Caveat Emptor -- a glimpse into Russian GDRs on LSE

Caveat Emptor -- a glimpse into Russian GDRs on LSE

Corporate Russia can be a puzzling field for Western investors, who often find it hard to read between the lines.

Applying governance standards and financial controls familiar to the City of London or New York may seem at times a rather cosmetic effort and leaves many scratching their heads trying to distinguish a good deal from one gone sour.

Aside from language barriers, cultural differences and often opposing views to what constitutes legitimate business practices, the good deals seem to grow harder to distinguish as the field becomes more sophisticated and intertwined.  This is precisely because many Russian companies adopted the Western letter of doing business, having learned the lingo and the standard operating procedures, but not necessarily following the same spirit when it comes to implementation.

While they do not hold exclusive license on cutting corners or conveniently disclosing only the flattering facts, establishing trust and determining predictable behavior is getting increasingly complicated, making investments in Russian companies a real roulette gamble.

Take, for instance, the example of increasingly common London Stock Exchange (LSE) listings of Global Depositary Receipts (GDRs) for Russian companies. The veneer of legitimacy allows these companies to raise additional capital from institutional investors more assured by the standardized scrutiny and regulations accompanying such listings.

However, while having GDRs listed on LSE can be reassuring, it alone does not constitute a guarantee that the fundamentals of a company are sound or that the principals act in good faith.

A recent look at one of Russia’s major industrial manufacturing companies, HMS Group (LSE: HMSG), presents mixed signals of the kind hard to interpret and reconcile with transparent governance practices, which can very well indicate the signs of a troubled enterprise.

The company purports on its website to be the leading pump and compressors manufacturer and provider of flow control solutions and related services to oil and gas, nuclear and thermal power generation and water utility sectors in Russia and the CIS.

Started as a pump dealer in 1993, the company, which is managed by its main shareholders and founders, surpassed $1 billion in revenues and paid dividends of $0.39 per share for the first time at the end of 2012, according to LSE data.

Through various incarnations over the past 20 years, HMS Group grew by acquiring strategic businesses, building the conglomerate into a leading supplier of parts and equipment for the very lucrative energy and utility sectors of Russia and the CIS.

In February 2011, the group floated 37 percent of its GDRs in an IPO and listed on the LSE main market. The future looked rosy and key financial indicators painted a positive growth curve.

Then questions started arising in relations to acquisitions made by the shareholders managers of the company and the valuation and accounting treatment of these transactions. Some of them at least, seem designed to artificially boost the company value and derive fringe benefits for the very same main shareholders who oversee the company.

The first red flag was the acquisition of Russian compressor producer KazanKompressorMash OJSC (KKM) in 2012. The acquisition of KKM was conducted in two stages. First, HMS Group directly acquired 77 percent of the company for $168 million. It later acquired another 14.5 percent for $9.8 million via the acquisition of another company, NIITurbokompressor (NIIT). Based on this price differentiation, it is likely that HMS Group acquired KKM for two to three times its real price. Should HMS Group have fully (100 percent) acquired KKM for the same price/share ratio as it paid when it acquired NIIT, it would have cost HMS Group only $61 million. Instead, HMS Group gained direct control by paying $168 million, which appears to be a deliberately overinflated purchase price.

Moreover, SINEK Investment & Development Ltd., the sovereign investment vehicle for the Russian Federation Republic of Tatarstan, had valued in its books 50.01 percent of KKM at $27 million. The price per share is four times lower than what HMS Group paid to acquire KKM. In addition, HMS Group purchased another 8.15 percent of KKM from Ronin Europe Limited for about $18 million (600 million Russian Rubles), representing again a price per share four times higher than the valuation according to SINEK’s books.

There are two clear beneficiaries in the overvaluation of KKM: Ronin Europe Limited, which hold the funds for an undisclosed beneficial owner, and the Republic of Tatarstan, which overvalued the business at its sale in order to most likely include a decent portion of kickbacks in it.

This type of complex transaction makes it highly likely that a party of HMS Group is behind Ronin Europe Limited and is siphoning funds for personal use by conducting the overvalued purchase of KKM.

Ronin Europe Limited is a Cyprus-based financial brokerage and asset management firm established to provide services to investors outside the Russian Federation and offer access to European financial markets, serving high-net-worth clients, according to its website.

A second red flag comes from the publicly listed HMS Groups accounts, containing $169 million of goodwill relating to acquisitions made by the group. The amount of goodwill has doubled in the last year alone and is explained in the accounts as the result of acquiring Apollo Goessnitz GMBH, a German specialized pump manufacturer.

Currently standing at 50 percent of the tangible assets, this level of goodwill is extremely high, especially for a manufacturing business.  This may very well be a sign of goodwill being exaggerated in order to try to artificially boost the value of the company, which is a common practice for struggling businesses.

Furthermore, as goodwill represents the amount paid for an acquisition in excess of the value of the tangible assets and fair value of that business, it begs scrutiny to determine if this was a conduit through which the main shareholders have siphoned cash out of HMS Group for personal use.

This sort of practices would give pause to even the hardiest of investors and add downward pressure on an already struggling stock price: HMS Group dropped from about $8/GDR to about $2.3/GDR since its listing in early 2011.

Adding to the uncertainty is the fact that HMS Group is audited by the Limassol, Cyprus office of PricewaterhouseCoopers Ltd. (PwC) and not the London-based main branch of the auditing group.

Their office is located next to the HMS Group’s official address in Cyprus, which is based at the premises of Chrysses Demetriades, one of Cyprus’ largest legal firms. The cozy relationship between PwC Limassol and Chrysses Demetriades is well documented and leaves room for doubt as to the rigorous scrutiny of the accounts.

Even so, PwC in its most recent opinion on HMS Group financials for the first six months of this year conducted only a review and not an audit. In its opinion the independent auditor explained: “A review is substantially less in scope than an audit conducted in accordance with International Standards on Auditing and consequently does not enable us to obtain assurance that we would become aware of all significant matters that might be identified in an audit. Accordingly, we do not express and audit opinion.”

PwC simply acknowledges that they did not see anything in the financial reports prepared by the company that would not be in accordance with International Accounting Standards 34 adopted by the European Union.

Messages sent to HMS Group CEO Artem Molchanov with specific questions regarding the transactions highlighted above did not produce any material answers confirming or denying these assertions.


About author:
Mr. Eugen Iladi is a Virginia-based freelance journalist covering mostly business, energy and conflict topics.