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By John Helmer in Moscow

Mechel (MTL:US), owned by Igor Zyuzin, fell sharply in Moscow stock market trading Wednesday on news the company is to acquire unlisted, West Virginia-based Bluestone Coal.

Without an official company statement so far, Mechel has revealed to brokers and Moscow industry sources that it has agreed to a valuation of Bluestone, owned by James Justice, of about $870 million, and will acquire 100% of Bluestone’s shares for $425 million in cash, and an issue of 80 million Mechel preference shares, currently worth about $310 million. The cash was paid at the end of last year, it has now been revealed, and the share issue will amount to a 19% dilution for current shareholders. Mechel’s acquisition will also mean taking on $135 million in Bluestone debt.

Mechel spokesman Ilya Zhitomirsky told Minesite the company is making no comment at this stage. He did not deny the Bluestone takeover. But he said he could not explain why there has been no reference to the purchase in Mechel’s filing to the US Securities and Exchange Commission (SEC) on January 22, when operational results for the past year were reported, despite the fact, now known, that the takeover had already been signed with Bluestone, and the down payment made.

Mechel is listed on the New York Stock Exchange, but owns no steelmaking assets in the US, and can claim no coal supply synergies in that country. Last year, Mechel produced 26 million tonnes of coal, 15 million of coking coal, and 11 million tonnes of steam coal; along with smaller volumes of iron-ore, nickel, ferroalloys, and steel. Until now, its only operations outside Russia have been steelmaking in Romania, Bulgaria, and Lithuania; and chromium mining in Kazakhstan.

The larger Russian steelmaker Severstal (CHMF:RU) owns considerable steelmaking capacity in the US, and has bought US coalmines to supply it through its wholly owned mining division, Severstal Resources, which is currently expanding into iron-ore in west Africa and gold in Russia.

Severstal’s acquisition of PBS Coals between August and November of 2008 was paid for with $1.3 billion in cash. Severstal justified the deal by claiming at the time: “Severstal expects to create value for its shareholders through benefits from the vertical integration of its upstream operations; the increase in self-sufficiency with regard to the supply of primary raw materials available to its North American operations will allow Severstal to control its operating costs. PBS’s central location will also mitigate transportation costs between Severstal’s facilities.” The share price of Severstal was already falling when the deal was disclosed, and it continued downwards. Current market cap of the Severstal group is $3.5 billion; Mechel, $1.6 billion.

Pennsylvania-based PBS holds about 361 million tonnes of JORC-estimated reserves, and the ratio of enterprise value to reserves value was 2.3 at the time of the Severstal takeover. Bluestone, which operates nearby, holds 460 million tonnes of reserves (JORC), but has been priced lower, on account of the subsequent fall in domestic and global demand for coal and steel, and in equity values. The ratio of enterprise value to reserves value of Mechel’s deal is 1.7.

Industry sources believe that when Bluestone put itself up for sale last year, Severstal and Tata Steel were among the potential buyers of the asset. Mechel has intimated that it struck a bargain with Bluestone by negotiating the takeover price down from an initial valuation of between $2 billion and $4 billion. Skeptics in Moscow, including government officials who already view Zyuzin’s business strategy with suspicion, are now asking why the deal was made at all.

Spokesman Zhitomirsky refused to say why Mechel failed to disclose the sale to the SEC. He was also asked why the company is making the US acquisition at a time when it claims to be unable to afford to sustain steel or coal production at its Russian plants, and is applying to the government in Moscow for a protective tariff to secure sales against imported coal. “I cannot comment on this,” Zhitomirsky responded.

He has acknowledged that Mechel is lobbying for a 5% to 15% protective duty to be imposed as soon as spossible on imports of coking coal to Russia, so as to improve domestic demand for Mechel’s products.

His boss Zyuzin is generally believed in the Russian market to have overpaid for previous mining acquisitions — of coking coal deposits in the Sakha region in January 2005, and again in October 2007, for a combined total of $2.7 billion; and of the Kazakh and Russian chrome producer, Oriel Resources, in March 2008 for $1.5 billion. Following the Oriel deal, transacted at a 90% premium to the prevailing market price, Mechel’s share price dropped 3%.

The stock markets have again begun to speculate against Mechel’s share price in the belief that Zyuzin has over-reached and mis-timed. With at least $3.2 billion in short-term debt due for redemption this year, Mechel’s position is considerably more vulnerable than Severstal’s, and more dependent on state bailout financing. Earlier this month, Zyuzin decided to withdraw an earlier, approved application for $1.5 billion in funds from the state bailout bank, Vnesheconombank (VEB), whose board is chaired by Prime Minister Vladimir Putin.

Instead, early this month, Mechel claimed to have substituted a higher interest-bearing line of credit of $1 billion from Gazprombank, secured, not by Zyuzin’s shareholding, but by assets of the group’s Russian coal subsidiaries. The bank is indirectly state-owned through Gazprom.
No details have been provided by Mechel of the impact of Gazprombank’s higher loan charges, but Minesite has been reliably informed that Zyuzin decided the price was preferable to accepting the collateral requirements of VEB. These are understood to have required Zyuzin to surrender a substantial bloc of his Mechel group shares. The size of the share collateral virtually amounted to a control stake in the group. Gazprombank’s collateral requirement is much more limited by comparison, with lower risk for Zyuzin of a state takeover.
Industry analysts in Moscow are unanimous in expressing the view that Mechel has over-paid for Bluestone, and that the deal is unwise. “We regard the price paid for the asset as excessive and the deal itself to be detrimental for Mechel’s valuation,” said Troika Dialog steel analyst Mikhail Stiskin, in a note to bank clients. “In our view, minority shareholders are not going to see any economic benefits from this expansion until coal markets begin recovering (which may well be several years from today), while being diluted now.”

According to George Buzhenitsa, steel reporter for Unicredit Securities in Moscow, “we view the acquisition as rather expensive, based on both operational and financial multiples and note that developed market public peers currently trade at 4.0X-4.2X 2008 EV/EBITDA. Other factors that could add to negative sentiment include the fact that the asset is located in a region with a relatively high cost base, which has not seen a devaluation of the local currency, and the current pricing environment in the coal market against a background of weak demand from end customers reporting 40%-50% utilization rates. We believe the new asset is also likely to dilute the group’s margins.”

A report from Uralsib Bank claimed the Bluestone buy “looks expensive, especially given the expected 50% decline in coking coal prices this year and current distressed m[arket]cap of Mechel.”

The only positives the Uralsib report could find in the deal disclosure are that “it provides some clarity on where Mechel spent the $425 mln last year”; and that “in the long-run Mechel may benefit given the good quality of the asset”. year”; and that ar”; and it is now clear

Industry sources, including his ex-partner and former co-owner of Mechel, Vladimir Iorikh, have noted before that Zyuzin may not have a long run to look forward to in Russia.

Last July,Zyuzin drew the ire of Prime Minister Vladimir Putin for an attempt to raise domestic coking coal prices, and withhold supplies from Russian steelmakers reluctant to pay the higher price. Putin attacked his reputation in two separate public statements, triggering a share price crash which wiped half the value off Mechel’s market capitalization at the time. The loss of value also revived the interest of state steel group, Russpetstal (RSS), in considering acquiring part of Zyuzin’s steelmaking group. Mechel was fined by the Federal Antimonopoly Service, and required to resume coal deliveries at a reduced, and closely monitored price level.

Until this week’s disclosure, Bluestone Coal was privately owned, with little information available. Current annual output is about 3 million tonnes, and for the 9 months to September 30, 2008, Ebitda is estimated to have been $100 million, on sale revenues totaling $300 million. The average sales price realized by Bluestone last year appears to have been a low $130 per tonne, suggesting the company is locked into long-term supply contracts, with prices and revenues expected to fall further this year.

Since the market cannot see why Bluestone’s profitabilty won’t drop, along with its capacity to cover its debt bill, the logic of Zyuzin’s move appears to be that US mining assets may have more enduring value than Russian ones — for his own account, that is.

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