Management discussion and analysis

Analysis of the income statement
Revenues

Driven by sharp price declines from the record highs reached in 2008, our consolidated revenues declined by 34% in 2009 to RUR 73.6bn from RUR 112.2bn in 2008 (2007 consolidated revenue: RUR 73.8bn). The revenue contributions by all of the major segments of our business have been discussed in previous sections. Below we provide a summary of how segment revenues have developed over the past three years.

* Including revenue from segment “other” and elimination of internal sales.

The key revenue driver across all segments in 2009 was the precipitous drop in prices across all product categories that began in Q4 2008. Graphs illustrating the price dynamics are available on this page. Volumes picked up following initial weakness at the beginning of 2009 as prices reached their lowest levels, first in nitrogen and then, later in the year, in phosphates as well. Overall, the company did not experience the kind of production slowdowns seen in Q4 2008, with external sales (excluding iron ore) returning to normalized, 2007 levels.

Cost of sales and gross margin

Cost of sales decreased in 2009 by 7% to RUR 41.4bn from RUR 44.5bn in 2008 (2007: RUR 32.7bn). This decline was lower than the 34% decline in revenues as major items in the cost structure did not decline at the same rates relative to the drop in fertilizer prices, and in some cases increased. For example, energy costs increased 13% to RUR 4.6bn due to incremental increases in Russian Federation electricity rates. This resulted in a lower gross margin of 44% for 2009 versus 60.4% in 2008 and 55.8% in 2007. The cost of sales structure is illustrated in the table below:

Distribution, general and administrative and other operating expenses

Distribution costs declined 21% in 2009 to RUR 18.4bn (2008: RUR 23.3bn; 2007: RUR 17.1bn). This was primarily due to a 12% decrease in transportation costs, as sea freight rates declined significantly and less product was sold on CFR and CIF terms. As a result, transportation costs fell by 12% in 2009 compared to 2008. Effective 1 February 2009, the Russian government cancelled export duties on nitrogen and complex fertilizers, and effective 1 May 2009 it cancelled export duties on exports of apatite. As a result of the cancellation of these export duties, which had been introduced in April 2008, this distribution cost item fell 92% in 2009 compared to 2008.

General and administrative (G&A) expenses increased slightly in 2009 to RUR 3.26bn vs. RUR 3.21bn in 2008 (2007: RUR 3.49bn). While nearly all items in this category other than depreciation and amortization decreased relative to 2008, the increase was driven by the creation of provisions for impairment of receivables in 2009, while the 2008 result benefited from the reversal of provisions. Trade and other receivables and related provisions are discussed further below.

EuroChem earned other operating income of RUR 225m in 2009 (2008: expense of RUR 325m; 2007: expense of RUR 1,323m) due almost entirely to foreign exchange gains on translation of cash balances, payables and receivables denominated in foreign currencies following a 27.6% weakening of the Rouble to the US dollar (average rate 2008 vs. average rate 2009).

Operating profit and operating margin

Our operating profit margin for 2009 fell to 15% from 36% in 2008 (2007: 26%) as the decrease in revenues significantly outpaced the decreases we were able to achieve in cost of sales and other expenses. Our EBITDA margin also declined to 22% for 2009 from 39% in 2008 (2007: 30%).

The following diagram analyses positive and negative influences of various components on our operating profit in 2009 relative to 2008.

Finance income and costs

Our finance income improved as the effects of the rouble depreciation subsided during 2009. We booked a financial foreign exchange gain of RUR 749m in 2009, compared to a loss of RUR 3,766m in 2008. This is income from translation of financial assets and liabilities, denominated in foreign currency – loans, deposits with banks and borrowings. Interest expense increased 58% year on year as a result of the US$ 1.5bn syndicated pre-export facility obtained in October 2008. We make monthly repayments on this facility.

In addition to finance income, EuroChem received gross dividend income amounting to RUR 2,168m from K+S AG in May 2009.

Taxation

The company’s consolidated effective tax rate for 2009 was 19.2% (2008: 24.2%; 2007: 20.1%), virtually equivalent to the statutory profit tax rate in Russia where most of the company’s assets are located, which was reduced to 20% as of 1 January 2009 from 24% previously.

Balance sheet

Working capital

In 2009 net working capital decreased to RUR 12.5bn from RUR 17.9bn in 2008 (2007: RUR 9.6bn). This is mainly due to decreases in inventories (minus 28%), trade receivables (minus 32%) and other receivables and current assets (minus 28%). Following the global fertilizer market slowdown in Q4 2008-Q1 2009 caused by unprecedented price volatility and the resulting reluctance to buy on the demand side, we were able to reduce inventories once product started moving again. Other receivables decreased, largely due to VAT reimbursements, which was largely a result of the more disciplined approach to the relevant document collection process.

This helped us reduce finished goods days down to 28 from 41 in 2009 (2007: 21). At the same time, we maintained tighter sales terms with predominantly prepayment or letters of credit confirmed by a financial institution with a credit profile acceptable to us; trade debtor days increased slightly to 11 in 2009 from 10 a year earlier (2007: 18). Tightening of credit terms extended to our counterparties was an important step that we took heading into the market turbulence of 2009, when we saw trade receivables identified as impaired increase to RUR 349m from RUR 165m at the end of 2008 (2007: RUR 904m). Management takes a conservative approach to creating provisions, and is taking measures to recover a portion of this impairment as the market situation stabilises in 2010.

Cash flow analysis

Cash flow in 2009 was significantly affected by lower prices for our products. Operating cash flow for 2009 was RUR 17.5bn, compared to RUR 26.8bn a year earlier, but was still higher than 2007: RUR 16.8bn. Free cash flow was negative at RUR 9.5bn due to RUR 18.6bn in capital expenditure (development of Gremyachinskoe potash deposit, construction of the new CAN and granulated urea capacity at Novomoskovskiy Azot and the new melamine production at Nevinnomysskiy Azot and construction of Tuapse bulk terminal). Another important factor was the purchase of 10,752,292 ordinary shares of K+S Group from MCC Holding Ltd for RUR 19.6bn, and an additional 1,499,297 shares on the open market for RUR 2.3bn between January and April 2009. In December 2009, EuroChem acquired an additional 2,982,252 ordinary shares of K+S Group through a rights issue for RUR 3.5bn paid in cash. Further detail on EuroChem’s purchases and sales of K+S AG shares is available in the consolidated IFRS financial statements that are part of this annual report.

The excess of investment outflows over the inflows from operations was financed predominantly by the US$ 1.5bn pre-export finance facility raised in October 2008.

During the year of 2009, the company did not pay dividends to our shareholders.

Net debt position and capital management

The company finances its operations through a combination of fixed rate and floating rate debt. Floating debt is represented by the US$ 1.5bn syndicated loan facility due September 2012, with equal monthly amortization starting April 2009. Fixed rate debt is represented by US$-denominated senior notes with a coupon of 7.875% due in March 2012. Additionally, the company raised a EUR 85m margin loan secured by shares in K+S AG, with an interest rate of three-month Euribor + 2.0%.

As the financial markets in Russia and abroad are showing signs of normalization against the backdrop of substantial global liquidity, the pricing for the company’s debt has gradually returned to normal after a brief spike observed in late 2008 to early 2009.

As a matter of policy, we restrict our net debt/rolling 12 months’ EBITDA to 2.5 times. At the end of the year, we had a net debt position of RUR 36.5bn and a net debt/EBITDA ratio of 2.21. We expect this ratio to remain at a similar level throughout 2010, which we believe to be a comfortable level for a BB/BBB rating given the liquid structure of our balance sheet.