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On Jun 20, we retained our Neutral recommendation on Russian miner Mechel OAO (MTL - Analyst Report). Though we are encouraged by the incremental opportunities stemming from its Elga mine, we prefer to tread with caution factoring in weak demand from Europe and high debt.

Why Retained?

Mechel suffered a loss in the first quarter of 2013, reported on Jun 18, hurt by the sale of its Romanian steelmaking assets. Declines across the board led to a double-digit slump in revenues. Sustained weakness was seen in the core mining segment. However, Mechel’s decision to buy back $100 million of ADRs (representing its common shares) reflected its confidence that the fundamental value of its share is higher and meets the interests of its shareholders.

Mechel, which currently retains a Zacks Rank #3 (Hold), is a leading domestic steel and coal producer with strong position in key businesses, including production of specialty steel and alloys. The company has the largest coal reserve base in Russia and is mainly focusing on growth and cost-cutting measures.

Mechel benefits from backward integration as it is capable of internally sourcing most of its raw materials. It remains focused on strategically diversifying and expanding its customer base, reflected by the recent long-term contracts for coking coal supplies with China's Baosteel Resources and Shasteel Group and South Korea's POSCO (PKX - Analyst Report).

The Elga deposit, which is among the world’s largest coking coal fields, is expected to reinforce Mechel’s position as a metallurgical coal producer through capacity expansion. 

Mechel continues the development of the Elga mine. It has constructed a seasonal washing plant at the site for accelerating production and sales of coking coal concentrate. The launch of the washing plant enabled the company to mine and process coking coal at Elga on production scale. The plant currently has an annual processing capacity of 3 million tons and there is ample opportunity for expansion of production and processing capability.

However, Mechel’s high debt level represents a serious concern. High leverage and interest burden may negatively impact the company and Mechel may not be able to keep up with its capital spending program.

Mechel is also challenged by weak demand from Europe and lower nickel pricing is impacting its Ferroalloy division. Moreover, the company is contending with lower coking coal sale prices, partly due to low demand.

Other Stocks to Consider

Other steel producers having a favorable Zacks Rank include Shiloh Industries Inc. and Kobe Steel Ltd. . Both hold a Zacks Rank #1 (Strong Buy).
 

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