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By John Helmer in Moscow

It’s just as normal, geologically speaking, for potash mines to subside and flood, as for high-profit businesses to be taken over, if the price is a bargain, commercially speaking. Deputy Prime Minister Igor Sechin deserves some credit for combining the two — reviving a two-year old geological anomaly, in order make the takeover of Russia’s most expensive potash miner affordable.

On October 29 last, Uralkali (URKA:LI) had a market capitalization of $6.373 billion. In the three months since July, it had lost 64% of its value, because of the global collapse in equity values. In comparative terms, this was marginally better than the Russian RTS stock market index as a whole, which had dropped 67% in the same period.

This week, Uralkali’s share price fell 20% in Monday trading, and now stands at $2.145 billion. It has lost $4.228 billion in value in the three-month interval since October 29, roughly double the decline of the RTS index. The potash miner has been losing asset value at a rate of $45 million per day, including Saturdays and Sundays.

But the spot price for potash has remained virtually flat, unchanging since last July. A big deficit in supply of potash in the first half of 2008, and rapid action by Russian and North American producers to cut output in the second half of the year have combined to hold the bellwether price for potash delivered to Brazil at the $1,000 per tonne mark. It is also being held up by demand drivers — a sharp contraction in grain inventories, and a forecast improvement in grain prices.

Uralkali’s North American peers also lost share value and market capitalization from July. But they bottomed in December, and have been gaining value since then. Potash Corporation (POT:US) is up 44% since its December low, and its current market cap is $22 billion. Mosaic (MOS:US) is up 60% since December, and its market cap at the moment is $16 billion. Comparing the ratios of share price to earnings (P/E), Uralkali dropped to 2.7 for 2008, compared to 11.7 in 2007; and compared to 5.3 and 5.5 for Potash Corp and Mosaic, respectively, in 2008.

What has done the damage to Uralkali, and what makes the October 29 the turning-point in its value, is the commission of enquiry Sechin ordered that day into the subsidence and subsequent flooding of Uralkali’s Mine-1, at Berezniki, in Perm region (central Russia).

This week, the Federal Environmental, Engineering and Nuclear Inspection Service (Rostekhnadzor) commission found Uralkali liable for negligence, although not at fault for the cause of the mine loss of October 2006. The report has been delayed past two reporting deadlines in December. The decision on what money penalties will be imposed has been deferred, and will be taken shortly by Sechin himself.

Uralkali is not commenting officially. But sources close to the company believe the contents of the Rostekhnadzor report do not materially change the terms it has been attempting to negotiate with Sechin for weeks.

A Moscow newspaper reports (and other sources confirm) that Rostekhnadzor has concluded that the mine subsidence was the result of a geological anomaly, for which Uralkali is not responsible. The first technical report on the mine loss in 2006 reached the same conclusion. But now there is a twist, the Hangman’s Knot. For Rostekhnadzor has concluded this time that, with timely geological surveys and early-warning measures, the company “could have taken measures to prevent it”. A source close to the company does not dispute the accuracy of the newspaper leak.

The Rostekhnadzor report has also calculated the cost of the infrastructure damage and replacement; relocation of a power plant and of Berezniki residents; and the loss of Mine-1 potash reserves. Total infrastructure costs and losses total $570 million, which reportedly includes the construction of a 53-kilometre rail bypass ($506 million), now being built by the Russian Railways Company (RZD). Two estimates of reserve losses were reportedly issued — a minimum of $706 million and a maximum of $2.372 billion. adding the mineral extraction tax that was lost to the federal government, and the two potential reserve-loss totals, for which Uralkali may be held liable, are $723 million and $2.5 billion.

If Uralkali is levied the full infrastructure and rail cost, plus a reserve loss charge, the company is thus facing from $1.3 billion to $3 billion in government-imposed charges.

“Essentially,” reports Troika Dialog analyst Mikhail Stiskin, “the preliminary conclusions do not matter much, as the commission gave the government a whole range of options for how to handle the case.”

Anna Kochkina, analyst for UnicreditAton in Moscow, is more pessimistic. “Thus far the company has agreed to contribute R3.0bn ($100mn), which appears insufficient to resolve the conflict. On a positive note, Uralkali is to be allowed to pay the penalties with a series of smaller payments rather than a lump-sum payment. We estimate that the company should be able to pay at least $500mn in 2009 based on its estimated cash reserves $380mn in 2008F and $165mn in cash generated in 2009F.”
UralSib Bank in Moscow publishes a more hopeful analysis. According to analyst Anna Kupriyanova, “the $600 mln estimate of infrastructural damages is in line with our base-case estimate for the fine that is built into our DCF model. Should the commission determine that Uralkali has to pay for the value of resources, the sum would be bearable as long as payment is not to be advanced immediately and is spread out over a certain time period.”

A financial analysis of Uralkali’s position at present suggests that it will generate EBITDA of $1.75 billion for 2009 and net income of $1.3 billion, if capacity utilization averages 67% and if the spot price for potash averages $800/tonne. At the end of 2008, the company was holding $300 million in cash, and had $470 million in debt. Troika Dialog analyst Mikhail Stiskin comments that “the worst case looks like a hefty $3 bln fine, though this is not mind-boggling or totally unmanageable, and we believe that the threat of a fine may now be used as a way to pressure Uralkali into a merger to create a mining champion in Russia.

The speculation cut Uralkali’s share price in Monday trading in Moscow and London by 20%; it now stands at just over $1 per share.

The takeover is not a new idea. The price is.

In December 2006, a state-powered strategy for acquisition and consolidation of the Russian fertilizer companies was drafted by Sibur-Mineral Fertilizers (SMF), then a brand new unit of the Sibur Holding. That in turn was the semi-divested downstream production and sales division of Gazprom. Headed by Dmitri Konov, it had a product portfolio including most of the petrochemicals (76% of revenues); tyres (16%), plastics feedstocks and chemical fibres (8%). Audited revenues in 2006 totaled Rb121.9 billion ($4.5 billion).

The holding’s motto, headlining its website, was (still is) “the art of subtle transformation”. Just how subtle Sibur needed to be was spelled out in the small print of the auditor’s notes to the IFRS financial statements for 2006. Referring to Russian transfer pricing rules, introduced in 1999, making taxable transaction prices that differ from market prices by more than 20%, the notes caution: “it is possible with the evolution of the interpretation of the Russian transfer pricing rules…that such such transactions could potentially be challenged in the future.”

Head of the new SMF was Andrei Teterkin (pronounce: tet-yor-kin), a petrochemicals executive at the defunct Yukos group, then head of strategy for the Evraz steel group. In February 2007, he took charge of SMF. In May he got the SMF board to accept what the company briefly described as “the concept of the development strategy focused on further company’s growth in Russian mineral fertilizers market.” According to an industry analyst, “I don’t believe Gazprom allows SMF to swim alone in the sea, so these papers were jointly produced, and it’s difficult to identify where the head sits.”

To build momentum behind his fertilizer asset plan, Teterkin briefed Moscow investment banks on his business plan, and leaked pages of it to the Moscow business media. The idea started to become public in July 2007 — buy up the Russian fertilizer makers, who depend on gas, and raise profitability on the spread between the cost of the input and the value of the output, especially when exported. At the time, SMF owned 76% of Kemerovo Azot Joint Stock Company (ammonia) and a minority stake in Orton JSC (Kemerovo), which it took over from the holding structure. In September 2007, it announced the purchase of 3.15% stake in Perm Mineral Fertilizers (PMF). Just how small mineral fertilizers amounted to in Sibur’s business was reported in the financial statements for 2006, before SMF was formed. In that year, sales of mineral fertilizers came to just Rb3.6 billion ($132 million), just 3% of Sibur’s aggregate sales.

According to Teterkin’s strategy document, SMF then held just 9% of the Russian nitrogen fertilizers market. By 2009, he said he was aiming to take more than a 50% share. But he was interrupted by the commodity price boom combined with the equity value boom, and in 2008 they halted Teterkin and SMF in their tracks. The main Gazprom board, along with the Sibur holding, decided to drop their mineral fertilizer ambitions because they had grown too costly.

Deputy Prime Minister Sechin has been an old, unforgetting rival of Gazprom’s chief executive, Alexei Miller, and of the Gazprom faction in government. Sechin’s plan of attack on Uralkali has taken over Teterkin’s strategy, with tactics of his own.

Eighteen months ago, Teterkin had said he wanted to take control of the potash fertilizer companies, and included them in his SMF plan. A source, who read the SMF business plan in 2007, told Minesite: “My personal opinion is that the potash part of the plan is far from alive, but it is there, in the papers.” Teterkin’s scheme required a local partner to accumulate the capital and cash required to enter the potash market, and then to launch an aggressive takeover. According to the original plan, if Teterkin got his way, by 2009 SMF would hold 58 % of the home market for ammonia; 65% for phosphate (apatite) fertilizers; and 48 % for potash fertilizers.

At the time, Uralkali was too big for SMF to swallow. Now, with help from a technical report on the 2006 incident, Sechin has cut Uralkali down to size, and pushed the rival takeover group out of the way.

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