Russian Utilities Stocks in 2010

Pavel Popikov
Senior Analyst
OTKRITIE Investment Bank (JSC)

After a steep drop at the end of 2008 amid the financial crisis, Russian utility-sector stocks significantly outperformed the Russian stock market in 2009. Even though the MICEX produced impressive gains (+120 percent in 2009), the MICEX Power index that gauges the performance of Russian electricity utilities companies showed a staggering 330 percent increase over the same period. Apart from the low base effect, this excellent performance was driven by the resilience to the economic downturn exhibited by the fundamentals of Russian utilities companies last year. Electricity demand was clearly less volatile than other economic indicators, while ongoing sector reform has been highly supportive of the companies’ financial performance. At the beginning of 2009 the entire sector was undervalued, so the best strategy then was to buy and hold almost all sector names and wait for handsome returns. For 2010, then, we believe that stocks must be cherry-picked, since not all of them offer definite benefits. We see the strongest fundamental upside in the most efficient generating names, i.e. RusHydro, TGK-1, Mosenergo and OGK-1. In the grid segment we find the switch to new RAB tariffs a pivotal issue, paving the way for a rerating of the segment. We recommend shares of Holding MRSK as the most liquid and undervalued name in this story.

According to data from System Operator, the country’s electricity consumption dropped 4.7 percent year on year in 2009. However, we believe that electricity demand in Russia has already begun to recover. As evidence, we point to the rebound from the first half of 2009’s year-on-year decline of nearly 7 percent, which is certainly more modest than the 12 percent domestic industrial production slump of January to November 2009. The last two months of 2009 showed a continuation of demand recovery, driven in part by the unusually cold weather in December. These trends have continued into January 2010. In addition, increased demand has helped to drive up liberalized electricity prices (through which 60 percent of electricity is traded), which are reaching new highs on the Russian wholesale electricity market in January 2010. We forecast a moderate (0.4 percent) recovery of electricity demand in Russia in 2010.

The Russian government is keenly aware of the need to move ahead with sector reform. The major results of the reform thus far are the smooth transition to a 60 percent liberalized electricity market share and the successful switch to new RAB-based electricity high-voltage transmission tariffs for the Federal Grid Company, both from the beginning of 2010. However, there are still some unanswered questions regarding reform of the sector that could significantly impact the investment case for the sector’s names. The two main issues on the agenda are the power capacity market for generation companies, and the parameters of the new RAB-based electricity distribution tariffs. The launch of the liberalized long-term power capacity market is planned for 2011, and we estimate that the liberalized capacity prices will be twice the average current regulated capacity tariffs. Approval of the capacity market launch by the state, which is expected in the first half of 2010, will increase the attractiveness of generation stocks, in our view.

 In the electricity distribution segment, represented by Holding MRSK and its subsidiaries (interregional distribution companies), 2010 will be a turning point in terms of the transfer to the new tariff regulation system. Currently, 17 of Russia’s regions operate under RAB-based distribution tariffs. On Jan. 19, Russian Prime Minister Vladimir Putin signed a decree stating that another 23 regions should be transferred to RAB tariffs by Jul. 1, 2010, and a further 29 regions by Jan. 1, 2011. New tariffs should provide distribution companies with a guaranteed return on their asset base. According to our estimates, the combined operating income of the entire distribution segment will double in 2010 (from 2009), while the combined net profit of all the companies will almost triple (2.8 times higher). At present, Russian distributors trade at market enterprise values (EV) of 30 percent to 45 percent of their preliminary initial RAB values, while for the comparable international companies this coefficient amounts on average to 140 percent.