Balanced outlook, but we remain defensive · 2014-01-14 · Balanced outlook, but we remain defensive A volatile market driven by global risk aversion The Russian equity market came

UBS Investment Research

Russian Strategy

Balanced outlook, but we remain defensive

A volatile market driven by global risk aversion The Russian equity market came under intense pressure in the last two months as aresult of rising risk aversion stemming from European debt woes and globalgrowth worries. Conviction is likely to remain low, volatility elevated and range-trading to prevail. While the outlook is now more balanced, we prefer to wait formore clarity and remain defensive.

Russia’s fundamentals remain intact…so far We believe the current situation is more benign than in 2008. Leverage ratios ofthe stocks that we cover have halved and maturity structures lengthened. Thegovernment continues to run a fiscal surplus, monetary policies are more efficient,and liquidity pressure is less acute. In the short term, growth rates are set to pickup, driven by higher consumption and public spending. Longer-term growth prospects depend on whether the new government prioritizes reform.

The market almost discounts a black-sky scenario Based on our sensitivity analysis, the Russian market now prices in Brent at closeto $70/bbl, not far from our black-skies scenario, which assumes $60/bbl.Therefore, there is a clear disconnect between actual macro risks and the stockmarket. However, fears the world is falling into recession would need to recede forinvestors to be comfortable that current oil prices are sustainable.

Investment themes continue to centre on liquidity, quality and yield In the wake of the sharp market decline, the outlook now looks more balanced, butwe remain defensive. Our favourite names are: Lukoil, Surgutneftegaz, Novatek,Uralkali, VimpelCom, Inter RAO and RusHydro. Among less-liquid names, we like Bashneft, TNK-BP Holding, Acron, Aeroflot, LSR, Etalon and RTKM pref.

Global Equity Research

Russia

Equity Strategy

Market Comment

18 October 2011

www.ubs.com/investmentresearch

Dmitry Vinogradov, CFA

[email protected]

+7-495-6482362

Bella Rabinovich, CFAAnalyst

[email protected]+7-495-648 2376

Chart 1: Implied P/Es under different oil price assumptions Chart 2: Implied ERP under different oil price scenarios

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This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 30. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

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mailto:[email protected]

mailto:[email protected]

Russian Strategy 18 October 2011

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Contents page

Executive summary 3 Recommendations 6

— Valuations have fallen to mid-2009 levels.............................................................9 — Leverage............................................................................................................11 — Liquidity..............................................................................................................15 — Currency mismatch risk has diminished .............................................................18

Policy response: So far so good 18 — Assessing fiscal vulnerability..............................................................................18 — Monetary policies have been prudent.................................................................19

Growth prospects 20 — Short-term growth outlook ..................................................................................20 — Medium-term macro outlook...............................................................................21

GEM investor positioning 25 Linking the oil price and EPS expectations 27

— Equity risk premium............................................................................................28

Dmitry Vinogradov, CFA

[email protected]

+7-495-6482362

Bella Rabinovich, CFAAnalyst

[email protected]+7-495-648 2376


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Executive summary The Russian equity market came under intense pressure in the last two months on the back of turbulence in global financial markets, concern over the slow progress in resolving the European debt crisis, and the risk of the world going into recession. As a result, investors have become considerably more anxious, causing risk appetite to fall sharply. In this environment, Russia, as we argued in our report ‘Global uncertainty to weigh on the market’, published 12 August, is far from a safe haven.

The Russian market has once again reconfirmed its high-beta status. Since early August, the RTS index has lost 27% compared with 18.5% for MSCI EM and 8.5% for MSCI World. In September, the RTS fell 21.2%, the steepest decline in the last 34 months. Lately, the market has pared some of its losses, but the correction has largely negated the outperformance in the first half of the year.

While the moves in the Russian equity market are comparable to what we observed during the 2008 crisis in terms of the size of the contraction and volatility, we think the current situation is fundamentally different. First, we note that during the 2008 crisis, the sharp contraction in share prices was associated with a sell-off in other asset classes. Specifically, bond yields skyrocketed and commodity prices came under pressure. This time around, however, the damage seems to be largely confined to equities.

We also believe that Russian corporates are now much better prepared to deal with a potential downturn. In this report, we present an analysis of their leverage position and conclude that the situation is materially better than in 2008. Leverage ratios – Net Debt/EBITDA and Net Debt/Equity – have halved since the 2008 crisis and are currently merely 38% and 10%, respectively. Furthermore, we conclude that the liquidity position has improved, as the maturity structure of liabilities has lengthened. Based on our analysis, almost all companies that we cover have sufficient cash flow to meet debt obligations maturing in 2011 and 2012. Domestic businesses no longer rely on dollar funding. Finally, debt markets are not closed, and companies can borrow externally. All of these factors combined represent a stark difference from 2008.

So far, the CBR and the Finance Ministry have been following highly sensible policies and avoided repeating the mistakes of 2008, such as excessive spending of reserves to protect the exchange rate, a slow response to liquidity pressures in the banking sector, and suspending trading on stock exchanges.

Fiscal vulnerability is one of the key risks to Russia’s investment case. However, during the first three quarters of 2011, the federal budget actually accumulated a surplus of Rb1.09tn, largely because spending was conservative. The Ministry of Finance expects the surplus to reach 2% of GDP in 2011, allowing the Reserve Fund to increase to Rb1.7tn by the end of the year from the current Rb0.8tn. This does not resolve the problem altogether but helps offset some short-term pressures.

Risk appetite has fallen sharply…

…and Russia has confirmed its high-beta status

Though Russian equities have plummeted, the situation is now fundamentally different from in 2008

Leverage is far less of an issue than it was in 2008… …and almost all companies we cover have enough cash to meet debt obligations in 2011-12

The CBR and Finance Ministry have learned from their mistakes of 2008

Fiscal vulnerability, though a risk, is not insurmountable


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Monetary policies have become more effective, as well. In our view, one of the key mistakes the government made in 2008 was delaying rouble devaluation, which cost the CBR $200bn of reserves, though we acknowledge this was partly a function of the CBR giving the banks an opportunity to close forex positions. The switch to the floating rate regime has allowed the government to avoid reserve losses this time around. It also helped to build confidence in the rouble, as dollar strengthening has not led to panic conversion of rouble savings into dollars as it did in 2008. In addition, the new policy improves the country’s fiscal position, as a weaker rouble due to lower commodity prices helps reduce the budget deficit. Finally, inflation is well under control: as of 10 October, it was below 7% y-o-y.

The liquidity situation in the banking sector also looks significantly better. The CBR now has much greater flexibility in channelling liquidity to banks. We also note that the volume in repo auctions organized by the CBR increased visibly in September and early October, meaning that the CBR is proactively dealing with liquidity problems in Russian banks. As a result, the interbank rate has risen far less than it did in 2008, when it spiked 25%.

While GDP grew slowly in 1H11, the pace of the recovery is likely to reaccelerate in 2H11. Overall, our macroeconomists expect higher y-o-y growth in 3Q-4Q11 given stronger consumption, higher public spending, a pick-up in credit growth, and, not least, positive base effects stemming from the poor growth in 2H10, which was depressed by a severe drought. Stronger GDP growth in 2H11 should alleviate some short-term concerns. For the full year 2011, we expect real GDP growth of 4.1%.

The longer-term outlook is obviously much cloudier. In our view, Russia needs to accelerate the reform effort to drive economic growth in the future. The upcoming change in leadership puts a question mark over how high on the agenda reform will remain. However, concerns about the world going into recession, tightened liquidity, and increased risk aversion are putting more and more pressure on the Russian leadership to refocus on domestic drivers in order to accelerate economic growth. Improving the investment climate should therefore be a top priority in order to achieve faster and more sustainable growth.

President Dmitry Medvedev has been vocal in promoting reforms. Mr Putin proposed him as Russia’s next PM, which is a position from which to oversee the practical implementation of reforms. During his four-year term, Mr Medvedev has gained political clout and implemented a number of important personnel changes. The latter indicates both that he is capable of pushing through tough decisions independently and that Putin views him as a long-term strategic ally, especially as he did not interfere with Mr Medvedev’s dismissal of former Finance Minister Alexei Kudrin. These factors put him in a good position to push through long-term reform projects.

The priority for the new government should be improving the investment climate. Pension reform is one of the issues that the new government will have to deal with in the short term. We also believe the government may continue to reform natural monopolies, as it has a relatively good track record in this area, with UES and Russian Railways being the prime examples. Gazprom therefore may be restructured.

Monetary policy has prevented rapid rouble devaluation and high inflation

Banking liquidity is much better than it was in 2008

GDP growth should accelerate in 2H11

Economic reform will be necessary to drive long-term economic growth

As PM, Medvedev should be in a strong position to push through reforms


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As a result of fund outflows, GEM investor positioning dropped to -0.1%. This may be interpreted as a positive sign, as it implies that investors have ample opportunity to add Russia exposure. The fact that the economy has so far been unaffected, commodity prices remain resilient and the policy response has been adequate could bring about a change in sentiment. The Russian market’s reaction to positive news flow from the US and the EU over the last couple of weeks shows that any turnaround could be sharp and quick.

As a result of the share price correction, the Russian market’s 12-month forward-looking PE has dropped to 4.2x. If the global macroeconomic outlook worsens, commodity prices will clearly be affected. A fall in the oil price would alter the earnings growth profile of Russian corporates. Based on our sensitivity analysis, the Russian market now prices in Brent at close to $70/bbl, not far from our black-skies scenario, which assumes $60/bbl. We note that oil has thus far remained firmly above $100/bbl. Therefore, there is a clear disconnect between Russia’s actual macroeconomic performance and that of its stock market. Nonetheless, for investors to be confident that current oil prices are sustainable, they need to be comfortable with the macroeconomic outlook, and fears that the world economy will slide back into recession must dissipate.

GEM investors are now underweight Russia, giving them ample room to add exposure… …and any turnaround could be sharp

The Russian market now prices in Brent at close to $70/bbl… …but investors are not confident that oil is sustainable at these levels


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Recommendations The fall in the Russian equity market has driven valuations to post-financial-crisis lows, which suggests that much bad news is already priced in. However, we note that the market has seen a sharp bounce over the past two weeks.

However, in our view, it is too early make a bullish call on Russia, as there is still no clarity on when the sovereign debt crisis in Europe will be resolved, and the risk of the world falling into recession persists. The latest source of unrest has been a surge in concern over growth prospects in China – until recently, the one part of the world where growth was holding up. In addition to these risks, there is the heightened volatility in the debt and currency markets – a trend that we observe elsewhere in GEM. The result of all this is a diminished appetite for risky assets.

In the wake of the sharp market decline since August, the outlook is now more balanced. The rebound in the Russian equity market may continue, but conviction is likely to remain low, volatility elevated and range-trading to prevail. Therefore, we prefer to wait for more clarity and remain defensive. Leverage is low, which should provide long-term support to the market. Investment themes continue to centre on liquidity, quality and yield.

We maintain our preference for the oil and gas sector given the lower volatility of crude relative to other commodities, low valuations and high dividend yields.

We believe the investment case for the Russian oil companies has significantly strengthened following the introduction of the “60-66” tax regime. The market, however, has largely ignored this, as it was outweighed by concerns about global growth and, consequently, the oil price. Similarly, the market has overlooked the benefits the sector receives from a weaker rouble, which has depreciated c10%.

Our top pick in the sector remains Key Call Lukoil [Buy]. The stock’s main catalyst is the upcoming investor day, where the company is likely to present a plan to stabilise oil production in Russia, provide estimates for near-term production upside from overseas projects, and potentially announce exploration results in West Africa. Surgutneftegaz [Buy] has the largest net cash position among the companies that we cover (c$25bn). Corporate governance is an issue, though this may improve once a new regulation forcing the company to publish IFRS financials enters into force. The dollar-based cash pile should protect the company’s earnings in the event the oil price plunges. This improves visibility on dividend payments. TNK-BP Holding [Buy], Bashneft [Buy] and Surgutneftegaz prefs offer among the highest dividend yields in the market (10%, 12% and 15%, respectively).

The gas sector is not as well-positioned. While Gazprom [Buy] should deliver record earnings in 2011 thanks to contractual export prices that lag the oil price, the outlook beyond 2011 is cloudy. Earnings pressure will come from likely decreases in prices under long-term contracts with European customers, a higher tax burden from the introduction of the MET, and slower domestic gas tariff increases. The latter is also a significant risk to Novatek [Buy]. However, the company has a superior production growth profile and profitability and a proven

Valuations are at post-financial-crisis lows…

…but it is still too early to be bullish on Russia

We prefer to wait for more clarity and remain defensive

Oil and gas is our preferred sector, especially given tax reform

Our top pick remains Key Call Lukoil; we also like Surgut, TNK-BP Holding and Bashneft

Gas is not as well-positioned, but our favourite name here is Novatek


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track record of value-accretive acquisitions. The stock should re-rate if it receives an export sales allocation (which is yet another risk for Gazprom), which has not yet been captured in our financial and valuation models. Novatek therefore remains one of our core holdings in the energy sector.

In the basic materials space, we believe steel companies are the most vulnerable. Steel demand is highly investment-driven, and producers would be hit hard by a potential global slowdown. Coking coal and iron ore producers are exposed to the same risk but to an even higher degree, as their cost structures are less flexible. The share prices of steel producers have been the most affected by the market correction.

Within the sector, we continue to stick with high-quality and defensive names. Severstal [Buy] should be more protected on the downside given its exposure to the gold business. NLMK [Buy] is the highest-quality name among Russian steel companies, though it is highly dependent on sales of semi-finished products to European markets and therefore sensitive to the resolution of the European debt crisis.

Norilsk Nickel [Sell] on a post-buyback basis trades on earnings multiples that exceed historical averages. Despite the high premium offered by the current buyback, we believe institutional investors will only be able to participate to a very limited extent. Also, its free float will diminish, reducing its weighting in the MSCI. Finally, corporate governance is an issue given the ongoing conflict between the core shareholders.

Recently-signed contracts make Uralkali’s [Buy] near-term earnings more predictable and resilient. The stock remains one of the most defensive in the basic materials space, as the potash price is less volatile than that of other commodities, and demand for it is consumption- rather than investment-driven. In addition, the stock should be supported by the recently announced $2.5bn buyback program. At current prices, this covers c10% of the outstanding shares – a quarter of the free float.

Prices for complex nitrogen fertilizers have been resilient, supporting Acron’s [Buy] fundamental case. As an exporter, it also benefits from a stronger rouble.

Banks have been among the worst performers since early August. As a result, their valuation premium to EM counterparts has turned into a discount. However, their operating performance has so far been resilient – in fact, in September Sberbank [Buy] posted record-high lending growth and NIM. Our earnings stress test analysis suggests there is upside to Sberbank’s fair value even in a bad-case scenario. Nevertheless, we would remain cautious on the sector until fears dissipate that we will see financial sector contagion and another recession.

In the wireless space, we like VimpelCom [Buy], given that 1) Russia is only c40% of the business versus 85% for MTS; 2) its FCF generation is stronger; and 3) its valuation is cheaper, especially on FCF yield. Nonetheless, the stock lacks clear-cut short-term catalysts. We also like Rostelecom prefs [Buy] due to their higher dividend yield and the strong possibility of an increase in the payout ratio.

Steel is the most vulnerable in the basic materials space…

…and we prefer defensive names Severstal and NLMK

We rate Norilsk Sell for several reasons

We like Uralkali’s predictable and resilient near-term earnings

Russian banks boast resilient operating performance… …but we would remain cautious until fears of financial contagion and recession dissipate

We like VIP’s diverse geographic exposure, strong FCF and cheap valuation versus MTS


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We are cautious on retailers near term. Magnit [Buy] and X5 Retail Group [Neutral], despite falling 39.7% and 53% from peak levels, respectively, still trade on punchy double-digit 2012E PE multiples. At the same time, recently released results suggest that operating performance is deteriorating, as evidenced by the negative y-o-y traffic growth in 3Q11 reported by both companies. A weaker rouble and potential pressure on consumers’ income should further weigh on growth and returns, which the market may take negatively because stocks are still priced for growth. We also note that both Magnit and X5 Retail Group have relatively high leverage: 2.3x and 4.3x Net Debt/EBITDA, respectively, at YE11. O’Key [Buy] trades on more reasonable valuation multiples, though the high share of fresh and non-food products in its sales mix, relatively high exposure to forex-denominated debt and low stock liquidity make it more vulnerable if risk aversion remains elevated.

Pharmstandard [Buy] trades on more attractive valuation multiples: high single digits compared with high double digits for retailers. It also provides a higher return on invested capital. Its revenues and earnings should be more resilient, as its products are non-discretionary. The risks stem from a potential margin squeeze if the rouble continues to weaken, as costs of goods sold (COGS) are predominantly dollar-based, and from corporate governance, which was called into question following the buyback and the dilution of Pharmstandard’s share in NTS+ (the main entity in the Generium R&D project) from 50% to 37.5% through a transaction that investors considered murky.

CTC Media [Buy] offers an attractive valuation, but it is a more cyclical stock than food retail or pharma because the bulk of its income comes from TV advertising. There is a risk that global FMCG companies are cutting advertising budgets for 4Q11 and FY12. We have also noted that CTC Media’s TV audience share has recently been soft, as competition from smaller and non-broadcast channels has increased.

Our Key Call Inter RAO [Buy] has exhibited defensive characteristics, materially outperforming the market since early September. We expect this to continue, as we believe its investment case is strong given that it operates in an attractive market segment, owns quality assets, implements a value-accretive strategy and offers an attractive growth profile as a result of acquisitions and the commissioning of new capacity. The company is less exposed to regulatory risks than the sector as a whole, as the majority of its electricity is sold in the spot market. Its exposure to the international trading business gives it a buffer against falling domestic electricity prices. RusHydro’s [Buy] fundamental case is less appealing, in our view, primarily owing to its acquisition strategy and ongoing share issues. Nonetheless, the stock has underperformed, which makes these negatives largely priced in.

Among less-liquid names, we like Aeroflot [Buy], which continues to enjoy double-digit passenger turnover growth rates and will deleverage its balance sheet thanks to the deconsolidation of Terminal D by the end of the year. We expect additional domestic market share gains on the back of stricter airline industry regulation and the acquisition of Rosavia. Etalon [Buy] and LSR [Buy] provide attractive exposure to the residential real estate market, where prices and volume growth remain at healthy levels…so far.

Retailers remain expensive despite deteriorating operating performance

PHST is cheaper and offers a higher ROIC and firmer revenues and earnings, though margin squeeze is a risk

CTC Media is attractively valued but highly cyclical

In utilities, we like defensive Key Call Inter RAO

Aeroflot is our favourite less-liquid stock


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Risk aversion causing underperformance

The turbulence in global financial markets, slow progress in resolving the European debt crisis, and fragile business and consumer confidence in the US have clouded the economic outlook and increased the likelihood that the world will go into recession, although the most recent statistics suggest that economic activity has so far remained relatively resilient. Anxiety among investors has increased visibly, causing risk appetite to fall sharply. This environment is not supportive of GEM equities, whose large losses in September completely wiped out their outperformance relative to developed markets since shares began to rebound in 2009.

Within GEM, Russia was far from a safe haven. The market once again reconfirmed its high-beta status. Since early August, when the crisis of confidence started to unfold, the Russian market has lost 27% compared with 8.5% and 18.5% for global and GEM equities. In September, the RTS index fell 21.2%, the steepest decline in the last 34 months. This largely cancelled out the Russian market’s outperformance in the first half of the year. Year-to-date, the RTS has delivered -18.1% versus -7.3% and -18.8% for global and GEM equities, respectively.

Chart 3: BRIC and EM performance since 2008 peak Chart 4: RTS vs. EM performance since 2007

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Valuations have fallen to mid-2009 levels As a result of the severe share price correction, valuation multiples have fallen to levels last seen in late 2008 - early 2009. Since the crisis, Russia has consistently traded at a significant discount to MSCI EM, though the recent correction has widened the discount to 49%. We note, however, that we have so far not seen any large-scale revisions to earnings forecasts. Therefore, the fall in equity markets has caused Russia to de-rate in absolute and relative terms. Performing an analysis based on trailing rather than forward-looking multiples does not change the picture materially.


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Chart 5: 12-month forward-looking and trailing P/E Chart 6: PE discount to EM

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However, a simple PE comparison is not sufficient to conclude whether or not the Russian market is attractive at current price levels. PE ratios may be low for a variety of reasons. Broadly speaking, the key component that is lost in earnings-multiple analysis is risk.

We therefore believe it makes sense to put the performance of the Russian equity market into context and compare it to the change in prices of other assets that may be representative of country risk. Specifically, we compared the equity market’s performance with the change in Russia’s sovereign 2030 dollar bond, which we use as a proxy for the risk-free rate in our valuation models.

We compared the change in the bond price with the equity market’s performance in the last two months and overlaid that on the performance of the same instruments during the 2008 crisis. The analysis suggests that in August-mid-October 2008, the market fell 60%. This compares with the 40% market correction over the same period in 2011.

However, the big difference is that in 2008, the bond market started reacting to risks to the global economy, which pushed up the sovereign bond yield by c600bp, causing a price contraction of 30%. In 2011, bond yields have been largely flat, and marginal weakness has only become visible in the last two weeks.


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Chart 7: Relative performance of bond and equity markets, 2008 Chart 8: Relative performance of bond and equity markets, 2011

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We acknowledge that sovereign bonds reflect sovereign risk rather than country risk in the sense that sovereign bond prices reflect a government’s ability and willingness to meet its debt obligations. As Russia’s leverage is very low – total public external debt as a percentage of GDP is 2.6% and debt as a percentage of CBR reserves is 8.8% – its sovereign bond yields remain sticky.

In our view, it makes sense to look at the performance of credit-default swaps, as they may provide a fairer representation of changes in country risk. Here, we have observed a much sharper movement than in the bond market. The 10-year Russian CDS spiked by almost 200 bp in August-October. This still lags the 900 bp move during the same period in 2008.

Leverage One reason that could explain the difference in performance patterns in equities and bond markets, as well as Russia’s underperformance relative to GEM equities, is the leverage of Russian corporates. This was a hot topic at the time of the 2008 crisis and was initially perceived to be a major threat to Russia.

We start our analysis by considering the existing external debt position and domestic debt and looking at how they have changed over the last three years. The evolution of external and domestic debt is presented in the chart below.


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Chart 9: External debt, $ bn Chart 10: Domestic debt, Rb bn

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We make the following observations:

External public debt has been largely flat. It is currently $45.34bn, or merely 2.6% of GDP.

External corporate debt is much more material. At the end of 3Q11, it totalled $317bn, increasing by a marginal 3% compared with the end of 3Q08. We note that government-controlled companies like Gazprom and Rosneft are significant contributors to this number. Also, this number includes inter-company loans related to direct investments of $74bn. Stripping this out would leave us with external corporate debt of $243bn.

External banking debt totalled $157bn, which represents a meaningful 21% reduction compared with the end of 3Q08. Furthermore, the net long forex position of the Russian banking sector is actually much healthier, as Russian banks own $68bn in net assets denominated in foreign currencies. This represents a turnaround relative to the situation in 3Q08, when foreign liabilities exceeded foreign assets by $62bn.

Domestic debt: The Russian banking system remains in the very early stages of development, as evidenced by the fact that total banking debt is c40% of GDP. This number has not changed materially in the last three years, as lending growth effectively resumed only in mid-2010.

As the discussion above shows, external corporate debt is the only area where leverage-related problems may appear. However what makes the current situation in this area significantly different from what we observed three years ago is that the term structure of external liabilities has lengthened significantly. Below, we provide Russia’s external debt repayment schedule, which shows that the country faces minimal repayments in the next two years. In fact, debt maturing in less than two years now accounts for 37% of total external debt compared with 44.2% in 3Q08.


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Chart 11: External debt repayment schedule, $ bn

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Furthermore, another important difference is that in 2008, the corporate sector was under significant stress, as external markets were essentially closed and debt rollovers were not happening. Russian banks were the only source of funding for refinancing by corporates. Given that the term structure was skewed toward short-term debt, Russian corporates were in a very tight forex liquidity position.

The situation now is fundamentally different. Bond issuance clearly declined in August and September, though external debt markets are far from completely closed. For example, Rusal secured $4.75bn from a syndicate of foreign and local banks in September, Uralkali raised $1bn from foreign banks, and Norilsk Nickel is in the process of drawing a $1.5bn loan facility from a syndicate of foreign banks.

Chart 12: New bond issues

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Nonetheless, we acknowledge that the ongoing sovereign turmoil may lead to a credit scarcity, which in turn would make corporate refinancing more expensive, negatively affecting the earnings power of Russian corporates. Again, this is a very different situation from 2008, when Russian corporates were effectively cut-off from external funding sources.


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As we highlighted above, the problem of leverage is not necessarily visible at the macro level. However, this does not necessarily mean that it will not reveal itself at the micro, i.e. sector or company, level. In 2008, the steel sector in particular was heavily indebted, which gave rise to significant investor concern and resulted in the sector’s underperformance. We therefore believe it makes sense to take our leverage analysis one step further and assess the specific risk to publicly traded companies.

We start our analysis by looking at the broad market represented by the universe of stocks under our coverage. We believe it makes sense to analyse Russia’s leverage position in the context of other global emerging markets. The purpose of this analysis is to see whether the underperformance over the past two months was really due to the leverage effect, as a market with higher leverage should arguably be more vulnerable in a downturn.

To measure leverage, we relied on two multiples: Net Debt/Equity and Net Debt/EBITDA. The analysis reveals that with Net Debt/Equity of 12.9% (10.3% in 2012) and Net Debt/EBITDA of 42.5% in 2011 (38.4% in 2012), Russia stands out as one of the least-leveraged markets in GEM. We also note that both measures almost halved relative to the situation during the 2008 crisis.

Chart 13: Market leverage, international comparison, 2011

Brazil

Mex ico

Peru

Venezuela

Latin America

Czech RepublicEgy pt

Hungary

Israel

Poland

Russia

South Africa

Turkey

EMEA

China

India

Indonesia

Malay sia

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GEM

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Net D

ebt/E

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, %

Source: UBS


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Chart 14: Market leverage, international comparison, 2012

GEMAsia + HK, SG

Singapore

Hong Kong

Asia

Thailand

Taiw an

South Korea

Philippines

Malay siaIndonesia

India

China

EMEA

Turkey

South Africa

Russia

PolandIsrael

Hungary

Egy pt

Czech Republic

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VenezuelaPeru

Mex ico

Brazil

Argentina

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Source: UBS

Liquidity We conclude our analysis of the leverage situation by assessing the liquidity requirements of the stocks that we cover. It is clear that publicly traded stocks in Russia do not face any solvency issues, but they may still be under liquidity constraints if their liabilities are dominated by short-term maturities. Again, the problem is not visible at the macro level, but it may exist on a sector or company level.

In general, the problem is now less acute because, as we highlighted above, companies have access to external markets. Nevertheless, it makes sense to look at how the ability to meet short-term obligations in an environment where refinancing is difficult has changed over time.

To measure liquidity risk, we added EBITDA (a proxy for cash flow) to year-end 2010 cash positions and subtracted the amount of debt falling due in 2011. We then repeated this exercise using 2012 numbers. The results of this analysis are summarized in the table below.


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Table 1: Earnings surplus (shortfall) of Russian corporates in 2011E and 2012E

Cash EBITDA Matures Earnings surplus Cash EBITDA Matures Earnings surplus Matures

$ mn 2010 2011E in 2011 2011E 2011E 2012E in 2012 2012E after 2012

Gas 15163 73405 6310 82258 9111 74355 8841 74626 32748

Oil 33039 84191 10407 106823 45352 74474 7150 112676 34781

Gazprom 14827 70434 6310 78952 8043 71110 8062 71092 30940

Lukoil 2368 20208 2125 20451 6989 18719 1556 24153 7513

Rosneft 4154 23076 4215 23015 5146 21104 2119 24131 15976

Surgutneftegaz 22321 10891 0 33212 29363 8360 0 37723 0

TNK-BP Holding 1088 13140 0 14228 1447 10830 0 12277 2075

Novatek 336 2971 0 3307 1068 3245 779 3534 1808

Gazprom Neft 1146 9082 425 9803 813 7538 739 7612 5919

Tatneft 265 3568 2658 1175 285 4243 906 3622 956

Bashneft 1067 3650 820 3897 648 2870 1819 1700 1622

EDC 629 576 164 1042 661 808 11 1458 720

Wireless 1813 14498 1376 14935 2607 15037 2545 15100 30883

VimpelCom 885 9571 1276 9180 2435 9948 1408 10975 24708

MTS 928 4927 100 5755 172 5089 1137 4125 6175

Steel 4340 12882 4964 12257 3283 15119 5111 13291 17348

Evraz 683 3107 625 3165 617 3485 308 3794 6878

Severstal 2053 4459 831 5680 2192 4917 847 6262 4464

MMK 515 2093 904 1704 357 2797 758 2396 1866

Mechel 341 - 2078 - - - 1718 - 3522

Novolipetsk 748 3223 526 3445 116 3920 1480 2556 618

Pipes 158 1136 414 879 191 1463 276 1378 3327

TMK 158 1136 414 879 191 1463 276 1378 3327

Non-ferrous 6042 7828 1236 12634 4983 6770 370 11384 1191

Norilsk Nickel 6042 7828 1,236 12634 4983 6770 370 11384 1,191

Precious metals 1007 4775 754 5027 1316 5382 1707 4991 10454

Polymetal 11 842 154 700 118 1270 207 1181 593

Polyus Gold 504 1232 0 1736 798 2026 0 2825 210

UC Rusal 491 2701 600 2592 400 2086 1500 986 9652

Coal 338 792 15 1115 646 1111 322 1434 49

Raspadskaya 323 667 0 990 641 870 303 1209 4

KTK 15 125 15 125 4 241 19 226 45

Transport 824 1240 225 1839 855 1567 409 2013 2949

FESCO 556 191 75 673 629 246 875 495

Novorossiysk Port 130 545 0 676 161 719 314 565 2281

Globaltrans 138 503 150 490 66 601 95 572 173

Automotive 101 223 310 14 55 238 0 293 633

Sollers 101 223 310 14 55 238 293 633

Airlines 660 688 176 1173 757 827 0 1585 1275


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Aeroflot 660 688 176 1173 757 827 1585 1275

Chemicals 736 3211 130 3817 738 4157 711 4184 2715

Uralkali 486 2556 50 2992 440 3377 350 3468 1793

Acron 250 655 80 825 298 780 361 717 922

Real estate 305 792 150 948 927 1345 760 1513 1915

PIK Group 143 162 40 264 150 472 561 61 750

LSR Group 44 387 36 394 91 590 122 558 984

Etalon Group 119 244 74 289 687 284 77 893 182

Construction 655 456 65 1047 771 610 0 1381 172

Sibirskiy Cement 1 130 65 66 6 229 0 235 172

Mostotrest 654 326 0 981 765 381 0 1145 0

Electricity 5984 10702 1146 15540 7126 11772 370 18528 7441

RusHydro 625 2416 208 2833 1837 2581 0 4417 995

OGK-2 351 495 501 346 461 510 0 971 5

FSK 889 2587 209 3267 2322 2970 0 5293 1531

Holding MRSK 1630 3851 175 5305 1759 4135 370 5524 4080

INTER RAO 2489 1352 53 3789 747 1575 0 2322 830

Fixed line 413 4061 2 4473 766 4460 4 5223 0

Rostelecom 413 4061 1.6 4473 766 4460 3.7 5223

Consumer 740 2532 770 2502 822 3507 1340 2989 5500

X5 Retail Group 271 985 350 906 159 1329 500 989 3275

Magnit 162 847 200 808 416 1178 400 1194 1089

O'Key 187 249 20 416 69 339 70 338 192

Dixy 53 209 50 212 31 307 220 118 369

Cherkizovo Group 68 242 150 160 147 353 150 350 575

Pharma 237 500 19 717 131 571 0 701 1

Pharmstandard 136 418 7 547 115 440 0 555 0

Protek 101 82 12 171 15 131 0 147 1

Media 177 270 0 448 160 323 0 483 0

CTC Media 177 270 0 448 160 323 0 483 0 Source: UBS

The numbers above show that the liquidity situation at the companies we cover has become even healthier since the 2008 crisis. Total debt obligations to be repaid in 2011 and 2012 are $28.5bn and $29.9bn, respectively. The numbers are insignificant in the context of the cash flow generation of Russian corporates.

Furthermore, our analysis suggests that no company in our coverage universe will experience an earnings shortfall in the event it fails to refinance its debt. We recognize that EBITDA is not a perfect proxy for cash flow, as it ignores working capital needs and needs to be adjusted for maintenance capex. In addition, our forecasts are based on an oil price assumption of $100/bbl in 2012 – a scenario that may not materialize if the world falls into recession, which would make our forecasts unattainable.


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However, the only areas where we may see significant problems with debt servicing are construction and real estate, which represent only a fraction of the Russian equity market. In 2008, debt repayment problems were not insurmountable, but the leverage position of TMK and Evraz cast a significantly bigger pall over the market overall.

Currency mismatch risk has diminished The final observation we can make on the leverage situation is that the currency mismatch risk has significantly diminished. Before the 2008 crisis, it was common practice for domestic businesses to borrow in USD, as companies benefited from both a lower rate and diminishing liabilities in rouble terms, as the rouble was steadily appreciating.

That all changed after the 2008 crisis, which saw the rouble devalued by c50% against the dollar. The experience made domestic businesses much more disciplined in managing their currency exposures. Looking at the companies that we cover, we note that the vast majority of domestic stocks have either no dollar debt at all or predominantly rouble-based financial liabilities. Again, there are some exceptions in the construction industry, but the exposures are not worryingly high.

Policy response: So far so good Institutional underdevelopment and less-than-optimal policy responses by the CBR and Finance Ministry to the crisis aggravated the market collapse in 2008. The sharp fall in economic activity was also a factor, but other economies faced the same risk, and the Russian market eventually suffered a much sharper economic contraction than its GEM peers.

Policy risk could also be the reason why Russian equities are underperforming now. We therefore assess the policy responses that we have seen so far on the fiscal and monetary side and also consider the short-term and medium-term prospects for real growth in Russia. Our overall conclusion is that the CBR and the Finance Ministry have so far followed highly sensible policies and avoided repeating the mistakes of 2008, such as excessive spending of reserves to support the rouble (though we acknowledge this partly a function of the CBR giving banks time to close forex positions) and a slow response to liquidity pressures in the banking sector.

Assessing fiscal vulnerability We start by assessing Russia’s fiscal position, which has recently been in the investor spotlight. In fact, in our strategy publications in August (‘Global uncertainty to weigh on the market’ and ‘Can the sky turn a darker grey?’), we highlighted this area as a more significant source of risk than it was in 2008, especially because increased expenditures had led to a deterioration in fiscal flexibility. We have never viewed Russia’s fiscal problems as insurmountable, even though the sensitivity to the oil price has increased significantly. For example, based on the most recent statements of the Ministry of Finance, the 2012 federal budget would be balanced at an oil price of $117/bbl. This has clear implications for Russia’s economic case.


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What we have found recently, however, is that while the issue has not been resolved altogether, the government has become more cautious with spending. During the first three quarters of 2011, the federal budget actually accumulated a surplus of Rb1.09tn, primarily because expenditures significantly lagged the planned amount: only 64% of what was budgeted was actually spent.

This indicates the Russian budget is highly likely to remain healthy in 2011 provided there is no significant decline in the oil price. In 9M11, the government accumulated a fiscal surplus of cRb1.09tn (c2% of GDP). Furthermore, the Ministry of Finance expects the fiscal surplus to be sustainable in the short term even though expenditures may increase in 4Q11. Moreover, the Ministry of Finance expects the Reserve Fund to grow to Rb1.7tn by the end of the year from the current Rb0.8tn.

Chart 15: Federal budget

-80%-60%-40%-20%

0%20%40%60%80%

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Source: Haver

The Reserve Fund will help offset some of the fiscal pressures in 2012. It is clearly not big enough to resolve the problem completely, but it will give the government more time to implement structural changes in the budget to make it sustainably more balanced and also more targeted toward spending that promotes long-term economic growth rather than social and military programs.

Monetary policies have been prudent In our view, one of the key mistakes the government made in 2008 was delaying rouble devaluation, which cost the CBR $200bn of reserves. The turbulence in financial markets clearly affected consumer and investor sentiment in Russia, accelerating capital outflows. Now, however, the CBR seems to have abandoned the policy of exchange-rate targeting, as evidenced by the rouble’s 10% depreciation against the dollar since the end of August.

As a result of the current policy, reserve losses have not been meaningful, although we recognize the pressure has not been as intense as in 2008. Interestingly, the rouble recently started appreciating. The floating regime, apart from preserving reserves, also allows the government to ease fiscal pressures, as a significant part of revenues are based in dollars, while expenditures are denominated in roubles.


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Also, the fluctuating exchange rate significantly reduces the public’s anxiety, so a weakening rouble does not necessarily lead to panic conversion of rouble savings into dollars, as it did in 2008. This is not to say that a switch into dollars has been completely avoided this time around, but the magnitude of it is not as significant as it was three years ago.

The more flexible exchange rate policy stems from the CBR’s greater focus on controlling inflation. When inflation started to reaccelerate in 2010, the CBR responded with monetary tightening. As a result, inflation, after peaking at 9.6% in May, started to moderate and is currently below 7% y-o-y. This is also partially a function of this year’s better harvest and the base effect.

Finally, we believe the CBR is now much more effective in terms of injecting liquidity into the banking system. Regulatory measures – such as providing unsecured loans, extending the repo list, providing Lombard loans, and generally increasing the size of injections – eventually alleviated liquidity pressures in the Russian banking system in 2008. However, it took the CBR some time to develop these mechanisms, and some of them were untested.

We believe the CBR now has much greater flexibility in channelling liquidity to banks. We note that the interbank rate recently increased somewhat, from 4.3% at the beginning of August to 6.6% currently, but the magnitude of the move is nowhere near the situation in 2008, when at one point Mosprime exceeded 25%. We also note that the volume in repo auctions organized by the CBR increased visibly in September and early October, meaning that the CBR is proactively dealing with liquidity problems at Russian banks.

Chart 16: Volume of repo auctions

0

150

300

450

21-J

un

21-J

ul

21-A

ug

21-S

ep

Rub

bn

Unsecured loans repos other (lombard etc) Total liquidity injected

Source: CBR

Growth prospects Short-term growth outlook Another area of concern that makes Russia’s investment case less appealing is the significant deceleration in growth in 1H11. Real GDP growth slowed to 4.1% in 1Q11 and 3.4% in 2Q11. Given the size of the economic contraction in 2009 and the level of oil prices in 1H11, those numbers are hardly inspiring.


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However, we believe growth momentum is likely to reaccelerate in 2H11. The statistics for August revealed that growth in output reached 6.5% y-o-y – the highest monthly rate this year. Retail sales rose 7.9% y-o-y in August, while real wage growth of 3.8% was the highest this year, and disposable incomes continued rising in line with the previous month. Fixed capital investment growth was 6.5%, a meaningful pick-up from the negative growth seen in early 2011. Finally, lending growth is accelerating: Sberbank reported that its lending portfolio grew 3.7% m-o-m in September after 3.3% m-o-m growth in August.

We believe essentially two things lag in Russia: fiscal spending and construction. Above, we highlighted the country’s improved fiscal position; however, the flip side is that with public spending growth essentially slowing to zero, consumption growth has decelerated. Given the guidance from the Ministry of Finance on the size of the Reserve Fund at the end of the year, government spending has to increase.

Construction growth trends are also not all doom and gloom. In relative terms, Russia actually fared better than its Eastern European counterparts. Furthermore, the industry recently returned to growth, posting 12.4% and 17.6% y-o-y growth rates in August and July, respectively.

In general, the most recent statistics on Russian banks suggest that consumers and corporates are actually willing to spend. This behaviour could change quickly if oil prices fall, but this scenario has not yet materialized.

Overall, our macroeconomists expect higher y-o-y growth in 3Q-4Q11 given stronger consumption and public spending, a pick-up in credit growth, and, not least, positive base effects stemming from poor growth in 2H10, which was depressed by severe drought. Stronger GDP growth in 2H11 should alleviate some short-term concern, but it would still leave full-year 2011 growth at little more than 4% – a good result that nonetheless could have been significantly better given the sharp contraction in 2009.

Medium-term macro outlook In the medium term, the question remains what is going to drive Russia’s growth. In 2008, the government provided economic stimulus by hiking fiscal spending. As we discussed above, fiscal flexibility has diminished as a result of those decisions, and the government will now be less able to provide fiscal support to the economy. Moreover, heightened macroeconomic risks make it even more important to streamline government spending through reform.

Clearly, Russia should focus on stimulating investment inflows in order to address structural weaknesses in the economy, above all, the dependence on commodity prices. The problem, however, is that since the 2008 crisis, little has been done to improve the investment climate. Furthermore, continued capital outflows and weak private investment activity – even with high commodity prices – are worrying signs.

Where we believe Russia compares unfavourably with other big emerging markets is its lack of a proper institutional and regulatory framework. It therefore needs to implement structural reforms addressing a broad range of issues, including privatization, corporate governance, reforming natural


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monopolies, taxation, developing financial institutions and stimulating foreign investment activity, etc. The implementation of these reform initiatives will be a powerful engine stimulating real sector growth.

Clearly, the prospects for implementing structural reforms are closely connected with the leadership issue. President Dmitry Medvedev has recently become much more focused on promoting the reform agenda and calling for the modernization of Russia’s economy. A number of specific steps in this direction have been taken, including the creation of the Commission for Modernization and Technological Development of Russia’s Economy, which identifies strategic areas for economic modernization and providing tax incentives in priority industries, e.g. IT. In general, however, progress has not been impressive.

The outlook for further reform has been made more uncertain by the fact that Russia will see a change in leadership next year. Speaking at United Russia’s congress, Dmitry Medvedev said that he would not run for president and asked the party to support current Prime Minister Vladimir Putin. The news was not a complete surprise. The key question now is what it means for the prospect of reforms. Vladimir Putin does have a track record of changing things; in fact, he implemented the oil tax reform that redistributed oil revenues away from the oil companies and to the government. However, the problem is that once Russia stabilized economically and politically, reform lost momentum, and Putin’s second term saw few new initiatives. The question is whether the situation will be different this time around.

It is difficult to make projections, as Putin has not announced a detailed economic programme. However, what makes us hopeful is that the underlying reasons that led Dmitry Medvedev to resume discussions on the need for reform are still there. The new president, regardless of his personality, will have to deal with exactly the same challenges.

Concerns about the world going into recession, tightened liquidity, and increased risk aversion are putting more and more pressure on the Russian leadership to refocus on domestic drivers in order to accelerate economic growth. Russia’s growth rate significantly decelerated in 2010 despite high oil prices. This means that Russia should prioritize the reinvigoration of structural reforms in order to achieve the following objectives:

Improve the investment climate and create the prerequisites for higher FDI inflows;

Increase the scope for productivity gains;

Improve economic efficiency.

All of that is probably impossible to achieve without launching a major reform aimed at improving the efficiency of the government. This broad objective involves improving performance in areas like transparency, corruption, efficiency of public spending and the way government-controlled companies are run.


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In looking at the prospects for reform, the good thing is that Dmitry Medvedev, who has been highly vocal in promoting the reform agenda, will remain a key decision-maker after next year’s elections. Mr Putin proposed him as Russia’s next prime minister, which is a very good position in terms of practical implementation of reforms. During his four-year term, Dmitry Medvedev has gained political clout and implemented a number of important reshuffles. These include the dismissal of long-time political heavyweights such as the presidents of Tatarstan and Bashkiria, the mayor of Moscow and, more recently, even Finance Minister Alexei Kudrin, who is very close to Mr Putin.

We will refrain from discussing how sensible it was to dismiss the person who deserves much of the credit for getting Russia through the 2008 crisis and who has always been committed to following prudent fiscal policies, which allowed Russia to accumulate reserves that it could use to support economic performance when the oil price collapsed.

The point we would like to make is that we think Dmitry Medvedev is a credible politician capable of making decisions on personnel, which is important given that he will have to form a new government if he gets appointed prime minister. It is also significant that Putin views him as a strategic political ally, as evidenced by the fact that he did not get involved in the row over Kudrin and did not block the dismissal of one of his key ministers. This also indicates that Putin views his partnership with Medvedev as long-term, which serves as a good foundation for pushing through long-term reform projects.

The priority for the new government should be improving the country’s investment climate. Given the existing limitations on increasing government-funded investments and questions surrounding the efficiency of those investments, we think the government needs to take measures to make Russia more attractive for private investors. This includes creating attractive conditions for domestic investors, which the capital outflow numbers suggest are far from optimal. Also, the level of foreign investor activity in Russia is significantly below what is observed in other big emerging markets.

Specific measures that would be welcome include limiting government involvement in pricing and broader economic decision-making, for which administrative reform efforts should be restarted. Protecting property rights is another priority, which will require judicial reform.

As our macroeconomic colleagues recently highlighted, specific measures to be taken include overhauling Russia’s legal and regulatory framework, with a particular focus on reducing red tape, corruption and arbitrary state interference; establishing a transparent and level playing field for both domestic and foreign companies, as well as private- and state-owned companies, including SMEs; improving the regime of corporate taxation and state aid; strengthening corporate governance and the rights of minority shareholders; upgrading financial sector supervision; modernizing infrastructure; raising productivity through education, training and better public health; pension reform; and implementing a transparent framework for monetary and exchange rate policy.

Pension reform is one of the issues that the new government will have to deal with in the short term. As a result of pension hikes in 2009, the pension fund


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now runs a deficit of Rb900bn. This is a major problem, as the demographic situation in Russia is deteriorating, which means the working population is shrinking and, along with it, contributions to the pension fund. At the same time, the pension burden will increase because of the aging population and rising life expectancy. This will further expand the pension deficit. Based on Ministry of Finance estimates, if the current tax system is preserved, the pension fund deficit will widen to 5% of GDP in 2020.

At the moment, the pension deficit is funded through the Welfare Fund, which currently totals c$90bn, suggesting it will be exhausted in three years even at the current pension deficit run rate. Therefore, the government will have to decide either to increase the pension age or change the tax regime in order to increase inflows to the fund.

The latter option is suboptimal, in our view. The government has already increased the payroll tax from 26% to 34%, leading many companies to switch to grey salary schemes. Increasing the tax burden may therefore not necessarily achieve the objective of raising tax revenues. Former Minister of Finance Alexei Kudrin has been a big proponent of increasing the pension age from the current 55 years for women and 60 years for men. It remains to be seen what the final solution will be, but our point is that the status quo is not sustainable.

We also believe the government is likely to continue reforming natural monopolies. It has a relatively good track record of implementing restructuring in this area. The most high-profile example is the break-up of UES, which, though it did not achieve the objective of fully transferring power sector assets to private investors, it still resulted in the separation of generation (a competitive market segment) from distribution and transmission, which remained regulated.

Another example is the restructuring of Russian Railways (RZHD), which is being implemented according to a three-stage plan. At the first stage, the railcar segment was liberalized, with private operators enjoying unregulated pricing and substantially increasing their market share. The next stage involves the liberalization of locomotive traction, due in 2012. The final objective is to allow non-integrated independent railway operators access to the infrastructure network, thus promoting competition. As part of the plan, RZHD established Freight Two, in which it plans to sell a 25% stake to other railway operators.

Provided the reform is implemented smoothly, it will result in the emergence of a more efficient railway transportation sector. As a result of the development of privately owned railway companies, with the major ones now publically traded, and the separation of businesses within Russian Railways, customers should benefit through improved flexibility, better service quality and more attractive pricing.

The obvious candidate for restructuring among natural monopolies is Gazprom. The company combines two distinctly different businesses: production and distribution of gas. Additionally, it holds a significant interest in the electricity generation business (Gazprom Energoholding controls 17% of installed capacity in Russia) and oil production through its 95% stake in Gazprom Neft. It is questionable whether such a complex and sizeable business can be run efficiently, and hence from a broader government perspective it seems to make


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sense to break it up and sell it to private owners, retaining control only over the gas transportation network and potentially preserving the right to export sales given that the gas market is not fully liberalized in Europe.

In the event production assets end up in the hands of private owners, we see significant scope for efficiency improvements and hence potential price reductions for end users. We note that privately owned Novatek reports opex/mcm of c$4 compared with Gazprom’s $10, based on our estimates. On the other hand, a spin-off of the transportation system may require an increase in transportation tariffs to finance network extension. This was the case with Federal Grid and Transneft. We note that Gazprom is involved in a number of capital-intensive projects, such as Yamal pipelines, South Stream and potentially a pipeline to China. As long as it continues to be engaged in these large-scale projects, the need for a relatively high transportation tariff will remain.

In our view, the restructuring of Gazprom is a very real possibility given the evolution of the company’s market position, both in the domestic and external markets. In the domestic market, Gazprom’s share of production has dropped from 90% in 2006 to 84% now. Thus, independent gas producers have become much more important players. Recent transactions whereby Gazprom sold licences to operating companies developing promising fields indicate that the process is likely to continue. Moreover, the government incentivises independent gas producers to grow production by obliging Gazprom to provide access to pipelines and keeping the gas MET relatively unchanged in the medium term.

In the export markets, Gazprom’s unwillingness to change its long-term take-or-pay contract to provide more flexibility to its customers has resulted in a dramatic contraction of its market share in Europe.

It is too early to say how exactly the potential restructuring would be implemented. Recent examples in which Gazprom has sold assets to competitors do not provide much comfort. For example, when Gazprom sold its 9% stake in Novatek, it turned out that the price was 35% below the prevailing market price. The other concern is that none of those transactions led to the return of extraordinary income to shareholders, as the funds were reinvested.

On the other hand, if the restructuring is based on the pattern of UES, whereby interested parties initially bought shares in the holding company and then exchanged them for production assets, the implications for minority shareholders in Gazprom should be different and provide a strong catalyst for the stock, as its true shareholder value should be able to crystallize.

GEM investor positioning The underperformance of the Russian equity market since August is fully consistent with fund flow trends. While at the beginning of the year Russian equity funds posted inflows as investors played the jump in oil prices, the situation reversed in August and September, with capital inflows turning into significant capital outflows. Since August, capital outflows from Russian funds have reached $2.6bn, bringing year-to-date capital inflows to $583m.


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Investor positioning was meaningfully affected as a result. At the beginning of the year, GEM portfolio investors were overweight Russia, with the overweight position peaking at 1.2% in January. This quickly reversed, however, and by the end of 1Q11, the overweight had changed to neutral. By the end of August, the positioning was 1% underweight.

Chart 17: Russia’s positioning in GEM

-2.5%-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%

00 01 02 03 04 05 06 07 08 09 10 11

Source: EPFR

The most recent trends in fund flows that we are seeing in Russia are in line with broader GEM trends. Total GEM fund flows year-to-date have been negative $29.2bn compared with inflows of $84bn in 2010, reflecting heightened risk aversion. Nevertheless, Russia’s underweight status is in sharp contrast to Latin American and Asian countries.

This may be interpreted as a positive sign, as it implies that investors have ample room to add Russian exposure. The fact that the economy has so far been unaffected, commodity prices have remained resilient and the policy response was adequate could improve sentiment. The way the Russian market reacted to the positive news flow from the US and the EU over the last couple of weeks shows that any turnaround could be sharp and quick.

Chart 18: GEM investor positioning

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Source: EPFR


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Linking the oil price and EPS expectations In our report ‘Global uncertainty to weigh on the market’ published on 12 August, we presented an analysis establishing the relationship between the oil price and EPS forecasts. In our view, the sharp movements in the equity market are a reflection of uncertainty on the macroeconomic front, with investor fears centred around the risk of the world going into recession. This scenario would mean lower commodity prices. The price of oil is the single most important risk for the Russian equity market. We therefore believe it would be useful to see what oil price the current valuations of the stocks that we cover imply.

We compared the oil price with 12-month forward-looking earnings forecasts for the universe of the companies that we cover. The results of this exercise are presented below. The correlation analysis reveals a very strong link between the oil price and our earnings expectations. The strength of the relationship is very high, as evidenced by the R2 of 82%.

Chart 19: Earnings regression against the oil price

y = 999.99x + 7519.7R2 = 0.8153

30000

60000

90000

120000

150000

30 40 50 60 70 80 90 100 110 120 130Brent

12m

forw

ard

earn

ings

Source: UBS, Bloomberg

We have modelled earnings outcomes under different oil price assumptions. In our modelling exercise, we relied on the outcome of our regression analysis for the oil price and earnings expectations detailed above. In our analysis, we assumed the relationship will stay unchanged, although we acknowledge that confidence can evaporate, in which case there could be further downside potential to our estimates. We then use earnings expectations to derive implied price/earnings multiples under different oil price assumptions. The results of this exercise are presented in the chart below.


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Chart 20: Implied PEs under different oil price assumptions

4.0

5.0

6.0

7.0

8.0

9.0

10.0

11.0

12.0

50 60 70 80 90 100 110Brent price, $/bbl

12m

fwd

P/E

Source: UBS

Equity risk premium As a result of the market sell-off, ERP has risen. We calculate ERP as the difference between the earnings yield of the market (the reciprocal of PE, which we use as a proxy for the cost of equity capital) and the risk-free rate. We use a 2018 dollar Russia Eurobond yield as a proxy for the risk-free rate. The analysis suggests that the market’s implied ERP has jumped from 10.9% at the end of June to 15.0% currently.

The chart above may give a somewhat misleading picture, as there is significant uncertainty over earnings forecasts, which may change significantly depending on the oil price outcome. Clearly, a contraction in earnings growth and consequently expansion in earnings multiples mean a reduction in the projected earnings yield. Below, we present a recalculated implied ERP for the Russian market using the data from the analysis above. Based on this analysis, implied ERP falls to 9.1% under $80/bbl oil, 7.6% under $70/bbl and 6.0% under $60/bbl oil. We note that our black-skies scenario is based on $60/bbl oil.

Chart 21: Implied ERP under different oil price scenarios

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

50 60 70 80 90 100 110

Source: UBS


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The final question is what ERP we consider fair. Based on that, we then draw a conclusion on the fair PE multiple, which in turn will allow us to identify which oil scenario the market currently prices in.

In our models, we currently use ERP of 6%. However, risks have heightened, which suggests that ERP should increase relative to the level that we used earlier this year. We believe the CDS can give a fair representation of the recent changes in the level of risk aversion. The CDS has moved materially, approximately 200 bp over the last two months. Using this as a benchmark for the change in the ERP suggests that ERP should equal 8%. Using this and solving for the implied PE gives us a PE multiple of 8.0x. This equals the PE multiple under the $70/bbl oil price scenario.

Chart 22: Implied ERP under different oil price scenarios

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

May

-08

Aug-

08

Nov-

08

Feb-

09

May

-09

Aug-

09

Nov-

09

Feb-

10

May

-10

Aug-

10

Nov-

10

Feb-

11

May

-11

Aug-

11

base $50 $70 $90

Source: UBS

Statement of Risk

The main risks we see in investing in Russian stocks are as follows. The global economy may fail to deliver the continuation of growth we expect, so leading to a fall in commodity prices, including oil. Global interest rates may also tick up more than expected due to global economic strength, thus upsetting (eventually) asset valuations. Key Russian-specific risks that investors in Russian equities face include: a deterioration in the political climate (sources of unrest include the Northern Caucasus), more state purchases of assets, and poor corporate governance in private Russian firms.


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Analyst Certification

Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers and were prepared in an independent manner, including with respect to UBS, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.


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Required Disclosures This report has been prepared by UBS Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.

For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request. UBS Securities Co. Limited is licensed to conduct securities investment consultancy businesses by the China Securities Regulatory Commission.

UBS Investment Research: Global Equity Rating Allocations

UBS 12-Month Rating Rating Category Coverage1 IB Services2

Buy Buy 59% 35%Neutral Hold/Neutral 35% 33%Sell Sell 6% 14%UBS Short-Term Rating Rating Category Coverage3 IB Services4

Buy Buy less than 1% 0%Sell Sell less than 1% 20%

1:Percentage of companies under coverage globally within the 12-month rating category. 2:Percentage of companies within the 12-month rating category for which investment banking (IB) services were provided within the past 12 months. 3:Percentage of companies under coverage globally within the Short-Term rating category. 4:Percentage of companies within the Short-Term rating category for which investment banking (IB) services were provided within the past 12 months. Source: UBS. Rating allocations are as of 30 September 2011. UBS Investment Research: Global Equity Rating Definitions

UBS 12-Month Rating Definition Buy FSR is > 6% above the MRA. Neutral FSR is between -6% and 6% of the MRA. Sell FSR is > 6% below the MRA. UBS Short-Term Rating Definition

Buy Buy: Stock price expected to rise within three months from the time the rating was assigned because of a specific catalyst or event.

Sell Sell: Stock price expected to fall within three months from the time the rating was assigned because of a specific catalyst or event.


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KEY DEFINITIONS Forecast Stock Return (FSR) is defined as expected percentage price appreciation plus gross dividend yield over the next 12 months. Market Return Assumption (MRA) is defined as the one-year local market interest rate plus 5% (a proxy for, and not a forecast of, the equity risk premium). Under Review (UR) Stocks may be flagged as UR by the analyst, indicating that the stock's price target and/or rating are subject to possible change in the near term, usually in response to an event that may affect the investment case or valuation. Short-Term Ratings reflect the expected near-term (up to three months) performance of the stock and do not reflect any change in the fundamental view or investment case. Equity Price Targets have an investment horizon of 12 months. EXCEPTIONS AND SPECIAL CASES UK and European Investment Fund ratings and definitions are: Buy: Positive on factors such as structure, management, performance record, discount; Neutral: Neutral on factors such as structure, management, performance record, discount; Sell: Negative on factors such as structure, management, performance record, discount. Core Banding Exceptions (CBE): Exceptions to the standard +/-6% bands may be granted by the Investment Review Committee (IRC). Factors considered by the IRC include the stock's volatility and the credit spread of the respective company's debt. As a result, stocks deemed to be very high or low risk may be subject to higher or lower bands as they relate to the rating. When such exceptions apply, they will be identified in the Company Disclosures table in the relevant research piece. Research analysts contributing to this report who are employed by any non-US affiliate of UBS Securities LLC are not registered/qualified as research analysts with the NASD and NYSE and therefore are not subject to the restrictions contained in the NASD and NYSE rules on communications with a subject company, public appearances, and trading securities held by a research analyst account. The name of each affiliate and analyst employed by that affiliate contributing to this report, if any, follows. UBS Securities CJSC: Dmitry Vinogradov, CFA; Bella Rabinovich, CFA.


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Company Disclosures

Company Name Reuters 12-mo rating Short-term rating Price Price date Acron AKRN.RTS Buy N/A US$38.34 14 Oct 2011 Aeroflot - Russian airlines2, 4, 5, 16 AFLT.RTS Buy N/A US$1.65 14 Oct 2011 Bashneft BANE.RTS Buy N/A US$48.50 14 Oct 2011 CTC Media16 CTCM.O Buy N/A US$11.81 14 Oct 2011 Etalon Group Ltd ETLNGq.L Buy N/A US$4.19 14 Oct 2011 Gazprom2, 4, 5, 16, 20, 22 GAZPq.L Buy (CBE) N/A US$10.55 14 Oct 2011 INTER RAO IUES.MM Buy N/A RBL0.04 14 Oct 2011 LSR Group LSRGq.L Buy N/A US$3.50 14 Oct 2011 Lukoil4, 5, 16, 20 LKOHyq.L Buy (CBE) N/A US$55.00 14 Oct 2011 Magnit16 MGNTq.L Buy N/A US$19.30 14 Oct 2011 Norilsk Nickel4, 5, 16, 22 GMKN.RTS Sell N/A US$212.00 14 Oct 2011 Novatek5, 20 NVTKq.L Buy (CBE) N/A US$127.30 14 Oct 2011 Novolipetsk Steel5, 20 NLMKq.L Buy (CBE) N/A US$26.60 14 Oct 2011 O'Key Group OKEYq.L Buy N/A US$5.64 14 Oct 2011 Pharmstandard PHSTq.L Buy N/A US$18.25 14 Oct 2011 Rostelecom (pref shares)5, 16 RTKM_p.MM Buy N/A RBL85.38 14 Oct 2011 RusHydro5, 16 HYDR.MM Buy N/A RBL1.13 14 Oct 2011 Sberbank2, 4, 5, 16, 20 SBER03.MM Buy (CBE) N/A RBL80.72 14 Oct 2011 Severstal20 CHMFq.L Buy (CBE) N/A US$12.78 14 Oct 2011 Surgutneftegaz16, 18, 20 SNGS.RTS Buy (CBE) N/A US$0.94 14 Oct 2011 TNK-BP Holding5, 20 TNBP.RTS Buy (CBE) N/A US$2.65 14 Oct 2011 Uralkali4 URKAq.L Buy N/A US$40.00 14 Oct 2011 VimpelCom3, 4, 5, 16, 20 VIP.N Buy (CBE) N/A US$10.16 14 Oct 2011 X5 Retail Group20 PJPq.L Neutral (CBE) N/A US$22.27 14 Oct 2011

Source: UBS. All prices as of local market close. Ratings in this table are the most current published ratings prior to this report. They may be more recent than the stock pricing date 2. UBS AG, its affiliates or subsidiaries has acted as manager/co-manager in the underwriting or placement of securities of

this company/entity or one of its affiliates within the past 12 months. 3. UBS Limited is acting as advisor to VimpelCom on the acquisition of OJSC New Telephone Company from KT

Corporation and Summit Telecom Global Management BV 4. Within the past 12 months, UBS AG, its affiliates or subsidiaries has received compensation for investment banking

services from this company/entity. 5. UBS AG, its affiliates or subsidiaries expect to receive or intend to seek compensation for investment banking services

from this company/entity within the next three months. 16. UBS Securities LLC makes a market in the securities and/or ADRs of this company. 18. The U.S. equity strategist, a member of his team, or one of their household members has a long position in the ADRs of

Surgutneftegas. 20. Because UBS believes this security presents significantly higher-than-normal risk, its rating is deemed Buy if the FSR

exceeds the MRA by 10% (compared with 6% under the normal rating system). 22. UBS AG, its affiliates or subsidiaries held other significant financial interests in this company/entity as of last month`s end

(or the prior month`s end if this report is dated less than 10 working days after the most recent month`s end). Unless otherwise indicated, please refer to the Valuation and Risk sections within the body of this report. For a complete set of disclosure statements associated with the companies discussed in this report, including information on valuation and risk, please contact UBS Securities LLC, 1285 Avenue of Americas, New York, NY 10019, USA, Attention: Publishing Administration.


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