Russia's resurgent arms exporter swallows up metal plants and more

By bne IntelliNews November 22, 2007

Graham Stack in Berlin -

Economic diversification is the new watchword in Russia, as oil prices soar and inflation surges. While both Kremlin liberals and hawks see this diversification as a desirable outcome, the latter see it coming from a resurgent defence sector.

As the de-monopolisation and privatisation of the electricity sector enters its final stage, on November 16 a controversial new law was approved by parliament's upper house, the Federation Council, on the creation of a state corporation Russian Technologies.

Despite the innocuous name, Russian Technologies is simply the highest and latest incorporation of Russia's state arms trader, Rosoboronexport (ROE), the monopolist interface between Russia's huge defence industry and the massive global weapons market. Russia is in the process of overtaking the US as the world's largest weapons exporter.

The new law will effectively free ROE from all control by government and parliament, making the secretive organisation answerable only to the Russian president. And for Sergei Chemezov, head of ROE, diversification of the Russian economy means going back to the future - by reviving the defence industry.

Ministry of Deprivatisation

ROE is one of the most anomalous entities in Russian politics and the economy. Formally, it is simply the state arms trader, a unitary state enterprise with monopoly rights on all arms exports - which total about $5.5bn per year - but as a unitary state enterprise completely subordinate to government officials.

However, because the defence sector is Russia's only exporter of high-tech goods, ROE has taken upon itself the task of achieving the country's diversification into high-tech - using dirigiste methods.

ROE punches so far above its weight because Sergei Chemezov has official status as a "Friend of Putin." His association with President Vladimir Putin goes back to the 1980s when they lived in the same apartment block in Dresden, East Germany.

Chemezov is seen as the main ideologist behind the creation of state-owned defence holdings - such as the United Aircraft-builders Corporation, the United Shipbuilders Corporation, and ROE's very own subsidiary, Oboronprom, which de-privatised and united Russian producers of rotorcraft.

Not content with this, however, ROE has long started to cast an envious eye on sectors that are mere suppliers to the defence sector - and to launch takeover bids of plants it considers vital. So it openly pursues a policy of "de-privatising" that contradicts official government doctrine.

ROE-driven deprivatisation has to date embraced helicopter producers, engine manufacturers, steel and titanium producers, and carmakers. So just how far is ROE prepared to take deprivatisation in non-defence sectors?

Titanium temptation

In late 2006, ROE subsidiary PromImpex acquired 66% of titanium producer VSMPO-Avisma, which as supplier of 65% of Airbus' titanium needs and 30% of Boeing's has strategic significance for the global aviation industry.

VSMPO-Avisma, the result of a merger in 2005, had a rocky history in terms of ownership, with an ongoing dispute between Renova and Renaissance Capital over a 13.4% stake. Soviet-era management held a controlling stake, with 73-year-old general director Vladislav Tetyukhin and chairman Vyacheslav Bresht each with 30%. At the time of acquisition, the company had a market capitalisation of $2.7bn.

During negotiations between ROE and VSMPO-Avisma management, tax inspectors suddenly filed back-tax claims against the company. A judge handling the case expressed considerable surprise about how Avisma might be credited with RUB10.6m of tax overpayment on March 13, 2006, and then, out of the blue, significant tax arrears materialised all of two weeks later. All evidence suggests that ROE instigated the charges to concentrate minds, and Tetyukhin later said as much in an interview with the Financial Times.

Whatever methods were used, Chemezov's arguments justifying the takeover were strategic; that VSMPO-Avisma's dependency on Boeing and Airbus meant there was a great risk of the company being acquired by foreign aviation concerns, to the disadvantage of Russian plane producers.

The real reason may have been to increase Russia's leverage over Boeing and Airbus producers EADS in order to deepen collaboration. Ultra-light titanium components are crucial to the new generation of airliners, such as Boeing's Dreamliner and EADS' next-generation Airbus - and global titanium supply is stretched. Both companies depend on Russia for supplies - and Russia depends on them for technology and partnership.


The ROE takeover has, thus, strengthened the titanium producer's partnership with Boeing. In August, VSMPO-Avisma formalised a joint venture with Boeing, Ural Boeing Manufacture (UBM), to manufacture components for the Dreamliner. Pressed titanium components made by a new UBM plant in the Urals, with start-up slated for late 2008, will then be finished at a Boeing factory in Portland, Oregon. UBM will also supply titanium components to Airbus.

So are further ROE acquisitions expected in the titanium-related industry?

Immediately after taking control of VSMPO-Avisma, Chemezov outlined a strategy of consolidating several companies involved in the production of titanium and molybdenum alloys. Many of these, however, are in Ukraine and Kazakhstan, such as Ust Kamenogorsk Titanium and Magnesium, the world's second-largest titanium sponge producer, so it's hard to see them being meekly shepherded into a Russian state-owned holding.

"VSMPO-Avisma does not stand to benefit from any further acquisitions that make the company the centre of a holding. But, on the other hand, nothing specific is known about what Rosoboronexport is planning. Rosoboronexport is full of secrets - they have a strategy of not revealing their true intentions. In fact, it's probably good for their business, because it reduces speculation about upcoming deals," says Renaissance Capital's small-caps expert Marina Alexeenkova.

True to form, this autumn, the ROE acquisition conveyor belt started moving again - into mining. Citing a shortage of carnalite used in titanium production, ROE's subsidiary OboronImpex acquired Kama Mining Company in a venture with Silvinit. The joint venture plans to acquire a licence to develop the Polovodosk potassium and magnesium salt deposit, and to build a $1.5bn plant to supply VSMPO-Avisma on an exclusive basis with 500,000 tonnes of carnalite annually. "Unmatched as it is in terms of financial and administrative leverage, the JV will be the most likely candidate to acquire the license and, given the central nature of the carnalite supplies issue for VSMPO-Avisma, should not be constrained by a lack of cash," believes Finam analyst Mikhail Frolov.

Mining marks a new departure for ROE - one that they are taking seriously. In November, bne reported that ROE had engaged UK-owned mining concern Aricom, a subsidiary of Peter Hambro Mining run by Peter Hambro's son Jay, as advisers to help them develop mining assets. "Rosoboronexport is very powerful in our sector," Jay Hambro told bne. "They said they wanted to benefit from our mining expertise in the future, as they don't have much mining experience. Holding Rosoboronexport's hand in this way will open a lot of doors for us," he added.

So is ROE becoming the world's first "mine-to-mine" integrated concern, with interests ranging from metal extraction to weapons export? In fact, its mining operations are not likely to expand greatly from these beginnings. But the move into mining is still indicative of the way ROE's core business of arms exports seems to effortlessly spread out like spilt beer across a table - from defence export, to producers, to metallurgy, to mining.

Cold steel

ROE has not just staked a claim on exotic ultra-light materials like titanium. ROE started targeting "specialty steels," ie. high-grade steels suitable for use in armour and other defence applications, in 2007. The vehicle for this is the RusSpetStal holding, 100% owned by ROE. Its first acquisition was 100% of the Krasnyi Oktyabr metallurgical plant in Volgograd early in the year. This was swiftly followed by RusSpetsStal's general director Sergei Nosov becoming head of the board of directors of Stupino steelworks.

Speaking at the Paris Airshow at Le Bourget in June this year, Chemezov named the Kulebaki metallurgical plant, the Volgograd machine-building plant, and Elektrostal plant in Stupino as having been approached to join the holding. But this, he said, was by no means an exhaustive list. "In fact, I cannot remember them all," Chemezov admitted.

Speculation has mounted that RusSpetsStal is gunning for the Chelyabinsk metal plant (ChMZ) owned by industrial group Mechel. Mechel declared in 2006 that it planned in the future to divest its metallurgical assets to focus on coal. However, analysts argue it will still require ChMZ over the medium term as a cash cow.

ChMZ was built in Soviet times specifically for the weapons-grade steel needs of the defence sector - and would be the jewel in RusSpetsStal's steel crown. But a powerful industrial-financial conglomerate like Mechel is a far tougher nut to crack than even a large manager-owned company such as VSMPO-Avisma. Chemezov admitted at Le Bourget that Mechel had rejected his advances, but "may change their mind as the holding develops."

In the meantime, RussSpetsStal has to content itself with two minor metallurgical acquisitions announced in October: Ruspolimet (over 50% for around $50m) and Stupinsky Metkombinat (59.3%).

In fact, analysts welcomed RusSpetsStal's involvement in these plants, saying both were threatened by raiders, and the appearance of a large strategic investor such as ROE would strengthen them. And this is also a claim advanced by ROE to justify its deprivatisation crusade - that many defence-related companies are financially troubled and afflicted by unstable ownership structures. And it's precisely this that also makes it easy for ROE to take control.

Whether RusSpetsStal is an impulse buyer or following a master plan for special steels will only become clear in the course of time. For, as Renaissance's Alexeenkova says, secrecy helps ROE snap up companies on the sly before market speculation makes it prohibitively expensive. ROE's financial resources are not infinite. It is, after all, only an arms trader.

"We don't know what [ROE] are going to do, and I suspect they don't know either. They're a very secretive bunch," says Renaissance Capital's metals and mining analyst Rob Edwards, echoing his colleague Alexeenkova.

Saving private AvtoVAZ

ROE's most high profile and controversial acquisition is AvtoVAZ, Russia's ailing privatised giant carmaker. Few understood the rationale behind a state arms intermediary getting involved in car production - except that the annual death toll on Russian roads is equal to that of a small war.

The takeover of AvtoVAZ itself resembled a military operation. A new ROE-appointed management team arrived at AvtoVAZ in December of 2005, backed by battalions of police dispatched from Moscow to eradicate organised crime from the plant.

The car giant AvtoVAZ, then valued at $2.27bn, with a workforce of 165,000 producing about half of Russia's needs in passenger vehicles, was seeing its market share recede in the face of a boom in foreign imports.

Its cross-ownership share structure - whereby the company was effectively owned by its own subsidiaries - weakened management incentives. However, this same structure also made it possible, given the Kremlin's blessing, for a new management team to take control with hardly a share purchased. Reputedly, one meeting between retirement-age AvtoVAZ director Vladimir Kadannikov and retiring presidential aide Igor Sechin was enough to clear the way for ROE to move in - and to start unravelling the ownership structure with the aim of taking 75% control.

ROE's declared goal in taking control was to turn the company around by cutting costs and forging foreign partnerships. Two years later, some of this has been achieved: costs have been cut, crime reduced, the cross-ownership structure is on its way out, and foreign partners in the shape of Magma and Fiat are on their way in. The share price has risen, but not profits or sales.

So has the emergency intervention run its course, or is there more to come? Deputy PM Dmitry Medvedev told business daily Vedomosti in September that government ownership of non-strategic assets such as AvtoVAZ would be short term and only for crisis-management purposes.

Sergei Chemezov and co. may have other ideas. He has repeatedly called for a national automobile corporation to be formed - and found enthusiastic support from the Federal Agency for Industry. The first step would presumably be a merger with truck producer KamAz, the state's share in which is due for privatisation this year. ROE is already represented on the board of KamAz, as is Troika Dialog investment bank, which supported ROE in taking over AvtoVAZ.

Analysts are deeply sceptical about closer ties between AvtoVAZ and Kamaz. "AvtoVAZ is not compatible with any other plants, and in the future is likely to downgrade to become a manufacturer of automobile components," says Alexeenkova.

Natalya Sorokina of CentreInvest Group says: "the Kamaz privatisation concept is full of contradictions, making it hard to say what the outcome will be. The automotive holding project is mostly just political talk. Kamaz are threatened by Swedish truck makers Volvo, who are soon to set up in Russia, but it is not clear how AvtoVAZ can help them."

In the course of 2007, a number of appointments strengthened ROE's role in AvtoVAZ's future. Firstly, Konstantin Titov, the governor of AvtoVAZ's home region of Samara region, resigned and was replaced by ROE-appointed AvtoVAZ director Vladimir Artyukhov, a close associate of Chemezov. None other than Boris Alyoshin, previously head of the Federal Agency for Industry, a Chemezov supporter and proponent of a national automotive holding, took over as general director of AvtoVAZ.

So does this mean that the national automotive holding, rejected out of hand by most analysts, is actually on the cards?

ROE is giving contradictory signals. Chemezov and Alyoshin both emphasise that the search for a strategic Western investor for AvtoVAZ remains the chief priority. In September, Chemezov then declared publicly that ROE would retain only a blocking stake of 25% plus 1 share in AvtoVAZ, with 25% sold to a foreign strategic investor and another 25% to a Russian metallurgist such as Alexei Mordashov of Severstal or Alisher Usmanov of Metalloinvest.

This might mean that the national automotive holding has been put on hold by government order. If so, it does not herald the end of ROE's expansionist deprivatisation campaign. Instead, it could well lead to its intensification - in defence-related sectors. Given the surge in AvtoVAZ share prices since acquisition, ROE can expect to earn $2bn from selling its stake - and there are plenty of areas where it could put that cash to good use.

ROE reloaded

The new bill creating the state corporation Russian Technologies (RT), which now only needs the president to sign it into law, charges the new corporation with promoting the sale of Russian high technology on foreign markets, as well as supporting industrial and defence enterprises in developing and producing, and attract investment into high-tech businesses.

Russian Technologies will own 100% of Rosoboronexport and all ROE affiliates. ROE will continue to work as arms trader, but RT will have management functions and own all licenses.

The president will personally name the supervisory and management boards, and the general director, and otherwise the corporation will be free from government oversight. RT will be entitled to independently conclude contracts, buy and sell securities, participate in the capital of Russian and foreign companies developing high technology, and sell any of its subsidiaries. In August, Chemezov declared IPOs would be held for AvtoVAZ, VSMPO-Avisma and Russian Helicopters by 2009.

This wide-ranging and vaguely-defined remit, however, still falls short of Chemezov's ambitions. He has publicly called for RT to replace the Ministry of Defence's Arms Procurement Agency as the body responsible for implementing the entire budget-funded procurement programme for the Russian armed forces.

This would give RT control of financial flows upwards of $20bn per year, according to business paper Vedomosti: $5-6bn worth of exports, over $10bn worth of state arms procurement and substantial revenues from ROE subsidiaries, making RT one of Russia's major economic subjects. RT would effectively become the Gazprom of the defence sector, free from both market constraints and governmental control.

However this proposal did not make it into the bill. RT is being allowed to buy up private companies - but not yet to privatise state agencies.

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