Nixing the Oil

S. Joulin

Gazprom’s share in the capitalization of Russia’s top-200 companies has slumped from one third to one fourth, with energy and banking operators meaningfully squeezing out oil and gas businesses.

Last year turned out to be pretty uneventful and calm for the Russian stock market, with the country’s top-200 companies getting their aggregate capitalization surging by $220 billion (+26%). The domestic market’s trillion-dollar capacity desperately needs more competitive infrastructure facilities including state-of-the-art stock exchanges and depositary-clearing centers. Notably, the aforementioned capitalization expansion had for the most part been driven by a growing number of more listings and secondary equity offerings. To be specific, Sberbank’s double expansion of its capitalization had primarily been assured through availability of positive market sentiments and “people’s IPO” that raised $9 billion. Gazprom happened to be disregarding the prevailing market trends and, as a result, had its market value plunging by $31 billion (-11%) (see Chart 1). Conversely, within just a single year the cut-off price surged by more than two times: Tomsk Distribution Company, the bottom-line operator on the list, is currently valued at $92 million. To point out, the aggregate weighting of the top-two giants (Gazprom and Rosneft) now happens to be lower than Gazprom’s weighting for the previous year.

Understandably, a shift in industry preferences on the part of prospective investors along with a boom of IPOS and secondary offerings served to bring down concentrations featured by the Capitalization-200 list. Gazprom’s value for last year was 52 times higher than that of the top-twenty’s smallest company Slavneft-Megionneftegaz. Today, the ever-lasting leader’s cap value appears to be just 32 times higher than that of Baltika, the firm closing the top-twenty list (see Table 1).

Admittedly, Russia has grown a good number of world-class corporations. While back in 1999 just two (Sic!) borrowers accounted for 20.3% of Sberbank’s loan portfolio, in 2006 top-ten domestic companies merely accounted for 15.4% of the same portfolio. Apart from Gazprom, we now can see dozens of domestic business champions raring to go and prosper. Importantly, capital concentrations in the national economy have been rapidly on the decline.

Stakeholders, Government in the first place, carried on their effort to sell off some of their business interests to minority shareholders. Big business has opted for the stock market, with public corporations controlling an ever-growing percentage of assets. As a result, the so-called “people’s IPO” notion has become generally embraced, with the numbers of investors now approaching a half-a-million figure.

Russian company shares have already shown some rather compelling trends. VTB, the acknowledged leader in the “people’s offering drive”, has issued more than 6.7 trillion shares. For comparison’s sake, S&P-500 (reflecting three quarters of US business capitalization) keeps track of less than five trillion shares issued by 500 firms and businesses. To emphasize, each human on the planet Earth could nearly account for 1000 VTB shares. Following completion of its stock split, Sberbank has now increased the total of its shares by a factor of 1000+ times. Energy companies likewise can boast of their impressive performance in that regard: each of the top-seven TGK combined heat-and-power providers is holding more than a trillion shares.

Stock exchange reaching for liquidity

The domestic stock market continued to get rid of poor-liquidity securities: sales have been outstripping capitalization trends. On selected business days the volumes of MICEX transactions came to be in excess of $10 billion. Just like in the previous year, all 200 equities keep trading on the stock exchange, with over-the-counter heavyweights like TNK-BP being left uncovered. To point out, the top-line liquidity category features 129 companies (rather than 97 for the previous year; see Chart 2). The companies, that do not have their equities treading on the domestic stock exchange but command ADR/GDR assets accessible internationally, have been passed as the dying out kind. Interestingly enough, the NYSE-launched MTS stock has been readily embraced by MICEX.

The principal challenge for the Russian stock market comes from non-resident companies (see Table 2) that have been through their foreign-based IPOs. Expert-400 features seven of those businesses. Just to remind, all RDR (Russian Depositary Receipts) discussion ended up with V. Milovidov, head of FSFR (Federal Service for Capital Markets) coming up with an idea to have foreign securities cleared for trading on domestic stock exchange grounds.

Second best after Gazprom

The Russian top-twenty list has been meaningfully reshuffled. First of all, the aggregate weighting of the leaders has slumped to 77% (down from 84% for 2006). Gazprom has suffered the most. Indeed, the company has been elevated from 10th to 6th place in the Financial Times Global 500 list of the most valued businesses. However, mention should be made of the fact that Gazprom’s capitalization vis-a-vis CBR reserves has nearly shrunk by a factor of two times (see Chart 1). As a result, one can see the owner’s (in this case the Government’s) clout contracting: once again the available CBR reserves have come to be higher than the value of stock held by the Russian Government.

Now Rosneft poses as second-largest Russian company in terms of market value. In the fall of 2006 the company consolidated its subsidiaries and set up a single business management and profit center, thereby completing the long-lasting effort to shape and energize a vertically integrated structure. Rosneft embraced the following 12 subsidiaries: seven extractive operations (Rosneft-Krasnodarneftegaz, Rosneft-Purneftegaz, Rosneft-Sakhalinmorneftegaz, Rosneft-Stavropolneftegaz, Yuganskneftegaz, Severnaya Neft and Selkupneftegaz), two processing enterprises (Rosneft-Komsomolsky NPZ and Rosneft-Tuapsinsky NPZ) and three support businesses (Rosneft-Arkhangeslsknefteprodukt, Rosneft-Nakhodkanefteprodukt and Rosneft-Tuapsenefteprodukt). With subsidiary-origin shares being swapped for Rosneft stock, the oil leader has radically boosted the liquidity of its securities on the stock exchange. Admittedly, it was only following its secondary offering that Rosneft managed to keep its second capitalization spot after Gazprom. To remind, when Sberbank rolled out its “people’s IPO”, it was elevated to second place for a short stretch of time. Incidentaly, Rosneft happens to be the only one domestic oil and gas company that has managed to improve its standing on the list.

Oil sector unfit for growth

The 2007 oil industry state of play is full of surprises (see Chart 3). In the first place, exclusively promising rates for energy supplies could not prevent a deep slump in the domestic oil and gas sector: major equities unsuccessfully continue trying to beat the highs set as far back as in May 2006. Though the recently introduced dedicated tax amendments have enabled oil companies to meaningfully improve their performance, the oil and gas sector has ceased to be the key driver for domestic stock market. One can hardly conclude that no one would be happy to see that the share of oil and gas firms on the Capitalization-200 list has contracted to fall below 50%. What is more, Russian oil and gas providers have likewise been rapidly losing their hard-won grounds on international markets. By way of example, the 2007 FT 500 list has had LUKoil dropped 19 places, while ConocoPhillips (holding a 20% stake in LUKoil) has been moved up 9 spots, with its market value, as a result, eclipsing that of Russia’s largest private oil operation nearly by two times. Clearly, if the trend is any guidance, the said foreign market player would most likely be a power center for the ongoing consolidation drive. Of course, private foreign oil operators have their own problems to grapple with: take Venezuela, for one.

Of late, domestic banks have enjoyed a stretch of god business climes: over the past three years their market value share has expanded from 3.3% to 12.6 %, the key credit for that improvement once again going to the Government. As it has grown up VTB to become a second “blue chip”, the Russian Government now thinks of RSHB, Gazprombank and TKB being appropriately outfitted to launch their own IPOs. Of course, it is always possible that those financial institutions would either proceed to that end independently or get acquired by Sberbank or VTB. Whatever option is taken up, the stock market will be the charted destination. Given the landscape, the secured capitalization level (12.6%) could best be viewed as baseline.

An effort to pursue the RAO UES of Russia reform and create TGK entities out of regional power generation companies has had the total of candidates shrinking from 85 to 76. Conversely, the electrical power engineering sector’s weighting has risen from 8.8% to 13.9% of the overall market value. Following completion of the reform, we expect that the numbers of energy providers would shrink by an order of magnitude. Of course, that transformation would take some time. It will hardly be a repeat of the fast 2002 electrical communications industry reform when seven interregional telecom corporations were set up without any further ado. Then, we are all in for a major trial: RAO UES of Russia is expected to leave the stock market arena once the industry reform is completed.

Inventories looking down, sales looking up

In the course of 2007 the averaged P/S ratio for Capitalization-200 companies had dropped to 2.25 (the figure for the previous year standing at 2.46), the P/E ratio slumping to 11.85 (the figure for the previous year being 14.45). Some private companies appear to have lost the best opportunity and ruled to push back their IPO programs, while other major operators, like VTB for one, managed to launch their public offering just in time. As a result, as many as 69 Expert-400 names (61 for the previous year) have now made it into Capitalization-200. Within a single year investors have repeatedly reshuffled the lists of best performers and under-achievers to see how they look against the aforementioned ratios (see Table 3 and Table 4). The uncontested leader Rusia Petroleum (Kovykta deposits has had its P/S standing diminished by a factor of four times. Conversely, electrical power engineering companies have improved their P/S performance: as many as 13 energy providers are already on the top-twenty list. Investors have increasingly come to the realization that sales are more compelling and lucrative than inventories or deposits. Interestingly, machine builders have started to leave the ranks of stock market outsiders (see Table 4 for lowest P/S ratios), with assorted retailers coming down to fill out the openings. Today, phenomenally inexpensive securities are nearly non-existent in the Russian marketplace. Just to remind, in the late 1990s most of domestic companies would have their market values lower than their sales and double earnings. Today, Dorogobuzh, that lost 48 positions (dropped down to 166th place with its P/S at 0.81 and P/E at 1.51), happens to satisfy this rather stringent requirement.

Debt capital pyramid

In the past year the IPO-launching companies not only managed to get their public status solidly established but also helped boost their shareholder value. However, debt capital markets turned out to be more bottomless than one could imagine. The total value of outstanding corporate bonds within a single year jumped by $58 billion (see Chart 4), the amount beating relevant IPO receipts by multiples.

To emphasize, the ongoing expansion of corporate debt market has been outstripping the impressive pace of growth featured by the domestic stock market. Over the past five years (by the close of August 2007), the corporate bond market had expanded by an order of magnitude and even more: from RUR84 billion to RUR1191 billion for ruble bonds and from $2 to $87 billion for euro bonds. Just to give a comparison: over the same stretch of time the MICEX ruble index and RTS dollar index had grown by less than six times. The matter is that the bond market expanded as it weakly responded to the prevailing external factors, world oil price hikes in particular, and unlike the brittle equity market, it displayed a good degree of stability. Comparisons against foreign markets hold a promise for the local debt capital market to continue growing in size (see Chart 5).

In terms of size the market segment for corporate bonds has already outstripped the GKO-OFZ segment. Importantly, some of the latest trends, that have been sustained over the last few years and are likely to continue, include the following features: government debt instruments being increasingly phased out by corporate securities; forex debt being incrementally replaced by ruble debt; bank lending being squeezed out by bond-based borrowings; bond maturities being extended and bond issues being increasingly diversified by sector, tenor and volume.

Yearning for expansion

Unfortunately, the year 2007 was off to a bad start. By close of the very first business day the RTS index slumped 6.4% shrinking down to 1799 basis points. Surprisingly, the market kept falling in the face of rosy financial reporting and accounting documents from big business operators: if the relevat financial ratios are any indication, Russia happened to switch from the league of high-end emerging markets over to a herd of low-end arenas. Given that last year the RTS index closed at 1922, January through August 2007 has nearly been a waste of time, with the domestic stock market no longer beaming a promise of good returns.

For twelve years now the market trends have been displaying some clear cyclical patterns. In fact, they started to be tracked on September 1, 1995, when the RTS index was kick-started at 100. Every two boom years (+353%, +261%, +163%, +178% by September 1997, 2000, 2003 and 2006) had been alternated by a year of “landing” (-86%, -13%, +8%, +19% by September 1998, 2001, 2004 and 2007). While the first cycle was primarily touched off by the 1998 financial meltdown, the second one was triggered by a meaningful drop in commodity prices, the third one was associated with the apprehension of Khodorkovsky, with the fourth one being explained away by an onset of the subprime mortgage lending crisis in the United States. Notably, the last Russian stock market downswing had somewhat put on hold the balance between RTS and Dow Jones index readings. By September 2007, the RTS index had come to stand at 14.4% of the Dow Jones index (14.1% for 2006).

As time marched on, two-year boom patterns started to lose in intensity and “landing” stretches became less prohibitive. Should one continue to rely of the vaidity of two-year “flourish” pattern contitnuity, its being directly reflective of the degree of prior “landing” severity and incremental decline in growth rates, it is quite possible to project that on September 1, 2009, the RTS index would be standing at a mind-boggling level of 4559, thereby growing beyond 25% of the Dow Jones index. Just to remind, our last year’s RTS index linear forecast for September 1, 2007, had merely come 7% short of the actually secured level (1920). The forecast notwithstanding, the market displayed a superior degree of conceit: September 2007 futures used to be traded while proceeding from an intolerably low level of 1590 (September 21, 2006) to an Olympian high of 2104 (July 23, 2007). So, the estimated 137% rise in the key Russian stock market indicator for two years out would be a good benchmark for expected returns.

Understandably, the ongoing expansion is unlikely to remain monotonous. Over tha past twelve years the index has grown by a factor of 19.2 times or 1820%. However, the Russian stock market continues to be reflective of seasonal shifts, with pertinent inputs being very much varied. The winter season poses as the key driver for our stock market, with the aggregate index boost amounting to 727%. Spring has provided 248% expansion of capital infusions and summer merely added 13% of the total value. The fall season is known to have wiped out 41% of market value held by investor accounts. Clearly, caution comes to be most relevant in these matters.

Chart 6. Russian division of profit	Chart 7. Forced march to parity
Chart 8. Winter is the main growth driver on Russia’s stock exchange

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