Can You Take Risks With an Undervalued Miner?

Jaiyant is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Usually, one wouldn't want to tread into the territory of Russian stocks. The precise reason being stocks based in Russia tend to be volatile because of governmental interference, political situations and influential people like (who else?) Vladimir Putin. On the upside, certain Russian stocks provide an opportunity for discerning investors to purchase under-priced stocks if they are willing to take risks.

One company that particularly interests me is Mechel (NYSE: MTL), which produces coal, iron ore, steel, nickel, electric power and thermal energy. In this article, I shall briefly describe what makes Mechel interesting even though it is in an unenviable position.

Why you must consider Mechel

Mechel is one of the foremost metal and mining companies in Russia and was incorporated as recently as 2003. It operates in Russia, the United States, Lithuania, Kazakhstan, Bulgaria, the United Kingdom and Ukraine. Russia holds immense amounts of natural resources and very few companies have access to them. Most companies that operate in Russia are Russian like Mechel. The vastness and potentially substantial wealth of resources in Russia can make any company that operates there truly profitable.

However, as we can see from Mechel's numbers, that is clearly not the case. Mechel has a market cap of $1.24 billion and an enterprise value of $11 billion. With a profit margin of -20.39% and an operating margin of -3.85%, things are certainly not going too well in the company. Mechel's return on equity was -46.40%, which clearly shows that the company is not able to make use of money invested by investors and return a profit. The company’s total debt of almost $10 billion makes things worse in the eyes of possible investors.

Still, I take a kinder approach to this company because of these 5 reasons:

1. Mechel has access to Russian resources, metals and energy.

2. Though Vladimir Putin famously criticized Mechel for using foreign subsidiaries to avoid taxes, last minute negotiations by senior Russian politicians helped Mechel to bounce back.

3. Coal and thermal markets are doing very badly, but China, India and other emerging economies still need sources of energy and often depend on thermal energy and coal. Though Chinese demand has drastically fallen, increased constructions in the hinterlands of the country will create sufficient market for companies like Mechel, which have always depended on China for sales.

4. Mechel has presence in energy-rich countries that are business friendly, unlike Russia. In the same breath, we must note that Russia has often taken a kinder approach toward Mechel in spite of rhetoric against the company that made its shares fall.

5. Mechel's PEG ratio is 0.07, which shows that it is greatly undervalued. It currently trades at $3 but the fact that it is so grossly undervalued makes it an interesting buy for those who are willing to take the risks.

Negatively valued peers

If you do not want to take risks and would like to invest in lucrative American mining companies for the sake of safety and stability, you can look at Arch Coal (NYSE: ACI) and the larger U.S. Steel (NYSE: X).

Arch Coal is the 2nd largest coal supplier only next to Peabody energy. With 32 active mines and more than 5.5 billion tons of proven coal reserves, Arch Coal is a good long term choice.

Like Mechel, Arch Coal is undervalued. In fact, with a PEG ratio of -0.60, Arch Coal is negatively valued. A negative PEG ratio is usually considered a bad sign but it is not always so. When a company's free cash flow is still improving, its earnings will not grow. Thus, a negative PEG ratio can only considered to be a bad sign when a business will likely not make any earnings in the future.

In the case of Arch Coal, the negative PEG ratio is probably because of pessimism related to thermal energy and coal exports. With an increased suspicion towards nuclear energy after the Fukushima disaster, countries like India and China may import more coal than they do right now. Then the negative PEG ratio will turn positive.

Arch Coal has a market cap of $885 million and an enterprise value of $5 billion. Before investing, you might also want to bear in mind that this is a company with a total debt of $5 billion.

U.S. Steel is one of the largest steel producers in the world. However, it has a PEG ratio of -1.12, making it negatively valued just like Arch Coal. With a profit margin of 0.12% and an operating margin of 1.16%, it is certainly not one of the most profitable companies right now.

The European economy, reduction in Chinese demand for steel and falling consumption rates in the U.S. have all contributed to U.S. Steel's woes. U.S. Steel's second quarter earnings will likely be just as dismal, thanks to the reasons I just mentioned. No wonder no one expects U.S. Steel to have good earnings, resulting in a negative PEG ratio.

However, the fruits of optimism and risk-taking will be its own reward. As construction projects expand across emerging nations, U.S. Steel will find its market grow. Now is perhaps the best time to invest in these undervalued and troubled mining companies as they are likely to rebound in the future.

My Foolish bottom line

If you are willing to take risks and invest in a company that has access to Russian minerals and metals, look no further than Mechel. It is undervalued at the moment but has a lot of support within the Russian government. If you would rather invest in American companies, Arch Coal and U.S. Steel maybe better options but they are riskier options.

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Jaiyant Cavale has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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