ZAZ CR engl 30Nov - Cbondsdata.cbonds.info/emissions/6033/ZAZ_CR_engl_30Nov.pdf · ZAZ: Spreading...

│ CREDIT RESEARCH │ Thursday │ November 30 │ 2006 Summary financials ZAZ (USD mn)

`04A `05A `06E ’07F Sales Total 842.2 1 183.7 1 289.2 1 932.5 Domestic Car Sales 744.8 1 112.3 1 049.3 1 487.6 Export Car Sales 75.4 44.1 214.8 414.5 Gross profit 200.2 173.1 114.5 193.9 EBITDA 125.1 64.2 68.2 114.8 EBIT 110.6 47.9 50.5 96.6 Net Profit 95.6 18.7 14.4 52.2 Net Fin. Debt 82.8 150.5 249.6 379.9 Equity 300.4 334.3 346.1 405.9 Key ratios `04A `05A `06E ’07F Gross margin 23.8% 14.6% 8.9% 10.0% EBITDA Margin 14.9% 5.4% 5.3% 5.9% Net Margin 11.4% 1.6% 1.1% 2.7% Net Fin. Debt / EBITDA 0.7 2.3 3.7 3.3 Net Fin. Debt / Equity 0.3 0.5 0.7 0.9 EBITDA / Int. Exp. 15.0 4.5 3.1 4.2 Source: company data, MDM estimates ZAZ standalone and consolidated financial performance, USD bn

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0.5

1.0

1.5

2.0

2.5

2004 2005 2006 2007 2008

Sales ZAZEBITDA ZAZ

of w ich 53% domesticaly Lanos

ex port 100% Lanos

Source: company data, MDM estimates Analyst Nikolay Bogatyi, [email protected] +7 (495) 795-2521

Investment case ▐ Dominating position in the local market. Zaporizhsky

Avtomobilebudivny Zavod (ZAZ) is one of Ukraine’s top 20 largest corporates and by far the largest car maker. ZAZ accounted for 54% of the Ukrainian passenger car sales by volume in 2005. Its product range includes 19 car models including both budget cars and Mercedes models. The bulk of cars are produced under licensing agreements with General Motors and DaimlerChrysler. Following acquisition of FSO, Poland’s largest automaker, ZAZ has further strengthened its relationships with GM DAT by signing the assembly and CIS distribution agreements.

▐ Rapidly growing consumer power in the region. The Ukrainian passenger car market grew at a CAGR of 35% in 2002-05, which puts it among the top three fastest growing European markets last year. The largely unsaturated new car market in Ukraine is expected to grow at a CAGR of 16% through 2010 (latest estimates for 2006 exceed 30%), supported by growing per capita income and developing car loan programs. ZAZ plans to further penetrate the lucrative Russian car market, which is growing by around 7% every year. In January-August 2006 real per capita income grew by 18.9% in Ukraine and by 12.1% in Russia.

▐ Competitive product. ZAZ’s key model for both the Ukrainian and Russian markets is the Chevrolet Lanos, which is priced below USD10,000. The Lanos is a good quality car that is technically superior to LADAs produced by Russia’s AvtoVAZ. Both cars are priced at comparable levels.

▐ Diversification away from Ukraine’s energy intensive industries. ZAZ’s key cost components are labor and spare parts. Ukraine’s labor force is one of the cheapest and well-skilled in Central and Eastern Europe. Energy accounts for less than 3% of ZAZ’s operating costs.

▐ Improving political and economic environment. In August 2006 Ukraine (B1/BB-/BB-) has eventually shaped a coalition government. Following that Moody’s and Fitch have revised their outlooks on Ukraine’s sovereign rating from Stable to Positive. In their commentaries the rating agencies highlight Ukraine’s increased political stability, continued growth of output and investments, ability to absorb gas price hikes and solid fiscal numbers.

ZAZ: Spreading Its Wings

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SWOT analysis Strengths: ▐ The clear leader in the Ukrainian car industry, with fast-growing operations in Poland. ZAZ accounts for 54% of

the Ukrainian car market by volume and operates two car plants, located in Zaporozhye (the only Ukrainian car plant equipped with a body shop) and Ilyichevsk, and one engine manufacturing plant in Melitopol. ZAZ’s output is more than six times greater than its nearest domestic competitor. With the acquisition of Polish FSO (Fabryka Samochodow Osobowych) in December 2005, ZAZ Group: ● tripled its consolidated production capacity and partly diversified away from Ukrainian country risk; ● gained access to European markets; and ● confirmed its strategic partnership with GMDAT, one of General Motors’ best performing divisions globally.

▐ Strong ties with GMDAT provide substantial comfort. In autumn 2006 ZAZ signed a 6-year contract assembly agreement with GMDAT that expanded cooperation between the two beyond a technology licensing and CIS distribution agreements signed in 2004 and 2005. The contract assembly agreement ensures that GMDAT will off-take a certain number of cars until 2011 at a fixed price to cover FSO’s operating expenses. ZAZ is also certified to General Motors’ quality compliance standards for the full-scale production of the Chevrolet Lanos – a bestselling model – and the Opel Astra. ZAZ also meets GM’s standards for the semi-knocked down (SKD) assembly of its Chevrolet range.

▐ Low cost producer. In 2005 ZAZ’s COGS per car of USD 6,500 was almost half the average1 of a selected peer group (USD13,000 per car). With energy costs representing less than 3% of COGS, ZAZ does not appear to be significantly exposed to growing prices for gas imports.

▐ Strong quality and product mix ensure higher revenue growth than other regional leading carmakers, such as AvtoVAZ. ZAZ makes 19 passenger car models, roughly in line with the world’s leading integrated carmakers, Toyota Europe (16 models) and Ford USA (21), but easily surpassing the number of models built by other CIS producers, such as AvtoVAZ (5) and Severstal-Avto (6). Like AvtoVAZ, ZAZ’s cars are predominantly aimed at lower middle class customers, who represent the fastest-growing market segment. ZAZ’s key product, the Chevrolet Lanos (28.6% of sales in 2005), is technically superior to the Lada, which is the key model of ZAZ’s main rival in the CIS, AvtoVAZ. In 2005 ZAZ sold more than 157,000 cars, up 22.8% on 2004, while AvtoVAZ’s sales decreased by 0.2% from 723,100 to 721,500 units. At the higher end, ZAZ is one of only a few companies in the world that can assemble DaimlerChrysler models, including the latter’s flagship Mercedes S-class model.

▐ Balanced sales and after-sales service system. Over 90% of ZAZ’s cars are sold in Ukraine via UkrAVTO, an affiliated company that owns a stake in ZAZ, operates about 405 dealerships across the country and has an estimated turnover of USD4 bn. This gives ZAZ a distinct competitive advantage domestically, as customers find it easier to buy and access after-sales service. UkrAVTO is also looking at acquiring a dealers’ network in Russia to assist ZAZ’s export operations (this is in addition to distribution support from GMDAT in Russia).

▐ ZAZ’s lenders have so far proven to be safe from political risk thanks to two factors: ● ZAZ benefits from government support2. ZAZ forms the backbone of the Ukrainian automobile industry, which is

a strategic and socially important sector: ZAZ cluster (including local suppliers) employs 112 000 people3, ZAZ

1 AvtoVAZ (6,700), Severstal-Avto (9,500), Ford (21,300), GM (17,900), Renault (12,300), Skoda (13,600), Toyota (18,000), Peugeot-Citroen (PSA) (11,000). Source: company reports, MDM estimates. Note: AvtoVAZ and Severstal-Avto’s data are for 2004.

2 Governments often seek to protect developing industries from international competition to maintain higher employment rates and help develop a strong domestic production base. For a time Ukraine extended such protection to its automobile industry, as Russia does today and France and the United States, for example, have done in the past.

3 Company data


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expensed USD 86 million as tax, social cost and wages in 9 months 2006. Duties on imported cars (25%) and tax breaks for domestic carmakers are in place, which indirectly stimulates the company’s top line.

● Strength and flexibility of strategic management. Under Tariel Vasadze’s4 strategic management, ZAZ weathered both the Kuchma-Yanukovich and Yushenko-Timoshenko regimes with no fallout for its creditors, including during the turmoil of the Orange Revolution.

Weaknesses: ▐ Dependence on state protection. Upon coming to power in 2005, Julia Timoshenko’s government partly abolished

import duties and tax breaks for domestic carmakers established under the government of former President Leonid Kuchma. This move had a major impact on ZAZ in 2005: the EBITDA margin at its operations fell from 14.9% to 5.4%. Profitability remained at the same levels in 2006E.

▐ ZAZ has lower EBITDA margins than its competitors (5.4% vs. 8.5% of the selected peer group average in 2005). ZAZ services low-income customers and is interested in achieving economies of scale. Hence the purchase of FSO presents a good opportunity for ZAZ to substantially increase output. ZAZ is also steadily increasing localization rate5, which leads to a lower components cost, which makes up to 90% COGS.

▐ ZAZ’s engine quality falls short of European standards. To export directly to Europe ZAZ would need to manufacture engines greater than 1.4 liters in size that comply with European Euro 4 environmental standards, and perhaps also produce diesel engines. At present it makes engines up to 1.3 liters that comply with only Euro 3 standards. ZAZ currently imports engines for the majority of its cars. This situation is likely to be continued in the medium term.

Opportunities: ▐ Growth of the Ukrainian car market. ZAZ is operating in a high growth market, in which there are currently only 98 cars

per thousand people vs. Russia’s 156 and the United States’ 765. Given such a low car penetration level, we expect the number of new cars to grow more than twice by 2010. ZAZ has placed an emphasis on economy models (groups B, C and D). These segments are witnessing the highest growth rates in Ukraine and the CIS at present, and combined are expected to grow at an 16% CAGR in 2005-10. The market is further driven by growing personal income and the proliferation of car loans.

▐ Export opportunities to Russia. ZAZ is better placed than industry peers to increase its localization ratio and therefore has a good chance of increasing exports to Russia next year. Duty free trade is possible if the localization rate is 50% or above. Production costs in Ukraine are lower than in Russia, so exports to Russia are a very promising potential revenue source, despite the higher transportation costs compared to Russian peers. ZAZ’s higher quality and Russia’s WTO accession should further enhance this opportunity.

▐ Export opportunities to Europe. The acquisition of FSO and the contract assembly agreement with GMDAT could ultimately lead to ZAZ exporting to European markets.

▐ Improvement in political situation lowers fundamental risks related to inflation, exchange rate and GDP growth. Political wrangling inside the country, or indeed outside the country (for example a repeat of last winter’s dispute with Russia over gas supplies) seems to have come to an end with the formation of a new coalition government and an agreement with Russia. Moody’s and Fitch both maintain a positive outlook on Ukraine’s political situation.

▐ In the event of a liquidity shortage ZAZ would have two main recourses to additional funds:

4 Vasadze is a deputy in the Verkhovna Rada, Ukraine’s parliament, and currently acts as honorary president of ZAZ. According to Forbes, he is the ultimate beneficiary of both ZAZ and Ukr-AVTO

5 See Glossary in Appendix 3 for a definition.


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● The possibility of selling FSO. ZAZ indicated that it has already had at least one offer to sell FSO at a premium to the price it paid. Should ZAZ be faced with a liquidity crisis, it has indicated that it could sell FSO or part of its assets.

● Support from UkrAVTO. As ZAZ’s strategic shareholder and the major off-taker, UkrAVTO has said that it would be ready to provide a Comfort Letter stating that it will ensure that ZAZ acts in the interests of its lenders and meets its obligations in full and on time.

Threats: ▐ Transfer pricing risk. As more than 90% of ZAZ’s sales are conducted through UkrAVTO, the company bears some

transfer pricing risk. In our view, this risk is limited by a pricing mechanism that fixes UkrAVTO’s commission (as a distributor and dealer) at a certain percentage of sales (according to the company this corresponds to 15%), but not completely erased.

▐ Dependence upon GMDAT. GM cars accounted for 66.5% of ZAZ’s total revenue in 2005. FSO buys engines from a GMDAT plant in Romania (Daewoo Romania), and GMDAT is ZAZ’s largest supplier of kits. Since GM’s models are expected to form the major part of ZAZ’s increased exports, we expect the company’s dependence on GMDAT to grow from a level that is already considerable. Should GMDAT halt supplies for some reason, ZAZ’s product range and revenues would suffer significantly. In view of the off-take contract between GMDAT and FSO, this is also true for ZAZ’s Polish operations. However, increasing localization rate for Lanos production under ZAZ own brand is set to decrease such dependence. Also according to the company, there are offers from other carmakers (e.g. Chinese Cherry, etc.) to replace GMDAT as ZAZ’s main supplier and the key contractor for FSO.

▐ The risk of a cash drain from ZAZ to finance FSO’s capex program or operations is covered by ● the off-take contract signed with GMDAT, which largely ensures the profitability of FSO operations, ● the intention of ZAZ’s management to spin off FSO into a JV with GMDAT (or with another global carmaker); this

would be a prerequisite for implementation of any substantial capex program at FSO. ▐ Competition from imports on the Ukrainian market. We think this risk will chiefly depend on the government’s tariff

policy in light of Ukraine’s accession to WTO and the state of diplomatic relations between Ukraine and Russia. Hence this risk seems rather remote to us. ● We expect Ukraine’s accession to the WTO to lead to greater competition on the Ukrainian car market.

Following Ukraine’s possible accession to the WTO in the next couple of years we anticipate the government will come under pressure to gradually lower import duties on passenger cars from the current 25%. This will take time (according to the company, the transition period for the gradual reduction of custom duties is likely to be set at seven years), but it will define the level of competition on the Ukrainian market and, eventually, ZAZ’s revenues.

● Competition from Russian producers on the Ukrainian market will intensify. Once the Russian subsidiaries of global carmakers (Ford, GM, Toyota, VW, etc.) have reached 50% localization rates, they will be able to export to Ukraine duty-free. We do not expect this to happen before 2010, however.

▐ Currency risk. Car kits represent 90.0% of ZAZ’s COGS, and about 55% of the kits are bought abroad for dollars or euros. Some 96% of revenues are generated on the local market in hryvna, so the company is subject to a fair amount of currency risk. Should the hryvna be significantly devalued, the company’s financial performance would likely suffer. However, ZAZ has indicated that it employs a hedging mechanism whereby it prices its products in U.S. dollars, hence reducing its exposure to currency risk. Moreover, we expect the hryvna to strengthen in the medium term, which would further mitigate the currency risk for ZAZ.

▐ Risk of unaccounted liabilities is low. According to the company, international law firm Chadbourn and Park recently investigated the FSO deal and concluded that it had been conducted legally. Poland’s Interior Ministry and antimonopoly authorities also scrutinized and approved the deal. As part of the FSO deal, ZAZ gave the Polish government an undertaking to maintain a pre-agreed production level, a guarantee there would be no job losses for five years and promised to adapt a new car model within agreed terms. The details of the deal were not disclosed, though according to the company these undertakings will not require more cash than forecast in its business plan and are limited by the gradual ramp-up of FSO’s operations foreseen under the assembly agreement with GMDAT.


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Company snapshot ▐ Ukraine’s leading car manufacturer with growing operations in Poland. ZAZ has grown via a number of successful

mergers and acquisitions and by investing in new equipment and cooperating with global producers such as GM and DaimlerChrysler. ZAZ operates three plants in Ukraine and one in Poland and accounted for 54% of the Ukrainian passenger car market by volume in 2005. Full production cycle models6 (the Tavria and the Slavuta) made up 12% of total revenues in 2005, the SKD production accounted for 55% of revenues and CKD production – for 33%. The Company expects that the share of full production cycle models will grow due to increasing localization rate of the Lanos. ZAZ sells its output via UkrAVTO and GM DAT CIS (Russia) -- >90% and <10% in 2005 respectively. UkrAVTO has the most widespread distribution network in the country and helps facilitate sales and after-sales servicing. GM DAT CIS (Russia) is ZAZ’s main export agent; its share in ZAZ’s sales is expected to grow going forward.

▐ ZAZ’s best selling model is the Chevrolet Lanos. The Lanos is a C class sedan with a price tag of up to USD10,000, and is a modernized 2005 version based on the platform for a 1997 Daewoo. By year-end 2006, this model is expected to form 44% of ZAZ’s output. The company’s entire range of cars consists of 19 models in practically all price segments of the market: groups A, B, C, D, E and H, plus 4 models of mini vans, light trucks and busses. The quality of ZAZ’s assembly complies with international quality standards such as ISO 9001-2001, etc. as well as with the requirements set out by all of its partners, including GM and DaimlerChrysler.

ZAZ revenue breakdown, % 2005 Group of pts, incl. by origin Models Revenue share ZAZ Tavria, Pickup, Slavuta 11.9% AvtoVAZ Lada 2107, Lada 2199 14.9%

GM Chevrolet Lanos, ZAZ Sens, Daewoo Nubira, Daewoo Leganza, Chevrolet Lacetti , Chevrolet Evanda, Chevrolet Aveo, Chevrolet Takuma, Opel Astra, Opel Vectra 66.5%

DaimlerChrysler Mercedes Benz, Chrysler 3.6% Trucks Tata, Dongfeng, MAZ 0.8% Spare parts and services 2.3% Total 100%

Source: Company data

▐ GM is ZAZ’s strategic partner. GM’s models accounted for 66.5% of ZAZ’s revenues in 2005. Cooperation with GM

takes the form of a general and licensing agreement and a contract covering deliveries of SKD kits. The two companies have been in discussions to establish a joint venture on the basis of ZAZ’s Polish subsidiary and to launch production of a new model by mid-2007. Cooperation with GM significantly increases ZAZ’s export potential; however, given that GM is ZAZ’s biggest supplier, should GM decide to cease working with ZAZ, the latter’s revenues could potentially halve, according to our calculations. ZAZ could mitigate the negative impact of such a scenario by entering into cooperation with another carmaker.

▐ ZAZ is expected to generate EBITDA of USD68.2 mn in 2006 on revenues of USD1.3 bn under IFRS. This would represent a small rise on the 2005 figures (+ 6.2% and +8.9%, respectively). More importantly, during 2006 ZAZ’s net financial debt has grown by USD100 mn, pushing the company’s net financial debt/EBITDA ratio to 3.7x. This hike is related to higher working capital requirements connected with the expansion of production at FSO, which is a core part of the company’s strategy to increase sales of the Lanos model (mostly made from FSO’s kits) in both the Ukrainian and Russian markets. We expect ZAZ’s net financial debt/EBITDA ratio to return to 2005 levels (i.e. below 3x) by 2008.

▐ ZAZ’s strategy envisages revenue growth and cost reduction. The company plans to increase revenues by expanding exports from 4% of total revenues in 2005 up to 40% by 2008. Domestic demand is growing significantly, and ZAZ will utilize spare kit capacity at FSO to help it achieve this goal. Cost reduction will be achieved through economies of scale, greater use of locally sourced components to raise localization rates.

6 Please see the Glossary


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▐ ZAZ is not legally liable for FSO debt as none of FSO debts has recourse to the parent company. Going forward ZAZ may sell FSO or split it off into a joint-venture with GM or another global car maker.

▐ The company has published IFRS financials since 2004. ZAZ also has experience in tapping the debt markets. In 2003 and 2004 ZAZ issued UAH144.5 mn (USD28.6 mn) worth of bonds maturing in 2006 (duly repaid by now), which helped it to diversify its sources of financing and extend its average debt maturity. The bond issues also meant ZAZ had to comply with financial disclosure requirements demanded by the local regulatory authorities.

▐ ZAZ plans to issue a USD125-175 mn CLN to partly refinance its current debt. The company plans to partly repay its current debt with the proceeds of the CLN by the end of this year. The funds will also be used to finance additional working capital and capex at the Ukrainian plants.


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Market analysis

The global automobile industry is cyclical, capital intensive and characterized by rather low profitability, so economies of scale play a crucial role in securing a competitive advantage. The consolidation process taking place in the industry is logical and is now entering a later stage after mergers and acquisitions have been completed when overlapping operations need to be trimmed, and investment and design efforts need to be combined on shared platforms (Renault and Nissan, for example, are using a shared platform for certain models).

Demand for new cars is slowing in developed markets against a background of falling GDP growth and higher energy prices. In Europe, 0.7% fewer new passenger cars were registered in 2005, while in Japan 0.2% fewer cars were registered in the year to April 2006.

Because of this slowing demand, leading global car manufacturers are looking to increase their presence on rapidly growing markets, such as Ukraine, Russia, India and China, and are preparing to compete with local players. To survive this challenge, producers in developing economies, including Ukraine, are lobbying for state protection for local industries, and some are also seeking to develop partnerships with global leaders not just for investment but also to help them increase output efficiency.

Ukraine weakened its state protection of the domestic car industry in 2005, though it remains substantial, lending ZAZ additional benefits in its home market. Moreover, a free trade agreement among the CIS countries gives ZAZ the opportunity to export cars duty free to the Russian market7, thereby giving it an "artificial" advantage over global carmakers in the Russian market.

Benefits derived from this state protection are critical when assessing the company’s credit risk. ZAZ has signed a general assembly and distribution agreement with GM, which is viewed as a positive outcome. This would give the company additional export opportunities (for example, to Central European markets and Russia) and would reduce ZAZ’s dependence on state protection.

ZAZ’s target markets ZAZ’s target markets are (in ascending order):

1. Ukraine; 2. The CIS, predominantly Russia; 3. Europe, mainly Poland, Romania, Bulgaria and the countries of the former Yugoslavia.

Ukraine Automobile consultancy group Autoconsulting states that about 265,500 new cars were sold in Ukraine in 2005, more than in Poland, the Czech Republic, Hungary, Slovakia, Slovenia, Estonia, Latvia or Lithuania. The Ukrainian market accounted for about 35% of the Central European market. Furthermore, the consultant expect that in 2006 the new passenger car registration will hit the growth rate of 39% and will reach a 369,000 new cars a year.

Against a background of stagnating global demand, the Ukrainian car market grew by 25% in 2005. This contrasts with Russian market growth of 7% and contraction (-0.7%) on the pan-European market (only Iceland and Latvia showed a higher growth in 2005 in Europe than Ukraine).

7 Only applies to cars with more than 50% localization rate (body shop, painting and welding).


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The potential growth of the Ukrainian market is relatively high, in our opinion. At the end of 2004 Ukraine’s car penetration level (number of cars per thousand people) was only 98, lagging most other European countries. For comparison, Belarus had 106 automobiles per thousand people, Russia 156, Poland 261 and Estonia 351.8

Car penetration vs. per capita GDP

Czech Republic

Ukraine 2010

Slovakia

PolandLithuania

RussiaUkraine 2004 -2010

Belorussia

AzerbaijanMoldova

Average CIS

Average Eastern Europe

0

100

200

300

400

0 3,000 6,000 9,000 12,000 15,000

GDP per capita, USD

Penetration, cars per 1000 people

Source: MDM estimates

Adjusting for disparities in GDP (number of cars per thousand people divided by GDP per capita), Ukraine had a penetration level of 0.07, Russia 0.04, CIS (Russia, Moldova, Ukraine, Belarus and Azerbaijan) 0.05, Eastern Europe (excluding Albania and the former Yugoslavia) 0.04, and the EU 0.01.

8 Source: Autoreview, European Automobile Manufacturers Association, MDM estimates, UN

Ukrainian macroeconomic forecasts 2005 2006E 2007F 2008F 2009F 2010F GDP (UAH bn,) 418.5 470.9 533.5 602.8 676.4 758.9 GDP growth (YoY, %) 2.4% 2.5% 4.3% 5.0% 5.2% 5.2% Inflation (producer price index, %) 9.5% 10.0% 9.0% 8.0% 7.0% 7.0% Population (’000 people) 46,929 46,624 46,364 46,169 46,069 45,968 Average UAH/USD exchange rate 5.13 5.09 4.98 4.81 4.67 4.60 GDP per capita, (USD ’000) 1,740 1,985 2,308 2,687 3,098 3,537 Passenger car market (’000 units) 4,899 5,184 5,480 5,786 6,010 6,420 New auto sales increase % (incl. replacements) 25% 39% 19% 10% 8% 8% New passenger car volumes (USD ’000) 2,257 3,458 4,515 5,400 6,122 6,943 Average automobile price (USD) 8,500 9,371 10,283 11,177 11,736 12,323

Source: UkrStat, MDM estimates


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We expect Ukraine’s adjusted penetration level will move closer to the East European average and fall in line by 2010. This would correspond to 41% growth in the general penetration level to 138 cars per thousand people, higher than Belarus’ current level, but lower than Russia’s.

Based on this assumption, we estimate that new car registrations (including the replacement of existing cars) will grow at a CAGR of 16% through 2010.

Besides GDP growth, which will lead to a further increase in disposable incomes, growth of the Ukrainian passenger car market will be influenced by the following:

▐ The development of a system for car loans. According to ZAZ, about 60% of its customers buy on credit. In comparison, in 2004 AvtoVAZ sold only one-quarter of its Lada cars (representing 46 % of the new car market) on credit;

▐ Number of aging cars. There is no official data on the number of automobiles over 10 years old. However, ZAZ estimates the average age at 18 years, while in Russia it is 16 years and in Eastern Europe 12 years. We estimate the average car age in Ukraine will reach Russia’s 2004 level by 2010, hence we expect the replacement rate of existing cars to accelerate, adding an extra percentage point to overall growth.

In 2005, economy B and C group cars accounted for 80% of the entire Ukrainian automobile market. Combined group C and B have been the fastest growing segment, with a 2002-05 CAGR of 39% according to new cars registered, while the market as a whole grew at a 35% CAGR in the same period. We anticipate groups B and C will grow along with the market average 16% CAGR; as well as we expect it to be the largest segment (accounting for 80% of cars in 2010), so ZAZ’s presence in this segment is important for future growth, in our view. ZAZ currently accounts for 59% of the group C and 65% of the group B segments.

ZAZ’s main competitors in the Ukrainian market are LuAZ, KrAZ and Eurocar (see Appendix 2), though the nearest competitor, LuAZ sold nearly 6 times fewer cars than ZAZ in 2005. In 2005 ZAZ accounted for 54% of the total Ukrainian car market by volume.

Ukraine passenger car market growth forecast (by car segment) Thousand cars 2006E 2007F 2008F 2009F 2010F CAGR’06-10 Group A 1.8 2.2 2.9 3.6 3.8 22% Group B 78.6 102.7 110.2 117.7 127.2 18% Group C 217.6 250.4 276.0 297.7 321.5 15% Group D 18.7 23.8 29.8 32.7 35.3 26% Group E 15.7 20.6 23.9 27.5 29.7 17% Group H 29.0 30.8 31.1 32.7 35.3 5% Luxury 0.9 1.1 1.2 1.2 1.3 9% Minivans 6.0 6.9 7.2 7.8 8.4 9% SUV 0.6 0.7 0.8 0.9 0.9 9% Total 369.0 439.1 483.0 521.7 563.4 16%

Source: Autoconsulting, MDM estimates

Ukrainian new passenger car sales, units 2003 2004 Change YoY 2005 Change YoY ZAZ (excl. export) 64,656 113,139 75.0% 142,647 26.1% LuAZ 11,408 22,258 95.1% 22,268 1.9% KrAZ 10,828 20,927 93.3% 19,130 (8.6%) Eurocar 5,480 8,420 53.6% 11,192 32.9% Other Ukrainian producers 4,216 9,580 127.2% 27,824 190.4% New imported cars 58,181 37,616 (35.3%) 42,414 11.7% Total 154,769 211,940 36.9% 265,475 25.3%

Source: Autoconsulting, Company data, MDM estimates


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The Russian Market ▐ The Russian market is attractive for ZAZ due to its sheer size: Russia is the fifth-largest market in Europe (after

Germany, France, Britain and Italy). An estimated 1.57 mn new cars were sold in 2005, making the Russian market approximately 6 times larger than the Ukrainian market. Although the Russian market is expanding at only quarter the rate of the Ukrainian market (7% vs. 25% in 2005), growth remains higher than in most other European countries and is expected to grow by 6.1% CAGR over 2006/2010.

▐ We regard the Russian car market as more competitive than Ukraine’s. AvtoVAZ is the predominant local producer, accounting for 40% of new car registrations in 2005, but there are also several local SKD producers, making Fords, Renaults and South Korean models. Moreover, global players such as Toyota, VW and Nissan have expressed an intent to enter the market. Media reports suggest these new entrants will produce a combined 900,000 cars per year once they reach full capacity.

▐ With regard to the Russian market, ZAZ has the following competitive advantages: 1) A competitive Chevrolet Lanos model, which is aimed at price sensitive middle class consumers, (see Appendix 5); 2) A CIS trade deal guaranteeing that cars made in one CIS country can be exported to another member country duty

free provided at least 50% of the production costs are attributable to locally sourced components. This gives ZAZ and other CIS producers a significant advantage over non-CIS manufacturers;

3) Its distribution in Russia will be conducted through GM’s network of dealerships, at least for the first few years. ▐ Over the next three years, ZAZ plans to export between 30,000 and 130,000 units per year to Russia, which would

correspond to approximately 5% of the total new passenger car registration in Russia. ▐ There is a potential conflict of interest between GM and ZAZ in Russia. At the end of May 2005, GM announced that it

will build its own plant in Russia. GM clearly considers the Russian market as a priority, so in the future it may not be happy to compete against ZAZ-built GM models in the same market. We therefore expect ZAZ to sell its models in Russia under its own brand name. However, we do not expect GM to roll out production at its Russian plant until 2009.

European markets ZAZ also plans to sell production from FSO to East European markets, in particular Poland, Romania and Bulgaria. The company plans to sell approximately 1,500 Lanos models a year in these markets.

Central European markets are not performing well. In 2005, new passenger car registration in Poland fell by 25.9 %, and in Hungary it was down 2.8 %; however, given that ZAZ plans to export less than 1% of output to European markets, we believe failure in this area would pose an insignificant risk to overall revenues.


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Operations

Operating flows The company’s operating flows are illustrated below:

ZAZ’s operating flows, 2005


GM supplies 68.8% of ZAZ’s kits. Other kit suppliers include VAZ, DaimlerChrysler, ТАТА and Dongfeng. Kits constitute 90.0% of ZAZ’s GOGS in 2005. The company’s revenue breakdown by assembly method is given in the chart below:

Over 90% of company’s sales are undertaken by UkrAVTO, which distributes cars through its own showrooms as well as via independent dealerships. Less than 10% are sold directly to GD DAT CIS and charitable or government organizations.

Ukraine is ZAZ’s core market, accounting for 96% of its total revenues in 2005 (about 150,000 units). 2005 export sales were insignificant at just 4% of total revenues (less than 10,000 cars). Most exports go to Russia, with the remainder going to Belarus, Azerbaijan, Armenia and other countries of the CIS. The company anticipates exports will constitute about 35-40% of total revenues by 2008 as it focuses more on the Russian market and to a lesser extent on developing European markets (Poland, Romania, former Yugoslavia, etc.).

ZAZ’s history The plant was originally commissioned in 1863 as an agricultural equipment workshop. Almost a century later, in 1958, the plant was converted to the production of small cars. The plant was partly privatized in 1994 and renamed to OJSC AutoZAZ, with the state retaining a 80% stake and the remaining 20% distributed among its employees.

Revenue breakdown by assembly type, 2005

full scale assembly ,

12%

SKD, 55% CKD, 33%



12

ZAZ shareholder structure


▐ In April 1998 Korean automaker Daewoo Motors and AvtoZAZ formed a 50-50 joint venture, AutoZAZ-Daewoo. ▐ Daewoo Motors went bankrupt in 2001; in May 2002 UkrAVTO acquired the state’s controlling stake in AvtoZAZ. ▐ In January 2003, Daewoo Motor’s stake in the JV was sold to Hirsch & Cie, a Swiss investment fund. ▐ AvtoZAZ’s shareholder is UkrAVTO, Ukraine’s largest car dealership and servicing company. It also owns several gas

filling stations, restaurants and real estate. UkrAVTO is also the official distributor in Ukraine for DaimlerChrysler, GM, Toyota, Nissan, Renault, Dongfeng and Tata. Since 1985 the company has been headed by Tariel Vasadze.

▐ In December 2005 ZAZ acquired an 81.2% voting stake in FSO (4.2% of the total share capital) from the Polish government. FSO is a large regional carmaker with state-of-the-art equipment that will help ZAZ improve its product quality and triples its current capacity to 450,000 units per year.

▐ In 2006, ZAZ bought back a 31.7% stake from AvtoZAZ, thus reducing the latter’s stake in ZAZ to 18.3%. In our view, treasury shares may be sold to a strategic investor.

ZAZ’s relations with UkrAVTO, FSO and GM have a significant impact on its operations, and hence warrant further discussion.

(I) ZAZ’s relations with UkrAVTO Distribution through the UkrAVTO has a positive effect for the company’s sales since its wide distribution and dealer network gives ZAZ significant competitive advantage over Ukrainian producers. ZAZ also delivers its products to five UkrAVTO distributors, independent distributors and state bodies (social programs).

ZAZ’s sales on the domestic market Dealer/distributor Products UkrAVTO’s share Share of sales on the local market, % AvtoZAZ-Service Tavria, Slavuta, Sens 100% 69.0% UkrAvtoZAZ-Service Opel, Chevrolet 100% 10.7% Trade and showroom center Avto Tata, Dongfeng 100% 0.1% Autotechnologia VAZ 50% 11.7% Avtokapital Mercedes, Chrysler 100% 0.7% Other / direct Tavria, Slavuta, Sens 0% 7.8% Total 90% 100.0%



13

Since mid-2005 ZAZ has been selling its output directly to distributors (as opposed to paying them a commission). The contracts with distributors are usually concluded for one year with an option to extend the term. The price charged by the distributors depends on the market but cannot be lower than 85% of the final price of the car. Price are defined regularly by the UkrAVTO board.

The risk of conflict of interest between ZAZ and UkrAVTO is decreasing due to a general management mechanism that has been adopted (see Management section).

Management. UkrAVTO is well represented in ZAZ’s top management: it has a 15% voting stake and two out of five seats

on the company’s supervisory board. Therefore strategic decisions are made in accordance with both ZAZ and UkrAVTO’s interests.

Operational management is run by ZAZ’s management board. Key members are given in Appendix 1. The company’s organizational structure is shown in chart above.

(II) FSO FSO has state-of-the-art automated full-cycle production; modernization was completed in 1999. ZAZ synergies with FSO lie in production capacities, products and cooperation with GM DAT.

FSO produces GM models and kits to GM’s quality standards. Since ZAZ’s acquisition of FSO, GM DAT has intensified negotiations with ZAZ over a long-term strategic agreement that may transform FSO into a joint venture. According to ZAZ, at the end of the 1990s FSO was owned by Daewoo Motors, which invested about USD1 bn to modernize the production

ZAZ organizational structure

Quality Dep.–Chief Controller

Deputy Chief of the Board for Production

Coordination and Planning Dep.

Marketing Dep.–Marketing DirectorR&D

Production Dep.–Production

Director

Operation & Energy Dep. –Chief Engineer

Exports Dep.

Commercial Dep.–Commercial

Director

Customs Procedures Dep. Financial Dep.

Automobile Manufacture

Chief of the Board

Supervisory Board Shareholders’ Meeting

Board of Directors

Auditing Commission

Personnel & Labour Dep.

Security & Regimen Dep.

Deputy Chief of the Board for

Supplies

Deputy Chief of the Board for Development


Marketing


Finance&Planning

Deputy Chief of the Board for Admin. Issues

Welding Shop

Painting ShopAssembly Shop

Stocking Shop

Quality Dep.–Chief Controller

Legal Dep. Chief Lawyer

Labour & Environment

Protection Dep.

Accounting Dep. Chief Accountant



14

facilities, about 80% of which was financed by Polish and Korean banks. Following this modernization full-cycle production of the Lanos and Matiz was launched, in addition to other models produced using CKD assembly. Daewoo’s bankruptcy curtailed FSO’s reorganization of other model production facilities, and in the absence of working capital and accumulating debts, production was stopped. The Polish government restructured FSO debts and took over management of the company. The deal was approved by the Polish and Ukrainian governments, and international legal company Chadbourn Park was brought in to clarify the deal’s legality. Following the deal, ZAZ holds 4.2% of FSO. ZAZ owns 81.2% of the voting shares, which gives it sole strategic and operational management. According to the company, the remaining shareholders loss of voting rights is irreversible.

Chevrolet Lanos kits are FSO’s main product, which are exported to Ukraine where they are assembled and sold on the domestic market or to Russia or other CIS countries. Thus, the common identity of the two companies’ basic car models adds to the potential synergies between the two.

(III) GM Cooperation with GM has widened ZAZ’s product range, quality, export growth prospects and production of new models. (ZAZ has technology license agreement signed with GM DAT). However, considerable risk lies in the fact that ZAZ depends quite heavily on one supplier.

ZAZ deals with more than 1,000 suppliers, including 837 in Ukraine, 120 in the CIS and 92 outside the CIS. Car kits form the bulk of the company’s cost structure, 68.8% of which are accounted for by GM supplies.

Under the most pessimistic scenario, where GM ceases supplying car kits, ZAZ’s management believes it could restart production in 6-9 months under cooperation with other producers, including Chinese Cherry, Korea’s Kia and Hyundai.

Contracts with suppliers are drawn up on an individual basis and depend on each supplier and each model produced.

FSO ownership structure Shareholder % in company’s capital % in votes ZAO ZAZ 4.2% 81.2% "AUTOPARTS FSO" Ltd. Daughter Company of FSO 0.7% 13.1% "ZOCAR" Ltd. under liquidation 0.2% 4.0% STATE TREASURY OF THE REPUBLIC OF POLAND 2.7% 0.0% DAEWOO MOTOR CO. LTD. 92.2% 0.0% INDIVIDUAL PERSONS 0.1% 1.7% TRADE UNION OF THE ENGINEERS AND TECHNICIANS 0.0% 0.0% TOTAL 100.0% 100.0%


ZAZ’s 10 largest suppliers, 2005 Supplier Country Terms of payment Currency Share in total supplies Possibility of replacement GM DAT Korea 100% prepayment USD 31% none FSO S.A. Poland 100% prepayment USD 20% exists LuAZ Ukraine 100% prepayment UAH 8% none Opel Germany 100% prepayment EUR 5% none Lit’e Ukraine 50% prepayment, 50% upon receipt UAH 1% exists Zaporozhstal Ukraine 50% prepayment, 50% upon receipt UAH 1% exists TATA Motors India 100% prepayment USD 1% none Mika – export Russia 15 calendar days from dispatch date RUB 1% exists Rosava Ukraine 100% prepayment UAH 1% exists Severstal Russia Irrevocable, divided confirmed credit note RUB Less than 1% exists

Source: company data


15

Production assets/technology

ZAZ’s Ukrainian operations ZAZ’s main production facilities are located in Zaporozhye, Ilyichevsk, Melitopol and Warsaw. Following the collapse of the Soviet Union ZAZ suffered from a lack of investment, but this situation changed with the arrival of Daewoo, which became ZAZ’s first foreign partner and investor, spending about USD195 mn on its production facilities. In 1998 ZAZ produced its first foreign models, the Daewoo Lanos and Nubira, at its Ilyichevsk plant. In May 2002 under an agreement between Daewoo Concern, DaimlerChrysler and JV AvtoZaz-Daewoo, the first serial production of Mercedes E and M class models was launched.

On the whole ZAZ’s Ukrainian facilities need further modernization. However, the present production methods, mostly non-automated CKD and SKD assembly, allow the company to maintain ISO 9001-2001quality standards as well as specific standards demanded by its foreign partners, including GM and DaimlerChrysler.

The Zaporozhye plant employs mainly the full cycle and CKD methods, and the localization level of its output exceeds 50%. The whole production process, provided that all materials and components are in stock, takes an average of 6 days, in line with global norms.

The Ilyichevsk plant uses only the SKD method. The plant is located near a port, which enables it to reduce transportation costs. The localization level at this plant is insignificant.

The Melitopol plant produces small car engines (up to 1.4 liters) that comply with EURO-3 standards, which exceeds quality requirements in Ukraine and the CIS, though they do not comply with European Union requirements (EURO-4).

ZAZ ‘s Polish operations ZAZ’s Polish operations consist of full cycle production (welding, painting and assembly) of up-to-date cars (Daewoo Lanos). FSO has a higher level of automation than the Zaporozhye plant (and therefore a higher production/employee ratio).

Relations with the state ZAZ is one the country’s largest regional businesses and generates up to 33% of local tax revenues. With about 20,000 workers, ZAZ is also one of the country’s largest employers. Given this, in case of difficulties we believe the Ukrainian government would step in to support operations to avoid social tension.

ZAZ’s financials are largely exposed to government’s policy on state protection for the industry (see Appendix 4). WTO accession is very important for the company’s prospects on the Ukrainian and Russian markets.

As for FSO, the European Commission is considering the company’s application for a one-off EUR80 mn handout to restructure the company’s debts and help launch production of a new model.

ZAZ Production facilities Plants Products Production capacity

Zaporozhskiy Tavria, Slavut, Pickup, Opel Astra, Lanos, Sens, Lada 2107, Lada 21093, Lada 21099

Full cycle production: 120,000 units; CKD assembly 40,000 units; SKD 5,000 units

Ilyichevsk Chevrolet Aveo, Chevrolet Lacetti, Chevrolet Evanda, Chevrolet Tacuma, Mercedes-Benz

(A,C,E,S,ML classes), TATA, Dong Feng 84,000 cars; 5,000 trucks; 5,000 buses; 2,000

tractors and trailers

Melitopol Transmission (engine and gear box), 1,1 -1,4-liter engines complying with EURO-3 norms 120,000 units

Warsaw Lanos 280,000 units Source: company data


16

Products ZAZ products (sales) 2003 2004 Change YoY 2005 Change YoY Full cycle production and CKD Tavria 11,877 13,954 17.5% 10,769 -22.8% export n/a 604 n/a Pickup 3,259 7,338 125.2% 3,875 -47.2% export n/a 2,955 n/a Slavuta 19,117 28,979 51.6% 21,361 -26.3% export 2,276 7,483 228.8% 2,052 -72.6% Sens 10,043 20,002 99.2% 21,669 8.3% Lanos Т150 100 n/a 4,427 4327.0% export n/a 4,192 n/a Opel Astra 1,757 n/a 2,143 22.0% VAZ 2109 14,149 n/a 23,146 63.6% SKD production Daewoo Lanos FSO 16,155 20,626 27.7% 16,371 -20.6% Daewoo Lanos Korea 1,052 6 -99.4% n/a Daewoo Nubira 1,677 19 -98.9% 1 -94.7% Daewoo Leganza 74 1 -98.6% n/a Chevrolet Aveo 4,162 n/a 16,570 298.1% Chevrolet Lacetti 3,435 n/a 11,041 221.4% Chevrolet Evanda 305 n/a 2,016 561.0% Chevrolet Takuma 754 n/a 2,054 172.4% Opel Astra 1,316 788 -40.1% 818 3.8% Opel Vectra 677 1,577 132.9% 1,713 8.6% Other Opel models 49 56 14.3% 213 280.4% Mercedes 663 822 24.0% 535 -34.9% Chrysler 18 n/a 70 288.9% Dacha 1,956 1,629 -16.7% 68 -95.8% VAZ 2107 n/a 7,662 n/a MAZ 15 39 160.0% 1 -97.4% ТАТА 17 n/a 590 3370.6% Dongfeng n/a 300 n/a Total 70,206 128,016 82.3% 157,216 22.8%



17

Strategy

The company’s strategy is following the dual track:

▐ Increasing sales, through domestic and export sales; ▐ Cost reduction.

Increasing sales ZAZ is planning to increase sales (FSO excluded) by a CAGR of 40% over the next three years, reaching about USD2.5 bn by 2008. To achieve this target, the company plans to:

▐ Significantly increase its export deliveries. ZAZ expects to increase exports up to 40% of total sales until 2008, up from 4% in 2005. Most sales will be directed to Russia, where the market is growing at 7% a year and is expected to grow 6.1% CAGR over the next five years. The main model for Russia will be the Chevrolet Lanos, whose main competitive advantage will be price. ZAZ plans to export between 37,000 and 130,000 cars per year, with about 95% going to Russia through GM DAT CIS.

▐ Increase sales in Ukraine at a CAGR of 20%, driven by a balanced product mix and the development of car loan financing.

Cost reduction ▐ ZAZ’s strategy is to remain a low-cost producer, focusing on price sensitive customers. To stay competitive, the company

plans to increase the rate of local production and therefore reduce dependence on more expensive supplied car kits. By 2009, ZAZ plans to cut costs by increasing the share of full cycle and CKD production to 67%, up from the current 45%.

▐ The company estimates that output will grow by a CAGR of 24% over the next three years, pushing down fixed costs per unit. Economies of scale will therefore play a significant role in cost reduction.

▐ ZAZ also aims at increasing automation of its production processes to increase productivity and to further reduce the cost per unit, this is rather in the longer term.


18

Financial and peer analysis Analysis of historical financials We have based our analysis on the following:

▐ ZAZ’s 2004 IFRS accounts audited by E&Y; ▐ ZAZ’s 2005 IFRS accounts audited by E&Y; ▐ Consolidated 2005 IFRS accounts (ZAZ + FSO) audited by E&Y; Summary financials, USD mn

2004A ZAZ

2005A ZAZ

2005A Consol.

2006E ZAZ

2006E Consol.

2007F ZAZ

2007F Consol.

2008F ZAZ

2008F Consol.

Income Statement Total Revenues 842.2 1 183.7 1 191.9 1 289.2 1 367.4 1 932.5 2 094.8 2 515.0 2 751.6 Gross Profit 200.2 173.1 172.4 114.5 124.7 193.9 210.7 286.4 313.9 EBITDA 125.1 64.2 58.2 68.2 70.4 114.8 120.3 168.4 184.0 Interest Expense 8.3 14.1 15.0 22.0 28.8 27.1 39.9 43.6 57.5 Net Profit 95.6 18.7 34.6 14.4 (2.2) 52.2 54.5 79.4 246.6 Balance Sheet Equity 300.4 334.2 368.3 346.1 638.6 405.9 752.8 499.6 864.6 Net Financial Debt 82.8 150.5 155.2 249.6 274.9 379.9 474.9 449.0 560.5 Fixed Assets 228.0 231.1 952.8 231.6 835.8 238.8 889.0 249.4 879.8 Total Assets 476.9 583.6 1 376.4 699.7 1 479.7 930.6 1 812.2 1 144.0 2 072.3 Cash Flow Operating CF 23.9 (49.0) n/a (50.1) n/a (85.4) n/a (9.4) n/a CAPEX 73.6 10.9 n/a 19.9 n/a 20.4 n/a 21.1 n/a Free CF (57.2) (75.8) n/a (100.3) n/a (124.8) n/a (55.7) n/a Ratios Sales growth (Y-o-Y) n/a 40.5% n/a 8.9% 14.7% 49.9% 53.2% 30.1% 31.3% EBITDA (Y-o-Y) n/a (48.7%) n/a 6.2% 20.8% 68.4% 70.9% 46.7% 53.0% Gross Margin 23.8% 14.6% 14.5% 8.9% 9.1% 10.0% 10.1% 11.4% 11.4% EBITDA Margin 14.9% 5.4% 4.9% 5.3% 5.1% 5.9% 5.7% 6.7% 6.7% Net margin 11.4% 1.6% 2.9% 1.1% (0.2%) 2.7% 2.6% 3.2% 9.0% Net Financial Debt / EBITDA 0.7 2.3 2.7 3.7 3.9 3.3 3.9 2.7 3.0 EBITDA / Interest Expense* 15.0 4.5 3.9 3.1 2.4 4.2 3.0 3.9 3.2 Debt / Equity 0.3 0.5 0.4 0.7 0.4 0.9 0.6 0.9 0.6 EBITDA / CAPEX 1.7 5.9 n/a 3.4 n/a 5.6 n/a 7.9 n/a Working Capital days 87 87 n/a 112 n/a 112 n/a 112 n/a

Source: company data *Interest expenses do not include bank charges and commissions

The swings in the company’s financial results between 2004 and 2005 is explained by the sensitivity of its operations to changes in state regulation.

To analyze the financial statements we used a dual approach: first we directly compared the company’s 2004, 2005 and expected 2006 results on a standalone basis, and then we evaluated the impact that FSO had on the consolidated accounts by the end of 2005.


19

Direct standalone comparison ▐ 2004: For ZAZ, 2004 (the first year it published IFRS accounts) was unusually successful, with revenues rising 95% y-o-

y and a record high EBITDA margin of 14.9% and net margin of 11.4% – several times the levels achieved by comparable companies.

▐ 2005: Changes in the tax regime in 2005 had a strong impact on ZAZ’s financial performance, curtailing profitability (please refer to Appendix 4 for a detailed description of changes in the tax environment). As a result, the company’s EBITDA and net profit fell below the peer sample average, although they were better than the figures for Ford (see the peer analysis section).

▐ 2006: In 2006, no improvement has been seen: sales have increased by a modest 8.9% (on the back of physical output, which grew 21%); EBITDA margin has remained around the same level at 5.3%; and net profit has fallen further from 1.6% in 2005 to 1.1% in 2006E. However, the company has put together all the elements of its strategy this year, which should allow it to boost sales by 50% in 2007: ● FSO was put into operations , ● Distribution network in Ukraine and Russia put in place, ● Localization rate was increased.

Revenue growth slower than the output is explained by the following: ▐ Changes in product mix in favor of B and C class autos, which mainly drove the increase in output and contributed to a

decline in average price by 8.1%; ▐ Improved service at UkrAVTO led to higher prices from distributors and dealers, which hit a benchmark of 15% of the

car’s selling price, compared to 10-12% in 2004 and 2005. According to the company, this arrangement will remain unchanged, or will be improved.

EBITDA margin remained largely in line with 2005 results (despite lower gross profit in 2006) thanks to lower operating costs, such as dealer and distribution commissions, transportation and other costs. The drop in net earnings is explained by the higher interest payment charge (up 56.1%) that resulted from greater financial debt, mostly related to increased working capital requirements. A 15-day slowdown in working capital turnover in 2006 will likely produce USD113.5 mn in working capital requirements. As a result, cash from operations will remain negative at USD49.0 mn and is not expected to turn positive until 2009. Capex is expected to hover around USD20 mn per year, mainly for maintenance, but also for modernization needs.

Debt and capital Financing needs will mainly be covered by additional debt (USD94.3 mn in 2006 and USD121.3 mn in 2007). An equity injection may also be possible if the company attracts a strategic investor. However, this is not included in the base case scenario. Together with the planned CLN issue, we expect that by the end of 2006, the company’s net financial debt should reach USD250 mn to finance working capital requirements, which are expected to grow in tandem with the top line. The net financial debt/EBITDA ratio is expected to reach 3.7 by end-2006, while the EBITDA/interest expense ratio should be 3.1.

The impact of FSO on the consolidated figures ZAZ purchased FSO in December 2005, so the Polish plant was consolidated in ZAZ’s 2005 figures for only one month of the 2005 financial year. This affected the combined entity’s P&L only marginally; the impact on the balance sheet was much more substantial.


20

The acquisition of FSO added USD8.2 mn in revenues, bringing the consolidated figure to USD1.2 bn. The lion’s share of FSO’s sales were made to ZAZ, which is reflected in the insignificant increase in the combined entity’s total sales. The impact on ZAZ’s EBITDA margin in 2005 was also insignificant – only 0.5 pp.

In 2006, as FSO’s operations gathered steam, its contribution to group sales reached 6%. However, as FSO has not yet broken even, its contribution to consolidated EBITDA was only about half of that to sales (+ 3.2%). FSO’s negative contribution to the group’s overall performance will most likely continue until 2008, and it will remain insignificant.

We anticipate the CLN issue will increase total debt to USD150 mn, as ZAZ has indicated that it will use all the proceeds to refinance its current loans, which mature in 2006 and 2007. Once the CLN has been issued, the company’s repayment schedule will be pushed back from 2007 to 2008.

Peer comparison To conduct the peer group analysis, we selected full-scale producers, including Russia’s AutoVAZ and several global players, whose product range is largely composed of B, C and D class vehicles: Ford, GM, Toyota, Renault, Skoda (part of VW group) and PSA Peugeot-Citroen. We also included Severstal-Avto, the only Russian SKD producer to publish IFRS financials. To compare the automotive divisions of the international manufacturers, we excluded the results of operations of their respective in-house finance units, where possible. It should be noted that calculation of the peer group average may be biased upwards, given that IFRS accounts are available for AvtoVAZ and Severstal-Avto IFRS only for 2004, when both companies had a good year.

The most suitable peer company for comparison with ZAZ appears to be Canada’s Magna Group, an independent producer of auto components whose assembly lines are used by many global car manufacturers, including GM, DaimlerChrysler and BMW.

-

0.5

1.0

1.5

2.0

2.5

3.0

2004 2005 2006 2007 2008-

0.5

1.0

1.5

2.0

2.5

3.0FSO sales contributionFSO EBITDA contributionSales ZAZEBITDA ZAZ

Source: company data

ZAZ debt portfolio as of 20 Nov 2006 Bank Value (USD mn) Currency Maturity Average rate Aval 80.4 USD / EUR / UAH 2006 -2007 5-8.9% PUMB 19.8 USD 2007 2.5-10.% UkrExim Bank 4.5 USD 2007 9.0-10.% CreditPromBank 3.2 EUR 2007 9.0% Raiffeisen 6.8 USD 2008 8.85% Ukrsib Bank 14.0 USD 2007 3.9 – 5.0% Alfa Bank 3.8 USD 2007 9.25% Industrial Bank 11.0 USD / EUR 2007 8.5-9.0% Calion 16.9 USD / EUR / UAH 2007 7.0-9.0% MDM Bank 75.0 USD 2006 8.5% Total ZAZ 235.4 n/a n/a 7.51% Total FSO 12.7 n/a n/a n/a

Total Consolidated 248.1 n/a n/a n/a Source: Company data

* UAH/USD, EUR/USD rate as 5.05 and 1.277 respectively


21

ZAZ’s productivity per worker (number of cars produced per year divided by the average number of employees) is 23% higher than for AutoVAZ (7,573 vs 6,147), and five times higher than Severstal-Avto (1,696). However, leading global auto producers show far better productivity per worker (22,727 for Ford, 27,018 for GM and 29,018 for Toyota). This difference can be explained by the higher level of automation featured on global producers’ assembly lines.

According to 2005 results, the average cost of goods sold per car produced by ZAZ was the lowest in the sample, after AvtoVAZ. Average COGS per car among the peer group was USD12,996, while ZAZ averaged USD6,500. Despite the fact that most car components and kits are purchased from

abroad (with an import duty), ZAZ is operating in a low-cost environment: it pays less for labor, energy and materials than its peers.

ZAZ’s EBITDA margin is lower than the sample average, which is largely explained by changes in Ukrainian tax and import regulations, thus in 2004 ZAZ EBITDA margin was 14.9%.

COGS/automobile, 2005

9,4696,7106,500

21,25917,91818,014

12,32310,997

13,548

0 5,000 10,000 15,000 20,000 25,000

Sev erstal-autoAutoVAZ

ZAZFordGM

Toy otaRenault

PSASkoda


*AvtoVAZ and Severstal-Avto figures based on 2004 financial results:

EBITDA margin, 2005 Net profit margin, 2005

15%10%

5%3%

13%9%

8%12%

11%

-1%

-10% -5% 0% 5% 10% 15% 20%

Sev erstal-autoAv toVaz

ZAZFordGM

Toy otaRenault

PSASkodaMagna

Av erage

7%3%

2%-3%

-8%6%

9%1%

4%3%

-10% -5% 0% 5% 10%


ZAZFordGM

Toy otaRenault

PSASkodaMagna


* AvtoVAZ and Severstal-Avto figures based on 2004 financial results Source: Company data *AvtoVAZ and Severstal-Avto figures based on 2004 financial results

Financial debt/EBITDA, 2005 EBITDA/interest expenses, 2005

0.81.82.3

4.5-16.4

0.62.4

0.80.30.3

-20 -15 -10 -5 0 5 10


ZAZFordGM

Toy otaRenault

PSASkodaMagna Av erage

7.94.64.53.3-0.7

122.639.1

83.729.4

415.5

-100 0 100 200 300 400 500


ZAZFordGM

Toy otaRenault

PSASkodaMagna

Av erage


*AvtoVAZ and Severstal-Avto figures based on 2004 financial results

Source: Company data *AvtoVAZ and Severstal-Avto figures based on 2004 financial results

*Interest expenses are or a net basis and do not include bank charges and commissions


22

ZAZ appears to be more leveraged compared to its peers: its financial debt relative to EBITDA higher then the sample average (2.3 vs 1.5, excluding GM as an outlier). This is explained by the unusually low EBITDA in 2005 and ZAZ’s above-average working capital requirements. Among the peer group, average working capital in 2005 was 23 days, compared to 82 days for ZAZ.

Working capital (days), 2005

5512

8211

5314

-324

-10

-11

-20 0 20 40 60 80 100


ZAZFordGM

Toy otaRenault

PSASkodaMagna

Av erage


*AvtoVAZ and Severstal-Avto figures based on 2004 financial results


23

Appendix 1: Tariel Vasadze, Board members and top management9

Tariel Vasadze Vasadze was born in 1947 and has worked in the car industry for 32 years. He holds an engineering degree, and began his career as an engineer in the design department at UkrAVTO, eventually becoming the company’s CEO. From 1992-2002, Vasadze was president of UkrAVTO. In 2002, he was awarded the Order of Merit, one of Ukraine’s highest awards. Until recently Vasadze chaired the supervisory boards at both ZAZ and AvtoZAZ, but he formally relinquished these posts after being elected to Ukraine’s parliament in March 2006.

Svetlana Kuznetsova Kuznetsova was born in 1947 and has also been working in the car industry for 32 years. She holds degrees in engineering and economics and is currently serving on ZAZ’s supervisory board.

Nikolay Evdokimenko Evdokimenko was born in 1961 and has 22 years of industry experience. He holds a degree in engineering and in 2003 received the Order of Merit (third degree), one of Ukraine’s highest awards. Evdokimenko is currently board chairman at ZAZ. He has previously served as executive board chairman, deputy board chairman in charge of production and shipments and commercial director.

Inna Zolotorevskaja Zolottorevskaja was born in 1962 and has an engineering degree. She has worked for ZAZ for 21 years, and is currently serving as financial director. Prior to this she was the deputy head for coordination and planning and deputy director in the same department.

Valery Krajny Krajny was born in 1948 and holds an economics degree. He has worked for ZAZ for 35 years, and at present he is deputy board chairman in charge of administration and construction. He has also served as administrative director and executive director in charge of capital investment and construction.

Vasily Krivonos Krivonosov was born in 1959 and has a degree in engineering. He has worked at ZAZ for 22 years, and is currently deputy board chairman in charge of production.

Jury Krjuchkov Krjuchkov was born in 1957 and holds an engineering degree. He has worked for ZAZ for 25 years, and is currently deputy board chairman in charge of shipments. Prior to this he served as director of the commercial department, sales director, and second deputy to the commercial director.

Sergey Filipenko Filipenko was born in 1966 and has a degree in engineering. He has been at ZAZ for 15 years, and at present is serving as deputy board chairman in charge of development. Prior to this he served as deputy technical director, senior designer and head of the development department.

Mikhail Daukshas

9 Source: ZAZ Information Memorandum, January 2006


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Daukshas was born in 1951 and has a degree in engineering. He has been at ZAZ for 25 years, an is currently deputy board chairman in charge of marketing. Prior to this he headed the quality assurance department and served as chief quality specialist.


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Appendix 2: Key Ukrainian Competitors

▐ Lutsky Automobile Plant (LuAZ) Lutsky Automobile Plant (LuAZ) is ZAZ’s main competitor, although it considerably lags ZAZ in terms of output and sales. In 2005 ZAZ’s output were 6 times higher than LuAZ’s.

LuAZ mainly makes VAZ, KIA and Hyundai cars from SKD assembly kits, and it also makes light trucks and buses. LuAZ has said it plans to set up CKD assembly production; however it has released no further details as of yet, so we assume this process will take some time.

▐ Kremenchug Automobile Plant (KrAZ) Kremenchug Automobile Plant (KrAZ) was set up as a Ukrainian-Russian joint venture, but in 2000 Avtoinveststroy Corporation (AIS) became the main shareholder and the plant’s chief distributor, which has benefited the plant’s development.

KrAZ produces Volga 3110s and 3115s from car kits supplied by GAZ (Russia). It competes with ZAZ only in the segment for D group cars. KrAZ has announced plans to stop production of Volga cars in favor of assembling VAZ and Ssang Yong Rexton automobiles. KrAZ’s capacity is 45,000 units a year, but in 2005 it assembled only 19,328.

▐ Eurocar Eurocar is the official representative of Skoda in Ukraine and assembles Skoda, VW and Audi cars from SKD kits. The VW and Audi assembly lines were launched in 2001. To promote its products domestically, Eurocar agreed to supply the Ukrainian government and ministries (which accounted for 22% of its revenues in 2004).

Eurocar’s product range and limited capacity (15,000 cars per year as of 2004) mean it cannot compete with ZAZ to a full extent. For example, ZAZ’s Chevrolet cars are much cheaper and more competitive than Eurocar’s.


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Appendix 3: Glossary ▐ Localization rate: the percentage of costs of an automobile that were sourced domestically: a localization rate of 50%

means the cost of domestically sourced raw materials, components and assembly work accounted for 50% of the total cost of an automobile.

▐ SKD (semi knock down): With SKD assembly, a car kit arrives without engine, battery, exhaust pipe, transmission and ignition system, which are supplied separately. SKD assembly involves hardly any complex mechanical processes and often requires a labor force that is less skilled and trained in comparison to CKD assembly. It is therefore much cheaper. SKD involves so-called “screwdriver assembly”, after which the automobile is ready for sale. SKD is adopted purely for tax benefits. With this method, the localization level does not exceed 40% and the production cycle is only 2-3 days.

▐ CKD (complete knock down): With CKD assembly, the body arrives either completely or partly assembled. This is full-scale assembly, differing from full cycle production as it does not involve making of the car body. The level of localization for CKD kits can exceed 50%.

▐ Full cycle production: full-cycle production implies that a car body is made at the enterprise. The localization level is typically above 50% for this type of production.

▐ Chevrolet Lanos: The Lanos is the equivalent of the ZAZ Sens, sharing the same body. However, the Lanos is equipped with a 1.5L Daewoo engine produced in Romania, and the Sens is shipped with ZAZ’s Melitopol engine. In this report we refer to both Chevrolet Lanos and ZAZ Sens as to Chevrolet Lanos, if not otherwise specified.

▐ Car groups. The main passenger car classes are: A, B, C, D , E and F. ● Group A: a compact class that includes the Mercedes Smart, Ford Ka, and Citroen C2. These cars are primarily

used in cities and are more fuel efficient than other groups. ● Group B: also referred to as small class, these cars mainly consist of 3- and 5-door hatchbacks. Group B is very

similar to group C, the difference being that B classes are smaller in size. Examples include the Ford Fusion, Opel Corsa, Hyundai Getz, and Peugeot 206.

● Group C: sometimes referred as the Golf class, includes the VW Golf, Peugeot 307, Opel Astra, and Renault Megane. This group is the most popular class in Europe, Ukraine and Russia.

● Group D: sedans and hatchbacks, such as the Peugeot 407, Audi A4, BMW 3 series, and Mercedes C class. This group is sometimes also referred to as the compact business class.

● Group E: business class automobiles, such as the Mercedes E class, BMW 5 series, Audi A6, Toyota Camry, and Peugeot 607.

● Group F: luxury cars, such as the Mercedes S class, BMW 7 series, and Jaguar XJ.


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Appendix 4: Legislative changes

The government of Prime Minister Yulia Timoshenko canceled several tax benefits and import duties that benefited domestic car manufacturers. These changes caused profitability at all Ukrainian carmakers to nose dive, prompting the government into a partial U-turn once it had realised the negative consequences of its move. The government reinstated some tax benefits for domestic car manufacturers and raised import duties on new foreign cars. These measures only partly mitigated the losses suffered by the local car manufacturers, and ZAZ in particular.

Legislative changes Date Legislation Effect on ZAZ

25 March 2001 Customs duty benefits abolished on car kits and accessories imported by Ukrainian carmakers Some tax exemptions cancelled (e.g. profit tax)

Costs increased by the amount of duties (which reached up to 25% of the kit cost) Effective income tax rate increased from 2% in 2004 to 48% in 2005%.

25 March 2005 Excise on cars reduced 10-fold Selling price decreased by less than 1%. In view of the low excise rates applied to the overwhelming majority of ZAZ products, the effect was insignificant

1 April 2005 Car manufacturers’ VAT-exempt status abolished Production costs automatically increased by 20%.

23 June 2005 Import duty removed on 200+ basic materials and accessories Unit costs decreased by 2-4%, depending on the model

2005 Import duty on imported cars raised from 15% to 25% Restriction of foreign competition on the domestic market



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Appendix 5: Competition in group C and Russian car market

Chevrolet Lanos Daewoo Nexia Renault Logan ВАЗ Kalina

Min. price, USD 9000 9200-11500 9200-12500 8500-10000 Body Sedan Sedan Sedan Sedan

Max. speed, km/h 172 170 162 170

Year 2005 1996 2005 2005 Trunk size, liters 322/958 530 510 380

Engine Gasoline, with dispersed injector

Gasoline, with dispersed injector Gasoline, with injector Gasoline, with injector

V, cm3 1498 1498 1390 1600

Power, hp/ revs/min 86/5800 75/5400 75/5500 80/5200

Drive Front wheel Front wheel Front wheel Front wheel Front wheel suspension

Independent, spring, McPherson, with stabilizer

Independent, spring, McPherson, with stabilizer Independent, triangular lever Independent, spring,

McPherson, with stabilizer City cycle 10.4 l/100 km 9.3 l/100 km 9.2 l/100 km 9.8 l/100 km

Country cycle 5.2 l/100 km 5.4 l/100 km 5.5 l/100 km 7.2 l/100 km

Fuel type А-95 А-92 А-95 А-95 Fuel tank, liters 48 50 50 50

Source: Autonews.ru

Hyundai Getz Hyundai Accent Volkswagen Pointer ВАЗ 2110 Chery Amulet

Min. price, USD 10190-16690 10500-11700 9520-13500 8600-11000 10990- 12500

Body Sedan Sedan Sedan Sedan Lift-back Max. speed, km/h 154 181 170 185 172

Year 2002 2001 2000 1997 2005 Trunk size, liters 245 375 285 450 420

Engine Gasoline, with dispersed injector

Gasoline, with dispersed injector

Gasoline, with dispersed injector Gasoline, with injector Gasoline, with injector

V, cm3 1086 1492 999 1499 1596 Power, hp/ revs/min 66/5800 102/5800 67/6000 94/5600 94/5500

Drive Front wheels Front wheels Front wheels Front wheels Front wheels

Front wheel suspension

Independent, spring, McPherson, with

stabilizer Independent, spring,

McPherson, with stabilizer Independent, spring,



McPherson, with stabilizer

City cycle 6.9 l/100 km 9.9 l/100km 7.4 l/100km 8.8 l/100 km 10.1 l/100 km

Country cycle 5.2 l/100 km 6.1 l/100 km 5.9 l/100 km 5 l/100 km 6,7 l/100 km

Fuel type А-95 А-92-95 А-95 А-92 А-92 Fuel tank, liters 48 45 51 43 60

Source: Autonews.ru

The following models were seleced for peer group comparison with a price level of about USD10,000: Daewoo Nexia, Renault Logan, Hyundai Accent and Getz, Сhery Amulet, Volkswagen Pointer, Lada Kalina and VAZ 10th family cars, which we view as the main competitors of the Chevrolet Lanos. However, car characteristics, as well as the target customer groups


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for these models, vary considerably. We believe that priority characteristics for this price segment (low to lower-middle) include price, operating costs and reliability. Prestige, design and safety do not play an important role for potential buyers. Extra options, such as hydrolic boosters, air conditioning and additional electronic equipment are added on top of the basic price.

Chevrolet Lanos

Strengths: Low price

Spacious interior

High assembly quality

Good technical quality

Safety

Weaknesses: No additional options are available, only basic model

Outdated design

High fuel consumption

Quasy, non -existent

Below average Above average Weight Parameter Coefficient : 0.25 0.50 0.75 1.0 25 Price VP, HG HA, CA RL, DN CL, VK, V10 20 Operating costs VP, CA DN, HG HA, V10, VK CL, RL 15 Reliability V10, VK DN, CA, VP CL, HA HG, RL 10 Technical characteristics DN, CA, VP VK, V10, CL RL, HA HG 10 Size VP VK, DN, HG, HA CA, СL V10, RL 5 Safety CA, DN VP, V10, VK CL, HA, RL HG 5 Comfort CA, DN, VP VK, V10 HA, CL RL, HG 5 Design DN, V10 CL, RL, VP CA, HA, VK HG

CL - Chevrolet Lanos, DN - Daewoo Nexia, RL - Renault Logan, VK - VAZ Kalina, V10 - VAZ 2110, CA - Chery Amulet, HG - Hyundai Getz, VP - Volkswagen Pointer, HA – Hyundai Accent


We selected various characteristics and weighted them according to their importance to low price segment customers. Price and operating costs, the most important factors, received weightings of 25 and 20, respectively. Design, comfort and safety are least important to these customers, so they received a weighting of five points each. We then assesed each model in the group under the listed parameters and determined its place with respect to the other group members. The lowest 25% are multiplied by 0.25, while the highest 25% are multiplied by 1.

The total score for each model is the sum of weights multiplied by the respective coefficients, as shown in the table below.

Model ranking Place Model Score 1 Hyundai Getz 96.25 2 Renault Logan 82.50 3 Chevrolet Lanos 78.75 4-5 VAZ Kalina 65.00 4-5 VAZ 2110 65.00 6 Hyundai Accent 62.50 7 Volkswagen Pointer 50.00 8 Daewoo Nexia 47.50 9 Chery Amulet 41.25


Chevrolet Lanos holds 3d position; it is surpassed only by the much more modern Renault Logan and the Hyundai Getz, which is far more expencieve when fully equipped. Chevrolet Lanos is the leader in terms of price and operating costs.


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We believe the sales volumes of the Chevrolet Lanos do not correspond to its price/quality ratio. The model has strong potential and is capable of taking 12-15% of the segment. However, its success will be conditioned on ZAZ’s ability to provide affordable and accessible post-sale service, keep the price low and diversify the basic model.

Disposable income growth and the high average age of cars in both Ukraine and Russia are the drivers behind expected annual automobile sales growth of 5-11%. We believe the Lanos can account for a solid share of this growth and reach a volume of 40,000 - 70,000 cars a year, not only by taking a share from its direct competitors (total sales in Russia in 2005 of 270,000), but also by attracting new drivers and competing with lower quality/obsolete cars such as the VAZ 2104-2107 (total sales in 2005 of 240,000).

2005 sales in Russia, number of cars

0 50000 100000 150000 200000

Cherry Amulet

Chev rolet Lanos

Volksw agen Pointer

Renault Logan

Hy undai Getz

Hy undai Accent

Daew oo Nex ia

VAZ 2110-12

ex pected sales v olume

Source: Autonews.ru


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MDM Financial Group Investment Division 33/1 Kotelnicheskaya Nab. Moscow, Russia 115172

Co-Head of Research Co-Head of Research

Alex Kantarovich, CFA [email protected]

Kim Iskyan [email protected]

Credit and FI Research Oil & Gas Mikhail Galkin [email protected] Andrey Gromadin, CFA [email protected] Nikolay Bogatyi [email protected] Nadezhda Kozakova, CFA [email protected] Denis Vodnev [email protected] Elena Morozova [email protected] Metals and Mining Maxim Korovin [email protected] Michael Kavanagh [email protected] Andrey Litvin [email protected]

Strategy, Economics, Banking Telecoms & Technology Alex Kantarovich, CFA [email protected] Elena Bazhenova [email protected] Peter Westin [email protected] Ekaterina Generalova Ekaterina [email protected] Irina Plevako [email protected] Editors/Production Consumer/Industries

Nathan Gardener [email protected] Kim Iskyan [email protected] Thomas Lavrakas [email protected] Tigran Hovhannisyan [email protected] Ekaterina Ogurtsova [email protected] Elena Afonina [email protected] Andrey Goncharov [email protected]

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