Research Notes

United Heavy Machinery

General information on the issuer

UHM (OMZZ)
Common shares	35,350,000
Preferred shares	2,750,000
Price, $ (common)	4.05
Market capitalization, $ mln	143

Financial indices, $ mln

Item	2002	2003	2Q. 2004
Sales revenue	434.288	546.235	176.157
Prime cost	325.563	392.979	123.080
Sales profit	21.119	40.397	13.488
Profit before tax	28.835	26.926	5.554
Net profit	31.277	22.688	5.359

Dividend history

Share	Dividend period	Dividend pay share, Rub
Preferred shares	2003	0.0012
Common shares	2003	0
Preferred shares	2002	0.0012
Common shares	2002	0

Price performance of OMZ shares and RTS Index

Source: RTS

Current price, $	4.05
Target price, $	4.9
Upside/downside potential	21%
Recommendation	Hold

Natalia Kocheshkova
Natali_k@finam.ru
8 (095) 204-81-65

After the merger was disrupted with Power Machines, UHM shares look bleak, have lost half of their market value and currently the company’s market cap stands at a mere $143 mln.

The potential of nuclear equipment market, currently targeted by UHM, does exist, although it could emerge most likely only in the medium and long-term outlook. At the same time, over the next couple of years UHM intends to continue restructuring its assets and production facilities, whose perspectives are still unclear. After the sale of UHM-MNP, the machine engineering giant’s market value dropped drastically, while the future efficiency of the assets acquired is not evident. The company’s debts remain high as before, although we would like to note that UHM has succeeded in rolling over its liabilities.

Thus, in our view, at present UHM shares are a high-risk investment vehicle. In the event that the above negative factors are removed and the programs are implemented, we can expect UHM to become more attractive in the eyes of investors.

SWOT analysis

Strengths/ Opportunities Leading position on the heavy machinery market Relative liquidity of its shares compared with other engineering peers Upside potential of the nuclear equipment market Acquisition of three subsidiaries from Czech Skoda Holding

Weaknesses/ Threats High debts Abortive merger with Power Machines Decrease in business scope after sale of assets Changes in exchange rates No common dividend payouts (anticipated by 2006 at the earliest)

Breakdown of UHM’s charter capital

Source: Company data

UHM is Russia’s largest heavy machinery producer, specialized in engineering, production, sales and servicing of equipment and machinery for nuclear power stations, mining industry, production of alloy steels and equipment for some other industries. The holding amalgamates several engineering entities.

After the recent sale of some assets, the structure of the company’s revenue changed drastically and became less diversified. At present the bulk of revenues are generated from sale of nuclear, metallurgical and machine-building equipment (previously oil and gas equipment was the No. 1 revenue driver). In addition, the output of nuclear equipment has become a top priority for the engineering giant.

Nuclear equipment

Equipment for nuclear power plants is mainly produced at the Izhora and Skoda JS plants. UHM commands roughly 28% of the world’s nuclear equipment market. At present, the engineering giant is the only domestic producer of machinery for nuclear power stations equipped with water-water reactor facilities and produces equipment for 5 out of 11 power blocks currently erected at the Russian nuclear power plants.

Mining equipment

UHM turns out equipment for all stages of open pit mining and refinery of mineral resources, such as: drilling rigs, walking draglines, caterpillar mining excavators, grinding and milling machinery. UHM holds nearly a 90% share of the Russian market of heavy mining excavators and draglines. Mining machinery is manufactured at the Uralmash and Izhora production facilities.

Metallurgical equipment

UHM is one of the leading manufacturers of forged pieces, mouldings, two- and three-layer sheets and plates made of alloy steel and alloys, shroud rings and other products. UHM is the only company in Russia capable of producing unit-forged billets for steam turbine rotors and turbine-type generators with capacity up to 1,200 MW. The company’s share on the market of forged and cast products is 35% and 30%, respectively. The engineering’s major producers of metal products are UHM-Spetsstal and Skoda Steel.

UHM’s current order book, estimated at $748.1 mln, looks as follows:

Atomic equipment 63%
Customized steel 12%
Mining equipment 8%
Industrial services 13%
Other 4%

Source: Company data

The primary contract in the nuclear segment involves supplying equipment to the Nuclear Power Corporation of India and the Kudankulam nuclear power plant. In the future, the holding intends to win new contracts to deliver its nuclear equipment to Russian, Bulgarian, Slovakian, Hungarian and Chinese companies.

As for UHM’s sales mix, most of the company’s revenues come from Russia and Asia. The holding intends to take proactive measures to raise its sales especially in Asia in the future. Here we would like to note that UHM’s market position is affected by fluctuating currency exchange rates, the declining dollar in particular, since 68% of its orders (without taking into account Skoda Steel and Skoda JS) are denominated in US dollars, 6% in euros and 26% in rubles, while the company records ruble-denominated expenses.

Market – potential does exist

Let’s take a brief look at nuclear equipment, the major revenue earner for UHM today. This sector is characterized by fierce competition. At the same time, in our view, the sector holds strong upside potential, which we attribute, first and foremost, to the ongoing power sector reforms in Russia.

Liberalization of the electricity market by 2007 could prompt investors to pour more funds into the power energy assets. The high depreciation rate of power engineering equipment and lack of investments in the power sector over the past several years, should also contribute to a greater flow on investment into power assets. Moreover, the entry of private investors into the domestic power sector should also boost investments in the industry.

On the back of rising prices for energy resources nuclear power plants have become increasingly attractive around the world (earlier growth was constrained at a number of nuclear power plants (NPPs) due to the much higher cost of their construction compared with thermal power plants). This fact gives us reason to assume that the nuclear equipment market will grow. According to experts’ calculations, NPPs should be able to compete with gas-fired thermal power plants when gas prices reach $40 per ton of oil equivalent. According to some estimates, the price of blue fuel could hit the above level this year, since gas currently goes for $37 per ton of oil equivalent.

To date, the world’s nuclear equipment market is estimated at $45 bln. According to some estimates, Russian nuclear equipment producers could manage to command up to one third of this market. In addition, UHM expects to see a rise in nuclear power production facilities in Asia, APR, Eastern Europe (Bulgaria, Slovakia and Hungary), and also in CIS member states.

UHM and Power Machines

This year the largest merger of Russian heavy machinery producers was aborted. UHM and Power Machines were expected to merge their assets on a parity basis. The merger was to allow these companies to cut their debts and enable them to provide domestic customers with more favorable terms to finance long-term contracts. The Newco was to specialize in production of equipment for power stations, while oil and gas industry facilities would be of lesser priority.

This merger deal was, first and foremost, of interest to UHM because of a greater free float of the new company’s shares (45%) and, consequently, the opportunity to boost liquidity of the holding’s shares.

However, Power Machines backed away from the merger with UHM, opting for a deal with German major Siemens. After the companies swapped their shares, designated for the merger deal, UHM’s losses totaled $20 mln, as it had to buy out 14% of its shares from Interros at a price twice as high as their market value.

In addition, while getting ready for the merger with Power Machines UHM did a lot to restructure its business. And, by the way, the company intends to continue restructuring its assets and production facilities further down the road. However, some time will elapse before UHM is able to produce and sell its products at pre-merger levels.

UHM’s acquisitions and disposals

The divestiture of non-core assets was one of the stages of the Power Machines-UHM merger. The first entity for sale turned out to be UHM-Marine and Oil & Gas Projects (UHM-MNP), sold off for $50 mln to the top managers of this company under the so-called management buyout scheme. As a result of this transaction, UHM’s aggregate debt was reduced by $70 mln, i,e. by the amount listed on UHM-MNP’s balance sheet.

We would like to note that in 2003 UHM-MNP managed to generate up to 40% of the machine engineering giant’s 2003 IAS aggregate consolidated revenues. After the sale of UHM-MNP, the holding has three divisions involved in manufacturing equipment for nuclear and mining industries and producing alloy steels.

In the future UHM is set to focus on production of equipment for the power generating companies. In pursuance of this strategy, UHM spent $40 mln to acquire three subsidiaries of Czech Skoda Holding: Skoda JS and Skoda Steel (Hute and Kovarny divisions).

Skoda JS specializes in the design, production and maintenance of nuclear equipment, as well as equipment for the chemical and petrochemical industries. Skoda Kovarny turns out components for four-stroke-cycle diesels and metal structures for wind power stations, while Skoda outputs steel and iron castings.

On the one hand, a positive factor is that the purchase of Skoda’s divisions should strengthen the holding’s positions on the power equipment market, which it currently targets, provide it with access to advanced technologies and unlock opportunities to break onto the East European market. The operations of Skoda’s entities should to some extent offset the losses UHM incurred following the sale of UHM-MNP.

On the other hand, Skoda JS and Skoda Steel will be unable to generate profits which UHM needs at the moment, as their profit margins are much lower than those of UHM-MNP, and the funds injected in these companies, as UHM officials reported, should translate into profits only in the future.

>Financial reports

In line with UHM’s 1H 2004 IAS unaudited consolidated financial statement, the holding’s revenues surged 32% to $176.2 mln, gross profit totaled $53 mln, or up 38% on the same period a year ago, EBITDA equaled $18.5 mln, whereas more than 40% of EBITDA was derived from sale of various assets (i.e. from sales but not operations). Before taking into account the financial effect from suspended operations as of June 30, 2004, OMZ’s net profit rose to $5.4 mln.

tem, $ mln	6m 2004	6m 2003	Change, %
Revenue	176.2	133.4	32%
Prime costs	-128.1	-94.8	35%
Gross profit	53.1	38.6	38%
Gross profit margin	30.13%	28.93%
Sales profit	13.5	9.3	46%
Sales profit margin	7.66%	6.94%
Net profit	5.4	4.7	15.2%
Net profit margin	3.0%	3.5%
EBITDA	18.5	13.5	36.9%
EBITDA margin	10.52%	10.14%

Source: Company data

Suspended operations refer to the company’ subsidiary UHM-MNP. Meanwhile, it should be noted that according to the holding’s reports this company is a more profitable business, since its profit margins are much higher than those of UHM itself with EBITDA margin at 16% (EBITDA came to $23 mln) and net profit margin was 7%.

The data released do not factor in the acquisition of Czech businesses Skoda JS and Skoda Steel. After these entities are consolidated, UHM financials will look much better. Taking into account the Czech entities acquired, UHM’s FY 2004 sales are expected to be $513 mln and net profit to reach $10 mln (versus $546 mln and $23 mln in 2003). However, according to the holding’s forecasts, net profit could total $34 mln by 2005 and its aggregate debt liabilities would drop to $190 mln from the current $262 mln.

UHM debts

It is UHM’s indebtedness, still at a high level, which is the main reason for concern among investors when estimating the issuer’s investment appeal.

According to recent developments, so far UHM has been able to avoid a debt crisis. The company has redeemed $30 mln credit notes ans refinanced its $180 mln debt. The company’s spokespersons say UHM’s debts will amount to $220 mln by year-end 2004, which is still a high figure for this company.

As a result of debt refinancing, Standard & Poor's (S&P) confirmed UHM’s rating as CCC+ with a “stable” outlook, with the national scale rating at “ruBB”. The rating agency also pointed out that the new timeframe for debt repayment raises no concern in the short term.

Valuation

Our valuation of UHM stocks uses the comparative method. We are aware that this method is characterized by discrepancies due to a high degree of irrelevancy in the comparative process. For this reason, we have adhered to comparative analysis, separating world producers of NPP equipment and producers of metallurgical and mining equipment (which accounts for over 80% of UHM’s revenue mix).

Ñompany	Country	Market cap, $ mln.	P/E	P/S	EV/S	EV/EBITDA
UHM		143	14.32	0.28	0.31	5.33
NPP equipment
ABB Ltd	Switzerland	12,587	16.16	0.67	0.76	10.04
Siemens	Germany	54,623	19.40	0.94	0.91	1.58
Alstom	France	465	neg.	0.04	0.21	3.46
Mitsubishi Heavy	Japan	11,47	27.12	0.37	0.44	6.44
Hitachi	Japan	2,105	13.96	0.03	0.09	1.13
Average			19.16	0.41	0.48	4.53
Metallurgical, mining equipment
Caterpillar	USA	31,012	28.22	1.36	1.97	12.77
Terex	USA	2,157	neg.	0.55	0.76	23.03
Atlas Copco	Sweden	9,3	19.59	1.44	1.51	7.83
Average			23.90	1.12	1.41	14.54

Source: Company data, Finam estimates

Since all industry peers relate to developed markets, we have adjusted our multiples by the country risk, which was calculated based on interstate comparisons in credit rating and equaled 0.66.

We assigned a weightage to each of the multiples (P/E, P/S, EV/S è EV/EBITDA). P/S, EV/S and EV/EBITDA were given a larger weightage. In our opinion, such a fiancial indicator as revenue is less subject to accounting adjustments than profit.

In the process of calculating the average value, we took into account a share of each product in the company’s revenue mix. As a result, the company’s share price stands at $4.90.

Nataly Kocheshkova

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Sector: Engineering
Company: OMZ

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