Ukraine engineering stocks dive as investors look under the hood

By bne IntelliNews May 2, 2011

Graham Stack in Kyiv -

With machinery exports booming, Ukrainian engineering stocks should be an interesting play for investors - were it not for these companies' horrible corporate governance.

Ukraine's machine-building output was up by a whopping 35% on the year in February, with exports playing a driving role. But exports still predominantly go to Russia, and for the sector to go global it urgently needs new capital and technologies. Yet a series of corporate governance scandals has recently afflicted Ukraine's engineering sector, crippling its attractiveness for investors just as it gains from currency devaluation and a commodity-led recovery in the Commonwealth of Independent States (CIS).

Political football is sometimes quite literally that in Ukraine's corporate world. One traditional derby runs between Ukraine's football oligarchs, the Surkis brothers - who comprise Hrihory, president of the Football Federation of Ukraine, and Ihor, chairman of Dyamo Kyiv football club - and Konstantin Hryhoryshin, owner of the Energy Standard group of power engineering companies. The derby kicked off in 2004 when the Surkis brothers allegedly diluted Hryhoryshin's stake in Dynamo Kyiv. However, it seems Hryhoryshin has won the return leg, with the feud now spilling over into ownership of electricity companies.

According to the Surkis brothers, Hryhoryshin has now diluted their 13.5% stake in the engineering giant Sumy Frunze, the biggest producer of gas-pumping equipment and a key supplier to Russia's gas firm Gazprom. Hryhoryshin owns 75% of the company. In October, Sumy Frunze announced it had divested a subsidiary to a new Cyprus offshore company that Hryhoryshin is believed to control - having first transferred Sumy Frunze's production facilities to the subsidiary. Now Sumy Frunze leases its entire facilities from the Cyprus company. The Surkis brothers have said they will fight the move: "If [Hryhoryshin] wants to wage war, we will wage war back," Ihor Surkis told journalists.

Hryhoryshin could not be reached for comments. Sumy Frunze said it could not comment on a shareholder conflict.

According to analyst Oleksiy Andriychenko of ART Capital brokerage, Sumy Frunze received $81m from the Cyprus company for the transferred subsidiary, with payment to be completed within five years - but it is now paying roughly $20m in rent per quarter. The rent is equivalent to as much as 20% of Sumy Frunze's annual sales. "If we conclude that the Cyprus company is controlled by Energy Standard, the scheme now allows it to accumulate 100% of all earnings from Sumy Frunze's production at Energy Standard, bypassing [Surkis'] Prosceno Trading. Thus in effect, Prosceno is left with shares that entitle it to a company that is unable to generate any profits and therefore is worth nothing," says Andriychenko.

Dragon Capital analyst Taisia Shepetko agrees that, "Energy Standard is siphoning off profits from the company and accumulating them at the holding group level."

Fourth-quarter results announced on February 25 underscored the disastrous financial impact the changes are having, with the company showing a net loss of $10.4m in the quarter, and 2010 net profit down 35% on the crisis year of 2009. As a result of the manipulation, Sumy Frunze's share price has plummeted a stomach-churning 60% since October, even as the Ukrainian Exchange index has climbed 50% over the same period.

More grist for the mill

The jittery market is now wondering whether a similar story is repeating itself at Hryhoryshin's other major listed company in the Energy Standard group called Zaporizhtransformator, the largest producer of power transformers in the CIS, and one of the largest in the world.

There is no shareholder conflict at Zaporizhtransformator, but preliminary 2010 results dished up an unpleasant surprise with the company recording a three-fold drop in profits in 2010 relative to 2009, well below forecasts. The jury is out on whether this is due to profits being accumulated on the level of the Cyprus holding company, or due to the after-effects of the 2009 crash on demand for investment goods in 2010. The company says the latter. "We are now expecting 2011 to set a record in terms of orders," says the company's press secretary, Anna Tischenko.

Controversial restructuring moves are afoot at another of Ukraine's leading engineering holdings, rail car and industrial equipment producer Azovmash, which is controlled by its president Oleksandr Savchuk, a deputy of the ruling Party of Regions. In contrast to Hryhoryshin, Savchuk is wrestling not with minority shareholders, but with the company's creditors.

Total Azovmash debt is put at $500m-600m. Savchuk finally reached an agreement with a pool of creditors in July on restructuring the debt, including a reshaping of the way that the group does business. This restructuring so far has meant the transfer of Savchuk's stakes in the group members to a Cypriot offshore company, Wessanen, announced January, as well as the creation of a management company for the group in Ukraine. The restructuring was completed at an April 6 shareholder meeting, possibly paving the way for the sale of a stake in the company. The Azovmash press service said it was not authorized to comment on the restructuring.

With the group having a history of alleged transfer pricing in favour of non-listed companies, the pool of creditors demanded a concentration of profit at the holding's listed Azovzagalmash company, the largest producer of cisterns in the CIS, to support servicing of the subsidiary's roughly $150m short-term debt. Creditors and investors were thus astonished on February 22 when Azovzagalmash announced that it had run up a preliminary net loss of $33m for 2010, compared with $25m of losses in the crisis year of 2009, far below forecasts. Some $27m of the $33m losses were incurred in the fourth quarter alone, due to a new surge in transfer pricing benefiting a non-listed group member, Azovzagalmash Trade House, which handles marketing. According to ART Capital's Andriychenko, in the last quarter of 2010, Azovzagalmash paid the trading house a whopping $19m in marketing expenses, compared with a previous maximum of $6m. The resulting losses now question whether Azovzagalmash will earn enough to service its debt. The group's new export orders in 2011 - including a massive $74m order from Russia's Brunswick Rail - are apparently being closed by the trading house, not the listed company.

There is no doubt that the restructuring has already savaged the group's second listed company, Mariupol Heavy Machinery. As part of the group restructuring, the company announced in December it would transfer its production facilities to Azovzagalmash and move to a lease relationship that would obviously transfer profits to Azovzagalmash. According to Oleksiy Gorovyy of Millenium Capital, which acquired 10.8% in the company from the State Property Fund a year ago, "the lease means all cash flows will be transferred away from Mariupol Heavy Machinery."

All this wrecked the investment case for the railcar producer, which up until now had had one of the biggest free floats on the market at around 25%. As a consequence, the company's share plummeted 48% from December 10 through the end of March. Then the announcement on March 31 of an upcoming 22-fold increase in the company' charter capital at a shareholders' meeting April 15 sent the stock plunging 40% from its end-March level.

There would also seem to be more turbulence up ahead at another key engineering plant - state-owned Turboatom, the largest CIS producer of power turbines. This time the story again involves Energy Standard owner Konstantin Hryhoryshin, but this time he is cast in the role of confrontational minority shareholder.

Hryhoryshin, who owns a 12% stake in the company through a Cyprus outfit Linfot, has aggressively pushed to increase his influence over the company, and has been bitterly opposed in this by the company's present management. Former president Viktor Yushchenko banned the privatisation of the state's 75% stake as a protective measure for the national champion. Almost immediately on current President Viktor Yanukovych coming to power in February 2010, the three-year conflict erupted again at Turboatom, with political manoeuvring, accusations of corporate raiding, and dodgy court decisions causing a suspension in trading of the share in April 2010. In December, the Ukrainian parliament then removed Turboatom from the list of countries excluded from privatisation, and in February 2011 the Rada again voted to confirm this decision. But in March, the head of the State Property Fund Oleksandr Riabchenko spoke out against any privatisation of Turboatom. Watch this space.

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