Flash notes

On August 22, various sources reported that POSCO, a leading world steelmaker, is interested in several unnamed Ukrainian assets: an iron ore mine and, possibly, a steelmaker and even a shipyard. We think that Zaporizhstal, together with CJSC Zaporizhya Iron Ore Combine, may be the targets.

According to a press release issued by Kovelmoloko, the company is going to increase its charter fund by 15.2 times to USD 58.61 mln. The final decision on increasing the charter fund is up to KMOL’s shareholders and will be made at the company’s AGM on August 27, 2008. Its management is planning to use the proceeds from the additional share issue toward the modernization and development of its assets. Our earlier target, adjusted for the share issue, is USD 0.20 per share. We reiterate our recommendation of “BUY” for Kovelmoloko.

The profitability of coke makers depends on the balance between the prices of furnace coke (70-85% of sales, used in iron & steel production) and coking coal (75-90% of costs, most important grades are K and Zh). During the week of August 11-15, Ukrainian coking coal prices increased dramatically: K grade concentrate appreciated from USD 227 to USD 378 per mt (+67%), whereas Zh grade concentrate jumped from USD 199 to USD 346 per mt (+74%) (source: Metal Courier). We fully expected such an increase (see our July 15 Flash Note) in our valuations of Ukrainian coke makers. During the same week, coke appreciated 15% (from USD 612 to USD 702 per mt), adding to the 30-60% jump during the week of July 7-11. We reiterate our valuations of the three best companies in the sector, in which such a coal price increase had been accounted for. The risk of a coke price decrease following the recent correction in steel prices is also discussed.

On August 15, Azovstal, the leading Metinvest Group steelmaker, announced its intentions to invest USD 1 bln into ecological improvements. We focus on one of the items of this program that were announced, a stepwise retirement of three coke batteries. We have long suspected that Metinvest will shut down these coke batteries eventually, which would likely secure a substantial, about 1.1-1.2 mln tpa, increase in output for Avdiivka Coke, the main Metinvest coke maker. Today’s news confirms our suspicions and strengthens the case for BUYing Avdiivka Coke.

The State Statistics Committee of Ukraine has announced CPI figures for July 2008. CPI fell 0.5% MoM, thus indicating monthly deflation for the first time since March 2006 and breaking the deflation record set six years ago. Therefore, YTD inflation went down to 14.9% (compared to 15.5% in June) and YoY inflation decreased to 26.8% (compared to 29.3% a month ago).

On July 30, Bagliy Coke launched its brand new coke battery No. 7-bis (490 thsd tpa). As a result of the launch, the output is expected to increase by 30% in 2008 (to 900 thsd mt), and further by 37% in 2009, reaching the long-term level of 1.23 mln tpa (source: Metal Courier). Source material supplies and sales should be secured through affiliation with the powerful Evraz Group, as well as due to the high domestic demand for coke. The launch increases capacity by 50%, and distinguishes the relatively small company as having the largest upside potential among the entire Ukrainian coke maker sector, which is very exciting right now.

It has just become clear that Enakievo ISW and Metalen LLC will indeed merge, and that this will happen soon. We take investors beyond overcoming these risks through the question of HOW the merger will happen. We emphasize that the minority shareholders of Enakievo ISW will be diluted 1.54 times in order to finance the acquisition of Metalen, according to the usual practice in Ukraine (Azovstal in 2006 is the most relevant example). The dilution is not a risk but a certainty, which has, for some time, been fully accounted for in our valuation of the company.

On July 11, 2008, coke prices in both Ukraine and Russia jumped 30-60%. Coal prices have much room to grow, and certainly will use some of it. This news is clearly negative for steelmakers and positive for coal mines. Our focus here is coke producers, which depend on a balance between coke and coal prices. In our view, both the profits and profitability of Ukrainian coke makers will increase even further in 2H08.

The Head of the National Bank of Ukraine (NBU) Council, Petro Poroshenko, announced that the official USD/UAH exchange rate in 2H08 will be at 4.85 UAH/USD. The official rate will not be allowed to leave a +/- 4% corridor, i.e. it must stay within the 4.65 to 5.05 range. The NBU has kept the UAH/USD exchange rate constant since 4M05, at the 5.05 level with an acceptable corridor between 4.95 and 5.25 UAH/USD.We view it as a step towards the floating exchange rate approach.

The June 06 AGM of Zaporizhstal detailed modernization plans and introduced corporate governance changes consistent with both more transparent functioning and takeover preparations. Both would be highly positive.