CAN IT GET ANY WORSE IN UKRAINE?

It has been more or less a year since I was last there in Kiev.  There has been a lot of change, and sad to say things have generally got worse for the average Ukrainian.  It is the way of change that the bad tends to come before the good, and it is also the case that there have been some positive developments particularly in respect of policies passed by the new parliament.  Implementation is of course another matter.  That has been patchy with plenty of resistance from vested interests, some of whom are close to the President.  Still given the flow of events Ukraine is now considered to be a better environment than the country of two years ago; but the price to get from there to here has been very high for Mr and Mrs Dnipro.  

Of course silly things still happen that retard a return to normality.  What is the point of aggravating Russia by cancelling flights between Moscow and Kiev when there are still significant economic activities between the two countries despite what is going on in the east?  There conditions seem a little bit better though one must hope it is not just a calm before another storm.  Cutting any channels of communication is particularly stupid just before officials have to go and tackle the one large residual debt not dealt with in the recent sovereign restructuring :  a loan from Russia.  Clearly the left hand does not know what the right hand is doing in Kiev or perhaps they do not care.  Pre the regional elections political point scoring was all the rage, though in fairness Ukrainian politicians do not have a monopoly on promising voters the sun and delivering Pluto.

My visit had to be brief due to the reduced level of our investments in the country that do not allow a greater allocation of time.  Sadly a couple of our companies have ceased to exist.  In one case the main manufacturing facility was vaporised by the fighting.  Against that other companies have managed to prosper at least relatively.  Our biggest holding is Ovostar.  Ovostar has worked its way up to be the number two producer of eggs in the Ukraine and is the market leader in dry and liquid egg products: actually the only producer of liquid in the country. Management have been careful with both the balance sheet and the pace of growth.  They also emphasised exports where they can to ensure they make the most of higher external prices and stronger currencies. The first half of 2015 showed reasonable results even expressed in US$, and excellent numbers in local currency terms. In terms of currency the company is net long the $ both in the income statement and balance sheet, but net short the Euro, and of course over 70% of its activities are in Hryvnia. Still it has avoided the problem too many companies in the country faced with 80% devaluation. Ovostar has the lowest debt/equity ratio and highest debt service coverage ratio in the listed sector.  This is a well-run concern that is a survivor and long term leader.
While quoted in Warsaw the company reports both in local currency and in US$ for the benefit of foreign investors. In one the growth is massive; in the other slightly negative. Capacity and production are planned to rise by a middle double digit amount through 2017. This looks achievable. The P/E for this year is probably around 5x. With about 50% of its output in branded product were Ovostar located anywhere else it would be valued much more highly, arguably between 10-12x. All of which is why it is the largest position in the portfolio.  Nice to see that legendary Canadian value investor Prem Watsa of Fairfax agrees.  He recently bought a stake in the company.  Please note this commentary does not constitute investment advice especially since the share is hard to buy or sell.  It is by way of context.  

There is not much left of what was once a flourishing stock exchange.  There are almost no companies still listed with a market capitalisation over $100 million.  The equity world is a wasteland with little trading.  Fixed income investors have had a more interesting ride.  Those brave few who took the plunge earlier this year before the renegotiation have done rather well.  So there is quite a bit of activity in that asset class; but for those of us more focused on equities, it is slim pickings for now; and likely to stay that way.  Reform of the Stock Exchange is on the agenda for April 2016.  A lot of good stuff is percolating through from the work of Dymtro Tarabakin, who has been seconded from Dragon Capital to drive the process.  Until the President signs off, we can only hope he will be able to find a way to close the loopholes that have allowed unscrupulous adventurers (and not just local oligarchs but foreign firms as well) to trample on the fig leaf of minority protection and demonstrate that no such thing exists in Kiev even 20 years after shares formally began trading.      

General impressions are that Kiev is a bit more lively than when I was there a year ago. To start with the Hyatt hotel had more guests; by no means a sell-out but closer to 40% occupancy than 20%. There was more traffic on the roads. Road side billboards were full of advertising and not just political stuff but plenty from real businesses presumably paying something. The atmosphere as I walked around was less tense.

Against that traffic at shopping malls is down about 20% y-on-y, and some retail sites off the main shopping areas look empty. The official numbers continue to show an economy in contraction, even if economists are predicting growth in 2016.  After what happened in 2014 and 2015 it is not out of the question, but a real sustainable recovery awaits resolution of political issues that are emotional as well as substantive.

Still all of this was before the regional elections. While these are local and in theory the central parliament is in place until 2019, stability could have been called into question if the voters showed a big shift away from the governing coalition. As one coalition party is not on the ballot some erosion was certain.  A bad result could even trigger a realignment. The polls suggested a modest, and therefore manageable decline, but pollsters have not had a good year anywhere, and one cannot put much faith in these ones. There are a lot of undecideds out there; and growing concern over government lethargy.  The first round was largely inconclusive with only moderate shifts in key cities.  Since a second round is required these results bear careful watching.

That aside there have been patches of genuine progress of late that underpins the potential for the economy to improve next year. Renegotiation of the sovereign debt was no victory but could be considered a necessary step. The relationship with the IMF, EBRD and other multilaterals remain supportive; and their support is vital.
Arguably most important the situation in the East is at least temporarily calmer. Long may that last even if no permanent resolution is in sight. Lastly an agreement has been reached with Russia for gas prices to be reduced, allowing subsidies to shrink, helping the balance of payments and taking pressure off the budget. Foreign reserves rose last month. Perhaps that is why government employees just got a 10-20% pay hike; or perhaps that was more to do with October's regional elections? Either way more hryvnia in their pockets should give a lift to local consumption and cover the cost of utility bills this winter that will be higher due to the IMF mandated subsidy reduction.

The elephant in the room remains corruption.  Progress there has been disappointing. Some people feel the country has swapped one set of crooks keen to enrich themselves for another. Certain countries have been expressing concern, including Canada and the UK.  The US Ambassador came in for criticism from some people I spoke to for not putting pressure on the government, presumably on the basis better our crooks than their crooks. Yet others feel he has been vocal in attacking this the most difficult challenge for the country.  Failure extends to limited reform of the legal system. At least one oligarch appears to have established his own local army. So resentment in the street is growing. As we know the street in the Ukraine can be a powerful force.

Property is always a good place to look to assess what is happening to the economy of a country. Here the statistics remain dire. Retail rents are off 50% even for prime sites - reflecting the currency collapse. Many landlords are switching to a low base plus a turnover percentage to retain tenants. Vacancy rates appear to have stabilised this year. Yet in office vacancies reached 20% the same level where they were briefly in 2009, while industrial rents are down 20%.

The residential picture is less transparent due to the growing gap between posted prices and clearing prices, but available data suggests that real deals are being transacted at per sq. ft. prices comparable to 2004, and raw land prices are down by over 70% or more from their 2008 peak. While conversations with people in the business suggest the floor has yet to be found, the view is that with construction at close to a standstill it would not take much to get a good bounce - especially in Kiev. The crane index is encouraging in the sense that there isn’t one! I only saw four during my visit, and none were moving. It is not often residential prices in a capital city decline by two thirds, as has happened here. This space starts to look tempting for investors without liquidity constraints, but only if there can be greater comfort that the security situation in the East really is stabilising, as it does appear to be doing.

Economic statistics are usually dry.  This blog tries to be both informative yet interesting.  Still I do think the best way to convey what has been going on in Ukraine is to add here an edited extract from a recent report on the country’s economic situation produced by SP Advisors, in the second week of October 2015.  

“The pace of economic decline continues to decelerate.  All data suggest the economy is touching the bottom. Nearly all the major sectors are close to launching a recovery.  The first green shoots are becoming visible. We maintain our view that 4Q15 will be the first quarter of growth (in qoq terms) after 7 straight quarters of decline and that the economy will be on a recovery path through 2016.

Growth in consumer prices gained pace in September (+2.3% mom) mainly driven by seasonal apparel and footwear, a ripple of deep hryvnia depreciation in 1Q15. Still, annual CPI decelerated to 51.9% from 52.8% in August. On balance, the disinflationary path Ukraine is currently on will continue, with weak consumer purchasing power playing the key role. We affirm our end-2015 CPI projection of 46% and expect a further drop-off to 10-15% in 2H16.

The latest news from the FX market is encouraging. The UAH/USD market rate has remained in the NBU's implicit UAH 21-23/USD target corridor.  The central bank grew gross reserves 1.2% mom in September to USD 12.8 bin (+70% YTD).”

SP tends to look at life from a local perspective through somewhat rose tinted glasses.  Perhaps they need such colour to preserve sanity in what has been a miserable place for residents.  Still one gets the sense - as I did - that provided nothing gets worse in the east, the country could see improvement next year.  For now when you look at the chart on monthly industrial output and retail trade, it really is a depressing picture.  Imagine having to live through that lot and then thank the stars for where you live.  The charts bellow are courtesy of the NBU.  They are a horror show.  Even Greece looks good compared to this lot.

       
I believe we are one of only three organisations left still managing an Ukraine investment portfolio, so if SP is right it would be a welcome development.  As investors, however, we have to put emotion and prejudice to one side : fight the fear and hold back the greed.   Ukraine in 2016 might just be one of those places where the brave will do well.  One thing we can say is that since 2013 it has been the worst formal equity market in the wold for $based investors.  It is unlikely to win in that booby prize three years in a row.