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Reaffirming Mechel at Neutral

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We have retained our Neutral recommendation on Russian miner Mechel OAO . While we are encouraged by the incremental opportunities stemming from its Elga mine, we remain on the sidelines considering weak demand from Europe and high debt.

Why Retained?

Mechel tuned to a loss in the fourth quarter of 2012, reported on April 15, hurt by weak demand. Revenues fell at a double-digit clip due to sustained weakness in the core mining segment. The company saw weak pricing for mining products in the quarter due to challenging economic conditions.

Mechel, which currently retains a Zacks Rank #3 (Hold), is a leading domestic steel and coal producer with a 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 expanding its customer base, reflected by the recent coking coal supply contracts with Baosteel and POSCO .

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 the 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 opportunity for significant expansion of production and processing capability.

However, Mechel’s high debt level represents a serious concern. The company could be handicapped because of its high leverage and interest burden and may not be able to keep up with its capital spending program.

Mechel is also faced with weak demand from Europe and its Ferroalloy division remains affected by lower nickel pricing. 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 are Shiloh Industries Inc. (SHLO - Free Report) and Kobe Steel Ltd. . Both hold a Zacks Rank #1 (Strong Buy).

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