Russian Fixed Income Weekly
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- Major placements this week: UTK, RZhD, FSK...

Rouble bond market: this week’s primary placements

UTK (Southern Telecommunications Company)

Auction date: Wednesday, December 14, 2005.

The company is planning to place its fourth bond issue with the following parameters. Size: RBL5bn, term to maturity: 4 years, quarterly coupons, principal amortisation schedule starting 1 year after placement, no put options, approximate modified duration: 2.25 years.

UTK is the sixth-largest regional telecom in Svyazinvest’s holding by revenue for 3Q2005. The company is rated Caa1/Stable by Moody’s and CCC+/Stable by S&P. On 5 December S&P upgraded the company’s rating for corporate governance from 4 to 4+.



Notes to the financial data:

(+) The company is demonstrating growing margins (excluding the bottom line), gradually improving its operational efficiency.
(-) The net income margin of UTK is increasingly suffering from enormous interest expense, which is perceived to be a result of the highly speculative level of the company’s credit quality. Naturally, this is also the reason why UTK’s interest coverage ratio is so low.
(-) The debt level of UTK continues to grow. Although the LT Debt/Capital ratio fell in 1H2005 from 52 to 45%, this occurred only because a large portion of the long-term debt became short-term during this period taking the ST Debt/Debt ratio to very high 60.2%. At the same time, the Debt/Assets ratio increased from 37% to 52% indicating a significant increase in total debt burden.
(-) Also as a result of the increase of the portion of short-term debt, in 1H2005 UTK experienced a notable reduction in its liquidity, which was reflected in the deterioration of the short-term solvency ratios, e.g. a fall in the current ratio from 0.31 to 0.22.
UTK’s revenues are expanding, as the doubled sales for 1H2005 were higher than the 2004 figure by approximately 7%. It would have been better to compare the results for 1H2005 with those for 1H2004, but the latter were not available. On the other hand, UTK appears to be behind the industry average in revenue growth. For example, in 1H2005 UrSI’s sales growth (calculated the same way) was 12%, VolgaTelecom’s – 11%.
UTK already has three floating bonds on the local market, namely UTK-1, UTK-2 and UTK-3. UTK-1 is currently the longest bond outstanding, trading at about 9.7% to maturity in 9 months. Naturally, the new, large issue is intended to refinance the company’s current obligations and extend the average duration of the debt.

Unfortunately, it would be wrong to base the pricing of UTK-4 on the market position of UTK-1, as the bond is very illiquid and differs a lot from the new issue in duration. The closest peer for UTK-4 is CenTel-4 (the issuer is rated B-by S&P and B/Negative by Fitch), which is located at 8.55% for 45 months. On the other hand, we have always considered the current level of CenTel-4 too high for its credit. We also must take into account that on 6 December, VolgaTel-2 (duration 2.5 years) was placed with a yield to put of 8.37%.

Taking into account the difference in credit and also the large size of the UTK issue, unusual for this borrower, we believe that UTK-4 should trade at least 1% over the comparable VolgaTelecom credit. This gives us an approximate value of 9.5% as the lower bound for the YTM of the issue at the primary auction. Considering that all of the latest placements in the telecom segment demonstrated a significant primary placement premium, we believe that the YTM of UTK-4 should be looked for in the range of 9.5-9.75% with 10% as a hardly achievable ceiling. Those who want to take the bond for sure should start betting for it at YTP 9.25%.

RZhD (Russian Railways)

Auction date: Thursday, December 15, 2005.

The company is planning to place its sixth bond issue (series 4, as series 6 and 7 were placed earlier this year) with the following parameters. Size: RBL10bn, term to maturity: 1.5 years, semiannual coupons, bullet maturity, approximate modified duration: 1.3 years.

Russian Railways are 100%-owned by the Russian government. The company is one of few Russian businesses having a full investment grade rating: BBB-/Stable by S&P, Baa2/Stable by Moody’s and BBB/Stable by Fitch.



There’s basically no uncertainty about the pricing of the new bond being placed. RZhD already has 4 floating rouble bonds, the closest one to the new one being RZhD-2, which is trading approximately at 6.9% to maturity in 24 months, which translates to 6.75-6.8% for the 18 months to maturity of RZhD-4. However, it is important to note that RZhD-2 is currently quite illiquid and its level may contain a small premium to the otherwise fair value.

Should there be the primary placement premium? The size of the new bond is quite large (RBL10bn), but the paper is very short, which means that many investors, including foreigners, will be intending to hold the issue to maturity. We believe that the fair value of RZhD-4 is located between 6.5 and 6.75% to maturity, but due to the high issue size the YTM will result in the upper half of this range, i.e. close to 6.7%.

FSK UES (Federal Grid Company)

Auction date: Thursday, 15 December, 2005.

The issuer is placing its third rouble bond with the following parameters. Size: RBL7bn, term to maturity: 3 years, semiannual coupons, bullet maturity, approximate modified duration: 2.6 years.

FSK UES is an integral part of the RAO UES system, and was created in 2002 in the course of the RAO UES reform with the aim of concentrating all energy transmission assets of the company under one roof. Currently, FSK UES directly controls about 30% of all high-voltage lines in Russia, while the rest is owned by 74 regional AO-energos, in which FSK UES has its stake (15% in 72 of them).

FSK UES is 100%-owned by RAO UES, which, in turn, is 52%-owned by the Federal government. FSK is rated B+/Stable by S&P.



Notes on the presented data:

(+) Overall, FSK’s figures are very good, especially on the income statement side, where the company demonstrates outstanding margins, which are in addition, expected to rise in 2005.
(-) These margins directly depend on the tariffs on energy transmission, which are largely out of FSK’s control as the tariff policy of FSK as a monopolist is strictly controlled by the government. Therefore, the future level of tariffs is a function of the negotiation power of FSK in discussions of this question with the government. As inflation is one of the most important current concerns of the Russian authorities, FSK UES may experience problems with raising tariffs in the future. This argument is, on the other hand, somewhat weakened by the fact that the portion of FSK’s tariffs in the final electricity bill paid by consumers is very small (less than 10%).
The short-term solvency ratios expected to be very high in 2005 (current ratio of 5.5), are the pure result of the new bond issuance. Naturally, the company expects that the entire sum received from the new bond will appear on the balance sheet in cash by the end of 2005.
(+) The leverage of FSK is very low: long-term debt is expected to reach only 12% of the company’s capital in 2005, while the total Debt/Assets ratio is likely to be close to 11%. In addition, the company will have no short-term debt at all.
(+) In comparison with RZhD, in 2004 FSK UES had stronger margins, much longer average debt duration, and higher liquidity.
(-) On the other hand, RZhD had a much larger scale, higher returns on assets and equity, and even lower debt level compared to other balance sheet items. The liquidity ratios were relatively low in 2004, but due to issuing very long RZhD-6 and -7 bonds this year they should significantly improve in 2005.
(-) RZhD is directly owned by the government, so its credit ratings are much better than that of FSK UES.
The latter three bullets were presented above in order to justify the pricing of FSK UES at a premium to existing RZhD issues. In addition, FSK UES has two floating bonds on the rouble market, the closest one, FSK UES-2 trading at 7.5% to maturity in 55 months. The equivalent yield of FSK UES-2 at the duration of the new FSK UES-3 (2.6 years) can be estimated at 7.15%, while the equivalent yield of RZhD bonds at the same duration is close to 7%.

The issue managers were marketing FSK UES-3 at 6.8-7.1% to maturity, but we believe that the bond is not interesting for purchase at such low yield levels. In the current market situation investors are demanding something to compensate them for the necessity to bear the bond on position over the New Year holidays, so we advise placing bets for FSK UES-3 at a YTM 7.2-7.35%.

Dmitry Dudkin, Moscow (7 095) 755 5480