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By John Helmer in Moscow

Noone, least of all Dmitry Pumpyansky, should be faulted for not anticipating exactly when the oil and gas bubble would burst. But what can be said of Pumpyansky’s calculation that he had at least two more years of defying gravity, and no hedge against the risk that he might be wrong?

Pumpyansky, who turns 45 years of age shortly, is the figure who managed the creation of TMK, Russia’s largest alliance of steel pipemills (ticker TMKS:LI), out of murky origins, and with associates who are now best left unnamed. His acumen is undoubted; so was his good fortune. Between October 2006 and November 2006, TMK jumped in price from $4 billion, when Pumpyansky arranged to buy out his Russian partners, Sergei Popov and Andrei Melnichenko, to $7 billion, which was the market capitalization of the company at its London initial placement offering (IPO). In the twenty months that followed to June 2008, TMK doubled its value to $9.4 billion.

By then Pumpyansky, the number-3 pipemaker in the world after Tenaris (Argentina, TS:US) and Vallourec (France, VK:FP), had set his sights on matching, besting, buying out, or swapping his stake into one of the other two. For that he needed to become bigger, and more international. And for that he needed to borrow money. The idea was impeccable; the timing was off. According to a new report issued in Moscow today by Troika Dialog, a Russian investment bank, Pumyansky led TMK into a serious miscalculation of financial and trade risks. These have placed the company today in dependence on favour from the Kremlin — favour which Pumpyansky has been unable to demonstrate on the way up.

Pumpyansky individually, or with others, controls 77% of TMK’s stock; 23% is the currently estimated free float. Market capitalization of TMK today is $720 million. Yesterday it was $835 million. Tenaris is currently at $12 billion and rising; Vallourec, $4 billion, and also on the up. From the banking point of view, it is difficult to catch a falling star, and put it into your pocket.

According to the Troika Dialog report, TMK will not go to the wall, nor be forced into a state takeover. “We believe that as TMK is the only Russian company producing a complete array of pipes for the oil and gas industry, it has sufficient strategic importance and can therefore count upon financial support from state banks if needed…Central to our argument is the assumption that TMK will be financially supported by the state when and if such assistance is required.” Troika analyst Mikhail Stiskin doesn’t mention the senior state officials, who share this assumption.

The vulnerability of TMK’s position is not fatal, according to Stiskin. “Speaking of the risks, we reiterate our view that default or bankruptcy is unlikely, although under certain circumstances TMK may have to issue new equity on terms detrimental to portfolio investors, thus diluting the value of their stock.” Market suspicion of such a move has driven TMK’s stock price down by 15% over the past month, though in trading since January 1, it is up a little.

While the energy and commodity price boom was sustaining oil and gas industry profits, TMK’s share price had moved in line with its international pipemaking peers, Tenaris and Vallourec. But neither the internationals nor global energy prospects have been able to prevent the Russian pipemaker from de-coupling from its non-Russian, or its Russian oil and gas peers, plummeting downwards in share price and market confidence. The reason, according to Troika Dialog — “mounting concerns about the company’s solvency”.

The Russian risk discount has also been applied to TMK’s Eurobonds, and has not improved, despite what Stiskin calls “positive changes in credit sentiment.”
TMK’s heavy indebtedness is “the biggest concern for fixed income and equity investors alike and the main reason for the low equity valuation,” Stiskin acknowledges. “The bulk of the debt ($2.2 bln) is short-term, i.e. falling due by end 2009 (for convenience, we are using this terminology throughout the report). Given that we think 2009 EBITDA will not exceed $1 bln, such leverage does look worrying.”

“Default risks cannot be disregarded. In our view, creditors among banks are likely to demonstrate flexibility and agree to modify the terms of the loans if necessary, if only because the opposite stance would be simply increase the insolvency risk.” Stiskin estimates that 45% of TMK’s short-term debt of abpout $1 billion, is rouble-denominated, and owed to major Russian institutions, including state banks.

The loan to finance the purchase of North American pipemaker IPSCO, closed in mid-2008, was $1.2 billion in total, arranged for a 12-month term, starting June 2008, with a three-month extension option. The lenders are ABN AMRO, Bank of Tokyo-Mitsubishi, Barclays Capital, BNP Paribas, ING, Natixis, Sumitomo Mitsui Banking Corporation, and Nomura. Security for payback are TMK’s four Russian mills — Volzhsky Pipe Plant, Seversky Tube Works, Sinarsky Pipe Plant and Taganrog Metallurgical Works.

A Eurobond issue of $300 million, issued in 2006 to finance Pumpyansky’s buyout of the two other Russian shareholders ahead of his IPO, must be repaid by September of this year.

A second Eurobond issue of $600 million, placed last July, was banked by ABN AMRO, Barclays Bank, ING, UBS, Natixis, Nomura, BNP Paribas, Mitsubishi, Renaissance Capital, and Royal Bank of Scotland. It was designed to refinance, and stretch out the term of the earlier IPSCO loan.

If Pumpyansky falls short in his refinancing requirement, he faces — not for the first time — the prospect of a takeover. “TMK may have to swap some of its debts for equity or invite onboard a strategic investor, which would be done at a depressed equity valuation,” concludes Stiskin — without mentioning rumours current before TMK launched its London IPO that Gazprom was considering some form of state-arranged takeover.

Several of TMK’s pressing problems have been caused by its acquisition in June of last year of the US pipemills of IPSCO. At the time of the deal, TMK said “the purchase of IPSCO Tubular’s US assets is an essential part of TMK’s strategy to expand the company’s global presence and increase offer of high-tech, premium-class, tubular goods for the oil and gas industry.” In retrospect, the deal appears to have been an attempt by Pumpyansky to leverage his Russian assets and revenues, and acquire a lift in his international equity price, on the road to a sale or swap with another international pipemaker.

It was a classic overreach ploy. He underestimated his ability to pay. He also misjudged the equity market’s judgement of the bid.

According to Stiskin, the US market is at saturation point for oil and gas pipes, and under pressure from falling demand and Chinese imports. “Apart from impacting TMK’s consolidated financial results, this could cause disappointment about the $1.7 bln spent on the deal.”

On balance, Stiskin concludes that TMK miscalculated the risks of the IPSCO buy. If Russia’s state bank draw the same conclusion, it is reasonable to suspect that bailout of his US exposure will not be as easy for Pumpyansky to arrange, as Evraz’s controlling shareholder, Roman Abramovich, has already demonstrated on behalf of Evraz’s $1.7 billion loan from Vnesheconombank (VEB), also for US assets.

Altogether, TMK agreed to pay $1.7 billion for IPSCO, of which only $1.2 billion was paid out immediately. The balance is payable to Evraz Group, Russia’s leading steel group, which took a 49% stake in one of IPSCO’s subsidiaries acquired by TMK. According to the terms of the deal, Evraz has an option to sell this stake to TMK exercisable from October 2009. In dire financial straits itself, with even higher leverage, Evraz, controlled by Roman Abramovich and Alexander Abramov, looks certain to do so.

Taking into account the capacity TMK acquired in IPSCO (1.3 million tonnes per year, mostly welded pipes), Stiskin estimates that TMK’s takeover price was equivalent to about $1,300/tonne. At that time, Stiskin says, the value was “some 70% below valuations of traded peers. On financial multiples, the deal was also appealing. Given the expected 2H08 EBITDA of the acquired assets, which at that time was estimated at $250 mln, TMK was going to pay EV/EBITDA of about 3.4, which was roughly one quarter of the sector average valuations. At this cost, TMK received a 10% share of the world’s biggest market for oil and gas pipes, which demonstrated a 15% CARG over the last five years, at once diversifying away from Russia and increasing exposure to its core market segment. In addition, TMK secured access to advanced technologies, some of which may be transferred to Russian soil.”

According to the Troika Dialog report, this was still a mistake on two counts. TMK’s ability to repay the debt financing for the deal evaporated with the decline in global demand for pipes, and the downturn in TMK’s Russian revenues. TMK also exaggerated IPSCO’s revenue-earning capacity.

“TMK [was] consciously betting on a massive improvement in IPSCO’s financial performance. According to TMK management, the 1H08 EBITDA of the acquired assets totaled just $100 mln, so the 2H08 results promised a 150% increase in income. Now that the oil price has plummeted from its mid 2008 highs, it remains to be seen how financially robust IPSCO’s performance will be. We forecast the 2009 EBITDA of TMK IPSCO to come in around $250 mln, a drop of 50% from 2H08 levels. ”

Stiskin also argues that TMK should have read the risk threshold of the oil and gas pricing bubble, because its revenue and profit results are closely correlated with capital expenditure by the oil and gas majors, particularly state-owned Gazprom, Rosneft, and Transneft. Troika Dialog is now forecasting a 26% year on year decline in oil capex (average across major producers under $45/bbl Urals price scenario). Stiskin reports: “average EBITDA/bbl of crude is expected to slide in 2009 by about 40%, from $23/bbl to $14/bbl. It is all but natural to expect that the Russian operations of TMK will experience a similar decline in revenues.”

Russian pipe consumption has been rising steadily since 2000; more than 50% of the demand for pipes in Russia comes from the oil and gas industry. After peaking in 2007, consumption slumped by an estimated 14% last year, principally because Transneft, the oil pipeline company, and Gazprom popstponed large-diameter pipe (LDP) procurements.

Domestic demand for other types of pipes is also contracting, due to cutbacks in oifield drilling and replacement. Demand for structural tubing has shrunk too, as the construction industry declines. On the positive side, costs should be cut as the steel scrap required for TMK’s furnaces falls in price, and as the rouble devalues.

Stiskin’s forecast is that “the combined effect of lower production volumes and prices should prevail and we expect TMK Russia’s gross profit from sales of seamless pipes – the company’s most important product segment – to fall almost 30% year on year, or 20% year on year on an output/tonne basis.” By cutting costs…we therefore forecast EBITDA of TMK Russia to decline by only 20% year on year to some $620-630 mln.”

Getting this number right is vital for TMK, because its foreign loan covenants require the company to maintain a debt to Ebitda ratio below 3.5. According to Stiskin’s analysis, if TMK manages to make Ebitda in 2009 of $871 million, excluding IPSCO, then “TMK should be able to meet [the ratio requirement], albeit narrowly.”

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