By John Helmer, Moscow
For a country of Russia’s physical size, trains are an obvious strategic necessity. So it’s peculiar that there is a monopoly for pulling and pushing those trains from place to place, and that this monopoly for building locomotives should be held by a single man, who, with Kremlin approval, has buried his interest in a secretive private company in The Netherlands. That company is called Breakers Investments. The man who controls it is Iskander Makhmudov  (image), otherwise known as the heir to Mikhail Chernoy’s (Cherney) copper and coal businesses.
Through the procurement of locomotives by state-owned Russian Railways (RZhD), money is moved from state-regulated transport tariffs collected by the rail operating units and from the state-subsidized RZhD investment budget through the Transmash group of companies; then in the form of dividends from Transmash’s profits it is paid into Breakers Investments. What remains a mystery is how the large profits declared by Transmash disappear when the balance-sheets of Breakers Investments show a loss.
The only disclosure of the Breakers Investments accounts appears in financial reports from Russian Railways (RZhD). That’s because the RZhD chief executive Vladimir Yakunin arranged with Makhmudov in 2007 to hold a 25% blocking stake in Breakers Investments. This should entitle RZhD to a 25% share in Breakers Investments profits. But according to RZhD, in 2008 and 2009 nothing came back from Amsterdam to RZhD’s investment income accounts. The corresponding Transmash accounts for those years show bottom-line profits of Rb1.7 billion ($58 million), and Rb807.8 million ($27 million). They were the years of economic crisis, dwindling rail cargo volumes, and shrinking revenues. Notwithstanding, Makhmudov moved 30% of the 2008 Transmash profit in dividends to Amsterdam; in 2009, when the net profit was half as much, the dividend payout ratio more than doubled to 65%. According to RZhD’s accounts for associated companies, Breakers Investments earned a negligible profit in 2008 and was loss-making in 2009. See page F-85 .
The Transmash accounts, published in Russian without standard international auditing controls, reveal that in 2010 net profit came to Rb5.7 billion ($187 million), and dividends of 26%, or Rb1.5 billion ($49 million), were paid to the shareholders in Breakers Investments. In 2011, Makhmudov and his associates needed cash, and the payout of dividends came to Rb2.3 billion ($78 million), 61% of the net income line of Rb3.8 billion ($129 million).
Where does this money go? And are the profits from building new locomotives headed for the same black hole?
Building new locomotives is an obviously good idea when the volume of cargo is growing, so RZhD explained in its March 2011 prospectus  to raise £350 million in 20-year loan participation notes from international investors. RZhD claimed it “ intends to allocate significant resources to maintain or replace its locomotive fleet, aimed at slowing its retirement rate to less than 1 percent per year. The average service life of a locomotive is between 30 and 40 years. In connection with the locomotive replacement and upgrade plan, the Company’s capital expenditures are projected to amount to RUR 131.8 billion for 2011 through 2013, of which approximately RUR 37 billion projected to be spent in 2011. The locomotives are expected to be manufactured by and purchased from Transmashholding and other locomotive manufacturers selected on a competitive basis. In certain instances, the Company may invest in design and development of locomotives by these producers subject to the relevant designs being transferred to the Company’s ownership.”
For the next three years, RZhD is projecting growth in cargo volume to be transported of 2.5%, 3.2% and 3.2%, respectively. Makhmudov needs to come to the rescue with more pulling and pushing power.
This month it has been announced  that RZhD will spend Rb85 billion ($2.7 billion) on buying 770 new locomotives; the precise time period for procurement, construction and delivery hasn’t been announced. According to the RZhD release, following a cabinet session to confirm the numbers of locomotives, the outlays, and the state subsidies, the new procurement will be a “record number… That is good news for French engineering conglomerate Alstom and its German competitor Siemens, which hold stakes in key Russian locomotive suppliers. ‘This is the most that the Russian Federation can produce per year,’ [Transport Minister Maxim] Sokolov said at a regular Cabinet meeting, which endorsed Russian Railways’ spending for next year. Industry and Trade Minister Denis Manturov said that Transmashholding, co-owned by Alstom, will supply most of the machines.”
There is a highly competitive global market for locomotive building, including Bombadier of Canada, Siemens of Germany, General Electric of the US, and Alstom of France. But the procurement process of RZhD for the new locomotive purchase isn’t open to all, and the press notice is misleading. That’s because RZhD’s procurement of locomotives isn’t competitive at all. Officially, RZhD sources say no decision has been reached yet on how much of the $2.7 billion will go to Transmash. Unofficially, industry sources believe almost all of it will.
A spokesman for Transmash says that in 2010 the Makhmudov group turned out 355 locomotives; in 2011, 434. A spokesman for RZhD says that in the same two years the company bought 393 locomotives, in 2011, 453. The numbers mean that between 90% and 96% of RZhD’s procurement comes from Makhmudov, and this percentage is likely to remain the same for the next round of purchasing.
It cannot be said that to date Makhmudov’s takeover of Transmash or Yakunin’s management of RZhD has been especially productive of the number of locomotives Russia needs. In 1989, by contrast, the Soviet Ministry of Railways bought 1,010 locomotives from domestic plants. The land area for powering trains across the Soviet Union was 22.3 million square kilometres, compared to 17.1 million square kilometres for Russia’s present territory. So now there are twice fewer locomotives rolling off the production line to drive trains across 23% less land. At this month’s cabinet meeting, Minister Sokolov admitted that 770 locomotives is the maximum which can be produced in Russia in a year; just three-quarters of the last Soviet total.
The way in which Makhmudov acquired his monopoly and shared it with Yakunin was as little noticed as Breakers Investments is secretive. Transmash made its initial appearance in 2001, with the takeover of the Bryansk Engineering Works (BMZ), a manufacturer of diesel locomotives. The takeover method was similar to that already tested by Makhmudov between 1996 and 2001 in his takeover of the steelmills, copper and coal assets which formed the core of his mining and metals business. By cancellation or withholding new procurement orders, and delay in payments, the pressure of bankruptcy was applied against BMZ’s then owner, Petr Baum’s Galls Group, by a combination of Transmash structures and Kuzbassrazrezugol, the Makhmudov coal-mining company. Ousting Baum, they then took over operational control of BMZ, and reorganized its shareholding, so that it became a part of the Transmash holding(TMX).
In 2002, Transmash followed by buying 25% of the shares of the Tver Railway Car (Carriage) Works, and a controlling interest in Muromsky Switch Factory. In 2003, control was established over the Novocherkassk Electric Locomotive Plant (Russian acronym NEVZ) and Kuvshinsky Transport Equipment Factory.
The story of the NEVZ takeover is illustrative. In its peak production years, before 1991, NEVZ turned out hundreds of locomotive and electric power units per year. After the collapse of the Soviet system, the orders and revenues dried up. A court ordered administrator for bankruptcy was introduced in 2000, and the legal procedures adopted which should have secured the company from liquidation for several years. However, Makhmudov and his allies created a parallel corporate structure, also called NEVZ, which drew orders from RZhD, and established operational control of the plant. At the same time, the old enterprise structure was left with its obligations and debts.
If the scheme was suspected to be a fraud at the time, noone has tested the evidence in a court of law. While other domestic groups saw the opportunity to buy into the railway engineering sector at discounted prices, over time Makhmudov and Yakunin have persuaded them all to sell to Transmash.
On November 19, 2007, the Federal Antimonopoly Service (FAS) issued a ruling authorizing the Amsterdam-registered Breakers Investments to acquire 100% of the Transmash holding’s assets in Russia. The application for authorization was filed on November 8, so the approval process was 11 days — exceptionally swift.
According to the published FAS statement, “the information and the documents presented, together with the petition, completely met requirements of Part 5 Article 32 of the Law on Competition. In the course of consideration of the present petition, the bases for initiating investigation of administrative offences are not revealed.”
The list of incorporated assets in the Transmash group, subject to the transfer, was identified by FAS from the Breakers Investments petition and published as follows: Open Company Transconverter, Joint-Stock Company Trading house ТМХ, Open Company INTELPRO ТМХ, Open Society Octyabrsky Electrorepair Factory, Joint-Stock Company Roslokomotiv, Open Company Transmashholding-Ukraine, Open Society Metrovagonmash, Open Society Enterprise of Social Service of Metrovagonmash, Open Society Kolomensky Plant, Joint-Stock Company Kolomensky Plant Trans-Baltic, Open Company Enkol, Open Company Kolomensky Plant-Invest, IP KolomnaBelTrans, Open Company Public Catering Industrial Complex, Open Company” Investment-diesel engine, Open Company Diselprom, Open Company Stroidiesel, Open Society Diesel Microprocessor Systems, Open Society ON BMZ, Open Society ON BS, Open Society Penzadieselmash, Open Society Tsentrosvarmash, Open Company Personal Computer BSZ, Open Society Demihovsky Machine-building Factory, Open Company Eye КМТ, Joint-Stock Company OVK ТМХ, Open Company Alkor, Open Company Binar, Open Company Delta, Open Company Jontek, Open Company Elite Business, Open Company Novocherkassk Electro-machine Construction Plant, Open Company NEVZ Personal Computer, Joint-Stock Company thermal power station NEVZ.
Market shares for Russia and the Commonwealth of Independent States of the Transmash units were investigated and reported by FAS as follows:
– Kolomensky and NEVZ, with more than 90% of the electric locomotive market
– Kolomensky, with about 80 % of the diesel locomotive market
– Demihovsky and Metrovagonmash, with about 80% of the market for electric trains and diesel-engine trains
– Metrovagonmash, with about 90% of the market for underground train cars
– Kolomensky and Penzadieselmash, with about 80% of the market for diesel engines for railways
Not at the time, and not since have there been precedents for the FAS to agree to permit the sale abroad of quasi-monopolists like this. The conditions the FAS attached to the transaction were minor technical reporting requirements, and the undertaking: “within 5 years not to increase the price [of goods supplied by TMX’s units] by more than 20 % per year for each kind of production without prior notification of not less than 30 calendar days”; and a 30-day notice requirement for “changes of structure of the group of persons of Closed company Breakers Investments B.V.”
In fact, the unprecedented Russian government authorization for this offshore monopoly structure was conditioned by the transfer of a 25% plus one share blocking stake in Breakers Investments to Yakunin’s RZhD. Announcement of that transaction followed within ten days on November 28, 2007. Nowhere does FAS note that Breakers Investments was wholly owned at the time of the transfer of the Transmash assets by two individuals, Makhmudov and his protégé, Andrei Bokarev, then chief executive of Transmash, and now chairman  of the Transmash board.
The FAS report didn’t disclose in 2007, but a later RZhD report indicates that RZhD had paid Rb9.3 billion (in 2007 equivalent to $317 million) for its share in Breakers Investments. Notwithstanding, open estimates of the value of the Transmash assets at the time indicated the lot should have been worth about $3 billion. Accordingly, the blocking stake in Breakers Investments should have been worth two and half times more than the reported RZhD transaction price.
Yakunin’s organization admits in its prospectuses that it can miscalculate badly because it doesn’t control its accounting. “The Group’s management information system and financial reporting functions,” records the March 2011 prospectus, “are less developed in certain respects than those of similar companies in more developed markets and may not provide the Group’s management with as much or as accurate information. The Group’s system of internal control over financial reporting is not designed for the preparation of consolidated IFRS financial statements. The Group does not have an integrated information system supporting preparation of its consolidated IFRS financial statements and its management and financial accounting and reporting systems are not unified…each subsidiary has its own accounting platform and the Company does not have a developed system of control over the preparation of financial statements by its subsidiaries.”