A Pure Play on a Russian Utility

As usual, I will start my column with an old Soviet joke.

Brezhnev and Napoleon meet in the next world.

"Oh-h-h, if only we'd had such a brilliant commander as yourself in the Soviet Union instead of Stalin," Brezhnev says to Napoleon, "then we wouldn't have allowed Hitler to cross our threshold."

"And if I had newspapers like your Pravda," says Napoleon, "not a soul would have heard about Waterloo."

Although today’s mainstream media might give you a few more facts about Russia, this joke reminds us how critically one should treat what one reads.

Peer Pressure

Against the consensus belief that August is a “bad month” for Russia – several past major crises have happened in this month – the past few weeks have been relatively quiet in Russia. The highlight was Vladimir Putin’s flight in an ultra-light aircraft leading a flock of cranes (yes! Watch it here. ), after which he compared opposition leaders to the weak birds who did not follow him.

Since the 2007 credit crisis, August has been a cruel month for Russian equities, delivering significant losses every year except 2009. This year, however, Russian stocks have slightly beaten the Emerging Markets (EM) in August (MSCI Russia up 1.0% vs MSCI EM down 0.7%), and extended their outperformance into the first half of September as well.

Yet, Russia still has a long way to go – about 30% to 35% – in order to close the valuation gap with its EM peers. The Russian market rallied strongly on the Fed announcement of QE3, with the RTS index up 7% on Friday, September 14. Another major catalyst for the market could be the placement of additional shares in Sberbank (as GDRs, Global Depository Receipts), a move that is expected shortly.

That speculation about Sberbank was written last week, and, as expected, on September 17, the Russian government sold 7.6% of shares in Sberbank to the public at about US$3.03 per share, valuing the placement at roughly US$5 billion. Such a placement will likely signal that the government is serious about selling its equity stakes in major state-controlled companies. Meanwhile, as of August 22, Russia became a full member of the World Trade Organization. This should lead to gains in efficiency and competitiveness over time.

A Different Kind of Utility

This month, I want to feature the shares of a "Pure Utility" that is the operator of a large oil pipeline system. The investment case for this company is quite simple and consists of three major components:

1) The stock is very inexpensive on a valuation multiple basis and trades at approximately a P/E of 2. 

2) Unlike Gazprom – another inexpensive Russian stock, which is threatened to lose some of its Western Europe market share and is exposed to gas price risk – this Pure Utility has no real headwinds to its operating and financial performance. And it is set for a gradual increase of oil and oil products throughput on the back of growing oil production in Russia, completion of new routes (such as East Siberia–Pacific Ocean), and development of port facilities. The 2008-2009 crisis proved that Russian oil transportation volumes are highly resilient to economic cycles.

3) There is a visible trigger for a re-rating of the stock: a possible increase in the payout ratio.

Having paid out only 2% of its IFRS (International Financial Reporting Standards) net profit for 2011, the company provided a 1.5% dividend yield on its preferred shares. The payout was equal to 25% of unconsolidated net income of the parent company under Russian Accounting Standards.

Anticipating a Big Re-rating

However, the government, and in particular the Ministry of Finance, is currently pushing to force all state-controlled entities to pay out 25% of consolidated IFRS profit. A respective regulation document is now under consideration and government approval is expected. The government’s logic is simple: Russia's fiscal position is gradually deteriorating, and dividends from the government-controlled companies are one of the "low hanging fruits" to fund the fiscal gap. Gazprom has recently moved to paying out 25% of IFRS net income and we expect our Pure Utility to adopt the same policy. 

Pure Russian utilities have so far been viewed as a separate case due to "substantial capex needs." Indeed, this distinction may be fair in regard to Federal Grid or RusHydro, electricity companies which are deeply free-cash flow negative. In contrast, our Pure Utility is so profitable that, according to sell-side analysts, in the next few years its operating cash flow should fully cover capital investments. In fact, in 1Q12, Pure Utility was free-cash flow positive.

If the government adopts the new "25% payout rule," Pure Utility's dividend yield should jump from 1.5% to almost 20%. Even if it is something in between (say a 5%-10% yield), this should be more than enough to ensure a major re-rating of the stock. 

Pure Utility is also improving its transparency. Being a completely closed company just 18 months ago, it now publishes regular updates on its operations and investment program, meets with analysts, and has even opened a Facebook page.

Our Pure Utility looks like an undervalued stock of a fundamentally robust company, with risks strongly skewed to the upside.

Alexei Medved was born and raised in Russia and later moved to the West. He received an MBA from Wharton Business School and worked for a major global investment bank, where from 1989 he developed the East European investment banking business. Since 1992, he has been running an independent business which concentrates on investments in Russia and the CIS. Contact: amvic@mail.com

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