Ukrainian Corporates and Banks

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1 Fixed Income Research Ukrainian Corporates and Banks EEMEA Corporate Credit Research Research Analysts Svetla Atanasova, CFA Jamie Nicholson More than what meets the eye Overview and Recommendations In this report we focus on the Ukrainian Eurobond issuers under our coverage, which span four industries: banks (Oschadbank, and Privatbank); food and agriculture (MHP, Mriya, and Avangard); energy (DTEK and Naftogaz); and metals and mining (Ferrexpo and Metinvest). We recognize that the negative perception of the Ukrainian sovereign is weighing on investor sentiment and demand for Ukrainian corporate risk. As a consequence, the Ukrainian corporate universe trades at wide spreads, while liquidity remains low, even for the better quality names. There are a few credits that we like in the long term namely MHP, DTEK Metinvest and Ferrexpo which we believe are likely to rally the most if Ukrainian sovereign spreads were to improve. However their respective bonds (except Ferrexpo s) are currently trading at tight spreads to the sovereign curve. At this point in time, from a relative value point of view, we like Mriya and Ferrexpo. We are also recommending the following switches: out of MHPSA15 into MRIYA16 for a pick-up of 25bps, and out of METINV15 into FXPOLN16 for a pick-up of 68bps. We have a negative view on Avangard. We see growth opportunities in the Ukrainian agricultural and energy sectors. We remain bearish on the Ukrainian banking system, which we think is inherently weak and lags peer CIS banking systems. In our opinion, the Ukrainian metals and mining sector is likely to recover in Q Our recommendations are summarized in the table below. We caution that in the near term, Ukrainian corporate trading levels will most likely follow the perception of Ukrainian sovereign risk and thus could be quite volatile. Exhibit 1: Ukraine corporates and banks recommendations Issuer New Recommendations Old Recommendations MHP Market Perform Market Perform Mriya Outperform Market Perform Avangard Underperform Not Rated Privatbank Market Perform Market Perform Oschadbank Market Perform Market Perform DTEK Market Perform Market Perform Naftogaz Not Rated Market Perform Metinvest Market Perform Market Perform Ferrexpo Outperform Market Perform Source: Credit Suisse ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES ARE IN THE DISCLOSURE APPENDIX. FOR OTHER IMPORTANT DISCLOSURES, PLEASE REFER TO

2 Table of contents Target Bond Universe and Scatter Plots 3 Ukrainian Sovereign Overview 5 Food and Agriculture 7 Industry overview 7 MHP Investment Recommendation 8 Mriya Investment Recommendation 1 Avangard Investment Recommendation 12 Banks 13 Overview of the Ukrainian Banking System 13 Privatbank Investment Recommendation 14 Oschadbank Investment Recommendation 14 Energy 16 Industry overview 16 DTEK Investment Recommendation 17 Naftogaz Investment Recommendation 19 Metals and Mining 2 Industry overview 2 Metinvest Investment Recommendation 21 Ferrexpo Investment Recommendation 22 Credit Profiles 24 Ukrainian Corporates and Banks 2

3 Target Bond Universe and Scatter Plots Issuer Coupon (%) Maturity Moody s / S&P / Fitch Rating Mid Price at 2 March 212 Mid Z-Spread (bps) at 2 March 212 Mid Yield (%) at 2 March 212 MHP /MHPSA 1.25% 29/4/215 B3/NR/B Mriya /MRIYA 1.95% 3/3/216 NR/B/B Avangard /AVINPU 1.% 29/1/215 NR/NR/B Privatbank 9.375% 23/9/215 B1/NR/B /PRBANK 5.799% 9/2/216 B1/NR/NR Oschadbank /OSCHAD 8.25% 1/3/216 B2/NR/B DTEK /DTEKUA 9.5% 28/4/215 B2/NR/B Naftogaz /NAFTO 9.5% 3/9/214 WR/NR/B Metinvest 1.25% 2/5/215 B2/NR/B /METINV 8.75% 14/2/218 B2/NR/B Ferrexpo /FXPOLN 7.875% 7/4/216 B3/B+/B Source: Credit Suisse, Moody s, S&P and Fitch Exhibit 2: Z-spread versus modified duration As of 2 March EXIMUK12 AVINPU15 PRBANK16 MRIYA16 PRBANK15 OSCHAD16 MHPSA15 NAFTO14 EXIMUK15 DTEKUA15 FXPOLN16 METINV18 METINV15 UKRAIN13 UKRAIN15 UKRAIN16 UKRAIN Source: Credit Suisse, the BLOOMBERG PROFESSIONAL service Ukrainian Corporates and Banks 3

4 Exhibit 3: Z-spread versus LTM net leverage (x ) As of 2 March AVINPU MRIYA FXPOLN16 METINV18 M HPSA15 NAFTO14 8 METINV15 DTEKUA Source: the BLOOMBERG PROFESSIONAL service, Credit Suisse Ukrainian Corporates and Banks 4

5 Ukrainian Sovereign Overview In this section, we discuss our view on the state of the Ukrainian economy. The following is an exact excerpt from the Credit Suisse economics research publication Ukraine: Delayed policy response to sharply higher risks, in the December 7, 211 Emerging Markets Quarterly and the team s February 212 Ukraine presentation. Reliance on commodity exports, large subsidies to domestic energy consumers and a rigid exchange rate make Ukraine particularly vulnerable to a global growth slowdown in the wake of the unfolding debt crisis in Europe. Having secured parliamentary approval for the reform of the country s pension system in September, the government chose to delay a planned increase in retail gas tariffs, fearing a further erosion of public support. This prevented the resumption of IMF financing and raised concerns among investors that the prevailing policy mix, including central bank support for the currency against a widening current account deficit, may not be sustained without large-scale financing sources. So far, Ukrainian officials have been pursuing a new gas deal with Russia for a potentially large subsidy, but have yet to secure a breakthrough. If market volatility persists, we cannot see a credible alternative to renewed IMF financing as a way to cope with large-scale IMF repayments in (nearly $6bn in total). Real GDP growth slowed in Q4 211 to 4.7% yoy (.5% qoq in seasonally adjusted terms), after 6.6% yoy (2.2% qoq sa) in Q3 and 3.8% yoy (.5% qoq sa) in Q2, due mainly to sharply weaker external demand. With agricultural output contributing 2.3pp to Q3 211 growth, the performance of the non-agricultural part of the economy over the last three quarters was fairly lackluster, in our view. GDP growth prospects in 212 are very uncertain due to weather-related disruptions to output and exports early in the year and a projected decline in agricultural output due to a much harsher start to the new grain season. The central bank estimates January 212 GDP growth at about 2% yoy. Inflation fell to an eight-year low of 3.7% yoy in January 212, from 4.6% yoy in December 211, thanks mainly to the continuing declines in food price inflation on the back of last year s bumper harvest. However, inflation is very likely to rebound later in the year, in view of unfavorable base effects, a likely decline in agricultural output and spending pressures ahead of the parliamentary elections in October 212. The current account deficit widened to 5.6% of GDP in December 211 from 2.1% of GDP in December 21, due mainly to sharp increases in the value of energy imports. The 12-month goods trade deficit was at 8.4% of GDP in December 211. December BoP data painted a slightly less negative picture compared to the previous several months, thanks mainly to a further slowdown in import growth, as well as lower household purchases of FX. However, the bill for energy imports looks set to rise in Q1 212, due in part to the impact of very cold weather, while export values will likely be curbed due to stagnant metal prices and export volumes. Accordingly, the deterioration of the current account is very likely to continue in 212, aggravating a key credit vulnerability. Ukraine s government funding needs in 212 also look challenging, given the lack of progress in the talks with the IMF. Besides the $1bn due to the IMF from the government, Ukraine is also facing the need to refinance the $2bn VTB loan maturing in June 212 and the $.5bn Eurobond (also in June). The likelihood of a new issue of some $1.7bn of Eurobonds in Q1 212 (targeted by the government) appears low to us. Accordingly, the government would have to rely primarily on domestic borrowing and Russia-related financing sources, in our view. Ukrainian Corporates and Banks 5

6 Exhibit 4: Ukraine Selected economic indicators E 212F 213F National accounts, population and unemployment Real GDP growth (%) Growth in real private consumption (%) Growth in real fixed investment (%) Fixed investment (% of GDP) Nominal GDP ($bn) Population (mn) GDP per capita, $ 3,888 2,473 2,84 3,67 3,89 3,98 Unemployment (% of labor force, end-year) Prices, interest rates and exchange rates CPI inflation (%, December to December) CPI inflation (%, average) Nominal wage growth (% change, December to December) Exchange rate (UAH per $, end-year) Exchange rate (UAH per $, average) REER (% change, December to December) Discount rate (%, end-year) Fiscal data General government fiscal balance (% of GDP) General government primary balance (% of GDP) General government expenditure (% of GDP) Gross general government debt (% of GDP, end-year) Money supply and credit Broad money supply (M2, % of GDP) Broad money supply (M2, % year-on-year change) Domestic credit (% of GDP) Domestic credit (% year-on-year) Domestic credit to private sector (% of GDP) Domestic credit to private sector (% year-on-year) Balance of payments Exports (goods and non-factor services, % of GDP) Imports (goods and non-factor services, % of GDP) Exports (goods and non-factor services, % change in $ value) Imports (goods and non-factor services, % change in $ value) Current account balance ($bn) Current account (% of GDP) Net FDI ($bn) Scheduled debt amortization ($bn) Foreign debt and reserves Foreign debt ($bn) Public ($bn) Private ($bn) Private debt net of trade loans and inter-company loans ($bn) Foreign debt (% of GDP, end-year) Foreign debt (% of exports of goods and services) Central bank gross FX reserves ($bn) Central bank non-gold FX reserves ($bn) (1) Real effective exchange rate, increase indicates appreciation. (2) Excluding impact of bank recapitalization and transfers to Naftogaz. Estimate for 211 expenditure includes.8% of GDP of additional allocations for settlement of VAT arrears accumulated in 21. (3) Scheduled amortization of the public sector. Source: State Statistic Agency, the BLOOMBERG PROFESSIONAL service, National Bank of Ukraine, IMF, Finance Ministry of Ukraine, Credit Suisse. Ukrainian Corporates and Banks 6

7 Food and Agriculture Industry overview Ukraine has some of Europe s most fertile agricultural land and 3% of the world s richest black soil. According to data from the EU Directorate-General for Agriculture and Rural Development, approximately 7% of Ukraine s total land area of 6mn hectares is classified as agricultural land. The soil quality in Ukraine is very high because the country is located in a black earth belt, with approximately 5% of all arable land classified as chernozem or highly fertile. Ukraine s favorable continental climate, vast territory, strategic location adjacent to the Black Sea ports, fertile land, and cheap labor offer substantial agricultural potential. Yet, grain yields remain low, mainly due to the use of obsolete machinery as well as limited use of fertilizers by individual farmers. Sophisticated agricultural producers such as Mriya and MHP benefit from an above average grain yield due to the use of modern equipment, which enables them to realize the full potential of the land. According to the State Committee of Statistics of Ukraine, agriculture contributed 9% of GDP as at Q Given the sector s importance to the Ukrainian economy, the state has been actively involved in managing food inflation as well as in maintaining adequate domestic stocks of grain. In the case of grain shortages due to prolonged droughts or an increase in international prices of grain, the Ukrainian government may reintroduce export duties to limit exports, as it did in 21 and H1 211 following a weak harvest in 21. The 211 harvest in Ukraine was strong, and we do not envision export bans in 212. As projected by the USDA (see Exhibit 5) crop production in the 211/212 harvesting campaign is expected to increase by 54.5% yoy. However, due to a very humid autumn, the winter crop in 211 may need re-sowing, therefore pushing crop yields lower for the 212 harvest. Uncertain land ownership and leasing practices are another feature of the Ukrainian agriculture sector. There is currently a moratorium on sales of farmland, which was recently extended to 1 January 213. Once the moratorium is lifted, agricultural producers such as Mriya and MHP have the first right to buy the land they have been leasing from individual landowners. Although we do recognize the unpredictability of potential land reform in Ukraine, the current leases generally span from five to ten years; therefore, we do not see any imminent pressure to invest in land acquisitions. Exhibit 5: Ukrainian agricultural crop supply and demand as at January 212 Mn tons Beginning Stock Production Import Domestic consumption Exports Ending Stocks Wheat 9/ /11 est /12 proj Coarse Grain 9/ /11 est /12 proj Corn 9/ /11 est /12 proj Total 9/ /11 est /12 proj Source: United States Department of Agriculture (USDA) Harvesting campaign runs July to June each year Ukrainian Corporates and Banks 7

8 MHP Investment Recommendation We are maintaining our Market Perform recommendation on MHP s bond maturing in 215 (ticker MHPSA). MHP is our top recommendation among the Ukrainian agricultural and livestock producers from a credit fundamental point of view. However on a relative value basis, since the beginning of 212, MHPSA15 has tightened significantly to the sovereign curve, specifically UKRAIN15. In the last 12 months, MHPSA was indicated at an average 3bps over UKRAIN15. As shown in Exhibit 6, the current spread differential between the two bonds is below the average and stands at c.229bps. Therefore at the current levels, we think that MHP is fairly valued, and there is limited potential for further significant tightening to the sovereign curve. We see value in MHP in the long term, especially if the sovereign risk improves. We view the company as the most solid credit in the Ukrainian agricultural sector. We like MHP s larger size, strong operational performance, vertically integrated business model, and better corporate governance practices than those of its domestic peers. Exhibit 6: Z-spread evolution for MHPSA15 versus UKRAIN15 12-month period 1,6 1,4 1,2 z spread 1, /11 4/11 5/11 6/11 7/11 8/11 9/11 1/11 11/11 12/11 1/12 2/12 3/12 MHPSA15 UKRAIN15 MHPSA15 UKRAIN15 Source: BLOOMBERG NEWS sm, Credit Suisse Issuer Coupon Moody s / S&P / Fitch (%) Maturity Rating Outlook Mid Z-Spread (bps) at 2 March 212 Credit Suisse Recommendation MHP (MHPSA) 1.25% 29/4/215 B3/NR/B Stable/NR/stable Market Perform Mriya (MRIYA) 1.95% 3/3/216 NR/B/B- Stable/NR/positive Outperform Avangard (AVINPU) 1.% 29/1/215 NR/NR/B- NR/NR/RWN Underperform Source: Credit Suisse, Moody s, S&P and Fitch MHP is Ukraine s largest poultry producer, with a market share of 5% of all industrially produced chicken in Ukraine as of Q We like MHP s vertical integration structure, which ensures 1% self sufficiency in fodder. In contrast with Mriya, MHP is less sensitive to grain prices because most of its grain cultivation is used as fodder (corn and sunflower seed), while wheat and rapeseed are sold to third parties. In Q3 211, grain sold to third parties represented just 6% of total revenues; however, due to MHP s high-yielding crops, it contributed 35% to EBITDA. Ukrainian Corporates and Banks 8

9 In our view, MHP has the best corporate governance practices among its Ukrainian peers. The controlling shareholder, Yuriy Kosyuk, is less of a public figure and without any strong political affiliations in Ukraine. MHP has also adopted sound principles in terms of open and timely reporting as well as conservative accounting practices. We believe that an important positive catalyst for MHP s long-term performance is its planned large-scale expansion plans. MHP has ambitious growth plans, which involve the construction of its Vinnytsia chicken farm, which MHP expects to increase annual production of poultry by 22, tonnes. The complex has two stages, with the first stage expected to be launched in 213, when 11, tonnes of new capacity will be added; it will reach full capacity in 215 at 22, tonnes per annum. The total capex required is $75mn, which the company intends to finance through its internal cash flows rather than through Eurobond issuance. MHP started construction of the Vinnytsia farm in 21, and altogether in 21 and 211 it invested $4mn in capex. In 212, the company projects capex spending of $33mn-$35mn, which is likely to result in negative FCF. MHP expects the extra supply to be met with increasing demand for poultry in Ukraine (see Exhibit 7 below), partly as a substitute for poultry imports, which currently stand at 2, tonnes per year, and by strong growth in exports. The local market is very fragmented, with no sizable competition for MHP. The company projects that many of the small local chicken producers will eventually fold, while MHP will gain market share. On the exports front, MHP recently resumed exporting to Russia. Although volumes will not be significant initially (less than 1% of total sales), we view this development as positive because Russia has traditionally been a tough export market because of import tariffs and strong local competition. Exhibit 7: Per capita chicken, beef, and pork consumption in Ukraine Actual and projected consumption Beef and Veal Pork Chicken Source: Food and Agricultural Policy Research Institute (FAPRI) The company has indicated that it is mostly looking to export to the Middle East. In 211 MHP opened new export sales markets in Libya, Lebanon, Uzbekistan, and Angola. As per Exhibit 7, long-term growth trends in chicken consumption are positive, as it is a cheaper protein alternative to beef and pork. MHP posted a very strong Q4 211 trading update. Poultry production volumes increased 7% yoy as a result of more efficient production. The company's facilities have been operating at full capacity. Sales rose 12% yoy, while domestic demand for chicken remained robust. Exports also increased strongly (up 8% yoy), as MHP opened new Ukrainian Corporates and Banks 9

10 export markets, mostly in MENA and Asia. These strong results were also supported by higher chicken prices (1% higher on average in 211). In terms of cultivated and harvested land for fodder, MHP increased its land for cultivation by 67% yoy. Following good weather conditions in 211, the harvest was very strong. The company produced 1.7mn tons of grains and oilseeds, which is 88% more than the harvest of 21. On the negative side, MHP has an FX mismatch between its mostly dollar-denominated debt (7%) and its UAH-denominated revenues. However, the growing share of exports acts as a natural hedge. MHP reported that $244mn of revenues from the export of sunflower oil, sunflower husks, and chicken meat in Q3 211 were denominated in dollars, which fully covered debt service expenses. Mriya Investment Recommendation We are changing our recommendation on Mriya s Eurobond due in 216 (ticker MRIYA) to Outperform from Market Perform. From a fundamental point of view, the company has good growth prospects, but is smaller relative to MHP, and has a weaker corporate governance structure and higher exposure to the volatile agricultural sector in Ukraine. In light of this we believe that MRIYA16 should trade at a premium to MHPSA15. In the last 12 months, the average spread between two bonds has been c.13bps, which we think is fair. However since the beginning of 212, MRIYA16 has underperformed MHPSA15 and the spread has widened substantially to 324bps. At these wide levels we see relative value in Mriya s bond, and in our view there is potential for the bond to close the gap on MHP. We recommend a switch from MHPSA15 into MRIYA16 for the same duration, pick-up of 25bps, and a reduction in LTM net leverage from 1.9x for MHP to 1.x for Mriya. Exhibit 8: Z-spread evolution for MRIYA16 versus MHPSA15 12 month period z spread 1,8 1,6 1,4 1,2 1, /11 5/11 6/11 7/11 8/11 9/11 1/11 11/11 12/11 1/12 2/12 3/12 MRIYA16 MHPSA15 MRIYA16 MHPSA15 Source: the BLOOMBERG PROFESSIONAL service, Credit Suisse While MHP is a vertically integrated poultry producer and its crop sales are a byproduct, Mriya is a full-scale farming company, whose produce is largely dependent on weather conditions, crop yields, and grain-pricing trends. Although we acknowledge that Mriya has a certain control of grain pricing due to the use of forward contracts as well as the use of storage silos where grain can be stored until prices increase, we perceive the business as inherently more volatile than MHP s. Ukrainian Corporates and Banks 1

11 Corporate governance at Mriya, while improving and better than corporate governance at Avangard, still lags MHP s best practices. For example, Mriya s entire sugar beet produce (2% of total crop mix for 211) is sold to the sugar plants operated by the Hyta family, which is also the main shareholder in Mriya (8% of all shares). From a sales point of view, selling the sugar beet production to a reliable customer is beneficial for Mriya; however, there is the underlying risk of any related party lending to finance the sugar plants working capital needs, as Mriya is only paid after the sugar plants sell their end products. Also there is no clarity about the margins at which sugar beet is sold; however, management has indicated that the transactions are at arm s length. As a mitigant, according to Fitch, related party loans have been limited to around 1%-2% of the group s assets. Mriya operates a highly profitable business, with an EBITDA margin of 58% in Q Such a high margin is largely a result of efficient use of machinery and technology, the usage of silo facilities for storage when grain prices are low, as well as overall economies of scale when compared to fragmented regional farmers. As shown in Exhibits 9 and 1, Mriya reported that its crop yields are above the Ukrainian average, while its production costs per tonne of grain are substantially lower. Exhibit 9: Mriya s crop yields versus Ukrainian average Tones/ha Exhibit 1: Mriya s production costs versus Ukrainian average $/tonne Winter Wheat Spring Wheat Winter Rapeseed Spring Rapeseed Corn Barley Buckwheat Potato Sugar Beets Corn Wheat* Mriya Ukrainian average Mriya Ukrainian average Source for both: Mriya Management Presentation as of December 211 However, we point out that margins are also influenced by the application of IAS41, according to which Mriya recognizes net revaluation gains and losses on its biological assets and agricultural produce. Such revaluation is subject to management estimates and often revaluation gains increase as new land is added (which is the case for a fast-growing company such as Mriya), inflating the top line. Such gains also constitute an early recognition of profits and can be quickly erased should crop quality or prices deteriorate adversely. Similarly to MHP, Mriya is in a growth mode, planning to add c.5, hectares of land per annum as well as to increase its silo capacity by 2, tonnes for grains and oilseeds and by 2, tonnes for potatoes. However we note that Mriya scaled back some of its previous growth plans in light of the uncertainty surrounding the EU debt crisis. We view such an action positively and as evidence of Mriya s flexibility and conservative financial management. Mriya intends to spend $12mn in capex in 212 to acquire land lease rights as well as to invest in machinery and construction of silos for grain storage. This commitment should be met by the company s internal cash generation and was also prefunded by Mriya s $25mn Eurobond issuance in 211. Liquidity is strong and is supported by an IFC working capital facility ($35mn), an IFC loan ($25mn), and an undrawn EBRD loan ($25mn). Ukrainian Corporates and Banks 11

12 Avangard Investment Recommendation We are initiating coverage of Avangard s Eurobond maturing in 215 (ticker AVINPU) with an Underperform recommendation. In our view, Avangard is the weakest credit among the three Ukrainian agriculture companies, which is also reflected in the sizable z-spread differential between AVINPU15 on one side and MRIYA16 and MHPSA15 on the other. Despite the initial z-spread widening of AVINPU15 on the day the allegations of mismanagement mentioned below were publicized, the bond traded well after the company s press conference refuting the charge and the subsequently published 211 trading update, which showed strong operational performance. However, we do not think there is any more room for tightening in the short to medium term unless corporate governance issues are resolved. Despite Avangard s public commitment at the time of its debut Eurobond issuance to improve corporate governance standards, we believe the company has some way to go before it can compare to both Mriya and MHP. We view as a negative the lack of two independent directors on Avangard s board (currently there is only one), the lack of transparency in the business structure, and the potential impact on the company from negative media reports about the company s main shareholder, Oleg Bakhmatyuk. We also remain concerned about the Ukrlandfarming-Avangard transaction, in which Bakhmatyuk consolidated his previously separately owned assets. We find it hard to see value in the argument that Ukrlandfarming is going to sell grain to Avangard at lower-thanmarket prices because there is no economic incentive for it to do so. Prior to the transaction, Avangard already managed to buy grain cheaper than the market average due to arrangements with farmers to provide working capital in exchange for purchasing their produce at a more favorable price. Additionally we view as negative the consolidation of a publicly traded entity, Avangard, under the umbrella of a privately held company, Ukrlandfarming. Such a transaction, in our view, further reduces transparency. We await the proposed IPO of Ukrlandfarming and further clarification of the new structure before we can take any comfort in its transparency and arm s-length practices. Bakhmatyuk is a public figure in Ukraine with a controversial profile because of various conflicts arising from his other business ventures. In February 211, Avangard was alleged in an article published by the Ukrainian press of mismanaging state agricultural grants that were supposedly not used for their stated purpose; as a result, Avangard came under government investigation. The company publicly denied the allegation, attributing the charge to an attack on Bakhmatyuk from opponents in some of his other businesses. As a result, we remain cautious on the company s still evolving corporate governance practices. We note that Avangard has a good operational track record and a profitable business model with strong growth momentum. In line with its peers, Avangard is seeking to expand both domestically and internationally. In its 211 trading update, the company confirmed that shell egg production volumes increased 34.7% yoy due to better efficiency and the launch of additional laying facilities. Exports increased 74.6% yoy, while sales jumped 25% yoy and average egg prices remained robust and increased 12% yoy. The company is planning $3mn in capex, which should be financed through internally generated cash flows. We do not expect any Eurobond issuance in the medium term. Avangard s net leverage is lower than that of peers and stood at.6x on a LTM basis. Ukrainian Corporates and Banks 12

13 Banks Overview of the Ukrainian Banking System The Ukrainian banking system remains the weakest among its CIS peers. The Russian banking system rebounded swiftly after the financial crisis of 29 and had a very strong performance in 211; therefore, we believe it is no longer a suitable peer for comparison purposes. The Kazakh banking system, on the other hand, remains a good proxy for comparison due to similar structural issues, such as high stock of NPLs, slow loan growth, elevated leverage, and weakened profitability. We track leading indicators for the three banking systems on a monthly basis and as shown in the table below, we note that even the Kazakh banking system has shown signs of revival (despite the ongoing BTA Bank crisis), while Ukrainian banks performance remains lackluster with no signs of any meaningful growth. Ukraine Kazakhstan Russia Retail loan growth % % -4.44% -4.77% -2.69% 8.32% -11.4% 14.3% 35.89% Corporate loan growth.51% 7.1% 13.86% 5.77% 1.15% 17.42%.26% 12.13% 25.97% Total loan growth -5.92% -.39% 8.94% 2.46%.3% 14.84% -2.49% 12.61% 28.2% Retail deposit growth -1.51% 28.92% 11.52% 28.55% 15.92% 24.12% 26.71% 31.17% 2.91% Corporate deposit growth % 25.3% 17.96% 18.9% 9.81% 1.15% 1.13% 16.7% 25.86% Total deposit growth -8.94% 27.54% 13.75% 21.53% 11.57% 14.33% 16.95% 23.14% 23.51% NPL ratio 1.% 12.2% 1.6% 36.7% 32.6% 35.% 9.5% 8.2% 6.6% Loan/Deposit 214.5% 167.5% 16.4% 116.3% 14.3% 14.7% 95.9% 87.7% 91.% Source: Central Bank of Russia, National Bank of Kazakhstan, National Bank of Ukraine, Credit Suisse In 211 Ukrainian loan growth remained in the single digits at just 8.9%, entirely driven by corporate loan growth of 13.9%. We note that as of December 211 the retail lending sector remained under significant pressure, as consumer confidence in Ukraine remained weak. In 212, we do not envisage a revival in retail lending, although we expect further growth in corporate lending, as most large Ukrainian corporates are likely to resort to bank funding if the capital markets remain closed for them. Total deposits grew 13.8%, exceeding loan growth and in line with the system-wide deleveraging trend. Nevertheless, total loans/deposits remained high at 16% and well above the peer group s leverage indicators. Asset quality remains weak. According to statistics published by the National Bank of Ukraine (NBK), the NPL ratio was 1.6% as of December 211. However, the NBK does not capture the full extent of NPLs in its impaired loan classification system, which according to Fitch are between 3% and 5% if restructured loans are included. We do not expect material improvement in asset quality trends in 212 because of a still challenging environment for consumers in Ukraine as well as our expectation that some of the restructured loans may migrate to the NPL bucket. The Ukrainian banks are better capitalized than before the 29 financial crisis; however, in light of the still very high stock of NPLs and the possible need for additional provisioning charges, we consider the system-wide capital ratio of 18.5% as of end-211 as merely adequate. Overall, we remain bearish on the Ukrainian banking system. In our view, 212 will be another year of working through NPL problems, building liquidity on the balance sheet while trying to preserve declining margins, as well as striving to find meaningful pockets of loan growth to boost profitability. Ukrainian Corporates and Banks 13

14 Privatbank Investment Recommendation We maintain our Market Perform recommendation on Privatbank s Eurobonds maturing in 215 and in 216 (subordinated). The recent outperformance of the bonds (ticker PRBANK) was mostly attributable to the repayment of one of Privat s Eurobonds, which matured in February 212. At this point we think the good news is out, and the bonds are now fairly valued relative to peers. We do not rule out further z-spread tightening; however, in our view, this is more likely to be driven by improved general risk appetite rather than any bank-specific news. Coupon Moody s / S&P / Fitch Mid Z-Spread (bps) Credit Suisse Issuer (%) Maturity Rating Outlook at 2 Mar 212 Recommendation Privatbank 9.375% 23/9/215 B1/NR/B Stable/NR/stable Market Perform (PRBANK) 5.799% 9/2/216 B1/NR/B Stable/NR/stable Market Perform Oschadbank (OSCHAD) 8.25% 1/3/216 B2/NR/B Stable/NR/stable Market Perform Source: Credit Suisse, Moody s, S&P and Fitch Privatbank is Ukraine s largest bank with total assets of $17.3bn at H As of June 211, the bank s loan portfolio had increased substantially by 16.4% ytd, well above the industry average growth rate of 5.7% ytd. Although some of the growth in the portfolio came from credit cards (up 48.9% ytd), it represented just 11.8% of total loans, and therefore it was an insignificant contributor to overall portfolio growth. Corporate lending represented 78.% of the gross loan book as of June 211, and most of the lending growth was attributable to the 16.8% ytd increase in corporate loans. Exposure to the oil trading sector was very high and stood at 32% as of June 211. There is very little transparency in the bank s lending practices to these oil trading companies, as most are interrelated and some reportedly represent significant business interests of Privatbank s main shareholders. The bank reported that related party lending represented 9% of total lending as at June 211; however, given the complexity of the group structure as well as the sizable lending concentrations to the oil industry, we believe that related party practices may be even more significant. Asset quality was also better than the industry average, with NPLs reported at 7% as of June 211. We believe the NPL ratio in the retail book is in line with the industry average, while NPLs in the corporate book are below average due to the recent rapid growth. Overall, we remain cautious, as we are not entirely comfortable with the bank s corporate governance practices and particularly the lack of clarity about the oil trading exposures. Privatbank s credit metrics appear stronger than those reported by peers; however, we need to see the year-end 211 financials before considering a more positive stance on the credit. Oschadbank Investment Recommendation We maintain our Market Perform recommendation for Oschadbank s bond maturing in 216 (ticker OSCHAD). OSCHAD16 offers a good spread pick-up versus EXIMUK15, which is the only comparable quasi-sovereign bank bond in Ukraine. The extra yield is meant to compensate investors for the uncertainty stemming from the Naftogaz lending exposure (45.3% of total loans as of H1 211). As communicated by the Ukrainian government, Naftogaz is likely to be restructured, and one of the options being discussed is a break-up of the company into several entities. At this point there is no clarity as to the fate of the UAH24.1bn of loans (as of June 211) that Oschadbank extended to Naftogaz under a state-directed lending initiative. Although the loans are not fully covered by a state guarantee, so far the government has been supportive in providing the necessary funding. Ukrainian Corporates and Banks 14

15 In our view, the government has no real incentive to demand immediate repayment of the funding it provides to Oschadbank should the Naftogaz exposure default. Instead, we think it is more likely to seize the UAH18.1bn of Naftogaz loans provided as collateral to the National Bank of Ukraine (NBK), which in turn extended UAH14.1bn of funding to Oschadbank as of June 211. We note, however, that the NBK demanded collateral covering more than 128% of the loan, which implies a sizable haircut on the Naftogaz exposure. On the positive side, Oschadbank has one of the highest margins among the top Ukrainian banks because any margin pressure is alleviated by earning a fixed margin from the Naftogaz exposure. Overall, we believe the performance of Oschadbank s note carries significant event risk and is largely dependent on developments related to its Naftogaz exposure. Ukrainian Corporates and Banks 15

16 Energy Industry overview Ukrainian energy policy developments are governed by the Energy Strategy of Ukraine until 23, which was ratified in 26 by the Ukrainian Cabinet of Ministers. The plan emphasizes optimization of the domestic energy production and consumption system, investing in energy infrastructure development, balancing pricing policies to ensure production costs are covered, as well as facilitating integration between the Ukrainian power system and the European system. To reduce dependence on natural gas, Ukraine s energy strategy envisions that by 23 heating and hot water utilities will convert to using electrical power fuelled by coal burning rather than natural gas firing. As reported by DTEK, coal is the most important fuel for Ukrainian electricity-generating companies, accounting for 96% of total fuel, while natural gas accounts for just 4%. Exhibit 11 below breaks down Ukraine s current electricity production as well as installed capacity and Exhibit 12 shows percentage utilization of the country s various energy sources: The charts show that both thermal and nuclear power plants are paramount to the country s electricity production. However, because of their already high capacity utilization, nuclear power plants (NPPs) have less potential than thermal power plants (TPPs) to meet future increases in electricity demand. As projected by the National Electricity Regulatory Commission of Ukraine (NERC), electricity demand is expected to grow at CAGR +2.9% between 21 and 22, mostly driven by industry demand rather than household consumption. Exhibit 11: Ukrainian electricity production Breakdown of Ukraine s electricity production as of 211 Installed capacity in MW Hydro 6% Thermal & Combined Heating Power Plants 33,774 Thermal 48% Nuclear 46% Nuclear Power Plants 13,835 Hydro Power Plants 5,458 Others.3% 1, 2, 3, 4, Source: DTEK, Data Processing centre of NPC Ukrenergo Ukrainian Corporates and Banks 16

17 Exhibit 12: Ukrainian energy capacity utilization Installed capacity utilization in % as of 211 Nuclear Power Plants 74.5 Thermal & Combined Heating Power Plants 32.4 Hydro Power Plants 22.8 Source: DTEK, Data Processing centre of NPC Ukrenergo Currently, Ukraine operates a Wholesale Electricity Market (WEM), which is guided by agreements among its members, and is operated by the state-owned company Energorynok. All electricity produced by the generating companies has to be sold to Energorynok, according to a set wholesale price mechanism that includes the following components: export prices for electricity, compensation for the services rendered by Energorynok as well as the system operator Ukrenergo, capex spent by the generating companies for plant modernization, and compensation for losses incurred due to supplying to privileged consumer categories. All electricity in the WEM is then distributed to end wholesale consumers (non-regulated tariffs) and households (regulated tariffs) by power distribution companies. Integrated companies, such as DTEK, participate at all levels of the value chain by mining coal, generating electricity in power plants, and then selling and distributing it to end consumers. Electricity tariffs for households are highly regulated and are among the lowest in Europe. As reported by DTEK, the average energy price for the European Union is.16 per Kwh, while it is between.25 per Kwh and.33 per Kwh for Ukraine. Although a substantial increase in tariffs is needed to operate the Ukrainian energy system efficiently, the timing and extent of such increases are difficult to judge given their politically sensitive nature and the existing government subsidies to the sector. DTEK Investment Recommendation We are maintaining our Market Perform recommendation on DTEK s note due in 215 (ticker DTEKUA). From a fundamental point of view, we like DTEK and we see the company as one of the most solid credits in Ukraine. In the long term, in our view, DTEK is likely to tighten materially should we have positive news on the Ukrainian sovereign risk. As shown in Exhibit 13, at present DTEK trades tight to the sovereign curve (specifically UKRAIN15). Since the beginning of 212, DTEKUA15 has rallied and is now quoted at just 135bps to UKRAIN15, given a 12-month average z-spread differential between the two bonds of 24bps. Therefore we see no significant tightening potential to the sovereign curve. Ukrainian Corporates and Banks 17

18 Exhibit 13: Z-spread evolution for DTEKUA15 versus UKRAIN15 12 month period 1,4 1,2 1, z spread /11 4/11 5/11 6/11 7/11 8/11 9/11 1/11 11/11 12/11 1/12 2/12 3/12 DTEKUA15 UKRAIN15 DTEKUA15 UKRAIN15 Source: the BLOOMBERG PROFESSIONAL service, Credit Suisse Coupon Moody s / S&P / Fitch Mid Z-Spread (bps) Credit Suisse Issuer (%) Maturity Rating Outlook at 2 Mar 212 Recommendation DTEK (DTEKUA) 9.5% 28/4/215 B2/NR/B Stable/NR/stable 95.5 Market Perform Metinvest (METINV) 1.25% 2/5/215 B2/NR/B Stable/NR/stable 85. Market Perform Source: Credit Suisse, Moody s, S&P and Fitch DTEK is the largest privately owned energy company in Ukraine, with a 46% market share in coal mining, a 29% share in power generation, and a 19% share in power supply as of December 211. We like the company s vertically integrated business model, which ensures self sufficiency in coal needed to fuel DTEK s thermal power plants. The company is present at all levels of the value chain from production to power distribution and sales. DTEK made a series of acquisitions in 211 and Q1 212 for which it is paid a total consideration of c.$411mn. The company signed a 49-year concession agreement to take control of DTEK Rovenkianthracite (six mines and three coal preparation plants) and DTEK Sverdlovanthracite (five mines and three coal preparation plants), and purchased under a nationalization program a 4.1% stake in Donetskoblenergo (a power distribution company), 25% in Kievenergo (a power-generating and distribution company) and a 45.1% stake in Zapadenergo (a thermal power-generating company), therefore increasing its ownership shares in the three companies to 71.3%, 71.8%, and 7.9%, respectively. If the results of the aforementioned new additions to DTEK s portfolio had been consolidated within the 211 production results, then versus actual 211 production stats, coal output would have been 36.8mn tonnes (up 6.7%), power generation 5.5 TWh (up 53%), and electricity sales 33.6 TWh (up 138.3%). In light of these acquisitions, DTEK is likely to report a significant increase in its production stats in 212 versus 211. The company does not provide EBITDA guidance for 212, but based on the above estimates of higher production, we expect a healthy increase in EBITDA. However, in our view, margins are likely to decrease, as some of the acquired assets are less efficient and DTEK needs to invest funds in modernizing and optimizing their capacity. Ukrainian Corporates and Banks 18

19 The group has ambitious capex plans, given the need for modernization of the newly acquired assets. DTEK reported that it intends to spend $1.6bn in each of the years 212, 213, 214, and $1.3bn in 215. The company confirmed it would fund such an extensive capex program through credit facilities that it borrowed at the end of 211 and in Q1 212 ($1bn of lines by Sberbank, VTB, Erste and ING, $11mn line by Ukrsotsbank, and $15mn line by Unicredit) as well as internal cash flows. DTEK is more likely to use bilateral facilities than to tap the Eurobond market in 212. However, we also note that the energy supply tariff set by the state energy regulator includes a markup for the incurred capex costs (8% of project implementation costs and 95% of environmental investments); therefore, in reality, investment costs for DTEK are lower. On a LTM basis, gross and net leverage were low at.7x and.5x, respectively, as of H Following the increased capex plans and the acquisition costs, we expect leverage to increase from the currently low levels. DTEK has communicated that it does not plan to exceed its internal gross leverage and net leverage targets of 2.x and 1.5x, which is in line with industry trends. DTEK s Eurobond prospectus includes a gross leverage covenant of 3.x. Naftogaz Investment Recommendation We are removing our Market Perform recommendation for the Naftogaz bond maturing in 214 (ticker NAFTO); thus, it is now Not Rated. The Naftogaz story has substantial political implications, and developments are entirely subject to the gas negotiations between Russia and Ukraine. The timing of the possible gas deal between the two countries as well as the imminent restructuring of Naftogaz poses a significant uncertainty in the near term. At the same time, the company s operational deficit totaled some 1.2% of GDP in 211 and can be reduced only via higher domestic tariffs or a significant reduction in import gas prices, and there have been no breakthroughs so far on either issue. In our view, a gas deal agreement may be reached after the Russian parliamentary elections in March; however, it is unlikely that such a deal would be finalized before May, when the new Russian cabinet will be formed. Given the uncertain timing and deal details, we have decided not to rate the NAFTO14. The Eurobond is unconditionally and irrevocably guaranteed by the Ukrainian sovereign and is affected by political and economic developments in Ukraine. Ukrainian Corporates and Banks 19

20 Metals and Mining Industry overview The summary below is based on the 17 January 212 Credit Suisse commodities research publication, Commodities Forecast Update: From Fear Flows Opportunity. Steel World steel production showed stabilization signs at the end of 211, and the growth rate is expected to be 4%-5% yoy for the years , mainly because of higher increases in China. Demand should return to trend in the next three to four years, excluding the China market, which should add 6mn-1mn tonnes of steel demand ex China annually. After the peak in Q2 211, steel prices have fallen on average to approximately $6 per ton. The US market is the only one where prices have increased significantly and the current level is around $77 per ton. This suggests the US may face a cycle peak this summer, then Europe (after three months) and Asia at the end of 212. Steel prices are expected to move along the cost curve. Iron ore Iron ore demand is expected to grow as steel demand increases. Incremental iron ore demand growth should be equal to 75mn-8mn tonnes per annum in Construction will remain the most important sector for steel demand (one-third of total demand), but the most influential growth factors in percentage terms are capital goods and transport. Iron ore was traded at $181 per ton in July 211, but after a sharp drop in basic material prices in August and September, the spot price equaled $116 per ton in October. Since November, the price has traded at $13 per ton-$14 per ton, which is an indicator for Q1 212 levels. Spot iron ore prices may test higher levels, but it depends on the Chinese macro situation and statistical data for March. The swap curve indicates weakening iron ore spot prices. However, lows around $12 per tonne have been tested by the market twice in the past two years. There seems to be a point at which iron ore production in China in excess of 1mn tonnes is unprofitable on a cash operating cost basis. Exhibit 14: Forecasted iron ore pellets prices LT Q1 Q2 Q3 Q4 Yr Avg Q1 Q2 Q3 Q4 Yr Avg Yr Avg Yr Avg (real) Iron ore pellets - 66% (Tubarao FOB) US$/t Iron ore pellets - (Tubarao FOB) US /dmtu Source: Credit Suisse Coking coal Coking coal prices come off in line with the rest of the bulk commodities in the final quarter of 211 as macro fears, softer demand, and benign supply dynamics all exerted downward pressure. Moving into 212, we envisage softer contracts in Q2, which will have been set against current prices, before a step higher on the back of a recovery in Asian steel production. Interestingly, these movements are a key factor in the improvement of steel producer margins, encouraging a step-up in mill run rates in the absence of an unexpected steel price slide. The caveat here is the potential for weather-related supply disruption, as many Queensland pits are still partially waterlogged and it would not take a great deal of rain to hamper production and railing again. Therefore, while prices now look to have stabilized at a level well off their recent peaks, the potential for a sharp bounce higher on the back of a supply-side shock is still a pivotal factor. Ukrainian Corporates and Banks 2