December 21, 2010 - 6:25pm EST by
2010 2011
Price: 9.28 EPS $0.00 $0.00
Shares Out. (in M): 278 P/E 0.0x 0.0x
Market Cap (in $M): 2,585 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0.0x 0.0x

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I believe an investment in Mechel preferred stock (MTL/P) represents a very compelling and timely investment opportunity with an expected dividend yield of around 12% and upside potential of 70% or more.  Furthermore, much of the risk can be hedged out with a short position in the ordinary shares (MTL) which trade at a ~60% premium to the preferred shares.

MTL is a Russia-based producer of met coal, iron ore and other steel-related materials.   As background, in April 2009, MTL issued $436 million in cash and 83.3 million preferred shares to buy Bluestone Coal from the Justice family in the U.S.  The remaining preferred shares are held by a subsidiary of MTL.  On December 13, 2010, the Justice family sold 8.3 million MTL/P shares in an offering (16.5 million ADRs) following an IPO of 16.7 million shares (33.5 million ADRs) on May 7, 2010.   From the IPO until the recent offering, MTL/P traded a large discount (30 to 40%) to the ordinary shares primarily as a result of very low liquidity and lack of investor focus.  I believe this discount will evaporate with increased trading liquidity (likely to settle out at $3 to $4 million daily) and a dramatic rise in the dividend payable over the next year.

The Company has 416 million ordinary shares outstanding and 139 preferred shares.  One ADR represents 0.5 preferred shares.  The preferred shares represent 25% of the share capital and are entitled to a distribution of 20% of U.S. GAAP net income (80% payout ratio).  This dividend was very low since the IPO due to depressed met coal and iron ore prices (dividend is paid on a lag - so 2010 dividend was based on 2009 net income).  Based on Street numbers of net income (before preferred dividends) of $1.5 billion for 2011, the preferred will be entitled to $300 million of dividends or $1.08 per ADR, representing a 12% yield.  Street estimates are for income to be even higher in 2012. 


How do the preferred and ordinaries differ?

The preferred stock lacks voting rights but otherwise is dominant to the ordinary shares in every material way.  Given that the ordinary stock is controlled by one shareholder (Igor Zyuzin), the voting rights of the freely traded shares are of limited value in my opinion.  On the other hand, the preferred is a more valuable security in my view since it receives the higher of an 80% payout ratio or the ordinary dividend.  If for some reason the company doesn't pay the preferred dividend, then the preferred shares effectively convert to ordinaries (with related voting rights) over that period.

Perhaps most importantly, since the ordinary shares are barely paid a dividend, they are continually reinvesting their share of retained earnings - effectively boosting future earnings and thereby increasing the future preferred dividends at no cost to the preferred shareholders.  So, unlike most preferred dividends which are fixed in nature, the preferred dividend should grow at a nice rate and effectively sweep value from the ordinaries (as they forgo their share of the earnings).  Basically, I believe that the preferred shares have a value well in excess of the ordinaries.


Price Target

If the preferred stock trades in line with the common over the next year plus the accrued dividend of ~$1 per share, the preferred should trade at around $16 per ADR (assuming the ordinary shares are flat).  This would represent ~70% upside.  Assuming the ordinary shares are priced to go up 10%, then the preferred ADR + dividend target would increase to around $17 per ADR or 83% upside.

There are instances in Russia of preferred stock trading at meaningful discounts to the ordinaries but those are situations (1) where it is difficult (if not impossible) to arb it due to foreign trading limitations or liquidity issues (ie, no ADR on the preferred) and (2) the required payout ratios are so low that the preferred stock is not particularly attractive.

I think this opportunity exists merely because the historical liquidity has been so low and no one has ever focused on this security (particularly as the dividend was low since it has been publicly traded).  Now that the liquidity has dramatically changed with the recent offering and the dividend yield will soar, I suspect we should gradually see the discount disappear and perhaps even turn into a moderate premium - yielding very attractive returns. 


Improved liquidity, increased analyst coverage of the preferred, higher dividends
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