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By John Helmer in Moscow

In a report issued this week, Troika Dialog, a Moscow investment bank, warns that a combination of operating financial risks, debt problems, and new coalmine costs will impact negatively on Mechel, the fifth-ranked Russian steelmaker and leading coking-coal producer. The report comes after last week’s trading on the Moscow stock exchange had slashed Mechel’s share price by 19% to $3.93.

This week, Mechel has dropped another 8% to $3.62. The current market capitalization of the group is $1.5 billion, down by almost 90% since the start of this year — a bigger loss of value than has been suffered by its Russian peers.

The report by Troika steel analyst Mikhail Stiskin concludes that “the stock is trading at a premium to international and Russian peers on forward multiples, which in our view is not justified by the fundamentals. Mechel (ticker MTL:US) has considerable financial leverage and major capex commitments, stretching its balance sheet and exerting pressure on cash flows. We also see a risk of significant losses in the group’s steel division, which is well known for its earnings volatility, and note that a big chunk of the company’s value is represented by the Elga [coalmine] project, which has serious execution risks.”

Mechel, which is controlled by Igor Zyuzin, has been reorganized into three semi-autonomous groups for steelmaking, ferrous alloys (including nickel), and mining (including coal and iron-ore). Earlier in the year, Zyuzin had been planning to spin off and separately list the alloys and mining divisions, in part to recoup the multi-billion dollar costs of the acquisition this year of the chrome mining and refining assets of Oriel Resources; and the purchase at a a state privatization auction in October 2007 of the Elgaugol and associated coal deposits in the fareastern region of Sakha. The ferroalloy and coal transactions cost $1.5 billion and $2 billion, respectively.

According to Stiskin, “we expect to see the biggest drop in profits in the steel segment, which has always suffered from extreme earnings volatility. As a result, the company’s focus on mining should significantly increase, with the contribution from the mining segment exceeding 70% of consolidated EBITDA.”

Mechel’s stainless steel division has been a target of takeover interest by the state steelmaking group, Russpetstal (RSS), for several years. Until recently, sources at RSS said there were higher priorities in their acquisition programme, and that Mechel’s assets were too costly to bid for. In September, according to Igor Alexeyev, head of strategy at RSS, there is an acquisition interest, although Mechel facilities had not been included in the short-term asset acquisition plan of RSS. “Our ability to fund a larger acquisition is limited,” Alexeyev noted.

A new debt for equity proposal, revealed late last week, indicates that the acquisition interest may be reviving.

According to a disclosure by Renaissance Capital (Rencap), Mechel has negotiated a credit line agreement with Gazprombank, a state-owned unit of the Gazprom group, for pledging a 25% shareholding in the Chelyabinsk steelmill, in return for $85 million. The book value of the steelmill collateral is Rb5.8 billion (approximately $200 million), more than two times higher than the value of the loan. This has suggested to industry sources in Moscow that the state may be preparing a heavily discounted entry into the company, if not a full takeover at this stage.

The transaction has not been disclosed on Mechel’s website, and is subject to approval by an extraordinary meeting of Mechel shareholders, scheduled for 15 January. According to Rencap analyst Boris Krasnojenov, “the company says that interest on the credit will not exceed 20% and the credit-line disbursement period is until 1 October 2009. According to the agreement, the credit line is to be provided in tranches not exceeding 180 days and the last tranche may not be provided later than July 2009. According to Mechel, the company considers Gazprombank’s credit line a credit backup.”

Ilya Zhitomirsky, the Mechel spokesman, said he had read the Rencap report, but would have no official comment. Sources close to the company claim that until the shareholders’ meeting next month, nothing has been decided.

Krasnojenov concludes there are “several questionable aspects of the transaction. 1) Mechel plans to collateralise a significant part of its core business for a relatively small credit line. 2) Mechel’s management confirmed during a conference call last week that the company has sufficient used and unused credit lines to finance its working capital requirements. As such it is unclear why management decided to take a fairly expensive credit line collateralised with a 25% stake in its core asset. 3) VTB extended Mechel a RUB15bn ($525mn) credit line at the beginning of the month and according to our estimates, Mechel is able to cover approximately 50% of its working capital requirement over 2009.”

“This makes us further question,” Krasnojenov said, “why Mechel has elected to obtain Gazprombank’s credit line under the current terms and conditions.”
Stiskin of Troika reports that its heavy debt repayment obligations put Mechel in a vulnerable position next year. “Mechel’s massive bank debt …raises concerns about the company’s ability to refinance its financial liabilities without resorting to government support. While we believe that the probability of Mechel defaulting on its liabilities is low, its oversized debt will remain a serious constraint for a long time.”

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