ROE in Russia: Solving the Puzzle

November 20, 2010


Russia is a high-ROE environment. Many sectors in Russia generate structurally high ROEs thanks to large entry barriers, a lack of capital and low cost structures. However, regulation in the oil, gas and utility industries drags down ROEs in these sectors and hence the overall market, and poor investments have tended to obscure returns in some other areas.

The Russian conundrum – profit but no cash flow. Over 2003-10, Russian companies in aggregate will generate an annual ROE of 16%, but no free cash flow. The difference stems almost entirely from the gap between depreciation and capex. There are two main causes for this: investment for growth, which is healthy; and under-depreciation, which is concerning.

How to solve it. For each sector, we estimate the appropriate level of maintenance capex, and thereby restate profits and assets to give adjusted ROE and P/E levels. This increases the 2011E market P/E by 20% to 9.0.

High-ROE sectors. There are a series of companies generating ROEs of over 15% both in the past and looking forward, even when adjustment is made. These are concentrated in the domestic sectors (banking, mobiles and consumer), but can also be found in the export sectors (gold, coal and fertilizers).

Low-ROE sectors. When profit and assets are adjusted for under-depreciation, the historic returns in the oil, gas and utility sectors are low and certainly under the cost of capital. However, the discipline of the market is likely to oblige the government to increase future returns to at least the cost of capital, especially in
the utility sector, which is more dependent on external capital.

Top picks among the high-ROE stocks. We favor companies that have structurally high ROE levels that are likely to last, and highlight Sberbank, MTS, Ural SI, Pharmstandard, Magnit, Globaltrans, LSR Group and CTC Media. Among the exporters (which face higher long_term taxation risk), we highlight Uralkali, Polymetal, Norilsk Nickel and NOVATEK. Within these stocks there, are of course few bargains to be had, but interesting opportunities are appearing with IPOs, and we highlight companies at under 10 times 2011E earnings, such as MTS or Sberbank.

Top picks among the low-ROE stocks. We favor companies where low ROEs are already priced in, but where changes to the regulatory environment are likely to liberate higher returns. Among these we highlight Gazprom and MRSK Holding.