MT Arcelor Mittal New

We are downgrading our recommendation on Mechel OAO (MTL) ADS's to Underperform from Neutral based on disappointing third-quarter 2011 results.

Mechel reported net income of $25.7 million in the third quarter of 2011, down 86.6% from the previous quarter’s consolidated net income of $191.9 million. Revenues also decreased 7.6% sequentially to $3.2 billion.

Mechel also has a major capital-spending program, which could pose a risk given the slow growth in global economies. In the first half of 2011, the company spent about $769.5 million on property, plant and equipment, and acquisition of mineral licenses, especially in the Mining segment (about $562.4 million).

In such a scenario of high leverage and low cash flows, we are concerned about high capital expenditure. Mechel’s debt-to-capital ratio hovered around 50% in the last couple of quarters. As of September 30, 2010, Mechel’s total debt was $9.5 billion.

Cash and cash equivalents amounted to $518.1 million at the end of third-quarter 2011. Higher debt results in a greater interest charge for the period. Moreover, a high leverage restricts the company’s ability to raise new debt for further financing.

Mechel holds the license to the undeveloped Elga coal deposit in the Sakha Republic, which contains large quantities of export-quality coking and steam coal. As part of the license conditions, as amended in May 2010, Mechel is required to meet certain operational milestones, including the construction of a rail branch line of approximately 195.7 miles in length by December 31, 2011 and completion of construction of the first phase of the Elga complex by December 31, 2013.

The current construction schedule is quite aggressive, and due to limited financing during the period from September 2008 to August 2009 and the global financial crisis, it may not be achievable. If the current construction schedule is not met, the subsoil license for Elga deposit may be suspended or terminated.

Mechel’s ferroalloy business is also witnessing a slow growth in prices, offset by rapidly growing input costs. The business has been affected by the recent weakening of mining and geological conditions at Voskhod chromites mine in Kazakhstan.

Lower production of chromites ore concentrate at the processing plant, which is used in the ferroalloy business, could hamper operations going forward. Infrastructural difficulties in South Africa are further affecting the chrome market while decreasing production of finished product globally.

In December 2011, Mechel reported the suspension of work at several facilities at two of Southern Kuzbass Coal Company’s mines. Following a check conducted at Lenin Underground and New-Olzherassk mines by the Mezhdurechensk territorial branch of the Southern Siberian department of the Federal Agency for Ecological, Technological and Nuclear Monitoring, work at the two mines’ was suspended resulting from the order of the Mezhdurechensk city court. This suspension of work affects production.

Despite a deteriorating pricing environment in the quarter, the mining segment managed to show a sequential revenue increase due to capacity restoration and development work in previous periods. We believe the company’s large capital-spending program, high debt and substantial interest burden are matters of concern.

Currently, Mechel has a short-term (1 to 3 months) Zacks #3 Rank (Hold rating) and a long-term (6 months) Underperform recommendation.

Mechel faces stiff competition from Arcelor Mittal (MT) and Norilsk Nickel Mining and Metallurgical Co.

 
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