Russia in 2010: Surviving and Thriving.

performing better in the run-up to the mid-April global market peak and with greater volatility since. As global growth indicators strengthen and the domestic recovery story gains momentum in 2H10, Moscow’s bourses are expected to move steadily upwards, with stocks and themes that are exposed to the domestic story leading the way. … but nervous summer expected. Global equity markets have been very volatile due to the solvency threats in Europe and concerns that global growth may fall into a double-dip recovery pattern. But, while the pace of recovery has slowed, the growth achieved thus far is holding firm. There is no evidence of a reversal. Our assumption is that while the summer months will remain volatile and investors nervous, the upward move in global markets is expected to resume in the autumn as the OECD forecast numbers become firmer. Against that backdrop, the best investment strategy in the summer is to establish a list of stocks to buy and to do so on days when global markets are weak. Domestic is becoming best theme. The best investment themes in Russia over the medium to long term will be those associated with investment in infrastructure; the rebuilding of industries that have been neglected for the past 20 years, such as agriculture, food processing, and pharmaceuticals; emerging-state sponsored technology sectors, such as those in the new InnoGrads (technology cities); and those linked to the development and broadening of the domestic economy.

Top conviction stocks

Aeroflot Armada Bashneft Gazprom Gazprom Neft IBS LSR Group LUKoil Magnitogorsk Mechel OGK-4 OGK-5 PIK Group Polyus Sberbank Siberia Telecom Silvinit St. Petersburg Bank TBK-BP Uralsvyazinform Vimpelcom Volga Telecom VTB Bank

Assumptions and risks

Looking for steady global growth. Our forecasts reflect a global backdrop in line with OCED growth expectations and the avoidance of a double-dip recession. We also use the Bloomberg consensus oil price forecasts. Our GDP growth forecast for 2010 remains unchanged at 5.5%; however, we have slightly lowered our inflation forecast, to 7.5% from 9.0%, and raised our ruble outlook to an average of RUB27.7 /$ for the full year.
Oil is still a substantial risk. The main risks to the Russia story are external. A reversal in global growth or a cut in China’s demand for commodities would have a material impact on our macro assumptions and on the government’s willingness and ability to fund planned investments in the economy. Although we believe that the next phase in Russia’s investment story will be about domestic investment and growth, the oil price will remain the critical backdrop for many years.
The fallout from the oil leak in the Gulf of Mexico has added significant medium- to long-term support to the oil price because of the tougher regulatory regime and more expensive operational cost base expected.

Valuations lagging in the recovery. The valuation gap between Russian equities and their global emerging market peers has widened over the past six months. This is because investors view Russia as a high-risk global theme and have not yet accounted for the recovery in the economy and corporate profits – we expect this to occur in 2H10.
Oil & gas stocks have fallen too far behind. The oil sector, in particular, has become very cheap. Although globally the sector is not rated highly, Russian names, such as LUKOIL (with a 2010 and 2011 PE of 3.4 and 3.8) and Gazprom (3.2 and 3.5, respectively) have fallen far behind.

Equity Issuance

No longer a seller’s market. Investor appetite for new equity issues remains low on all markets. In total, Russian companies have raised $7.5 bln via IPO and SPO issues. Almost half of that was subscribed by the state for issues in the electricity sector. The four IPOs completed so far this year have raised a total of $2.85 bln, and they are all trading at a loss against the issue price.
Best demand is for domestic themes. Russian companies ideally need to raise around $100 bln to pay off debts and fund growth. The outlook for this year, however, is less favorable than had been hoped for, and it is likely that only between $10 bln and $15 bln will be raised, of which only half may be IPOs, compared to the $25 bln originally forecast.

Fund Flows and investor activity

Oil price is critical. Investors continue to add net new money to emerging market funds, but at a much slower pace than in 2009. Most money is going into safer balanced funds, as opposed to country-specific funds. However, Russia has attracted more new money than the other BRIC-oriented funds in 2010 to date. Last year’s favorite, Brazil funds, have been losing money for most of this year.
Russia relies on global demand. But, while adding new money to Russia funds, investors are still not drifting far from a neutral stance while waiting for greater conviction about the global and domestic recovery. Investors are continuing to broaden out beyond the biggest names, as investors look for exposure to stocks in potentially fast growing domestic industries. Gazprom is still by far the biggest under-weight name on average in EM Russia funds relative to its weight on the MSCI Russia Index.
Opportunities relative to MSCI. Later in this note we identify stocks that are “out of sync” in the average EM Russia portfolio relative to the MSCI Russia Index structure. Apart from Gazprom, the other major underweight is in electricity shares which, in aggregate, represent a weight of 6.18% of the MSCI Russia Index, but only 2.15 % of the average portfolio within a Russian EM fund. Analysis of this data series also shows that investors have consistently been buying stocks such as NOVATEK and VTB, and that the two main candidates for inclusion in the MSCI Russia Index during the autumn review are Magnitogorsk Steel and MRSK Holding.

Investment Themes

Low valuations. Russian assets are still priced as if the crisis remains in place rather than resolved. There is some justification for a discount in assets due to the heavy reliance on the current oil price and China demand for commodities, but the current discount is excessive in many stocks in our opinion. The oil sector is a good example of where big stocks are unreasonably underrated. LUKOIL is trading on a P/E of 3.4 and 3.8 for this year and next, while its EV/EBITDA rating is 2.4 and 2.6, respectively. For Gazprom, which has been adversely affected by the hype surrounding shale gas potential, its P/E ratings are 3.2 and 3.5, while its EV/EBITDA multiples for 2010 and 2011 are 3.0 and 3.2, respectively.
Second tier manufacturing. Valuations in this sector have also fallen to extremely low levels, in part because investors often avoid the risk of investing in illiquid names, but also because of the strong earnings recovery expected in these names. Many names here are also long-term growth stories. Ulan-Ude Aviation (UUAZ) is one of those. It is one of the main producers of helicopters in Russia and that industry is expected to see sustained long-term growth (see sector summary later). Yet the stock trades on a 2010 P/E of 3.3 and 3.0 for 2011. In terms of EV/EBITDA multiples, it trades at 1.2 and 1.1 for 2010 and 2011. Mashinostroitelny Zavod (MASZ) is one of the main players in the uranium industry and trades at a P/E of 3.7 and 3.2 for this year and the next, while EV/EBITDA is respectively 2.5 and 2.2.
Domestic recovery. The economic recovery is now underway and is expected to broaden during 2H10 and into 2011. We forecast a slower recovery in retail spending, due to a cautious stance by consumers, however, this should pick up in 2011 as the recovery gathers pace. The best way to play this theme is via the mobile telecoms, banks and transportation stocks.
Industrial restructuring. Restructuring is now entering the final phase in the fixed-line telecom industry, and by early 2011 the multiple inter-regional telecom operators will be replaced with a new telecom blue chip, Rostelecom. The best way to play that theme is via the regional telecoms having the best upside to the conversion valuation and top stock picks). The utilities sector restructuring is also moving ahead and will see an improvement in revenue, costs and margins for most stocks. Refer to the sector note and top stock picks for best way to play this theme.
Mergers in strategic industries. This is a theme that has been muted ever since the liquidity crisis in late 2008. To date, little has happened, however, as is currently the case in the fertilizer sector, that we may see greater activity in this theme in 2H10 and into 2011, as the state could “encourage” mergers in these sectors as a condition for financial support and to achieve higher levels of efficiency.
Infrastructure. Investment into improving infrastructure is one of the government’s main priorities over the medium to long term. Roads, railways, ports, pipelines and transportation (airlines and cargo), are among the industries that fit this theme.
Modernization agenda. Both President Medvedev and Prime Minister Putin have stressed the need for Russia to cut its reliance on – and vulnerability to – the import of “basic” items, such as food, medicines, and basic technologies. This includes food, pharmaceuticals and technology Expect to see an increasing number of initiatives, and state spending, to help the agriculture and food processing industries grow faster. Both the president and the prime minister have referred to Russia’s reliance on important medicines as a national embarrassment, while the InnoGrad (technology parks) scheme is aimed at creating a better domestic technology base.

Key Assumptions

OECD growth forecasts to be met. Our assumptions for the domestic economy and earnings growth are based on sustained growth in the global economy. We specifically discount the risk of a double-dip recession or a major reversal in China’s growth and demand for imported commodities. We assume that the recently updated OECD forecasts for global growth will be met. Furthermore, the current low inflation rates in developed economies, especially in the US, will start to increase by 4Q10, and the US Fed will already start to raise interest rates in the autumn. Full-year US inflation is expected to reach 3.0% in 2010 and rise to 3.5% in 2011.The OECD predicts even stronger growth in the largest developing economies.
Market consensus of $80/bbl for oil in 2010. We base our macro assumptions on a 2010 average oil price of $79.2/bbl for Urals crude ($80.80/bbl for Brent), followed by $84.3/bbl in 2011. This is the market consensus forecast based on Bloomberg data and it is also consistent with OPEC’s declared price targets.
Economic activity to pick up in 1H10. We expect the recovery in the domestic economy to gain momentum during 2H10. After a sluggish first quarter, activity has already improved in 2Q10. Our forecast for GDP growth this year is 5.5%, before dropping to 3.8% in 2011. Our 2010 forecast is higher than the official government forecast of 4.0%, as we believe this figure has been deliberately held at a conservative level to allow for positive surprises later this year. Export earners continue to be the main growth drivers, while domestic demand is only slowly beginning to recover. We have downgraded our forecast for retail sales from 5.3% to 4.6% YoY growth this year, as we expect that consumers will be more inclined to save than return to their previous spending habits before 2011, when we forecast retail sales to grow 6.8% YoY.
More focused government. It is assumed that the government will be much more pro-active in pursuing its spending and investment priorities as well as in its efforts to improve foreign investor perceptions of Russia as an investment option.
Rising inflation later this year. Inflation is currently at a historic low, and this has allowed the Central Bank to cut its refinance rate to 7.7% by the end of May. We have reduced our previous inflation forecast from 9.0% to 7.5% for 2010, due to the current low rates. However, we do expect inflation to pick up later this year as the economy improves and global inflation starts to increase. For this reason, we forecast a higher rate of 8.0% for 2011.
Improved ruble outlook. Our year-end ruble-dollar exchange rate is forecast at RUB28.2/$, implying an average full-year rate of RUB29.1/$. For 2011, we assume a year-end rate of RUB26.4/$, averaging RUB27.7/$ for the full year. For the ruble-euro rate, our end-2010 forecast is RUB35.3/EUR and RUB36.9/EUR for the end of 2011. This is also partly based on our forecast for the dollar-euro rate of $1.30/EUR for end-2010, and a similar rate for end-2011 6.0% risk-free rate. In our valuation models, we use a risk-free rate of 6.0%, which is based on the yield on long-dated Russian Sovereign debts. Our equity risk premium is set at 5.6, which is the standard rate of 4.0% multiplied by 1.4 to reflect the volatility in the market. Our target prices are mostly based on discounted cashflow analysis, except for the metals and mining sector where we use a peer group comparison.
Stability. We assume that both politically and socially, Russia will remain stable throughout the election process.