Russia going cheap
An explosion of activity has made Russia one of the most active countries in the world for ECM issuance, but the recent secondary market volatility has left Russian stocks at a discount to other emerging markets. The development of Russian depositary receipts promises a surge of issuance from foreign-registered companies looking to take advantage of the huge increase in wealth across the region, reports Ian Forrest.
Russian ECM activity more than doubled to record levels of US$53.5bn in 2007, despite the fact that investors were concerned about a range of issues. Uncertainty over the political transition process and how the government planned to deploy its huge oil and gas revenues were both significant factors, and some investors felt that valuations had got ahead of themselves in late 2006.
As a result many chose to look for opportunities in Brazil, China and India instead, but strong economic growth and a rising oil price continued to attract others to Russia.
The chance to gain exposure to sectors away from the dominant oil and gas industries was a big attraction for investors, and the year saw transactions across a wide range of sectors including retail, banking, real estate and pharmaceuticals.
The largest deal of the year was the hugely successful US$8bn privatisation IPO of banking group VTB. A US$365m IPO by consumer electronics m.video was completed at a premium to its main comparable, Dixy Retail, and Bank St Petersburg became the first independent bank to float.
The parliamentary elections last December proved a watershed moment for many investors because they showed clear support for President Putin and his transition plans.
However, the Russian equity markets suffered in January, alongside most major markets, on concerns about the credit crunch and the growing possibility of a US recession.
The RTS index fell 16.8% in the space of a month, a fall which was enabled to some extent by the high level of recent issuance in Russian stocks which has made them among the most liquid in the emerging markets universe. Annual trading volumes globally have reached US$6bn–$8bn and half of that takes place in Russia itself.
The first quarter of the year is always fairly quiet for ECM activity, but market volatility weighed heavily on issuance and volumes of just US$3.8bn were recorded in the first two months. That increased to US$3.9bn in March, although most of that was from the privatisation of regional energy groups.
After a volatile first quarter the Russian market is now trading on a 2008 P/E of 10, compared with 12 at the beginning of the year, and some analysts believe it is relatively good value compared with other emerging markets. "The Russian market has the lowest P/E ratios of all the major emerging markets, with only Hungary and Turkey on lower multiples," said Ovanes Oganisian, Russian equity strategist at Renaissance Capital.
There are also signs issuers have adjusted their expectations of what can be achieved in current market conditions. "Valuation expectations came down at the end of last year. The performance of the stock market over the past year has not matched the country's good economic growth, or the rise in commodity prices globally," said Reinout Koopmans, co-head of CEEMEA ECM at Deutsche Bank.
Oil and gas stocks make up 50% of the Russian stock market by market value and have underperformed for the last year. Tax rules governing the oil and gas sector are regarded as partly to blame for that, along with constraints on capacity increases. The sector is trading on a 2008 P/E of 8.8 times, representing a 20% discount to other emerging markets. Sector earnings are expected to grow by 5.3% this year, somewhat lower than the 6% average for emerging markets.
"Oil stocks have been almost completely immune from the recent surge in the oil price. They are seriously undervalued because any surplus above US$30 per barrel goes to the government," said Anton Cherny, head of ECM at Renaissance Capital.
The government is pulling in US$1bn per day from oil and gas exports and has built up a fund totalling US$1trn since 2000. Last year revenues from those sectors accounted for 65% of government tax receipts, and this year they are forecast to rise to 70%.
The government plans to use the funds to make the economy more diverse and less dependent on oil and gas revenues. "One major aim now is to move the oil and steel sectors up the value chain by building refineries, LNG plants and smelters. Another part of this drive is to enable other industries to move towards producing finished goods rather than simply exporting raw materials such as timber", said Chris Weafer, Chief Strategist at Uralsib.
Metals and mining stocks are trading on a 2008 P/E of 8.9 times, but the consensus among analysts is for a 3% decline in earnings this year due to a combination of increasing supply and falling prices for metals such as nickel.
Sector peers in other emerging markets are forecast to fare better, with earnings growth of 7.7%. However, the large IPOs of aluminium giant Rusal and Mechel's coal mining operations are not expected to be affected because of continued demand for those particular commodities. "I expect to see several large issues in the metals and mining sectors over the next 12-18 months. Other sectors with good potential for issuance are transportation, building and construction and industrials", said Deutsche Bank's Koopmans.
Valuations have also slumped in the real estate sector, in common with Western European peers. Price-to-NAV ratios have fallen sharply across the sector over the past 12 months and few bankers expect to see many deals this year.
The retail sector remains relatively small, and trades on a 2008 P/E of 24, but it is expected to see further activity this year. Supermarket group Magnit began pre-marketing on a US$500m follow-on deal at the end of March and one of its main peers, X5 Retail, is expected to complete one of the largest deals of the year with a US$1bn follow-on offering. The deal will also be notable as the first test of the new Russian Depositary Receipts (RDR). The security became available last year and was developed to enable foreign issuers to list in Russia, which has been all but impossible until now.
The regulators are especially targeting companies that have most or all of their operations in Russia, but are owned by a foreign-registered holding group. The recent shift in sentiment towards foreign companies listing in Russia is such the financial regulators are also now publicly discussing the possibility of allowing foreign issuers to list ordinary shares in Moscow.
RDRs are likely to be popular with two groups of companies. Firstly, those that have most of their operations and assets in Russia, but which have, for tax reasons, chosen to register outside Russia. They are technically foreign, but investors regard them as essentially Russian. Evraz and Aricom are examples. "RDRs are a good way for them to offer their shares to Russian-based investors", said Cherny.
RDRs are also likely to be popular with companies based in other CIS countries, such as Ukraine, Kazakhstan and Armenia, where there is a limited amount of capital available in the home market. However, few major issuers from the developed countries in Europe are expected to use the opportunity to list in Moscow. "I don’t expect to see many major Western European companies looking at an RDR listing in the foreseeable future", said Cherny.
The arrival of RDRs raises a question mark over the future of GDR listings in London, but some bankers expect them to remain popular with some issuers, especially for larger deals where companies are looking to raise over US$1bn. However, at the top of the scale some companies are deterred by the fact that GDR listings do not qualify for inclusion in indices such as the high profile FTSE100.
One example is oil giant Rosneft which raised US$10bn from its London listing in 2006 but did not get into the FTSE 100, whereas Kazakh mining group Kazakhmys did qualify with a much smaller IPO because it opted for a full listing.
The combination of a robust underlying economy and continued growth in consumer spending is expected to support ECM activity in the second half of the year, with a number of deals in several sectors beyond the dominant oil, gas, metals and mining areas, imminent. "We expect that investors will have the chance to get more exposure to under-represented sectors such as agriculture, infrastructure and insurance this year," said Cherny.
The food production and agriculture sectors could also see more activity because they are seen as safe havens on the back of high consumer spending. There are only two major quoted stocks in the sector at present, Razgulay and Cherkizovo, but they have both comfortably outperformed the market over the past year and there appears to be a good opportunity for others to follow.
There is a good pipeline of real estate deals, mostly from developers looking to raise funds, but demand from investors remains low following the poor performance of some real estate issues last year. "I expect that only a few, those involving high quality assets, will actually get done", said Cherny.
However, prospects for ECM activity in the immediate future remain bright. Russia is not overweight in most GEM funds and large international investors are expected to look more at Russia this year.
Uralsib's Weafer believes there are plenty of reasons to expect an increased level of issuance later in the year. "Russia is in an investment sweet-spot right now. The political transition process has now been sorted out, GDP growth in 2008 is forecast to be 7%¬¬-8% and consumer spending is forecast to rise by 15%. We have a target of 3,000 for the RTS by the year end, depending on an improvement in the current level of market volatility."