Mechel meltdown

By bne IntelliNews July 30, 2008

Ben Aris in Berlin -

Mechel CEO Igor Zyuzin

Is this the start of another Yukos affair? The public criticism of mining and metals company Mechel by Prime Minister Vladimir Putin over the last few days has sent the company's stock plummeting and dragged the rest of the bourse with it. Some stocks are now trading at 2006 levels and unsettled investors are afraid a new re-nationalisation attack has been launched.

On the face of it Mechel is in deep trouble. First Putin called for an Antimonopoly Committee (FAS) investigation into the company for non-market pricing - charging more for domestic sales than for exports and so profiteering. Then on Monday, July 28, he followed up with the threat of a tax investigation, which really put the willies up already nervous investors.

Mechel shares fell 29.5% on the RTS, closing at RUB423 per share, and 20.1% on the NYSE Euronext Stock Exchange, falling as low as $16.12 during the day on July 28 to trade at $19.26 by the close of trading. Exactly a week earlier, the shares closed at $40.6.

There are two possible explanations: having renationalised the most important assets in the oil sector, the Kremlin is now eyeing the metals sector; or this is a one-off case and Mechel is being punished for breaking the rules.

Analysts are being cautious - it is never a good idea to stick your neck out too far where the Kremlin is involved - but most believe the Mechel affair is the latter. A few banks have already been brave enough to put out a 'buy' recommendation on Mechel. But many have suspended their recommendations - the analyst equivalent of throwing their hands in the air in exasperation. However, the consensus seems to be that the "Mechel affair" will be contained and investors will look back on July as a huge buying opportunity.

Case of bad business

The evidence suggests this affair has more to do with Mechel misbehaving than a Kremlin plan to nationalise steel assets.

The first point to note is that Putin called on the FAS to investigate the issue. While this agency, headed by Yuri Artemyev, has had little press, it is one of the most liberal and market orientated of the state organs. It has regularly brought cases and imposed fines against abuse of market power, and targeted foreign investors, state-owned entities and well-connected oligarchs alike, often winning in court. The FAS is not a political weapon and while Artemyev can, and sometimes is, bullied, he largely judges a case on its merits.

Kicking off the campaign with the FAS strongly suggests that Putin was annoyed by the company's business practices more than anything else. The PM cited Mechel's domestic price of coking coal at RUB4100 ($176) versus the export price of RUB1,100 used to sell to Swiss trading companies controlled by Mechel before being immediately sold on to the international market at a price of $323. In other words, this is a classic transfer-pricing scheme, used by all Russia's oligarchs in the 1990s to siphon hundreds of billions of dollars out of Russia into offshore havens and avoid taxes.

It was this practice - among others - that Putin banned in his famous first meeting with the oligarchs as president in 2000, when he told the oligarchs to stop stealing. It's shocking that a big company would still be making use of this sort of practice post-Yukos. But then again, maybe it's not so surprising.

Legally, there is a lacuna where transfer pricing is involved and Mechel could argue it was working within the law. However, so did Yukos when it argued that it used tax breaks to get its effective tax rate down to 12-13% against the headline rate of 24%. Putin has called for companies to be more "socially conscious." He doesn't mean Russia's oligarchs should give more to charity, what he means is that they shouldn't take advantage of the incomplete rules. Everyone got the message after Yukos' bankruptcy and made damn sure they were paying 24% at the end of that year. (Indeed, Lukoil even promised to pay, "more than we legally have to.")

The Duma is moving quickly to close these loopholes, rushing through new legislation that will be passed (in all three readings no doubt) on September 15.

"[Transfer pricing] the tax base reduction, withdrawal from taxes inside the country, creation of deficit on domestic market, the growth in prices on metallurgical product that reflects in the price growth for all spectrum," the prime minister said in late July.

From this perspective, Putin's comments were not a prelude to changing the ownership of Mechel, but the exercise of "administrative resources" in lieu of a working law. In the same way the Kremlin lent heavily on the food processing industry in November last year to "voluntarily" refrain from raising prices despite galloping inflation amongst food products.

On Tuesday, July 29, the FAS said that other metal companies maybe subjected to fines for anti-market practises. Artemyev confirmed that the service is considering Evraz Group among possible violators as well.

This is probably the start of a broadening of the campaign. But what should become clear is that this isn't an attack on companies per se, but an attack on dodgy business practices that companies have fallen into. This would be entirely keeping with the way the FAS works, which tends to go on sector-wide campaigns rather than just investigate individual companies. For instance, it caught several high street banks - both Russian and foreign - colluding with insurance companies to fix prices earlier this year. Prior to that, it attacked money transfer companies that forced smaller banks to sign exclusive contracts.

Then came Putin's threat of a tax investigation in Mechel, which is much more serious.

At worst, a big tax bill could force the company into bankruptcy. In a less extreme scenario, it could be used to force Mechel to sell itself to a state entity or sell some of its assets. The best-case scenario would be if Mechel settles with the taxman and pays the taxes it would have paid if it had exported the coal at "real" prices.

There are serious tax implications here, but what was almost comical was Putin's furiousness when CEO Igor Zyuzin suddenly pulled out of the public meeting with the PM, claiming illness, when Putin was revving up to give him a public roasting. Putin doesn't lose his cool often, but when he has on a few occasions he tends to lash out. This was one of those occasions.

The next step

What will happen next? On balance, the most likely scenario is a fine will be imposed by the FAS for abusing prices and a tax bill will be presented for lost revenue to the state from the transfer pricing.

The FAS fine will be modest, but the tax bill will be larger, but doesn't have to be so large as to cripple the company. This process will take several months to play out. Artemyev told television network Vesti on July 28 that the FAS might fine Mechel an amount equal to 1% of its annual revenue. The tax investigation has not formally started yet.

Coming on top of the row between the Russian and British shareholders at TNK-BP, the timing of this fracas couldn't have been worse. Analysts at UniCredit are putting the probability of a change of ownership at Mechel at 50% and the chances of peaceful resolution at 20%. However, other long-in-the-tooth Russia watchers are giving a visible sigh as this is all very familiar. Russia remains a volatile market. For its part the state was rallying round to do some damage control by Tuesday.

The presidential point man for economic affairs, Arkady Dvorkovich, was talking about how undervalued the market was on Monday, and First Deputy Prime Minister Igor Shuvalov, who is third in command in Russia, played down the Yukos scenario fears on July 29. "I see this [the repetition of the Yukos case] as the most unlikely scenario. Nothing is impossible, the probability theory suggests, but if I had the opportunity I would exclude it. The most likely scenario is the company's interaction with state agencies. We would like to see no strain coming," Shuvalov said in answer to a question from Interfax in Moscow.

If this is really the case, then the current imbroglio represents a huge buying opportunity as some analysts are suggesting. But few investors have shown the nerve to get back into the market just yet.

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