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We initiate credit coverage of Kazakhstan Temir Zholy (KTZ) with a Hold recommendation on its dollar-denominated Eurobonds, maturing in 2016, 2020 and 2042. The recommendation reflects our Stable assessment of the issuer’s credit quality and our view of the instrument’s yields as fair, compared to Eurobonds of other investment grade quasi-sovereign issuers.

We view the spread between Eurobonds of KTZ and KazMunaiGas (KMG) of 10-30bp as fair at the moment. Narrowness of the spread reflects that the market similarly assesses the risks of KMG and KTZ, which we agree with. Meanwhile, we view the current spread between Eurobonds of KTZ and Russian Railways (RZD) of minus 60bp as too wide. The spread widened due to a growth of yields of RZD Eurobonds (Ваа1/ВВВ/ВВВ). According to our estimates, the spread would become fair after contracting to a range of zero to minus 30bp, given the difference in ratings and maturities.

Kazakhstan Temir Zholy (KTZ) is a regulated monopoly mainline railway network operator and a leading freight railway company. 100% of KTZ’s shares are owned by the state through the Samruk-Kazyna fund. We view the probability of receiving support from the government as high, given the strategic importance of the company to the country’s economy.

Stable outlook on the issuer’s credit quality is based on our expectations of the continuing reliance of the Kazakhstan economy on commodities and the inevitably high role of rail transport. This implies high level of government support, both in the form of capital injections and tariff regulation. Business profile of the company benefits from the stable and regulated nature of the rail transportation sector, strong market position, high growth potential of transit and export traffic that jointly provide a high level of standalone creditworthiness. Standalone creditworthiness is limited by high interdependence between railway systems of Kazakhstan and Russia, intensifying competition from private railway operators and pipeline transport, high level of deterioration of the fleet, and long-lasting subsidy of socially important passenger transportation at the expense of freight traffic.

KTZ’s credit profile remains under pressure of negative free cash flows, relatively high leverage and large investment needs, which will substantially increase the debt level further. However, profitability growth, fueled by higher tariffs, and stable operating cash flows support the company’s credit profile.

We expect the company’s credit risk to remain tied up with the sovereign credit risk of Kazakhstan. In our opinion, the company’s credit quality will remain high thanks to the continuing government support.