COMMENT: EADS stake is a test case for Kremlin's public-private partnership

By bne IntelliNews March 1, 2007

Alfa Bank in Moscow -

While it is tempting to link the likely cancellation of Aeroflot’s $3.2bn order for Boeing aircraft with President Vladimir Putin’s recent speech in Munich and the generally tougher line taken by the Kremlin over US policies, the more plausible reason is the Kremlin’s ambition towards EADS and its efforts to secure a trade/investment deal with the EU.

The order for 22 new aircraft is instead expected to go to Airbus/EADS as part of the "barter" deal that may see the Russian state eventually build its equity stake to between 20% and 25%. Currently the state, via VTB, has an equity stake of between 5% and 7% (it declared at 5%, but is thought to have acquired some additional equity since) in EADS.

Having a blocking minority stake (or at least an "influential" minority stake) is as important an element of the state’s plan for strategic industries as is its plan to have strategic partners acquire a similar stake in the Russian national champion companies.

Aeroflot: "the company of the dream"

Putin and some of his senior ministers have clearly said that while a key element of the state’s approach towards the national champion companies in the so-called strategic industries is that the state will have control, this control only needs to be at the 51% level. The same will apply to joint ventures between the state companies and other partners in the strategic industries. So, for example, the state only has a 51% stake in Gazprom and we know that it plans to eventually reduce its equity in Rosneft to 51%.

Similarly, the end result of the Sakhalin-II dispute with Royal Dutch/Shell is that the state-controlled Gazprom has 51% while its partners have the other 49% and operational control. A similar result is expected when the final terms of the Shtokman deal are agreed.

The remaining 49% equity in the state companies is to be used both to support market IPOs and/or bring in a strategic industry investor. That investor may be allowed to acquire the full 49% or a maximum 25% depending on the industry. But the critical element is that the Kremlin believes that having such a strategic investor (eg. Siemens in Power Machines) is very important if the Russian company is to modernize as quickly as possible. The strategic partner brings in expertise, experience, technology and international trade relationships that the Russian company typically lacks.

Air partner

EADS is the chosen industry strategic partner for the newly created Russian aviation national champion, United Aircraft Corporation (UAC). One of the main companies in the newly created UAC is Irkut, in which EADS has an existing 10% stake. It is still not yet known what percentage of the total UAC will be transferred to Irkut shareholders – some elements of the structure have yet to be clarified – but at the end of the process it is expected that EADS will be encouraged to build up its holding (over time for sure) to between 20% and 25% of the national champion. That way UAC can maximize the benefit of the relationship with a company with a proven product.

For EADS there is the prospect of preferential access not just to the Russian market but also to other markets, like China and India, where Russia is currently bartering energy cooperation in exchange for increased trade and investment flows. In future the products of UAC will be sold to these countries just as military hardware is now, ie. according to the Kremlin’s plan.

To make that arrangement work most effectively, Russia wants to have at least an influential minority stake if not a blocking stake. We see the same type of deal in place already in downstream gas in Germany and planned in Italy (with ENI), France (Gaz de France) and the UK (most likely with Centrica).

The tactic is becoming clear. The issue of energy cooperation with Europe came to a head just after the VTB acquired the 5% stake in EADS. That provoked a severe negative reaction in Europe and resulted in Putin canceling the proposed structure of the Shtokman deal just ahead of a trip to see Germany’s chancellor. It is very clear that the issue of energy cooperation is now directly linked to Russia being allowed to acquire equity stakes like that of EADS as well as the removal of other trade problems.

EADS is in need of further equity financing. The Kremlin has made it clear that Russia can provide a lot of that in exchange for equity. Another carrot is the fact that Russia can immediately be an important market, ie. by switching the Boeing contract. For the UAC national champion model to work, EADS needs to be involved - the same as with most of the other national champion models.

Agreement on better access for Russian investment into European companies and of removing often politically inspired trade barriers is the Kremlin’s demand for the energy deal that the EU wants. This "barter" is one of the most important agenda items that Putin wants in place before his current presidency ends. It is an important element in the industrial and economic model that we expect to be the key initiative of the next government from March 2008.

2007 is, in our view, the last year in a long period of preparation under Putin when the Kremlin initially ensured it had total domestic political control and, in this term, started putting together an industrial control structure based on national champion companies within the identified strategic industries. For investors, therefore, it is important to know which are the strategic industries, what is the state’s likely involvement and at what "phase" in the process can minority investors make money and which phases should be avoided.

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