ATON - Transneft - How Generous is the Russian Government - Aug 22, 2012.
How Generous is the Russian Government?
In this report we initiate coverage of Transneft's preferred shares with a target price of $1,597/share, which implies downside potential of 7%. We assign a SELL rating to the stock. We believe that Transneft has a high internal value but its release is constrained by poor transparency and corporate governance, uncertainty over privatisation and an unclear dividend policy.
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All eyes on privatisation. We believe that expectations of privatisation have been driving Transneft's preferred shares for two years. On 7 June 2012 the government announced its new privatisation plan which implies the reduction of its stake in Transneft to 75% + 1 share in total capital or selling of 4% of ordinary shares. Given that the state aims to sell such a small stake we believe that privatisation is aimed at improving Russia's image rather than generating budget revenues. We believe that investors would not be interested in the sale of such a small stake unless Transneft offers higher dividends.
Dividends define value. We use two approaches to derive our target price for Transneft's preferred shares: a dividend discount model (DDM) and a discounted cash flow model (DCF). Our DDM is based on two scenarios related to dividend
payout ratios (10% and 25% of IFRS net income). We employ the DCF to determine the theoretical target price of the ordinary shares (which are not publicly traded) and then calculate the target price of the preferred shares based on a fair discount. The company's future dividend policy defines the value of the prefs, in our view. On our estimates, all else being equal, Transneft should be able to generate aggregate FCFE of RUB485bn in 2012-20E. However, its ability to pay higher dividends does not necessarily translate into the government's willingness to do so. We see a risk that spare cash could be withdrawn from the company to support the state budget and uncertainty over Transneft's dividend policy is one of the key risks to Transneft's shareholders.
Investment Case: Too Many aIfsa
We initiate coverage of Transneft's preferred shares with a target price of $1,597/share, which implies downside potential of 7%. We assign a SELL rating to the stock. We believe that Transneft holds a high internal value which is constrained by its low level of transparency, poor corporate governance, uncertainty over privatisation and unclear dividend policy.
Target price calculation. We derive our target price for Transneft's preferred shares via two approaches: a dividend discount model (DDM) and a discounted cash flow model (DCF). The DDM valuation assumes two scenarios related to the company's dividend payout ratio (10% and 25% of IFRS net income). We use a DCF model to determine the theoretical target price of the ordinary shares (which are not publicly traded) and then calculate our target price for the preferred shares based on a fair discount.
Privatisation is a major driver. On 7 June 2012 the Russian government announced a new privatisation scheme. Under the plan, the state would reduce its stake in Transneft's charter capital to 75% + 1 share. We use this as our base assumption for valuing Transneft's shares. Given that the state aims to sell only 4.0% of the ordinary shares (3.1% of total shares), we believe that privatisation is aimed mainly at improving Russia's image, rather than generating budget revenues. On our estimates, if the state sells 4% of Transneft's ordinaries at RUB100,000/share (nearly a 100% premium to the current price of the prefs), revenues to the budget would reach only RUB22bn. We estimate that Transneft could easily pay this amount to the state in dividends for the ordinaries (100% state-owned) in 2013 out of company's FCFE of RUB71bn for that period. The suggested privatisation terms make the company less sensitive to the market environment and therefore less sensitive to the placement's timing when compared to the other companies on the privatisation list. At the same time, we think the amount of dividends paid to minorities is what really matters for preferred shareholders. We believe that the sale of such a small stake would not be interesting for investors unless Transneft commits to changing its dividend policy.
Shift in revenue drivers. In 2007-11 the major revenue driver for Transneft was increased tariffs, which were attributable to the specifics of tariff calculation for oil transport via the company's trunk pipelines. A key component of the tariff formula is the company's capex needs. In 2007-11, Transneft's capex CAGR was 9.4%, but we expect it to be -4.3% in 2011-20E due to the company's reduced need for new project financing. In this situation we expect the major revenue driver to switch to oil and oil product turnover growth. According to the state's General Scheme of Oil Industry Development in Russia to 2020 (released in 2010), oil production should increase to 527mnt in 2020 vs 511mnt in 2011 (CAGR = 0.3%). Meanwhile, the production of light oil products (gasoline, jet fuel and diesel) should increase to 175mnt in the period, up from 115mnt in 2011 (CAGR = 4.8%) due to ongoing major refinery upgrades. This should secure growth in oil product turnover for Transneft. On our estimates the share of revenue from oil product transportation in total revenue should increase from 4.6% in 2011 to 8.3% in 2020. Our forecast implies an 8.8% CAGR in 2012-20E for revenue from oil product transport vs total revenue expansion of only 2.1% in the same period.
Shift in cash flows. We expect a major shift in Transneft's financial condition in 2012: the company should generate positive free cash flow to the firm (FCFF) for the first time since 2005 due to reduced capex and stable operating cash flows. This year should signal a major shift in the company's cash flow structure. ESPO, Transneft's most expensive investment project, should be completed by YE12 and capex this year should register a decline of 33% YoY. Revenue depends on oil and oil product turnover and tariffs, which are rather constant, while management's efforts directed at lowering the cost of purchased supplies, productivity improvements, energy efficiency, etc., should allow the company to improve its profitability. Lower capex combined with stable operating cash flows and moderate debt repayments imply
higher free cash flows to equity (FCFE). We expect FCFF to remain positive in our forecast period (2012-20E), and Transneft should enjoy high free cash flows to equity (FCFE), creating the opportunity to pay higher dividends.
Dividend policy is key to shares' valuation. On our estimates, starting from 2013 Transneft should be able to generate significant FCFE, enabling it to potentially pay higher dividends. Total FCFE in 2012-20E could reach RUB485bn, while a 25% dividend payout ratio would require only RUB417bn for both the ordinary and the preferred shares. However, the company's ability to pay higher dividends does not necessarily translate into the government's willingness to do so, in our view.
How to extract spare cash from a state-owned company: Option 1. Current government oil industry policy is aimed at stimulating production growth in order to secure stable budget revenues and encouraging refinery upgrades to improve fuel quality. Transneft's ability to generate high FCFE could be exploited to support oil companies, in our view (for example, by reducing oil transportation tariffs). Capital expenditures are an important component of the tariff formula, so any decline in Transneft's capex could result in lower transportation tariffs.
How to extract spare cash from a state-owned company: Option 2. Another approach could involve the introduction of a special tax. In June 2010, the Ministry of Finance suggested cancelling the zero property tax benefit for natural monopolies (such as Gazprom, Transneft, and Russian Railroads) and introducing rates of 1.1% from 2012 and 2.2% from 2013. According to Transneft's estimates, this measure would cost it RUB27bn in 2013, RUB33bn in 2014, and RUB35bn in 2015. While the government did not approve the ministry's proposal, it could potentially return to the table in the future.
From risks to triggers. Our low valuation of Transneft's preferred shares reflects risks related not to the company itself, but to its main shareholder, the state. Transneft's dividend policy is determined solely by the government, which alone will determine if higher dividends should be paid to the preferred shareholders. Another key risk is the possible cancellation of privatisation of the ordinary shares; privatisation has been a major driver for the stock over the last two years. The elimination of these risks could change our valuation assumptions and our target price. The company has attempted to improve its transparency and corporate governance over the last two years (aimed at supporting privatisation on attractive terms for minority investors), and if this trend continues we may need to review our investment case.
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For further Information please contact: Aton OOO (LLC),
27 Pokrovka str., bld.6, 105062 Moscow, Russia
phone: (495) 777-66-77, (495) 228-38-99
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|Publication:||Russian Banks and Brokers Reports|
|Date:||Aug 23, 2012|
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