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Strategy I Research December 22, 2011
EQUITY R E S E A R C H
Ukraine in 2012: Reacting to Global Headwinds
Research | Research@phoenix-capital.ua | tel. +38 044 254 62 75
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Ukraine in 2012: Reacting to Global Headwinds

Unfolding euro-zone crisis and slackening global growth shaped the performance of Ukraines equity market in 2011. Having significant sensitivity to dynamics in international equity movements, the UX Index plunged 42% YtD as of December 21. Locally traded Ukrainian equities underperformed regional peers. The country's shares traded abroad to a great extent, resulted from squeezing liquidity on the domestic stock market. The Ukrainian equity market paid little attention to domestic economic progress in 2H11 concentrating more on worldwide financial sentiments. The countrys GDP increased by 5.3% Y-o-Y in 11M11, according to the governments provisional estimates. In 2012, global economic growth will slow: Europes GDP will increase by 0.7% Y-o-Y and the EMEA region will grow by 3.2% Y-o-Y. On a breakdown of countries, Polands economy will expand by 3.2% Y-o-Y and Russias GDP will pickup by 3.6% Y-o-Y. Compared to other countries, Ukraine is expected to record somewhat higher GDP growth at 3.9% Y-o-Y, according to our estimations. Despite a number of risks we have a moderately positive view on Ukraines equities in 2012. During rallies the advancement of domestic stocks is often excessive; in a time of retreat - Ukraines market overreacts in its decline. While currently investors tend to ignore attractive valuation levels, as market sentiments stabilize in 2012 Ukrainian stocks will recoup some of their incurred losses. Amid global financial turmoil we recommend to follow a bottom-up approach in designing an equity strategy for Ukraine. Our Top Picks List in Ukraines equity universe includes companies from industries such as agriculture, machinery, power generation and mining. Also, we tend to choose foreign listed stocks as having larger liquidity and better disclosure standards compared to domestically traded equities. In the agricultural industry we recommend buying stocks of MHP (MHPC LI) as the company has a stable market for poultry which will be only marginally affected throughout the crisis. Also, MHP will post a sizable increase in revenue from growing grain in 2011. Other top picks in the agricultural sphere are Agroton (AGT PW) having established business operations and IMC (IMC PW) as a requisite for promising growth. Among domestically traded stocks we prefer the non-cyclical Motorsich (MSICH) for its secured long-term orders backlog and its competitive position on the CIS helicopter engine market. In the mining industry our Top picks include Ferrexpo (FXPO LN), Sadovaya Group (SGR PW) and Coal Energy (CLE PW). These companies, however, represent more risky investment targets with their significant exposure to the commodity cycle. On the Ukrainian fixed income market we expect some of the strongest corporate and banking notes to outperform sovereign issues. Our recommendations in the corporate segment include Metinvest and DTEK maturing in 2015. The companies increased their LTM EBITDA in 1H11 by 39.4% and 31.6% respectively, compared to their performance in 2010. Both companies will post net debt/EBITDA ratio close to 1x in 2011, according to our estimations. At the same time, prices for these notes dipped drastically when compared to sovereign issues. Among banking Eurobonds, our first choice is Ukreximbank notes: EXIMUK 15 and EXIMUK 16 as these have too wide spread for quasi-sovereign risk. We also identify value in PrivatBank being the largest financial institution in Ukraine with YTMs for its Eurobonds hovering above 17%.
Research | Research@phoenix-capital.ua | tel. +38 044 254 62 75 3 Real GDP growth, %, Y-o-Y Nominal GDP, $bln GDP per capita, $'000 Industrial sectors growth, %, Y-o-Y CPI inflation, %, eop PPI inflation, %, eop UAH/$, eop UAH/$, avr Current account balance, $bln Current account balance, % of GDP Source: Phoenix Capital estimates Figure 1. Performance of UX index vs. other markets, YtD, $ rebased UX MICEX FTSE 100 MSCI FM CEE + CIS 2011E 5.0% 162.9 3.6 7.5% 6.4% 15.3% 8.00 8.00 -7.4 -4.5% 2012F 3.9% 180.9 4.0 4.7% 8.9% 14.5% 8.20 8.10 -6.2 -3.4%
140% 120% 100% 80% 60% 40% 20% 0%
Aug-11
Sep-11
Jan-11
Feb-11
Mar-11
Jun-11
Nov-11
May-11
Source: Bloomberg, Phoenix Capital estimates
Dec-11
Apr-11
Oct-11
Jul-11
Table of Content
Macro Outlook ............................................................................................. 5

Economic growth ............................................................................................................... 6 Balance of payments and currency ................................................................................... 7 Fiscal policy and government debt .................................................................................... 8 Monetary indicators ........................................................................................................... 9 Inflation .............................................................................................................................. 9
Fixed Income.............................................................................................. 11
Sovereign Eurobond sector outlook ..................................................................................12 Corporate and bank Eurobonds outlook ...........................................................................13
Equity strategy ........................................................................................... 14

Top picks in Ukraines equity universe .............................................................................15 Agriculture ........................................................................................................................16 Machinery .........................................................................................................................20 Metals and Mining ............................................................................................................22 Banks ...............................................................................................................................26
Top picks: company profiles ..................................................................... 29

DTEK ................................................................................................................................29 Metinvest ..........................................................................................................................29 Ukreximbank.....................................................................................................................30 PrivatBank ........................................................................................................................30 IMC ...................................................................................................................................31 Agroton .............................................................................................................................31 MHP .................................................................................................................................32 Motor Sich ........................................................................................................................32 Sadovaya Group...............................................................................................................33 Coal Energy ......................................................................................................................34 Ferrexpo ...........................................................................................................................34
Macro Outlook
Ukraines economy in 2011 performed in line with our expectations for the most part The Ukrainian macroeconomic performance this year tends to follow our expectations as outlined in the Outlook for 2011. Economic growth will approach our initial forecast of 5% Y-o-Y given that in 10M11 domestic output expanded by 5.3% Y-o-Y - according to provisional estimates. As expected, domestic demand stepped up as the major driver for economic activity in the country. This outcome was largely the result of the low comparison base in 2010 and rising government capital expenditures. Contribution of net exports was negative due to larger-than-anticipated widening of the trade balance. However, slackening global demand derailed prospects for Ukraines economic recovery in the end of this year. On the supply side, industrial sectors recorded major slowdown as metallurgy saw a decline in export orders in 2H11. The agricultural sector posted an unexpectedly high growth rate driven by record grain harvest. In addition, retail trade and construction maintained double-digit growth rates throughout most of the year, providing evidence of healthy pickup in domestic demand. All in all, economic growth in Ukraine in 2H11 turned out to be better than previously expected. GDP growth figures exceeded the governments forecast as well as market consensus. The major impact from EU sovereign debt woes and weak global economic fundamentals on Ukraines economy was a cut from external capital markets and deterioration in balance of payments. As result, central bank reserves and the hryvnias exchange rate came under pressure. Despite intensified risks, the National Bank of Ukraine was able to withstand pressure and cover FX market deficit, although it lost a significant portion of its reserves. Headline inflation decreased to its lowest level in the past several years backed by notable deceleration in the growth of food prices. Exchange rate stability also contributed to easing inflation risks. We forecast GDP growth of 3.9% Y-o-Y in 2012 It is more difficult to forecast economic performance for the upcoming year compared to this years outlook. More variables remain undefined in the equation, with Ukraines economic fortunes relying on potentially unstable global financial developments. The economy will slowdown and GDP growth will land at 3.9% Y-o-Y, according to our base-case scenario in 2012. Headline inflation will pickup from the current exceptionally low level and reach 8.9% Y-o-Y. We expect only moderate devaluation of the hryvnias exchange rate with average rate of UAH8.1/$1 during a year. It is our prediction that the deficit on the current account will contract on general economic moderation and reach $6.2 bln or 3.4% of GDP. Plus, with the slowdown in terms of economic growth, the government risks breaking its promise of a 2.5% of GDP budget deficit in 2012.
2007 7.9% 143.3 3.1 10.2% 16.6% 23.3% 5.05 5.03 (5.3) -3.7% 2008 2.3% 179.6 3.9 -3.1% 22.3% 23.0% 7.50 5.28 (12.8) -7.1% 2009 -15.1% 112.9 2.5 -21.9% 12.3% 14.4% 7.98 8.10 (1.7) -1.5% 2010 4.2% 137.4 3.0 11.2% 9.1% 18.8% 7.97 7.95 (3) -2.2% 2011E 5.0% 162.9 3.6 7.5% 6.4% 15.3% 8.00 8.00 (7.4) -4.5% 2012F 3.9% 180.9 4.0 4.7% 8.9% 14.5% 8.20 8.10 (6.2) -3.4%
Economic growth turned out to be better than market consensus
Figure 2. Key macroeconomic indicators and forecasts 2005 2006 Real GDP growth, %, Y-o-Y 2.7% 7.3% Nominal GDP, $bln 86.2 107.8 GDP per capita, $'000 1.8 2.3 Industrial sectors growth, %, Y-o-Y 3.1% 6.2% CPI inflation, %, eop 10.3% 11.6% PPI inflation, %, eop 9.5% 14.1% UAH/$, eop 5.05 5.05 UAH/$, avr 5.12 5.05 Current account balance, $bln 2.5 (1.6) Current account balance, % of GDP 2.9% -1.5% Source: State Statistic Committee of Ukraine, NBU, Phoenix Capital estimates
Economic growth
Global economic growth and credit conditions will determine the economys results in 2012 The prognosis of receding GDP growth in 2012 to 3.9% Y-o-Y depends primarily on global developments with the main uncertainties consisting of sovereign debt problems in the EU and foreign credit availability. Economic growth in 2012 will vary over the year, according to our projections. While in 1H12 economic dynamics will follow the slowing trend established in the end of 2011, already, in 2H12 we expect GDP expansion to pickup. Ukraines economic growth forecast for the next year is based on the following factors: External demand for Ukraines exports is set to weaken dragged down by slowdown in global GDP. Slacking foreign demand will push growth in industrial sectors to 4.7% Y-o-Y. Foreign debt capital market will be closed for Ukraines private borrowers and the government for the most of 1H12. The government will need to seek funding from international financial institutions or quasi-sovereign funds. The growth rates in consumer and investment expenditures will moderate but remain in higher single-digit territory. Inflation will not exceed 10% Y-o-Y. Contribution of net exports will remain negative. Ukraines economic recovery broadened compared to the previous year with solid growth observed in major base industries in 10M11. Only the dynamics in industrial sectors leveled out due to weak export growth. Retail trade and construction bolstered by strengthening consumer and investment expenditures increased at double-digit rates, respectively.
Figure 3. Major economic industries improved performance in 10M11 10M10 20% 15% 10% 5% Construction 0% -5% -10% Industrial sectors GDP 10M11
Retail trade
Agriculture
Source: State Statistic Committee of Ukraine
Industrial sectors will record rather weak performance in 2012. Commodity-linked metallurgy, mining and chemical industries will be battered by expected correction in output prices. Utilities will be less affected by fluctuations in global economic activity and will follow the general flow of the economy. Light and hotel economy sectors should be supported by income tax exemptions. On a comparative basis, we expect that sectors positioned on the domestic market to fare better compared to export-driven industries.
6
Balance of payments and currency

In 2011 the deficit on the current account will widen to 4.5% of GDP Widening of the current account deficit in 2011 was more than initially expected due to surge in natural gas prices and the moderation of export growth. Also, an increase in fixed capital investments of 21.2% Y-o-Y in 9M11 was partially covered through machinery imports, which contributed to an increase in the trade deficit. On the financial account, capital inflows drained in September-October leading to an aggregate deficit in the balance of payments. The shortage was financed through the sale of NBU international reserves which declined to $34.2 bln in October. However, the hryvnias exchange rate remained stable with only minor fluctuations observed throughout the year. In 2011, the gap in CA will reach $7.4 bln or 4.5% of GDP, according to our estimations.
Figure 4. NBU covered the shortage in the current account in 3Q11 Current account 6 5 4 3 2 1 0 -1 Aug-11 Sep-11 Jan-11 Feb-11 Mar-11 Jun-11 Apr-11 May-11 Oct-11 Nov-11 7 Jul-11 -2 -3 1Q10 Source: NBU 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 0.990 0.995 1.000 NBU FX interventions Financial account Figure 5. USD/UAH exchange rate fluctuations were less than 1% in 2011, index, Jan-1 taken as base date 1.010
1.005
Source: Interbank market data
CA deficit will contract to 3.6% of GDP in 2012
We forecast that the shortage in the current account will contract in 2012. However, the decline will be rather moderate contrary to the crisis in 200809 and the government and central bank will not risk devaluating the hryvnia in 2012. The possible natural gas price discount to $230/tcm (as reported in Ukraines media) will provide the largest improvement to the current account. With an expected 35 bcm natural gas purchases, a price cut will save approximately $6 bln in 2012. With terms of the natural gas agreement still undisclosed, we do not incorporate a price discount in our estimations and assume that the gas price will rise marginally in 2012. As a result, the current account deficit will land at $6.6 bln or 3.6% of GDP. The surplus on the financial account will shrink as Ukraines economy will be cut from international debt capital markets throughout most of 1H12. Consequently, an aggregate of current and financial accounts will record a gap in 2012, covered through the sale of NBU international reserves.
Hryvnia exchange rate will average UAH8.1/$1 in 2012
The hryvnias exchange rate will remain almost fixed for the most of the next year with only marginal fluctuations allowed by Ukraines central bank. On the brink of parliamentary elections in the fall of 2012, the government and the NBU will not risk devaluating the exchange rate. Therefore, we forecast the UAH/USD rate to average 8.1 in 2012 and decrease to 8.2 in the end of the year. There is a chance that the government may boost social expenditures immediately before parliamentary elections. These expenditures may be transformed into FX purchases, thereby weighing on the exchange rate. Costs of keeping the hryvnia fixed will result in a loss in the NBUs international reserves, which we expect will decline to $26 bln.
Fiscal policy and government debt

Figure 6. Budget deficit contracted by 78.2% Y-o-Y in 10M11, UAH bln 300 250 200 150 100 50 0 Revenue Source: Ministry of Finance Expenditures Deficit 10M10 10M11
The government plans to proceed with fiscal consolidation in the next year by slashing the budget deficit to 2.5% of the GDP from the expected 3.5% of this years GDP. In 10M11, the fiscal gap contracted by an impressive 78.2% Y-o-Y to UAH 12.4 bln, reserving room to speed up expenditures in the end of the year. Budget revenues grew by 36.5% Y-o-Y while expenditures increased 8.5% Y-o-Y in 10M11. Accounting for general economic slowdown in the next year, plus the resulting loss of budget revenues, we expect the deficit will reach 3% of the GDP. The government will be tempted to step up expenditures in the middle of the year before the parliamentary elections scheduled in October. We estimate that the impact of fiscal policy on inflation, and the hryvnias exchange rate next year to be rather moderate. As foreign debt capital markets will be closed for Ukraines borrowers during most of 1H12, the government will need to tap into the domestic bond market, or IFIs to cover the fiscal gap. We forecast that public debt in 2012 will expand mostly in line with the nominal GDP, therefore, leaving the ratio of government debt/GDP marginally changed at 42% of the GDP ($76 bln).
Monetary indicators
Despite some retrenchment in recent months, the hryvnia denominated deposit increased 11.4% YtD in October, based on provisional data. FX deposits surged 18.7% YtD as households converted some hryvnia savings into US dollars. In total, deposits recorded 14.5% YtD growth in 10M11. Aggregate credits advanced only by 10.3% YtD in October dragged down by a 0.9% YtD drop in FX loans. Ukraines central bank tightened banking liquidity in September-November striving to maintain a stable hryvnia exchange rate. Correspondent accounts dived below UAH10 bln, which is considered a critical level. As a result, the overnight interbank rate surged to 20% from the average 2.6% in 1H11.
Figure 7. Interbank O/N rate surged to 20% in October 25% 20% 15% 10% 5% 0% Feb-11 Apr-11 May-11 Aug-11 Sep-11 Nov-11 Jan-11 Mar-11 Jun-11 Jul-11 Oct-11 Figure 8. NBU decreased banking liquidity to defend hryvnia s exchange rate, correspondent accounts, UAH bln 30 25 20 15 10 5 Feb-11 May-11
Sep-11
Aug-11
Source: NBU
Source: NBU
As the economy heads into a slower growth period, advancement in credits in 2012 will be sluggish. Total loans will increase by 11% Y-o-Y in the next year, according to our estimations. As liquidity contracted, banks started to offer higher interest rates on deposits which increased to 15.4% for UAH denominated accounts. As a result, increased costs of credit hampered expansion of loans. Factors such as high credit interest rates, banks aversion to taking on new risk and weak demand for credits will weigh on bank lending in the next year. Interest rates will decrease only marginally in 1H12, while large retrenchment is expected for 2H12.
Inflation
The trend of slowing CPI inflation will not be preserved in the next year, according to our estimations. The influence of exceptionally low food inflation will fade in 1H11, while the result of the harvesting campaign in the next year is largely uncertain. However, the government will keep its eye on prices of socially important food items on the brink of parliamentary elections in the fall of 2012. Therefore, we project only gradual strengthening of food inflation in 2012. Revision of natural gas prices will put downward pressure on input costs and, thereby, headline inflation. Also securing lower gas prices will enable the government to extend the period of an increase in utility tariffs.
Nov-11 9
Apr-11
Jan-11
Mar-11
Jun-11
Jul-11
Oct-11
Budgetary and monetary factors will have a modest impact on CPI inflation in the next year. The government plans to slash the budget deficit to 2.5% of GDP in 2012, according to the agreement with the IMF. Money supplys influence on inflation will be limited due to subdued expansion of new credits. As a result we forecast CPI inflation to inch up to 8.9% Y-o-Y in 2012.
Figure 9. CPI inflation trend for food products 14% 12% 10% 8% 6% 4% 2% 0% Feb-11 Apr-11 May-11 Aug-11 Sep-11 Nov-11 Jan-11 Mar-11 Jun-11 Jul-11 Oct-11 10% 5% 0% Feb-11 Apr-11 May-11 Aug-11 Sep-11 Nov-11 10 Jan-11 Mar-11 Jun-11 Jul-11 Oct-11 CPI inflation Food Utilities Figure 10. PPI inflation remained close to 20% for most of the year 30% 25% 20% 15% PPI inflation Metallurgy Machinery
Fixed Income
Market advancement in 1H11 was halted by unfolding euro-zone risks Ukraines Eurobond market started in 2011 with impressive price growth boosted by the U.S. Federal Reserve's asset purchase program and rising demand for risky securities. Expectations for globally strengthening economic growth bolstered the nations debt market. As a result, in 1H11, major corporate and bank note yields dipped to their lowest level. Ten-year sovereign Eurobonds experienced a drop in yields to 7.1%. YTMs on issues of Metinvest, DTEK, and MHP maturing in 2015 declined to 6.5%, 7.0%, and 7.9% respectively. However, the market situation reversed in 2H11 following an outbreak of EU sovereign debt problems. Demand for risky assets evaporated battered by weakening global economic growth. In Ukraine, private companies and the government were cut from international debt markets causing them to abandon their plans of tapping into the Eurobond market. Nonetheless, the economy performed rather well with 5.3% Y-o-Y GDP growth in 11M11. Sovereign yields leaped above 10% on riskaversion As a result of intensifying euro-zone financial woes, Ukraines yield curve leaped nearly 3 p.p. and exceeded 10% YTM on the long-end. The spread for ten-year sovereign Eurobonds rose to 950 bps from 420 bps in 1H11. The cost of insuring Ukraines ten-year US dollar debt against default as measured by CDS surged to 800 from 470 in 1H11.
Figure 12. CDS on Ukraine's 10 Year US dollar debt leaped to 800 1100 1000 900 10 8 6 4 2 0 Aug-11 May-11 Sep-11 Mar-11 Feb-11 Jun-11 Apr-11 Oct-11 Nov-11 Jul-11 800 700 600 500 400 300 Aug-11 Sep-11 Jan-11 Feb-11 Mar-11 Jun-11 Apr-11 Oct-11 May-11 Nov-11 11 Jul-11
Figure 11. Spreads widened for Ukraines sovereign notes, p.p. Ukraine 13 spread to UST 14 12 Ukraine 21 spread to UST
Source: Bloomberg
Source: Bloomberg
Corporate and bank issues experienced even more dire performance compared to Ukraines sovereigns. Spreads to UKRAIN for corporate notes widened to above 200 bps, while compared to UST yield premium surpassed 1,000 bps. The increased spread is predominantly a result of the surge in country risk in Ukraine. Most corporate issuers financials improved in 2011. On an important note, some of the strongest corporate issuers were able to secure favorable bank financing and relied on operating cash flows to cover capital expenditures.
On a relative scale, Ukraines sovereigns underperformed Russian and Turkish Eurobonds. Ukraine 20 spread to Russian and Turkish sovereigns rose to nearly 550 bps and 450 bps respectively.
Figure 13. Ukraine sovereign spread to Russian and Turkish notes widened, p.p. UA20 spr. to RU 7 6 5 4 3 2 1 Feb-11 Apr-11 May-11 Aug-11 Sep-11 Nov-11 12 Jan-11 Mar-11 Jun-11 Jul-11 Oct-11 UA20 spr. to TU
Source: Bloomberg
Sovereign Eurobond sector outlook

Global financial developments will weigh on Ukraines sovereigns In the upcoming year, performance in Ukraines sovereign Eurobond market segment will largely depend on global financial developments (predominantly in the EU) and the governments ability to refinance maturing debt obligations. In 2012, the Ukrainian government will need to repay nearly $9.4 bln. Also, beginning from the next year the government will face large redemptions on debt to the IMF of $3.8 bln. Continuing cooperation with the Fund remains a critical issue for Ukraine. However, at the moment, the government remains reluctant to carry out the IMFs obligatory requirement of hiking up natural gas prices for households. With Fund credits on hold, the government will need to tap into financing from quasi-sovereign Russian financial institutions, in our view. Possible revision of gas prices will improve governments external financial position Among expected positive initiatives, possible downward price revision of natural gas supplied from Russia will provide notable improvement for countrys external financial position. According to media reports, Ukraine may obtain a 42% discount to the current price which will significantly slash the deficit in the CA and alleviate pressure on the FX market. While advancement in public debt/GDP ratio in the next year will be only marginal reaching 42% - we do not expect Ukraines sovereign Eurobonds to fully recoup incurred losses in 2011. With global interest rates remaining at their lowest levels and weak forecasted economic growth, we estimate sovereign issues to post only a moderate rebound in the next year. Also, accounting for high uncertainty regarding the outcome of eurozone debt woes, the volatility in government Eurobonds will remain above average.
Moderate rebound in sovereigns is expected in 2011
Corporate and bank Eurobonds outlook

Corporate and banking Eurobonds should perform better compared to sovereigns We expect Ukraines corporate and bank notes to outperform sovereign Eurobonds in the next year. Most corporate issuers managed to improve financial performance in 2011. Companies such as DTEK and Metinvest increased their LTM EBITDA in 1H11 by 39.4% and 31.6% compared to performance in 2010. At the same time, prices for major corporate notes dipped drastically compared to sovereign issues. DTEK 15 and Metinvest 15 are among our Top Picks in the corporate Eurobond universe. In the banking market segment we favor notes of state-owned Ukreximbank and the largest bank - PrivatBank. DTEK is the leading vertically integrated power generating company in Ukraine. It has low sensitivity to global swings in economic activity and derives its revenues primarily from the domestic market. The company seeks to expand its presence in the power generating sector to above 60% of the market share through participation in privatization deals. Also, the company obtained control over two large state mining holdings Sverdlov- and Rovenki anthracite, thereby, increasing its share in the countrys coal extraction to nearly 45%. DTEKs market leading position, secured credit lines, high resistance to fluctuation in external economic conditions, and strong ownership structure distinguish the company from other corporate issuers and make the companys Eurobonds the best relative value choice. Metinvest notes maturing in 2015 pays YTM of 11.8% having duration of 2.8. METINV 15 spread to Ukraines sovereign yield curve widened to 220 bps, reflecting primarily an intensified risk aversion. At the same time, the company reported a 67.6% Y-o-Y increased in EBITDA to $2.0 bln in 1H11. Accounting for correction in output volumes and prices in 2H11, we estimate the ratio of net debt/EBITDA will not breach 1x in 2011. Ukreximbank and PrivatBank provide the best relative value among bank notes Among banking Eurobonds, our primary choice are notes of Ukreximbank: EXIMUK 15 and EXIMUK 16 which are priced to yield 12.2% and 14.8% respectively. Ukreximbank is the strongest Ukrainian bank serving as the governments financial agent; its CAR was 31.4% in the end of September, 2011. Spreads for EXIMUK 15 and EXIMUK 16 to UKRAIN of 250 bps and 550 bps provide an attractive valuation point in terms of quasi-sovereign risk. PrivatBank Eurobonds PRBANK 15 and PRBANK 16 offer yields of 17.0% and 19.6% respectively. Spreads for these issues in reference to the sovereign yield curve increased more than threefold to 850 bps and 740 bps with a price discount of 21% and 38% respectively. During the crisis of 2008-09, PrivatBank was punctual in terms of debt repayment. Considering PRBANKs financial position - we are confident that it is capable of fully servicing its Eurobonds. Furthermore, in consideration that it is the largest financial institution in Ukraine, PrivatBank will easily obtain financing from the central bank if necessary.
Figure 14. Top picks in Ukraines Eurobond universe Rating, M/F/S B2/B/ B2/B/ B1/B/ /CCC/ B1/B/ B1/B/ YTM 12.3% 12.3% 12.7% 15.4% 17.0% 17.1% Price 92.4 94.4 88.5 71.5 98.9 79.1 Spread to UST, p.p. 12.0 12.0 12.4 15.0 16.9 16.8 Spread to UKRAIN, p.p. 2.1 2.1 2.5 5.6 8.8 7.0
DTEK and Metinvest are our Top picks in the corporate market segment
DTEK 15 Metinvest 15 Ukreximbank 15 Ukreximbank 16 PrivatBank 12 PrivatBank 15 Source: Bloomberg
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Equity strategy
Global sentiments shaped Ukraines equity market performance The unfolding euro-zone crisis and slackening global growth shaped the performance of Ukraines equity market in 2011. Being sensitive to the dynamics in international equity movements, the UX Index plunged 42% YtD as of December 21. Other markets exhibited less dire results: in the UK, FTSE 100 lost 9.7% YtD, in Russia the MICEX dropped 20.9% YtD, and regional indicator MSCI FM CEE + CIS fell 23.9% YtD. Locally traded Ukrainian equities underperformed regional peers and the countrys shares traded abroad - largely due to squeezing liquidity on the domestic stock market. The WIGUKR Index, representing Ukrainian companies trading in Warsaw, posted 41.2% YtD decline. The Ukrainian equity market paid little attention to domestic economic progress in 2H11 concentrating on worldwide financial sentiments. The countrys GDP increased by 5.3% Y-o-Y in 11M11, according to the governments provisional estimates. Thus, Ukraines economic growth will outperform that of most neighboring countries in the region this year, reaching slightly above 5% Y-o-Y (close to our initial forecast). In 2012, global economic growth will slow: Europes GDP will increase by 0.7% Yo-Y and the EMEA region will grow by 3.2% Y-o-Y. The breakdown of countries is as follows: Polands economy will expand by 3.2% Y-o-Y and Russias GDP will pickup by 3.6% Y-o-Y. Compared to other countries, Ukraine is expected to record higher GDP growth at 3.9% Y-o-Y, according to our estimations.
Figure 16. Performance of UX index vs. other markets, YtD, $ rebased UX FTSE 100 MICEX MSCI FM CEE + CIS
The countrys economic growth turned out to be better than in neighboring countries
Figure 15. Economic growth in selected countries and regions, %, Y-o-Y 2011E 6% 5% 4% 3% 2% 1% 0% Europe USA EMEA Poland Source: Bloomberg, Phoenix Capital estimates Russia Ukraine 2012F
140% 120% 100% 80% 60% 40% 20% 0%
Aug-11
May-11
Sep-11
Mar-11
Jan-11
Feb-11
Jun-11
Apr-11
Oct-11
Nov-11
Source: Bloomberg, , Phoenix Capital estimates
Tight external credit conditions will weigh on markets in the upcoming year
In 2012, the Ukrainian stock market will remain vulnerable to global sentiments, paying less attention to developments inside the country. European sovereign debt problems, along with its fragile banking system, will continue exert considerable pressure on domestic equities. The risk of global recovery slowing down will have lower implications as Ukraines GDP growth is currently reliant on robust domestic investment demand and consumer expenditures.
Dec-11 14
Jul-11
Parliamentary elections next year should not change political landscape significantly
Parliamentary elections scheduled for October may also heighten political risks connected to investments in Ukrainian assets. Revised election law introduced a mixed electoral system in which 50% of parliamentary deputies would be chosen based on closed-party lists and the other half would be determined by a single-winner; single mandate districts. The changes were introduced in order for the ruling Party of Regions to maintain a majority of seats in the next Parliament. As the Party of Regions is likely to win the upcoming Parliamentary elections, we do not expect significant changes to Ukraines political landscape in the end of 2012. Among other political developments, Yulia Tymoshenko is not expected to be released any time soon, thereby undermining prospects for Ukraines integration with Europe. In a political sense, the country will seek to find balance among the EU and Russia in an attempt to secure greater benefits in economic cooperation while losing a decisive political strategy. In consideration of a number of risks, we hold a moderately positive view on Ukraines equities in 2012. While during rallies domestic stock advancement is often excessive, at a time of retreat Ukraines market decline surpasses foreign equities. Currently, investors tend to ignore attractive valuation levels. However, as market sentiments stabilize in 2012, Ukrainian stocks will recoup some of their incurred losses.
Top picks in Ukraines equity universe

Amid the global financial turmoil, we recommend following a bottom-up approach in designing an equity strategy for Ukraine. Our Top picks list in Ukraines equity universe includes companies from the following industries: agriculture, machinery, power generation and mining. Also, we tend to choose foreign listed Ukrainian companies with greater liquidity and better disclosure standards over domestically traded equities. In the agricultural industry we recommend buying stocks of companies such as: MHP (MHPC: LI), IMC (IMC: PW), and Agroton (AGT: PW). Ukraines agricultural industry exhibited impressive growth this year with a record high harvest of 56 MT. In 2012, we expect the grain harvest will slide, but remain above previously recorded averages. The industry is expected to absorb a significant amount of investments in the upcoming years, taking in to account ample spare capacities for expansion. MHP (MHPC LI) collected a record grain harvest in 2011, which coupled with a 15% Y-o-Y increase in poultry prices boosted company performance. Results reported for 9M11 imply that MHP has every chance to satisfy management's expectations and post $410 mln EBITDA in 2011, compared to $344 mln, according to our forecast. Based on the DCF model the companys stocks have an upside of 84%. Amid correction in soft commodity prices, we estimate Agroton (AGT PW) will marginally grow its EBITDA to $36 mln in 2011. The companys sustainable business model plus prospects for steady growth make it an attractive investment opportunity. With a target price of $8.4 per share, the stock offers a 51% upside. Industrial Milk Company (IMC PW) has an aggressive expansion plan for the upcoming years; implementation of which will depend on the company's ability to attract financing. The companys EBITDA will increase to $ 25 mln in 2011 (+38.9% Y-o-Y) and expand to $ 39 mln (+56.0% Y-oY) in 2012. We view IMC PW as a more risky investment, however, with an upside of 137%.
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Among domestically traded stocks we like non-cyclical Motorsich (MSICH). In 2011, Motorsich secured a 5-year contract with Russian Helicopters for the total delivery of 1,300 helicopter engines, totaling $1.2 bln, having already designated the bulk of its production with stable orders. Key growth drivers for MSICH will be the development of An148/158 jet production in Ukraine, in addition to the anticipated serial output of military transport An-70 aircraft. The company will raise its EBITDA to $ 246 mln (+19.0% Y-o-Y). We have an upside of 189% for MSICH - based on the DCF model estimation. In the mining industry, our Top picks include Ferrexpo (FXPO LN), Sadovaya Group (SGR PW), and Coal Energy (CLE PW). These companies, however, represent more risky investment targets, having significant exposure to the commodity cycle. We expect Ferrexpo to report around $790 mln EBITDA in 2011 (+29% Y-o-Y). Even assuming a 5-10% Y-o-Y cut in the 2012 EBITDA to around $720-750 mln, due to weakening iron ore prices, Ferrexpo trades at 3.3x EV/EBITDA multiple, which implies a 27-30% discount to peers. Since the IPO debut in December 2010, Sadovaya raised debt financing of $36 mln from EBRD and $25 mln from OTP Bank (Ukraine). Sadovaya Group will spend these funds on the expansion of a high-profitable waste recovery segment, commissioning new longwalls and funding a long-term project of constructing a new mine. The company is expected to report EBITDA of $ 21 mln (+29% Y-o-Y) in 2011. Based on DCF model results, the upside on SGR stands at 133%. Coal Energy will record a 314% Y-o-Y increase in EBITDA to $ 53 mln in 2011, according to our estimations. Two thirds of Coal Energys product is produced from underground mining. Coal Energys coal extraction is expected to increase by 46% Y-o-Y in FY12. The company is targeting expansion of its highly profitable waste recovery segment. The company plans to launch a new waste recovery unit in May 2012. CLE has an upside of 54% to its current share price.
Figure 17. Top Picks in Ukraines equity universe Avg. daily MCap, $mln trading volume, EV/EBITDA 11E 1M, $000 MHP 1,204 706 5.2 IMC 71 19 3.2 Agroton 121 34 3.3 Motor Sich 565 497 2.4 Ferrexpo 2,473 4,436 3.3 Sadovaya Group 102 52 3.8 Coal Energy 277 42 5.6 Source: Bloomberg, Phoenix Capital estimates
P/E 11E 5.3 3.9 5.5 3.3 4.3 7.3 6.4
Upside, % 84% 137% 51% 189% 30% 133% 54%
Agriculture
Grains: harvest sets record, prices fall Ukraine collected a record harvest of an estimated 56 MT (+44% Y-o-Y) in 2011. Weather conditions favored agricultural producers - key grain yields increased by 33% on average, to 3.8 t/ha. Winter wheat harvest reached 22.4 MT (+33% Y-o-Y), barley production totaled 9.1 MT (+7% Y-o-Y), while corn yields reported 6.4 t/ha implying a total harvest of 20 MT (+67% Y-o-Y). With such a bountiful harvest, Ukraine could potentially export over 27 MT of grain in 2011/12, however, actual export volumes will be 25-30% lower due to export restrictions. Export duties were in force in July-October (the export duty on barley will remain in force until January 1, 2011).
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Easier access to international markets and significant crop volumes available for sale will be characteristic of the Ukrainian agricultural market in 1H12. However, the situation may change dramatically in 2H12 when the largest portion of 2011s collected record harvest is sold. Although, it is premature to comment on next years harvest, Ukraine is expected to collect 30-40-% less winter wheat in 2012 due to insufficient precipitation last fall. Significant losses of winter crops may result in a 15-20% decline of the total harvest for 2012, which we estimate at 48 MT. A hawkish outlook has already raised suspicions on new export restrictions that may be employed next year.
Figure 18. Grain harvest, MT 60 50 40 30 20 10 0 2005 2006 2007 2008 2009 2010 2011E 2012F Source: State Statistic Committee, Phoenix Capital estimates
Oilseeds & oils to maintain global leadership
Ukraine will maintain its global leadership position in the oilseed and oil segment. The country has collected 8.8 MT (gross weight) of sunflower seed (+14% Y-o-Y). Sunflower is the most popular oil bearing crop in the country with nearly 90% of the harvest consumed by the domestic processing industry. Vegetable oil production is an export-oriented business. Ukraine traditionally exports 90%-95% of produced sunflower oil and is expected to supply international markets with 2.9 MT out of 3.1 MT produced in the 2011/12 season, according to the USDA. Therefore, the country will maintain its status of the largest sunflower oil producer and exporter in the world with a market share of 52%.
Figure 19. Largest sunflower oil exporters, MT 6 5 4 3 2 1 0 Source: USDA 58% 58% 18% 11% 13% 13% 2009/10 1% 3% 21% 10% 2010/11 3% 4% 4% 17% 8% 2011/12 F 3% 2% 52% Other EU-27 Turkey Argentina Russia Ukraine
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The situation regarding the domestic sunflower seed and oil market is largely a result of existing policy. Currently, sunflower seed exports from Ukraine are subject to an 11% export duty, which will be reduced to 10% in 2012, according to Ukraines agreement with the WTO. The EU has proposed to lift export duties on sunflower seed in the framework of the Deep and Comprehensive Free Trade Area (FTA) currently under negotiation. The duty rate on a proposed 100 kt quota will decrease gradually to nil over the next 15 years, according to statements by Ukrainian government officials. This will stimulate Ukrainian sunflower seed exports and may increase the existing supply-demand gap on the Ukrainian market. Oversupply of sugar triggers drop in prices The biggest sugar beet harvest in the past five years turned out to be a disaster for Ukrainian sugar producers. The country collected 18 MT of sugar beet - enough to produce over 2.3 MT of sugar in 2011/12. With an annual average consumption of 1.9 MT, the surplus supply will total 400 kt. Foreseeing overproduction in 2011/12, Ukrainian sugar producers started considering export opportunities. Most market participants consider the Middle East as the main export destination for the next couple of years. Exports to neighboring Russia and the EU are restricted as a result of high export barriers in the form of protective quotas and export duties. Despite these broad statements, we are skeptical about the prospects of Ukrainian sugar producers on international markets due to the high cost and price of beet sugar compared to its alternative produced of sugarcane. Although beet sugars price plunged 36% since its peak in July 2011, to $715 per tonne, there is still a $90 per tonne premium to cane sugar.
Figure 20. Sugar prices in Ukraine and on international markets, $/t Ukraine, beet sugar London, white sugar New York, raw cane sugar Figure 21. Sugar production and consumption, MT 3.0 2.5 2.0 1.5 1.0 0.5 0.0 2005 2006 2007 2008 2009 Source: State Statistic Committee, Phoenix Capital estimates 2010 2011E Sugar ouput Average consumption
1,200 1,100 1,000 900 800 700 600 500 400 Jul-11
Aug-11
Sep-11
Oct-11
Nov-11
Dec-11
Source: Expert-agro
Feverish attempts to utilize excessive volumes of sugar triggered talks regarding its use for biofuel production within Ukraine. We believe that the governments hopes in this respect are bound to disappointment - for the following reasons: first, biofuel production is undeveloped in Ukraine and the demand is practically nonexistent; second, overproduction is typically a one year event in Ukraine and we expect farmers will decrease land planted under sugar beet in 2012, as was done before in 2007. Ukraine is likely to encounter a deficit on the sugar market again in 2012/13.
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Milk production growth will depend on state support
Livestock farming remains the most troublesome segment in Ukrainian agribusiness, with the milk and dairy industry suffering the most. Milk yields per cow with a growth rate (CAGR) of 3% in 2005-11 could not compensate for the permanent decline in dairy cow headcount, and as a result, domestic raw milk production continued to slide. Milk output decreased by 1.8% Y-o-Y to 10.4 MT in 11M11. Market participants state that the situation in the industry is unlikely to change and blame the government for ineffectively regulating the industry. According to the new Tax Code, state subsidies to milk producers should be paid by government agencies and not paid by dairy producers as they were previously. The new system was not fully implemented and as a result, milk producers did not receive the promised subsidies. Meat production demonstrates stable growth over the past five years, owing primarily to rapid development of the poultry segment. Total meat output is estimated at 3.1 Mt in 2011, implying 5% Y-o-Y growth. For 2012, we foresee 6% Y-o-Y growth to 3.3 MT. Poultry will account for 5560% of total production. The increasingly higher share of poultry is the result of unaffordable pork and beef prices for a large portion of domestic consumers. Thus, we project that Ukrainians will continue to substitute other kinds of meat with more affordable poultry in the medium term. Government subsidies for producers engaged in livestock farming will total UAH 2 bln ($247 mln) in 2012, the Ministry of Agrarian Policy announced. State support will include partial compensation of construction costs for dairy farms, providing financing on beneficial terms and reimbursement for interest expenses on banking loans, etc. The declared measures are clearly a positive sign, however, the non-transparent allocation of funds may nullify all government attempts to stabilize the situation in the industry. We assume that milk production will remain stable in 2012 at 11.2MT, while first signs of growth will be seen starting from 2013.
Figure 22. Milk production, MT 16 14 12 10 8 6 4 2 0 2005 2006 2007 2008 2009 2010 2011E 2012F Source: State Statistic Committee, Phoenix Capital estimates
Meat production growth is driven by poultry segment
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Machinery
Machinery leads Ukraines industrial production growth The Ukrainian machinery sector is demonstrating the sharpest advance compared to other industries in 2011. Industrial production in Ukraine climbed 7.8% Y-o-Y in 11M11, while machinery output ramped up 17.4% Y-o-Y. The sectors average monthly aggregated revenue during 10M11 increased by 37% Y-o-Y to $1.4 bln. This growth was collectively driven by all machinery subsegments, including equipment production and transportation vehicles. Such enterprises execute long-term orders and usually react to the affect of economic slowdown later than commodity producers. We expect the machinery sector to continue reporting growth in 1Q12, probably at a somewhat lower pace and with further correction possible - depending on the extent of global economic slowdown.
Figure 23. Monthly aggregated revenues of Ukraines machinery sector and 10M average, $ mln 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Source: The State Statistic Committee of Ukraine, Phoenix Capital estimates Monthly 10M average
Aircraft engine production is driven by the demand for helicopter and airplanes in CIS countries
Aircraft engine production is not the largest subsegment when compared to Ukraines whole machinery industry, although it is the most important for the Ukrainian equities universe owing to Motor Sich (MSICH); one of the most liquid and promising stocks. MSICHs performance in future years will be driven 1) by the stable demand for new helicopters in CIS countries, as well as the world (See Figure 24). The company secured production of 1,300 helicopter engines in a five-year contract with Russian Helicopters. 2) by expansion of the An-148/158 project in the short-term, as well as the An-70 project in the mid-term. At present, 7-9 units of An148/158 are being manufactured in Ukraine and Russia and this amount per year may increase 2-3x in the following years.
Figure 24. Global helicopter market forecast military and civil, units 3,000 2,500 2,000 1,500 1,000 500 0 2011F 2012F 2013F 2014F 2015F 2016F 2017F 2018F 2019F 2020F Source: Russian Helicopters, Frost&Sullivan 20 Military Civil
Railcar production in 2012 close to full capacity, but at lower price
Freight car production in Ukraine is a key driver in the machinery sector, occupying a third of the total sectors revenues. Output of railway carriages in Ukraine increased by 37% Y-o-Y to approximately 47,800 units in 11M11 on the back of rising demand for rolling stock in the CIS region. As a result, Ukrainian enterprises operated at maximum capacity. Such a high demand arose primarily from critical age related wear and tear of the freight cars. Secondly, increased cargo transportation led to an insatiable shortage of rail cars. We expect Ukrainian rail car producing plants to operate near full capacity in 2012. The main risk will be related to a possible price decline caused by the launch of new production capacities in Russia, which will increase total CIS capacities to 100,000 units in 2012, and thereby balance expected annual consumption in the region.
Figure 25. Rail freight and passenger turnover in Ukraine Cargo, bln tonnes/km 25 20 15 10 5 0 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Source: The State Statistic Committee of Ukraine Passenger, bln passenger/km 10 8 6 4 2 0
In 2011 the high business season for lead-acid batteries ended sooner
Monthly production of lead-acid batteries is dealing with the effects of seasonality, although the high business season which traditionally lasts from September to January has already experienced an abrupt cut in November of 2011. The evident reason for that was expected economic slowdown and the deteriorating financial strength of wholesale resellers, which serve as intermediaries between the producers and final consumers of aftermarket batteries. In the long-term, demand for lead-acid batteries will grow parallel to the expected increase of active vehicles in CIS countries and other regions.
Figure 27. Ukraines SLI automobile batteries monthly export and import, 000 units Monthly export Monthly import 600 500 400 300 200 100 10M average of export 10M average of import
Figure 26. SLI monthly automobile battery production in Ukraine, 000 units 650 600 550 500 450 400 350 300 250 Sep-10 May-10 May-11 Sep-11 Jan-10 Mar-10 Jan-11 Nov-10 Mar-11 Nov-11 Monthly production 11M average
Jul-11
Jul-10
0 May-10 Sep-10
Nov-10
May-11
Source: The State Statistic Committee of Ukraine
Source: The State Statistic Committee of Ukraine 21
Sep-11
Jul-10
Jan-10
Mar-10
Jan-11
Mar-11
Jul-11
Machinery stocks offer exposure to aircraft engines and railcar production
Motor Sich is the best choice among machinery stocks, remaining the leader in terms of expected return (upside of 189%) and liquidity (up to $2 mln per day trading). Therefore, the company will outperform other names, once positive sentiment returns to the market. Railway rolling stock producers remain at risk due to the anticipated decrease of railcar prices in CIS regions. When placed under closer observation, Kryukiv railcar (KVBZ) has strong appeal in comparison to its local peers as a result of historically strong margins (17% EBITDA margin in 2H11). Luhanskteplovoz (LTPL) also improved profitability (EBITDA margin grew from 3% 1Q11 to 19% in 2Q11), but the sustainability of such earnings are still questionable.
Figure 29. Average daily trading volume of machinery stocks YTD, $ 000 1,840 1825 127
Figure 28. Machinery sector stock performance, YTD, as of 21 Dec. 2011
-28% -37% -51% -67% -79% -42% -100% -80% -60% -40% -20% 0%
MSICH KVBZ LTPL SVGZ WES UX
1,820 120 100 80 60 40 20 0 MSICH
51
45
38
SVGZ
KVBZ
LTPL
WES
Metals and Mining

Steel production in Ukraine will advance at 4-5% Y-o-Y in 2012 In 2011, the backbone of Ukraines economy, the steel and mining industry, was recovering from the crisis of 2008-09 while simultaneously dealing with volatility of commodity cycles. The worlds weak demand for steel products, coupled with excessive steel making capacities prevents Ukrainian companies from increasing steel output higher than 7% Y-o-Y in 2011. The countrys annual production will be close to 34.9 MT, the same level observed in 2002, which is slightly above our forecast. We expect that Ukraine will increase steel output by 4-5% in 2012 to 36-37 MT, in the best case scenario. Throughout the year, the bulk of this growth will appear at the end of 1Q12 and the beginning 4Q12. During the first three months of 2012, the world steel market will experience the following developments: 1) digestion of accumulated stockpiles, after the construction sector in China decreased consumption, and prices weakened globally, 2) awaiting to see the results after loosing the monetary policy of the Chinese government and the extent of these actions.
Figure 30. Crude steel production in Ukraine, MT 45 42.8 40 35 30 25 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011F 2012F Source: The State Statistic Committee of Ukraine, Phoenix Capital estimates 22 29.8 36.6
Lower production increase on weaker 2012 GDP growth in key regions
Steel output is highly correlated with GDP growth in key consuming regions. Ukraine is export-oriented above 82% of total steel products are sold abroad. Since 75% of exports go to the MENA region, East-Central and Southern Europe and CIS countries (See Figure 8 on the page **) in 2011, receding GDP growth forecasts imply lower expected steel production increase in Ukraine. The main contributor to the sectors advance in 2012 will be Dneprostal, a brand new electric steel-smelting complex, which plans to start production next year and manufacture 700 kt of steel. We expect Ilyich Stal, Zaporizhstal and Alchevsk Steel will achieve 5% Y-o-Y production increase, as they manufacture value-added flat products. Other companies will post a mere 2-3% increase in operating performance as long as they either operate on the depressed market of construction steel or already function at full capacity. Overall, the capacity utilization ratio among Ukrainian steel makers will improve a bit to 79% in 2012, compared to results a year ago. In 2011, steel prices experienced 15-22% Y-o-Y growth, which was mostly cost driven and lagged behind the appreciation of iron ore (+33-52%) and steel scrap (+51%), because demand for steel products has yet to return to a healthy state. We expect average annual prices for steel products to advance by 7-8% Y-o-Y in 2012, which indicates rather tough competition for clients among steel makers. Rising competition from Chinese producers already pushed Ukrainian companies to markets closer to Ukraine in 9M11 sales to South East and East Asia declined to 14%, compared to 26% in 2010. This change was accompanied by the product mix improvement. Higher value-added hot rolled flat steel came into first position, occupying 28% of total exports. Sales of semi-products decreased from 48% a year before to 43% in 9M11. Export growth in 2012 will be mainly caused by more political stability in the MENA region.
Figure 32. Geographic breakdown of Ukrainian steel exports in 9M11, % 3% 1% Middle East East-Central and Southern Europe CIS Southeast and East Asia Africa Western and Northern Europe Latin America North America
Ukraine redirected exports from Asia to Europe, while improving product mix
Figure 31. Product mix of Ukrainian steel exports in 9M11, %
7% 7% 9%
4% 28%
Hot rolled flat steel Slabs Billets Rebar Structurals
4%
3%
14%
32%
17% 26%
21%
24%
Rods and rails Cold rolled and coated
Source: Metal Courier, Phoenix Capital estimates
Source: Metal Courier, Phoenix Capital estimates
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Iron ore pricing will depend on Chinas growth
During 9M11 iron ore producers benefited from the market deficit, which held world prices on 63.5% fines in the high range of $170-200 per tonne (CFR, China). The slowdown in the Chinese economy experienced by the end of 3Q11 translated into decreased real estate prices in the country, falling steel prices and steel output. Coupled with natural disasters in Japan and Taiwan, which switched out metal consuming industries for the short-term - the slowdown in China caused spot iron ore prices to collapse in October to $127 per tonne. Further price growth will depend on whether the Peoples Bank of China will continue to relax monetary policy. We regard the possibility of this event as highly supportive to iron ore stocks.
Figure 33. Spot iron ore fines prices, 63.5% Fe content (CFR, China), $ per tonne 210 190 170 150 130 110 90 70 50 May-10 May-11
Sep-11
Sep-10
Nov-09
Nov-10
Mar-11
Jan-10
Mar-10
Jan-11
Source: Bloomberg
Quarterly price setting evolves towards following spot global prices
Easing of the iron ore market deficit, which occurred in autumn 2011, triggered further development of the pricing mechanism. Until recently, quarterly contract prices for iron ore have been set on the level of the average spot prices for the last quarter with a one month time lag. After Octobers plunge in prices, steel makers primarily in China, are pushing iron ore producers to use spot prices, as a reference for contracts. As a result, those mining companies, which accepted such new approach, will have to endure a decrease in selling prices. Ferrexpo (FXPO) is a price taker and exports all of its products, so the company is highly exposed to this trend, which will materialize in lower selling prices in 4Q11. But even after accounting for the decrease, the average annual selling price for the company appears to reach $163 per tonne in 2011, or 9% higher than we have projected. North Ore Mining and Processing Plant (SGOK), operates on a less flexible local market, enjoys stable prices iron ore concentrate and pellets the recent volatility in iron ore prices which has not yet been accounted for. Hence, the company will report record earnings in 2011. One of basic steel inputs, coke, follows the general trends in steel and hot iron production. The Ukrainian industrys coke output in 2011 will reach 19.6 MT (+5.4% Y-o-Y), but dynamics in 2012 will be more flat, along with a projected 2-3% Y-o-Y growth in hot iron production. Notwithstanding moderate anticipated growth in 2012, long-term plans of Ukrainian steel and mining groups foresee a considerable increase in production, which translates into a rising demand for coke in 2-3 years. Taking into account the fact that captive coke manufacturers in these groups operate at close to full capacity levels, and that other free capacities throughout the country are ageing, we expect the coke producers to initiate capacity expansion programs. This primarily relates to Avdiyivka Coke (AVDK), a subsidiary of Metinvest.
Captive coke plants of key steel and mining groups on the brink of capacity expansion
Nov-11 24
Jul-10
Jul-11
Coal sector is unraveling its potential
The coal mining sector is enjoying renaissance in Ukraine, as previously improperly financed state companies fall into private hands or are being prepared for privatization. Thus operating efficiency in the sector is considerably improving. The second positive growth factor is increased electricity production at thermal power plants (+9.6% Y-o-Y in 10M11), which as a result triggered domestic coal consumption. Ukraines total coal mining approaches 81.5 MT in 2011, which supposes an 8.4% Y-o-Y increase. Growth of thermal coal extraction (+12.4% in 10M11) is considerably contributing to the sectors advance. Steam coal exports are steeply augmenting as well to 5.5 MT in 10M11, which is 20% up Y-o-Y. Despite possible macroeconomic disruptions due to the ongoing debt crisis in the Euro zone, coal remains among the most demanded commodity in the long-term.
Figure 35. Average quarterly coking coal and steam coal prices in Ukraine, $ per tone 250 200 150 100 50 0 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 Coking coal "K" (concentrate) Steam coal
Figure 34. Average quarterly coking and steam coal mining in Ukraine, MT 16 14 12 10 8 6 4 2 0 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 Coking coal Steam coal
Source: Ministry of Energy and Coal Mining of Ukraine
Source: Metal-Courier, Ministry of Energy and Coal Mining of Ukraine
The bulk of listed metals and mining names fell more drastically in 2011 than the UX Index
Since the beginning of 2011, the Ukrainian Exchange Index decreased by 42% YTD. Five out of nine selected Ukrainian metals & mining stocks, listed on local and foreign exchanges, have outperformed this downward trend. The reason for the plunge was the sharp cut in profitability resulting from a margin squeeze (pure steel names and Avdiyivka Coke), or individual problems (corporate conflict and trading suspension at Yasynivka Coke). In terms of liquidity, the average daily trading volume of the two companies is above $1 mln YTD from the beginning of 2011 to mid December. It is important to note that four of the companies also have the potential to reach this investment threshold in the short-term (AVDK, AZST, ENMX and YASK). In 2012, we expect Avdiyivka Coke, Azovstal, Enakievo Steel stocks to move in close correlation with the local stock market, while some individual growth stories related to capacities expansion are still possible. Alchevsk Steel, is being closely watched by the authorities, and will continue to adhere to its recently improved practice of avoiding transfer pricing. Among other names, Ferrexpo, Sadovaya Group and Coal Energy are full-fledged public companies, listed on foreign exchanges and in strict compliance with certain corporate governance rules. FXPOs stock performance will largely depend on global iron ore prices, which will remain strong in 2012 on average, we believe, therefore leading to an upward rebound from the recent easing of stock prices.
Ukrainian metals & mining universe offer opportunities in iron ore and coal mining
4Q11 25
SGR and CLE are examples of organic growth on the coal market with strong emerging demand.
Figure 36. Metals & mining stock performance, YTD, as of 21 Dec. 2011 CLE SGOK FXPO SGR AZST ALMK AVDK ENMZ YASK -42% -80% -70% -60% -50% -40% -30% Source: Bloomberg, Phoenix Capital estimates -20% -10% 0% UX Figure 37. Average daily trading volume of metals & mining stocks YTD, $ 000 6,400 -13% -33% -35% -41% -55% -57% -57% -63% -70% 6,300 1,400 1,200 1,000 800 600 400 200 0 FXPO ALMK AVDK AZST ENMZ SGR YASK CLE Source: Bloomberg, Phoenix Capital estimates SGOK
Banks
Banks pursued a conservative lending policy in 2011 Ukraines banking industry managed to improve its performance in 2011 despite euro-zone financial problems and deteriorating global economic growth. After the crisis in 2008-09 banks pursued a rather conservative lending policy and tightened their credit standards. As a result, countrys banks were characterized by significantly lower risk taking behavior in 2011. We expect this tendency will be maintained in the next year. In line with our expectations for this year, loan loss reserves set on downward trend in 2H11. The ratio of LLR/gross loans slid to 19% in September from 19.3% in June. In addition, close to our forecast, gross loans advanced by 9.6% YtD in 11M11 driven primarily by robust corporate lending. Retail credits retreated by 2.5% YtD in 11M11. Credit expansion was shored up by hryvnia loans (+20.2% YtD) while FX lending was mostly restricted by the central bank. Lending was battered by a squeeze in liquidity in 4Q11 In 4Q11, credit growth nearly stalled as the NBU decreased banking liquidity. The policy was designed to keep the hryvnia exchange rate stable decreasing the demand for foreign currency. At the same time, interbank interest rates surged to post-crisis highs, which in turn led to rising credit costs in the economy.
Figure 38. Banks loan portfolio and reserves Loan portfolio, UAH bln, (LHS) 860 810 760 710 660 610 1Q10 Source: NBU 26 2Q10 3Q10 4Q10 1Q11 2Q11 3Q11 LLR/Gross loans, %, (RHS) 20% 18% 16% 14% 12% 10%
Banking industry improved financial performance
Ukrainian banks managed to improve interest revenues and stepped up income from tariffs for services in 2011. Net interest income increased 5.6% Y-o-Y in 9M11 while fee and commission income surged 23.7% Y-o-Y. Following a decline in LLR/gross loans ratio, the banking industry recorded a drop in loan loss reserve charges by 19.7% Y-o-Y. However, banks also stepped up administrative expenditures by 33.1% Y-o-Y which resulted in a net loss of UAH 5.6 bln recorded in 9M11 compared to the UAH 10 bln loss in 9M10. Contrary to aggregate results for the banking industry, the Top 10 Ukrainian banks turned profitable in comparison to recorded net loss in the previous year. Net profit for the ten largest banks (which account for 53.7% of industrys total assets) amounted to UAH 0.6 bln in 9M11 compared to UAH 1.1 bln net loss in 9M10. Improved financial performance is mainly attributed to higher cost effectiveness of the largest financial institutions. Administrative expenses in this banking group grew by only 13.2% Y-o-Y in 9M11. In addition, the largest banking institutions showed a stronger increase in net interest income.
9M10 Total banks 38.0 84.7 (46.7) 9.0 11.0 (1.9) 1.5 (35.8) (25.8) 2.8 (10.3) 0.3 (10.0) 9M11 Total banks 40.1 83.0 (42.9) 11.2 13.4 (2.2) 2.0 (28.8) (34.4) 4.3 (5.6) (0.1) (5.6) 9M10 TOP 10 21.9 46.8 (24.9) 5.3 6.2 (1.0) 0.8 (17.3) (13.2) 0.9 (1.5) 0.5 (1.1) 9M11 TOP 10 23.5 46.5 (23.0) 6.4 7.6 (1.2) 1.0 (16.4) (15.0) 1.0 0.6 0.0 0.6
Top 10 banks turned profitable in 9M11
Figure 39. Ukraines banking industry income statement, UAH bln
Net interest income interest income interest expense Net fee and commission income fee and commission income fee and commission expense FX trading income/(expense) Loan loss reserves charges Administrative expenses Other income/(expenses) Income before taxes Tax expenses Income after taxes Source: NBU
Banks will follow a conservative growth strategy in 2011
The Ukrainian banking sector will follow a conservative growth strategy in 2012, according to our projections. More buoyant recovery will be restrained by the countrys GDP growth slowing down to 3.9% Y-o-Y. Also, Ukraines financial industry will be battered by ongoing sovereign debt woes in euro-zone countries. However, this time around banks are much better prepared for the possible negative ramifications arising from the crisis. The capital adequacy ratio (based on UAS) stood at 18.7% in November, while the regulatory required level is 10%. Asset quality has improved as non-performing loans were sufficiently covered by reserves. New loans were mainly allocated to the safest market segments, which were hryvnia denominated credits to corporate borrowers. According to our predictions, banks will preserve a risk-averse approach towards distributing new loans in 2012. Gross credits in the economy will grow by 10% Y-o-Y in the next year. In addition, banks will mostly concentrate on corporate loans denominated in local currency. The NBU is expected to maintain a tight monetary policy, targeting to maintain a stable exchange rate of the hryvnia in 1H12. Thus, credit interest rates will further increase weighing on the availability of financing in the economy. Among banking groups, the Tier 1 group of banks according to NBU classification will record better financial results than compared to the general industry. These banks rely on a more diversified stream of revenues and depend to a lesser extent on the interests of business owners. Only the group of the largest banks will manage to record growth in net income in 2012, while other banks will struggle to break even.
Loans will increase by 10% Y-o-Y in 2012
27
The Ukrainian banks assets base have no exposure to euro-zone sovereign or banking debt obligations - as the central bank restricted these investments. However, the industrys funding base relies heavily on financing that could be provided by parent banks located in Europe. In November the share of foreign interest in Ukrainian banks equity inched up to 41.6%.
28
Top picks: company profiles

In the Ukrainian equity universe we selected stocks that we estimate represent the best relative value. The companies are currently trading at attractive price levels with valuation multiples hovering at their lowest ranges over the past year and a half. These companies will show robust annual financials for 2011, and will maintain upbeat results in the next year, according to our calculations.
DTEK
Donbas Fuel and Energy Company (DTEK) is the leading privately owned energy company in the country with a vertically integrated operating cycle. The companys business activities include: coal mining, power generation and distribution. DTEK is a part of System Capital Management the largest financial and industrial group in Ukraine owned by Rinat Akhmetov. DTEK has reinforced its position on Ukraines coal extraction and power generation markets. In December, the company signed an agreement with the government for concession of state coal mines: Rovenki- and Sverdlovanthracite for 49 years. DTEK plans to spend UAH 6 bln on investments for further development of these mines. With new assets under control, the company increased its share in the countrys coal production to 44.8% or nearly 44 MT. On December 9, the company purchased a 25% stake in Kyivenergo for UAH 450.5 mln increasing its share to 71.89%. Kyivenergo is a monopoly company that produces and supplies electric power and thermal energy in Kyiv, possessing two plants with a total capacity of 1.2 GWt. Also, DTEK will increase its stake in Zakhidenergo up to 71.9% for the price of UAH 1.9 bln. In light of its new acquisitions, the company strengthened its grip over Ukraines power generation market with a 69.7% market share. DTEKs development strategy will require sizable capital expenditures in the upcoming years. The company obtained financing from Russian VTB and Sberbank with a total amount of $ 832 mln to back its expansion program. DTEK recorded solid operational performance in 9M11, having boosted coal extraction by 17.9% Y-o-Y and power generation by 8.6% Y-o-Y. In consideration of financial indicators, the company posted a 92% Y-o-Y increase in EBITDA and a 71% Y-o-Y surge in net profit in 1H11. Accounting for new borrowing, we estimate the ratio of net debt/EBITDA will not breach 1x in 2011.
Metinvest
Metinvest is a vertically integrated metals and mining company comprised of assets in industries such as iron ore mining, coking coal mining and steel production (including pipe rolling). Following the acquisition of Ilyich Iron and Steel Works, the companys ownership structure has changed with SCM and Smart-Holding decreasing their stakes to 71.25% and 23.75% respectively. Volodymyr Boiko, the CEO of acquired Ilyich Iron and Steel Works, controls 5% of the company. Metinvest eyes to significantly expand its business in the upcoming years and plans to more than double its steel production capacity to 30 MT. In 2010, the company produced 13.8 MT of crude steel and ramped up output volume by 78.7% Y-o-Y in 9M11. Based on operational results in 2010, the company was ranked 23rd on the list of global steel makers. The company also aims to acquire a 50% stake in Zaporizhstal, Ukraines metallurgical plant that produced 3.4 MT of crude steel in 2010.
29
Despite deteriorating activity on export markets, Metinvest will improve its financial results in 2011. The company increased its top line 71.5% Y-o-Y in 1H11 while EBITDA grew 67.6% Y-o-Y to $2 bln. In addition, net profit more than doubled to $1.1 bln. The companys management expects EBITDA will reach $3.6-3.7 bln, implying growth of 41-45% Y-o-Y in 2011. Upbeat financial results will be driven primarily by a surge in production volumes - crude steel output will pick up to 14.7 MT in 2011. Metinvest secured a five-year amortizing credit facility with a balance of $850 mln in August at a rate of LIBOR+3%, and increased the amount to $1 bln in November. Earlier in the year, the company received $100 mln from UniCredit, $75 mln from Rabobank Group, $175 mln from Russian Sberbank, and sold 7 year Eurobonds for a total of $750 mln. We estimate the company will report net debt of $3.6 bln in the end of 2011, with net debt/EBITDA ratio close to 1x.
Ukreximbank
Ukreximbank is the third largest bank in Ukraine with 100% state ownership. The bank serves as the governments financial agent in its cooperation with IFIs, foreign governments and international organizations. Ukreximbanks principal activity is concentrated in financing export-import operations of state-owned and private enterprises. The bank relies primarily on wholesale funding. Having strong backing from the government Ukreximbank boasted a capital adequacy ratio of 31.4% as of September 30, 2011. Due to the nature of its operations, the bank is active on the Eurobond market with a sum of $1.1 bln US dollar denominated outstanding notes and UAH 2.4 bln in hryvnia-linked issues. Ukreximbank has a 20.2% share of its liabilities borrowed on the interbank market. The banks credit strategy is focused entirely on the corporate market segment. Corporate loans increased by 8.2% YtD as of September 30, 2011 and accounted for 98.1% of the gross credit portfolio. As corporate loans have a lower risk profile compared to retail loans; the bank reported a LLR/gross loans ratio of 16.3% compared to 18.8% for the Top 10 largest banks. Ukreximbank earned UAH 59.2 mln net profit in 9M11, implying an increase of 70.1% Y-o-Y. Charges against loan impairment decreased only by 6% Y-o-Y to UAH 2.1 bln and continued to weigh on banks financial performance. We expect the bank will maintain its focus on corporate clients, maintaining only marginal operations in the retail market segment in the future.
PrivatBank
PrivatBank is the largest privately owned bank in Ukraine with total assets amounting to UAH 141.4 bln or a 13.7% share in the banking industry, as of September 30. The bank is expected to retain its leading position on the market in the upcoming years. PrivatBank recently changed its ownership structure: Igor Kolomoiskyi and Genadiy Boholubov decreased their stakes to 33.75%, while Triantal Investments Ltd acquired a 24.99% share of the banks equity. Ukraines banking industry has been reshaped in the recent year by the entrance of numerous foreign financial institutions. Nonetheless, PrivatBank retained its leading position on the market, with a 17.2% share in total deposits in the banking system as of September 30, 2011. The bank has the second most widespread branch network in Ukraine after the state-owned Oschadbank.
30
PrivatBank remained profitable during the crisis in 2009, contrary to the majority of other privately owned banks in Ukraine. In 2010, the bank posted a net profit of UAH 1.4 bln. In 9M11, the bank generated UAH 979.7 mln net profit; its target for the year is set at UAH 1.5 bln. The bank has a well diversified funding base with customer deposits covering 96.3% of gross loans. The banks low reliance on wholesale funding made it possible for the bank to abstain from approaching creditors for restructuring needs during the crisis in 2009.
IMC
Industrial Milk Company Current price, $ Target price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA 11E P/E 11E Source: Bloomberg, Phoenix Capital estimates IMC PW 2.25 5.35 137% 71 19 3.2 3.9
Industrial Milk Company (IMC PW) is a mid-sized agricultural holding focused on corn production, wheat, sunflower and potato. The company is also one of the Top 10 industrial milk producers in Ukraine. In order to finance land bank expansion and business development, IMC floated 23.9% of its shares on the WSE in May 2011 and raised $29.8 mln to finance additional expansion. Our bullish outlook for the company is based on its solid operational performance and ambitious expansion plans for the upcoming year. IMC receives around 70% of its revenues from cultivating three main crops: corn, wheat and sunflower (43%, 14% and 12% respectively in 2010). The company collected 31 kt (+68% Y-o-Y) of winter wheat and reported a sharp increase in sunflower and corn yields to 2.6 t/ha (+21% Y-o-Y) and 9 t/ha (+57% Y-o-Y), implying a total grain harvest of 173 kt in 2011. Abundant crop production volumes should mitigate the negative effects of ongoing price correction. The company has expanded its land bank by 28% since IPO in May to 47,700 ha and has announced a preliminary agreement for the acquisition of an additional 9,500 ha by the end of the year. IMC intends to cultivate 100,000 ha in 2012. Increase in areas currently operating, and the shift towards greater production of highly profitable potatoes, should become the main value drivers for the company's performance. Announced CAPEX program for 2012 worth $72 mln, should be largely financed by debt. In consideration of the current market conditions, we are wary concerning the company's ability to attract planned debt financing. The inability to secure sufficient funds puts the company's expansion plans at risk.
Agroton
Agroton Current price, $ Target price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA, 11E P/E, 11E Source: Bloomberg, Phoenix Capital estimates AGT PW 5.57 8.42 51% 121 34 3.3 5.5
Agroton Public Ltd. (AGT PW) is a large, diversified agricultural holding involved in crop farming, animal breeding and food processing. Currently, its land bank totals 154,000 ha planted primarily under wheat and sunflower. Sunflower traditionally accounts for around 30-35% of Agroton's crop portfolio, which is above the norm recommended by the best practices of crop rotation. As a result of improper crop rotation employed by the company, wheat and corn yields came in below Ukraines average levels at 2.7 t/ha and 4.7 t/ha. The total grain and oilseed harvest is estimated at 250 kt, or 4% above last years harvest.
31
Despite slowdown in grain production, we see a potential upside in AGT PW stock, with our estimates based on the company's growth prospects. Agroton successfully raised $50 mln via Eurobond placement in July 2011 which made it possible to redeem outstanding debt and finance its investment program. Thus, Agroton currently has sufficient funds to finish construction of a new 82 kt grain silo and complete the full poultry production cycle after launching the breeding facility. Land bank expansion plans assume an increase in the area in operation by 50,000 ha in the next five years, or by 6% annually. The decision to follow a moderate growth strategy appears to be logical in light of the current unstable economical environment. We believe that Agroton's sustainable business model and prospects for steady growth make it an attractive investment opportunity.
MHP
MHP Current price, $ Target price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA 11E P/E 11E Source: Bloomberg, Phoenix Capital estimates MHPC LI 11.22 20.60 84% 1,204 706 5.2 5.3
MHP (MHPC LI), is the largest-Ukrainian poultry producer and accounts for 50% of the countrys industrially produced chicken meat. It operates four poultry production farms with a total capacity of 360,000 tonnes of broiler meat per year. The company has a significant cost advantage over other poultry producers as it is 100% self-sufficient with fodder, which is produced at three plants from its own forage. Currently, several large-scale development projects are aimed at strengthening the companys position across all operational segments, in addition to minimizing costs and increasing bottom line. The launch of a 220 kt poultry production facility is scheduled for early 2013. The first biogas production complex will be finished in 2012 and a meat processing plant in the EU may be acquired in the nearest months. Meanwhile, MHP beefs up its crop production segment, which is expected to be the main value driver in 2011-2012. The company collected 1.7 MT of grain harvest, including 1.06 MT of corn and 264 kt of wheat. A great portion of the harvest was sold forward at above market prices, thus MHP estimates that revenue from grain trading will reach $150 mln (4.2x Y-o-Y growth). Outstanding results in the crop farming segment indicate that the company has every chance to satisfy managements expectations and post EBITDA of $410 mln or even higher in 2011.
Motor Sich
Motor Sich Current price, $ Target price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA 11E P/E 11E Source: Bloomberg, Phoenix Capital estimates MSICH UK 272 786 189% 565 497 2.4 3.3
Motor Sich (MSICH) is the largest producer of aircraft engines in the CIS region. Around 80% of helicopters in Russia are equipped with engines produced by the company. While it is exporting 94% of its products; 73% of its revenue comes from Russia. In addition to key products, TV3-117 and VK-2500 helicopter engines, and rising output of airplanes engines, Motor Sich generates revenue by providing engine overhauls and other services for aircraft equipped with its engines (32% of total revenue). In 2011, Motor Sich signed the first long-term contract with Russian Helicopters for five-years, for a total of 1,300 helicopter engines, worth around $1.2 bln. Since previous agreements were arranged for around one year, the company has now secured the sustainability of around one third of its revenue. As a long-term goal, Russian Helicopters is planning to produce up to 1,420 civil and 2,180 military helicopters, during 20112020 - implying demand twice as much for helicopter engines in Russia. Even taking into account launching of the projects, aimed at increasing local production of helicopter engines, we estimate that Motor Sich will be able to maintain sales to its traditional customers in Russia.
Supplies of helicopter engines are secured for five years
32
Airplane engine production will be a growth driver for Motor Sich
When sales of helicopter engines will comprise the core of Motor Sichs business, production of airplane power units will provide growth for the company. Engines for An-148/158 regional jets serve as the first niche for Motor Sich to capture this growth. An-148/158 aircraft have already entered the serial production stage and the number of interested airlines is growing. 47 solid orders for these airplanes can provide 3-4 years of intense production for aircraft manufacturers, as well as considerable segment growth for Motor Sichs operational results - represented by D436 engine output. A joint venture, signed in November 2011 between Ukrainian state aircraft manufacturer and a Kazakh company, regarding the production of An-140 aircraft, will set up a third production site, outside of Ukraine where An-140 turboprop airplanes will be produced, thus providing additional demand for modification of Motor Sichs TV3-117 engine. Two other aircraft projects An-70 and An-124 can potentially provide huge additional backlog for MSICH. We believe that they are not fully priced-in, as long as both projects are still in the developmental stage. Driven by a strong backlog in orders, Motor Sich has considerably improved its financial result. The companys revenue boosted 22% Y-o-Y to $493 mln, EBITDA grew 45% Y-o-Y to $187 mln, and its net income on the P&L accountant increased 22% Y-o-Y to $109 mln. Since the company was exempt from paying profit tax for ten years in 2010, its accrued amounts of profit tax are forwarded upon when it comes to financing of project development. Hence, adjusted net income appears to be close to $167 mln in 9M11 (up by 87%). We expect the company to increase EBITDA in 2012 by at least 12% Y-o-Y to $272 mln.
Financials are set for advance
Sadovaya Group
Sadovaya Group Current price, $ Target price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA 11E P/E 11E Source: Bloomberg, Phoenix Capital estimates SGR PW 2.37 5.52 133% 102 52 3.8 7.3
Sadovaya Group (SGR PW) is a Warsaw-listed Ukrainian coal producer. Its business model is comprised of coal production from reprocessing third party coal, underground mining and waste recovery. These segments occupy an estimated 59% in total of the companys raw coal in 2011, 36% and 4% respectively. The firm produces anthracite and semi-anthracite (lean) coal. Sadovaya Group exports 5% of its product and plans to increase its share of sales abroad to 30% in the upcoming years. The company has 24.5 MT in JORC 2P underground coal reserves and 43.2 MT in resources. SGRs major beneficiary shareholders are Alexandr Tolstoukhov and Sergey Stetsurin 38% and 37% of indirect ownership respectively. Sadovaya Group has set a strategic goal to increase the share of underground mining in total coal production and develop its waste recovery segment. Consequently, the company has been raising capital to fund its aim to expand. The IPO in December of 2010 brought in around $30 mln to the company in gross proceeds. In November of 2011 Sadovaya Group secured $36 mln in project financing from EBRD for development of four coal beneficiation factories, two of which will be launched in 2012. The company took out a $25 mln five-year loan from OTP Bank (Ukraine) in December 2011. As a result, Sadovaya will refinance its short-term debt and fund the construction of a new mine at Roskoshny mining field. Sadovaya Group is one of the most dynamic growth stories among public coal names. We expect it will report EBITDA in 2011 of around $21 mln (+29% Y-o-Y), which, may experience further growth by 62% Y-o-Y to $34 mln. Apart from the organic growth outlook, the company may benefit from participating in privatization of Ukraines coal sector. Currently, the company is contemplating options of applying for a long-term lease of undisclosed state mines.
Sadovaya Group raised capital to fund organic growth
The companys development may be triggered by privatization of Ukrainian coal sector
33
Coal Energy
Coal Energy Current price, $ Target price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA 11E P/E 11E Source: Bloomberg, Phoenix Capital estimates CLE PW 6.15 9.47 54% 277 42 5.6 6.4
Coal Energy (CLE PW) is a Warsaw-listed and seventh largest Ukrainian private coal producer in terms of coal mining with subsidiaries; it is located in the coal-abundant Donbass region. The company includes ten underground mines, a waste reprocessing subsidiary and a coal cleaning plant. Coal Energy produces steam coal (81% of total amount), as well as coking and dual purpose coal. Its abundant 151 MT JORC 2P reserves ensure more than 33 years of operations. The company mined and produced coal from waste recovery at 1.6 MT in FY11, which implies 180% growth Y-o-Y. Coal Energy is exporting 42% of its product (according to 1QFY12). The primary shareholder of CLE is Lycaste Holdings, owned by Viktor Vyshnevetsky and Marina Vyshnevetska. Coal Energy is targeting 2.8 MT of coal production in FY13 and 5 MT in FY16 of coal in the next five years. With having raised $80 mln in gross proceeds during July 2011 IPO, Coal Energy had already launched a new longwall at Novodzerhinskaya Mine in October, which made it possible to increase the monthly output of coking coal by 12% M-o-M. Furthermore, during FY12, Coal Energy will be conducting mechanization of two longwalls at Chapaeva mine, preparing five additional longwalls and intensifying the output of operating longwalls, so that a further increase in coal mining in FY13 will be possible. In addition, the company intends to launch a second beneficiation plant for coal production from waste in May 2012, which will more than double CLEs current capacities of waste recovery (to 2.6 MT of rock material reprocessing). We project that the companys EBITDA will reach $70 mln (+33%) in FY12 and augment to $92.6 mln in FY13.
Coal Energy is investing funds from IPO into expansion
Ferrexpo
Ferrexpo Current price, $ Upside, $ MCap, $mln Avg. daily trading volume, 1M, $ '000 EV/EBITDA, 11E P/E, 11E Source: Bloomberg, Phoenix Capital estimates FXPO LN 4.20 30% 2,473 4,436 3.3 4.3
Ferrexpo (FXPO LN) is Ukraines largest iron ore pellet exporter and its second largest producer. Currently, the company is operating at Poltava Mine in Central Ukraine, processing the extracted iron ore into high quality pellets with 62% and 65% Fe content. Ferrexpo is now operating at the full capacity of 10 MT per year. The company is developing a second pit, Yeristovo mine, aiming to increase pellet output by 20% to 12 MT in 2013. One of the largest iron ore resources in the world is owned by the company with around 20 bln tones of resources, according to the national methodology, and up to 6 bln tones of JORC resources including 1.5 bln tonnes of 2P reserves. The majority shareholder of Ferrexpo is Konstantin Zhevago, acting as its CEO, and owning a 51% stake in the company. Ferrexpo is operating on the iron ore market, which used to be driven by the global deficit, resulting from rising demand in China. After the Chinese government took measures aimed at cooling Chinas economy during 2011, they obtained results and real estate prices experienced correction iron ore demand and prices decreased in October of 2011 by a third to $127 per tonne. Prices quickly rebounded to $145 per tonne. Beginning December 2011, The Peoples Bank of China started to relax its monetary policy by cutting the reserve requirement rate. It is expected that these actions will be repeated in January 2012. This will spur the Chinese economy and iron ore prices respectively. Therefore, we expect iron ore prices to remain firm, on average, in 2012 - basically at the same level seen in 2011. Concurrently, Ferrexpo trades at 3.3x EV/EBITDA 2012F multiple, which implies a 27-30% discount to peers, even if assumes a 510% Y-o-Y cut in Ferrexpos 2012 EBITDA to around $720-750 mln.
Chinese government can spur the countrys growth in 2012, and iron ore market as well
34
27/23 Sofyivska St. Kyiv 01001, Ukraine t.: +380 44 254 6275 f.: +380 44 254 6295 www.phoenix-capital.ua research@phoenix-capital.ua
Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that, with respect to each security or issuer that the analyst covered in this report: all of the views expressed accurately reflect his or her personal views about those securities or issuers; and no part of his or her compensation was, is or will be, directly or indirectly, related to the specific recommendations or views expressed by the analyst in the research report. Conflict of Interests Phoenix Capital, its directors and employees or clients might have or have had interests or long / short positions in the securities referred to herein and might at any time make purchases and / or sales in them as principal or an agent. Phoenix Capital might act or has acted as a market-maker in the securities discussed in this report. The research analysts and / or corporate banking associates principally responsible for the preparation of this report receive compensation based upon various factors, including quality of research, investors / clients feedback, stock picking, competitive factors, firm revenues and investment banking revenues. Disclaimer This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of any state, country or other jurisdiction where such distribution, publication or use would be contrary to law or regulation or which would subject Phoenix Capital to any registration or licensing requirement within such jurisdiction. All material presented in this report, unless specifically indicated otherwise, is protected by copyright to Phoenix Capital. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of Phoenix Capital. The information and material presented in this report are not to be considered as an offer or the solicitation of an offer to sell or to buy or subscribe for securities or other financial instruments. Phoenix Capital may not have taken any steps to ensure that the securities referred to in this report are suitable for any particular investor. Phoenix Capital will not treat recipients as its customers by virtue of their receiving the report. The investments or services contained or referred to in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about such investments or investment services. Information and opinions presented in this report were obtained or derived from sources Phoenix Capital believes are reliable, but Phoenix Capital makes no representations as to their accuracy or completeness. Additional information is available upon request. Phoenix Capital accepts no liability for loss arising from the use of the material presented in this report, except liability arises under specific statutes or regulations applicable to Phoenix Capital. This report is not to be relied upon in substitution for the exercise of independent judgment. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, express or implied, is made regarding future performance. Information, opinions and estimates contained in this report reflect a judgment at its original date of publication by Phoenix Capital and are subject to change without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities or financial instruments. Some investments discussed in this report have a high level of volatility. High volatility investments may experience sudden and large falls in their value causing losses when that investment is realized. Some investments may not be readily realized and it may be difficult to sell or realize those investments, similarly it may prove difficult for you to obtain reliable information about the value, or risks, to which such an investment is exposed.

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Strategy I Research December 22, 2011

Ukraine in 2012: Reacting to Global Headwinds

Research | Research@phoenix-capital.ua | tel. +38 044 254 62 75

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Strategy I Research December 22, 2011

Ukraine in 2012: Reacting to Global Headwinds

140% 120% 100% 80% 60% 40% 20% 0%

Source: Bloomberg, Phoenix Capital estimates

Strategy I Research December 22, 2011

Macro Outlook ............................................................................................. 5

Equity strategy ........................................................................................... 14

Top picks: company profiles ..................................................................... 29

Strategy I Research December 22, 2011

Economic growth turned out to be better than market consensus

Strategy I Research December 22, 2011

Source: State Statistic Committee of Ukraine

Strategy I Research December 22, 2011

Balance of payments and currency

Source: Interbank market data

CA deficit will contract to 3.6% of GDP in 2012

Strategy I Research December 22, 2011

Hryvnia exchange rate will average UAH8.1/$1 in 2012

Fiscal policy and government debt

Strategy I Research December 22, 2011

Strategy I Research December 22, 2011

Source: State Statistic Committee of Ukraine

Source: State Statistic Committee of Ukraine

Strategy I Research December 22, 2011

Strategy I Research December 22, 2011

Sovereign Eurobond sector outlook

Moderate rebound in sovereigns is expected in 2011

Strategy I Research December 22, 2011

Corporate and bank Eurobonds outlook

DTEK 15 Metinvest 15 Ukreximbank 15 Ukreximbank 16 PrivatBank 12 PrivatBank 15 Source: Bloomberg

Strategy I Research December 22, 2011

140% 120% 100% 80% 60% 40% 20% 0%

Source: Bloomberg, , Phoenix Capital estimates

Strategy I Research December 22, 2011

Top picks in Ukraines equity universe

Strategy I Research December 22, 2011

P/E 11E 5.3 3.9 5.5 3.3 4.3 7.3 6.4

Upside, % 84% 137% 51% 189% 30% 133% 54%

Strategy I Research December 22, 2011

Oilseeds & oils to maintain global leadership

Strategy I Research December 22, 2011

Strategy I Research December 22, 2011

Milk production growth will depend on state support

Meat production growth is driven by poultry segment

Strategy I Research December 22, 2011

Strategy I Research December 22, 2011

Railcar production in 2012 close to full capacity, but at lower price

Source: The State Statistic Committee of Ukraine

Source: The State Statistic Committee of Ukraine 21

Strategy I Research December 22, 2011

Machinery stocks offer exposure to aircraft engines and railcar production

Figure 28. Machinery sector stock performance, YTD, as of 21 Dec. 2011

MSICH KVBZ LTPL SVGZ WES UX

1,820 120 100 80 60 40 20 0 MSICH

Source: Bloomberg, Phoenix Capital estimates

Source: Bloomberg, Phoenix Capital estimates

Metals and Mining

Strategy I Research December 22, 2011

Lower production increase on weaker 2012 GDP growth in key regions