Investment opportunities in

August 2014 Time to Invest in Ukraine

The chance for large scale modernization in the post-Soviet space

July 2014 How to stop the endless “transition” of post-Soviet economy into the “crony capitalism”? Start reforms now and modernization tomorrow!

The Ukrainian economy bears the scars, left by the former government. Exports to Russia have declined because of political reasons. But the major problem of the Ukrainian industry is a lack of capital. The recent political changes give Ukraine an opportunity to be the first big country in the post-Soviet space to make a real large-scale transition from the government-controlled to free market economy. Ukraine has the potential to for successful modernization and liberal economic reform. These are the prerequisites for success of the deep reforms and the modernization plan:  The political revolution resulted in a “the turn to the West,” making a free market a necessity  The new Ukrainian government consists of professionals motivated by the country’s best interests  The domestic market is close to the “bottom.” This is true for both financial assets and consumer activity. To avoid deeper crisis, Ukraine needs to rise private capital in 2014-2015  Manufacturing in Ukraine is competitive due to (a) the low cost of highly qualified labor, (b) the large domestic market and (c) a weak local currency.

It will help to attract capital for the first stage of reforms and modernization over the next 4-5 years. If the program of reforms really starts now, foreign direct investment will flow into Ukraine as it did into Poland, the Czech Republic, Slovakia 20 years ago. This is the unique chance, as the EU industrial producers will have to modernize local production facilities to get access to the market.

Portfolio investment will return to Ukraine as soon as financial market institutions can be restored.

3 Ukrainian economic sectors expected to contract in 2014-15

 Industries that are strongly dependent on the Russian economy: • Railcar production (e.g. Azovmash, Krukivsky Carriage Works, Stakhanovsky Carriage Works, Luganskteplovoz, Dneprovagonmash) • Heavy and power engineering (e.g. Turboatom, Elektrotyazhmash) • Paper and cardboard production (e.g. Kiev Cardboard and Paper Mill, Rubezhnoye Cardboard and Packaging Mill) • Ceramics (e.g. Slobozhansk Building Ceramics, Kharkov Tile Plant, Altcom-Keram, ATEM Group)

 Industries that are significantly dependent on the Russian economy: • Furniture manufacturing (e.g. MERX, Liga-Nova, Progress, Art Metal Furniture) • Electrical and special engineering (e.g. Yuzhmash, , Zorya-Mashproekt) • Confectionary (Roshen, KONTI, AVK) • Pipe and other metalworking (e.g. Metinvest)

 Energy intensive industries: • Fertilizers and other chemicals (e.g. Ostchem, Dniproazot) • Nonferrous metals (e.g. Artyomovsk Non-Ferrous Metals Processing Works, Zaporozhye Titanium & Magnesium Combine)

4 Sensitivity of Ukrainian economic sectors to exports to Russia

Sensitivity of Ukrainian economic sectors to exports to Russia

60 , % , Railcar/locomotive production

Heavy and power engineering

50 production

40 Paper and cardboard production

Electrical engineering

Ceramic industry 30 Furniture manufacturing

Fertilizers and other chemicals 20 Textile industry, apparel and footwear manufacturers Pipe and other metal-working Sugar and confectionery industry Building materials industry Non-ferrous metals industry Iron and steel industry

Ukraine's export to Russia as a part of total total of part a as Russia to export Ukraine's Bread and other cereal products 10 Glass industry Plastic and rubber products Milk and dairy products production manufacturers Pharmaceutical industry Alcohol and soft drink producers Oils and fats producers Vegetable producers and processors Meat and meat product producers Sunflower and other oil-bearing 0 plant producers Cereal0 producers 10 20 30 40 50 60 70 80 Ukraine's exports to Russia as a part of total exports, %

Source: State Statistics Service of Ukraine

5 Actual and potential consequences of worsening trade regulation between Ukraine and the “Customs Union” (Russia)

 Ukraine finally signed the Association Agreement with the EU on June 27th. This is likely to lead to a decrease in Ukrainian exports to Russia. Russia is likely to implement both price (import duties up to 15-20% of Ukraine’s export price) and non-price trade (import quotes, strict certification, etc.) barriers.

 Ukraine’s exports to Russia were valued at $15 bn in 2013. Approximately 70% of this sum was paid for machines and equipment (incl. transport vehicles), ferrous metals and metal products and chemicals. But only Ukraine’s export of spare parts and components within the production chains in the defense industry and heavy and power engineering are vital for Russia. These exports are valued at only $4 bn per year. In the same year, Ukraine imported goods from Russia valued at $23.2 bn and more than 2/3 of this sum was paid for energy supplies.

 A deterioration in Ukraine-Russia trade terms in 2013 resulted in an $8 bn decline in Ukrainian exports to Russia and a $5.2 bn decrease in imports from Russia. According to expert estimates, further changes in trade terms could reduce Ukrainian exports to Russia by another $4-8 bn annually. The same time imports from Russia could be reduced by not more than $2-4 bn per year.

 The scale and severity of punitive sanctions against Ukraine following the signing of the economic part of the association agreement with the EU not completely clear yet, because: . Kazakhstan is in the process of joining the WTO and is not interested in problems from the Ukrainian side . Belorussia is economically interested in trade with its second most important neighbor . Such sanctions would be a double-edged sword for Russia itself, because Ukraine receives at least 5 per cent of Russian exports, including around $10 bn in non-commodity exports; the Russian defense industry also depends on some Ukrainian machine-building companies for components

6 Russia as part of Ukraine’s external trade

Ukraine exports, $ bn (2013) Agricultural products Foodstuffs, incl. oils Mineral raw materials Chemicals to Custom Union Wood & paper products to Russia Textiles, apparel, footwear Total Products from stone, gyps, cement Basic metals and metal products Machines and equipments, incl. vehicles Other industrial products

0 2 4 6 8 10 12 14 16 18 20 Source: State Statistics Service of Ukraine Ukraine imports, $ bn (2013) Agricultural products Foodstuffs, incl. oils Mineral raw materials Chemicals to Custom Union Wood & paper products to Russia Textiles, apparel, footwear Total Products from stone, gyps, cement Basic metals and metal products Machines and equipments, incl. vehicles Other industrial products

0 5 10 15 20 25 Source: State Statistics Service of Ukraine 7 Trade between Ukraine and Russia

Ukrainian exports to Russia (2013) 35,6% Agricultural products (5.0%) Foodstuffs, incl. oils (7.9%) 2,7% Mineral raw materials (4.9%) 5,0% Chemicals (11.7%) Wood & paper products (6.6%) 22,0% Textiles, apparel, footwear (1.4%)

7,9% Products from stone, gyps, cement (2.1%) Basic metals and metal products (21.9%)

4,9% Machines and equipments, incl. vehicles (35.5%) 2,1%1,4% Other industrial products (2.7%) 6,7% 11,7% Source: State Statistics Service of Ukraine Ukrainian imports from Russia (2013) 64,2% Agricultural products (0.6%) Foodstuffs, incl. oils (3.0%) Mineral raw materials (64.0%) Chemicals (9.9%) Wood & paper products (2.1%) Textiles, apparel, footwear (0.4%) Products from stone, gyps, cement (1.0%) 3,0% 0,6% Basic metals and metal products (6.7%) 0,6% 10,0% Machines and equipments, incl. vehicles (11.4%) 2,1% 11,5% 0,4% Other industrial products (0.6%) 8 6,7% 1,0% Source: State Statistics Service of Ukraine Russian companies potentially suffering from changing of trade terms

• Natural gas producers ($8.7 bn)*: e.g. Gazprom • Petroleum product manufacturers ($3.9 bn): e.g. LUKOIL, Rosneft, Tatneft • Coking coal producers ($1.0 bn): e.g. Raspadskaya, Mechel • Nuclear fuel manufacturers ($600 mln): e.g. TVEL • Manufacturers of refrigerators, TV-sets and other household appliances ($ 420 mln): e.g. local Russian factories of Samsung, LG, Phillips etc. • Automobiles and component part manufacturers ($386 mln): AVTOVAZ, KAMAZ, Avtoframos (Renault), local Russian segments of Hyundai, Volkswagen etc. • Complex fertilizer producers ($379 mln): e.g. Eurochem, Phosagro • Automobile tire manufacturers ($154 mln): e.g. SIBUR-Russian tires, Nizhnekamskshina • Manufacturers of components for railcars ($100 mln): e.g. Russian Railways contractors • Electric generator manufacturers ($100 mln) • Tea and coffee producers ($78 mln) • Bearing manufacturers ($50 mln) • Controlling instrumentation manufacturers ($50 mln)

* Total exports from current Russian industrial producers to Ukraine in 2013 9 Necessary reforms in Ukraine for the nearest future (2014-2015)

1. Rapid response to deterioration in Ukraine – Customs Union terms of trade

 Special incentives for Ukrainian exporters to Customs Union states (during transition period)

 Intergovernmental agreements on mutual protection of investments with Custom Union states tied to preserving a favorable customs regime for export of Ukrainian goods to EU countries

2 . Fundamental reforms to improve business conditions

 Tax reform (tax incentives for investors, tax holidays for new projects, accelerated depreciation, VAT refund)

 Arbitration court s

 Law enforcement system

 Increase the power of local authorities (incl. business taxation and licensing issues)

3. Reforms to defend Ukrainian business and labor market

 Laws in the interest of Ukrainian capital: antimonopoly regulation, regulation of public procurement, concessional lending business and preservation of banks with domestic capital

 Laws that motivate qualified specialists to work in Ukraine: education loans, low taxes and development of option-based compensation for highly paid employees

10 Steps to revive economic growth

1. Change the industrial structure of the economy

INSTRUMENTS: Industrial development programs and tax credits, accelerated depreciation on equipment (tax benefits), stimulus for energy efficient equipment, tax holidays for new technological projects, modernization of higher education (to transform technical institutes into branches of European and American universities)

2. Open the domestic market to foreign companies with high level of production localization

INSTRUMENTS: Accelerated transition to EU standards, simplification of licensing, zero duties on components at high level of production localization, stimulate strategic investors to invest to human capital, make direct investment a priority over portfolio investment within the next 5 years

3. Change the practices of courts, tax and law enforcement bodies

INSTRUMENTS: Significant rotation of judges (incl. interregional rotation), independence of the judiciary from other branches of government, improve the qualifications of arbitration judges, large-scale law enforcement reform according to EU standards, reform the VAT system

11 Poland’s success story: an example for Ukraine?

1. Which European country offers the right economic reforms model for Ukraine to follow? 1) Twenty years ago the Polish economy was a similar size and structure and had the same problems 2) The successful reforms in Poland in the 1990s can be used as a model in Ukraine now (monetary stabilization, reform of the banking system, liberalization of business regulation, privatization of infrastructure, structural reforms, etc.) 3) Ukrainian business could be a serious competitor in Eastern Europe. To stimulate growth, an integration plan is necessary (connected with EU financial support)

2. Is it possible to compare Ukraine with Poland today? How to repeat Poland’s 'success story' in the next 5-10 years in the situation of political instability and historical drawbacks: 1) the nation is still in the process of self-identification; 2) were always famous for engineering and scientific talent, but not long term private business experience (this difference is based on much longer “Soviet” period) 3) Poland completely changed top level of government bureaucracy on the early stage of reforms

But, starting from the bottom, with the right package of reforms, Ukraine has a chance for fast modernization of export-oriented industries and the agro-industrial sphere. An inexpensive and highly qualified workforce and position “near the EU, but without full scale EU bureaucratic regulations” offers excellent opportunity for growth. 12 Poland’s success story: can Ukraine do the same?

GDP per capita and average wages in Ukraine and Poland 25,0 1400 Ukraine - average monthly wages, $ (r.h.s.) 1 245 1 146 1 155 Poland - average monthly wages, $ (r.h.s.) 1200 20,0 1 067 1 084 Ukraine - GDP per capita, thsd $ 986 988 1000 Ukraine - GDP per capita (PPP), thsd $ 841 15,0 790 800 Poland - GDP per capita, thsd $ 692 637 Poland - GDP per capita (PPP), thsd $ 577 595 600 10,0 493 374 400 344 330 400 268 282 236 5,0 207 158 111 200 77 71 87 48 69 65 40 42 58 0,0 0 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: IMF, State Statistics Service of Ukraine, Central Statistical Office (Poland) Foreign direct investment, cumulative, $ bn 180,0 170,1 158,0 162,3 158,1 160,0 152,0 140,0 128,5 Ukraine 123,7 120,0 Poland 100,0 92,5 80,0 73,7 56,8 55,3 58,2 60,0 50,3 40,3 40,1 44,8 30,2 33,9 35,6 40,0 24,2 29,5 16,1 19,8 16,9 21,6 20,0 9,3 10,9 6,8 9,0 0,53,0 0,96,3 1,4 2,1 2,8 3,3 3,9 4,6 5,5 0,0 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 13 Source: State Statistics Service of Ukraine, Central Statistical Office (Poland) Poland’s success story: how to become more attractive for investors?

Industrial structure of cumulative foreign direct investment, %

1,6 Agriculture, Forestry and Fishing 0,4 2,6 Mining and Quarrying 0,3 4,8 Food products, beverages and tobacco products 6,1 0,3 Textiles and wearing apparel 0,2 0,9 Wood, paper, printing and reproduction 2,7 3,6 Chemicals and chemical products 6,3 Ukraine Poland 13,9 Basic metals and fabricated metal products 4,8 2,1 Engineering (machinery, electrical, electronic, optical and … 8,8 2,1 Manufacturing n.e.c. 5,1 3,4 Production and distribution of electricity, gas and water 3,5 1,7 Construction 2,7 10,2 Wholesale and Retail Trade 12,8 5,7 Transportation and Telecommunications 5,0 0,5 Accomodation and Food Service Activities 0,3 29,7 Financial and Insurance Activities 31,5 16,2 Real Estate Activities 3,3 0,7 Other Services 6,1

0,0 5,0 10,0 15,0 20,0 25,0 30,0 35,0

Source: State Statistics Service of Ukraine, Central Statistical Office (Poland) 14 Has the Ukrainian stock market already hit bottom?

Ukrainian stock market legislation and infrastructure are extremely poor, even by FIS country standards, and obviously prevent any large-scale investment from large foreign institutions. Institutional changes and incentives for companies to list are needed.

Ukrainian stock market performance 1600 60,0 PFTS Index 6-months average daily value traded, mln $ (r.h.s.) 1400 MSCI Ukraine Index 6-months average daily value traded, mln $ (r.h.s.) 50,0

1200 MSCI Ukraine Index (UAH)

MSCI Ukraine Index (USD) 40,0 1000 PFTS Index (UAH) 800 30,0 PFTS Index (USD)

600 20,0

400

10,0 200

0 0,0

Source: Bloomberg

15 Ukrainian equities are priced on average at 50-70% discount to GEM

Market Cap, $ P/E EV/EBITDA EV/Sales P/Book EBITDA Country / Region DVD yield bn 2014 2015 2014 2015 2014 2015 2014 2015 margin

EM AMERICA 18.9 12.6 7.8 6.9 2.0 1.8 1.7 1.6 3.1% 24% Argentina 22 NEG 7.3 4.5 3.6 1.3 1.1 1.9 1.6 1.5% 28% Brazil 848 16.5 10.0 6.9 6.2 1.7 1.6 1.4 1.3 4.0% 25% Chile 154 19.7 14.4 9.1 8.0 1.8 1.7 1.6 1.5 2.6% 20% Colombia 143 18.4 15.9 8.7 7.6 3.3 3.0 1.7 1.7 3.1% 38% Mexico 362 24.4 16.9 10.2 9.0 2.4 2.2 2.6 2.4 1.6% 23% Peru 41 27.5 12.3 - - - - 2.1 1.9 1.7% -

EM EASTERN EUROPE 8.6 7.5 4.9 4.7 1.1 1.1 0.9 0.9 4.2% 24% Czech Republic 29 12.9 13.6 6.7 7.1 3.1 3.1 1.4 1.4 5.9% 47% Hungary 15 25.7 9.0 5.7 5.3 0.9 0.9 0.8 0.8 3.1% 16% Poland 134 15.1 12.8 6.2 6.0 1.2 1.2 1.3 1.2 4.2% 19% Romania 16 12.4 8.4 - - - - 1.2 1.1 3.7% - Russia 556 5.1 5.1 3.3 3.4 0.9 0.9 0.6 0.6 4.5% 28% Turkey 186 12.3 9.5 8.9 7.5 1.5 1.3 1.5 1.3 3.2% 17%

EM ASIA 13.8 12.1 10.2 9.1 2.2 2.0 1.8 1.7 2.8% 21% China (Shanghai) 1 461 9.4 8.4 7.5 6.7 1.3 1.2 1.3 1.2 3.5% 18% China (Hong Kong) 732 12.8 14.1 15.4 13.8 3.4 3.1 1.3 1.2 2.9% 22% India 929 17.9 14.1 10.6 9.4 2.0 1.9 2.5 2.2 1.6% 20% Indonesia 242 16.2 13.2 9.5 8.6 2.8 2.6 3.1 2.7 2.6% 30% Malaysia 366 16.9 15.1 10.6 9.8 3.2 3.0 2.1 2.0 3.0% 30% Pakistan 39 10.5 8.2 5.8 5.1 0.9 0.9 2.2 1.9 4.9% 17% Philippines 144 22.7 17.2 13.3 11.7 4.1 3.6 2.8 2.5 2.0% 31% Thailand 274 14.7 11.8 8.4 7.7 1.4 1.4 2.0 1.8 3.4% 17% Vietnam 30 14.1 13.4 9.8 7.9 3.1 2.6 2.3 2.0 2.2% 33%

MSCI GEM 8 264 13.4 10.4 7.6 7.0 1.4 1.3 1.4 1.3 2.8% 18% GEM MCAP WEIGHTED 14.2 11.5 8.9 8.0 2.0 1.8 1.7 1.5 3.1% 22% GEM MEDIAN 15.6 12.8 8.7 7.6 1.8 1.7 1.7 1.6 3.1% 23%

Ukraine 14 5.0 3.8 2.3 2.2 0.5 0.5 0.7 0.7 3.1% 21% Discount/Premium to GEM 63% 63% 70% 68% 65% 63% 52% 51%

Source: Bloomberg 16 Most attractive economic sectors

 Non-mining industries with good growth potential and a relatively short payback period : • Cereal production and processing (e.g. UkrLandFarming, MHP, New Century Holding, Mriya Agro Holding, Kernel) • Sunflower and other oil-bearing plant production and processing (e.g. Kernel, Cargill, ViOil, MHP, Agrokosm)

 Industries with good growth potential under a liberal EU trade regime and/or investment in equipment: • Food (e.g. Avangardco, MHP, Obolon, Milkiland, Milk Alliance) • Furniture manufacturing (e.g. MERX, Liga-Nova, Progress, Art Metal Furniture) • Building materials • Plastic products (e.g. Ukrplastic), cars accessories and tools

 Industries with low sensitivity to Custom Union trade and economic policy: • Commercial real estate (Kiev, Dnepropetrovsk, Kharkov, Odessa) • IT services • Transportation and storage (e.g. Lemtrans, Ukrferry) • Sea ports (Odessa Commercial Sea Port, Commercial Sea Port of Illichivsk, Yuzhny Commercial Sea Port)

17 Ukrainian listed equities: Buys

Net EV/EBITD Market Cap Sales EBITDA P/S P/E P/E Income A Company Industry Ticker Exch. Currency mln $ mln $ mln $ mln $ TTM TTM TTM 2015

Kernel Holding SA Agriculture KER PW PLN 856.0 2 796.8 188.0 NEG 0.3 10.0 N/A 4.9

Ferrexpo PLC Iron/Steel FXPO LN GBp 1 316.5 1 581.4 501.7 262.0 0.8 3.9 5.0 6.5

MHP SA Agriculture MHPC LI USD 1 585.0 1 496.1 423.5 NEG 1.1 6.5 N/A 5.3

Avangardco Investments Food AVGR LI USD 632.3 661.2 301.2 236.0 1.0 2.9 2.7 3.1

Astarta Holding NV Agriculture/Food AST PW PLN 358.2 505.6 123.7 NEG 0.7 5.5 N/A 6.8

Industrial Milk Co Agriculture IMC PW PLN 104.1 114.8 54.1 26.1 0.9 4.2 4.0 2.3

Ovostar Union NV Food OVO PW PLN 140.1 89.9 36.8 30.6 1.6 4.0 4.6 6.8

Centrenergo PAT Electric CEEN UZ UAH 230.0 630.5 N/A 40.8 0.4 N/A 5.6 N/A

UkrTelecom Telecommunications UTLM UZ UAH 272.0 535.8 N/A NEG 0.5 N/A N/A N/A

Poltava GOK Corp Iron/Steel PGOK UZ UAH 248.0 712.2 133.4 32.0 0.3 3.8 7.7 N/A

Motor Sich PJSC Machinery-Diversified MSICH UZ UAH 424.6 726.0 N/A 125.6 0.6 N/A 3.4 2.1

DTEK Electric DNEN UZ UAH 232.2 826.0 N/A 109.1 0.3 0.6 2.1 N/A

DTEK PJSC Electric ZAEN UZ UAH 158.8 954.6 N/A 0.2 0.2 10.7 N/A N/A

North Ore Mining and Iron/Steel SGOK UZ UAH 1 549.3 1 128.8 513.6 375.7 1.4 3.4 4.1 N/A Processing Plant PJSC

Source: Bloomberg

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