Aton - Dinnur Galikhanov - Russian Smaller Copper and Zinc Producers - 2010.04.15

8/7/2019 Aton - Dinnur Galikhanov - Russian Smaller Copper and Zinc Producers - 2010.04.15

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DinnurGalikhanov:+74957776677(ext.2677)

[email protected]

Forprofessionalinvestors only.Thisdocumenthasnotbeenpreparedinaccordancewithlegal

requirementsdesignedtopromotetheindependenceofinvestmentresearch. Pleaserefertoimportant

disclosuresandanalystcertificationattheendofthisdocument

UralsBaseMetalProducersLookingforHiddenValue:Withthisreportweinitiate

coverageofthreeRussianbasemetalproducersthatusuallyslipundertheradarof

mainstreamemergingmarketsinvestors:GaiskyGOK,UchalinskyGOKand

UralelectromedthreesubsidiariesoftheUralsMiningandMetallurgicalCompany

(UMMC).Thecompaniesprovideexposuretogrowinginfrastructureinvestmentin

Russiaandtotheeconomicrecoverythatweexpect,bothdomesticallyandglobally.

Russiancoppersharpriseinexportslimitsproductiondownside:DespiteRussias

apparentcopperconsumptionfallingbyover50%YoYin2009,Russiancopperoutput

dippedonly4%,primarilyduetoadoublingofexports.Russiancopper,whilehigh

purity,isnotcurrentlyLondonMetalsExchange(LME)certifiedwhichmeansthatthe

companiescansellthemetalinexportmarketsatadiscount,undercuttingtheir

competitorswithoutattractingthewrathoftheregulators.WeexpectRussiancopper

exportstoremainstrong,supportedfurtherbyrestockingintheEUandUSaswellas

continuedstrongdemandfromChina.

Russianzincprovingresistanttoexternalfactors:TheRussianzincindustryhas

shownstrongresistancetoexternaleconomicinfluences.Productionwasdownjust

1%YoYin2009,at262kt;netexportswere27%lowerYoY,whichledtoa6%YoY

increaseinapparentconsumptionto222kt.Whileweadmitthatthefullincrease

cannotbeattributedtorealdemand,webelievethatRussianzincconsumptionis

relativelystablevscertainothermetals,drivenbyastrongrecoveryinthesteel

industrythemainconsumerofzincinRussia.Moreover,weexpectRussianzinc

consumptiontoseefurtherexpansionasaresultofitsexposuretothegrowing

constructionsector.

Weseeglobaleconomictrendsassupportiveforcommodities,althoughprice

volatilityissettocontinue:Theenvironmentforcommoditiesislikelytoremain

volatileascompetingmarketforcescontinuetoinfluenceinvestorsentiment.

Nevertheless,whilewedonotexpectcommoditiestorepeattheirstellar2009

performancethisyear,thereshouldbeenoughdownsideprotection.Weanticipatea

numberofmarkettriggersthatwebelieveshouldbecommoditypricesupportive.

Whiledollarstrengtheningcontinuestocauseshorttermvolatility,keymarketsfor

commoditiestheEUandUSarestartingtoshowsomesignsofasustained

economicrecovery,thoughdemandforcommoditiesinthoseregionscouldbelimited

torestockingatthistime.Moreover,liquiditytighteninginChinaisyettohaveany

noticeableeffect,whilestrengtheningChineseexportsshouldsustainstrongdemand

forawiderangeofcommodities.

InitiatingwithaBUYbasedonupsidepotentialandexposuretotherecovery:The

companiesunderourcoveragemaybelessvisiblecontrastedwithNorilskNickelor

Rusal,butnevertheless,theyplayasubstantialroleinthesector:UELMisoneofthe

largestcopperrefineriesintheworld;GGOKisRussiassecondlargestcopper

producer,whileUGOKisthelargestsupplierofzinctotheRussianmarket.Webelieve

thecompaniesoffersubstantialpotentialupside(rangingfromaround40%toover

100%),whichwouldjustifytakingonthehigherrisksassociatedwithinvestinginthese

lesserknown,lesstransparentandlessliquidstocks.

MARKETINGMATERIAL

METALSANDMINING

15April2010

RUSSIAN COPPER AND ZINC PRODUCERSTreasures of the Urals

Note:Pricesasof13:00on12 Apr2010throughoutthereport(unlessotherwisestated)

Coverage MktCap $1,042mn

Fair MktCap $1,796mn

Potential upside 72%

12MStock,MetalsandIndexperformance

0% 100% 200% 300%

UGOK

Gold

Silver

LME3MZinc

LME3MCopper

FTSE350 Mining

RTS

UELM

GGOK

RTS2

Source:Bloomberg

Company FV($/share) Upsidepotential

GaiskyGOK 671 124%

UchalinskyGOK 20.60 42%

Uralelectromed 118 96%

YtDStock,MetalsandIndexperformance

20% 0% 20% 40% 60%

LME3MZinc

UGOK

Gold

LME3MCopper

Silver

FTSE350 Mining

RTS

GGOK

RTS2

UELM

Source:Bloomberg


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2

Contents

InvestmentCase...................................................................................................3CompanyFactCards.............................................................................................7SettingMetalPricesInLineWithConsensus.......................................................8HighlightingtheRisks...........................................................................................9RussianCopper:CountingOnEconomicRecoveryandExportStrength ..........11

CopperIndustryOverview .......................................................................... ............. 11RussianCopperProducersExportsSavetheDay.................................................. 12

RussianZinc:ResistingtheElements .................................................................17ZincIndustryOverview....................................... ...................................................... 17

GlobalFactors:SupportiveForCommoditiesButConduciveToVolatility........22AStrongerUSDollarStillaFactororJustaDistractor?........................................ 22LiquiditytighteninginChinaisyettohaveanynoticeableimpact.......................... 23RealDemandorJustStockpilingandSpeculation?.................................................. 23

CompaniesSection

GGOK:CopperWhopper.28

UGOK:StrengthinZinc;GrowingExposuretoCopper.37

UELM:BreakingAwayFromOldMisconceptions47

AppendixIUMMCCopperProductionFlows .................................................57AppendixIIRussian2020StrategyfortheMetalsIndustry............................58AppendixIIIUELMProductFlow.....................................................................60


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3

Investment Case

Withthisreportweinitiatecoverageofthreecopperandzincproducingsubsidiaries

oftheUralsMiningandMetallurgicalCompanyUMMCtwominingcompanies,

GaiskyGOK(GGOK)andUchalinskyGOK(UGOK),andthecopperrefinery

Uralelectromed(UELM).WeassignBUYratingstoallthreeaswebelievethatthe

companiesoffersubstantialupsidepotentialandcouldbeexposedtotheresumption

ofinfrastructureinvestmentinRussiaandagradualrecoveryinkeyglobalmarkets.

Moreover,webelievethattherecentcommoditypricerallyhasnotbeenfully

reflectedinthestocksshareprices.

Figure1:Fairvalueandratingsummary

Company TickerFairvalueper

share($)

Currentshare

price($)

Upside

potentialRating

GaiskyGOK GGOKRU 671 300 124% BUY

UchalinskyGOK UGOKRU 20.60 14.50 42% BUY

Uralelectromed UELMRU 118 60 96% BUY

Source:Bloomberg,Atonestimates

Valuationsstilllagglobalpeers

WebaseourcompanyvaluationsonaweightedaverageofourDCFcalculation,6xour

forecast2010P/Eand4xourforecast2010EV/EBITDA,ina50:25:25ratio.

ToarriveatourvaluationmultiplesweassessedtrailingP/EandEV/EBITDAmultiples

forpeersfrombothdeveloped(DM)andemergingmarkets(EM).Thehistoryofthe

majorityofRussianlistedstocksdoesnotgobackfarenoughtoanalysetheir

behaviourduringthepreviouseconomiccrises,butwebelievethatananalysisoftheir

pricingtrendspriortoandfollowingtherecentcrisisgivesanindicationofthe

potentialforpriceappreciation.Therefore,webasedourpeergroupanalysisontwo

distinctperiods:precrisis(200607)andtroughtorecoveryperiod(200809).

Lookingattheprecrisisvaluationmultiplesforthepeergroup,wecanseethatDM

companiesweretradingatP/Emultiplesofaround1015x,attimesrisingto20x.On

anEV/EBITDAbasis,thesamecompaniesweretradingatapproximately56x,with

somecopperproducerstouchingEV/EBITDAratiosashighas8x.Inemergingmarkets,

metalproducershavehistoricallytradedatP/Esof810xandEV/EBITDAmultiplesof

25x,althoughsomeChinesecompanies(e.g.XinjiangXinxin,TonglingNonferrous)

havetradedashighas1415x(P/E)and510x(EV/EBITDA)atprecrisispeaks.

DuringtheprecrisisperiodRussiancopperproducerstradedatP/Esofbetween4x

and8x,andEV/EBITDAsof24x.Inroughtermstheselevelsputthemata50%

discounttotheirDMpeersanda40%discounttotheirEMpeersonaP/Ebasis.In

termsoftheEV/EBITDAmultiple,Russiancompaniestradedata50%discounttotheir

DM,anda25%discounttotheirEMcomparables.

AsillustratedinFigure2,globalpeersarecurrentlytradingat2010P/Esofaround13

14xindevelopedmarketsand1819xinemergingmarkets(basedonBloomberg

estimates).


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Figure2:Globalcomparisons

2010E 2011E

P/E P/S EV/S EV/EBITDA P/E P/S EV/S EV/EBITDA

(x) (x) (x) (x) (x) (x) (x) (x)

Russianpeers(mean) 2.8 0.6 1.0 2.4 2.5 0.6 0.9 2.2

Russianpeers(median) 2.8 0.5 1.1 2.4 2.4 0.4 1.0 2.2

Developedmarkets(mean) 13.6 2.3 2.5 7.7 13.3 1.9 2.1 6.3

Developedmarkets(median) 13.4 2.1 2.5 7.1 10.6 1.9 2.2 5.8

Emergingmarkets(mean) 18.7 2.7 2.7 11.0 14.6 2.3 2.4 8.6

Emergingmarkets(median) 19.0 2.4 2.3 10.8 12.7 2.1 1.9 7.8

AverageDMDiscount 80% 74% 59% 67% 79% 73% 58% 64%

AverageEMDiscount 85% 78% 59% 78% 82% 77% 56% 73%

Source:Bloomberg

OnanEV/EBITDAbasis(consensus2010estimates),DMpeersaretradingatmultiples

of78x,whiletheratiosfortheirEMpeersstandat1011x.AssumingthatbothDM

andEMratiosreverttotheirhistoricalnorms,webelievethatthethreestocksunder

ourcoveragecouldbevaluedataround48x2010P/Eand35x2010EV/EBITDA.We

thereforeusemidpointmultiplesof6xforecast2010P/Eand4xforecast2010

EV/EBITDAasthebasisforourvaluation.

Whileamultiplesbasedmethodallowsustocomparethestocksshareprice

performanceinrelationtotheirglobalpeers,avaluationbasedonDCFgivesabetter

reflectionofthecompaniesmediumtermgrowthpotential.Therefore,weassigna

greaterweightingtoourDCFforecastwhencalculatingthecompaniesfairvalues.Our

DCFmodelsincorporateaterminalgrowthrateof1%andWACCassumptionsranging

from11.5%to12.6%dependingoneachstocksassumeddebtcostandgearinglevels.

InFigure3belowweprovideasummaryofthevaluationrangesforourcovered

stocks:

Figure3:Valuationrangesforthestocks

2010EP/E 2010EEV/EBITDA

Currentshare

price($/share)Fairvalue

($/share) DCF

4x 6x 8x 3x 4x 5x

GaiskyGOK 300 671 563 560 840 1120 452 717 982

UchalinskyGOK 14.50 20.60 16.32 17.09 25.63 34.18 17.69 24.13 30.56

Uralelectromed 60 118 100 87 131 174 93 139 186

Source:Atonestimates


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5

InFigures47belowwesummarisekeyvaluationratios,performanceinformation,and

productionandfinancialdataforthethreestocksunderourcoverage.

Figure4:Keyvaluationratios

GaiskyGOK UchalinskyGOK Uralelectromed

Keyvaluationmetrics

Commonsharesinissue(mn) 0.6 38.1 5.1

MktCap($mn)185

552

304

Netdebt($mn) 212 61 238

EV($mn) 397 614 542

BV($mn) 233 514 370

P/Eratios(x)

2008 22.0 9.0 7.4

2009E 5.3 5.3 12.3

2010E 2.1 3.4 2.8

2011E 1.9 3.2 2.4

EV/Sratios(x)

2008 1.2 1.2 0.8

2009E 1.4 1.5 0.9

2010E 1.1 1.1 0.7

2011E 1.0 1.0 0.6

EV/EBITDAratios(x)

2008 5.3 4.8 4.5

2009E 4.4 3.8 6.4

2010E 2.4 2.5 2.3

2011E 2.2 2.4 2.0

P/Bratio2009E(x) 0.8 1.1 0.8


Figure5:Recentstockperformance


1M 9% 7% 10%

3M 16% 5% 38%

6M

25%

38%

50%

YtD 16% 5% 38%

1Y 216% 21% 106%

52weekhigh($) 300 15.50 60

52weeklow($) 95 8.00 21

Dailyt/o($) 24,683 42,952 19,500

Freefloat(%) 15.4% 11.5% 18.4%

Freefloat($mn) 28 64 56


Figure6:Keyproductionfigures


Copperinconcentrate(kt)

2008 75 91

2009E 78 96

2010E 79 96

2011E 85 98

Zincinconcentrate(kt)

2008 6 116

2009E 6 109

2010E 6 104

2011E 6 99

Refinedcopper(kt)

2008 348

2009E 330

2010E 350

2011E

361

Source:Companydata,Atonestimates


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Figure7:Keyfinancialfigures($mn) GaiskyGOK UchalinskyGOK Uralelectromed

Revenue($mn)

2008 325 497 685

2009E 282 422 583

2010E 369 544 772

2011E 412 585 837

EBITDA($mn)

2008 75 127 122

2009E 91 160 84

2010E 164 245 236

2011E 183 258 269

Netincome($mn)

2008 8 61 41

2009E 35 105 25

2010E 87 163 111

2011E 97 171 128

EBITDAmargin(%)

2008 23% 26% 18%

2009E 32% 38% 14%

2010E 44% 45% 31%

2011E 44% 44% 32%

Netmargin(%)

2008 3% 12% 6%

2009E 13% 25% 4%

2010E 23% 30% 14%

2011E 23% 29% 15%



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7

Company Fact Cards

GaiskyGOK(GGOKRU)Copperconcentrateproductiongrowthstory

Overview

SecondlargestcopperconcentrateproducerinRussia,operatingoneofthelargest

copperdepositsinthecountryGai.Producescopperandzincconcentrates,gold,

andsilver.Copperconcentrateaccountsforapproximately70%ofrevenuesandgolda

further17%(2009E)

Bullpoints

Oneofthemostundervaluedstocksamongcopperproducers,byourestimates(124%potentialupsidetothecurrentshareprice).

Companyexpectsoreprocessingcapacitytoincrease33%,to8mntpa,byYE13. Sharepricelagsfarbehindtheongoingcopperpricerally.Bearpoints

MajorityownershipbyUMMCresultsinlowtransparency;minorityshareholderrightsmaypotentiallybeatrisk(Freefloatof15.4%);Lowstockliquidity

ReportsunderRussianAccountingStandards(RAS)maybelessreliablethanIFRS

UchalinskyGOK(UGOKRU)Largezincconcentrateproducer;strongbalancesheet

Overview

Thelargestzincconcentrateproducerandthirdlargestcopperconcentrateproducer

inRussia.Zincconcentrateaccountsforaround21%ofsales,copperconcentrate57%,

gold12%,andsilver6%(2009E).

BullPoints

Thecompanyplanstoincreaseoreprocessingcapacity20%byYE12,to6.5mntpa. DownsideprotectionprovidedbyzincdemandthecompanyremainsRussias

singlelargestsupplierofzincconcentrate

Growingcopperconcentrateoutputincreasesexposuretohigherpricedcopper Lowdebtlevel,strongbalancesheetBearPoints

Reductioninzincconcentrateoutputby26%by2015duetofallingoregrades UMMCsmajorityownershipleadstolowertransparency;potentialrisktominority

shareholdersduetolowfreefloat(11.5%);lowliquidity

FinancialsunderRASnotasreliableasunderIFRS

Uralelectromed (UELMRU)Russiaslargestcopperrefinerywithgrowingcapacity

Overview

ThelargestsinglecopperrefineryinRussiaandamongthetop20largestintheworld.

Capableofproducingupto380ktpaofrefinedcopperandcopperproducts.Good

DeliverystatusfromLBMAforgoldandsilver,intheprocessofreceivingLME

certificationforitscoppercathodeoutput.

BullPoints

Tollingschemeremainsmisunderstood,despiteUELMstollingfeesbeingreasonablyhigh($250300/tonne)vsglobalbenchmarks(2009RCof$165/tonne).

UELMplanstoincreaserefiningcapacity32%byYE12,to500ktpa. Lagsbehindglobalpeers,offering96%potentialupsidetothecurrentshareprice.BearPoints

TollingschemeusageinRussiastillhasnegativeconnotationsandisthusfearedbythemarket;thismaycausenegativesentimentamonginvestors.

Possibledelaytorefineryexpansionduetofinancialcrisis. UMMCscontrolmayleadtolowtransparencyandpotentialriskstominority

shareholders(freefloat:18.4%).RASbasedaccountingislessreliablethanIFRS.

GGOKlargecopperconcentrateproducer

GGOK'sshareofRussiancopperin

concentrateproduction(2009E)

Norilsk

69%

Other

Co's

3%

UMMC

other17%

GGOK

11%

Source:Reuters,InfoGeo,ResearchCentreMineral

UGOKlargestzincconcentrateproducer

UGOK'sshareofRussianzincin


UGOK

70%

Other

Co's

26%

UMMC

other

4%

Source:Reuters,Companydata

UELMRussiaslargestcopperrefinery

UMMC's share ofRussianrefined

copperproduction(2009E)

Norilsk

45%

Others

1%RMK16%

UMMC

38%

Source:Companydata,Reuters


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Setting Metal Prices In Line With Consensus

OurmodelsrelyonpriceassumptionsthatarebasedonthecurrentBloomberg

consensus.Thisisbasedonpriceforecastsfromatleast15analysts,whichwebelieve

givesareasonablereflectionofthecurrentmarketsentiment.

ThesummaryofcurrentconsensuspriceforecastsisgiveninFigure8.

Figure8:Metalpriceassumptionssetinlinewithconsensus

2005 2006 2007 2008 2009 2010E 2011E 2012E 2013E 2014E

LME3MCopper($/t) 3,507 6,679 7,103 6,886 5,199 6,875 7,358 7,743 6,668 6,500

LME3MZinc($/t) 1,393 3,248 3,249 1,901 1,689 2,307 2,513 2,423 2,232 2,200

SpotGold($/oz) 445 605 697 872 974 1,150 1,187 1,035 989 950

SpotSilver($/oz) 7.32 11.59 13.39 14.97 14.70 18.00 19.00 16.45 15.40 15.00

Source:Bloombergconsensus(asof12Mar2009),Atonestimates

Basemetalsreturntoprecrisislevelsin2010andcontinueaiminghigher

Themarketcurrentlyexpectspricesforthemajorityofbasemetalstorecovertotheir

precrisisaveragesin2010andtocontinuerisingthrough201112onthebackof

improved

economic

conditions

and

growing

demand

(Figures

9,

10).

Figure9:Copperpriceassumptions Figure10:Zincpriceassumptions

1840

1599

1578 1

789

2790

350

7

6679 7

103

6886

5199

6668

6500

774

3

735

8

687

5

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010E

2011E

2012E

2013E

LT

$/t

1137

905

797 84

4 106

4 139

3

3248

3249

1901

1689

2232

22002

423

2513

230

7

0

500

1000

1500

2000

2500

3000

3500

4000

4500

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010E

2011E

2012E

2013E

LT

$/t

Source:Bloombergconsensus,Atonestimates

Goldandsilverstillusedasinflationhedgesandsafehavens

Theexpectationinthemarketisforgoldtotradeataround$1,1501,190/ozin2010

11,whilesilverisexpectedtoreach$1819/ozthroughthatperiod(Figures11,12).

Figure11:Goldpriceassumptions Figure12:Silverpriceassumptions

279

271 31

1 364 4

10 445

605

697

872

974 989

95010

35

118

7

115

0

0

200

400

600

800

1000

1200

1400

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010E

2011E

2012E

2013E

LT

$/oz

4.95

4.38 4.

61 4.89

6.68

7.32

11.59 13

.39 14

.97

14.70

15.40

15.0016

.451

9.00

18.00

0.00

5.00

10.00

15.00

20.00

25.00

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010E

2011E

2012E

2013E

LT

$/oz

Source:Bloombergconsensus,Atonestimates


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9

Highlighting the Risks

Wehaveapositiveoutlookonthecompaniescoveredbythisreportandbelievethat

someoftherisksusuallymentionedinconnectionwithRussianstocksmaybe

outdatedorbasedonerroneousconcepts.However,westillneedtodrawinvestors

attentiontotherisksthatmaystillberelevantforthestocksunderourcoverage.

Low

free

float:

This

is

often

quoted

as

the

main

risk

associated

with

investing

in

Russianstocks.Theaversiontoholdingminoritysharesincompanieswithlowfree

floatmaystemfromthecolourfulhistoryofRussianbusinessrivalriesfromthe

relativelyrecentpast.AtthetimesomeRussiancompanieswereknowntoactwith

completedisregardforminorityshareholders,usinghostileanddilutiveshareissuesas

instrumentsofgainingcontrol.

ThesedayslowfreefloatisstillacommonfeatureofRussianstocks,includingwell

knownnames,listedoninternationalstockexchanges.Rusal,thelatestentranttothe

equitymarkets,hasafreefloatofjustunder11%,whilethefivelargestlistedRussian

steelmakershavefreefloatsrangingbetween13%and28%.NorilskNickelhasthe

largestfreefloatamongtheRussianmetalsandminingnames,atjustunder40%.

Thefreefloatsofthecompaniesunderourcoverage(GGOK,15.4%,UGOK,11.5%,

UELM,18.4%)haveremainedstablesinceatleast2006,accordingtocompanyfilings.

WithUMMCbusyinvestingingrowingandmodernisingthebusiness,preferringto

financetheprocessthroughdebt,ratherthanturningtoshareholders,weseetherisk

ofactionsthatabusetherightsofminorityshareholderaslowatthemoment.

Nevertheless,theriskshouldnotbediscountedcompletely.

OneofthesituationswhereweseethisriskarisingisinpreparationforapossibleIPO,

whichhasbeenmentionedoncountlessoccasions,butinourviewremainsunlikelyin

theshortterm.Theholdingcompany,UMMC,maywishtoconsolidateitscontrolover

thesubsidiariesprioritsentryintotheequitymarket.Itcouldtrytopurchasethe

subsidiariessharesintheopenmarketor,morelikely,makeatenderofferin

exchangeforcashorequityintheholdingcompany.Thereisariskthatsuchanoffer

couldbemadebasedonvaluationsthatdiscountthetruevalueofthesubsidiaries.

Shouldthissituationmaterialise,theshareholderswouldhavetoassessthemeritsof

sellingtheirsharesatadiscountvsthelikelygainfromtheparentcompanyspotential

IPO.

Lowliquidity:Asaresultofalimitedfreefloatandlowcapitalisation,theliquidityof

thestockscoveredinthisreportremainsquitelow,withdailytradingvolumesinthe

pastthreemonthsaveragingaslowas$19,500anduptoaround$43,000,depending

onthecompany.Investorshavetotakethisriskintoaccountwhenmakinginvestment

decisionsregardingthestocks:itmaynotalwaysbepossibleobtainaccurate

indicationsofthestockstradingprice,marketcapitalisationortransactioncosts.It

mayalsobedifficulttoadjustpositionsinthestockswithintimeframesdesiredby

investors.

Inadequatecorporategovernancestandards:Russiancompaniescorporate

governancestandardsareawellresearchedtopicanditisbroadlyunderstoodthat

theystillhavealongwaytogo,withthecurrentprogressslowandarduous.The

recentacquisitionofacontrollingshareinChelyabinskZincPlantbyUMMCand

RussianCopperCompany(RMK)onceagainraisedconcernsoverapotentialworsening

ofcorporategovernanceatChelyabinskZinctheinternationallylistedcompany.

Whilewecannotdiscountthepossibilityofthathappening,wemayalsoseethisasan

opportunityforUMMCtouseitsexperiencemanagingalarge,publiclylistedcompany

togainabetterappreciationofinternationalcorporategovernancerequirementsand

standardspriortoitsownpotentialentryintotheequitymarket.


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1

0

Withrespecttothecompaniescoveredinthisreport,weareencouragedthatAndrey

Kozitsyn,GeneralDirectorofUMMC,isanactivememberoftheRussianNational

CouncilonCorporateGovernance(NCCG),anonprofitorganisation,whichunitestop

managersfromlistedRussiancompanies,investmentprofessionalsandfederal

governmentrepresentatives.ThecouncilischairedbyVladimirPotanin,majority

shareholderinNorilskNickel.Itactsasanadvisorybodyaimingtoimprovelegislation

andintroducemodernstandardsofcorporategovernancetoRussiancompanies.

Lowtransparencyandinadequatereportingstandards:Russianaccountingstandards

(RAS)areoftenviewedasinadequateincomparisonwithIFRSorUSGAAP.Whilewe

donotnecessarilysharethisviewcompletely,weagreethatRussianaccounting

reportsoftenleavemuchtobedesiredintermsofqualityofreportingandthe

disclosureofkeyfinancialandoperationalfacts.Reportingtoshareholdersisoften

kepttotheminimumspecifiedbythecurrentlegislation.

AccordingtonumerouscommentsmadebyUMMCsmanagementinthepast,the

holdingcompanyhasbeenreportingitsfinancialsunderIFRSsince2003(althoughthe

reportswereaimedatcreditinstitutionsandarecurrentlynotavailablepublicly).

However,theholdingssubsidiariesarestillreportingunderRAS.

OurexperiencewiththeUMMCsubsidiarieshasgenerallybeenpositive,bothinterms

offinancialreporting(makingallowancesforcertainshortcomingsoftheRussian

financialreportingstandards)andintermsofdirectcontactwiththecompanies.The

companiesweregenerallyopenwithrespecttodiscussingthemainaspectsoftheir

businesses:operationalfactors,productflows,revenueandcostdrivers,capital

budgets,workplans,etc.However,whenanalysingtheareasofthebusiness,which

wereconsideredcommerciallysensitivebythecompanies,wehadtorelyonourown

judgementwhenmakingconclusions.

Politicalrisks:TherecenthistoryofRussianlistedcompanieshasnumerousexamples

ofthenegativeconsequencesacommentbyagovernmentofficialorachangein

political

priorities

may

have

on

an

enterprise.

While

no

Russian

listed

companies

may

beconsideredimmunetotherisk,thoselistedasstrategicenterprisesbythe

Russiangovernment,ofwhichUMMCisone,couldbebetterinsulated.

Financialrisks:UMMCsubsidiarieshavesubstantialinvestmentprogrammesaimedat

modernisingtheirbusinessesandincreasingoperatingcapacity.Attheonsetofthe

crisistheparentcompanyriskedbreachingcovenantsonsomeofitsloans.However,

bycuttingcostsanddeferringsomeofitscapitalprojects,thecompanymanagedto

stabiliseitsfinancialposition.Itrefinanceditsdebtobligations,whichcurrentlystand

ataround$3bnintotalforthegroup,accordingtotheUMMCmanagements

commentsinthemedia.Thecompanycurrentlyreliesonsupportfromgovernment

ownedbanks,however,thereisnoguaranteethatsuchrelationshipswillcontinueor

willbesupportedbythegovernmentinthefuture.


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1

Russian Copper: Counting On Economic Recovery and Export Strength

Russiawasrankedamongthetop10globalcopperproducersandconsumersin2008

anditssubstantialreservebasehassubsequentlyallowedittoplayanimportant

roleintheinternationalcoppertrade.TheRussiangovernmentexpectstheindustry

toremainexportorientedintheshorttomediumterm,andforecaststhecountrys

apparentconsumptiontoreturntoprecrisislevelsonlybyaround2015.

CopperIndustryOverview

Copperisoneofthemostwidelyusedoftheindustrialmetals,findingitswayintoa

multitudeofdifferentapplications.AscanbeseenfromFigure13,electrical(e.g.

cables,wires)andconstructionapplications(e.gtubes,buildingparts,fittings)account

foraround70%ofglobalcopperconsumption.

Figure13:Worldcopperconsumptiontrends

Worldrefinedcopperconsumption

byenduse (2008)Industrial

machinery

9%

Construction

28%

Transportation

12% Consumer

products

9%

Electrical

42%

Worldcopperconsumption

byregion(2008)

USA

11%Europe

26%

Restof

Asia

21%

Japan

7%

Africa

2%

China

26%

Australia

1%

Restof

America

6%

Source:CRU

ChinaconsumesoveraquarteroftheworldscopperoutputwithAsiaasawhole

accountingforaround55%ofglobalcopperconsumption.Consumptionofthemetal

inEuropeandtheUSisnonethelessalsoquitesubstantial.

Globalcopperreservesarerelativelyabundant.TheUSGeologicalSurveyputsthe

worldstotalprovedreservesataround540mnt(whichaloneshouldbesufficientfor

around35yearsofproductionatcurrentoutputlevels).Chile,theUSandPeru

accountedforaroundhalfofglobalcopperproductionin2008,whileRussiawasin

sixthplace,witharound750ktofmineoutput(Figure14).

Figure14:Topminedcopperproducers(rankedby2008output) Mineproduction(kt) Reserves(kt)

Country 2005 2006 2007 2008 2009E

Chile 5,320 5,360 5,560 5,330 160,000

US

1,140

1,200

1,170

1,310

35,000

Peru 1,010 1,049 1,190 1,270 63,000

China 755 890 946 950 30,000

Australia 927 859 870 886 24,000

Russia 700 725 740 750 20,000

Indonesia 1,070 816 797 651 31,000

Canada 567 607 589 607 8,000

Zambia 436 476 520 546 19,000

Poland 523 512 452 430 26,000

Kazakhstan 402 457 407 420 18,000

Mexico 429 338 347 247 38,000

Othercountries 1,720 1,835 1,840 2,030 70,000

Worldtotal(rounded) 15,000 15,100 15,400 15,700 540,000

Source:

US

Geological

Survey,

Mineral

Commodity

Summaries,

Jan

2010


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Thecoppermanufacturingcyclecanbesubdividedintothreeroughstages:

1.Miningandcopperconcentrateproduction

2.Smeltingandrefining(attimesseparatedintotwostages)

3.Semifinishedandfinishedproductfabrication

Aswithallbasemetals,themaindriverbehindmineandconcentratingoperations

locationsistheavailabilityofsufficientmetalcontentintheore/soiltomakecopper

extractioneconomic.Smeltingandrefiningfacilities,ontheotherhand,relyonthe

availabilityoffuelandelectricityandarethereforelocatedintheareasinwhichthese

energysourcesareavailablecheaplyandinabundance.Finally,fabricationplantstend

tobelocatedincloseproximitytotheultimateconsumers.

Dependingonarangeofoperationalandeconomicfactors(e.g.theavailabilityof

economicallyexploitablemetaldeposits,theirlocation,transportinfrastructure,

availabilityofpower,etc.)countriesand/orcompaniesmayhavesignificantpresence

inallthreestagesorspecialiseinaparticularone.

Chile,forinstance,theworldslargestcopperproducer,producedanequivalentof

5.3mntofthemetalinminedproductionin2008.However,only3.1mntofthiswas

refinedinthecountry,withtherestbeingexported,primarilytoAsia.Finally,only

0.1mntofrefinedmetalwasconsumedinthemanufactureofcopperbasedproducts

(Figure15).

Figure15:Coppermining,refiningandconsumptiontrends(2008,kt) Minedproduction Refinedproduction Refinedusage

Chile 5,328 3,058 103

UnitedStates 1,335 1,282 2,020

Peru 1,268 464 55

China 951 3,791 5,198

Russia 705 862 650

Source:ICSG

Chinesemines,incontrast,producedtheequivalentofjustunder1mntofcopperin

2008.Itishowevertheworldsbiggestcopperrefinerandconsumer,usingcopper

concentrateimportedfromelsewheretoproducearound3.8mntofrefinedcopper.

Thecountryconsumescloseto5.2mntofrefinedcopper,withthebalancecoveredby

importsofrefinedproduct,andinternalandexternalcopperscrapsupplies.

RussianCopperProducersExportsSavetheDay

TheRussiancopperindustryisreasonablybalancedbetweenthethreemanufacturing

stages,althoughexposuretoeachmanufacturingstagediffersbyproducer,aswe

discussbelow.

ThecurrentcircumstancesoftheRussiancopperindustry,notdissimilartoother

metalsoperationsinRussia,aredominatedbytheirSovietlegacywithsomeofthe

largestmetalsdepositslocatedintheSovietrepublics,whicharenowindependent

states.Asaresult,afterthedemiseoftheSovietUnion,manyRussianbasemetal

producersfoundthattheirmainoronlysuppliersofrawmaterialswerenow

independentcompaniesandrelationshipshadtoberebuiltandbasedonanentirely

different,freemarketorientedapproach.Aluminiumandzincproducerswerethe

hardesthitwiththecopperindustrylessaffectedgiventhatRussiasowncopper

reservebaseissufficientlylargetosatisfythelocalindustrysrequirements.


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InthisreportwefocusonUMMCcompaniesoperatinginthetwomainstagesofthe

coppermanufacturingprocess(seeAppendixIfortheoutlineofUMMCsexposure

todifferentstagesofcopperproduction):

Miningandconcentrateproduction(GGOK,UGOK),and Refining(UELM)

Themarketishighlyconcentratedatbothstages,withonlythreecompanies,Norilsk

Nickel,UMMCandRussianCopperCompany(RMK),controllingalmosttheentire

market.ThesituationmaychangeinthenearfuturewhenthelargeUdokancopper

depositinEastSiberia,whichiscurrentlybeingdevelopedbyMetalloinvestandstate

ownedRostechnologii(RussianTechnologies),commencesproduction.

Themarketisslightlylessconcentratedatthefabricationstage,althoughallthree

companieshavebeenactivelyconsolidatingassetsinthisspaceandnowhaveavery

sizeablefootprintinthisportionofthemarket.

Miningandcopperconcentrateproduction

Russianofficialstatisticsdonotdisclosecopperconcentrateoutputbreakdownby

enterprise,citingcommercialconfidentiality.Consequentlywehavereliedpartlyon

companydata,butlargelyonavarietyofotherstatisticalsources(bothinternational

theReutersBaseMetalsDatabaseandtheInternationalCopperStudyGroup(ICSG)

andRussian:statisticaldatamaintainedbyInfoGeoandtheresearchbureauMineral)

toarriveatwhatwebelieveisareasonablyaccurateestimateofthemajorproducers

concentrateoutput.

NorilskNickeldominatestheRussianmarketintermsofcopperconcentrateoutput

(justshyof70%,onourestimates).Thisisnotsurprisinggiventhatthecompany

controlssomeofRussiaslargestdeposits,wherecopperisproducedasabyproduct

ofnickelmanufacturing.UMMCisthesecondlargestproducer,supplyingaround29

30%ofthecountryscopperconcentrate.TherestissuppliedbyRMKandsomeother

smallerenterprises(Figure16).

Figure16:LargedepositsmakeNorilsktheleadingcopperconcentrateproducer

ShareofABC1reservesoflargest

Russianproducingdeposits(2007)

Oktyabrskoe

(Norilsk)

50%

Gai

(UMMC)

15%Talnakhskoe

(Norilsk)

25%

Yubileynoe

(UMMC)

5%

Volkovskoe

(UMMC)

5%

UMMCsubsidiaries as %ofRussian

copperconc.production (2009E)

Norilsk68%

Other

Co's

3%

GGOK

11% UGOK

7%

UMMC

other

11%

Source:Source:Reuters,InfoGeo,ResearchCentreMineral,Atonestimates


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InFigure17weprovideanestimatedbreakdownofcopperconcentrateproductionby

Russiasmainproducers.

Figure17:Russiancopperconcentrateproductionbycompany(kt) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

NorilskNickel 425 453 455 465 485 495 505 505 505 505

UMMC 136 149 158 179 187 187 195 205 209 206

of

which:

GaiskiyGOK 59 66 69 72 75 73 74 75 75 78UchalinskyGOK 28 34 35 46 48 48 50 51 55 50SafyanovskayaMed(partofUELM) 28 26 29 30 32 32 32 32 32 32OtherUMMCassets 21 23 25 31 32 34 40 46 46 46

RMKtotal 10 11 13 14 14 14 14 14 14 14

Others 10 15 15 11 10 10 10 10 10 10

Grosstotal 581 628 641 669 696 707 725 734 738 736

Source:Reuters,Companydata,InfoGeo

Refinedcopperproduction

Withrespecttoprocessingcopperconcentrateintorefinedcopper,thebalanceof

control

shifts

significantly

away

from

Norilsk

Nickel,

which

produces

around

45%

of

Russiasrefinedcopper,onourestimates.TheremainderisprocessedbyUMMC

(around38%)andRMK(around16%)andseveralothersmallcompanies(Figure18).

Figure18:Refinedcopperproducers Figure19:Theworldstop20copperrefineriesbycapacity,2009(ktpa)

UMMC's shareofRussianrefined

copperproduction(2009E)

Norilsk

45%

Others

1%RMK

16%

UMMC

38%

900

500

490

470

450

450

415

400

400

400

395

390

380

380

380

360

350

350

345

330

330

0

200

400

600

800

1000

Guixi

Birla

Chuquicamata

CodelcoNorte

Toyo/Niihama

Amarillo

ElPaso

LasVentanas

Jinchuan

Morenci

Hamburg

PyshmaUELM

CCRMontreal

Escondida

Sterlite

IioRefinery

Yunnan

Jinlong

Olen

Onsan

Norilsk

Source:Companydata,Reuters,Atonestimates Source:ICSG

UMMCownsoneofthelargestcopperrefineriesintheworldbyinstalledcapacity

Uralelectromed(UELM)intheRussiantownofPyshma(Figure19).ICSGestimates

UELMscapacityat390ktpa,althoughwebelievethatthisfigurecouldincluderefined

copperproducedbyUMMCsothersmallersubsidiaries.UMMCitselfreportedUELMs

nameplateannualcapacityat300kt,butconfirmedthattheplantiscurrentlyableto

producearound350380ktofrefinedcopperperyear,withanincreaseinitscapacity

to500ktplannedbyYE12.


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InFigure20wegiveasummaryofrefinedcopperoutputbythemainRussian

enterprises.

Figure20:Russianrefinedcopperproductionbycompany(kt) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

NorilskNickel 413 475 454 467 447 452 425 423 419 402

UMMC 315 330 333 296 345 355 357 381 351 333

RMK

Total

76

80

66

86

121

137

170

175

144

139

Others 5 6 6 6 6 6 6 6 6 6

GrossTotal 803 891 859 856 919 950 957 985 920 880


Relianceonexportsremainssignificant

ModernRussiaisanetexporterofrefinedcopper.Weanalysedrecenttrendsin

Russiancopperproductionandtrade,basedondataprovidedbytheRussian

governmentsrecentlyadoptedStrategyontheDevelopmentoftheRussianMetallurgicalIndustryto2020(MetalsStrategy2020)andthelatestofficialstatistics.

Thecountryscopperimportsareinsignificant,whileitsexportsaveragedaround

350ktperyear,orroughlyaround3540%ofitstotalrefinedcopperoutputbetween

2003and2008.However,astheconsumptionofrefinedcopperbymanufacturersof

copperbasedproductswithinthecountryincreased,theshareofexportsgradually

decreased,fallingto28%oftotaloutput(270kt)in2006.

Nevertheless,exportsreliancewasonceagainconfirmedin2009,whennetexportsof

refinedcoppermorethandoubled,risingfrom290ktin2008to590kt.Thiswaslargely

asaresultoffallingdemandwithinRussia.

Relianceoncopperisexpectedtoremainsignificant:theRussianMetalsStrategy

2020assumesthreemodesofdevelopmentforthesector:passive(orinert);resource

oriented;andinnovative(seeAppendixIIforadetaileddescription).Dependingonthe

approach,thestateexpectsproductionofrefinedcoppertoremainataround850900ktin201011,risingtoaround9501050ktby2015(Figure21).

Figure21:Russianrefinedcopperproductionandconsumption(kt)

284

715650

591664684623

515

372310

430

750

900

520390

600

400

200

0

200

400

600

800

1000

1200

2003

2004

2005

2006

2007

2008

2009

2010E

2011E

2015E

2020E

Production (inert) Production(innovative)Netimport(inert) Netimport(innovative)Apparentcons(inert) Apparentcons(innovative)

Source:Russian2020MetalsStrategy,InfoGeo,Atonestimates

AscanbeseenfromFigure21,internalconsumptionofrefinedcopperisnotexpected

toreturntoprecrisislevelsuntilsometimebetween2011and2015.Asaresult,

MetalsStrategy2020forecastsexportstobeintheregionof450550ktin201011.


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WhiletheimportanceofChinaasanexportdestinationforRussianproducersis

graduallyincreasing,EuropeandtheMiddleEastremainitsmainmarkets.Inthis

regard,thecurrentgradualimprovementincopperdemandbeingseeninthe

EuropeanmarketsonthebackofrestockingshouldplayintotheRussianproducers

handsandprovidefurthersupportfortheirexports.

Moreover,bothNorilskNickelandUELMhavealreadyappliedtolisttheircopper

cathodesasbrandsfordeliveryattheLME,withtestsofUELMscopperforbranding

alreadyproceeding.ThemoveshouldallowRussiancopperproducerstoboosttheir

profitsasLMEbrandingwouldallowthemtoselltheircopperatLMEquotedprices,

whilenonLMEregisteredmaterialissoldatadiscount.Whilewebelievesellingata

discountwasanadvantageduringthetimeofthecrisis,allowingthelowerpriced

Russianmaterialtogainlargermarketshare,inafullyfledgedrecovery,differentiation

basedonquality,ratherthanprice,wouldbemorebeneficial,inourview.

WenotethatUELMsgoldandsilverarealreadyincludedontheGoodDeliverylist

oftheLondonBullionMarketAssociation(LBMA).


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Russian Zinc: Resisting the Elements

Russiascontributiontoworldzincoutputisrelativelymodestbyglobalstandards

despiteitsreservebasebeingamongthelargestintheworld.Thecountrysindustry

waslittleaffectedbytheeconomiccrisismainlythankstothestrongperformanceof

galvanisedsteelmanufacturers.WebelievetheRussianzincindustrywilllikelyfocus

onsupplyingthecountrysinternalneeds,withdemandgrowthbeingboostedbythe

construction

sector,

in

particular.

ZincIndustryOverview

Zincispredominantlyusedasacoatingforsteelandironinordertoprotectthese

metalsagainstcorrosion(galvanising).Thisisgraduallyreplacingmoretraditional

methodssuchascolourpolymercoatingandpainting.Zincisalsowidelyusedinalloys

suchasbrassandinavarietyofchemicalapplications.Globally,aroundhalfofzinc

productionisusedingalvanising,andover30%isutilisedinalloys(Figure22).

Figure22:GlobalandRussianprimaryzincusage

Globalzincusagebyfirstuse

(2007)

Other

11%

Galvanising

47%Alloys

33%

Chemicals

9%

Russianzincusagebyfirstuse

(2008)

Other

6%

Galvanising

62%

Alloys

18%

Chemicals

14%

Source:GlobalLME,Russia ChelyabinskZinc

InRussiagalvanisingisbyfarthelargestapplicationforzinc,accountingforover60%,

withalloyandchemicalproductionconsuminganother32%.

Intermsofglobalminedzincproduction,Russiaplaysarelativelymodestrole,with

thetopproducersbeingChina,PeruandAustralia(togetherproducingaround44%of

theworldsoutputofzinc(Figure23).

Figure23:Topminedzincproducers(rankedby2008output) Mineproduction(kt) Reserves(kt)

Country 2005 2006 2007 2008 2009E

China 2,547 2,844 3,048 3,186 33,000

Peru 1,202 1,202 1,444 1,603 19,000

Australia

1,329

1,338

1,498

1,479

21,000

Canada 667 638 630 716 8,000

US 748 727 803 779 14,000

India 472 503 558 616 10,000

Kazakhstan 364 410 446 459 17,000

Mexico 476 469 452 442 14,000

Ireland 445 426 401 398 2,000

Othercountries 1,896 1,890 1,849 2,024 62,000

ofwhichRussia 156 163 171 171 40,000Worldtotal(rounded) 10,146 10,447 11,129 11,702 540,000

Source:ILZSG,USGeologicalSurvey,MineralCommoditySummaries,Jan2010

Nevertheless,Russianzincreservesareamongthelargestintheworld.Theestimates

ofthesereservesdifferbysource(weuseABC1reservesquotedinRussiansources);however,itranksamongthetopthree.


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Ironicallythen,Russiaisatpresentessentiallyshortofzincconcentrate. Thisis

anotherlegacyoftheSoviettimes.FollowingthebreakupoftheSovietUnion,around

80%ofthereservebaseandaround50%oftheconcentrateprocessingcapacitywas

lost(themajorityofzincminingandconcentratingcapacitywasbasedinKazakhstan,

withsomeinUzbekistan).Asaresult,thecurrentRussianzincconcentrateoutputcan

coveronlyaround70%oftheinternalzincrefiningcapacity.InFigure24we

summariseRussianzincconcentrateoutputbyenterprise.

Figure24:Russianzincconcentrateproductionbycompany(ktofcontainedmetal) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

UMMC 96 102 115 123 124 124 129 124 122 115

ofwhich:

GaiskiyGOK 12 10 13 12 12 9 8 8 6 6UchalinskyGOK 84 92 102 111 112 115 121 117 116 109

RMKTotal 11 12 12 10 12 12 18 28 30 23

Dalpolimetal 20 18 23 22 19 19 16 19 19 15

Grosstotal 127 132 150 156 155 156 163 171 171 153


UMMCandRMKremainthemainsupplierstotheRussianmarket,withUMMC

producingaroundthreequartersofthecurrentRussianzincconcentrateoutput

(Figure25).

Figure25:UchalinskyGOKremainsthemainzincconcentratesupplierinRussia



UGOK

70%

Other

Co's

26%

UMMC

other

4%

Source:Reuters,Companydata

DalpolimetalslocationintheFarEastofRussiamakesthetransportationofzinc

concentratetosmeltersinthewesternpartsofthecountryuneconomic.Therefore,its

zincconcentrateoutputisexported.Russianzincrefinerieshavetorelyonimports

fromKazakhstan,UzbekistanandnonCIScountriestosatisfytheirproduction

requirements.

Russianzincconcentrateproductioncouldincreasebyover100%byYE13whenthe

Ozernoedepositisexpectedtocomeonstream,withforecastcapacityofaround250

300ktofzincequivalentinconcentrateatpeakproduction,accordingtooperator,East

SiberianMetalsCorporation(MBC).OzernoecouldbefollowedbyHolodninskoe

deposit(alsooperatedbyMBC)shortlyafterthat.About50%oftheoutputfromthose

depositscouldbeexported.Thesedevelopmentsalongwithsomesmallerfields,as

wellascapacityincreasesatexistingfacilities,shouldensurethatRussianrefinedzinc

productionbecomesalmostfullyselfsufficientinzincconcentrateby2020,as

envisagedbytheRussianMetalsStrategy2020.

Intermsofrefinedzincproduction,theRussianmarketisevenmoreconcentrated

thanforcopper.DuringSoviettimesRussiahadthreerefineries.Oneofthem,Belovo

Metallurgicalplanthasbeenidleforaconsiderablelengthoftimeandnoplansto


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1

9

revivetheplanthavebeenannounced.AsaresulttheRussianmarketissuppliedby

tworefineries:ChelyabinskZincandElektrotsinkinVladikavkaz,controlledbyUMMC

(Figure26).

Figure26:OnlytwocompaniesproduceallofRussiasrefinedzinc

BreakdownofRussian

refinedzincproduction(2009E)

Chelyabinsk

Zinc

55% Elektrotsink

45%

Source:Reuters,CompanyData

ThemarkethasbecomeevenmoreconcentratedafterUMMCandRussianCopper

Company(RMK)completedthepurchaseofa58%holdinginChelyabinskZinc.Asa

resultUMMChasbecomepracticallyamonopolyinrefinedzincproductioninRussia.

Figure27belowgivesabreakdownofRussianrefinedzincoutputbyplant.

Figure27:Russianrefinedzincproductionbycompany(kt) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

ChelyabinskZinc 146 156 166 177 152 116 148 165 166 120

Elektrotsink 81 81 88 75 81 90 88 88 98 90

Grosstotal 227 237 254 252 233 206 236 253 264 210


Refinedzincusagesteelmakersinthelead

Intermsofzincrefiningandrefinedzincconsumption,theworldslargeststeel

producingcountriesare,unsurprisingly,inthelead(Figure28).

Figure28:Majorrefinedzincconsumingcountries(2008)

Refinedzincproduction Refinedzincusage

China 3,913 4,015

US 286 1,003

Japan 616 485

Germany 292 564

SouthKorea 739 504

Russia 262 222

Source:

ILZSG,

Metals

Strategy

2020

Thesituationisnotsurprisinggiventhatthemajorityofglobalzincproductionisused

inprotectingzincandironagainstcorrosion,asdiscussedabove.

Intermsoffinalapplication(i.e.areasoffinaluseforzincbasedorzinccovered

products)about32%ofglobalrefinedzincoutputisusedintheproductionofvehicles,

machineryandengineering,witharound45%ofzincusedinconstruction.The

remaindergoestovariousconsumergoodsandelectricalequipment(Figure29).


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2

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Figure29:Russianzincuseinconstructionandotherareasisstilllow

Globalzincusagebyend use

(2003)

Construction

45%

Transport,

general

engineering32%

Consumer,

electrical

23%

Russianzincusagebyend use

(2007)

Other

10%

Transport,

machinery,

engineering

70%

Construction

20%

Source:InternationalZincAssociation,Russian2020MetalsStrategy

InRussia,theultimateusesofzincandzincproductsdifferconsiderablyfromglobal

trends,withthemajorityendingupinvehicleandmachinerymanufacturingand

generalengineering.Onlyabout20%ofrefinedzincisaccountedforbyconstruction

relatedapplications.

Exposuretomachineryandvehicleproductionwasoneofthereasonsthat,we

believe,allowedRussianzincconsumptiontoremainreasonablyrobustduringthe

economiccrisis.AscanbeseenfromFigure30,followingadifficult4Q082Q09,

productionofHotDipGalvanised(HDG)sheetbyRussiansteelmakershasrecovered

strongly,evenapproachingprecrisislevelsin3Q09.Thedipin4Q09wasmainly

seasonal,inourview,andtherecentsteelproductionfigures(JanFeb2010)remain

quitestrong.

Figure30:RussianHDGtradedynamics

450

623 618

527481

584

358

260

599

501

788

329

200

0

200

400

600

800

1

Q07

2

Q07

3

Q07

4

Q07

1

Q08

2

Q08

3

Q08

4

Q08

1

Q09

2

Q09

3

Q09

4

Q09

'000tonnes

Production Export Import Apparentconsumption

Source:MetalCourier

Statesupportoftheautosector,aswellasincreasedinfrastructurespending,werethe

maindriversbehindtherevivalofdemandforgalvanisedsteel,inouropinion.In

addition,Russiansteelproducersmanagedtoincreasetheirexportsales,primarilyto

theCIScountries.

Asaresult,theapparentconsumptionofzincinRussiawasmarginallyupduring2009,

increasingbyjustover6%YoY,toaround220kt(Figure31)


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2

1

Figure31:Russianzincproductionandconsumptiontrends

246219

83115

174195 206 209

267322

222

217 267

410

300

100

0

100

200

300

400

500

2003

2004

2005

2006

2007

2008

2009

2010E

2011E

2015E

2020E

Production(inert) Production(innovative)Netimport(inert) Netimport(innovative)Apparentcons(inert) Apparentcons(innovative)

Source:Russian2020MetalsStrategy,InfoGeo,Atonestimates

Weexpecthigherinfrastructurespendingtobethemaindriverbehindrefinedzinc

consumptiongrowthinRussiaintheshorttomediumterm.Anumberof

infrastructureprojectsareeitherunderconstructionoralreadyapprovedtheSochi

Olympics,the2012APECsummit,tonamejustafew,togetherwithawholehostof

federalroadandbridgeconstructionprojects(seeourSpecialSituationsteamsreport

BridgeoverTroubledWater,23Mar,foradetailedreviewofthemainRussiantransportationinfrastructureprojects).Theseschemeswillcallforincreasedamounts

ofzinc,givenitsprimaryfunctionasaprotectorofsteelusedinconstruction.

AccordingtoUMMC,Russiahasover40enterprisesprovidinggalvanisingservices

(includingtherecentlycommissionedplantatUELM).Anumberofsteelgalvanising

facilitiesarecurrentlybeingbuiltaroundRussiatoenablewideruseofsteel

galvanisingforconstructionpurposes.

TheRussianMetalsStrategy2020envisagesthattheshareofconstructionintotalzincconsumptionwillrisefromthecurrent20%toaround33%by2020.Asaresult,

Russianrefinedzincconsumptionisforecasttoincreasefromaround200ktpa(2010)

tobetween260300ktby2015and300400ktby2020(Figure31).


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LesspublicisedistheChinesecurrencysroleTheChineserenminbi(RMB)remains

closelypeggedtothedollar,virtuallyreplicatingtheUScurrencysmovesagainstother

currencies(includingtheeuro,forinstance).Therefore,webelievethatChinese

demandforcommoditiesshouldnotbeaffectedtoanygreatextentbyfuturedollar

appreciation.Onthecontrary,anyweaknessincommoditypricesonthebackofa

strongerdollarcouldonceagainbeusedbytheChineseasanopportunitytorestock.

RoubleappreciationismoreconcerningfortheRussianproducers.Whatismore

seriousforRussianbasemetalproducersisnotthestrengthofthedollarvstheeuro,

butrathertheongoingstrengtheningoftheroubleagainstbothcurrenciesontheback

ofstableoilprices.Astrongerroublemeansthatwhentranslatingcompanyfinancials

intoUSdollarsforvaluationpurposes,weendupwithconsiderablyhigherdollar

denominatedcosts,squeezingtheprofitmarginsonwhichwerelyforourassessment

ofthecompanysinvestmentappeal.

LiquiditytighteninginChinaisyettohaveanynoticeableimpact

TherecentjumpintheChineseCPIratehasreignitedfearsofliquiditytighteningby

thecountrysgovernment,whichmayresultinacontractionindemandfor

commodities.Theseworriesareoverrated,inourview.

TheChinesegovernmenthasalreadyputinplaceanumberofmeasurestoreduce

banklendingandlimitexcessliquidity:thepaceofYoYgrowthinbanklendingslowed

fromaround34%to30%throughout4Q09.Andwhilewearecertainthatthe

governmentwillcontinuethisagenda,wetendtoagreewithmarketcommentators

whoexpecttheChineseauthoritiestofavourgradualcoolingoverabruptanddrastic

cuts.Indeed,asweseefromthereportsoninternationalnewswires,thegovernment

appearstobeaimingforanapproximately10%annualgrowthrate,whichwouldbea

majorbullishfactorforcommodities.Moreover,judgingbytherecentofficialstatistics

oncommodityimportsintoChina,liquiditytighteningmeasureshaveyettohaveany

noticeableimpactonthecountryscommoditiesappetite.

Figures33and34,illustratetherecenttrendsintwoofChinasmaincommodity

imports,copperandironore,oftenusedasproxiesfordemandforthesematerialsin

theglobalmarket.Chineseunwroughtcopperandcopperproductsimportsrose42%

MoMinMarch,to456kt(justbelowthealltimehighof477ktreachedinJune2009).

IronoreimportsalsoincreasedinMarch,rising20%MoM,tojustover59mnt.

RealDemandorJustStockpilingandSpeculation?

The

unprecedented

growth

in

Chinese

commodity

imports

throughout

2009

and

the

lackoftransparencywithregardstotherealstateofthecountryseconomyand

Figure33:ChineseMarchcopperimportsrise42%MoM Figure34:whileironoreimportsgoup20%MoM

200

100

0

100

200

300400

500

Jan08

Mar08

May08

Jul08

Sep08

Nov08

Jan09

Mar09

May09

Jul09

Sep09

Nov09

Jan10

Mar10

40%

20%

0%

20%

40%

60%80%

100%

China copperimports CopperimportgrowthMoM(%)

TightscrapmarketpushesMarchimportof

copperand copperproducts up42% MoM

20

30

40

50

60

70

80

90

Jun08

Jul08

Aug08

Sep08

Oct08

Nov08

Dec08

Jan09

Feb09

Mar09

Apr09

May09

Jun09

Jul09

Aug09

Sep09

Oct09

Nov09

Dec09

Jan10

Feb10

Mar10

mntonnes

Chinaironoreimports Ironorestocksat Chineseports

despite the holidaysand iron

oreimportsrising6%and 20%

MoM,respectively, inFebMarch

Ironorestocksat Chinese portsincreasedonly

marginallyinFebruaryMarch2010...

Source:Bloomberg Source:Bloomberg


24/62

2

4

manufacturinghaveledmanytobelievethattheincreaseinimportswasdueto

stockpilingandspeculationratherthananindicationofgrowingrealdemandfor

commodities.OneofthemajorconcernsamonginvestorsisthatChineseproducers

hadstockpiledsufficientrawmaterialinventoriestolastforseveralmonthswithout

theneedforreplenishment.

Wewouldagreethattheincreaseincommodityimportsin1H09wasdrivenprimarily

bythedesiretoreplenishrawmaterialinventorieswhilepriceswerelow.However,

importshavesubsequentlynormalisedand,whileaspeculativeelementmaystillbein

play,ourviewisthatthecurrentcommodityimportlevelsgiveamoreaccurate

reflectionofrealdemandinthecountry.Thereisplentyofstatisticalandanecdotal

evidenceinthemarkettosupportthis.

ReturningtoFigure34,itisinterestingtonotethatdespitetheshortmonthof

February(furthershortenedbytheChineseNewYearholidays)ironorestocksat

Chineseportsincreasedonlymarginallyduringthemonth.Stocksstoodat69.6mntat

theendofFebruary,upjust2%fromtheendofJanuary,whileironoreimportsinto

Chinaincreased6%MoMinFebruary.This,webelieve,wouldimplythatstock

drawdownbysteelmakersremainedstronginFebruary,suggestingthatatleastapart

oftheironoreimportswentstraightintosteelproduction,ratherthansimplybeingaccumulated.ThepaceofdrawdownbecameevenmoreapparentinMarch,withiron

oreimportsincreasing20%MoM,whileportstocksincreasedtoaround71.5mnt,

whichisgrowthoflessthan3%.

Moreover,accordingtoMarceloAwad,CEOofAntofagasta,oneofthemajorcopper

producers,speakingattheReutersMiningSummitrecently,thecompanyssales

representativestoChinahavereportedthatthefabricatingplants,whichareamong

themainconsumersofrefinedcopper,wererunningclosetocapacity.Assuch,the

companybelievesthatcurrentimportdemandisverymuchreal.

Chineseinternalproductionlevelscannotbeusedasanindependentindicationof

demand

unless

there

is

evidence

that

the

output

is

generating

revenue

instead

of

simplybeingaddedtoinventory.Inthisregard,webelievethatChineseexportsmay

beoneofthemaindrivingforcesbehindthecountrysmanufacturingefforts.In

FebruaryandMarchthesehavecontinuedtheirsurge,postingincreasesof46%and

24%YoY,respectively.Thefigureswerequiteobviouslydrivenbythelowbasefactor

(thevalueofexportsinFeb2009cameinataround$65bn;inMar2009itwasjust

over$90bn).WehavethereforelookedattheabsolutelevelinsteadofsimpleYoY

comparisons.AscanbeseenfromFigure35,despitetheseasonalslowdowninJanFeb

2010,exportsin1Q10wereactuallyslightlybetterthanin2008,theyearofrecord

exportsfromChina($105bnin1Q10vs$102bnin1Q08).

Figure35:Yetanotheryearofrecordexportsinthemaking? Figure36:Although,notallexportsaresurgingyet

40

302010

0

102030405060

70

Jan08

Mar08

May08

Jul08

Sep08

Nov08

Jan09

Mar09

May09

Jul09

Sep09

Nov09

Jan10

Mar10

%

80

6040200

20406080100120

140

$bn

ValueofChinese exports ChineseexportYoYchange%

2009average exportvalue

Chinese exportssustainedtheir

positivegrowthmomentuminMarch

Chinese exportvaluesinJan Mar'10are similarto

levelsofJan Marof2008,the yearofrecordexports

2000

1000

0

1000

2000

3000

4000

5000

6000

7000

8000

Jan08

Mar08

May08

Jul08

Sep08

Nov08

Jan09

Mar09

May09

Jul09

Sep09

Nov09

Jan10

'000t

Steelproductimport Steelproductexport Netexport

Theperiodofbeingnet importer

ofsteelwas shortlived...

althoughChinese steelexports

are yettorecovertopastpeaks



25/62

2

5

GiventhestateoftheeconomiesofChinasmaintradingpartners,wewouldnotgoas

farassuggestingthatChinaisonthevergeofrepeatingitsstellar2008export

performance.AsFigure36shows,notallindustrialexportsaredoingwell.The

anaemicsteelexportlevelcouldbeexplainedbythelackofrealdemandforsteelin

theregionalmarketsthathavenotexperiencedthesameamountofstimulusdriven

growthasChina.Moreover,Chineseexportsofcertaintypesofsteelwererestrained

byrestrictivequotasimposedbytheUSandEU.Finally,growinginfrastructure

spendinginChinaonthebackofstimulusspendingcouldalsohavedivertedalarge

partofthesteeloutputtowardsinternalprojects.Thispicturecouldchangeinthe

comingmonths,oncetherestoftheworldenterstherestockingphase.

Restockingwhenwilltherestoftheworldfollowsuit?

WhileChinahasbeeninrestockingmodeforoverayear,thesamecannotbesaidfor

othermajoreconomies.Theresultsoftheeconomiccrisishavebeensosevereandthe

recoverysoslowincomingthatthemanufacturingindustriesintheUSandEurope

havespentalmosttwoyearsindestockingmode(i.e.runningdownthebuildupof

excessstockratherthanmanufacturingnewproducts).IndustrialproductionintheUS

andEUhadfallenbyasmuchas13%and20%YoY,respectivelybythemiddleof2009

andhasjuststartedtomoveintopositivegrowthterritory,helpedtoalargeextentby

thelowbasefactor(Figure37).

Figure37:Industrialproductioninkeyeconomies(YoYchange%) Figure38:GDPgrowthinkeyeconomies(YoYchange%)

25%

20%

15%

10%

5%

0%

5%

10%

15%

20%

25%

Jan06

Apr06

Jul06

Oct06

Jan07

Apr07

Jul07

Oct07

Jan08

Apr08

Jul08

Oct08

Jan09

Apr09

Jul09

Oct09

Jan10

%chgyoy

China China5Yaverage US Eurozone

Afterthesurgeof'09,Chinese IPgrowth

rateis backtoits 5Yaveragelevels...

whilebothUSand Europeare starting

toshowsomesignsofrecovery

10%

5%

0%

5%

10%

15%

20%

1Q03

4Q03

3Q04

2Q05

1Q06

4Q06

3Q07

2Q08

1Q09

4Q09

%chgyoy

China US Eurozone

ChinaGDPgrowthrate

continuestogainmomentum...

whileUSand EUappear

tohavestabilised


AndthisindustrialproductionrecoveryintheUSandEUisgraduallybeingreflectedin

theratesofeconomicgrowth.AlthoughquarterlyGDPgrowthratesinthedeveloped

worldstillremaininnegativeterritory,theyaretrendingup,raisinghopesofpositive

growthin2010(Figure38).

Weexpectthattheearlystagesofthatgrowthwillbedrivenbyrestocking,ratherthan

therecoveryofrealdemand,asthemanufacturingsectorwillhavetorebuildheavily

depletedinventories.Wehavealreadyseensomeevidenceofrestockinginsteelandit

appearsthattheprocessisabouttocommenceinthebasemetalsmarket.

Figure39illustratesthedrawdownofLMEcopperinventoriesduring2009ontheback

ofChinesebuying.Theprocesstookplaceintwostages:initialpurchasesatthe

beginningoftheyearwerefollowedbyamuchstrongerdrawdowninAprMay2009,

thetraditionalseasonforcoppermarketrestocking.Asaresult,LMEcopper

inventoriesdipped53%fromthepeakofaround550ktattheendofFeb2009tothe

lowofaround257ktinmidJuly2009.


26/62

2

6

Figure39:Copperrestockingin2Q10couldindicatethetruestateofdemand

0

100

200

300

400

500

600

01Jan08

01Mar08

01May08

01Jul08

01Sep08

01Nov08

01Jan09

01Mar09

01May09

01Jul09

01Sep09

01Nov09

01Jan10

01Mar10

0%

5%

10%

15%

20%

25%

30%

LMEstock('000tonne s) Ca nce ll edwarrantsas %ofLMEstock

Judgingbythe numberofcancelledwarrants,

copperstockat LMEis expectedtogodown...

...but2Qwithdrawals

are keytoasustained

stockreduction

Source:Bloomberg

Thisprocessmayberepeatedthisyear,albeitatalessdramaticpaceduetoreduced

purchasesbyChina.Thenumberofcancelledwarrants,themainindicatorofthesize

ofthecopperinventorywaitingtoleavetheLMEwarehouses,hasrisenthrough1Q10

andstoodatjustover5%ofthetotalstockinmidMarch.AsaresulttheLMEcopper

inventoryhasfallen8%fromthe555ktpeakattheendofFeb2010toaround511ktat

thetimeofwriting.

ThekeydifferencebetweentheMar2009andMar2010figuresisthegeographical

spreadofthecancelledwarrants(LMEhaswarehousesaroundtheworldtoeasethe

deliveryofphysicalmetaltocustomers).In2009,around55%ofcancelledwarrants

werefordeliveriesfromwarehousesinAsia,withtherestbeinginEurope.TheUS

warehousessawvirtuallynoactivityatthetime.Thistime,however,around32%of

thecancelledwarrantsrelatetodeliveriesfromtheUSwarehouses,45%fromEuropeandjust23%fromAsia.Thiscouldindicatethatsomeinterestincopperisreemerging

intheUSandEurope.Indeed,coppermanufacturershavereportedanincreasein

ordersfromthoseeconomies.

Whileitistooearlytointerprettheabovepictureasanindicationofdemand

resurgenceintheUSandEU,wecouldinterpretitasasignthatrestockingby

manufacturersinthosemarketsisalreadyunderway.AswemoveintotheAprilMay

restockingperiodforkeycopperconsumers,wewillwatchthedrawdownofLME

copperinventoriescloselyasanindicationofthesupplydemandbalanceinthe

marketandthepaceofrestockinginthekeyglobaleconomies.


27/62

2

7

Companies


28/62

2

8

WeinitiatecoverageofGaiskyGOK(GGOK)withaBUYratingandafairvalue

estimateof$671/share,representing124%upsidepotential.Thecompanylooks

undervaluedbothintermsofourDCFvaluationandacomparisonwithdeveloped

andemergingmarketpeers.Moreover,therecoveryinbasemetalpriceshasyetto

bereflectedinthestocksperformance.

Figure1:GGOK:Russiassecondlargestcopperconcentrateproducer

GGOK'sshareofRussiancopperin

concentrateproduction (2009E)

Norilsk

69%

Other

Co's

3%

UMMC

other

17%

GGOK

11%

ShareofABC1reservesoflargest

Russianproducingdeposits(2007)

Oktyabrskoe

(Norilsk)

50%

Gai

(UMMC)

15%Talnakhskoe

(Norilsk)

25%

Yubileynoe

(UMMC)

5%

Volkovskoe

(UMMC)

5%

Source:Reuters,InfoGeo,ResearchBureauMineral,Companydata,Atonestimates

Organicgrowthexpectedthroughcapacityexpansion.GGOKsinvestmentprogrammeisaimedatincreasingthethroughputcapacityofitsenrichmentplantby

33%(from6mtpato8mtpa)byend2013,whichwillboostcopperandzincoutput.

Thecompanyexpectsa42%increaseincopperconcentrateproductionbyend2013.

Copperconcentrateandgoldoutputmakeuparound86%ofthecompanystotal

sales.Withtheexpansionoftheenrichmentplantcapacity,thecompanybelievesits

copperconcentrateproductionshouldjumpbyupto42%byend2013.GGOKhasalso

indicatedthatitsgoldandsilveroutputwouldremainflatgoingforward.

Mostbasemetalpricesexpectedtorecovertoprecrisislevelsin2010.The

Bloombergconsensusestimatesthatweuseinourcalculationshowthemarket

expectscopperpricestoreturntoprecrisislevelsin2010,implyinganaverageprice

of$6,875/t,up32%YoY,($7,265/tin1Q10),beforehittinganewaveragehighof

around$7,358/tin2011.Zincisexpectedtorise37%YoYin2010,toaround$2,307/t

($2,306in1Q10),beforetradingatanaverageof$2,513/tin2011.

Ourvaluationsuggeststhestockhasupsidepotentialof124%.BothourDCFmodel

andcomparativeanalysissuggestthatthemarkethassignificantlyundervaluedGGOK:

thecompanytradesata66%discounton2010EEV/EBITDAtodevelopedmarket

competitorsanda77%discounttoemergingmarketcompetitors,whileourDCF

valuationof$565/sharesuggests88%upsidepotentialtothecurrentshareprice.In

addition,whilemostmetalspriceshavealmostrecoveredtoprecrisislevels,GGOK

stilltradesathalfitsprecrisispeak,whichisnotjustified,inourview.

GAISKY GOKCopper Whopper

BUY

Fair value $671

Potential upside 124%

Bloombergcode GGOKRU

Reuterscode GGOKI.RTS

Price(ordinary,$) 300.0

Price(preferred,$) n/a

Potentialupside(%) 124%

Potentialupside,prefs(%) n/a

ADRratio(x) n/a

Sharedata

No.ofordinaryshares(mn) 0.6

No.ofpreferredshares(mn) n/a

Dailyturnover($mn) 0.02

Freefloat(%) 15.4%

Marketcapitalisation($mn) 185

Majorshareholders

UGMK 84.6%

FINANCIALS($mn) 2009E 2010E 2011E

Revenue 282 369 412

Grossprofit 97 172 192

EBITDA 91 164 183

Netincome 35 87 97

EPS(USD) 57 140 157

Grossdebt 232 283 298

Equity 233 320 416

Assets 510 644 760

VALUATION

P/E(x) 5.3 2.1 1.9

EV/EBITDA(x) 4.4 2.4 2.2

Earningsgrowth(%) 319% 145% 12%

P/B(x) 0.8 0.6 0.4

RoA(%) 6.9% 13.4% 12.7%

RoE(%) 15.1% 27.1% 23.2%

PERFORMANCE

1M(%) 9%

3M(%) 16%

12M(%) 216%

52weekhigh($) 300.00

52

week

low

($)

95.00


29/62

2

9

Companybackground

GGOKisthesecondlargestcopperconcentrateproducerinRussia,afterNorilskNickel.

Copperconcentrateandgoldbarsareitsmainproducts,whichweexpectcontributed

upto86%ofsalesin2009.Weforecast2009copperinconcentrateproductionof78kt

(+4%YoY)andgoldoutputof1.6tonnes(4%YoY).GGOKsellsitsconcentrateto

majorityownerUMMCanditsgoldbarstoGazprombank.Concentratetransactions

areata4849%discounttoLMEcopperandzincprices.

GGOKoperatesthreepolymetallicdeposits,withtotalorereservesofmorethan

300mnt,andalimestonemine(Figure2).Atthecurrentenrichmentplantcapacityof

6mntpa,theassetslifespaniscalculatedtobearound50years(disregardingany

followupexploration).

Figure2:Reserves

Deposit MineralOrereserves,

mnt

Annualmining

capacity,ktpa

Lifespan,

years

Gaiskoye Cu,Zn,Au,Ag 300 5,000 50

Kamenskoye Au,Ag 1 300 1

Osennee

Cu,

Zn,

Au,

Ag

7

500

2

SeveroIrklinskoye Limestone

Source:Companydata

GGOKownsfourotherdepositsinvariousstagesofdevelopment,butweexpectsthis

supplementaryresourcebasetosubstituteretireddepositstoallowthecompanyto

maintainproductionatcurrentlevelsratherthanboostitsproductionvolumes.

Ownershipanddividends

UralsMiningandMetallurgicalCompany(UMMC)isthemajorityownerofGGOK.Total

freefloatamountstoaround15%,allowingthedailyvolumetradedtoaveragearound

$25,000overthepastthreemonths.

Figure3:Ownershipstructure

UMMC,

84.6%

Free

float,

15.4%

Source:Companydata

Alowfreefloatandthepresenceofasinglemajorshareholderareoftencitedasrisks

forminorityshareholdersinRussia.Moreover,inGGOKscasethelowtransparencyof

theparentcompanymayposeahighercorporategovernancerisk.Inthepastsome

Russiancompanieshavelaunchedhostileanddilutiveshareissuesandengagedin

otheractivitiesthathavefloutedthewishesandrightsoftheirminorityshareholders.

Onthepositiveside,GGOKsfreefloathasremainedstablesince2006.Moreover,the

companycurrentlyfinancesitsexpansionprogrammebyincreasingborrowings,not

ThetotallifespanofGGOKassetsis

around50years,disregardingfollowup

exploration

Freefloatis15%,or$26mnbasedonits

currentmarketcap


30/62

3

0

throughissuingequity.Henceweconsidertheriskofnewshareissuesandfreefloat

dilutiontobelow.

GGOKhasnotpaidanydividendssince1993,whenitwasincorporatedintoanopen

jointstockcompany(OJSC).Withthecurrentinvestmentprogrammeinfullswing,we

wouldnotexpectanydividendpaymentsinthenearfuture.

ProductiongrowththroughcapacityexpansionGGOKproducescopperandzincconcentrates,goldandsilver.Through200508

copperconcentrateoutputremainedrelativelyflatataround75ktpa.Changesin

productionofothermetalswerealsoinsignificant.Copperconcentrateproduction

shouldaccountforaround93%ofthecompanysoutputandaround70%ofsales.

Althoughtheshareofpreciousmetalstototalproductionisminor,itaccountsfor

around22%ofsales(Figure4).

Figure4:Salesvolumesandrevenuebreakdownbyproduct

Sales volume breakdown(2009E)

Copper

93.4%

Silver

0.03%

Gold

0.002%

Zinc

6.6%

Revenuebreakdown (2009E)

Other

7%

Zinc

2%

Gold

17%

Silver5%

Copper

69%


Recently,

the

company

reported

that

in

2009

its

output

of

copper

in

concentrate

grew

4%YoY,to78kt,althoughgoldoutputfell4%YoYto1.6tonnes.

ThecurrentcapacityofGGOKsenrichmentplantisaround6mntpaoforeprocessing.

Bytheendof2013thecompanyplanstoincreaseitscapacityby33%to8mntpa.This

shouldresultinefficiencyimprovements,leadingtoanincreaseincopperandzinc

production.Thecompanyexpectstheexpansionoftheenrichmentplanttoboost

copperinconcentrateproductionto111kt(up42%)andzincto7.7kt(up39%)

respectivelybyYE13,althoughwehavemodelledamoregradualincreaseinoutput

(Figure5).Thecompanyhasalsoindicatedthatitsgoldoutputwouldremainrelatively

flatgoingforward.

Figure

5:

Production

schedule

75 75 78 7985 90

97 1041118 6 6

6

6

78

7

6

50

60

70

80

90

100

110

120

130

2007

2008

2009E

2010E

2011E

2012E

2013E

2014E

2015E

Copper,kt Zi nk,Kt


Copperoutputforecasttoincreaseby

upto42%,to111ktby2013

Copperandgoldremainkeyproducts,

generating86%ofrevenue,withzinc

andsilvercontributinganother7%


31/62

3

1

Financialsproductiongrowthandmetalpricesarethemajordrivers

GGOKshowedaconsiderableimprovementinfinancialsthrough200308,mainlyon

thebackofmetalpriceincreases.Inparticular,revenuegrewataCAGRof44%,from

$88mnin2003to$260mnin2006,whenEBITDAandnetincomemarginsreached

peaksof43%and26%,respectively.However,marginsweresubsequentlycurbedbya

considerableincreaseinCoGSandSG&Aexpenses,pushingthe2008EBITDAmargin

down23%andthenetmarginto3%,althoughwebelievethatpartofthatreduction

wasduetothesharpfallincopperpricesin2H08(Figure6).

Figure6:Breakdownofkeyfinancials

0%

20%

40%

60%

80%

100%

2006

2007

2008

2009E

2010E

Netincome Incometa xOtherexpense(net) Interestexpense,(net)SG&A CoGS


Our2009forecastisbasedonGGOKs3Q09RASfinancialresultsandrecentlyreleased

productionvolumes.Whileweexpecta13%YoYreductioninrevenueto$282mnon

thebackoflowercopperandzincpricesin1H09,weforecastmarginstoimproveon

thebackofeffectivecostcontrol.Thecompanymanagedtobringdownits9M09CoGS

byaround29%vs9M08.

Wedonotexpectthecostreductiontobefullysustainablegoingforward,and

thereforeforecastGGOKsCoGStogrowataCAGRof12%in201012vsa9%CAGRin

revenuesduringthatperiod.However,wedoanticipatethatthelowercostbasewill

haveapositiveimpactonmargins,assummarisedinFigure7below.

Figure7:Keyfinancialfigures($mn)

2005 2006 2007 2008 2009E 2010E

Sales 148 260 302 325 282 369

EBITDA 37 111 104 75 91 164

EBITDAmargin 25% 43% 34% 23% 32% 44%

Netincome 17 67 53 8 35 87

Netmargin 12% 26% 18% 3% 13% 23%


Weforecastrevenuegrowthof31%YoYfor2010,to$369mn,drivenbyhighermetal

pricesandanincreaseincopperoutput,whichweexpecttorise2%YoYtoabout79kt.

WeexpectthistogenerateanincreaseinEBITDAof79%YoYto$164m,withnet

incomeclimbing145%YoYto$87mn,demonstratingthefirmsoperationalleverage.


32/62

3

2

Debtloadismanageable

GGOKsdebtpositionremainsmanageable,inourview.Bytheendof2009weexpect

grossdebtofaround$232mn,withlongtermdebtaccountingformorethan90%of

thetotal.Thisimpliesagrossdebt/EBITDAratioof2.5x,downfrom3.2xattheendof

2008(Figure8).

Figure

8:

Debt

load

0

100

200

300

400

2005

2006

2007

2008

2009E

2010E

2011E

2012E

2013E

2014E

2015E

0.0

1.0

2.0

3.0

4.0

Gross debt(LHS $mn) EBITDA(LHS $mn)

Gross debt/EBITDA(RHS)


Duetotheongoingexpansionprogrammeweexpectthedebtloadtoremainstablein

thenearfuture.Nevertheless,weconsiderthecurrentlevelofdebttobemanageable

aswebelievethatinternallygeneratedcashflowsshouldbemorethansufficientto

servicefuturerepaymentcommitments.Moreover,GGOKshouldbeabletorelyon

theongoingsupportofitsparentcompany,UMMC,forwhichitisthekeyproducing

asset.

Valuation

WebaseourvaluationonaweightedaverageofourfiveyearDCFcalculation,withacombinationof6x2010forecastP/Eand4x2010forecastEV/EBITDAmultiples,taken

inproportion50:25:25,respectively.OurDCFmodelassumesaterminalgrowthrateof

1%andaWACCof11.9%.Thisresultsinafairvalueestimateof$671perordinary

share,implying124%upsidepotential(Figure9).WethereforeratethestockaBUY.

Figure9:Elementsoffairvaluecalculation($/share)

717671

840

563

300

0

200

400

600

800

1000

Current

share

price

DCF

P/E

EV/EBITDA

Fairvalue


Withinthisvaluation,webelieveourDCFcalculationallowsustoincorporatenotjust

thecurrentfinancialpositionofthecompanybutalsoitsvisiblefuturedevelopment

opportunities.WesummariseourDCFapproachinFigure10below.

Grossdebt/EBITDAratioisaround2.5x


33/62

3

3

Figure10:GGOK DCFmodel($mn,unlessotherwisestated)

2010E 2011E 2012E 2013E 2014E 2015E

NOPLAT 114 128 127 78 59 63

Amortisation 28 31 33 31 32 34

Capex 100 83 67 31 32 34

ChangeinWC 6 10 11 3 8 5

FCFF

36

66

83

81

51

58

WACC(%) 11.9%

DiscountedFCFs 270

Terminalvalue 290

Netdebt,2009E 212

Fairequityvalue 348

Numberofshares(mn) 0.6

Fairvalue($/share) 563


OurDCFvaluationincorporatesGGOKsgrowthplans,andresultsinafairvalue

estimateof$563pershare.Inourdownsidescenario,wealsoconsideredascenario

whereproductionvolumesremainflat,withthecompanysimplyseekingtomaintain

marginsattheirfiveyearhistoricalaverage.ThiswouldresultinaDCFof$455/share,

whichrepresents52%upsidetothecurrentshareprice.

WehavealsolookedatthesensitivityofourfairvaluecalculationtovariousWACCand

terminalgrowthrateassumptions,assummarisedinFigure11below.

Figure11:FairvaluesensitivitytoWACCandterminalgrowthrateassumptions Terminalgrowthrate

WACC 0.0% 0.5% 1.0% 1.5% 2.0%

9.9% 730 747 765 786 809

10.9% 686 699 713 729 747

11.9% 649 659 671 683 697

12.9% 618 626 635 645 656

13.9% 591 598 605 614 622


OurcomparativeanalysisgivesanideaofGGOKsupsidepotentialinlightofthe

currentmarketenvironmentandgeneralinvestorattitudetowardsthesector.We

havecomparedGGOKwithRussianpeersandcopperproducersfrombothdeveloped

markets(DM)andemergingmarkets(EM).

AsshowninFigure12below,thecompanyissignificantlyundervaluedvsDMandEM

peersonboth2010Eand2011Emultiples.Inparticular,GGOKtradesat84%and89%

discountstoDMandEMpeers,respectively,basedonitsforecast2010EP/Emultiples

(Figure12).

Figure12:GGOKcomparisonwithpeers(medianvaluationratios)

2010 2011

P/E(x) P/S(x) EV/S(x) EV/EBITDA(x) P/E(x) P/S(x) EV/S(x) EV/EBITDA(x)

Russianpeers 2.8 0.5 1.1 2.4 2.4 0.4 1.0 2.2

Developedmarkets 13.4 2.1 2.5 7.1 10.6 1.9 2.2 5.8

Premium/(Discount) 79% 76% 57% 66% 78% 76% 57% 62%

Emergingmarkets 19.0 2.4 2.3 10.8 12.7 2.1 1.9 7.8

Premium/(Discount) 85% 79% 53% 77% 81% 79% 49% 72%

GaiskyGOK 2.1 0.5 1.1 2.4 1.9 0.4 1.0 2.2

DMPremium/(Discount) 84% 76% 57% 66% 82% 76% 57% 62%

EMPremium/(Discount) 89% 79% 53% 77% 85% 79% 49% 72%



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3

4

Basedonourforecast2010EEV/EBITDAmultiples,GGOKtradesata66%discountto

DMcompaniesanda77%discounttoEMones.

WebasedourvaluationofGGOKon6x2010forecastP/Eand4x2010forecast

EV/EBITDA,resultinginvaluationsof$840/shareand$717/share,respectively.

AsummaryofourfairvaluessensitivitytovariousP/EandEV/EBITDAmultiplesis

giveninFigure13.

Figure13:FairvaluesensitivitytoP/EandEV/EBITDAmultipleassumptions P/E

EV/EBITDA 4.0 5.0 6.0 7.0 8.0

2.0 468 503 538 573 608

3.0 535 570 605 640 675

4.0 601 636 671 706 741

5.0 667 702 737 772 807

6.0 733 768 803 838 873


A

final

thought:

GGOKs

shares

still

lag

the

recovery

in

metal

prices

WehavelookedattheperformanceofGGOKsstockvsthecopperpricerecovery

sincethebeginningof2009.Figure14belowrevealstwodistinctperiodsintheprice

performancesofcopperandGGOKsshareprice.WhileintheprecrisisperiodGGOKs

sharestrackedchangesinthecopperprice,theyhavefailedtodososincethestartof

therecovery.

Figure14:PerformanceofGGOKsharesvscopperprice

0

2000

4000

6000

8000

10000

Jan07

Apr07

Jul07

Oct07

Jan08

Apr08

Jul08

Oct08

Jan09

Apr09

Jul09

Oct09

Jan10

Apr10

0

200

400

600

800

1000

Copper,$/t(lhs) GGOK,$/share(rhs)

Source:Bloomberg

Wenotethatwhilethecopperpriceisapproachingitsprecrisishighsandhasalmost

returnedto$8,000/trecently,GGOKssharesaretradingatlessthanhalftheirearlier

levels.Thisdivergenceisnotjustifiedinourview,andhenceweseethepotentialforanupwardcorrectionintheshareprice.


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KeyFinancials

Figure15:Incomestatement(RAS,$mn)

2008 2009E 2010E 2011E 2012E 2013E 2014E 2015E

Sales 325 282 369 412 439 410 423 446

CoGS 245 185 197 220 245 277 312 329

Grossprofit 80 97 172 192 194 132 111 117

SG&A 34 28 36 40 43 40 41 44

Operatingprofit 46 70 136 152 151 92 69 73

EBITDA 75 91 164 183 185 124 101 107

Interestexpense,(net) 7 27 20 23 23 14 10 11

Otherincome 12 32 29 33 35 33 34 36

Otherexpense 39 33 37 41 44 41 42 45

EBT 12 42 108 121 120 70 51 53

Incometax 1 7 22 24 24 14 10 11

Netincome 8 35 87 97 96 56 40 43

Margins(%)

Gross 25% 35% 47% 47% 44% 32% 26% 26%

Operating 14% 25% 37% 37% 34% 23% 16% 16%

EBITDA 23% 32% 44% 44% 42% 30% 24% 24%

Net 3% 13% 23% 23% 22% 14% 10% 10%


Figure16:Balancesheet(RAS,$mn)

2008 2009E 2010E 2011E 2012E 2013E 2014E 2015E

PP&E 126 123 146 164 174 174 174 174

Constructioninprogress 282 263 313 347 370 370 370 370

Totalnoncurrentassets 408 387 460 512 545 545 545 545

Inventories 35 45 40 42 44 49 56 59

Accountsreceivable 22 41 45 56 66 62 64 67

Other 27 17 19 20 21 21 23 23

Cash 3 20 80 129 177 116 121 157

Totalcurrentassets 88 122 185 248 308 249 262 306

Totalassets 496 510 644 760 853 794 808 851

Totalequity 199 233 320 416 512 569 609 652

Longtermloans 219 215 252 265 262 153 128 130

Deferredtaxliabilities 9 9 9 9 9 9 9 9

Totallongtermliabilities 227 224 261 274 271 162 137 139

Shorttermloans 20 17 31 33 33 21 19 14

Accountspayable 49 36 32 36 37 42 43 45

Totalshorttermliabilities 70 52 64 69 70 63 61 60

Totalliabilities 297 277 325 343 341 225 199 199

Totalliabilities&equity 496 510 644 760 853 794 808 851



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WeinitiatecoverageofUchalinskyGOK(UGOK)withaBUYratingandafairvalue

estimateof$20.60/share,representing42%upsidepotential.AlthoughourDCF

modelshowsonlymodestupside(duetofallingzincoutput)thestockstilllooks

undervaluedcomparedtoitspeers.DespitethelowerupsidecomparedtoGGOKor

UELM,thestockoffersastrongbalancesheet,withlowerdebtcomparedtoits

peers.

Figure1:UGOKRussiaslargestzincconcentrateproducer



UGOK

70%

Other

Co's

26%

UMMC

other

4%

UGOK'sshareofRussiancopperin

concentrateproduction (2009E)

Norilsk

69%

UGOK

7%UMMC

other

21%

Other

Co's

3%

Source:Reuters,Companydata,Atonestimates

Companyplanstoincreaseplantcapacityby20%in2012.Copperandzinc

concentratesalesaccountforaround77%ofUGOKsrevenues.Weestimatethat

UGOK(includingitsSibaysubsidiary)produced96kt ofcopperconcentrate(up5%

YoY)and109ktofzincinconcentrate(down6%YoY)in2009.Thecompanyintendsto

increaseitsenrichmentplantcapacityby20%,from5.4mntpato6.5mntpaby2012,

boostingitscopperconcentrateproductionby8%.

Zincconcentrateproductiontofall.Wehaveincorporatedcompanyguidanceonzinc

concentrateoutputinourmodel,assuminga26%reductioninproductioninthenext

fiveyears,from109ktcurrentlyto81ktin2015.Asaresult,weexpectzincssharein

revenuegenerationtodecreasefromthecurrent21%to17%in2015.

Mostbasemetalpricesexpectedtorecover

Aton - Dinnur Galikhanov - Russian Smaller Copper and Zinc Producers - 2010.04.15

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Transcript of Aton - Dinnur Galikhanov - Russian Smaller Copper and Zinc Producers - 2010.04.15