Ben Aris in Berlin -

Last year was Ukraine's annus mirabilis. Despite not being with a functional government for more than two years, the stock market more than doubled, daily trading volumes more than trebled and unprecedented amounts of foreign direct investment (FDI) arrived in the country.

Ukraine's economy has reached a critical mass where it seems to grow without effort, fuelled by soaring incomes and the promise of closer integration with Europe. Analysts agree that 2008 promises more of the same, partly because Ukraine now has a government, but more importantly because all the parties in the Rada have pro-business policies. The arguments will be more about manoeuvring for advantage rather than any serious debate on policy.

"Utilities, metals, mining, machine building and real estate stocks all rose by over 200% on average in 2007. The entry of large foreign investment funds; an emerging domestic investor base; solid economic growth despite political upheaval; improving corporate transparency and profitability as well as the discovery of many new and undervalued stocks all factored in the Ukrainian market more than doubling in value," Dragon Capital said in its 2008 report.

"We see a number of factors likely to help the market sustain its rapid growth. With no elections scheduled in Ukraine for the next two years, the government has a great opportunity to jumpstart long-awaited reforms in the agriculture, energy, coal and transportation sectors. Another important issue is reform of the regulatory environment for the stock market and improvement of corporate governance standards," says Dragon.

Growth

Ukraine's economy continues to boom and more than any other country in the region it is consumer spending that is driving the growth. The economy finished 2007 with 7.2% growth although this is expected to cool a little in 2008 with the consensus being 6.9%.

"Domestic demand remains a key factor behind Ukraine's economic growth. Over the last three years, household consumption has expanded by 15% on year on average, fuelling domestically-oriented sectors. Consumption was stimulated by steady growth in salaries, induced by high demand for labour force and repeated upward revisions of the minimum wage, remittances from Ukrainians working abroad, development of small businesses and a boom in bank lending. We expect household consumption to remain the major catalyst of GDP growth in Ukraine over 2008 and 2009," Dragon said in its monthly economic focus in December.

Ukraine's economic performance depends heavily on commodity industries. Industries such as extraction of fuel and non-fuel materials, metallurgy, agriculture and chemicals account for up to 30% of total domestic output and GDP and about 50% of the country's foreign trade, says Dragon. The external shocks of 2007 are likely to take the edge off growth this year.

"Economic growth in 2008 is unlikely to surpass this year's expected growth of over 7%, while the World Bank and IMF forecast a slowdown to a 5.5% growth rate. If these expectations were to materialise, the Ukrainian market would most likely be under pressure. We expect growth of 6.9%," says Renaissance Capital.

In the past, both the IMF and World Bank have proven themselves to be extremely bad at forecasting growth in Eastern Europe - usually coming in one or two percentage points below the actually result.

The rapid growth in personal incomes and availability of credit financing makes Ukrainian consumers among the strongest growth drivers for 2008. "For Ukraine, a country with a 46m population, it is a natural and fundamentally strong approach to base its economic growth on domestic consumption. Having analyzed individual sectors and current per capita consumption there, we conclude that many areas of the Ukrainian economy are still heavily under-penetrated compared with both developed markets and developing CEE economies. Overall, consumption catch-up is a long-term convergence play that will support growth and market value in relevant companies for years to come," says Dragon.

Consolidation of the metallurgy, engineering, and banking sectors will gather pace, say analysts at Renaissance, offering opportunities for investors. However, after almost two years of frenetic M&A activity in the banking sector, growth of the financial system is likely to slow in 2008. "We expect banks to increasingly focus on profitability rather than market share growth," says Renaissance.

But the excitement that investment bankers are feeling as they go into 2008 is palpable. Long a backwater in the CIS, Ukraine is now firmly on international investors' radar and given the route taken by countries like Russia in the last decade, there is a strong sense of "it's our turn" coming through all the investment bank reports.

"Ukraine is a developing market, which means numerous growth opportunities and a lot of potential to be unlocked in the future. Its definite strengths that will help the market realize its potential include above-7% real GDP growth, abundant natural resources (fertile arable land; huge deposits of iron ore, coal, manganese, etc.) and a large population of 46m with rapidly rising disposable income, which creates a vast domestic consumption base spurring economic growth. Reflecting the country's healthy macro fundamentals are strong FDI and portfolio investments, which provide a positive surplus on the capital account. Besides, favourable external conditions have promoted growth in Ukrainian export-oriented industries," says Dragon, commenting on their Strengths, Weaknesses, Opportunities, and Threats analysis of the country's potential.

Macro problems

The Ukrainian economy is healthy, but still faces several real challenges in 2008.

The major problem for 2007 proved to be inflation. Ukraine was badly affected by the acceleration of food price rises (which represents over 55% of the CPI basket compared with Russia where it is 40%), as well as continued growth in energy prices. Ukraine has adjusted to 2007's gas price increase of about 42%, passing most of the tariff increases through to both industrial and residential customers.

Inflation was well into double digits by the end of 2007, driven by food and energy price increases: in December inflation reached 16.6% on year, the highest level since 2000. Prices of food and non-alcoholic beverages again were the main factor behind CPI growth last month, rising 2.9% on month and 23.7% on year. "Russia and Ukraine have negotiated a gas price increase to $179 per thousand cubic metre in 2008, which constitutes a 33% increase over the 2007 level. However, we expect that Ukraine's level of energy dependency will continue to decrease. As prices for energy get closer to international levels, Ukrainian companies will invest more in energy-saving technologies, or will seek integration with international partners. We see this process continuing in 2008, accompanied by a steady inflow of FDI," says Renaissance Capital.

Another macro debate raging is a decision to free the exchange rate. The National Bank of Ukraine has held the hryvna/dollar exchange more or less constant at $1:UAH5 for several years now.

But the pressure on the NBU to widen the trading band is increasing. The NBU has said that it agrees the band will have to be widened, so the issue now is when this will this happen. There are mixed signals on this front and politicians like President Viktor Yushchenko (a former NBU chairman) say "no time soon." However, the consensus is an appreciation of the hryvna is coming and probably in the next two years.

Another headache is the widening current-account deficit. After running healthy surpluses in 2004, a deficit appeared and was up eight-fold in 2007 to reach $2.2bn, or 2.2% of GDP, over the first nine months of the year (full 2007 results are not out yet).

However, the flood of investment into the country of about $10bn in 2007 adequately covered this gap, so the deficit is not a problem at the moment. The government has time to address this problem and the NBU even managed to increase hard currency reserves to $30bn, or up 60%, over the year.

PFTS

Last year was a watershed for the Ukrainian bourse. The market's capitalization more than doubled to $107bn in the first 11 months of 2007, and now represents approximately 84% of GDP. Daily trading volumes also soared from about $8m at the start to the year to $30m by December.

The PFTS Index of 18 blue chip stocks is up 127.3%, making it the best performing market in the world. Over the last three years, the market capitalization of Ukrainian stock market has expanded eight-fold, to $133bn, with the free float rising to $13bn from just $1.0bn in 2004 and the number of stocks traded actively and covered by analysts increasing 6-fold, to more than 100.

The index's best performers in 2007 were the integrated energy utility Kievenergo (+402%), generating utility Donbassenergo (+315%), and engine manufacturer Motor Sich (+306%).

"2007 has been marked by unprecedented growth in the Ukrainian equity market. The market's main drivers were increasing expectations for the reform and privatisation of the energy sector, strong commodity prices, and increases in capital expenditure and infrastructure spending," Renaissance Capital said in its end-of-year report.

The market was driven by investors' expectations of more reform and the privatization of the energy sector, strong commodity prices, and increases in capital expenditure and infrastructure spending.

"These factors complemented corporate restructuring and improving corporate governance as companies prepared for capital markets transactions. Despite 2007's political turmoil, Ukraine continues to see strong capital inflows, as investors seem to look beyond this to other factors," says Renaissance Capital.

source: Dragon Capital

Stock picking

In contrast to the relatively developed Russian market, Ukraine's equity capital market is still a plain vanilla deal: the key to making money from Ukraine in 2007 was to get into the market early. It didn't really matter what you bought.

The same will be true for this year. While stock picking is still the main pastime of most analysts, the low trading volumes, free floats and the small number of stocks on offer mean that when to invest is the biggest investment decision. The trick is to be there before the main body of international investors arrive.

Having said that construction, power and the oligarch-controlled companies are the obvious companies to choose as the ones most likely to outperform the index, say analysts.

IPOs

A wave of IPOs/private placements (at the moment there is little distinction between the two in Ukraine) is gather momentum too. Companies have until recently been too small or growing too fast to want to IPO, but with valuations skyrocketing that is changing.

There were several IPOs in London and Warsaw that usher in a new era that will enable investors to access new sectors while providing a new source of investment capital to fuel further strong growth.

In 2006, the market for Ukrainian IPOs/PPs was estimated at $464m (up 116% on year), and in 2007 it surged by 267% to $1.7bn (not counting non-listed private placements). Dragon expects IPOs/PP to top $2.4bn in 2008.

The number of deals rose by 19% on year, to 19 in 2007, while average deal size tripled to $90m from $29m in 2006. Also, the average size of floated stakes reached 36.2%, an increase from 28.0% in 2006 and 27.4% in 2005, which indicates that domestic companies are ready to part with fairly large stakes in order to attract cheaper financing and gain exposure to a wider circle of investors to support liquidity of their stocks. "The flurry of new IPOs and new transparent privatization tenders will inject fresh liquidity into the equity market to meet strong demand from both foreign and domestic investors," says Dragon.

At the same time, there has been an about face in many companies' attitude to corporate governance. Whereas in the former president Leonid Kuchma-era the game was to make your company structure as complicated and opaque as possible to avoid taxes and re-nationalization. However, as companies start getting ready for international IPOs and closer cooperation with Europe many, like Systems Capital Management, have begun to get their houses in order.

"Transparency, improving reporting practices and surging profitability have become the hallmarks of a new approach to corporate governance undertaken by a growing number of Ukrainian companies. This is a welcome contrast to the dominant pattern of just a few years ago when most business owners did not seem to care about increasing the market value of their assets and kept their de jure public companies de facto private, heavily understating sales and profits," says Dragon. "Interestingly, the radical improvement in financial disclosure in the corporate sector began in 2005 during the premiership of Yulia Tymoshenko, who recently regained the post."

As Tymoshenko has already brought the privatization issue - and pass privatizations - to the top of the agenda, the appeal of political insurance through bringing in outside investors (and the improvements in corporate governance this requires) has increased again and is expected to be a trend in 2008.

The most dramatic example of the benefit of this change of heart was probably seen in the M&A talks launched by Pivdenniy GOK major shareholders, Privat Group and Smart Group, with Russia's Evraz Group and Metinvest, respectively which saw Pivdenniy GOK's price increase by a massive 1,258% between April and December 2007.

According to preliminary estimates, metallurgical companies are set to lead the market in terms of new equity capital raised in 2008, while food and beverage, and real estate companies should also be able to raise about $0.5bn each in their respective sectors.

Privatisation

"The return of Yulia Tymoshenko to the prime minister post expectedly triggered speculation that her new government might resume the re-privatization drive it had started in 2005. At the time, the government announced plans to re-privatize up to 3,000 companies, which forced many enterprises to suspend investments and worsened the overall investment climate in the country. We do not take the current re-privatization rumours seriously, and the new Cabinet's first actions makes us confident there will be no return to the practices that discourage investment," says Dragon.

Privatization is expected to bring in $1.7bn to the budget this year, with some of these funds likely to enter the stock market.

Ukrainian stocks expensive?

Following the phenomenal rise in valuations in 2007, some have asked if Ukrainian stocks are not starting to look pricy. Opinion on where the valuations go from here is mixed, but everyone agrees the market is definitely going "up."

The PFTS Index P/E multiples have expanded rapidly, from 9.5x at the start of 2006, to 16.5x at the beginning of 2007. It was approaching 24.9x by the end of December. "This translates into over 50% multiple expansion this year. According to consensus estimates, the aggregate earnings of the PFTS' basket of constituents are expected to grow 37% this year. While strong earnings growth has been capping multiple expansion, there is a chance that the reduced earnings growth over the next year will lead to a contraction. Thus, already next year the consensus estimate for index earnings growth is noticeably lower at 14.5% (Bloomberg estimate). This translates into an 18.8x forward looking P/E. As the figure shows, over 2007 the Ukrainian market has changed from being an attractively priced one (relative to other emerging markets) into a more expensive one," says Renaissance Capital.

Likewise Dragon takes a cautious stand on this year's performance: "While the massive growth on the Ukrainian market outpaced the rest of the world last year, history is not indicative of the future. Investors that made triple-digit returns (and even quadruple-digit returns in some cases) on many domestic stocks are unlikely to enjoy growth as remarkable in 2008. We conservatively estimate this year's stock market growth at 30% on year, taking positives from macroeconomic drivers such as domestic consumption growth and higher investments in modernization of various sectors of the economy."

Others argue this sort of argument underestimates the momentum of growth and expect the market to do much better. "It is true that many stocks are now trading on a par to their Russian peers - or even at a premium," says Peter Keller, head of research at Millennium Capital. "But consider that corporate earnings are rising by about 60% a year - and that is just what the companies report; it could be higher - and the valuations won't look high for long."

Stepping back and comparing Ukrainians market with that of Russia clearly Ukraine still has a long way to go. Daily turnover on the RTS was in the millions of dollars at the end of the 1990s and now is counted in the billions of dollar. Likewise at the end of 1999 the Russian market capitalization was about $100m and is now at $1 trillion.

These are the sort of levels that Ukraine is enjoying today (proportionally speaking). Making a back of the envelope calculation comparing the two markets then the market capitalization of Ukraine's equity capital market should triple over the next five years if it follows the same course as Russia. And most analysts believe that this "catch-up" process will actually go much faster as most investors have been down this road before.

Still, Renaissance Capital is cautious on earnings growth in 2008: over the first nine months of 2007, industrial earnings have grown 30.3% to $6.73bn. This was largely a result of top-line growth of 29% and an improvement in transparency, along with efficiency gains of 1.3%.

In particular, around one-third of this earnings growth is attributable to non-energy mining and metallurgy, both of which are benefiting from a strong price environment. At the same time, the largest contributors to the earnings margin improvement were mining and engineering industries, the bank says.

Few of the other investment banks working in Ukraine have commented on this aspect of the story. But in Russia Renaissance Capital has always erred on the cautious side as selling equity that rose more than you said they would is always easier than the selling stock that underperformed your recommendations.

That said, earnings are still very dependent on external factors. At the moment the metals and mining sector comprises over 40% of the market capitalisation of free float in Ukraine, and therefore aggregate earnings growth is likely to continue being influenced by the commodity price environment.

The same is true for Russia where oil, gas and metal companies made up 80% of the RTS index at the start of 2007 and 50% by the end of the year. So from this perspective Ukraine's market is more insulated from the swings of the international commodity market than its bigger brother to the north. The big unknown in this equation is the impact of increasing gas prices on earnings, which the Russians increased from the start of this year.

Domestic investors a force in equity market

Based on data compiled by the Ukrainian Association for Investment Business (UAIB), the funds under management by domestic mutual funds reached $386m on September 30, and the gross equity/fixed income allocation was 64:36. The equity allocation has therefore grown significantly from the 50% allocation registered at the beginning of the year.

"The growing domestic investor base has been a major contributor to market strength in 2007. The latest open access opinion poll conducted by the PFTS exchange revealed that about one-third of respondents believe that the weight of domestic investors in total trading is 10-15%. Another third say the domestic share is between 15-20%, and the remaining respondents think domestic investors contribute 20-25%. In our view, domestic investors still represent up to 15% of the total base," Renaissance Capital said in its end-of-year strategy note.

Under the current market conditions (a still overheated equity market and a relatively relieved domestic fixed income market), the asset allocation should realistically target a 30:70 equity/fixed income ratio, says Renaissance Capital.

Fixed income

Despite the brouhaha on international debt markets, Ukraine successfully placed two Eurobonds last year for a total of $1.2bn (37% below the 2005 volume).

The first, a $500m, five-year issue that pays a 6.385% semi-annual coupon and placed in June slightly lifted Ukraine's sovereign yield curve. The second, a $700m, 10-year Eurobond paying a 6.75% coupon was sold in November, increasing Ukrainian Eurobond yields by 40-75 basis points. As a result, EMBI+ Ukraine exceeded the global spread index for the first time since July 2006.

In the weeks following the placement, Ukrainian Eurobond prices went up, slightly narrowing Ukrainian spreads over benchmarks US Treasuries. By the end of the year EMBI+ Ukraine reached 269 bps (up 137 bps on year), exceeding the global spread by 37 bps.

In 2008, the Finance Ministry plans to borrow $1.6bn externally to finance the budget deficit. Taking into account volatile foreign markets, but Dragon's analysts say this is enough and any more should be raised on domestic debt markets.

In 2007, the government attracted $0.7bn in domestic debt, or 95% of the full-year domestic borrowing target. The Finance Ministry was selling 1.5 -, 3- and 4-year bonds, placing them at weighted yields of 7.01%, 6.56% and 6.37%, respectively. At the same time, investors ignored long-term (7- and 10-year) paper. The government plans to borrow $1.5bn on the domestic market through primary placements in 2008.

Ukrainian companies defied last year's subprime turmoil, selling a record $1.98bn of Eurobonds (up 3% on year), with new names accounting for 53% of the total issuance. Banks borrowed 81% of the total volume, or $1.6bn, striving to satisfy surging domestic demand for loans. Overall, the banking sector currently accounts for almost 40% ($4.7bn) of total outstanding Ukrainian Eurobonds and 69% of corporate Eurobonds. The sector's yield range is rather wide, 8-12%, above sovereign and municipal bonds' 6.5-8.5%, but below corporate non-bank Eurobonds' 9.5%-13.5%, says Dragon.

"We expect corporate Eurobond issuance in 2008 to at least match last year's (about $1.6-2.0bn), with the banking sector to maintain leadership. In particular, supply from medium-sized banks and industrial companies may increase due to a backlog left over from last year in anticipation of more favourable interest rates," says Dragon.

Favourite sectors

Real Estate and Construction: Construction is booming across the region, but it is especially strong in Ukraine. Renaissance Capital recommend all the companies with an exposure to the sector. We highlight cement producers and other building material manufacturers. This also includes companies that are exposed to the theme, such as real estate developers, construction equipment manufacturers, and pipeline makers and incidental industries, says Renaissance Capital.

Land: Continued acquisition of land by agricultural companies, expected liberalization of the local land market and growth in land prices are important value drivers for agricultural companies with vast land reserves (Astarta Holding, UkrRos) and listed companies with sole exposure to land. These and other companies also stand to benefit from higher prices and growth in demand for food products such as sunflower oil (Creativ Group), soybean meals (Creativ, Kernel), sugar (UkrRos, Astarta) and dairy products (Ukrproduct). Among food companies we also have a positive outlook on beer producer Slavutych Brewery due to continued growth in beer consumption in Ukraine and the company's capacity expansion, says Dragon.

Energy: We also see a lot of potential for electricity companies as they modernize their generating (Centrenergo, Zakhidenergo, Donbasenergo) and distributing (Kyivenergo, AES-Kyivoblenergo) capacities to meet steadily growing demand from Ukraine's expanding economy, says Dragon.

Banks: The domestic banking sector, which did not suffer from the US subprime crisis due to zero exposure to it, should be one of the primary beneficiaries of Ukraine's consumption boom. The domestic economy is still strongly under-leveraged, with the end-September 2007 Net Debt/Equity of Ukrainian companies averaging an estimated 18%. The same holds true for insurers, as non-life insurance in Ukraine is still undeveloped and life insurance is virtually non-existent. We expect domestic banking sector assets to expand by up to 50% and insurance industry to grow by about 35% in 2008, implying continued interest in banking stocks (Raiffeisen Bank Aval, Forum Bank, Ukrsotsbank, Rodovid Bank, Ukrinbank, Ukrgazbank, Megabank) and insurance stocks (Universalna Insurance, Oranta Insurance) , says Dragon.

Consumer Sector: There are many attractive companies in other consumer-related sectors such as pharmaceuticals (Laona, Farmak, Kyivmedpreparat), retail trade (Retail Group, Anthousa) and pulp and paper (Koryukivka Paper). A number of domestically oriented machine-building companies also enjoy a favorable outlook, particularly coal machinery manufacturers (Druzhkivsky Machinery, Svitlo Shakhtarya), railway transportation producers (Kryukiv Rail Car, Stakhaniv Rail Car, MZVM, Azovzahalmash) and automotive companies (LuAZ, Kremenchuk Wheel) , says Dragon.

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