Buying Acres for Rainy Day

D. Grishankov, D. Kabalinsky

Notably, big business is known to have been spending twenty percent of its earnings for capital expenditure ends.

Over the entire thirteen-year stretch that Expert RA has been in business, we have proceeded from the only-one assumption that Big Business poses as a backbone of Russian economy, with the top-line companies’ earnings sooner or later necessarily being converted into investments. Clearly, it is only with this approach providing the guidance that one can count on any measure of long-term economic expansion. Should this theory be true to life, today we are enjoying the right landscape for investment projects to be escalated in the most proactive manner. Understandably, three years of sustained economic growth energized by the upbeat external market sentiment and ongoing domestic consumer boom obviously amounts to a solid length of time sufficient for the requisite resources to be accumulated. One could hardly get a more favorable set of conditions for the cherished investment projects to be kick-started.

Admittedly, Big Business investment drives have largely been assessed indirectly. This year we decided to fill out the gap and run a dedicated research study. Surely, getting the valid data on the values and areas of investments from any and all Expert-400-listed companies appears to be a mission impossible. Given that neither individual company surveys not Russian-standard accounting and financial reporting documents can provide any valid body of knowledge, we chose to take a somewhat different route to secure the requisite data.

Out of the latest Expert-400 rating findings we have short-listed the companies whose websites carry full IFRS or US (UK) GAAP financial statements and reports. We could only pick out just over 50 companies (which is very clear testament to the degree of transparency that our Big Business can really boast of). Those companies generally account for 52% of revenue generated by the Expert-400-covered businesses. Following scrutiny of the IFRS of GAAP financial reports,* we gleaned some valid knowledge on the total of capital expenditure and on investments committed to buy into other companies (long-term investments under Russian accounting regulations). As a matter of fact, that body of knowledge has been used to underpin our research study. Of course, this kind of selective approach can hardly provide for a comprehensive picture. Notwithstanding the circumstance, the Study’s findings allow to draw some compelling and, now and again, even totally unexpected conclusions.

Investing Covertly

Aggregate 2006 investments from Expert-400’s 50 companies amounted to RUR2 trillion. Should this value be brought against the total of capital expenditures and long-term investments tracked by official statistics, the aforesaid fifty large-sized companies would account for 28.7% of the entire capital invested in Russia’s economy. Even the more graphic picture would be provided by the said companies’ capital investments being brought against the all-Russian capital expenditures, with the 50 companies’ weighting standing at 36.6%. With all due respect for Russian Big Business and its accomplishments, it appears to be doubtful that those figures can be as meaningfully translated into comparable effects on nationwide investment trends, particularly given that in selected sectors aggregate investments carried by relevant IFRS reports come to be much higher than those posted by official statistics providers.

Chart 1. Investments of seven oil and gas companies approached 1 trillion rubles in 2006

The oil and gas sector’ landscape comes to be especially striking in this regard. Our sampling holds seven companies whose 2006 capital expenditures totaled RUR801.9 billion (see Chart 1). Meantime, merely RUR 559.7 billion happened to be invested in the fuel and energy (including coals) extraction sector, according to Rosstat statistics. Understandably, oil and natural gas companies invest not only in extractive operations but also in refining, processing, transiting and distribution businesses. Interestingly, even if you add in RUR130 billion invested in Gazprom gas pipeline construction projects, RUR53 billion invested across Russia in oil refining activities and RUR34.4 billion invested in natural gas refining and distribution facilities, you will never reach the high capital expenditure number stated above.

To point out, the oil and gas sector makes the more impressive but not the only one example to that effect. Though retailers can hardly be passed as a highly concentrated sector, the 2006 retailer-origin capital expenditures amounted to RUR52 billion, according to Rosstat. However, the relevant investments from just four retail chains (X5 Retail Group, Magnit, Sedmoy Kontinent, 36,6 Pharmacy Chain) reached RUR20.3 billion — nearly 40% of the aggregate industry capital expenditure reported by official statistics.

Of course, one could try and explain this state of play by Russian companies incrementally boosting their investments in foreign countries. However, one should be advised of the fact that Russian capital has for the most part been committed to upgrade some properties, purchase the needed industrial equipment and implement selected construction projects, rather than make acquisitions of foreign assets. It appears to be most unlikely that domestic corporations would be so heavily committed to support new development projects. Looks like official statistics on investments have not been reflective of the real landscape.

Chart 2. Retailers and machine-builders were capital investments dynamics leaders in 2006

The matter is that, as they put together their source accounting statements for the official statistics authorities, local companies now and again would understate their accomplishments, while being justly fearful of unwelcome tax burdens. Conversely, no matter how hard the assigned government statisticians try to get the true picture by way of making adjustments for “covert investment projects” as they proceed to research the relevant industry-related balance sheet numbers, they are rarely fully equipped to provide the right assessments of investments made. Admittedly, the errors in question can hardly be viewed as some bad omen: after all, the actual domestic capital expenditures at least come to be 15%-20% higher than the numbers carried by official statistics reports.

Funding comes above all

The companies we rate are known to have been much more active in their investment engagements than smaller-sized companies. Admittedly, the overall value of 2006 investments (including capital expenditures and acquisitions of interests in other companies) had merely grown by 14.3%, the unimpressive expansion level mostly being reflective of excessively high-value M&A deals completed in 2005, rather than a slump in the overall investment effort. Just to remind, in 2005 Gazprom paid out more than $13 dollars to make an acquisition of Sibneft. Clearly, it was only to be expected that in the course of 2006 Gazprom’s financing of its acquisition deals would drop by as much as 83%.

In the course of last year domestic business investment strategies had primarily been driven by capital investment projects that in aggregate accounted for more than 85% of all investments across Russia. To point out, CapEx numbers have been rapidly on the rise. The year 2006 saw capital expenditures grow by 44.9%, with Russia-wide capital outlays in effective prices having expanded by 26.8%. Notably, retailers and machine builders have been most active in rejuvenating and upgrading their capital assets, with relevant outlays being boosted by 77% and 76% (see Chart 2) accordingly.

Understandably, retailers remain pro-active because of the ongoing competitive battles in the marketplace. Better earnings have come to be nearly directly reflective of the retailers expanding their chains, the drive obviously asking for solid capital infusions. By way of example, the Magnit retail chain (CapEx leader that has nearly boosted its capital outlays by four times over the reporting year) on average spends in the area of $200 thousand to have just one point of sale appropriately outfitted. To emphasize, in the course of 2006 Magnit succeeded in launching 393 new stores. What is more, the company keeps investing rather aggressively in setting up a chain of hypermarkets — a new format that the retailer wants to get established and excel at. The machine building sector has been primarily expanding through meaningful capital investments from GAZ Group that is about to launch assembly of DaimlerChrysler’s Chrysler Sebring- and Dodge Stratus-derived GAZ Siber vehicles. However, when it comes to the aggregate size of investments in the industry, machine builders continue to pose as outsiders: in 2006 five of the industry’s surveyed companies had merely posted a total of RUR11.4 billion in capital expenditures, the amount being two times lower than the pertinent figure for the four retailers covered by our research study.

Chart 3. Transport companies bear the heaviest investment burdens

Investments in fuel & energy and transport sectors have always been perceived as a key driver of national economy. Of course, should relevant growth rates be the only issue on the discussion agenda, economy watchers would have nothing to complain about. In the course of 2006 capital infusions in upgrading and expanding transport, oil & gas and energy companies had been up by 58.9%, 58.5% and 43,5% respectively, according to our findings. Interestingly enough, government-run companies had been the biggest investors in their operations. Leading in the oil & gas sector had been Gazprom and Rosneft; in transportation – RZD, Transneft and Transnefteprodukt; in energy – RAO UES of Russia.

Setting things right again following completion of the Sibneft acquisition deal, the Russian gas monopoly set out to invest most aggressively in constructing natural gas pipelines and developing new gas fields. The company’s capital investments for the reporting year (2006) had been up 60.7% as they reached RUR441 billion. Notably, Gazprom’s investment program for the current year has been confirmed to stand at RUR779.4 billion, with the upward trend most likely to be sustained over the coming years. Importantly, Rosneft’s capital outlays to support expansion of the available oil extraction and processing capacities had been growing even faster than that, with the 2006 CapEx figure escalating by 71.2%. Private oil companies could hardly boast of such performance, according to our findings. The best-performing private operator LUKoil, for one, had its 2006 capital outlays grown by 55.1%. NovaTEK’s capital investment program appears to have been a repeat of 2005. Meantime, for the Russian oil sector to be meaningfully expanded, at least $300 billion should be committed to support a range of capital investment projects, according to L. Fedun, LUKoil vice president. To underscore, this value comes to be ten times the total of oil industry capital outlays for 2006. So, private oil holdings ought to move without delay and put together some fresh and more ambitious investment plans for business expansion.

It is only government-run transportation monopolies that can compete at par with fuel & energy giants in terms of capital investments. By way of example, RZD’s capital outlays for the reporting (2006) year reached RUR262.9 billion as brought against RUR196.8 billion for the year before. Transneft’s and Transnefteprodukt’s capital investments in developing their oil pipelines had grown by more than 2.3 times to reach RUR167.1 billion.

Chart 4. Despite oil and gas companies’ large investments, their volume in 2006 is less than net earnings

Base metals make the only one major sector where major market makers had their capital investment strategies focused not so much on upgrading and reengineering goals as on corporate building efforts. The matter is that metals operators have already completed their principal capacity rejuvenation projects, and in terms of their efficiency particulars the leading domestic metals holdings are very much at par with the world’s best and feel solidly protected against market sentiment jitters. To underscore, what they are now primarily interested in is available domestic and foreign-based core-business properties. Capital investments for the reporting year (2006) from the industry’s leading companies had been up 10%, with the outlays committed to make acquisitions of new properties growing by 4.8 times. By way of example, in the course of 2006 Novolipetsk Metals Industrial Complex (NLMK) spent as much as $2.2 billion to buy into a number of other companies. To be more specific, Novolipetsk Metals spent $550 million to acquire a stake in VIZ-stal; $750 million- to secure an interest in Prokopyevskugol and Altaykoks coal companies; $805.5 million – to set up a joint venture together with Duferco Group, with a 50% stake held by NLMK.

Bearing investment burdens

Today, the surveyed companies appear to have been committing as much as 20% of their earnings to support assorted investment projects. Add in pertinent amendments to get the official statistics appropriately adjusted for unreported capital investments, and you would still come to the realization that the updated investment burden borne by the domestic business community is lower than the actual value. The thing is that total capital expenditures and long-term investments accounted for 16.6% of aggregate revenues generated by domestic enterprises in the course of 2006.

Clearly, the heaviest burden is borne by the country’s transport monopolies that can hardly be sufficiently resourced to proceed unassisted and assure further expansion of railways and pipeline infrastructure facilities. On the one hand, their receipts are subject to a measure of tariff regulation, but on the other hand, the projects assuring further economic expansion appear to be nearly Herculean. Clearly, Russian economic growth would for the most part be negative should those huge undertakings fail to be pursued. Interestingly, RZD’s 2006 capital investments almost accounted for one third of the company’s earnings. Now, when it comes to Transneft and Transnefteprodukt, Russia’s largest oil pipeline operators, their aggregate investment values have come close to their annual sales and outstripped pertinent net earnings by a whole order of magnitude. Understandably, the State has come to be the principal direct or indirect investor for assorted infrastructure development projects. To add, the aforementioned companies either directly or through private-sector businesses have likewise posed as most meaningful fund-raisers for those large-scale projects. To give one graphic example, RZD plans to have the available in-house funds and debt capital committed to finance 75% of its long-term capital investment program.

Given the industry landscape dynamics, the telecommunications companies and cell telephony operators, in the first place, are expected to be particularly hard pressed as far as capital outlays go. The matter is that their business assets need to be rejuvenated nearly on a scheduled basis. What is more, you can only effectively break into a new market provided you command sufficient capital to make an acquisition of a new company holding the right licenses and committed customer base. The industry’s 2006 investments had come to reach nearly one third of total earnings (see Chart 3). Meantime, the persistent cut-throat competition serves to heavily constrict the opportunities for market players to improve their profit margins. Clearly, communications services providers lack the requisite resources to fully finance their capital investment drives. Interestingly enough, the sector’s aggregate neat earnings for 2006 had come to be 2.3 times lower than the total value of pertinent capital infusions (see Chart 4). Given the circumstance, most operators are just compelled to turn to banks or debt market players in order to raise most of the funds needed to support implementation of their investment strategies.

Understandably, il and gas companies are much better off in that regard. Their windfall profit tax deductions notwithstanding, those companies generally remain to be well resourced in order to effectively support large-scale investment projects. Oil and gas operators’ capital outlays account for close to 18% of the revenues and just 80% of net earnings. Of course, one normally has to tap outside funds to make an acquisition of some high-priced property. By way of example, an acquisition of Sibneft and Yuganskneftegaz resulted in the new owners bearing a much higher debt burden. No matter what kind of spending strategies they pursue, Russian oil and gas companies continue to be sufficiently resourced to meaningfully upgrade their production assets and develop infrastructure capacities.

Discuss in the forum