> The top line and EBITDA came in 4% ahead of our forecast at $3,201 mln and $678 mln, respectively. The negative effects of lower ferrous pricing and reduced steel volumes were fully offset by ruble depreciation, lower input prices in the steel division and better cost management in the mining division. As a result, group EBITDA jumped 11% Q-o-Q to $678 mln and the EBITDA margin was lifted to 21, from 18% in 2Q11.
> Mining revenues added 4% on the quarter to $1,147 mln, solely on the back of increased physical sales volumes. However, lower realized prices weighed EBITDA down 8% to $512 mln. Cost management was strong across all segments and Mechel saw a much improved performance at Yakutugol, which restored its capacity. Yakutugol's cash costs declined 11%, from $37/tonne to $32/tonne. We remind that the Nerungrinskaya washing plant had an accident at the thickeners shop in late 2010 and was re-launched in 1Q11, only achieving full capacity in late August 2011. The full recovery of the washing plant enabled the company to produce a better product mix for export markets (China) and keep average realized prices for coking coal almost flat at $206/tonne, versus $210/tonne in 2Q11.
> The market price decrease for coal and iron ore in 3Q11 obviously benefited Mechel's steel division. Despite a 13% Q-o-Q drop in revenues to $1,796 mln, steel EBITDA improved to $153 mln, up from a meager $65 mln during 2Q11. The division's EBITDA margin also recovered to a more reasonable 8.5% from the bottom of 3.2% in 2Q11 as the company scaled down sales of low-margin, third-party metal via Mechel Service Global and increased its own product sales. The third quarter is traditionally a strong period on the domestic market for construction steel, and Mechel diverted more sales from export customers.
> As usual, the contribution from the ferroalloy and energy divisions was minimal. Ferroalloy posted EBITDA of just $3 mln, due to the combined impact of high production costs for nickel and chrome and weak pricing. The energy division booked a $7 mln loss on the EBITDA line, as generation dropped due to seasonal repairs ahead of the heating season.
> Mechel's bottom line was hit by $296 mln in forex losses due to debt revaluation, as circa 50% of the company's debt is denominated in dollars. As such, the headline net income for 3Q11 came in at $26 mln, while for 9m11 it stood at $527 mln. Assuming no further forex losses for 4Q11 and some $250 mln in net income for the period, the full-year tally could hit $770 mln, 20% of which could be paid out to preferred shareholders. This is equal to $154 mln, or $0.55 per preferred ADR ($1.11 per local share). However, given mounting liquidity pressures and the need to refinance a chunk of debt next year ($2.6 bln) it is becoming increasingly likely that lenders will not allow any dividend payments.
> Liquidity management was disappointing. Operating cash flow was negative to the tune of $15 mln on the back of increased working capital. The latter jumped another $200 mln during the quarter to $2.7 bln as Mechel accumulated inventories, mainly in the steel division. Total capex stood at $600 mln - the company completed some small projects in its steel division (blast furnace No 5 and the replacement of Converter No 2 at Chelyabinsk Metallurgical Plant) and, more importantly, it continued to advance Elga. As a result, net debt rose to a whopping $9.0 bln (versus $8.6 bln at end 2Q11). This puts rolling net debt/EBITDA at 3.6, above the recently renegotiated covenant of 3.5 that was set through year end (increased from the previous 3.0). We think Mechel is very likely to breach covenants, and banks will be forced to reset the ratio.
> Given the deteriorating market backdrop, the company has already downsized its capex for 2011 from $2.3 bln to $1.8 bln, and for 2012 it expects to spend just $1.1 bln. This is down from $1.8 bln in our model, meaning that projects delayed in 2011 will now be shifted beyond 2012. For 2012, Mechel expects to pour $500-600 mln into Elga and $300 mln into Universal Rolling Mill, implying that the expansion of South Kuzbass has been put on hold for the time being. Furthermore, Mechel expects some release of working capital in 4Q11-1Q12, so deleveraging should commence in earnest, but we believe at a slow pace.
> Overall, the results are not very encouraging, and Mechel seems to be the least prepared for a potential downturn among domestic peers in light of its heavy debt load. We believe the company's obligations will be refinanced, potentially by state banks, given its importance and size, so we are not that perturbed by the generally short maturities, but the EV is taking a beating. Mechel's 9m11 EBITDA stands at $1,856 mln, and assuming the company will generate some $550-600 mln in 4Q11, the full-year results could be roughly $2,400-2,450 mln. This is below our current forecast of $2,601 mln and 12% beneath the consensus estimate of $2,800 mln.
Mikhail Stiskin, Irina Lapshina, Zaurbek Zhunisov and Anton Rumyantsev
