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By John Helmer in Moscow

Russian steel and mining group faces government investigation after announcement of spinoff and IPO plan for coal-mining and ferroalloy units

The Mechel group (MTL:US, NYSE; MTLR:RU, RTS) — Russia’s leading specialty steelmaker and one of the leading producers of coking coal in the world — has lost 5% off its Moscow-listed share price on Thursday, following the public announcement two days earlier that it is under Russian government investigation for price-rigging and other anti-trust violations.

Russia’s Federal Anti-Monopoly Service (FAS) announced on July 15 that it has opened an inquiry into price-rigging and other anti-trust violations by the Mechel Group’s coal division. The move is the first ever taken by Russia’s anti-trust watchdog against coking coal suppliers to the Russian steel industry.

Mechel is very sensitive to signals from the federal government, as the steel division has been a takeover target for two years past. For the time being, Mechel is claiming it knows of no complaints from clients regarding its coking coal supply or price policy. The company spokesman has also announced that “we haven’t received any official documents about the case.”

The FAS action may, however, be the prelude to intensifying pressure on Mechel to limit its coking coal exports, and restrain share-listing ambitions for the coal and iron-ore division, and possibly for the ferroalloys division also.

The last major problem Mechel had with a federal government agency in Moscow occurred in late 2004, when agents of the Interior Ministry raided the offices of a Mechel trading subsidiary in Moscow, searching for documents related to what appeared at the time to be a tax investigation. No charges or administrative proceedings followed, however. Company sources said at the time that the raid was intended to deter Mechel, which held a 17.1% stake in rival steelmaker Magnitogorsk Metallurgical Combine (MMK), from bidding for the 17.8% state stake on auction later that month. Mechel then sold its stake to controlling MMK shareholder, Victor Rashnikov, who went on to bid successfully for the state stake.

This week’s FAS statement, posted on the agency website, says it has studied the domestic coking coal market, and as a result, “has initiated a case against Mechel Trading House» Ltd., Yuzhny Kuzbass open joint stock company, and Yakutugol Holding Company – members of the group of entities of Mechel – for breaching Part 1 Article 10 of the Federal Law «On Protection of Competition» (abusing dominant position). FAS Russia, being concerned with possible price increase for coking coal and coal concentrate on the Russian market, sent enquiries to all main producers of coking coal and coal concentrate in order to study the level of coal supplies to domestic market, pricing procedures and price behaviour, as well as the planned level of supplies and prices for the year 2008.”

FAS added that it is also charging Mechel’s trading unit, as well as its mine affiliate, YuzhnyKuzbass, with having unlawfully “terminated supplies of coal concentrate to NLMK [Novolipetsk Steel], which was economically and technically unjustified.”

A source at NLMK told Mineweb that Mechel had abruptly cut off deliveries in June. No reason was given, the source said. He added that NLMK had lodged a complaint with FAS. Another Mechel coalmine affiliate, Yakutugol, has also been charged by FAS for legal violations “by refusing to conclude a contract for supplying coal concentrate to «NLMK» OJSC without economical or technically justification.”

Mechel’s share price was slow to react on the NYSE, where the steelmaking group in Russia first listed in 2003, and where this week’s price trend has been flat to positive at around $42. The more sensitive Russian stock exchange has slashed Mechel’s price by 15% since it hit its 52-week high on May 7. With a current market capitalization of $19.4 billion, Mechel has outperformed its Russian steelmaking peers, rising in price and value by 219% over the past 52 weeks. Evraz, with a market cap of $36.8 billion, has grown by 102%. Both have substantial coal-mining divisions. The less endowed they are with coal and iron-ore, the less well the Russian steelmakers have performed in price and value terms.

The FAS action may be a harbinger of the warning that Mechel’s good fortune must now be shared with the rest of the domestic steel sector, and the state as well.

Russian law provides that price-fixing violations are punishable by a fine of 1% to 15% of a company’s profits gained from those sales. It is not clear, however, for how long the alleged price-fixing has been going on. A report by MDM Bank analyst James Lewis warns that “perhaps more important than the possible consequences for Mechel, though, are those for the industry: We view the allegations as possibly the latest in a string of recent measures to control rising coal prices and, in turn, steel prices. These started with discussions of export taxes on steel back in May (in which the FAS was also involved) and continued earlier this month with consideration of restrictions on coking coal exports. Now, rather going after the industry as a whole (efforts that have so far resulted in no immediate relief to rising coal and steel prices), it is possible that the government could be targeting individual producers. Whether or not Mechel was indeed engaged in price-fixing, we believe that such individually targeted measures could be more effective in convincing all major Russian coal producers (Mechel, Raspadskaya) to tread more carefully in their pricing policies.”

Announcing the plan to spin off the coalmines in a separately listed Mechel Mining unit — with IPO planned for November — Mechel has said the scheme will “increase management efficiency,” without diluting group control by chairman and chief executive, Igor Zyuzin. Even after separate listings of the spinoffs, “control of the sub-holdings will always remain with Mechel,” investment relations director Alexander Tolkach has announced.

In 2007 Mechel mined 21 million tonnes of coal, half coking coal, half steam coal. With its new acquisitions in Yakutia, this unit is planning to build production up to about 60 million tonnes per annum, making one of the largest coal sources in Russia. In late 2007, market valuation of the mining division was estimated at between $7 billion to $9 billion.

In terms of profitability, calculated as the Ebitda margin, mining is the most lucrative of the group’s businesses with a 39% margin, buoyed by coal and iron-ore prices. Steelmaking generated a margin of 25%; power, just 4.5%.

Starting with the 2004 episode, state pressure tactics proved to be relatively more nerve-wracking for Zyuzin’s former co-partner, Vladimir Yorikh, and he decided to sell his stake to Zyuzin in 2006-2007. Yorikh earned $1.5 billion from the transfer of his 42% shareholding. Had he not been impelled to exit, and waited for the current market capitalization of the group, Yorikh’s stake would now be worth five times as much.

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