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Aton - TRANSPORT INFRASTRUCTURE: Bridge Over Troubled Water - Mar 23, 2010.

Coverage initiated: Russian bridge builders. In this report we launch our coverage of Russia's bridge builders. With more than a dozen transport infrastructure construction stocks listed in Russia, investors are presented with a somewhat perplexing choice. Thus, with this in mind, we commence our coverage by focussing on the companies primed to benefit from some of the following value-accretive themes: exposure to politically-backed high profile projects; geographic diversification across Russia; improved corporate governance and transparency; and strong growth potential.

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Huge planned state spending - the first point of call: In 2008 the government adopted a series of development programmes which assumed more than $2trn in state investments into the transport infrastructure sector over 2010-30. This included $830bn to be invested into highway infrastructure. While the economic downturn has pulled the wind out the state's sails with regards to its spending capacity, we argue that the state cannot ignore the degree of the modernisation works required and investors therefore cannot overlook the potential growth opportunities in the turnaround.

Mostotrest - the Olympics play: On top of being Russia's biggest bridge builder with 5.5% market share, Mostotrest's order book includes several projects which we deem politically too important to suffer from major cutbacks, such as preparation works for the 2014 Winter Olympics in Sochi. In addition, we believe that the company's strong financial profile, with the industry's highest 9M09 EBITDA margin of almost 20% (coming on the back of 30% YoY revenues growth) completes a robust investment case for Mostotrest.

Dalmostostroy - a big fish in a growing pond: We consider Dalmostostroy to offer the best exposure to Russia's Far East region as the company is engaged in the overhaul of Vladivostok's infrastructure in the run up to the 2012 APEC summit - another politically sensitive project. Also, we note that Dalmostostroy's leading role in the region, holding 40% market share in 2008, could make it a potential target for consolidation.

Bamtonnelstroy - tunnelling for victory: Russia's largest tunnel construction company Bamtonnelstroy holds an order book of $2.1bn spanning the next five years. The company's key project is the construction of a huge tunnel system which is a fundamental part of the Sochi Olympics preparations. Moreover, Bamtonnelstroy stands out from its peers for having a fixed dividend payout ratio of 10% on its preferred shares, with a current dividend yield of 11%, on our estimates.

Mostootrjad 19 - down, but far from out: We view Mostootrjad 19 as the best investment tool for gaining exposure to the St Petersburg authorities' plans to invest $8.3bn in transport infrastructure projects over the next three years. Additionally, we believe that the stock's sluggish performance in 2009 (-23%) is not an accurate reflection of the company's 4Q09 financials, which we expect to surprise on the upside once Mostootrjad 19 releases its FY09 financial report (due in Apr 2010).

Impulse - getting it right from the start: In this report we also draw investors' attention to Impulse, a young blossoming player in Russia's bridge building sector. We highlight Impulse as it is showing signs of potential to become Russia's first infrastructure construction company with high corporate governance standards and decent financial transparency. Added to this is impressive growth in financials (revenues up 47% YoY in dollar terms in 2009) and a $120mn contract to construct a bridge in Vladivostok.

Investment summary

With this report we commence our coverage of Russia's transport infrastructure construction companies. We have chosen to launch our analysis with coverage of Mostotrest, Dalmostostroy, Bamtonnelstroy and Mostootrjad 19, to which we assign BUY ratings, as we argue that these companies are best positioned to take advantage of the overhaul of Russia's transport infrastructure system. Specifically, these companies' operations are focussed on bridge and tunnel construction projects. Furthermore, in this report we also present a case for Impulse, a relatively new addition to Russia's infrastructure construction peer group, whose holding company plans to launch a private placement by offering a new share issue in 2010.

Road infrastructure sector outlook

Sector overview: Bridging the infrastructure gap

Given that the export of natural resources is the lifeblood of Russia's economy, it would be natural to assume that Russia has an advanced transportation network to facilitate deliveries of the country's production. On a similar note, Russia also offers the shortest route between the EU and Asian countries. It takes up to 30 days to deliver goods by sea from Asia to Europe while Russia's Trans-Siberian railway can halve the delivery time to 12-15 days. However, as we outline in this report, decades of underinvestment into Russia's road network, the final link between goods and their final destination, has left the country's road system trailing those of both developed and emerging economies.

This has naturally had a detrimental impact on the Russian economy. Figure 5 below, which presents an international comparison of various countries' road densities relative to their populations and size, should give investors an idea of the huge catch-up work that Russia has to embark on (although any readers who have experienced Russian roads more than 100km from Moscow will already be all too painfully familiar with the dire state of affairs). Nevertheless, we argue that the state has grasped the urgency of the problem and is willing and able to outlay substantial investment so that Russia's transport industry can begin to approach its vast potential. We therefore anticipate an enormous improvement in Russia's road infrastructure over the coming years on the back of accelerating state spending. However, given the extent of the modernisation works required and the long investment horizon implied by the state's spending plans, we have tailored our stock selection process to identify companies which we believe can capture the greatest benefits from increased government expenditure within the shortest timeframe.

Too bad to get worse: Lack of infrastructure arrests economic growth

According to Russia's Ministry of Transport, around 62% of Russian federal highways do not comply with safety, technical or environmental criteria, while approximately 13% of bridges need to be completely replaced. In 2007, then president and current Prime Minister Vladimir Putin lambasted Russia's transport problems, emphasising that economic losses stemming from the poor state of Russia's transport infrastructure average $30bn a year. Figure 5 underscores the degree to which Russia's road infrastructure lags those of international peers. For example, in terms of road network density, Russia holds 46.1km of paved roads per 1,000 km2, which looks alarmingly low when compared to 187.2km in China, 557.7km in India and 459.5km in Canada. In fact, the density of Russia's existing road network is more on par with that of Ethiopia (38.6km) and Burkina Faso (46.3km). At the same time, we note that auto transport has remained the second largest method for shipping goods in Russia over the past decade (excluding pipelines, in terms of tonnekilometres). However, Figure 6 exemplifies the scarcity of road infrastructure in Russia, showing how in 2008 the share of cargo transported by automobile (in terms of volume relative to distance) was just 9% vs more than 40% in the US, Germany and France. Furthermore, we argue that this situation means that Russia's auto transportation industry remains heavily underdeveloped. We thus reiterate our view that the underdevelopment of Russia's road transportation network is the product of significant underinvestment over the past decade, during which Russia's spending on highway infrastructure has averaged a mere 1% of GDP. This is four times lower than expenditure in the EU and six times lower than in China over the same period. The huge growth potential for Russia's transport infrastructure industry would therefore appear obvious. However, as we discuss below, the prospect of this growth being achieved hinges almost entirely on whether the state injects sufficient financing.

Too good to be true: The state's spending to be scaled back

Over the past 10 years approximately 90% of all projects in Russia's transport infrastructure construction industry have been financed either by federal or regional budgets. During 2008, Russia's Transport Ministry proposed several ambitious modernisation programmes for Russia's transportation network. These projects include aThe Development of Russia's Transport Network over 2010-15a (approved by the government in May 2008), aThe Development of Russia's Railway Transport Through to 2030a (approved in June 2008) and finally aThe Transport Strategy of Russia until 2030a (approved in Nov 2008). These three programmes combined imply more than $2trn in state investments into the sector over 2010-30 (excluding spending on overlapping projects). Of course these proposed spending levels were drawn up before the crisis, in a vastly more favourable climate of higher oil prices, greater availability of credit, and stronger economic growth. Though the state has yet to provide revised forecasts for its spending plans, for the sake of our models we have produced adjusted projections, shown in Figure 8 below. For 2009, we estimate that the state's spending on highway infrastructure fell by around 55% to $7bn. Going forward, we assume that investment into the sector does not return to the 2007-08 levels of $17-19bn until 2015. On the upside, we note that although spending was massively cut in money terms, we nevertheless expect physical volumes, i.e. kilometres of roads constructed, number of bridges put into operation etc, to see a less pronounced decline. We believe this would largely be due to lower construction materials prices, i.e. cement, structured steel, concrete, and others, which have fallen 40% on average from their 2008 peaks due to the slowdown in the construction industry. As a result, we estimate that at least 900km of new federal highways will be constructed in 2010, or an 11% decrease on 2009 (this sharply contrasts with an approximate 55% estimated drop in dollar terms). Nevertheless, the 1,010km increase in Russia's federal highway network in 2009 expanded the overall network length by an unexciting 1.8 ppts, while China's highway system grew by about 6% YoY in 2009, or by 6,756km according to the Transport Unified Development Association (TUDA).

Stock selection

In light of the massive influence of federal and regional budgets (as well as state-owned companies such as Russian Railways) on transport infrastructure spending, having financed around 90% of all projects over the past decade, the uncertainty over the extent of the pullback in state spending complicates the stock selection process. With this in mind, we shift our focus away from plans to overhaul the entire sector and instead concentrate on companies undertaking projects which we feel are either politically too important to be cancelled, or where state spending has already been earmarked for the next three years. This second approach also, in our view, brings the sector within a tighter investment horizon, in the context of state programmes with extremely distant 2030 end dates.

Too political to fail: APEC 2012 summit and the 2014 Sochi Winter Olympics

We have therefore singled out Vladivostok and Sochi, located at opposite ends of the country, as likely focal points for investment in the short-to-medium terms.

APEC 2012. Located in Russia's Far East region, Vladivostok is due to host the Asia-Pacific Economic Cooperation (APEC) summit in 2012. Established in 1989, APEC is a forum of 21 Pacific Rim countries which cooperate on regional trade and investment with the objective of enhancing economic growth and prosperity in the region. APEC estimates that its members account for approximately 40% of the world's population, around 54% of global GDP, and about 44% of world trade. In estimating the costs of hosting the 2012 summit, the Russian government has downsized its first projection of spending of around RUB382bn ($14bn). Later, at the end of 2008, the government estimated expenditure of RUB284bn ($10.2bn), including RUB202bn ($7.3bn) earmarked by the federal budget, necessary to carry out essential infrastructure improvements in the region. These include upgrade works on the sewage system, roads, bridges, and water pipes as well as the construction of a huge conference centre to host the summit. Among the major transport infrastructure projects due to be undertaken in the region, we highlight the building of a 3,150 metre suspension bridge from Vladivostok to Russky Island (the location of the planned conference centre).

A contract worth RUB17.9bn ($600mn) to build this bridge, which crosses the Golden Horn Bay, was won in June 2008 by Pacific Ocean Bridge Company. Additionally, also in the region USK MOST is undertaking a second major bridge project which crosses the Eastern Bosphorus to Russky Island. President Dmitry Medvedev approved this project and the awarding of the contract to USK MOST as general contractor in Aug 2008. The contract was valued at RUB32.2bn ($1.1bn) by 2012. Separately, we note that the economic downturn has naturally raised concerns that the state would be unable to complete these huge redevelopment projects in time for the summit and so would host the event in St Petersburg instead. However, we stress that Putin has strongly emphasised the importance of hosting the event in Vladivostok as currently planned. For our part, we see little logic in hosting an APEC summit in the European part of Russia.

Stocks to watch: We believe that at least two listed companies, Dalmostostroy and Bamtonnelstroy, should benefit from the planned turnaround in Vladivostok's transport infrastructure. We also highlight ISK Impulse which we expect to capitalise on bridge construction activity in the region. Please refer to the company sections of this report for further discussion.

XXII Winter Olympic Games to be held in Sochi 2014. In Mar 2009, Deputy Prime Minister Dmitry Kozak said that costs to construct the necessary sporting facilities and other infrastructure would be around RUB218bn ($7.2bn). On top of this, the state plans to build a highway and railway between Adler and Krasnaya Polyana (connecting the regional airport with the ski resort) which could cost a further RUB242bn ($8.1bn), pushing the total construction costs up to $15.3bn. This figure exceeds even the state's initial strategy approved in 2006, which envisaged spending of RUB313.9bn ($11.2bn), including RUB185.8bn ($6.6bn) of federal budget funds. Though these are, admittedly, large sums amid a weak economic climate, we stress that much of the infrastructure planned to be built is necessary in order to comply with the International Olympic Committee's standards. This incentive, we feel, improves the likelihood of the projects actually coming to light. Nevertheless, we reiterate that the standout project of the planned transport infrastructure construction programmes in the region is a parallel highway and railway between Adler and Krasnaya Polyana. This road is intended to extend 49km and include six railway tunnels, three automobile tunnels and three service tunnels, with a total length of 27,412km. All in all, the new highway should give home to 28 bridges, 59 car overpasses, and three new train stations. The combined road from Adler to Alpika-Servis (Krasnaya Polyana) should be finished by 3Q11. As noted above the state, the project's chief financer, has estimated the total cost of constructing the Adler-Krasnaya Polyana highway at RUB242bn ($8.1bn). USK MOST and Bamtonnelstroy are engaged in the construction process.

Stocks to watch: We believe that the likes of Bamtonnelstroy, Mostotrest, Inzhtransstroy Corporation and Transstroy Corporation should benefit the most from the transport infrastructure turnaround in Sochi as these companies have already won construction tenders in the region. Please refer to the company sections of this report for more information.

Industry risks

Like other small cap Russian stocks, the risks both to company performance and minority shareholders for the names covered in this report are substantial. We have outlined the key threats here and attempted to reflect these risks in our company-specific risk premiums incorporated into our WACC calculations.

Mediocre transparency and poor corporate governance

We believe that by far the most significant risk to minority shareholders in Russia's transport infrastructure industry is poor transparency. Sector companies do not produce financial statements on a consolidated basis or in accordance with IFRS. Shareholder structures are also often highly complex. Furthermore, very few companies have a code of corporate governance and even fewer have established departments to communicate with investors and shareholders. That said, we have observed improvements in the industry. For example, Mostotrest plans to prepare IFRS-based financial reports from 2010 while Bamtonnelstroy has started publishing its quarterly reports under RAS.

Inefficient procedures for state tenders

The requirements for companies to participate in state tenders for construction projects are rather lax. This can therefore result in a company with a poor track record or insufficient capacity winning a contract simply by offering a hefty discount to the tender's starting price. Often this company then, due to a lack of capacity, hires subcontractors (usually other participants from the tender) to complete the project, placing heavy pressure on the other companies' margins. Nevertheless, we believe that the dilapidated state of Russia's transport infrastructure and the massive volume of funds which the government intends to invest in the sector are likely to be strong incentives for the state to gradually improve the procedures for its tenders.

Low stock liquidity

Low share liquidity is another strain on sector stocks. The combined average daily turnover for Mostotrest, Dalmostostroy, Bamtonnelstroy and Mostootrjad 19 barely exceeds $1mn. Also, most sector companies have their shares listed on the RTS Board - Russia's OTC market.

Almost total dependence on state orders

The economic slowdown has raised the strong possibility of a slash in the state's colossal transport infrastructure spending plans, which were outlined prior to the crisis. In light of the government's fundamental role in financing the vast majority of sector projects, we have conservatively

modelled its spending on road infrastructure to be cut by 50% in 2010E, 60% in 2011E, 60% in 2012E and 60% in 2013E from the existing levels outlined in the current state programmes. These discounts are based on our subjective assumptions, which were derived from our analysis of the projects' construction material requirements, as well as the necessity to upgrade infrastructure in the particular regions involved.

Road infrastructure industry overview

The costs structure: Building a yellow-brick road

Road construction is an expensive business. In Figure 12 we present approximate estimates for the breakdown of the construction cost of one kilometre of two-lane road in order to provide readers with a rough idea of the construction costs in Russia. These calculations are based on data from the Moscow State Automobile and Road Technical University (MADI). Based on retail prices, we calculate that in Russia around $342,000 (excluding VAT) is needed to pay for baseline construction materials in order to build one kilometre of standard two-lane road with a speed limit of 80km/hr. Although spending on construction materials has historically been the largest cost component in road construction, Figure 14 shows how costs on average increase by 1.5x if a bridge, overpass or intersection is also built. Finally, apart from direct costs associated with road construction, the relocation of existing infrastructure such as residential buildings can also substantially increase the final bill. The chart below demonstrates how such costs can dramatically push up total expenditure. Overall, our estimates suggest that construction costs to build one kilometre of two-lane road in the city of Samara (a medium-sized city with a population of 1.1mn) would be around $1.7mn, while it would cost more than $45mn to construct the same road in Moscow. In light of these dramatic differences, we believe it is more appropriate to assess each project separately.

Industry structure: The state is the lifeblood

As mentioned, federal and regional budgets as well as spending by state-controlled companies like Russian Railways have financed more than 90% of road construction projects in Russia over the past decade, according to the Ministry of Transport. In developed countries this share has generally not topped 30-40%. This situation is, in our view, the product of the absence of effective legislation governing private ownership or operation of roads in Russia. Simply put, the lack of a law regulating public-private partnerships (PPPs) in Russia largely prevents local and international companies from investing in road infrastructure. As a result, the state is currently the only major source of financing for road development in the country.

Tender process. We note that in 2008 the state introduced a new law tightening the criteria for participating in state tenders for construction projects. For example, participating companies should have completed similar projects over the preceding five years with a cumulative value of at least 20% of the value of the current tender. Also, participants are required to make a deposit of 10-30% of the project's value if it exceeds RUB500mn ($16mn). The introduction of these rules was aimed at limiting the use of front companies and improving tender transparency. We note that prior to this law coming into force there were frequently instances of companies being created with the sole purpose of winning a tender at any cost, namely through dampening prices. Usually such front companies do not have sufficient expertise or capabilities to execute the actual work, leading to delays in the project actually materialising, costs overruns, and losses for subcontractors. Although inefficiencies in state tender processes remain, we believe that these are being gradually eliminated.

Financing process. The financing schedule usually incorporates an immediate advance payment of around 5-10% of the contract's value. However, according to our conversations with sector companies, state financing throughout the year can be irregular in its timing. This factor thus requires road builders to utilise their own funds as well as credit facilities to finance working capital.

Construction process. One of the most interesting features of the road construction process is that the general contractor usually subcontracts up to 30% of the contract. For example, this could include ground works where it is impractical to relocate the general contractor's own machinery or when the general contractor does not have sufficient expertise in certain areas, such as in sewage systems.

The market structure: Assessing the industry size

There are a vast number of extremely small companies operating in Russia's transport infrastructure industry, and so in order to quantify the market in terms of revenues we have prepared a sample of these companies. Using the SPARK-Interfax database, our main screening criteria were that the sample companies should have a licence to construct roads and bridges and 2008 RAS revenues should exceed RUB1bn ($33mn). We also note that our sample companies' aggregate revenues accounted for around 97% of the sector's total revenue in 2008. We note that since 100 out of the 150 companies selected are either closed joint stock companies or limited liability companies, the most recent year where there is available annual financial data for all of the companies is 2008. Our estimates indicate that the sample companies' revenues have grown at a CAGR of 50% since 2005 and reached $20.6bn in total revenues by 2008. This figure is consistent with the state's spending on road infrastructure in 2008 of $19.7bn. Our analysis suggests that Mostotrest is Russia's largest transport infrastructure construction company in revenue terms. Although the company's market share across Russia was just 5.5% in 2008, Mostotrest was the leading bridge builder in the Moscow region with a share of more than 17%, on our estimates. That said, we believe that the industry's high fragmentation creates an excellent potential backdrop for consolidation.

Industry structure developments: Potential consolidation in sight

Russia's transport infrastructure construction industry was marked by high M&A activity over 2005-08 as many sector companies fought to cement their market positions in anticipation of sharp growth in state spending. During that period, holding company RU-COM, together with other partners, acquired control in Novosibirskavtodor (2008 revenues of $91mn under RAS) and Dalmostostroy (2008 revenues of $188mn under RAS). RU-COM also combined with Russian Railroads to gain control over Mostotrest (2008 revenues of $1.2bn under RAS). In addition, Infrastructura (a Russian infrastructure construction company in which Roman Abramovich held an undisclosed stake until it was sold in 2009 to his business partner Valery Abramson, according to Kommersant) bought infrastructure construction assets from Sistema-HALS. The company has also recently completed the acquisition of Mosinzhstroy (2008 revenues of $1bn under RAS). Going forward, we expect the pace of M&A activity in the sector to resume after the credit crunch-induced slump in 2009. Specifically, we identify at least four groups of companies that we expect to be looking to strengthen their market positions: Mostotrest, Infrastructura, Transstroy Corporation and USK MOST. We expect these companies to expand through acquiring regional bridge builders and bridge construction materials producers. Also, potential mergers with satellite companies are very likely, in our view. We note, for example, that Mostotrest and Mostootrjad 19 are long-term partners who have cooperated on a number of projects in Moscow and St. Petersburg. Meanwhile, Dalmostostroy (controlled by one of Mostotrest's major shareholders) has officially accumulated 1% of the shares of Mostootrjad 19. As a further indicator of this possible trend, we note that Mostotrest acquired a 25% stake in Mostostroy-11 in early Mar 2010 (2008 revenues of $305mn under RAS), and is ramping up its transport infrastructure projects in Russia's Tyumen region.

Mostotrest

- We initiate coverage of Mostotrest with a BUY. Our DCF-model yields a 12-month fair value of $1,374 per common share, implying 63% upside potential.

- Russia's largest bridge buildera[bar]Mostotrest is Russia's largest listed transport infrastructure construction company in terms of revenues. Although the company's market share across Russia was just 5.5% in 2008, Mostotrest was the leading bridge builder in the Moscow region with market share in excess of 17%, according to our estimates.

- a[bar]with the potential to become even bigger. In Feb 2010, the company revealed that it had bought a 25% stake in Mostostroy-11. Although the deal price has not been disclosed, this stake could have been valued at $25mn, based on Mostostroy- 11's market price at the time. This acquisition reinforces our view that Mostotrest has a strong balance sheet and has the potential to become the consolidation centre for Russian bridge building assets.

- Strong and diversified order book...Headquartered in Moscow, Mostotrest has extended its operations across Russia. We estimate the company's order book at about $3bn, which we expect to secure a steady revenue flow over 2009-11. In addition to projects in Moscow and St Petersburg, which we estimate to account for about 47% of the company's current order book, Mostotrest is engaged in the reconstruction of the M-4 Don federal highway ($357mn), the construction of the Adler Ring in Sochi ($165mn), a road intersection on the M-27 Djugba-Sochi-Georgia federal highway ($100mn), a bridge project in Sochi ($60mn) and others.

- a[bar]on the back of a healthy financial profile. In mid-Nov 2009, Mostotrest released strong 3Q09 RAS financial results. The company posted an EBITDA margin of 19% on revenue of $307mn (+40% QoQ). At the same time, net income grew by 4.7x QoQ to $47mn. In rouble terms, Mostotrest's revenue was up 28% YoY. For 9M09, the EBITDA margin increased by 11 ppts YoY to 21%, while net income reached $108mn. We believe that the significant improvement in profitability was likely the result of the drop in raw materials prices. Based on 9M09 RAS financials, Mostotrest has become Russia's most profitable listed bridge builder by EBITDA margin.

- Improvement in transparency should support valuations. Mostotrest's board of directors' meeting in mid-Jan 2010 approved the company's transfer to IFRS and the hiring of KPMG to prepare the company's consolidated financials for 2008-09. We regard this as a positive step towards better company transparency, which should in turn support the company's stock performance.

Model assumptions

Revenue

We forecast Mostotrest's revenue using the company's existing order book. At the same time, for potential new company contracts over our forecast period we examined Russia's aTransport Strategy through to 2030a to identify projects where Mostotrest may participate. We then selected projects which align with Mostotrest's geographical focus, taking into consideration the company's track record in specific regions. Also, for the sake of conservatism, we discounted the state's spending on the selected projects listed in the government's investment programme by 50% in 2010E, 60% in 2011E, 60% in 2012E and 60% in 2013E. These discounts are based on our subjective assumptions, which were derived from our analysis of the projects' construction material requirements, as well as the degree of necessity to upgrade infrastructure in the particular regions involved. Thirdly, we weighted Mostotrest's revenue from potential contracts by a subjective probability of between 65% and 80%, based on our assumptions on the company's level of involvement in each project.

We then calculated our final estimate of the company's revenue flow over 2010-15E. We note that, during the above-described modelling process, apart from selecting projects from Mostotrest's home regions, i.e. where the company has a strong track record (Moscow, St Petersburg, and Rostov), we assumed that the company could bid for a number of infrastructure construction projects across Russia. To err on the downside, we weighted the company's possible revenues from such projects by a probability of 25-30%. Finally, in addition to construction projects, we model the proportion of revenues from maintenance services remaining relatively flat at 10-12% over our forecast period.

CoGS

Raw materials and labour costs have accounted for more than half of Mostotrest's expenses over the past five years. Going forward, we do not expect any significant changes in the company's CoGS structure. We estimate that structured steel, cement, concrete and gravel accounted for more than 67% of all raw materials consumed by the company over 2005-09. After the rally in raw materials prices in 2007, a significant correction took place in 2009 on the back of low demand from construction companies. The Builders Association of Russia has indicated that construction material prices started to tentatively creep up in Nov-Dec 2009, despite prices historically tending to weaken during this part of the year. According to the Moscow Stock Exchange, cement prices stabilised over Dec 2009 - Feb 2010 at $73-75 per tonne.

Given the dramatic fluctuations in road infrastructure construction costs and requirements for constructions materials from project to project, we estimated Mostotrest's expenditure on these cost components by tracking the company's average price paid for construction materials for the linear metre over the past five years. We then modelled this price to grow in line with our forecast CPI rate over 2010-15. As a result, we project Mostotrest's spending on construction materials growing at a CAGR of 12.0% over 2009-15. The second-biggest item in the company's cost structure is labour expenses. In 3Q09 the company's headcount was 14,690 employees. Going forward, we do not anticipate any significant changes in Mostotrest's number of personnel and hence model the average salary to grow in line with our CPI forecast plus 3 ppts (this adjustment is to reflect the higher cost of living in Moscow, where the company operates, compared with other Russian regions).

EBITDA

Over 2005-08 Mostotrest's full-year EBITDA margin fluctuated between 10-13%. However, in 2009 it jumped to 30% in 1Q09. It dropped back to 13% in 2Q09 and rose again to 24% in 3Q09. We largely attribute the wider EBITDA margins to the collapse in raw material prices. In addition, Mostotrest managed to curb SG&A growth to 19% YoY in 9M09, while revenues expanded 28% YoY over the same period. Although 2009 is likely to be exceptionally strong in terms of EBITDA margins for Mostotrest (we forecast a 22% margin vs 13% in 2008), we anticipate the company's profitability decreasing to 12% in 2010 on the back of a number of projects in Sochi and Moscow reaching their peak construction phases and thus demanding large-scale purchases of construction materials. Looking further ahead, we forecast Mostotrest's EBITDA margin recovering to 2009 levels only by 2013-14 thanks to improvements in construction technology and the final stages of transport infrastructure construction projects in Sochi, Rostov, Moscow and St Petersburg.

Net income

We apply a standard 20% corporate tax rate in our forecasts. We also assume no dividend payments as the company does not have a defined dividend policy and has not paid out dividends since 2005.

Balance sheet and cash flow statement

Mostotrest has a healthy balance sheet with a net debt/EBITDA ratio of 40% for 9M09. Although the company held around $200mn in short-term borrowings at the end of 3Q09 (87% of the total debt), we believe that this debt burden is manageable. Firstly, Mostotrest's cash position at this point was $130mn. Secondly, the state's requirement that construction companies deposit 10-30% of a project's value in order to participate in a tender means that bridge builders tend to hold a large portion of shortterm debt on their balance sheet. Mostotrest typically enters as many tenders as possible in order to improve its chances of winning and so must have sufficient funds on hand. Furthermore, given that a tender process can last for several months, bridge builders sometimes have to draw credit to support their liquidity positions. We also note that Mostotrest has relatively low capex requirements, which historically have not exceeded 5% of revenue. Since we do not model the company making any significant acquisitions during our forecast period, we assume that the company would be able to finance its capex through its own operating cash flow. We stress that this low level of investment does not generally result in problems with capacity deficits as bridge builders can usually easily locate subcontractors to complete projects. However, we estimate that this approach results in the company sacrificing 3- 5% of a project's gross margin.

Dalmostostroy

- We initiate coverage of Dalmostostroy with a BUY rating. Based on a DCF model we estimate a 12-month fair value of $183 per common share, implying 68% upside potential.

- Attractive exposure to Russia's Far Easta[bar]Headquartered in Khabarovsk, Dalmostostroy is the leading bridge construction company in Russia's Far East region. The company's revenue in 2008 was $188mn, with about 64% of this generated from the construction of railway bridges and 27% from road bridges. The company estimates that it held about 40% of the bridge construction market in Russia's Far East in 2008.

- a[bar]and the transport infrastructure turnaround for APEC 2012. Vladivostok is to host the Asia-Pacific Economic Cooperation summit in 2012. In 2008, the Russian state outlined spending of around RUB284bn ($10.2bn), including RUB202bn ($7.3bn) earmarked by the federal budget, to overhaul the region's infrastructure in preparation for the summit. Adding support to the state's plans, Prime Minister Vladimir Putin has specifically named state spending on APEC 2012 projects as a top priority and an area where cutbacks due to the economic climate should be limited. In Nov 2008, Dalmostostroy signed a subcontract to build a bridge over the Golden Horn Bay in Vladivostok. The company should receive about RUB7.2bn ($240mn) in revenues from this project until 2011. In addition, Dalmostostroy signed $180mn in new contracts in late 2009, increasing the company's overall order book to $680mn over 2010-12.

- Improvements in corporate governance a potential trigger...Dalmostostroy stands out among its sector peers for creating a corporate relations department in Dec 2008 in an attempt to improve its corporate governance. Also, the company reports quarterly financial results timely, while its annual reports run comprehensive analysis of the company's plans, including capex targets.

- a[bar]However, areas for improvement are aplenty. The company still has much to do on this front. For instance, after Dalmostostroy won the contract to construct a bridge over the Golden Horn Bay in Nov 2008, it was required under Russian law to make a buy-back offer to its shareholders as the contract's value exceeded the company's net asset value (NAV) at the time by more than 50%. The company set the buy-back price at RUB3,590 per share ($137 per share), or around 10% below the market price of $150 at the time. Also, in May 2009 Dalmostostroy announced plans to participate in a tender (which was later cancelled) to reconstruct a bridge over the Amur River in Khabarovsk. Given that the potential contract's value (RUB9.2bn, $306mn) exceeded the company's NAV, Dalmostostroy offered its minority shareholders a buy-back option. However, the price was set at RUB999.09 per share ($31 per share) while the market price was $85.

- A ticket to the Far East. We believe that Dalmostostroy could be viewed as a tempting acquisition target for consolidation and exposure to Russia's Far East projects. The company could ultimately end up in Mostotrest's orbit, in our view.

Model assumptions

Revenue

We used Dalmostostroy's current order book, which amounts to $650mn, to estimate the company's revenues over the next three years. For later years, in a similar approach to our forecasts for Mostotrest, we assessed which construction projects incorporated into the government's aTransport Strategy through to 2030a could involve Dalmostostroy. Again, for the sake of conservatism, we reduced the state's spending on the selected projects by 50% in 2010E, 60% in 2011E, 60% in 2012E and 60% in 2013E. Furthermore, in determining our revenue estimates, we weighted Dalmostostroy's possible revenues from these potential additional contracts by a certain subjective probability (50-70%). As a result, we forecast Dalmostostroy's total revenues to grow at a CAGR of 7.5% over our forecast period and reach $240mn by 2015.

CoGS

The company's CoGS structure is similar to Mostotrest's, with the exception of services, which we estimate constituted 12% of Dalmostostroy's CoGS in 2009 vs 6% for Mostotrest. This difference is, in our view, due to Dalmostostroy's relatively small size compared with Mostotrest (the latter's revenues were 6x higher in 2008). Nevertheless, given that bridge construction is both companies' primary activity, we believe that our assumptions regarding Mostotrest's raw materials costs can be applied to Dalmostostroy. As for labour costs, we forecast Dalmostostroy's average salary to grow in line with our CPI forecast.

EBITDA

Dalmostostroy's EBITDA margin has remained relatively flat in recent years, hovering around 13% over 2005-07. Although the 2008 EBITDA margin contracted to just 8% (likely impacted by the surge in construction materials prices) we expect that based on the company's strong 9M09 results, Dalmostostroy should produce an EBITDA margin of at least 10% in 2009. Going forward, we conservatively project Dalmostostroy's EBITDA margin to be largely unchanged over the next few years and forecast an improvement only in 2013.

Net income

We have modelled a standard 20% corporate tax rate. We also assume that Dalmostostroy pays no dividends over our forecast period taking into consideration that the company does not have a formal dividend policy. That said, the last time it did pay dividends was 2006 when the company distributed $1.2mn, or 20% of its RAS net income.

Balance sheet and cash flow statement

Dalmostostroy is free of debt issues, in our view, with a net debt/equity ratio of 0.2x at the end of 3Q09. That said, like its sector peer Mostotrest, Dalmostostroy also has a large portion of short-term borrowings which are used as for deposits during construction tenders. Nevertheless, going forward we expect that Dalmostostroy would be able to finance its capex through its own operating cash flow, provided that it does not launch any largescale M&A deals.

Bamtonnelstroy

- We initiate coverage of Bamtonnelstroy with a BUY. Our DCF-model yields a 12- month fair value of $4,884 per common share, suggesting 44% upside potential. Based on a DDM-model, we estimate a fair value for Bamtonnelstroy's preferred stock of $1,449 per share, or 78% upside potential.

- Russia's largest tunnel construction company...Bamtonnelstroy is Russia's largest tunnel construction company with a current order book of around $2.1bn spanning the next five years. The company faces limited competition in Russia given that it is one of the few companies to hold tunnel heading equipment capable of constructing railroad tunnels up to 13 meters in diameter.

- a[bar]undertaking construction projects in Sochi. Bamtonnelstroy is engaged in the construction of a tunnel system along the Adler-Krasnaya Polyana highway, which is being built in the run up to the Sochi Winter Olympics. We believe that President Medvedev's visit to Bamtonnelstroy's construction sites in Sochi underscores the company's importance as one of Russia's leading construction players.

- Improvement in transparency should support valuations. In 2009 Bamtonnelstroy broke with tradition by publishing its 9M09 RAS financial report. Prior to this release, there was almost a total absence of information on the company's financial profile. We view this development as a sign that Bamtonnelstroy is striving to improve its transparency and corporate governance, which could lend substantial support to the company's stock performance.

- A healthy financial profile. Over the past five years Bamtonnelstroy has maintained its position as one of Russia's most profitable infrastructure construction companies. Its 9M09 EBITDA margin of 20% was second only to Mostotrest's 23%. And while Mostotrest has only recently improved its profitability (historically its EBITDA margin had not previously exceeded 13%), Bamtonnelstroy's average margin over the past three years has stood at 23%.

- A compelling case for preferred dividends. Bamtonnelstroy's preferred shares bear a fixed payout ratio of 10%. We estimate the current dividend yield at 11%.

- Exposure to a large infrastructure construction company. We believe that Bamtonnelstroy could be viewed as an investment tool for gaining indirect exposure to SK MOST, one of Russia's largest infrastructure construction companies, given that SK MOST owns 87% of Bamtonnelstroy. We estimate that SK MOST's 2008 consolidated revenue surpassed $1.3bn. Although there is little evidence of a potential consolidation of Bamtonnelstroy, we argue that such a move would support the company's valuations, on the reasoning that if Bamtonnelstroy became part of a larger company, it could receive additional orders from SK MOST

Model assumptions

Revenue

We used Bamtonnelstroy's current order book as a basis for estimating the company's revenue flow over the next five years. As discussed, the shining light in Bamtonnelstroy's order book is the construction of a huge tunnel system in the Sochi region.

CoGS

The company's CoGS structure differs from a pure bridge builder's due to the higher share of DD&A, which we estimate at 6% for Bamtonnelstroy. The higher proportion of DD&A is the result of the use of more complex and expensive equipment such as roadheaders and tunnel excavators employed in tunnel construction. Nevertheless, the two biggest items in the company's CoGS remain raw materials costs and labour expenses. We have modelled raw materials costs moving in line with our estimates outlined earlier in this report. For labour costs we forecast the company's average salary rising in line with our CPI forecast, adjusted upward by 2 ppts. We have made this adjustment in order to reflect the fact that tunnel construction requires a larger share of highly qualified engineers, designers and machinery operators.

EBITDA

As stated above, Bamtonnelstroy has remained one of Russia's most profitable transport infrastructure construction companies over the past three years. Going forwards we forecast Bamtonnelstroy's EBITDA margin to remain within a range of 19-26%.

Net income

We keep the company's corporate tax rate constant at 20% in our forecasts. With regards to dividends, Bamtonnelstroy's policy states that it pay out 10% of its RAS net income as preferred dividends, which we have incorporated into our model.

Balance sheet and cash flow statement

Bamtonnelstroy has a generally solid balance sheet with a net debt/equity ratio of 0.5x for 9M09. As a result, we believe the company should be able to finance its future capex through its own operating cash flow.

Mostootrjad 19

- We initiate coverage of Mostootrjad 19 with a BUY. Our 12-month fair value of $2,841 per common share is based on a DCF model and suggests 56% potential upside.

- St. Petersburg infrastructure projects to drive financials. In 2009 St. Petersburg's authorities announced plans to spend around $8.3bn on transport infrastructure in the region over 2010-12. Headquartered in the city, and with local market share of 33%, Mostootrjad 19 is in our view on course to take advantage of the authorities' massive spending plans.

- Signed contracts should secure revenues of at least $200mn over the next three years...We estimate that Mostootrjad 19's current order book would supply the company with at least $200mn in annual revenues over 2010-12. The key revenue generators include the construction of several parts of the Western High Speed Diameter (WHSD), a major ring road project in St. Petersburg, and a roof for Zenit Football Club's new stadium.

- a[bar]while new orders have the potential to build up annual revenues to $450mn by 2012E. We believe that Mostootrjad 19 has the potential to assume additional contracts on the WHSD as well as projects connected with the reconstruction of the M-9 Baltics, M-10 Scandinavia, M-11 Narva, and M-20 St Petersburg-Belarus federal highways. In total, we estimate that these projects could add up to $1bn to the company's current order book. Moreover, the company's management has spoken of its plans to participate in construction tenders in Sochi worth around $500mn.

- From hero to zeroa[bar]Mostootrjad 19's 2009 financial performance was poor: for 9M09 under RAS revenues fell by 70% YoY to $95mn and net income collapsed almost 90% YoY to $11mn. As a result, the company's stock price lost 23% in 2009, which looks a fair reflection of the financials, in our view.

- a[bar]and back again! Nonetheless, we argue that Mostootrjad 19's financial profile should recover significantly in 2010 as we are expecting EBITDA of $28mn on revenues of $374mn. Furthermore, we stress that 9M09 financials can be misleading as sector companies often receive payments for contracts in the final quarter of the year.

- Another potential candidate for consolidation. We believe that large Russian infrastructure construction names may look upon Mostootrjad 19 as offering attractive exposure to St. Petersburg's transport infrastructure projects. Mostootrjad 19's first key advantages are that it is a privately held company with no visible affiliation to any powerhouses, and it is focused primarily on the St. Petersburg region. Secondly, the company has cooperated closely with Mostotrest on projects in Moscow and St. Petersburg. We therefore propose that, in theory, if Mostootrjad 19 were consolidated into Mostotrest, shareholders of both companies should benefit through gaining exposure to one of the most lucrative groups of construction markets in Russia - Moscow, St. Petersburg and Sochi.

Model assumptions

Revenue

Our revenue forecast is primarily based on Mostootrjad 19's existing order book. In addition, we have pinpointed certain projects listed in the Russian government's aTransport Strategy through to 2030a in an attempt to identify potential infrastructure construction projects where Mostootrjad 19 could participate over 2012-15. As discussed above, we have discounted the state's proposed spending on the selected projects in order to take into account the impact of the economic downturn. We have also weighted Mostootrjad 19's estimated revenues from these potential contracts by probabilities with a range of 65-75% to arrive at our final estimate of the company's revenue flow over 2010-15E.

CoGS

The company's CoGS structure shares many similarities with that of Mostotrest; raw materials and labour are the principal cost items. We forecast the company's spending on raw materials to grow at a CAGR of 12.3% over our forecast period. As for labour costs, we model the company's average salary growing in line with our CPI forecast.

EBITDA

Mostootrjad 19 posted an EBITDA margin of 8% for both 2008 and 2009. We expect the company to maintain a margin of approximately this level going forward.

Net income

We assume a standard 20% corporate tax rate in our forecasts. In terms of dividends, we have modelled a payout ratio of 10% over our forecast period. Although the company's lack of a formal dividend policy raises certain doubts over the visibility of future dividends, we note that Mostootrjad 19 has over the past four years paid out in the region of 8-60% of its annual RAS net income.

Balance sheet and cash flow statement

Based on 9M09 figures Mostootrjad 19's balance sheet looks fairly strong to us with a net cash position of $20mn. Our estimates imply that the company's operating cash flow should be sufficient to cover its capex needs over our forecast period.

Impulse

- The star latecomer among Russia's bridge builders. In this section we present Impulse, a Moscow based infrastructure construction company. Though Impulse is not listed, the company's 100% owner, Anwick Holding, plans offer up to 1,000 new shares in 2010 (20% post-money) to raise capital to finance Impulse's further development. According to Impulse, it intends to expand its operations via organic growth and value-accretive acquisitions of other businesses and assets with a primary focus on infrastructure construction in Russia.

- A solid platform for growth...Impulse has a healthy financial profile and solid growth prospects, in our view. At YE09, the company's net debt/EBITDA and net debt/equity ratios were 0.9x and 0.3x, respectively. In 2009, revenues increased by 47% in dollar terms to $35mn, with the net margin improving from negative territory to 2%. Based on its existing confirmed order book, we expect Impulse's revenues to grow by 2.5x YoY to $100mn in 2010E.

- a[bar]thanks to a strong order book. Impulse's order book already holds signed contracts amounting to $170mn over 2010-11. Approximately $120mn of this amount is associated with a bridge construction project in Vladivostok in preparation for the APEC Summit in 2012 (construction started in 1Q10). Additionally, Impulse has $30mn in signed contracts for 2010 for a variety of construction and engineering projects in Moscow and St Petersburg. Furthermore, the company plans to participate in a number of construction tenders during 2010 which could potentially add up to $180mn in new contracts to its order book over the next two-to-three years.

- Transparent exposure to Russian infrastructure. We believe Impulse has the potential to become Russia's first infrastructure construction company with a high corporate governance profile and decent financial transparency. Anwick Holding has said it is committed to issuing annual financial statements under IFRS (starting for 2009, due in Apr 2010) and following a declared policy of protection for minority shareholders.

- Construction specialists with a solid track record. Over 60% of Impulse's top management have a military engineering background and have overseen the construction of many large-scale and complex infrastructure projects. The company's General Director Alexander Kripak was previously head of the Russian Naval Service's construction wing. We believe that the previous experience of the company's management has resulted in a strong emphasis on efficiency and high quality in Impulse's operations.

Company overview

Established in 2008, Impulse is a junior infrastructure construction company 100% owned by Cyprus' Anwick Holding. In Jan 2010 Impulse took a huge stride forward in expanding its operations by signing a RUB3.6bn ($120mn) subcontractor's deal to build a section of the De Friz to Sedanka bridge in Vladivostok. This new bridge forms a part of a state programme to turn around Vladivostok's transport infrastructure in the run up to the APEC summit in 2012. The company expects to complete the construction process by Oct 2011. Besides the above-mentioned contract, Impulse holds around $50mn in signed orders to construct numerous infrastructure objects in the Moscow region, St Petersburg, Penza and Tyumen. On top of this, we believe the company could add up to an additional $120mn to its order book this year. Among key projects where we expect the company may succeed in the tender process include the construction of infrastructure for a floating nuclear power plant in the Kamchatka region. We estimate that this project could generate up to $90mn in revenues for the company over the next two years.

Financial profile

We regard Impulse as having a strong financial profile. In 2009 RAS revenues were up by around 50% in dollar terms underpinning, in our view, the company's growth potential. Furthermore, we argue that the company's net debt/EBITDA and net debt/equity ratios of 0.9x and 0.3x at YE09, respectively, illustrate Impulse's robust liquidity position.

Corporate governance

Unlike many of its Russian peers, Impulse has an established IR department providing a high level of disclosure on the company's finances and operations to the group's shareholders. Anwick Holding, which controls Impulse, issues monthly management accounts and yearly consolidated financial reports under IFRS. Moreover, encouragingly, minority shareholder protection mechanisms have been put in place, including veto rights related to significant strategic, operational and financial matters.

Indicative valuation

Based on a comparison of international bridge builders' valuations (see Figure 84 below), we estimate an indicative value for Impulse of $55-105mn. In calculating our indicative valuation for the company, we first assessed the recent IPO of India's infrastructure construction company Man Infraconstruction. We took this approach as we feel that Man Infraconstruction could be used as a proxy in valuing Impulse, given that the Russian company is seeking to launch an IPO. The example of Man Infraconstruction may, therefore, provide readers with an understanding of the market's perception of companies from this sector.

Man Infraconstruction is a Mumbai-based construction company that offers construction services for port, residential, industrial, commercial, and road infrastructure projects. Based on the company's IPO materials, its current order book is $445mn. In 2009, Man Infraconstruction's revenues were up 126% YoY to $122mn, while its EBITDA increased 145% YoY to $31.3mn. On 11 Mar, Man Infraconstruction placed 5,625,150 shares during an IPO where the book was oversubscribed by more than 60x. The deal price was fixed at INR252 per share ($5.6), valuing the whole company at around $277mn. Based on market consensus estimates, Man Infraconstruction was priced at 13.5x 2010E earnings and 12.7x 2011E earnings.

Aton OOO (LLC)

27 Pokrovka str., bld.6, 105062

Moscow

Russia

(495) 777-66-77

(495) 228-38-99

aton-line@aton-line.ru

www.aton.ru
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Publication:Russian Banks and Brokers Reports
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Date:Mar 23, 2010
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