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Uralsib - Russia Equity Research - MRSKs - Key Link in the Electricity-Supply Chain; Tariff reform unlocks shareholder value - Feb 10, 2010.


Tariff reform unlocks shareholder value

Investment case becomes clearer. We reinstate coverage of Russian distribution companies to take account of the substantial improvements from the introduction of the new tariff system and the appearance of reliable IFRS financial data. The distribution segment makes up a significant portion of the Russian utilities sector, generating approximately 40% of total revenues from lowvoltage electricity distribution across Russia. A number of regional distribution companies (MRSKs) and their controlling shareholder MRSK Holding have become an important part of the Russian stock market over the last six months, with improving liquidly.

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Neutral to positive sector outlook. We have Buy recommendations and the following DCF-derived target prices on distribution companies: MOESK (MSRS) $0.076/share, Lenenergo (LSNG) $1.22/share, Lenenergo preferred shares (LSNGP) $1.13/share, MRSK Center and Volga (MRKP) $0.0127/share, MRSK Center (MRKC) $0.054/share, MRSK South (MRKY) $0.0092/share, MRSK Siberia (MRKS) $0.0142/share, MRSK Ural (MRKU) $0.016/share, MRSK Holding $0.22/share for ordinary shares and $0.152/share for preferred shares; Speculative Buy MRSK North-Caucasus (MRKK) $16.96/share; Hold MRSK Volga (MRKV) $0.0044/share, MRSK North-West (MRKZ) $0.0053/share.


Profits to improve on back of new tariff system. The return on RAB is to increase from 6% to 12% over a three year period.

The RAB tariff is the main driver. Transition to the new RAB tariff system is unlocking shareholder value.

Tariff reform to continue in 2010. The approved energy-saving law stipulates total long-term tariff regulations starting from 2011.


Approved numbers may differ from expectations. RAB expectations do not match the finally approved figures for 2010.

Valuation risks during potential consolidation. The final consolidation scheme remains unknown, raising some risks.

Everything for investment. Distribution companies' dividend policies remain unclear.


Upside on EV/EBITDA and DCF. The sector is highly undervalued both on 2010E EV/EBITDA and on DCF.


Profitability to improve in the next three-five years. The key parameter of distribution companies' profitability is the yield on RAB. The specifics of the approved regulation parameters is that yields for the first year of regulation will be 6%, increasing to 9% in the second year and 12% in the third year. As a result, distribution companies will have respective sales and EBITDA CAGRs of 13% and 15% in 2010-13. We see this operating profit growth as a core value driver for the distribution companies. In addition, all additional investments will bring companies a 12% yield. We expect the sector's EBITDA margin to increase from 15% in 2010 to 20% in 2013 and then to stabilize.

RAB tariffs instead of cost-plus tariffs are the main driver

RAB - a long-term solution for the network. Transition to a new regulation system based on returns on RAB should allow distribution companies to attract long-term loans to finance utility-sector investment projects. Under the RAB regulation system, return on capex for distribution companies will become more predictable, increasing shareholders' value.

Cost-plus system not economically viable. Following the collapse of the Soviet Union, Russia was left with excess electricity distribution capacity as the industrial-military complex was shrinking, and electricity consumption with it. As there was no need to build new capacity, the government set distribution tariffs on a cost-plus basis, which only allowed distributors to cover their costs and basic maintenance needs, and left them with few or no funds to invest in capacity modernization or expansion.

Cost-plus method not economically viable for several reasons:

- Tariffs are set once per year based on the previous year's cost performance. The tariff is set to cover the previous year's costs and provide limited amounts of additional funds to keep the company profitable. Under this system, distributors have little incentive to cut costs or improve efficiency; as to do so would mean being saddled with a lower tariff the following year.

- As the government provides no funding for investment in the distribution sector, tariffs are the only effective mechanism through which funds can be raised. The cost-plus method is woefully inadequate in this respect. Furthermore, even if the government were to agree to raise tariffs to help distribution companies finance capex, cost-plus tariffs would not necessarily give the companies sufficient incentive to undertake investment projects with the highest NPV, and would not promote the most effective execution of these projects.

- Cost-plus tariffs provide no motivation for distribution companies to upgrade their assets and switch to more efficient equipment, as they have no incentive to reduce operating costs. This factor has depressed demand for new equipment, removing a substantial number of potential orders for Russia's power equipment producers, and caused the distributors to fall behind international peers in terms of technology.

New pricing system to promote cost-cutting and generate funds. The disadvantages of the cost-plus tariff system have become more evident with the development of the Russian economy, and ongoing reform in the electricity sector. The new assetbased pricing system is designed to encourage cost-cutting and to generate sufficient funds to cover companies' investment programs. New tariffs will be set to provide a guaranteed level of return in relation to a company's stipulated RAB. The value of the asset base will be determined according to the valuation methodology, which is based mainly on the depreciated replacement cost of its assets, although the individual characteristics of the distributor's local region are also taken into consideration.

Providing an incentive for long-term planning

Moving away from one-year tariff horizon ... The previous one-year tariff horizon of the cost-plus system significantly limited distributors' planning abilities. Under the new RAB-pricing system, tariffs will no longer be set annually.

a[bar] will facilitate long-term investment planning. Greater tariff predictability will allow companies to plan long-term investment better, as they will have a clearer idea of how implementation of new projects will impact future tariffs. RAB tariffs will provide management with an incentive to choose efficient investment projects to boost profitability. Moreover, all capex spent on expanding and upgrading distribution capacity is guaranteed to be covered by the resulting higher future electricity distribution tariffs calculated under the RAB principle.

Opening access to debt financing

Sector leverage currently very low. Russia's electricity companies are significantly underleveraged compared to both emerging- and developed-market peers. During the Soviet era, all sector investment was funded from the federal budget. Until recently, investment projects in the sector were few and far between, meaning that companies had no need to raise debt. Russian distributors currently have average debt/equity of 0.36 and debt/EBITDA of 2, well below the respective averages of 1.03 and 5.3 for developed market peers.

Debt to become important financing source. The RAB-based tariff system is more transparent, as distribution companies will have a clear understanding of how the tariffs will be set for several years ahead; this stands in stark contrast to the outgoing cost-plus system, under which tariffs were revised each year somewhat unpredictably. With the introduction of RAB pricing, companies will, for the first time, be able to develop long-term strategies and construct elaborate financial models. This will lower distributors' credit risk and make any debt they issue more attractive to investors. We, therefore, believe that debt will become a viable future source of funding with which distributors may finance investment.

Economically efficient behavior. Another major advantage of RAB pricing over cost-plus is that RAB pricing increases the incentive for distribution companies to cut costs and raise efficiency. The new tariffs will be dictated by the value of the companies' assets. This will encourage the companies to expand and improve the quality of their asset bases, which will result in higher revenues. In addition, as the tariffs will not depend on costs, it should also encourage cost-cutting, as any reduction in costs would directly boost the companies' profits.

All major costs could be rationalized. The distribution companies' major costs consist of D&A, salaries, transmission fees, electricity losses, and maintenance and repairs. Under the cost-plus tariff system, the companies tended to increase their costs out of proportion to receive higher tariffs the following year. This led to widespread inefficiency, and we thus regard potential cost reductions as a strong driver for revaluation of the electricity distribution sector in the medium term, as distributors will have a golden opportunity to increase profitability significantly.

Additional nine regions from 1 January 2010

Eight regions switched to RAB in 2009. Implementation of the new tariff system started in 2009, when pilot projects for the RAB regulation system were chosen for MRSK Center (TverEnergo, LipetskEnergo and BelgorodEnergo); MRSK Center and Volga (TulaEnergo and RyazanEnergo); MRSK Ural (PermEnergo); MRSK South (AstrakhanEnergo and RostovEnergo). Unfortunately, we do not have separate management accounting data for MRSKs' RAB-based regions, although companies that had partially switched to RAB enjoyed 15% EBITDA margins in 9M09 against just 13% for those operating under the cost-plus system.

Some delays were expected in early 2009 As a result of the economic slowdown and changes in MRSK Holding's management, the process of transition to a new regulation system slowed down somewhat in 1H09. Investors expected the transition to RAB to be postponed, as distribution companies missed the application deadline. Initially, MRSKs were supposed to apply for the new tariff system by 1 May 2009 in order to make the transition by 1 January 2010.

Process accelerated in 2H09 The FTS approved a special regulation in September 2009 that allowed distribution companies to apply for the new tariff system as late as 1 November 2009. The boards of directors of all distribution companies have instructed management to make every effort to switch to the new system this year.

Result of 2009 effort. Starting from 1 January, nine additional regions were switched to RAB: MRSK North-West (NovgorodEnergo); MRSK Siberia (GornoAltaiskie Grids, OmskEnergo and TomskEnergo); MRSK Center (KurskEnergo and YarEnergo); MRSK Center and Volga (VladimirEnergo, KalugaEnergo and UdmurtEnergo). The approved RAB figures differ from initial expectations as shown in the table. As a result of the RAB introduction, the distribution tariff in the regions may increase from 20 to 30% YoY in 2010.For the remaining companies that did not switch to RAB; we expect YoY distribution tariff growth to be in line with the inflation estimate of 9% YoY in 2010.

Tariff reform to continue in 2010

Governmental energy-saving initiatives supporting sector. In November 2009, President Dmitry Medvedev signed a law regulating energy saving and energy efficiency in Russia. According to the law, all distribution companies that were formed during UES restructuring are to be subject to long-term tariff regulation starting from 1 January 2011, and possibly including a switch to RAB. We see the approval of the energy efficiency law as a strong supportive factor for distribution companies, and expect the process of new tariff system adoption to continue in the regions this year.

Unlimited tariff growth unlikely. We expect the majority of distribution companies to complete their transition to the RAB regulation system this year. The main reason for the potential delays in the introduction of RAB is the very strong growth of distribution tariffs, which may reach 30-40%. To mitigate such high tariff growth, regulators may introduce a special methodology that will cap the annual tariff growth rate and postpone excess returns.


Approved numbers may differ from expectations. We have already witnessed several cases when the approved RAB did not match the expected numbers. For example the RAB for Lipetsk region, Yaroslavl region and Tomsk regions was approved at levels that below MRSK Holding's previous guidance by 17%, 31% and 21% respectively. However at the same time approved RAB for Kursk region Novgorod region and Kaluga region was above the initial guidance by 17%, 28 and 42% respectively. This means that until a final decision is made by the energy commission for a certain region, the estimates from MRSK Holding can be considered only as an indication of the potential RAB.

Distributors to be valued at initial RAB/fixed assets of 1.8-3.0. As an additional source of RAB valuation MRSK Holding (MRKH - Not Rated) CEO Nikolai Shvets announced in October 2009 that that the initial RAB/fixed asset ratios will be in a 1.8- 3.0 range. We view this news as positive for the sector, as it confirms guidance of RAB that was earlier disclosed by MRSK Holding. Even based on the low-end multiple, MRSKs' RAB will total $20.8 bln, which is close to initial $19.0 bln estimate.

The majority of regions will remain cost-plus regulated in 2010. With some obvious progress in the introduction of RAB, the number of regions that adopted a new tariff system has reached 17, which is only 25% of the 67 regions within the MRSK universe. The issue is complicated by the fact that each region has its own regional energy commission, whose approval is necessary. The energy commissions report to the local governments, which are influenced by concerns about tariff growth for industrial consumers and the population.

Potential asset consolidation raises valuation risks

Consolidation of MRSK holding and its subsidiaries. Sector leaders, including Deputy PM Igor Sechin, Energy Minister Sergei Shmatko, and MRSK Holding CEO Nikolai Shvets, last summer announced their support for the consolidation of MRSK Holding and its subsidiaries to increase the reliability of the distribution network and bolster MRSK Holding's operating cashflows; its cashflows currently come from tiny subsidiaries' dividend payments and user charges from MRSKs. There are several scenarios that may be realized, as MRSK Holding may gain operating control over certain MRSKs' distribution businesses: this would be the easiest way to consolidate Tyumenenergo as a 100% subsidiary, although full consolidation of all MRSKs is also a possibility. In addition, late last year, some regional media cited statements made by FGC's management on the potential consolidation of FGC and MRSKs.

Government stake in consolidated company should not fall below controlling. In the event of full-scale consolidation of MRSK Holding, the government will have to work closely with minority shareholders in regional MRSKs and MRSK Holding itself to maintain its controlling stake in the fully consolidated company. The largest minority stake in MRSK Holding belongs to Gazprom Energo Holding (11%), while the largest minority shareholders in MRSKs are Gazprom, SUEK, LUKOIL, IES holding, and other portfolio investors in the Russian utilities sector.

Not optimal structure for efficient management. If MRSK Holding is consolidated on a full-scale basis, the consolidated company will be extremely large, with branches in the majority of regions in European Russia, the Urals, and Siberia. The efficiency of the operating management may consequently drop as a result of the complicated decision-making procedures. In order to make the management structure efficient, we expect a sophisticated IT platform and management solution to be integrated, which may require additional time and capex.

Privatization of MRSKs an alternative scenario. In the course of UES's restructuring, privatization of the regional distribution companies was considered as an option for long-term sector development. Prior to the privatization of the distribution companies, management contracts may be tendered to private companies to attract experienced management. We see the privatization scenario as very unlikely under the current centralization trends that have been noted among sector leaders (and have been noticed in other industrial sectors too).

Everything for investments

Capex expectedly huge and uncertain. According to MRSK Holding's guidance, total capex should reach $7 bln over the next 2 years. Such large capex programs will leave little cash for minority shareholders in the medium term, as all of the companies' profits will be reinvested in new-asset construction. Additionally, some distribution companies' investment programs are currently under review, which increases uncertainty. On the positive side, with the introduction of the RAB tariff, all capex will generate post-tax yields of 12%, which is likely to be attractive for investment if the Russian investment case continues to develop.

Underinvested segment. Russian distribution networks have been facing significant investment shortages since the collapse of the Soviet Union. The main reason for low investment in the sector was the huge spare capacity that emerged as a result of the drop in electricity consumption in 1991-2000. The second reason was government attempts to keep electricity tariffs at their lowest possible levels, resulting in a lack of operating cashflow to finance capex.

Sharp capacity deficit in 2006-08. As a result of low investment in the electricity distribution networks and demand for new connections to the network, only part of the connection applications was satisfied. In order to meet the challenge of the new connections, companies were allowed to charge so-called connection fees. The connection fee was to cover the cost of constructing the additional distribution capacity required for new connections to the network.


RAB in 2011. We base our target prices on DCF models with an assumption that RAB tariffs will be approved for all distribution companies starting from 1 January 2011. RAB estimates are based on the relevant indications from MRSK Holding.

Return on capital. Yields on RAB will be at 6%, 9% and, 12% for the first three years, inline with the regulations approved by local energy commissions, plus 12% for all additional RAB that will be built as a result of capex-program implementation.

Capped tariff growth. The main thing limiting full-scale RAB tariff implementation is rapid growth in distribution tariffs in some regions. To reflect this, we have limited expected tariff growth for distribution companies in 2010-2012 to a maximum of 25- 30% in our models.

WACC. The WACC in our models varies from 14% to 16%, and varies due to MRSKs' different stages of progress in adopting new tariff systems.


Asset-based valuations. Russian distribution companies are trading at an average EV/RAB of 0.44 (from 0.18 to 0.98). International peers that work on a similar RAB concept are trading at an average of 1.4 (from 1.1 to 1.8). We see Russian utilities as undervalued, although this discount is partly justified by uncertainty over the final parameters of RAB for the majority of distribution companies.

Financial multiples Russian distribution companies are undervalued under 2010E EV/EBITDA and overvalued on 2010E P/E. In addition to rising RAB yields in 2010E, 2011E, and 2012E, we expect them to see strong operating cashflow growth, unlike their international peers, which have more moderate growth prospects.

DCF valuation. Our DCF models suggest average upside of almost 40% in the distribution sector. We have Buy recommendations on the following distribution companies: MOESK (MSRS) $0.076/share, Lenenergo (LSNG) $1.22/share, Lenenergo preferred shares (LSNGP) $1.13/share, MRSK Center and Volga (MRKP) $0.0127/share, MRSK Center (MRKC) $0.054/share, MRSK South (MRKY) $0.0092/share, MRSK Siberia (MRKS) $0.0142/share, MRSK Ural (MRKU) $0.016/share, MRSK Holding $0.22/share for ordinary shares and $0.152/share for preferred shares; Speculative Buy MRSK North-Caucasus (MRKK) $16.96/share; Hold MRSK Volga (MRKV) $0.0044/share, MRSK North-West (MRKZ) $0.0053/share.


Growth potential, but consolidation risks remain. Moscow Unified Electricity Company (MOESK; MSRS - Buy) services Moscow city and the Moscow region, which is Russia's leading regions in terms of wealth, pace of economic development, and growth in electricity demand. We reinstate coverage of MOESK with a target price of $0.076/share - which implies 61% upside to the current price - and a Buy recommendation. However, we highlight the risks associated with the company's further consolidation with Moscow's municipal distribution assets, which is controlled by the Moscow government. We expect consolidation of the assets to take place in 2010, and considering the uncertainty over the valuation of the distribution assets, the deal could be quite risky for MOESK's minority shareholders.

Only Moscow region under coverage. MOESK operates only in the Moscow city and region. The total area covered by the company is close to 47,000 sq km, one of the smallest in the sector. The company supplies electricity to 17 mln people, which is almost 12% of Russia's population.

Strong GRP growth pushes electricity consumption. Moscow city and region is one of the leaders in terms of electricity-consumption growth. Before the crisis, demand for electricity in the region rose at a 2000-08 CAGR of 4.4% versus 2.3% for the country overall; the major factor behind the changes was the significant growth in GRP (2000-07 CAGR of 9.3% for Moscow region versus 6.9% for the entire country). The effect of the crisis has been quite moderate, as electricity consumption in Moscow region dropped just 2%YoY in 2009 versus 4.6%YoY in 2009 for the country as a whole. We expect Moscow region to retain its leading position in electricity-consumption growth.

Local consumers can afford tariff hikes. The average personal income of $911/month (2007 figure) in the Moscow region is the highest of all MRSK regions. It indicates that consumers in the region can still afford to pay for electricity and distribution.

Forthcoming consolidation may add some uncertainty. The process of consolidating Moscow area distribution grids consisted of two stages: the first stage, which has been completed, was distribution assets in Moscow city and region being consolidated into a single entity now called MOESK. However, the second stage - the consolidation of MOESK and Moscow distribution assets controlled by Moscow authorities - is still in the pipeline. The main question regarding consolidation is the valuation of distribution assets, which has not yet been disclosed.

Moscow city government seeking blocking stake. The company's core shareholders are MRSK Holding (50.9%) and Gazprom (26.7%). The Moscow city government owns 7.6%, and if the consolidation of MOESK and Moscow distribution assets goes ahead, it will probably raise it to 25%.

Premium under EV/RAB. MOESK trades at EV/RAB of 0.51, implying a 17% premium to the domestic peer average of 0.44.


Exposure to rapidly growing region. We reinstate coverage of Lenenergo with a 12-month target price of $1.22/share, which implies 28% upside to the current market price of $0.95/share, and assign a Buy recommendation. We also have a target price of $1.13/preferred share, implying 43% upside, and a Buy recommendation. The company serves the Leningrad region, which is second only to Moscow in terms of prosperity and electricity demand. Recovery of the Russian economy will push industry output and residential construction higher. Meanwhile, the region is a leader in terms of salary growth commercial/industrial profitability, meaning that local consumers are in apposition to absorb potential tariff hikes. On the risk side, the company still operates under the cost-plus tariff system, and the timing of the final switch to RAB is still unclear.

Promising region. Lenenergo is an electricity distribution company operating in two regions (St. Petersburg and the Leningrad region) in Northwest Russia, with a total area of 87,000 sq km and supplying electricity to 6.2 mln people. St Petersburg is the second-largest city in Russia. The area has become an important center for Russia's car industry, while residential construction is among the most active in the country.

Local government has blocking stake. The company's core shareholders are MRSK Holding (50.3%) and the St Petersburg government, which received a 25.2% blocking stake via the company's additional share issue in 2008. On the risk side, the government being a shareholder might result in moderate tariff growth, as the local authorities may be interested in capping tariff growth to ease the situation for local industry.

In line with domestic peers. The company is trading at an EV/RAB of 0.43, which is close to its domestic peers at 0.44 EV/RAB.


Clear leader with 60% of electricity distribution covered under RAB in 2010. We reinstate coverage on MRSK Center with a 12-month target price of $0.054/share, implying 103% upside to the current market price. We have assigned a Buy recommendation for the stock. MRSK Center leads the way in the transition to the RAB tariff system, with five regions (making up 60% of the company's total electricity distribution) already operating under the new tariff system. The timing of the switch to RAB is a key factor in the valuation of distribution companies. Additionally, the blocking stake in the company is divided among several private investors, which will likely protect the interests of minorities during the potential consolidation of MRSK into a single entity.

Strong position on the local market. MRSK Center operates in 11 regions in central Russia, covering a total area of 458,000 sq km and supplying electricity to 13.7 mln people - 9.6% of the country's population. The company has a monopoly on the distribution of electricity in the Kostroma, Belgorod and Smolensk regions. MRSK Center also controls more than 70% of electricity supplies in the Yaroslavl, Tver, Tambov, Orel, Lipetsk, Kursk, Voronezh and Bryansk regions. The company's share of the electricity distribution market in these regions is around 85%.

Minority interests are likely to be protected. We view the company's shareholder structure as quite favorable for minorities, considering that a 30% stake is divided among several major private investors. This is likely to protect minority interests in the event of the company's assets being consolidated. Before the consolidation, all MRSKs must undergo a valuation. Given that the blocking stake is owned by several major shareholders, we believe there is only a moderate risk of the company receiving a poor valuation, as this could lead to the deal being blocked.

Undervaluation unjustified. Based on a sector specific multiple, MRSK Center looks very attractive, trading at an EV/RAB of 0.32, which implies a 26% discount to its domestic peers.

MRSK CENTER AND VOLGA Transition to RAB halfway complete

Among the leaders in the transition to RAB. We reinstate coverage on MRSK Center and Volga with a 12-month target price of $0.0127/share, implying 79% upside to the current market price. We have assigned a Buy recommendation on the stock. MRSK Center and Volga are among the leaders in the transition to the new tariff system, which is a key factor for the valuation of distribution companies. Since 1 January 2010, the company has five regions operating under the RAB tariff system, which is almost 50% of the total electricity distributed by the company. This accelerated transition to RAB implies a higher target EV/RAB valuation, as a result of the stronger growth in the company's operating cash flow and lower WACC, to account for lower risks associated with the initial RAB valuation.

Strategic location in central Russia. MRSK Center and Volga operates across nine regions in the central part of European Russia, and along the River Volga. This area spans 409,000 sq km and has a population of 13.3 mln people - 9.4% of Russia's total. This area encompasses Vladimir, Ivanovo, Kaluga, Kirov, Nizhniy Novgorod, Ryazan and Tula, as well as the republics of Marii El and Udmurtiya.

Shareholder structure. The company's core shareholder is MRSK Holding, which owns a 50.4% stake. In addition, more than 22% of the company is controlled by EnergoSouz and Jamica Limited (companies also present in MRSK Center's shareholder structure). Although these companies' stakes are less than 25%, we expect them to play an active role in potential consolidation of the sector and protection of minority interests.

In line with domestic peers. Based on a sector specific multiple, the company looks quite attractive, trading with an EV/RAB of 0.45, which is in line with its domestic peers.


35% downside but Hold recommendation. We reinitiate coverage of MRSK North-West with a 12-month target price of $0.0053/share, implying 35% downside to the current market price of $0.008/share. We have assigned a Hold recommendation to the stock. We note the rather low valuation of the company's initial RAB - the lowest valuation among MRSKs - and believe this initial RAB could be revalued, which will clearly have a positive impact on the company's valuation.

Strong position on local market. MRSK North-West operates in seven regions of northwestern Russia (excluding St Petersburg and the Leningrad region), spanning 1.6 mln sq km (9% of total Russia's land area) and supplying electricity to 6.3 mln people, or 4% the country's population. The company operates 100% of grid connections in the Pskov, Murmansk and Komi regions; more than 70% of grid connections in the Arkhangelsk, Vologda and Karelia regions; and more than 50% of the grid connections in the Novgorod region.

Only 8% of the company's operations will come under RAB in 2010. At the end of 2009, the FTS approved a switch to the RAB tariff system for only one region operated by MRSK North-West - NovgorodEnergo. Following the transition to RAB, the regional entity's distribution tariff will rise with a CAGR of 23% in 2010-2012. Despite strong growth in the regional tariff, the overall impact will be fairly moderate, as NovgorodEnergo's electricity output makes up only 8% of MRSK North-West's total electricity output.

Lowest initial RAB valuation. Based on initial RAB/fixed assets multiple, MRSK North-West is the most undervalued, with a valuation of 0.9, compared to domestic peers, which trade at an average of 1.9. Based on this, we expect the company's initial RAB to be revalued upwards.

Shareholder structure. MRSK Holding has a 55.4% stake in the company, while 6.2% is held by Mellon Bank. The remaining 38.4% is divided among several other shareholders.

Highly overvalued on EV/RAB. Based on a sector-specific multiple, the company is also quite expensive, trading at an EV/RAB of 0.98, implying a 123% premium to domestic peers.

MRSK SOUTH Close to 2014 Olympic Games

58% upside and Buy recommendation. We reinitiate coverage of MRSK South with a 12-month target price of $0.0092/share, implying 58% upside to the current market price of $0.0058/share. We have assigned a Buy recommendation for the stock. In 2010, more than 50% of the company's electricity output will fall under the RAB tariff system, which is a key factor for the valuation of distribution companies. On the risk side, we believe the potential merger with KubanEnergo (KUBE - Not Rated) (which was blocked in 2008) poses a dilution risk to the company's minorities.

Southern part of Russia, excluding the Krasnodar region. MRSK South operates in four regions in the southern part of Russia (Rostov, Astrakhan, Volgograd and Kalmikiya) covering 423,000 sq km and supplying electricity to 13.7 mln people - 9.6% of the country's total population. Unfortunately, the company does not operate in the Krasnodar region (the site for the 2014 winter Olympic Games), despite the fact that this region is close by.

Unresolved issues with KubanEnergo may lead to some uncertainty. When MRSK South was established through the merger of several regional distribution companies, KubanEnergo (operating in the Krasnodar region) was supposed to be consolidated with it. However, in 2008 the consolidation was blocked by Neft-Activ, a Rosneft subsidiary. As a result, the controlling stake in KubanEnergo was inherited by MRSK Holding, and it did not become part of MRSK South. Uncertainty over its switch to RAB has left KubanEnergo in a precarious position, considering the ambitious investment program required for the 2014 winter Olympic Games. Projects will be financed in part by KubanEnergo placing additional shares in favor of MRSK Holding in 2010. However, we do not expect this to fully solve the company's problems. We believe that KubanEnergo will switch to RAB in the next one-two years and will be finally merged with MRSK South. In that case, the potential consolidation might add some uncertainty in terms of the companies' valuation.

Shareholder structure. MRSK Holding has a 52.7% stake in MRSK South, while a blocking stake (26.6%) is divided between Renaissance Securities and Management Consulting. We believe Management Consulting is affiliated with LUKOIL, which is very active in Southern Russia (LUKOIL owns TGK-8 - a key player in the region's heating and electricity market.)

Discount to domestic peers. On a sector specific multiple (EV/RAB), MRSK South trades at 0.29, which implies 34% discount to domestic peers' average (0.44).


The dark horse of the sector

Higher upside on the back of higher risks. We reinstate coverage of MRSK North-Caucasus with a 12-month target price of $17/share, implying 186% upside to the current market price of $5.93/share. We have assigned a Speculative Buy recommendation for the stock. Based on the preliminary valuation of the company's initial RAB, the company's shares may become the best buy in the distribution universe. Currently, the company is trading at an EV/RAB of 0.18, which implies an incredible 60% discount to domestic peers. Additionally, the transition to RAB at the announced parameters will see a rapid growth in the company's operating cashflow. On the risk side, we believe it is possible that the initial RAB could be revised. Additionally, the timing of the full switch to RAB is still unclear and may take place later than other MRSKs. Another potential problem is that end customers in the region do not have good payment discipline, and if there is a significant increase in tariffs, it may only lead to an increase in the company's receivables.

One of the smallest MRSKs. MRSK North-Caucasus operates in eight regions in the North Caucasus region of Russia, covering 170,000 sq km and supplying electricity to 9.1 mln people, or 6.4% of the country's total population. In terms of the company's installed transformer capacity, grid length and electricity output, it is one the more modest MRSKs.

A lot of uncertainty over the switch to RAB. The North Caucasus is known for the poor payment discipline of end consumer. One reason for this is low personal incomes (based on 2007 data, the average monthly income in the region was around $220 - the lowest figure among regions where MRSKs operate). This has a double-edged effect, as almost 28% of the electricity in the region is consumed by the residential users. The needs to modernize electricity grids in the region - coupled with the switch to RAB - will likely push tariffs higher. This may lead to a further deterioration of payment discipline and an increase in the company's receivables. Given these factors, the regional authorities may intervene in the company's transition to RAB or cap the company's tariff growth. Currently, the company does not have a single region operating under the RAB tariff system.

Highest initial RAB valuation only adds to uncertainty. MRSK North-Caucasus has the highest initial RAB/fixed assets ratio in the sector at almost 4.3, compared to 1.9 for its domestic peers. This valuation implies a higher downside risk to the company's valuation, as it could potentially be downgraded.

Shareholder structure. MRSK Holding makes up 58.3% of the company's shareholder structure, while 41.7% is divided among minority shareholders.

Incredible discount under EV/RAB. Based on an EV/RAB multiple, the company trades at 0.18, which implies an incredible 60% discount to its domestic peers at 0.44.

MRSK VOLGA The center of Russia's car industry

3% upside and Hold recommendation. We reinstate coverage of MRSK Volga with a 12-month target price of $0.0044/share, implying 3% upside to the current market price. We have assigned a Hold recommendation to the stock. On the risk side, not one of the regions where the company operates is covered under the RAB tariff system, which may hurt financials in 2010. In addition, the low average personal incomes of the region and the difficult situation at AvtoVAZ and its associated companies (a key industry in the region) may lead authorities to cap the company's tariff growth or postpone the full transition to RAB.

The Volga region is center of the Russian car industry. MRSK Volga operates in seven regions (Chuvashiya, Mordovia, Ulyanovsk, Penza, Samara, Saratov and Orenburg) in Russia's Volga region, covering 403,000 sq km and supplying electricity to 12.7 mln people, which is equal to 8.9% of the country's population. The region is at the heart of the Russian car industry and the future dynamics of electricity consumption will depend on development of this industry in general, and AvtoVAZ in particular.

Tariff growth could be capped. Currently, MRSK Volga does not have a single region operating under the new tariff system. In the company's transition to RAB, we see a risk that tariffs may be capped by the government. Almost 50% and 15% of electricity in region, respectively, is consumed by industry (AVTOVAZ represents a significant part of this sector) and the population. The average monthly income in the region is one of the lowest in Russia at $300, compared to the national average of $430.

Premium to domestic peers. On a sector specific multiple (EV/RAB), the company trades at 0.49, which implies a 12% premium to domestic peers.

MRSK URALS Exposure to industry growth

73% upside and Buy recommendation. We reinstate coverage of MRSK Ural with a 12-month target price of $0.0159/share, implying 73% upside to the current market price of $0.0092/share. We have assigned a Buy recommendation for the stock. We view MRSK Ural as a strong distribution company, ideal for gaining exposure to the ongoing economic recovery, as it operates in the Urals region - the center of the Russian metals industry. On the negative side, we note that only 23% of the company's electricity output will come under the RAB tariff system in 2010.

Center of Russian industry. MRSK Ural operates in three regions in the central part of Russia around the Urals Mountains, covering a total area of 525,000 sq km and supplying electricity to 12.9 mln people - 9.1% of the country's total population. In terms of electricity output, the company controls more than 59% of the distribution market in the Perm region, 84% in the Sverdlovsk region and 78% in the Chelyabinsk region. These regions are home to major Russian industries like metallurgy.

Only one region to use RAB in 2010. Only one regional distribution entity (located in the Perm region and making up 23% of the company's total output) was switched to RAB at the end of 2009. This will help MRSK Ural absorb higher costs from growth in tariffs from the Federal Grid Company.

In line with domestic peers under EV/RAB. Based on a sector specific multiple, the company trades at an EV/RAB of 0.42, which almost in line with domestic peers.


Still about oil

At the heart of Russia's oil industry. TyumenEnergo operates in the Tyumen region of Russia, covering a total area of 1.5 mln sq km and supplying electricity to 3.4 mln people - equal to 2.4% of the country's total population. The region is the heart of the Russian oil and gas industry, which accounts for 64% and 91% of Russia's oil and gas production, respectively. Accordingly, oil and gas companies make up almost 80% of total electricity consumption in the Tyumen region. Considering that the population accounts for another 8%, electricity consumption in the region is very stable. In 2009, while Russia saw a 4.6% YoY decrease in consumption, the Tyumen region posted almost zero declines.

First candidate for consolidation. With MRSK Holding owning 100% of TyumenEnergo's shareholder capital, we believe TyumenEnergo will be one of the first companies to be involved in any consolidation of the distribution sector.


39% upside with a Buy recommendation. We reinstate coverage of MRSK Siberia with a 12-month target price of $0.014/share, implying 39% upside to the current market price of $0.01/share. We have assigned a Buy recommendation on the stock. In terms of potential triggers for the name, we highlight the potential sale of a minority stakes in the company by SUEK and Norilsk Nickel, which also own generation assets in the region. Regarding risks, we note that only 10% of the company operates under RAB in 2010. Additionally, we expect the company to post a net loss of $74 mln in 2010, mainly as a result of a surge in costs due to higher tariffs from the Federal Grid Company.

One of the largest MRSKs. MRSK Siberia operates in the Altai, Buryatiya, Krasnoyarsk, Chita, Omsk and Kemerovo regions as well as Khakasiya, covering 2.2 mln sq km (one of the largest areas covered by distribution companies) and supplies electricity to 14.4 mln people. The company also manages distribution grids in the Tomsk and Tiva regions that have not been consolidated into a single company. MRSK Siberia also has one of the longest grids, largest electricity distribution volumes, and the largest transformer capacity of Russian distributors.

Only two regions under RAB in 2010. Only two regional distribution entities (accounting for 10% of the company's total output) had switched to RAB at the end of 2009. This switch, however, will help minimize the negative impact of higher tariffs from Federal Grid Company (we expect these tariffs to account for 37% of the company's total costs). Despite this, we forecast the company to post a net loss of $74 mln in 2010.

Shareholder structure. With a 52.9% stake, MRSK Holding is the company's controlling shareholder. SUEK (28.1%) and Norilsk Nickel (8.2%) are minority shareholders in MRSK Siberia. Both companies own other electricity generation assets in the region (SUEK owns Kuzbassenergo and TGK-13; while Norilsk Nickel owns OGK-3 along with Gusinoozerskaya GRES and Kharanorskaya GRES, which are located in the Baikal region). Ownership of these stakes in MRSK Siberia is prohibited under Russian law (as they were received through reorganization of UES and the consolidation of MRSK Siberia; according to the law they have to sell those distribution or generation assets by 2011), thus we believe it is likely that SUEK and Norilsk Nickel will sell these stakes - a move that would become another trigger in the name. The timing of this potential deal is still unclear, however.

Discount to domestic peers. Based on a sector specific multiple, MRSK Siberia also looks quite attractive trading at an EV/RAB of 0.35, which implies a 21% discount to domestic peers of 0.44.


Potential center of sector consolidation

Hedge against sector risks. We reinitiate our coverage of MRSK Holding with a 12-month target price of $0.218/common shares and $0.152/preferred shares. We have assigned a Buy recommendation for both shares. We view MRSK Holding as one of the best choices in the sector. Its shares are the most liquid in the electricity distribution universe, and its current market capitalization might allow the holding to join the MSCI Index. In addition, MRSK Holding is the sector hedge against any shift in the general transition to the RAB tariff system or any limitations on tariff growth in certain regions. We expect MRSK Holding to be at the center of the potential consolidation of the distribution sector.

Controlling stakes in all MRSKs. MRSK Holding's core assets are its controlling stakes in 11 interregional distribution companies (MRSKs), including 100% in TyumenEnergo, controlling stakes in five other distribution companies and seven electricity retail companies.

Under state control. The company's core shareholders are the Russian federal government (55%) and Gazprom (11%), with the latter being a key player in the Russian utilities market.

URALSIB Capital, 8, Efremova St, Moscow, Russia,119048,


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Publication:Russian Banks and Brokers Reports
Article Type:Company overview
Geographic Code:4EXRU
Date:Feb 10, 2010
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