Russian mining company, Mechel OAO (MTL) recorded net income of $120.8 million in the first half of 2010, flipping losses of $471.4 million in the first half of 2009. Revenues in the first half soared 76.1% year over year to $4.3 billion on higher sales volume, particularly of coking coal. Sales were previously impacted by weak demand for steel and coking coal, as well as foreign exchange losses. Higher revenues and lower production costs yielded operating income of $555.1 million against operating losses of $40.9 million in the corresponding period of 2009.
 
Segment Performance
 
Mining Segment: Mechel’s profitability in the first half was primarily driven by strong performance in the Mining segment, which deals with coking coal and iron ore concentrates. As a percent of sales, operating income jumped to 28.01% in the first six months of 2010 from 7.5% in the year-ago period. Higher coal prices triggered a 77.9% growth in revenues to $1.3 billion in the segment, which formed 29.7% of the total revenue. Production of both coking coal and value added coal products, such as anthracites and PCI that are used in steel production saw a jump of 136% (to 5.4 million tons) and 274% (to 1.1 million tons), achieving pre-recession levels.
 
Steel Mining Segment: Revenues from the Steel Mining segment made up 57.3% of total revenue, soaring 84.1% year over year to $2.5 billion. The segment reported operating income of $101.8 million versus operating loss of $142.8 million in the first half of 2009. Pig iron production increased 24% to 2 million tons, while steel production went up 19% to about 3 million tons. Flat and rolled steel production shot up 45% and 24%, respectively.
 
Ferroalloy Segment: Ferroalloy segment sales totaled $227.5 million, up 73.7% from the year-ago level. The segment constituted 5% of consolidated revenue. The segment recorded operating income of $4.7 million against operating losses of $30.3 million. Mechel’s Ferroalloy segment is facing higher raw materials and electricity cost which increases production costs for ferronickel and ferrochrome products. Difficult mining and geological conditions at its Voskhod chromites mine had a negative impact on the company’s chromite business. Chromite ore production is declining, which results in lower ferrochrome production at the company’s Tikhvin Ferroalloy facility.
 
Power Segment: The Power segment generated 7.7% of revenues, which totaled $333.2 million, up 30% year over year. Operating income for the segment in the first quarter increased 37.1% to $16.9 million. Electric power generation improved 27% and heat power generation improved 7%. Mechel emphasizes on cost control and uses cheaper coal for power generation. This helped the company cut about 8% of its costs in the first half of 2010, however it remained above year-ago levels.
Financial Position
Mechel has a large capital-spending program. Capital expenditure for the first half of 2010 amounted to $508.2 million, of which $298.9 million was invested in the mining segment, $168.4 million in the steel segment, $37.5 million in the ferroalloy segment and $3.3 million in the power segment. Total debt was about $6.6 billion, compared with cash and cash equivalents of $237.7 million as of June 30, 2010.
Outlook
Mechel is optimistic about the pricing trends in the mining segment. The company has two major projects under the mining segment: Elga Coal Deposit development and construction of Ulak-Elga railway. The company plans to commence coal mining at the Elga deposit by the end of 2010. Completion of construction at the Sibirginsk mine of Southern Kuzbass Coal Company would pull up the mine’s output to 2.4 million tons per annum.

Mechel is strengthening its steel business with acquisitions and modernization of plants. In July this year, Mechel commissioned its steel processing machines and slab concaster #2 as part of the reconstruction of the arc-furnace smelting shop #6 of Chelyabinsk Metallurgical Plant. This is likely to boosts production of cast slabs to 1.2 million tones annually. In September, the company commenced operations at a new electric steelmaking complex with annual slab production capacity of 300,000 tons at Izhstal OAO. Mechel also ventured into three new openings, expanding its distribution network into other countries in the first half. However, the company foresees steel demand weakening by the end of 2010.
 
Zacks Recommendation
 
Currently, Mechel has a short-term (1 to 3 months) Zacks #4 Rank and a long-term (6+ months) Neutral recommendation.
 
Near-term View
 
Mechel’s ferroalloy business is witnessing 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. We believe 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 is also affecting the chrome market, decreasing production of finished product globally. Further, Mechel has a major capital-spending program, which could pose a risk, given the slow growth in global economies. We are concerned about high capital expenditure in a scenario of high leverage and low cash flows.
 
Long-term View
 
We are encouraged by Mechel’s focus on organic expansions and cost cutting measures. The company has the largest coal reserve base in Russia. It has also entered into various agreements to supply its rail products to large Russian metal mining companies. We are positive on the company’s favorable business profile, which has a high degree of backward integration and a low-cost structure. Management’s strategy of shifting its coal business from domestic to export markets is also encouraging. Additionally, Mechel’s key assets are located close to the major steel consuming markets.
 
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