Press Clippings

It has been another good year for M&A teams in Russia, despite the bad publicity generated by the battle over Yukos.This year has demonstrated the great attractiveness of Russia for foreign investors even with the risks associated with Yukos. It has also shown that many Russian and CIS companies have now reached a level of maturity where an aggressive acquisition strategy is a natural part of their development.

On the face of it, 2004 was a step-back from the optimism of the Russian M&A market that existed for most of 2003. While that year began with Russia's largest foreign M&A so far — BP's US$9bn merger with TNK — 2004, by contrast, has ended with Yukos' core asset being auctioned by the state to state-owned Rosneft for a similar amount.

Yet if you look deeper, beyond the headlinegrabbing farce of Yukos, it has still been a good year for M&A.The fact that companies like General Electric, UBS and Conoco-Phillips have been prepared to make multi-million dollar investments amid the uncertainty generated by Yukos shows how attractive the Russian market is.

Indeed, it has the fastest growing telecom sector in the world, the fastest growing dairy sectors, one of the most attractive steel sectors, probably the fastest growing consumer credit sectors — and that's not even to mention oil and gas, in which Russia is, respectively, the second-biggest and biggest export in the world.

If you are a big multinational in consumer goods or commodities, you need a very good reason not to be here. And, with the Yukos situation reaching some sort of resolution, 2005 looks to be an even better year for deals.

Russians take to consumerism

In 2004, one of the best areas for M&A was the consumer sector. Incomes have risen by an average of 9% for each of the last three years, and the consumer sector as a whole has doubled in size over the last decade. Russians are taking to consumerism in a big way, with flagship stores like IKEA reporting profits up by 20% in 2003.

Many Russian consumer companies set up in the mid 1990s have now reached a critical mass, with annual turnover greater than US$50m, whereby they can hire investment bankers and work out a development strategy — either to buy other companies, or to sell out, or to float or raise debt.

Supermarket companies such as Kopeika, Sedmoi Kontinent and Pyaterochka have been among the most aggressive, expanding rapidly into the regions and increasing their store network, often through acquisitions. Sedmoi Kontinent raised funds for its continued expansion through an IPO in November 2004. Several other retail companies, including retail chain Perekryostok and food company Cherkizovsky, say they plan to do the same in 2005.

FDI in the consumer sector also stayed strong, with companies such as Danone, Coca-Cola and Heineken committing several million dollars to further investment. Heineken bought two breweries in the summer.

The consumer credit sector was one of the most exciting aspects of 2004, with Russian consumers beginning to leverage up in their acquisition of cars, fridges and other consumer goods.The consumer credit market has grown 65% since 2001, and foreign banks are jostling to enter the market.

GE Capital bought Delta Credit from the Delta private equity group for around US$150m. General Electric's CEO, Jeffrey Immelt, said in a recent meeting with President Putin that GE also plans to invest around US$200m in the energy sector over the next few years.

Also in the finance sector, UBS bought out its Russian brokerage partner, Brunswick, for around US$160m.The Swiss bank already owned 50% of the company.The management of Trust investment bank, meanwhile, bought the company from Menatep in an MBO worth around US$100m, in the middle of the 2004.

Delta Capital's sale of its consumer finance business was a rare deal in a rather quiet private equity market.This was surprising given that economic fundamentals are so strong and equity valuations are generally depressed, now would seem to be the perfect time for the big global private equity firms to turn their attention to Russian companies. Several global firms like Carlyle made initial steps into Russian in 2003, but those steps have not amounted to anything concrete so far.This is likely to change in 2005.

In the meantime, several new Russian private equity funds are taking advantage of their absence. For example, in December 2004 a private equity fund called Renova Capital, set up by Viktor Vekselberg, owner of TNK-BP and SUAL, made its first acquisition, of a pharmaceutical company called Natur Produkt.The fund is typical of the new breed of Russian PE funds — dynamic, highly aggressive, and not afraid to take risks.

Big deals in commodities, bigger to come

Meanwhile, at the top end of the market, large commodities companies were helped by record global commodity prices. Concerns about political risk, meanwhile, encouraged large commodity companies to diversify their assets by looking for acquisitions abroad. The biggest deal of the year (not including the special case of the auction of Yuganskneftegaz ), and Russia's largest privatisation ever, was Conoco-Phillips's acquisition of just over 7% of LUKoil for around US$2bn in September 2004.The deal gives the US company access to sizeable reserves, and the right to increase its stake to 20%. Many in the market saw the deal as an indication of how large energy deals could be expected to occur in the future — personally brokered by the Kremlin, with foreign investors being granted minority stakes.

In the same month,Total-Fina-Elf signed preliminary contracts for 25% plus one share in Novatek, the second biggest gas company in Russia.The deals show that, despite discouraging statements recently by some supermajors, Russia remains one of the very few markets in the world where they can hope to acquire large reserves of oil and gas.

Russian energy companies have themselves been making large deals in the CIS and beyond.To take one example, LUKoil started off the year with a US$265m acquisition of 795 petrol stations in the US, bought from its soon-to-be partner, Conoco-Phillips. Later in the year, CEO Vagit Alekperov signed deals for two new blocks of Kazakhstani Caspian Sea, and said he intended to invest a further US$13bn in Caspian projects over the next 15 years.The company also signed a US$1bn production sharing agreement for four gas fields in Uzbekistan.

But the real headlines were grabbed in 2004 by Gazprom.The Government made clear that it wanted to increase its stake in the company to a majority before it liberalised trading in Gazprom shares to allow foreign equity investors to invest without restrictions. It in the process of doing that via the swap of 10% of Gazprom treasury shares for Rosneft, the state oil company, in a deal worth around US$9bn.

Gazprom has also invested around US$2bn into the electricity sector, particularly UES and Mosenergo, over the last 12 months. Many are now trying to persuade the company and the Government to set limits on Gazprom's investments into the electricity sector, so as not to scare off other potential investors. Because Gazprom is also the supplier of gas to all electricity companies, some are concerned it could use its monopoly position in the gas market to put competitors in the electricity market at a disadvantage.

Many bankers believe that M&A in the energy market is ready to boom, as soon as the reform process is clarified by the Government. Several foreign investors are ready to invest billions of dollars even now, before the Government creates new regional electricity companies, but they need the Government to clarify which direction reform will take. It is in the hands of the Government whether this M&A boom will take place or not.

Metals and mining doing well

Companies in this sector have made great efforts to become vertically-integrated, internationally diversified, and capable of accessing markets through local subsidiaries. For example, Severstal bought Rouge Industries, the US steel company, for about US$230m in January 2004.The main point of the deal was to give Severstal access to the US market through a local operator, who would not be subject to the US' often punitive steel tariffs.

Norilsk Nickel, meanwhile, bought a 20% stake in Gold Fields, in March 2004, for around US$1.2bn, which was the biggest ever Russian cross-border deal. The deal allowed Norilsk to diversify out of both nickel and Russia.

Both Norilsk Nickel and Severstal illustrate the international ambitions of Russian commodities companies. Norilsk was the first Russian company to buy a US company, Stillwater Mining, in 2003. Severstal, meanwhile, bid unsuccessfully for Ukrainian steel mill Krivorozhstal — the company was sold to local business interests. However,Viktor Yuschenko has said that, as president of Ukraine, he will re-open the privatisation, giving Severstal another shot at the company. It is also bidding for Stelco, a US steel company.

Late in 2004, the metals market was treated to its biggest deal of the year — a management buy-out of MMK, whose management bought the Government's 23% stake for around US$790m, as well as Mechel Steel's 17% stake, for a similar amount.

The metals market is also expecting another big billion-dollar merger, of a Russian metals company and a foreign company, in early 2005.

CIS market plays

An example of how international expansion is by no means limited to Russian companies is the Donbas Industrial Union, one of the largest holding groups in Ukraine, and one of the main players in the steel sector. Over the course of 2005, the company has made several steps to become a fully vertically-integrated multinational. On the one hand, the company has bought up several iron ore mines in Ukraine and Russia to provide it with raw material. On the other hand, it has bought factories in Poland and other EU countries to give it access to the EU market without tariff restrictions. It is now looking to complete the next stage in its development, which would be a merger or strategic alliance with a foreign investor.

Other sophisticated CIS companies are looking to make acquisitions abroad. Kazakh banks, for example, are increasingly expanding abroad. Kazkommertsbank bought a subsidiary, MosKommertsBank, in Moscow, and another bank in the Kyrgyz Republic. Bank TuranAlem has also said it wants to invest around US$100m in the CIS.

Russian companies, meanwhile, are also looking to the CIS for acquisitions. In the consumer and telecom sector in particular, as the domestic markets near saturation, companies are looking to continue their excellent growth records by moving into markets like Kazakhstan and Ukraine. For example,Vimpelcom, Russia's second-largest mobile company, has been battling it out with MTS for assets in CIS countries. Both companies recognise that the amazing rate of growth in Russia's regions, with Vimpelcom adding a million new customers each month, cannot last forever.

Thus Vimpelcom made a move in September 2004 to acquire Kar-Tel, Kazakhstan's second-largest mobile operator. It succeeded in buying the company for US$350m. MTS, meanwhile, bought 75% of the largest operator in Uzbekistan, Uzdunrobita, earlier in the year.The Alfa group, one of the main shareholders in Vimpelcom, has been active too — it bought the only mobile company in Turkmenistan, Barash Communications Technology, for around US$55m this year.

The Alfa Group and Telenor, the other main shareholder in Vimpelcom, also own an operator in Ukraine, KievStar.With MTS already present in Ukraine via UMC, it is conceivable that Vimpelcom's shareholders will broker a merger between Vimpelcom and KievStar.

Another company with a strong CIS expansion strategy is Wimm-Bill-Dann, the juice and dairy manufacturer. Over the last two years the company has bought several dairies and juice companies throughout the CIS. It continued that strategy this year with the purchase of the largest dairy in Uzbekistan.

Outlook for 2005

If 2004 can be considered as a good year for Russian M&A, then many hope that 2005 will be a great year. Many large foreign companies with the intention to buy Russian companies have been waiting on the sidelines for the Yukos affair to come to some sort of conclusion before they go ahead with deals.

Political risks are still a concern. But given the remarkable growth of several markets in Russia and the CIS — by no means merely oil — then the question becomes not ‘should foreign companies enter the market?' but ‘how can they successfully manage the risks associated with the market?', particularly as those risks are unlikely to go away in the foreseeable future.

For big M&A, concerns over political risk underline the need for a local partner.That can either mean, for more straightforward deals, a local bank, familiar with the workings of the Russian governmental bureaucracy, who know which government officials' approval is needed for a deal to occur. Even multimillion dollar investments can be delayed simply because the foreign investor does not know how to negotiate the sometimes bewildering forest of Russian bureaucracy.

On the other hand, for larger deals, perhaps in the banking or energy sector, then it helps to have a local trade partner, one whose interests are fully aligned with your own, who can represent the consortium in negotiations with the Government.

Despite the ups and downs of the Russian market in 2004, an increasing number of foreign companies are deciding Russia is a place they can do business. And an increasing amount of Russian companies are using their large cash piles to expand abroad, including into the EU and US.

The Russian business community remains pragmatic.They remember the Russian proverb — ‘when things look bad, that is the time to buy. And when things look perfect, that's the time to sell'. Many believe now is an excellent time to buy.