CENTRAL ASIA'S GOLD PLAYERS PROLIFERATE: THE CASE OF KAZAKHGOLD

Synergies seem in place, as KazakhGold suffers from
overcapacity in processing facilities, whereas Polyus needs the
extra refining business if it wants to meet its projected
production targets. KazakhGold's painful financial situation
only intensifies the bear-bull relation.

By mid May this year, KazakhGold had still not published its
complete figures for 2008, missing the deadline imposed by
watchdogs over the London Stock Exchange on which the company
is listed. Glimpses of what could be behind the delay have
popped up this month, prompting Fitch Ratings to downgrade the
enterprise only a week after it had reaffirmed its - already
negative - assessment. The company rating went down from CCC to
C, while unsecured debt worth US$200 million was rated RR4.

"The downgrade follows KazakhGold's failure to make a coupon
payment of US$9.735 million on its 200 million senior unsecured
notes which was due on 6 May 2009," a comment by Fitch dated
May 20 read, which dismissed the "technical reasons" given by
the company for the delay and its promise to pay up within 30
days.

UNDER A SINGLE UMBRELLA

KazakhGold goes back in history to the dark days of Stalin's
collectivization wave which swept through Kazakhstan from 1928.
The following year, the discovery of new deposits in the North
and the Northeast of the country led to the formation of a new,
centrally controlled entity intended to boost further
exploration and development. Originally, each new deposit had
its own team, but in the course of the 1950s the business was
consolidated under a single umbrella on the order of Nikita
Khrushchev, leading to an annual output of almost a quarter
million oz per annum.

Today, KazakhGold is under control of a Kazakh family by the
name of Assaubayev, headed by clan-leader Kanat Assaubayev. An
overwhelming majority of the members of the board consists of
his relatives. The first attempt by the cash-strapped
Government to privatize the enterprise failed and the new owner
went bankrupt in 1996. Most of the Assaubayevs have degrees in
both engineering and economics, which explains how they could
make the enterprise survive.

SENDING NET PROFIT DOWN

KazakhGold's resources (presumed) and reserves (assumed),
all categories included, amounted to 59.8 million troy ounces
when calculated by former Soviet standards in January 1, 2008.
The company has raised money and also spent a substantial part
of its revenue over the last couple of years on processing
plants, which work through so-called carbon-in-pulp as well as
heap-leaching treatment, and a process brought in from Western
countries called flotation technology. Technical progress,
however, has sent mining and treatment costs soaring - even
though flotation in the longer run is meant to save costs.

The investments required to optimize output from existing
operations seem to have put a brake on new exploration
activities. In summer 2005, five more licenses were obtained
from the Kazakh government for exploration and development. The
most promising projects are Azkhal in the area of Semipalatinsk
in the central-east of the country acquired in July, and
Kaskabulak and Akshatau in the area of Karaganda in the central
part of Kazakhstan.

Finally, Yuzhd-Karaultaube and Kyzylorskoye were added to
the list of future assets, both located in the Northern
province of Aktobe. Heap-leaching at Kaskabulak, an abandoned
mine from Soviet times, has yielded minor quantities of gold,
but further exploration and modernization of logistics and
processing facilities requires funding which KazakhGold seems
unable to free from its own financial resources.

MODEST-LOOKING INCREASES

Meanwhile, bills keep accumulating at a time when financial
support is harder and harder to come by. KazakhGold's financial
expenses went up from US$2.57 million in the first half of 2007
to just over US$9 million in the first six months of the
subsequent year. Tax bills have been soaring as well, tripling
between the same periods of time to more than US$9.3 million,
sending net profit down by 25 per cent on-year to no more than
US$3.5 million. Gold production from KazakhGold's own mines,
set against rising costs, went down from 81,531 to 66,853 troy
ounces on-year in the first half of 2008.

By purchasing ore and non-refined gold for processing, the
company has nevertheless managed to increase its gold sales for
the first half of the year to 76,211 ounces from 67,588 in the
same period of 2007. By increasing ore provisions for
processing from external sources, KazakhGold hopes to reach its
output target in the order of one million oz by 2011, for which
around 14 million tonnes of ore are needed. This is an
ambitious target which poses "major challenges" in present-day
euphemist business jargon when it comes to the investment
side.

HOLDING OUT ON DIVIDENDS

Given higher prices on open world markets, the rise in sales
income despite modest-looking increases in final output as
reported by the company can easily be explained. Gold prices in
the middle of 2008 came close to a US$1,000 per ounce which is
almost twice its market value one year earlier, and confirm
sales revenues as reported by KazakhGold. In the first half of
2008, the company's average sales price of gold amounted to
US$832 per troy ounce - up by 42 per cent on-year, KazakhGold's
half-year report reads.

Yet, finances are known to be tight - to the extent that
over the summer of 2008 the board proposed to shareholders that they keep holding out on dividends - "...until the
plant modernization program has been completed and our
facilities reach their designed output capacity," in the
report's words. This, together with the present trouble
regarding paper pay-off, points at bottlenecks in terms of
liquidity availability. Shares in KazakhGold have not done well
of late on the LSE, whereas those in Polyus Gold have been
soaring and the company's default rate has been all but
eliminated. The fact that the miners' appeal to the Kazakh
Government for the same support as the banking sector has
received a lukewarm response, except for a warning against mass
lay-offs, is also yet one more encouragement for both parties
to combine forces.

INTO INDUSTRIAL DEVELOPMENT

The mutual attraction between KazakhGold and Polyus Gold can
also be easily read from the latter's balance sheet and
commercial results. From 2003 through to last year, sales
revenue more than tripled from just below US$300 million to -
for the first time - just topping US$1 billion in 2008. For the
first time since 2003, the company worked debt-free, thanks to
cautious short-term investments of only US$285 million, down
from US$1.271 billion in the previous year. Polyus is sitting
on 72.3 million troy ounces of gold, meaning a cash realization
in the order of around US$65 billion at current open market
prices. Three-quarters of its output of well over a million
ounces per annum (1.222 million in 2008) come from the two
fields Olympiada and Tyryada, both located in the vicinity of
Krasnoyarsk, not far from the Eastern section of the border
between Russia and Kazakhstan. Other fields in operation
include those in the regions of Irkutsk, Magadan, Amur and
Sakha, all further to the East.

A WIN-WIN SITUATION

The big dilemma for the Kazakh government, which is among
the authorities whose green light will be needed if a merger
agreement between the two would-be partners is to be reached,
is whether to stick to the patriotic principles on its agenda
or to go along with globalization arm-in-arm with its mighty
neighbor to the North. It looks, in all, very much as though
the need for financial resources should prevail over
sentiments. The fact that populations in the areas where
KazakhGold is operating have large ethnic Russian proportions
only adds to the need for stability on the labor front which
can only materialize through strong productivity outlooks.

From the point of view of an investor, KazakhGold seems to
have but little choice either. It is hard to see how, with its
current negative ratings, the company can build up a solid
financial portfolio through more syndicated loans abroad, while
domestic banks in Kazakhstan are in no position to jump in.
Raising capital on open markets through stock issuing is also a
remote option.

Takeover options hanging over the markets, like that of
KazakhGold, may tempt some traders to buy into paper with
little other motive than profit-taking after the operation.
This momentarily raises capital value, but it does not raise
capital. In all, one could label KazakhGold shares "sell"
should a deal with Polyus fall through (unless a white knight
appears on the scene which seems unlikely) and "hold" with the
outlook of a deal being clinched. As for Polyus, given the
company's sheer size, stock assessments are unlikely to be
influenced much by the issue. This means that in these current
negotiations, the Russian party finds itself in a win-win
situation.

(TCA)

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