Utilities in the Political Spotlight

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The shares of the Russian Utilities sector in April have significantly outperformed the entire Russian stock market and the World's indices. The MICEX Power index, which captures the performance of the entire sector, has surged by 28 percent during the month, while the MICEX index advanced only by 17 percent and S&P500 added just 9 percent. At the same time the performance of the Russian Utilities stocks was not uniform across the sector. The shares of power generating companies surged by 45 percent on average during the period, FGC UES advanced by a whopping 47 percent, while the distribution stocks were the sector's laggards, adding only 16 percent on average in April. The positive performance was driven by the favorable news flow during the month, and Utilities have finally started to regain their position on the Russian equities market after falling the most in the midst of the financial crisis.

The Russian Utilities sector reforms have not yet been completed and so the risk of failure has been dragging down the stocks since the beginning of the crisis. However, in April the sector finally came under the political spotlight. In the first week of April during his speech to the State Duma, Prime Minister Vladimir Putin addressed the Russian Electric Utilities sector. He made clear that, firstly, the government does not plan to freeze the natural monopoly tariffs, including tariffs for the Utilities sector, although the state plans to limit the growth of regulated tariffs next year compared to 2009. Secondly, he said that the government plans to partly subsidize residential electricity consumers by providing additional funds to Russia's regional authorities in order to offset "excessively" high retail tariffs in some of the regions in order to improve the overall stability.

On April 9 the long anticipated Cabinet meeting on the Utility sector's long-term investment program took place. The initial program, ambitiously called GOELRO-2 (after the first plan to electrify Russia in 1920), was developed by RAO UES under overly aggressive assumptions about the expected growth in electricity demand. In the current economic environment of dropping demand some of the planned capacity additions can cause excessive supply. There was an atmosphere around the market of anticipation that the government may allow the companies to not fulfill their obligations to invest and build. That would have immediately freed up short-term cash flows of electricity generating companies and lifted the financing risks. As it happened, the Cabinet has agreed to postpone the investments of state-controlled utilities, which was read positively by the market, even though no words were said regarding the privately owned TGKs and OGKs. The Energy Minister Sergei Shmatko said, however, that private generators may also be allowed to postpone their investment projects provided they have the right reasons.

Another piece of positive news for power generating companies came in the middle of April, when the Energy Ministry announced that the capacity market model for electricity generation companies will be finalized in 2Q09. The capacity market has still not been launched in Russia, which is devastating for strategic investors. The major owners of generating companies are facing the risk of not being able to guarantee sufficient, or any, return on their investments. Thus, despite uncertainty about the capacity market model itself, at the moment the probability of its implementation, e.g. the launch of the capacity market, is one of the biggest drivers of value for generation stocks. This was the main reason of the April's rally in the stocks of OGKs and TGKs. The outperformers were the shares of OGK-3 (+73 percent) and OGK-4 (+62 percent), which also published very strong 2008 financials, showing earnings growth and significant amount of cash on the balance sheet. The shares of Mosenergo (+76 percent) received additional boost when the Energy Ministry published its forecast of a much lower expected electricity demand drop in Moscow and the region in 2009, compared to the country's average. This also helped MOESK, an electricity distribution company working in Moscow region and a less liquid stock, to shoot up by 124 percent in April.

The Utility sector's outperformer, FGC UES, announced in the middle of April that it will be fully switched to a RAB-based new tariff system by 2010. FGC opts for an initial RAB valuation of 619 billion rubles ($17.4 billion), which will raise the transmission tariff by 72 percent in 2010 and by 27 percent in 2011. This made the company look very cheap on multiples: EV/IRAB of 0.33x and 2010E EV/EBITDA of 2.9x, implying 40 percent to 50 percent discount to Emerging Market peers and caused a continuous rally in the stock during the month.

In the near future we expect correction in the Utilities sector, as the positive news flow was mostly played by the market. An important risk for the sector's 2010 financials is the state's decision on next year's regulated tariffs, and at the moment the Ministry of Economic Development is proposing a significant cap on the tariffs growth next year. However, we note that the negative effect of this caps should be softened by the electricity market liberalization, as in 2010 it is expected that 70 percent of electricity will be sold on the free market. In the medium term we see a potential for another rally in generation stocks, which could be sparked by positive news regarding the capacity market launch. Although, unfortunately, the timing of the government's final decision on this issue is uncertain at the moment.