Run Down by the Russian Express

Co-owners of Transmashholding had selected an underfinanced segment of machine-building industry to create an effective and explosively growing business valued at almost one billion dollars. Nonetheless, predicting its future prosperity is not a safe thing to do, considering its debt burden and competition from international giants.

By Andrey Vinkov

Growth of Transmashholding financial turnover strikes imagination – 10 times in the past 5 years

To make its appearance on the capital market more effective, Transmashholding needs only one thing: better technologies and know-how than those it inherited from the Soviet Union.

Breeds Well Without Food

The demand for passenger cars and locomotives has been colossal. During the Soviet era, about 58% of all funding into the railway transport went to finance rolling stock. For example, in 1989 USSR financed 1.5 thousand locomotives, 60,000 freight cars, and 2.8 thousand passenger cars. In current prices, the funding from all sources was RUR 6.9 trillion. In comparable prices, this is 55 times more than what can be afforded by the monopoly railway operator Russian Railways.

But the cost structure has remained the same. The situation with the fleet of cars and locomotives is very difficult. In 2005, Russia produced 45 diesel and 107 electric locomotives, while the shortage of locomotives at the beginning of 2006 was 6.4 thousand units. In expert assessment, in the coming 5 years total demand of the Russian Railways and private railway operators will reach 14 thousand units. To be able to meet that demand the new Transmashholding will have to increase production by several factors of ten.

Clearly, as the Russian Railways continues to raise tariffs, Transmashholding must be getting an ever increasing volume of orders. Which it does: production increases by 30 to 40% every year, and revenues are soaring. In one year, Transmashholding plans to increase revenue from USD 1.46 billion in 2005 to USD 2 – 2.4 billion this year (See Chart).

The company does not disclose its net profits. It could be the profits are not as good as the owners would have wanted. Transmashholding complains the Russian Railways uses its monopoly status to bring down the prices it pays to the suppliers; sometimes the margin it allows is lower than the inflation rate. This is not a good sign, because with low margins the company has to debt-finance the development of new technologies and purchases of new equipment, but that cannot last forever. And the debt burden is piling up. In the assessment of Expert magazine, the consolidated debt of Transmashholding now exceeds USD 0.5 billion. Unfortunately, there aren’t any grounds to believe that further expansion would be financed from equity.

A Bait for Russian Railways

This autumn Transmashholding plans to come up with its second bond issue worth almost USD 150 million. The proceeds will not go to finance production. Transmashholding will use the resources to consolidate its assets. In summer, president of Russian Railways Vladimir Yakunin announced negotiations to acquire a controlling stake in Transmashholding, but, he said, the transaction may only come through if Transmashholding becomes the direct shareholder in the machine-building companies it now owns indirectly.

Strange as it may seem, until recently Transmashholding had been just a nominal holding company. This March, the company applied to the Federal Anti-Monopoly Service (FAS) asking for permission to consolidate its main production assets: up to 100% of shares in the Bryansk Machine-Building Plant, Metrovagonmash, Demikhovski Machine-Building Plant, Kolomenski Plant, Novocherkasski Electric Locomotive Plant, Oktyabrski Electric Locomotive Repair Plant, Penzadieselmash, Tsentrosvarmash, and Bezitskaya Steel. Until recently, Transmashholding had not owned a single asset which it controlled. It operated as a management company, leasing out the plants and their equipment.

The analysts value Transmashholding at USD 0.9 – 1.0 billion, with due account of country risks and adjustments for low transparency of data. But should the Russian Railways choose to become a shareholder, Transmashholding may become much more expensive and profitable. The two companies are close partners. The holding has several long-term cooperation agreements in place with the railway operator worth about USD 10 billion. If the merger comes through, it will be able to take a more balanced approach to the funding for the purchase of railway cars and locomotives.

Transmashholding needs additional funding not only to buy out the shares in controlled companies from its owners. To avoid any doubt that Transmashholding has been created for speculative purposes, the management of the company tries to persuade the Russian Railways that it pursues a strategy of innovation.

Transmashholding made first attempts to find and purchase new technologies a little more than a year ago. In 2005, it set up Transconverter, a joint venture with Siemens. The JV specializes in the development and production of high-voltage static converters for passenger cars, electric locomotives and electric trains. Siemens transferred the rights to Transconverter to produce this equipment. Strangely, Siemens had agreed to have Transmashholding as the controlling shareholder in the JV. In the coming years, the JV plans to develop and start commercial production of asynchronous drive, a so-much needed new generation technology for the Russian railway industry.

The second step was marked by the acquisition of FTD Dessau, an oldest engineering and production center in Europe. Back in the old days, East German company Waggonbau Dessau specialized in the production of sleeping cars and refrigerator cars. But the company had to change its specialization in the early 1990s after the break-up of the Warsaw Pact and the unification of Germany. Now, the company is mainly in the R&D business: it develops and produces pilot versions of new rolling stock (passenger cars, suburban and inter-regional trains), inner city trains and parts and accessories. FTD Dessau has essentially become an outsourcing engineering center. Over the years major transport machine-building companies, including Alstom, Bombardier and Siemens, placed orders with FTD Dessau. What the acquisition means for Transmashholding is primarily access to already available technologies. In particular, FTD Dessau can offer interesting solutions for drives, aluminum body, sliding doors, and tram production technologies. “With time, we would have developed and implemented such technologies ourselves”, Transmashholding officer Artem Lednev has explained to the Expert. ”But we have to hurry. Russia will soon join WTO, and by that time we have to build up competitive advantages to withstand the test of price/quality in competition with foreign players for orders from the Russian railway operators.”

The third, and probably the most ambitious undertaking of Transmashholding is participation in the project to build high-speed railways. It co-founded the company High-Speed Railways, and now owns 24.9% of its shares. Russian Railways is expected to own 75% plus one share in the project. The new company will pursue the project of building a high-speed railway linking Moscow and Saint Petersburg, which had been first conceived back in 1991. The estimated project cost is more than USD 4 billion. On this project, Makhmudov’s company managed to outrun its own partner Siemens. Siemens wanted to build the tracks and supply trains and equipment for the project, but the Germans were not allowed to play the first fiddle in this megaproject. One reason for that could have been a lack of cooperation of Siemens in handing over some of its new technologies to Transmashholding.

In general, Western producers of similar equipment prefer to become “friends” with Transmashholding. In addition to a JV with Siemens, Makhmudov’s company now has a JV with the Canadian Bombardier and is in discussions with the French Alstom. Despite this, there have already been a number of occasions where foreigners overtook Transmashholding in its own market.

The Battle for the Ukrainian Giant

“Railway machine-building is a highly research and capital intensive industry”, says an industry report of investment company Atlanta Capital. “This consideration brings the industry players together in order to pool financial and technological resources to implement innovative projects and create new technologies. We have witnessed consolidation of the railway industry in Western Europe, North America and Asia. The process has resulted in the creation of powerful industry players, such as Siemens, Bombardier, Alstom, General Electric and Kawasaki, who between themselves hold more than 75% of the world market”. Clearly, Transmashholding is still a far cry from those giants. Catching up is worth a try, though - if those competitors do not nip its initiatives in the bud.

One such initiative is the acquisition of Ukrainian Luganskteplovoz, a unique company for the former Soviet Union. Historically, it was the place where heavy-duty locomotives were manufactured for the Soviet railways. These products are in high demand in almost every CIS country. Of course, Transmashholding” has to develop that business. It has done a lot already: two new heavy-duty locomotives (one with collector-type and the other asynchronous type engines) have been developed and are undergoing certification testing, and there is already a program in place to modernize the Bryansk Machine-Building Plant (BMZ) to start mass production of heavy-duty locomotives. But starting such production from scratch at BMZ is much more expensive than modernizing Luganskteplovoz. The second option is clearly a preferred one for Transmashholding.

But that option may not be an easy one, considering the announced plan to privatize Luganskteplovoz.

In the summer of 2006, the State Property Fund of Ukraine (FGIU) announced an auction for the sale of 76% of Luganskteplovoz. The starting price was almost USD 60 million. As of August 28, FGIU signed 5 confidentiality agreements with potential customers covering information about Luganskteplovoz. Preliminary bids were submitted by three foreign and two Ukrainian companies: Ukrainian Energy Standard and Avtokraz, Transmashholding, Siemens and Polish company Kolej Baltycka. Siemens participation is a clear indication that the concern is interested in the railway market of the former USSR.

This is a challenge for Transmashholding. The company will be able to address it only if it gets a carte-blanche for strategic cooperation from the Russian Railways.