour. “Stripping out $225 mln in expected pref dividends in the next 5 years, we calculate that the pref shares were issued for $16/share (in five years’ time). Applying the same discount rate of 15%, that would imply an issue price of $8/share today. This is a premium to ordinary shares, but the final cost of the deal will only be determined in 5 years. On the face of it this deal seems expensive.”

A report by Unicredit of Moscow comes to a lower valuation of the deal at this stage at $986 million. But analysts Marat Gabitov and George Buzhenitsa are more skeptical of its value to Mechel shareholders. “We believe additional information on the possible increase/decrease of the deal’s consideration is too remote to have any meaningful impact on the stock’s performance. We retain our view that the acquisition was rather expensive, based on both operational and financial multiples. We believe the fact that the asset is in a region with a high cost base that has not experienced local currency devaluation could add to negative sentiment due to currently weak coal prices and demand from end customers, who are reporting 40%-50% utilization rates.”

They recommend selling Mechel’s shares. But the first reaction of the market to the announcement on Wednesday was to add 3% to the share price in Moscow trading. Positive sentiment followed at the start of US trading, but then abated. By day’s end, at $6.15, Mechel was up 1.5%.

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