ZAO KREMLIN: The Phoenix of Russian aviation

By bne IntelliNews November 2, 2007

Graham Stack in Berlin -

This is the fourth in a series of pieces by bne that look into the development and structure of ZAO Kremlin, the Russian state conglomerate that the Kremlin is creating.

The cream of the Kremlin elite gathered in the rundown town of Komsomolsk-on-Amur in Russia's Far East at the end of September to celebrate what they hope will be the Phoenix of Russian aviation: the unveiling of the Sukhoi Superjet 100, the first new civilian aircraft to be produced since the fall of the Soviet Union.

The launch of the Superjet is a triumph for ZAO Kremlin, the financial-industrial-military group that the state has been informally building up to rescue the most important parts of the Russian economy. Critics have lambasted the state's increasing involvement in commerce, yet a project like the Superjet would have been impossible to bring off without serious state support.

A 1998 US Embassy report on Russian aircraft building found that: "The aviation sector has been seriously afflicted by the market reforms [and] the factories are operating at only a fraction of their capacity and the uncertain privatisation process has added to the chaos."

Only five aircraft were manufactured in 1996 by an industry capable of churning out 650 a year, and the Russian scientific community had lost over 40% of its personnel, with aviation amongst the worst affected. And even this handful of planes failed to meet international safety and environmental standards. Key civilian manufacturers such as Aviastar SP were bankrupt. Air transportation had collapsed. And after de-monopolising Aeroflot, the 260 so-called 'babyflots' were so tiny that none could muster the funds to order new planes.

Russia's aviation industry was crashing. But suddenly in 2000, it dramatically pulled out of its nosedive as the economy unexpectedly recovered following the 1998 financial crisis.

Devaluation of the ruble and default on Russia's debt was a very black cloud with a very silver lining; after the economy was restocked with cash following the crisis, pent-up demand for goods and services suddenly burst open and almost every business catering to the consumer flourished.

Aviation was no exception and as the cash poured in, aviation debts were paid off and orders for new aircraft started to flow in, initially driven by newly created leasing companies.

Aviation got a double boost as the state started to spend on defence - aircraft making and defence have always gone hand in hand in Russia. A government rearmament programme has seen the state orders for military aircraft slowly return to something approaching Western levels.

Finally, domestic demand for new aircraft took off. With rapid growth in air transportation (approx. 8% per year since 2001) and the discarding of obsolete Soviet aircraft, there has been huge demand for modern, cost-effective airliners. Market volume over the next five years is estimated at 300 aircraft.

The question is whether Russian aviation can get its act together to compete for this demand.

Ivanov champions aviation...

Sergei Ivanov, the hawkish Pink Floyd fan who was Putin's Minister of Defence for six years, is now first deputy prime minister with a remit for economic diversification.

The rationale is simple: Russia already has a world-class high tech sector - the defence sector, and aviation in particular. Russia's way forward is to fall back on Soviet strengths and make defence sector expertise work for civilian production.

"I believe we should focus our efforts on civil aviation... In sporting terms, I mean that we can get our corporation into the premier league of leading global players on the aviation market," Ivanov told national daily Izvestiya in an interview in September.

"For one thing, the significance of air power for national defence is growing. Secondly, aviation has stimulated for decades now the development of state-of-the-art technologies, serving as a growth locomotive for science and manufacturing. Russia cannot simply take a backseat here. Thirdly, aviation is one of the few high-tech sectors where Russia, for all the difficulties experienced in the 1990s, is still globally competitive. It is precisely in aviation that the model of innovation development that is the only alternative to the dead end of a resource-based economy. And finally, Russia's enormous distances require the development of civil aviation as the basic and in some cases only form of transport," he said.

Thus, like the Russia's double-headed eagle emblem, the idea of the United Aviation Company (UAC) - the state-owned national champion into which all of ZAO Kremlin's aviation assets have been bundled - is to fuse the military and civil aviation sectors that were separate in Soviet times. The civil aviation sector collapsed in the 1990s, and is still comatose, while military aviation survived and has since flourished as an export business; Soviet fighter jets were designed to compete internationally in the most direct possible sense and remain in high demand on international markets.

"By combining successful military aviation enterprises and failed civil ones, the state is trying to pull the whole industry up, using money from the federal budget, state resources, and the best managers from the private sector," is how Yakov Pappe from the Institute of National Economy sees the process.

The UAC will also rationalise sector. The Soviets ran a system of "internal competition" between aviation plants that stimulated productivity, but left behind ruinous duplication of production facilities. "Unification is crucial because Russian aviation is intended to compete globally, not on the domestic market," explained UAC's head Alexei Fyodorov in his first interview in the job. "Competing globally demands maximum integration of all the resources we have at our disposal."

...and short-changes Irkut

However neat the theory, the practice of reintegrating the aviation sector was always going to be turbulent: the state still owns more than 51% in only four aviation joint stock companies (JSC).

The largest stumbling block was JSC Irkut, Russia's main aviation manufacturer, with sales figures for 2006 matching those of MIG and Sukhoi combined, and boasting half of the total order book for the entire Russian aviation sector. There was no way ZAO Kremlin could build up a national champion in the form of UAC without including Irkut in the holding.

And to make things really complicated, Irkut pulled off the first defence sector IPO in 2004. Post-IPO, the management stake had dropped from 70% to 44%, and with a state package of only 12%, compared with the 32% held by institutional and private investors, and another 10% held by Airbus maker EADS.

It was generally assumed that Irkut's clout would give it a leading role in any national corporation. But with state control and the national development increasingly a priority, the 100% state-owned JSC Sukhoi - with its very own civilian Superjet in the pipeline - to everyone's surprise emerged as the core of the new aviation national champion.

Most analysts agree that pressure was exerted on Irkut to join UAC, and it got short-changed in the process. In the words of Dmitry Vasiliev from Centre for Analyses of Strategies and Technology: "Deloitte & Touche evaluated each shareholding using a bracket range. In order to maximize the state's ownership share in the UAC, its shareholding in individual companies was consistently priced at the top of the range. State officials then consistently chose the top-end value for state companies and thus maximized the state's ownership share in the UAC. Moreover, in order to boost the MiG price, the state wrote off RUB19.5bn of debt."

"The thing that really intrigues me is that nothing at all has been made known about the basis for the Deloitte & Touche calculations in the first place," says Vasiliev.

Market players were dumbfounded when Deloitte & Touche valued Sukhoi at $2bn-$2.2bn аnd Irkut at less than half of that at $940m. However murky the evaluation, the results were very clear-cut: Irkut management gained less than 10% of UAC for its 38% of Irkut. Considering Sukhoi owned 12% of Irkut, this gave the state complete control.

Irkut management had told Troika Dialog investment bank as late as July 2006 specifically that they expected to receive 30-40% in UAC, according to bne's sources. So why did Irkut's owners agree to so much less?

Like many partly privatised companies returning to the state's bosom, management ownership leaves the company vulnerable. In the case of Irkut, management was co-opted by being offered the top post at UAC - Alexei Fyodorov, chairman of the board of Sukhoi and owner of 18%, was named manager of the newly formed UAC. He was also promoted within the pro-Putin party United Russia.

At the same time, fraud charges were brought against another of Irkut's owners and board members, Sergei Tsivilev, connected to the supply of fake MiG parts to Poland. The charges were dropped shortly after Irkut signed off on the UAC deal going ahead.

And the process of building up UAC is still not finished. Several other firms are on the short list for inclusion into the holding. "Similar conflicts could accompany the complex task of corporatising Kazan Aviation Production Association and the MiG Corporation as JSCs," says Vasiliev.

Renaissance Capital's Marina Alexeenkova agrees: "The integration of the businesses will be a complicated process, as UAC needs to determine the product range and the needs in terms of production units and capacity utilization."

Projects and partners

One major reason for wanting Sukhoi to be the core of UAC was that Sukhoi was already doing what was needed: diversifying from defence into civil aviation, in the form of the Superjet 100 unveiled in Konsolmolsk-on-Amur on September 27.

The Superjet is serving as the flagship product for UAC. Despite many sceptics, it is looking increasingly real - and Sukhoi Civil Aircraft's order books have started filling up - with the number of firm orders steadily approaching 80. The first test flight is scheduled for the end of the year. Viktor Subbotkin, director of Sukhoi Civil Aircraft, says he aims to sell 800 planes by 2024, with production rising to 100 per year, and total market demand for 5,700 regional jets. Still, the Sukhoi plane will face stiff competition from Brazil's Embraer and Canada's Bombardier.

Next up, according to UAC head Fyodorov, is the Ilyushin-Yakovlev MC-21 project for short-medium range airliners to replace Tu-154 airplanes, a workhorse of Russia's aviation. He sees considerable synergies existing between MC-21 and the Superjet. Rollout is slated for 2015.

All plans for larger passenger planes are dependent on the place UAC takes in international partnerships, with Boeing, an important partner in the Superjet project, and especially EADS, Russia's apparent partner of choice in aerospace. Specifically, the question is whether EADS will deliver Russia a line for the assembly of the next generation A320 airbus modification. As an alternative, UAC is eyeing participation in the Chinese "Big Plane" jumbo project.

There are no illusions about national autarchy: all new airliners will be developed on the basis of broad international cooperation, as was also the case with the Sukhoi regional jet project.

Including both new and Soviet-era models, UAC plans to build 431 passenger planes over the next four years, plans that Vasiliev finds "completely realistic."

A minimum of $10bn in investment will flow from the state budget by 2015 into project development, and roughly the same amount will flow from the private sector, including foreign investors. A private placement of $0.5-1bn is planned for this year, to be followed in 2008 by an IPO that could dilute the state's share from 90% to 75%.

National champions - growth locomotive or runaway train?

ZAO Kremlin's national champion "growth locomotive" is gathering pace. For a national champion comes seldom alone: along with establishment of UAC, in May 2007, the merger of five regional airlines into AirUnion, with a state blocking package was announced - and billed as a national champion among regional carriers, as Aeroflot is internationally. In the same way, the creation of the United Shipbuilding Corporation in 2007 went hand in hand with merging shipping companies Sovcomflot and Novoship.

There is a domino effect at work with national champions, which sees the state squeezing out the market. Establishing one tends to cause a knock-on effect all down the line: regarding aviation suppliers, holdings are currently being set up in the engine sector, the electronics sector, and the weapons-grade steel sector. VSMPO-Avisma, supplier of titanium to Russian aviation as well as Boeing and Airbus, was "deprivatised" in 2006. The risk is that national champions end up less a dream team than a chain gang.

As Kremlin-critic Yuliya Latynina recently caustically commented: "It should be noted that each manufacturing enterprise in Russia produces something needed for our defence. Even at the underwear mills there must be facilities for making long underwear for the military. So any enterprise, except McDonalds, can be taken under state control for the reason of its involvement in the defence-oriented production cycle."

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