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By John Helmer in Moscow

In the milk business, sanctimoniousness can induce more nausea than salmonella.

President Dmitry Medvedev big-noted his re-election campaign with a speech at the St. Petersburg International Economic Forum on Friday with this seeming call for competition to stimulate economic growth. “No matter how many state-owned enterprises we might have,” Medvedev said, “modernisation will above all be achieved through the efforts of private business, and only in a competitive environment. The state’s job is to ensure a good business climate for Russian and foreign entrepreneurs, and a fair and honest competitive environment.”

Not long after he said that, there was a ceremonial signing of an agreement between Danone, the French milk product, baby food and water company, and the Russian dairy company Unimilk, to merge their operations and assets in Russia. Before the transaction signing, three dairy producers dominated the Russian market – Wimm Bill Dann (WBD), with a 28.3% market share; Unimilk with a 16.5% market share, and Danone with 14.3%. After Medvedev’s modernization, there are now two, with a combined market shares of almost 60%. Danone is now dominant with more than 30%.

Milk (of up to 3% fat content) is defined in Russian statutes and regulations as a socially important product, and its pricing is regulated, so as to put a cap on the profit margin of producers and retailers. Unrestricted, and with much greater profitability, are the value-added dairy products like kefir (sour milk), smetana (sour cream), tvorog (cottage cheese), yoghurt, and matured cheese. The market share of the new combination in the higher-value product market will be even greater.

France’s Finance Minister Christine Lagarde participated in the transaction ceremony at St. Petersburg. Five years ago, her predecessor, Thierry Breton , and the rest of the French cabinet blocked the US company Pepsico from making a takeover offer for Danone, calling the latter a “flower of our industry”, a “jewel”, a national champion in the food sector; and judging an American takeover hostile.

Oddly, the international milk industry source, DairyReporter.com, failed to find out what the French are paying for their Russian takeover, and the French are not precise. The Moscow newspaper Kommersant quotes a source close the deal as saying the French will pay Unimilk shareholders €120 million for a 12% bloc of shares. If that’s true, Unimilk is being valued at €1 billion ($1.2 billion). That is less than Unimilk reports as its sales revenues for last year of Rb43 billion ($1.4 billion).

Because Unimilk is closely held through a Cyprus registered company by two shareholders, Andrei Beskhmelmitsky (image) and Andrei Bloch, the available financial reports are not presented in audited international financial standard format. In 2008, the company says it was loss-making. By the end of 2009, revenues were up 7%, and the profit line was in the black again. But debt was reported at almost Rb15 billion ($487 million). It’s impossible to say how difficult Beskhmelnitsky and Bloch have been finding their banks to be for refinancing; or how much pressure they may have been under to accept a discounted buy-out price from Danone.

In March of 2008, Beskhmelnitsky, who is also chief executive of Unimilk, claimed he was planning an initial public offering (IPO) for his shares. But he didn’t give a target valuation; the crash followed in September of that year; and the IPO failed to materialize. Before the crash, according to Beskhmelnitsky, he had sold a 10% stake to U.S. Capital International Private Equity Fund for $175 million. Reuters quoted Beskhmelnitsky as conceding: “We were satisfied with the size of the deal and also with the estimate of our company by experienced investors, who confirmed the value that has been created.” Beskhmelnitsky describes his early counting-house career with two unusual agribusiness financial operations in Russia, Inkombank and Rabobank of the Netherlands. So if Beskhmelnitsky and his partner thought that $1.75 billion was fair value for Unimilk in a boom period, then it cannot be inexperience leading them to miscount their selling price today.

Another clue revealed in Danone’s official releases is that the indebtedness it expects to grow from this transaction amounts to €1.3 billion ($1.6 billion), and that within twelve years it will have the option to own most, if not all of Unimilk. Look carefully at Danone’s public announcement of what has happened: “Danone will control 57.5% interest in the new entity, while the current shareholders of Unimilk will hold 42.5%. The transaction will be carried out principally through a contribution of assets, supplemented with a cash purchase of shares by Danone. Danone’s net financial debt will increase by €1.3 billion principally as the result of the value of the put options which will be granted to the current shareholders of Unimilk. These options will allow them to dispose part or all of their shares in the new entity, Danone being able to hold 100% of these shares in 2022.”

Pavel Isaev, Unimilk’s head of communications, declines to say what valuation Unimilk has accepted from Danone in the transaction. Masking the transaction price doesn’t quite conceal the fact that Unimilk’s selling shareholders seem to have accepted a valuation of their company in 12 year’s time of just over $3 billion, and allowed Danone to take control now – for roughly one-third of that price, and without paying (or without appearing to pay) the conventional control premium, let alone the bonus usually offered for taking command of an entire sector. Since such transactions are usually checked at the Kremlin gate before completion, Unimilk’s owners appear to have been allowed to exit at a discount. Depending on your baseline valuation, the discount is between 10% and 30%.

A Kremlin spokesman declined to say how Danone’s takeover of 30% of the Russian diary market represents what Medvedev had spoken of in St. Petersburg as “a fair and honest competitive environment.”

Food sector analysts from Moscow investment banks were asked to calculate Unimilk’s selling price, and to judge the discount at which Danone is getting hold of it. According to Troika Dialog analyst Victoria Sokolova, “the deal values Unimilk at 10.5 times its 2009 EBITDA [Rb4.7 billion, $155 million] or a 20% discount to Wimm Bill Dann’s ADRs…” She added that the discount is justified “due to its smaller market share, lower regional penetration and fewer premium brands in the product portfolio…We argue that Wimm Bill Dann is already successfully competing against Danone and Unimilk to date (having grown market share over 2010).”

According to Tigran Hovhannisyan of Uralsib Bank, there have been strong competitive pressures on Unimilk this year, and it has been losing market share to WBD, particularly in the northwest around St. Petersburg. WBD attributes these gains to better marketing strategy. According to Hovhannisyan, Unimilk’s owners may have lost their nerve. “If they see loss of market share, they go soft on the multiples, and are more ready to sell at a discount.” He said that something similar had happened in March of 2008, when the Russian juice company Lebediansky sold 76% of its shares to Pepsico for $1.4 billion. Lebediansky’s profits had been declining before the sale, and the takeover price was just under the prevailing market capitalization.

Yelena Mills, Alfa Bank’s analyst for the consumer foods sector, said she will not discuss the valuation of Unimilk’s selling price. She reported to clients that “the combined group also has significant ambitions to expand operations and market share in the baby-food segment, addressed by Unimilk’s brand Tema and Danone’s Nutricia. In our view, this combination is likely to intensify competition in the Russian/CIS dairy and baby-food market.” Mills declined to say whether she means there will be more or less competition in the Russian market. What may happen, according to other analysts, is that the highly fragmented ownership of dairy product brands in Russia’s regions may be pressured into selling to one of the two remaining national brand-name companies.

Unimilk was asked whether the loss of market share this year had triggered Unimilk’s shareholders into selling at a discount. The company’s press spokesman, Yevgeniya Lampadova, declined to say.

The Federal Antimonopoly Service (FAS) is the final arbiter of the competition effects of the Danone deal. If the Kremlin has already given its approval – deputy prime minister Victor Zubkov, who is in charge of the agriculture and food sector, also attended the signing ceremony — the FAS review will be a formality. But for the time being, Teymuraz Haritonashvili, head of the FAS department with jurisdiction over the transaction, is saying he is not going to play poodle. “We will look, not only at the general share of this incorporated company in the Russian market, but also we will analyse how much market share it will control in each of the segments of dairy production.” It is possible the FAS was not consulted in advance of the deal between Danone and Unimilk.

In a release on June 18 by the Moscow law firm of Egorov, Puginsky, Afanasiev & Partners, it said it had been the advisor to the deal.

Dmitry Afanasiev, the chairman of of the firm, is not known for hiding his light under a bushel. He told the Financial Times: “The traditional dairy markets in Russia are strong and it’s smart for Danone to develop its stronghold in the segment by merging their Russian assets with Unimilk’s.”

That suggests that Afanasiev is supporting Danone’s takeover. The firm’s website says: “Legal advisers to the transaction were Egorov Puginsky Afanasiev & Partners.” The firm also suggests it had acted as “legal advisor” in the other markets where Danone and Unimilk are operating. “Danone’s legal advisers in Ukraine, Kazakhstan and Belarus were member firms of CIS LCN, a network of leading law firms providing integrated legal advice across the CIS region”. This implies that Afanasiev may have been canvassing the prospects for approval of the merger with the Russian government, as well as with the other CIS governments. According to Afanasiev’s announcement, “[his firm] regularly represents international companies doing business in Russia and Russian companies going international. The firm regularly acts for the Russian Federation in transactional and litigation matters.”

A source at Egorov Puginsky Afanasiev said Danone had asked for the firm’s advice, and that the firm had been acting for Danone.

Afanasiev’s career record provides a clue to what he does, and for whom. After studying law at the University of Pennsylvania (he didn’t graduate), he was a partner of Bruce Marks in a Philadelphia and Moscow-based firm, whose first major litigation success was a racketeering damages claim by the Russian titanium group VSMPO against a group of US investors; the latter settled out of court. That was followed by another racketeering damages claim, this time in the Russian aluminium business against Oleg Deripaska. After persuading Deripaska to pay more than $60 million to the Zhivilo brothers, who were the clients of Marks and Afanasiev, Afanasiev and Marks parted company; Afanasiev went on to become Deripaska’s lawyer. He claims credit for advising on the merger of Russia’s two aluminium companies, Rusal and SUAL, into the Russian aluminium monopoly; and he now sits on the board of Rusal. For a time in 2008-2009, when Deripaska was attempting a hostile takeover of Norilsk Nickel, Afanasiev held a seat representing Rusal on the Norilsk Nickel board.

If Russian titanium, aluminium, nickel and copper are any guide, Afanasiev may be regarded as a founding father of Russian anti-trust enforcement. Another way of putting that is that he may be the prospective monopolist’s or oligopolist’s best source of advice for negotiating with the FAS. In the Rusal prospectus, issued to the Hong Kong Stock Exchange last December, Afanasiev was reported as having “participated in the drafting of some of Russia’s federal laws, including antitrust legislation”. Rusal also describes him as a founding member of a Russian business promotion group in the US, and as the recipient of “a commendation from the President of Russia for achievements in defending human rights.”

Drinking milk comes close to being a human right; selling it is generally worth defending. Competing to sell it in Russia has been worth defending, although last week it proved more profitable for some to sell out.

Danone shares, which are listed on the New York Stock Exchange, as well as the Paris bourse, with a market capitalization of almost $35 billion, had been rising all month, but fell 1% on the news. Wimm Bill Dann (WBD), the only publicly listed of Russia’s dairy companies, lost 9% on the deal disclosure. That is because Danone is expected to sell its 18.4% stake in WBD, since the FAS is unlikely to allow the foreign company to hold such a large cross-shareholding in its major competitor in the Russian market.

On this expectation, Danone’s sale of WBD’s shares will depress the market price. WBD’s market cap was $2.73 billion before the Danone deal, and Danone’s stake worth $503 million. Today, WBD opened at $2.59 billion, and Danone’s stock has dropped in value to $477 million. If Danone knew the FAS would condition its approval of the Unimilk deal on the disposal of the WBD shares, then Danone may have been anticipating a write-down of the share value, and covered that in its transaction.

The stock markets may also be calculating that now that Unimilk is out of the way, competition against Danone, which is proposing to invest heavily in more Russian assets and market share, will be tough for WBD’s earnings and profits.

From now on, the foreign company will dominate not only the Russian dairy market, but also that of Belarus, Kazakhstan, and other former Soviet states.

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