MRSK Initiation RAB Roll-out Offers RABid Value Summary The roll-out of RAB-based tariffs across the country is the single most important value-driver in Russia’s power distribution space. By the beginning of 2011, the new scheme will be fully implemented. The new regime will secure stable and transparent returns on distribution assets, facilitating the financing of the sector’s formidable CAPEX needs. Our preferred play on the theme is MRSK Holding, which not only offers one of the biggest upsides in valuation terms but is also the most liquid stock. Our other top picks – out of 13 names covered in this report – include MOESK, MRSK Center, MRSK Center-Volga and MRSK Urals based on valuation, geography and transparency. Investment Case RAB story likely to play out over the next six months: The share of MRSK Holding’s regional branches operating under an RAB tariff regime is expected to rise from 29% to 100% by the beginning of 2011. This roll-out will be the major catalyst for MRSKs over the coming months and is not fully reflected in current prices. Compelling EV/RAB multiples: Current EV/RAB multiples are mainly in the range of 0.4-0.5x, suggesting significant upside to our DCF- based EV/RAB metrics of up to 0.8x for some stocks. Current valuations seem out of sync with RAB-implied capital returns. RAB regime necessary to secure financing for modernization: Russia’s distribution networks require massive investments into renovation and modernization to enhance the reliability of electricity supply and remove bottlenecks. This will only materialize if regulated tariffs allow companies to generate sufficiently high returns on invested capital. MRSK Holding is our preferred stock in the sector: 70%+ upside combined with high liquidity suggest that MRSK Holding is the best way to play the theme, in our view. MOESK, MRSK Center, MRSK Center-Volga, MRSK Urals our top picks: These MRSK names provide the highest upside supported by a combination of the lowest inherent regulatory risk, good geography and high transparency. Valuation & Risks Valuation: We value the underlying MRSKs using DCF based on the expected parameters of RAB-based tariffs. We value MRSK Holding using an equally weighted blend of DCF and sum-of-the-parts approaches and apply a 25% holding discount to the latter. Risks: The sector’s performance will be subject to regulatory risk, particularly the risk of lower iRABs than those expected by MRSK Holding. A key indication to investors will come on July 1, when 19 more regions are expected to adopt RAB-based tariffs. The CAPEX programs of MRSKs have yet to be finalized, posing another risk to our valuation. Finally, the low liquidity of many MRSK names is another risk facing these stocks. Target prices and recommendations Company 12M TP Upside Rating MRSK Holding $0.184 71% O/W MRSK Center $0.069 115% O/W MRSK C&V $0.015 135% O/W MOESK $0.075 72% O/W MRSK Urals $0.020 152% O/W MRSK N.C. $11.2 161% O/W MRSK South $0.0080 55% O/W Tomsk DisCo $0.024 48% O/W MRSK Volga $0.0050 43% O/W MRSK Siberia $0.013 30% E/W Lenenergo $0.91 25% E/W Kubanenergo $6.1 4% E/W MRSK N.West $0.0043 -40% U/W Source: Bloomberg, Alfa Research Current EV/RAB multiples, MRSKs 0.16x 0.29x 0.32x 0.38x 0.39x 0.39x 0.40x 0.44x 0.45x 0.47x 0.51x 0.81x 0.00x 0.20x 0.40x 0.60x 0.80x 1.00x MRSK N.C. MRSK Urals Tomsk DisCo MRSK C&V Lenenergo Kubanenergo MRSK Sib. MRSK Center MRSK Volga MRSK South MOESK MRSK N.W. Source: Company data, Bloomberg, Alfa Research Share price performance -30% 70% 170% 270% 370% MRSK Holding MRSK Center MRSK Cente&Volga MRSK Volga MRSK Northwest MRSK Siberia MRSK NC MRSK Urals MRSK South MOESK Lenenergo Kubanenergo Tomsk DisCo 1M Change YTD Change Source: Bloomberg RESEARCH DEPARTMENT [email protected]The contents of this document have been prepared by Alexander Kornilov of OJSC Alfa Bank ("Alfa Bank") as Investment Research within the meaning of Article 24 of Commission Directive 2006/73/EC implementing the Markets in Financial Instruments Directive (2004/39/EC). Please refer to the further important information in relation to this Document located on the last page. www.alfa-bank.com Alexander Kornilov, Ph.D. Senior Analyst, Moscow (+7 495) 788-0334 Fedor Kornachev Analyst, Moscow (+7 495) 795-3735 Elina Kulieva, Ph.D. Analyst, Moscow (+7 495) 789-8509 Russian Equity Research Utilities June 30, 2010
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MRSK Initiation RAB Roll-out Offers RABid Value
Sum
mar
y
The roll-out of RAB-based tariffs across the country is the single most important value-driver in Russia’s power distribution space. By the beginning of 2011, the new scheme will be fully implemented. The new regime will secure stable and transparent returns on distribution assets, facilitating the financing of the sector’s formidable CAPEX needs. Our preferred play on the theme is MRSK Holding, which not only offers one of the biggest upsides in valuation terms but is also the most liquid stock. Our other top picks – out of 13 names covered in this report – include MOESK, MRSK Center, MRSK Center-Volga and MRSK Urals based on valuation, geography and transparency.
Inve
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RAB story likely to play out over the next six months: The share of MRSK Holding’s regional branches operating under an RAB tariff regime is expected to rise from 29% to 100% by the beginning of 2011. This roll-out will be the major catalyst for MRSKs over the coming months and is not fully reflected in current prices. Compelling EV/RAB multiples: Current EV/RAB multiples are mainly in the range of 0.4-0.5x, suggesting significant upside to our DCF-based EV/RAB metrics of up to 0.8x for some stocks. Current valuations seem out of sync with RAB-implied capital returns. RAB regime necessary to secure financing for modernization:Russia’s distribution networks require massive investments into renovation and modernization to enhance the reliability of electricity supply and remove bottlenecks. This will only materialize if regulated tariffs allow companies to generate sufficiently high returns on invested capital. MRSK Holding is our preferred stock in the sector: 70%+ upside combined with high liquidity suggest that MRSK Holding is the best way to play the theme, in our view. MOESK, MRSK Center, MRSK Center-Volga, MRSK Urals our top picks: These MRSK names provide the highest upside supported by a combination of the lowest inherent regulatory risk, good geography and high transparency.
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Valuation: We value the underlying MRSKs using DCF based on the expected parameters of RAB-based tariffs. We value MRSK Holding using an equally weighted blend of DCF and sum-of-the-parts approaches and apply a 25% holding discount to the latter. Risks: The sector’s performance will be subject to regulatory risk, particularly the risk of lower iRABs than those expected by MRSK Holding. A key indication to investors will come on July 1, when 19 more regions are expected to adopt RAB-based tariffs. The CAPEX programs of MRSKs have yet to be finalized, posing another risk to our valuation. Finally, the low liquidity of many MRSK names is another risk facing these stocks.
The contents of this document have been prepared by Alexander Kornilov of OJSC Alfa Bank ("Alfa Bank") as Investment Research within the meaning of Article 24 of Commission Directive 2006/73/EC implementing the Markets in Financial Instruments Directive (2004/39/EC). Please refer to the further important information in relation to this Document located on the last page. www.alfa-bank.com
Alexander Kornilov, Ph.D. Senior Analyst, Moscow
(+7 495) 788-0334 Fedor Kornachev
Analyst, Moscow (+7 495) 795-3735
Elina Kulieva, Ph.D. Analyst, Moscow
(+7 495) 789-8509
Russian Equity ResearchUtilities
June 30, 2010
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TABLE OF CONTENTS:
Investment Summary ......................................................................................................4 Our Top Picks.................................................................................................................6 MRSKs on multiples .......................................................................................................8 Key events to watch......................................................................................................10 Risks.............................................................................................................................10
Valuation ........................................................................................................................12 DCF-derived fair EV/RAB varies among the companies...............................................12 WACC: The main factor affecting EV/RAB; major discrepancy among MRSKs ...........13 Initial RAB: The main valuation factor is still uncertain .................................................14 MRSK Holding valuation...............................................................................................16 EV/RAB waterfall analysis ............................................................................................17
Limited Impact on End-User Tariffs .............................................................................21 How much regulatory risk? ...........................................................................................21
Distribution Segment at a Glance ................................................................................23 The second-largest segment of the Russian electricity sector......................................23 The economics of the DisCo business..........................................................................27
The place of DisCos in the sector’s value chain.................................................................................... 27 Electricity loss reimbursement ............................................................................................................... 28 The technology of electricity distribution................................................................................................ 29
RAB-based tariff setting: How does it work?.................................................................31 RAB framework to replace inefficient and archaic “cost plus” tariff setting approach ........................... 31 RAB introduction timeframe................................................................................................................... 34 The principles of RAB-based tariff setting ............................................................................................. 36
Company Profiles ..........................................................................................................41 MRSK Holding ..............................................................................................................41
MRSK Center ...............................................................................................................56 MRSK Center DCF valuation................................................................................................................. 59 MRSK Center condensed financials...................................................................................................... 60
MRSK Volga .................................................................................................................81 MRSK Volga DCF valuation .................................................................................................................. 84 MRSK Volga condensed financials ....................................................................................................... 85
MRSK South.................................................................................................................86 MRSK South DCF valuation .................................................................................................................. 89 MRSK South condensed financials ....................................................................................................... 90
MRSK North Caucasus.................................................................................................91 MRSK North Caucasus DCF valuation.................................................................................................. 94 MRSK North Caucasus condensed financials....................................................................................... 95
Tomsk DisCo ................................................................................................................96 Tomsk DisCo valuation.......................................................................................................................... 99 Tomsk DisCo condensed financials .................................................................................................... 100
Investment Summary Russia’s power distribution sector will be mainly driven by regulatory change in the near- to medium term. Based on our estimates, current stock prices fail to reflect the capital returns implied by the roll-out of RAB-based tariff regimes, which is anticipated in the next months. Considering the valuation upside together with factors like transparency, geography and stock liquidity, MRSK Holding, offering upside of more than 90%, is the best way to get exposure to the theme. However, a number of regional players, in which MRSK Holding has mostly majority stakes of 50% to 60%, offer attractive opportunities in valuation terms, with upsides of between 43% and 161% for our O/W-rated stocks, combined with acceptable liquidity. These names include MOESK, MRSK Center, MRSK Center-Volga and MRSK Urals.
In total, in this report we initiate coverage of 13 stocks from the sector, including MRSK Holding and all its listed subs: MOESK, Lenenergo, Kubanenergo, Tomsk DisCo, MRSK Holding, MRSK Center, MRSK Center-Volga, MRSK Northwest, MRSK Volga, MRSK North Caucasus, MRSK South, MRSK Urals and MRSK Siberia.
Having eight O/W ratings out of 13 MRSK names indicates our generally positive stance on the country’s power, mainly based on the following considerations:
• The introduction of RAB-based tariffs is the major value-driver and catalyst for the MRSK story. RAB-based tariffs have been introduced at only 29% of MRSK Holding’s regional branches. Since this story has not been played out yet and the regulatory decisions remain to be seen, we believe many MRSK names offer very attractive upside combined with a clear-cut catalyst.
• The RAB regime finally provides a transparent framework, allowing companies to earn sufficient returns on invested capital to generate and attract the necessary funds for the sector’s formidable CAPEX needs. Power distribution is the poorest part in the Russian power sector, which we believe to be one of the most attractive industries of the Russian economy. With the introduction of RAB-based tariffs, one of the key ingredients for financing the segment’s CAPEX needs is being established.
• Stable business with limited risk once RAB-based regulation is introduced. RAB-based regulation assumes tariffs will be set for a five-year period, after which they will be revised. This stable and predictable business means there is limited risk for investors. Once the active phase of the CAPEX cycle is over, MRSKs may become an attractive dividend play. All the abovementioned factors make MRSKs a very attractive investment vehicle for risk-averse investors.
Six reasons to be bullish on distribution
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Figure 1: Current EV/RAB multiple Figure 2: Average daily turnover
0.16x
0.29x 0.32x0.38x 0.39x 0.39x 0.40x
0.44x 0.45x 0.47x0.51x
0.81x
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MR
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Source: Bloomberg, Company data, Alfa Research Source: Bloomberg
• Pure domestic play with no currency exposure. Because their businesses are purely domestic, MRSKs’ cash flows do not have any exposure to currency risk. This makes the stocks especially attractive given the ongoing turmoil in the Euro zone.
• EV/iRAB multiples of mainly 0.4-0.5x look very compelling. MRSKs are mainly trading within a range of 0.4-0.5x EV/RAB (see Figure 1 above). This looks extremely cheap given that our fair EV/RAB for some names reaches almost 0.8x.
• Possible privatization. MRSKs may be privatized, though this is unlikely before the full introduction of RAB-based tariffs, i.e. before 2011. Regardless, privatization may be a long-term trigger for MRSK stocks.
Our ratings and 12M TPs for the 13 MRSK names we cover are summarized in the table below. MRSK Holding, MRSK Center, MRSK Center-Volga, MOESK and MRSK Urals offer the highest upside and stronger catalysts than their peers.
MRSK Holding, MRSK Center, MRSK Center-Volga, MOESK and MRSK Urals our top picks
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Figure 4: % of iRAB approved by regulators Figure 5: % of branches with RAB tariffs
100%
54%45%
35% 34%25% 24%
18%
0% 0% 0% 0%0%
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Source: Alfa Research Source: Alfa Research
Our Top Picks Through its holding structure, which controls all MRSKs, MRSK Holding provides exposure to the entire distribution segment. Moreover, MRSK Holding is the segment’s most liquid stock, with a daily turnover on MICEX of $3.3 mln compared with $560,000 for the most liquid underlying MRSK. We therefore recommend that investors looking for liquidity go O/W MRSK Holding.
Because MRSK is structured as a holding, it is useful to compare its MCap with the SoP valuation implied by the MCaps of its underlying assets (the value of Tyumenenergo, which is not listed, is also taken into consideration):
Figure 6: MRKH MCap vs. marked-to-market SoP Figure 7: MRKH discount to SoP value
Source: Bloomberg, Company data, Alfa Research Source: Bloomberg, Company data, Alfa Research
As can be seen from the above charts, MRSK Holding’s discount to its SoP value has narrowed to virtually zero, though there was a period when it was obviously mispriced, trading at a premium over the value of its underlying assets.
In our SoP valuation of MRSK Holding, we nonetheless apply a 25% discount, which we believe is appropriate in valuing a holding company vs. its underlying assets. Compared with the market-based discount, our valuation of the stock looks conservative.
MRSK Holding ($0.184; O/W, +71%): the most liquid distribution play
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MRSK Center is our favorite among the holding’s underlying assets for the following reasons:
• The company has the highest percentage of its iRAB already approved by the regulator (see figures 4 and 5 above) as well as one of the highest shares of branches that have already introduced RAB-based tariffs. The company is scheduled to adopt RAB-based tariffs at all its remaining branches as of July 1. If this happens, MRSK Center will be the first multi-regional MRSK to be 100% regulated under the RAB framework, thus reaping the benefits earlier than its peers;
• Because of the previous point, MRSK Center has the lowest regulatory risk among MRSKs, particularly with regard to lower-than-expected iRAB;
• MRSK Center has the highest transparency and best disclosure among MRSKs;
• The stock is the third-most-liquid after MOESK and MRSK North Caucasus;
• Because it operates in regions not deemed strategic by the Russian government, we believe MRSK Center has a good chance of being privatized once the privatization process is launched.
MRSK Center-Volga is very similar to MRSK Center and enjoys practically the same advantages:
• It has one of the highest percentages of iRAB approved by regulators (45%) and the highest share of branches under RAB (56%);
• MRSK Center-Volga also has much lower regulatory risk (e.g. lower-than-expected iRAB) than peers;
• The company also has a good level of transparency with an adequate IR department;
• MRSK Center-Volga is relatively liquid, though not as liquid as MRSK Center or MOESK;
• Like MRSK Center, the geography of the company’s business makes it a likely candidate for privatization.
We like MOESK primarily for the location of its business:
• Operating in the city of Moscow and the surrounding Moscow region, MOESK has good prospects for its business going forward given the massive increase in capacity that will be connected to its networks once developers carry out planned projects in the region. In other words, we believe MOESK provides the best exposure to an increasing customer base;
• Favorable geography also means there is little risk of a deterioration in payment discipline;
• MOESK is the most liquid underlying MRSK, with an average daily turnover of more than $0.5 mln.
MRSK Urals boasts the following advantages:
• Half its branches have already adopted RAB, including Kurganenergo, in which the company holds a 49% stake;
• The company operates in the highly-industrialized Urals region, and manufacturing growth will ensure a sustainable increase in its
MRSK Center ($0.069; O/W; +115%): lowest regulatory risk, highest transparency
MRSK Center-Volga ($0.015; O/W; +135%): more liquid than peers, low regulatory risk, good transparency
MOESK ($0.075; O/W; +72%): a bet on geography
MRSK Urals ($0.02; O/W; +152%): exposure to highly industrialized regions
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customer base (the company operates in the Sverdlovsk, Perm, Chelyabinsk and Kurgan regions);
• MRSK Urals is one of the cheapest MRSKs, trading at only 0.29x EV/RAB.
MRSK North Caucasus presents an interesting case. Though our iRAB estimate for the company is half that guided by MRSK Holding, and we applied the highest WACC of any MRSK to reflect the high level of risk inherent in the stock, the company looks extremely cheap, offering huge (161%) upside to our target price.
Nonetheless, despite its upside, we do not include the stock in our top picks list because of valuation risk. In particular, the company faces the worst payment discipline, a problem inherent to the Caucasus. Moreover, none of its branches has yet adopted RAB-based tariffs, increasing the risk that unfavorable initial RAB parameters will be set. Finally, the company operates in a region that investors tend to avoid because they consider it politically unstable and dangerous.
Nonetheless, we assign an O/W rating to the stock because our valuation incorporates many of these risks. We recommend the stock to investors with a high appetite for risk, an idea supported by the stock’s high liquidity.
MRSKs on multiples Russian MRSKs are trading at decent discounts to global electricity distribution peers on 2011E EV/S, EV/EBITDA and P/E. Since they will not fully adopt RAB-based tariffs until the beginning of 2011, we believe it makes little sense to at multiples for previous years (e.g. 2010).
MRSK North Caucasus ($11.2; O/W; +161%): huge upside, but very risky play
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Figure 8: Russian MRSKs on multiples vs. global peers Company Country Mcap EV/Sales EV/EBITDA P/E EBITDA margin $ mln 09 10E 11E 09 10E 11E 09 10E 11E 09 10E 11ERussian companies MRSK Holding Russia 4,570 0.6 0.6 0.5 3.0 3.7 2.6 9.9 79.7 9.1 22% 16% 19%MRSK Center Russia 1,353 1.2 1.0 0.8 5.0 3.2 2.1 13.4 5.3 2.7 25% 31% 38%MRSK Center-Volga Russia 730 0.9 0.7 0.6 5.4 5.9 2.8 28.5 neg 4.8 16% 13% 21%MRSK Volga Russia 618 0.9 0.8 0.6 4.9 5.6 3.2 14.1 26.9 6.2 18% 14% 20%MRSK Northwest Russia 681 1.0 0.9 0.7 7.7 15.4 4.9 n/m n/m 12.2 13% 6% 14%MRSK Siberia Russia 911 1.0 0.8 0.7 9.4 10.0 4.6 neg neg n/m 11% 8% 15%MRSK North Caucasus Russia 126 0.5 0.4 0.4 5.4 6.4 3.1 neg neg neg 9% 6% 11%MRSK Urals Russia 679 0.6 0.5 0.4 3.0 2.3 2.1 4.8 3.9 2.8 20% 22% 21%MRSK South Russia 259 1.1 0.9 0.7 5.1 5.2 2.9 neg 7.1 2.4 21% 18% 26%MOESK Russia 2,110 1.4 1.4 1.4 3.4 4.4 5.0 5.9 18.0 15.0 42% 32% 27%Lenenergo Russia 747 1.6 1.4 1.4 4.3 4.4 6.1 8.1 20.6 neg 37% 32% 23%Kubanenergo Russia 104 0.7 0.6 0.5 4.3 3.8 3.9 1.8 neg 4.0 16% 15% 13%Tomsk DisCo Russia 67 0.5 0.5 0.4 2.7 6.2 4.2 5.5 n/m 16.7 18% 8% 10%Russian MRSKs average 0.9 0.8 0.7 4.9 5.9 3.7 10.2 23.1 7.6 11% 9% 10% Emerging Markets Eletropaulo Brazil 3,300 0.9 0.8 0.8 4.5 4.0 4.3 6.5 7.2 8.6 20% 20% 18%Cia General De Electr. Chile 2,387 1.4 1.6 1.5 8.9 8.4 7.9 9.3 15.9 13.8 16% 19% 19%Aksu Enerji ve Ticaret Turkey 23 11.6 10.4 13.2 14.3 12.7 17.8 6.8 7.6 11.0 81% 82% 74%Zhytomyroblenergo Ukraine n/a n/a 0.5 0.4 n/a 5.8 5.0 n/a n/a n/a n/a 8% 8%Kirovogradoblenergo Ukraine n/a n/a 1.0 0.8 n/a 24.3 17.8 n/a n/a n/a n/a 4% 5%Zakarpattiaoblenergo Ukraine n/a n/a 0.6 0.5 n/a 11.1 8.7 n/a n/a n/a n/a 5% 6%Zaporizhzhiaoblenergo Ukraine n/a n/a 0.3 0.2 n/a 12.1 8.8 n/a n/a n/a n/a 2% 3% Average EM 4.6 2.2 2.5 9.2 11.2 10.1 7.5 10.2 11.1 39% 16% 15%RU DisCos premium/discount to GEM -80% -63% -72% -47% -48% -64% 36% 125% -32% -72% -44% -33%Source: Bloomberg, Alfa Research
Figure 9: EV/RAB multiples of Russian MRSKs vs. global companies Company Country Mcap EV/RAB $ mlnRussian companies MRSK Holding Russia 4,570 0.41MRSK Center Russia 1,353 0.45MRSK Center-Volga Russia 730 0.39MRSK Volga Russia 618 0.44MRSK Northwest Russia 681 0.81MRSK Siberia Russia 911 0.39MRSK North Caucasus Russia 126 0.16MRSK Urals Russia 679 0.29MRSK South Russia 259 0.47MOESK Russia 2,110 0.51Lenenergo Russia 747 0.40Kubanenergo Russia 104 0.38Tomsk DisCo Russia 67 0.32Russian MRSKs average 0.42Emerging Markets Transelectica SA Romania 325 0.78Average EM 0.78MRSKs Premium/discount to EM peers -46%Developed Markets National Grid UK 25,535 1.41Terna Spa Italy 7,223 1.27SP Ausnet Australia 1,752 1.01Elia Belgium 1,878 1.16Average DM 1.21MRSKs Premium/discount to DM peers -65%Source: Bloomberg, Company data, Alfa Research
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MRSKs trade at discounts to foreign RAB-based regulated companies (we used only high-voltage transmission companies where the RAB value was available).
Key events to watch We highlight the following events that will affect MRSKs’ share price performance and should therefore be closely watched by investors:
1. July 1, 2010: Adoption of RAB-based distribution tariffs in many regions in Russia. Although it is arguable whether the government will be able to set these tariffs as prescribed by the Schedule (see Figure 58 with the RAB transition schedule on pg. 34 of the report), the date will be very important for MRSK stocks because it will show whether or not the government is actually going to cut iRAB vs. the numbers expected by the companies themselves. Disappointing final iRAB figures are the biggest concern expressed by investors, especially given the possible tariff cuts for the Federal Grid Company proposed by the Ministry of Economic Development.
2. 2H10: Approval of methodology for regulation of quality of electricity distribution. The quality of power supply is a very important issue and must ultimately be addressed by the RAB-based tariff regulatory framework. Quality-control rules and criteria are being developed, and we expect them to be finalized by the end of this year. The main component of these rules for MRSKs would be additional penalties and fines that could be imposed if a company fails to satisfy the prescribed level of electric supply quality.
3. January 1, 2011: Complete adoption of RAB-based distribution tariffs by all Russian regions: According to the abovementioned schedule, Russia must entirely adopt RAB-based distribution tariffs as of the beginning of next year. It goes without saying that this is a very important date for MRSK stocks.
Risks Because the majority of MRSK Holding’s regional branches have yet to adopt RAB-based tariffs, we consider the determining of the initial parameters of RAB as the major risk facing MRSK shares. The key unknown is the level of iRAB for those regions where the new tariffs have not been introduced yet, while recent comments from the Ministry of Economic Development about possible cuts to FGC’s RAB-based tariff growth rates in 2011-12 increased investor concern over the government willingness to reduce iRAB for MRSKs to smooth out the sharp increases in distribution tariffs unavoidable upon transition to an RAB-based framework.
Because this is a major risk, we recommend investors go O/W those names with the highest percentage of iRAB already approved (or alternatively, the highest share of branches that already operate under the RAB framework). This is part of the reason why MRSK Center and MRSK Center-Volga are among our top picks.
Since CAPEX is another important component of RAB-based tariffs, the precise CAPEX plans are not yet known for many regional branches of MRSKs where RAB-based tariffs have not yet been introduced. It is no surprise that MRSK Holding has not provided a consolidated investment program, since it has not been finalized.
We therefore believe that higher-than-expected CAPEX poses a serious downside risk to our valuation owing to the discrepancy between our WACC estimates and the regulatory rate-of-return of 12% applied to the new RAB of
Key events to watch
Regulatory risks: lower-than-expected iRAB
CAPEX program has not been finalized
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DisCos. In other words, until WACC converges with the rate of return, the investment activity of MRSKs will be value-destructive.
Poor liquidity is another risk facing MRSK names. Except for MRSK Holding, MRSKs are relatively illiquid, reducing their appeal for international investors.
Most MRSK names are illiquid
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Valuation DCF-derived fair EV/RAB varies among the companies We used DCF to value each MRSK. We then valued MRSK Holding based on a 50:50 blend of DCF and sum-of-the-parts using the fair values we calculated for all its underlying assets, including Tyumenenergo, which is not listed.
Below, we summarize the key assumptions and components of the methodology used in our models to value MRSKs:
• We use a bottom-up approach in our MRSK model: we model each regional branch individually because tariffs are determined separately for each region, and then we combine them together in our full MRSK model;
• We assume RAB-based tariffs will be introduced in accordance with the schedule approved by the government (see Figure 56 in the “Distribution Segment at a Glance” section of this report) except for those regions that have said they will delay introduction;
• By default, we use the RAB numbers provided by MRSK Holding except in the case of MRSK North Caucasus (see discussion below);
• We assume the first regulatory period for all branches which have not yet adopted RAB-based tariffs will be for five years;
• Repurchase costs for lost electricity are linked to our recently updated electricity price outlook (see our report “GenCos: Upgrading on Strong Catalysts, Improved Price Outlook” of June 22);
• We link our electricity transmission charge to the tariff growth for FGC in 2010-12 approved by the regulator, while our forecast thereafter is based on our FGC model;
• The regulatory X-factor is assumed to be 1% p.a., while to be on the safe side, we conservatively assume a 0% actual efficiency gain from MRSKs’ OPEX;
• Our WACC takes into consideration six company-specific factors discussed below;
• We assume a 0% perpetual growth rate;
• In calculating our terminal-year cash flow, we use RAB depreciation in place of financial-accounting-based D&A charge;
• We apply smoothing if the expected tariff increase in a given year exceeds 35%. Based on the tariff growth rates of those MRSK branches where RAB-based tariffs have already been introduced, we do not believe regulators are likely to allow MRSK tariffs to rise by over 35-40%. The smoothing mechanism is an important part of RAB-based tariff regulation (for more information, see the “Distribution Segment at a Glance” section of this report);
• Ignoring connection-fee revenues. Since the role of the connection fee mechanism will fade away upon the introduction of RAB-based tariffs, we assume connection fee revenues will be zero starting in 2010;
We use DCF to value MRSKs
Key assumptions
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• Other regional networks removed from throughput and financials. Many MRSKs have other regional distribution networks in their covered regions whose operations are usually reflected in both electricity throughput and P&L numbers. These regional companies (also known as “TSOs” in accordance with their Russian acronym) are usually affiliated with local authorities and have nothing to do with MRSKs in ownership terms. Since it is hard to predict the future impact of these other regional distribution networks on MRSKs’ business, we adjust the MRSK numbers to completely remove the effect of these companies.
The table below summarizes our valuation of all underlying DisCos of MRSK Holding:
Our DCF-derived EV/RAB multiple varies within a range of 0.3-0.8x, predominantly reflecting the high discrepancy in WACC among MRSKs (see the discussion on WACC below). There are also other factors in our models that affect our fair EV/RAB multiples (see the charts below with our reconciliation of EV/RAB for all MRSKs).
WACC: The main factor affecting EV/RAB; major discrepancy among MRSKs Our build-up WACC estimates incorporate six different company-specific factors, including whether it publishes IFRS accounts, the level of transparency and disclosure, the presence of a large institutional investor among the shareholders (e.g. Prosperity Capital Management and MRSK Center), payment discipline in the regions covered by the MRSK (e.g. MRSK North Caucasus receives the highest premium for this kind of risk) and regulatory risk, defined as the level of exposure to possible reductions in iRAB (those MRSKs with a high share of branches already under RAB-based tariffs have lower risk, and vice versa). The sixth risk is liquidity, based on the daily turnover of the stock.
The table below summarizes our WACC estimates for all covered MRSKs (we assumed a 30:70 D/E gearing ratio, which is in line with what the FTS used to set the rate-of-return for RAB-based tariffs):
Valuation summary
We incorporate six company-specific factors into our build-up WACC calculation
The charts below show that those MRSKs with the lowest WACC have the highest DCF-based EV/RAB multiples.
Figure 12: MRSKs ranked by fair EV/RAB Figure 13: MRSKs ranked by WACC
0.76
x0.
71x
0.67
x
0.64
x0.
62x
0.60
x
0.54
x
0.43
x0.
42x
0.42
x
0.38
x0.
33x
0.31
x
0.00x
0.20x
0.40x
0.60x
0.80x
1.00x
MR
SK C
ente
r
MO
ESK
MR
SK C
&VM
RSK
Ura
ls
MR
SK N
.Wes
t
MR
SK V
olga
MR
SK S
outh
MR
SK S
iber
ia
Tom
sk D
isC
o
Lene
nerg
oTy
umen
ener
go
Kuba
nene
rgo
MR
SK N
.C.
12.7
%
13.4
%14
.1%
15.5
%
16.4
%
17.1
%17
.1%
17.8
%
17.8
%
18.3
%19
.2%
21.1
%
21.8
%
0.0%5.0%
10.0%15.0%20.0%25.0%30.0%
MR
SK C
ente
r
MO
ESK
MR
SK C
&V
Lene
nerg
oM
RSK
Sib
eria
MR
SK U
rals
MR
SK S
outh
MR
SK V
olga
MR
SK N
.Wes
tTo
msk
Dis
Co
Kuba
nene
rgo
Tyum
enen
ergo
MR
SK N
.C.
Source: Alfa Research Source: Alfa Research
Initial RAB: The main valuation factor is still uncertain The key factor determining MRSKs’ valuation is the initial regulatory asset base (iRAB). This parameter, however, remains uncertain for 71% of the regions covered by MRSK Holding. Moreover, Elvira Nabiullina, Russia’s Economic Development Minister, recently announced plans to cut next year’s tariff increase for the Federal Grid Company, spurring fears of possible cuts in the initial RAB estimates for many of the regions where RAB-based
We base our valuation on MRSK Holding’s guided iRAB numbers, but they may change
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distribution tariffs are being introduced. We have written before that this is more likely intended to smooth the increase in FGC’s tariffs and lengthen its regulatory period to five years from the current three; nonetheless, many investors are very concerned that the initial parameters of RAB-based tariffs could deteriorate under pressure from the Economic Development Ministry, which tends to prioritize fighting inflation.
We share these concerns and believe that July 1, 2010, when many MRSK Holding branches must adopt RAB-based tariffs, will be a very important date for investors, since it will show whether or not the approved iRAB numbers differ substantially from those guided by MRSK Holding.
We base our valuation of MRSKs on the numbers provided by MRSK Holding except in the case of MRSK North Caucasus, which seemed exaggerated relative to the net PP&E value of the company. The iRAB numbers we use in our models are provided below:
Figure 14: iRAB numbers assumed in our valuation MRSK Full RAB value iRAB value iRAB value % of iRAB approved to date RUB mln RUB mln $ mln MRSK Center 414,395 118,012 3,934 54%MRSK Northwest 80,607 29,688 990 18%MRSK Siberia 253,452 81,624 2,721 25%MRSK Urals 139,276 74,769 2,492 35%MRSK South 112,473 37,297 1,243 34%MRSK Center and Volga 217,940 79,443 2,648 45%MRSK Volga 158,608 53,981 1,799 24%MRSK North Caucasus 45,570 29,343 978 0%MOESK 603,987 207,079 6,903 0%Lenenergo 180,000 92,256 3,075 0%Tyumenenergo 230,918 119,191 3,973 0%Kubanenergo 96,805 24,622 821 0%Tomsk DisCo 17,080 5,421 181 100%Source: Company data, Alfa Research
The reason why we adjusted MRSK North Caucasus’s iRAB is highlighted in the charts below. The iRAB/Net PP&E ratio based on MRSK Holding’s guided figure looks abnormally high, and the assumed depreciation of MRSK North Caucasus’s assets is strangely low. We therefore adjusted this number, applying the average iRAB/Net PP&E ratio of 1.8x to find the iRAB for the company. The adjusted number is shown in the table above.
Source: Company data, Alfa Research Source: Company data, Alfa Research
MRSK Northwest’s iRAB figure looks abnormally low at 1.0x Net PP&E vs. the MRSK Holding average of 1.8x. Although we acknowledge that there is
We cut MRSK Holding’s iRAB estimate for MRSK North Caucasus
MRSK Northwest’s iRAB looks extremely low
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significant upside risk to this iRAB number, we nonetheless use it in our valuation in the absence of any other estimates for the company’s iRAB: MRSK Northwest has the poorest corporate governance and lowest transparency among MRSKs and refused to give their own guidance for their initial regulatory asset base. Only one branch out of six, Novgorodenergo, has adopted RAB-based tariffs.
Regardless, we note that there is significant upside to our current valuation of the stock should the actual iRAB numbers exceed those guided by MRSK Holding.
MRSK Holding valuation We value MRSK Holding using the equally-weighted blended results of the holding’s consolidated DCF and SoP valuation using our fair value for all its components. The details of our DCF valuation of MRSK Holding are provided in the “Company Pages” section of this report. The blended valuation is summarized in the table below:
Figure 17: Blended target price calculation, MRSK Holding DCF SoPWeight 50% 50%Fair EV 17,169Net debt 4,029Minority interest 4,954Fair equity value 8,186 5,813Number of shares, mln - com 41,042 41,042 - pref 2,075 2,075Assumed pref/com discount 0.9158x 0.9158xFair value p.s. $0.191 $0.135Blended fair value p.s., com $0.163Blended fair value p.s., pref $0.149WACC 12.9%Blended 12M TP, com $0.184Blended 12M TP, pref $0.168Current share price, com $0.107Current share price, pref $0.078Upside, com 71%Upside, pref 115%Rating, com O/WRating, pref O/WSource: Company data, Bloomberg, Alfa Research
We apply a 25% discount to our SoP valuation, the discount at which holding companies usually trade to the aggregate value of their underlying assets.
Our SoP valuation is summarized below:
We apply equally-weighted results of DCF and SoP valuation
We apply a 25% holding discount to our SoP valuation
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Figure 18: MRSK Holding SoP valuation, $ mln DCF-based Equity Value Holding stake Equity value attr. to HoldingMOESK 3,201 51% 1,629 MRSK Center 2,581 50% 1,297 MRSK Center and Volga 1,501 50% 756 MRSK Volga 751 68% 508 MRSK Northwest 349 55% 194 MRSK Siberia 1,018 53% 538 MRSK North Caucasus 271 58% 158 MRSK Urals 1,418 52% 731 MRSK South 341 52% 176 Lenenergo 798 46% 365 Kubanenergo 393 25% 100Tomsk DisCo 87 52% 45 Tyumenenergo 1,233 100% 1,233 Total equity value 7,730 Less: 25% holding discount 1,932 Discounted equity value 5,797 Number of shares, mln - com 41,042 - pref 2,075 Assumed pref/com discount 0.9158x Fair value p.s., com $0.135 Source: Company data, Alfa Research
Figure 19: Five largest contributors to MRSK Holding’s value, $ mln
1629
1297
1233
731
756
2083
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
MOESK MRSK Center TyumenenergoMRSK Urals MRSK Center and Volga Other
Source: Alfa Research
EV/RAB waterfall analysis The waterfall charts below reconcile our EV for the MRSKs with their theoretical value assuming an EV/RAB multiple of 1.0x. We separate the impact of the following factors affecting our DCF-based EV/RAB multiple:
• WACC discrepancy: WACC differs from the regulatory rate-of-return;
• OPEX discrepancy: We assume a 0% efficiency gain in actual OPEX vs. the regulatory 1% annual X-factor;
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• D&A factor: This shows the discrepancy between accounting D&A charge and RAB depreciation;
• WC factor: This reflects the difference between modeled net working capital changes and the regulatory ones incorporated into RAB-based tariffs;
• “Cost +” factor: This reflects the influence of the “pre-RAB” cash flows, i.e. those which are generated under “cost-plus” tariffs;
• Tax factor: The discrepancy between accounting and regulatory income taxes;
• Smoothing factor: This reflects the impact of smoothing on RAB-based tariffs;
• Supply segment factor: This shows the contribution of supply assets’ (retailing companies) cash flows belonging to the MRSKs, if any;
• XR factor: This accounts for exchange-rate fluctuations affecting ruble-denominated cash flows converted into dollars.
Limited Impact on End-User Tariffs How much regulatory risk? In Russia, distribution tariffs account for a relatively small share of the end-user electricity tariff compared with the power generation component. The charts below provide a breakdown of Russia’s end-user tariff:
Figure 33: End-user tariff composition, 2009 Figure 34: Change in end-user tariff breakdown after RAB introduction
Source: Market Council Source: Market Council, Alfa Research
The above charts show that the total share of the “grid” component in end-user tariffs (i.e. including both transmission and distribution components) will rise from 32% currently to 36% in 2012, a very small increase. As a result, distribution tariffs could increase sharply without having a significant influence on end-user tariffs.
Generation component Market infrastructureTransmission component Distribution componentRegional generation Retailing charge
Source: Market Council, Alfa Research Source: Market Council, ATS, Alfa Research
The most important conclusion to draw from all this is that in combating inflation, the government should be more concerned about double-digit annual gas tariff increases for domestic customers, predominantly in the power sector, rather than the infrastructure component, including the grid. The latter
Distribution tariff makes up only 27% of end-user price, reducing regulatory risk
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has a much lower influence on the end-user tariff than power generation, whose costs are driven exclusively by the gas tariff increases lobbied for every year by Gazprom.
The table below shows that distribution is a relatively small component in overall electricity prices. These numbers speak for themselves.
Distribution Segment at a Glance The second-largest segment of the Russian electricity sector The distribution business in the Russian utilities sector is currently represented by large, state-controlled MRSK Holding, which holds controlling stakes in 13 regional distribution companies – MRSKs and two standalone DisCos which have not been merged into the respective MRSKs (Kubanenergo and Tomsk DisCo).
MRSK Holding was created as part of the breakup of UES in mid-2008 and obtained UES’s controlling stakes in several MRSKs. The MRSKs in turn were consolidated on the basis of 58 small standalone distribution companies (DisCos, or RSKs in Russian), which were created as a result of the unbundling of vertically-integrated AO-energos by line of business, the bulk of which occurred in 2004-2005.
However, in some rare cases distribution networks remained owned by non-unbundled energos, specifically the four energos that were independent of UES (Bashkirenergo, Novosibirskenergo, Tatenergo and Irkutskenergo) and remote energos (primarily in the Russian Far East). In particular, Far East Energy Company, or DEK, owns 100% of Far East DisCo holding distribution networks in Amur, Khabarovsk, Primorye regions and Southern part of Yakutia Republic.
Apart from MRSK Holding, a significant portion of low-voltage distribution networks in some regions are still owned by local municipal authorities, particularly in Moscow and St. Petersburg.
According to government regulations (in particular, the government resolution of December 21, 2001, No. 881 “On the Criteria of Ascribing Transmission Lines and Network Units to the United National Power Grid”), all networks with voltages below 220 kV must be included in distribution companies, including those that are part of national transmission networks. All lines with voltages of 220 kV and higher have eventually been passed under the umbrella of the Federal Grid Company (FGC). Although some DisCos own overhead and cable network lines with 220 kV or higher voltages, these lines are not part of the Unified National Power Grid.
The structure of MRSK Holding is presented on the next page:
The Russian distribution segment represented by MRSK Holding, which includes 13 underlying distribution companies
The distribution sector is comprised of low-voltage networks referred to as “last mile” businesses
MRSK Holding structure
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Figure 38: MRSK Holding structure
* Note: Yantarenergo is not pure DisCo owning some power generating assets as well Source: Company data, Alfa Research
The grey boxes represent pure distribution companies, i.e. the underlying MRSKs, while MRSK Holding also holds controlling stakes in some retailing companies, predominantly in the Caucasus region, and some other assets, including 100% of Yantarenergo, which is a vertically-integrated utility in the Kaliningrad region.
The geography of MRSK Holding and its subsidiaries is shown on the map below:
Figure 39: MRSK Holding geography
Source: Alfa Research
Twelve out of the 13 underlying distribution companies of MRSK Holding are listed and trade on Russian stock exchanges. The charts below compare the underlying companies by revenue, EBITDA, throughput and MCap:
Kubanenergo
Independent energos
Isolated areas
MRSK Center
MRSK Center-Volga
MRSK South
MRSK North Caucasus
MRSK Northwest
MRSK Volga
MRSK Urals
Tyumenenergo
MRSK Siberia
Moscow United DisCo
Lenenergo
Tomsk DisCo
Kubanenergo
Independent energos
Isolated areas
MRSK Center
MRSK Center-Volga
MRSK South
MRSK North Caucasus
MRSK Northwest
MRSK Volga
MRSK Urals
Tyumenenergo
MRSK Siberia
Moscow United DisCo
Lenenergo
Tomsk DisCo
Twelve subsidiaries of MRSK Holding are listed
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Figure 40: MRSKs by 2009 revenue, $ mln Figure 41: MRSKs by 2009 EBITDA, $ mln
0 500 1,000 1,500 2,000 2,500 3,000
Tomsk DisCoMRSK N.C.
KubanenergoMRSK South
LenenergoMRSK N.W.
MRSK VolgaMRSK Siberia
Tyumen-goMRSK C&V
MRSK CenterMRSK Urals
MOESK
0 200 400 600 800 1,000 1,200
Tomsk DisCoMRSK N.C.
KubanenergoMRSK N.W.
MRSK SiberiaMRSK SouthMRSK VolgaMRSK C&VLenenergo
MRSK UralsTyumen-go
MRSK CenterMOESK
Source: Company data, Alfa Research Source: Company data, Alfa Research
Figure 42: MRSKs by 2009 throughput, GWh Figure 43: MRSKs by Mcap, $ mln
0 20,000 40,000 60,000 80,000
Tomsk DisCoMRSK N.C.
KubanenergoMRSK Siberia
MRSK N.W.MRSK SouthMRSK UralsTyumen-go
MRSK VolgaMOESK
LenenergoMRSK Center
MRSK C&V
0 500 1,000 1,500 2,000 2,500
Tomsk DisCoKubanenergo
MRSK N.C.MRSK SouthMRSK VolgaMRSK Urals
MRSK N.WestMRSK C&VLenenergo
MRSK SiberiaMRSK Center
MOESK
Source: Company data Source: Bloomberg, Alfa Research
After power generation, the distribution segment is currently the second-largest segment in the Russian utilities sector in terms of market cap, amounting to $13 bln, or 18% of the total market cap of all listed companies in the Russian utilities universe.
MRSK Holding is now the fourth largest name in the sector in terms of MCap after RusHydro, Federal GridCo and OGK-4. Mosenergo and Inter RAO are the two other largest names in the power sector.
Among MRSKs, MOESK, MRSK Center and MRSK Siberia are the three largest stocks, having the highest MCaps at the moment.
Distribution is the second-largest segment in the Russian utilities sector by market cap
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Figure 44: Russian electricity sector MCap, $ bln Figure 45: Distribution is the 2nd largest segment
41
125 1 3
13
0
10
20
30
40
50
60
70
80
90 Generation Distribution TransmissionVICs Supply Other
Generation54%
VICs7%
Other4%
Transm-n16%
Distrib-n18%
Supply2%
Source: Bloomberg, Alfa Research Source: Bloomberg, Alfa Research
Figure 46: MRSK Holding has 4th largest MCap, $ Figure 47: Top 5 underlying MRSKs by MCap, $ mln
13.412.0
5.0 4.6 3.8 3.3
0.0
4.0
8.0
12.0
16.0
20.0
Rus
Hyd
ro
FGC
OG
K-4
MR
SKH
oldi
ng
Mos
ener
go
Inte
r RAO
2,110
1,353911 747 730
0
1,000
2,000
3,000
MOESK MRSKCenter
MRSKSiberia
Lenenergo MRSKCenter
and Volga
Source: Bloomberg, Alfa Research Source: Bloomberg, Alfa Research
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The economics of the DisCo business The place of DisCos in the sector’s value chain For a better understanding of the role of distribution companies in the Russian utilities sector, we have provided a chart showing the place of DisCos in the sector’s overall value chain:
Figure 48: Current place of DisCos in sector value chain
electricity flowsmoney flows
Supply Companies
pay retail electricity tariffHydro-OGK
Electricity consumers - participants in WEM
Federal Grid Company
(National Grid)Small end users
pay generators' price
Block-Stations
Major Consumers
Rosenergoatom
pay distribution tariff
Distribution Companies
IPPs
Retail Electricity Marketpay transmission tariff
Wholesale Electricity Market
OGK/TGK
purchase electricity losses
Source: Alfa Research
The above figure demonstrates that distribution companies in Russia have supply companies as their main consumers. Supply companies purchase electricity from generators on the wholesale market and then re-sell it to their customers on the regional level. However, they are obliged to pay distribution tariffs to the DisCos for the physical “last mile” delivery of the electricity to end-users.
On the other hand, DisCos are obliged to pay transmission tariffs established by the government to the Federal Grid Company. This transmission tariff is set by the Federal Tariff Service. In fact, this payment for electricity transmission by DisCos is a component of their operating expenses, amounting on average to 20-30% of total OPEX and thus always reflected in the respective tariff for DisCos. Transmission tariffs are thus passed through distribution tariffs onto supply companies purchasing the electricity on the wholesale market, and eventually onto their customers through regional end-user tariffs.
Essentially, DisCos’ role in the sector value chain protects them from the non-payment and cash accumulation problems still persisting in some problematic regions of Russia. Supply companies fully take on these risks as they directly interact with end-users, including households, regional communal services and small and medium-sized industrial consumers. Meanwhile, supply companies are obliged to pay DisCos for providing physical electricity distribution services regardless of their ability to collect cash from their end-user customers on a timely basis. At this time, supply companies are exposed to much greater risk from this situation and are thus less predictable than distribution companies, for whom local authorities constitute the sole uncertainty regarding state-controlled regulations.
However, during the crisis in 2009, many MRSKs faced serious problems with non-payment owing to the poor payment discipline of end-user customers, who were late in paying their suppliers. This in turn made it difficult for the suppliers to pay MRSKs.
Figure 47 depicts the value chain in the Russian utilities sector as it is expected to be after the completion of all the transformations caused by the current cycle of reforms:
DisCos collect cash from supply companies but are obliged to pay tariffs to the FGC
DisCos’ position in the value chain better protects them from non-payments unlike supply companies
The role of MRSKs will remain the same going forward
The DisCos’ position in the value chain is unlikely to change as even the new tariff regulation scheme does not assume any change in the role of DisCos in the industry.
Electricity loss reimbursement Distribution networks accept electricity from high-voltage grids owned mainly by the Federal Grid Company and other suppliers (i.e. power plants directly connected to distribution networks). Transmission of this electricity to end-consumers through their low-voltage distribution networks is then referred to as the “last mile.” However, as with any electricity transfers over a network, DisCos lose a portion of the transmitted electricity in the process, which they are then obliged to reimburse through additional purchases.
In Russia, all DisCos purchase power from supply companies to compensate for their electricity losses in accordance with the tariffs set by the local Regulatory Energy Commissions for loss payments. Electricity loss reimbursement expenses in the framework of approved loss standards are included in the tariff for DisCos because this is an item of operating expenses for the companies. DisCos are thus able to purchase their losses on the wholesale market, where prices are usually lower than retail tariffs set by supply companies. However, this is not currently favorable because of the high cost of equipping all DisCos’ reception centers with electricity calculation systems. Nevertheless, Russian DisCos do not rule out that they may begin purchasing electricity directly on the wholesale electricity market soon.
The mechanism for DisCo electricity loss reimbursement is shown in Figure 48 below.
DisCos reimburse electricity losses through purchases from supply companies
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Figure 50: Electricity loss reimbursement
High-voltage Grid DisCo End Consumers
Electricity input
Electricity salesElectricity sales
Electricity losses
Supply Company
Purchases losses
Electricity bought from supply company
Source: Alfa Bank Research
Generally, total electricity losses pertaining to networking companies (both transmission and distribution) are divided into two main types: technological losses and commercial losses. The former occur due to the physical process of electricity transmission through the networks and change depending on the state of the networks, their depreciation, the outdoor temperature and other factors. More significantly, there is a strong negative correlation between voltage and loss, a result of the physics of electricity.
Commercial losses, on the other hand, are caused by poor counting of electricity leading to ordinary theft. Commercial losses are currently considered the main lever for diminishing total electricity losses via implementation of modern technologies for better measurement of electricity consumption.
The technology of electricity distribution The main technological process behind electricity distribution is shown in Figure 49. Electricity is supplied to DisCos from a national grid through electric power supply centers, which are generally owned by the Federal Grid Company as they involve high-voltage networking assets. The electricity then goes to distribution centers (owned by DisCos) via high-voltage supply cables and is then delivered to transformer centers through distribution cable lines, which lower electricity voltage and deliver electricity through transformer substations to end users.
Electricity distribution involves a number of stages
Electricity losses over networks are divided into two types
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Figure 51: Electricity distribution technology National Grid
Electric Power Supply Center High-voltage
Distribution Center
Transformer Center
Transformer Substation 1
Transformer Substation 2 … Transformer
Substation N 0.4 kV
End electricity users
Supply Cables
Distribution Cables
Source: Alfa Bank Research
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RAB-based tariff setting: How does it work? RAB framework to replace inefficient and archaic “cost plus” tariff setting approach In 2011 the electricity market will be fully liberalized, i.e. the generating business will become completely deregulated (except for electricity sold to households). On the other hand, monopolistic businesses, primarily networks including distribution and transmission, will become state-regulated. However, the current “cost plus” mechanism is set to be replaced with the more progressive and internationally accepted RAB regulation-based system.
“Cost plus,” as its title suggests, involves setting tariffs by tying them to the regulated company’s operating costs, interest expenses, taxes, dividends and necessary capital expenditures financed through own funds, deriving so-called “necessary regulated revenues.” The distribution tariff is then calculated by dividing necessary regulated revenues by electricity sales, i.e. electricity input net of network losses. Figures 50-51 below compare the typical breakdown of “cost plus” distribution tariffs for Russian MRSKs.
Income tax Income taxControllable OPEX Controllable OPEX
Non-controllable OPEX Non-controllable OPEX
"Cost +" revenue RAB tariff revenue
Depreciation
Source: Alfa Research Source: Alfa Research
“Cost plus” tariff regulation approach has three major drawbacks discussed below.
“Cost plus” tariffs for regional DisCos are set on an annual basis by local regulators (Regional Energy Committees). Tariff-setting usually becomes a subject of debate between local governments – who control the Regional Energy Committees – and their regional DisCo’s management, meaning that establishing economically justified and adequate tariffs under “cost plus” directly depends on the lobbying abilities of the local DisCo management. Tariff-setting under “cost plus” thus becomes more a political than an economic issue.
The “cost plus” system, because of its reliance on operating expenses and political favor, is not ideal for DisCos. On the contrary, it sometimes leads to artificially exaggerated operating costs in order to justify higher tariffs. If a company reports that it has substantially reduced costs within the previous regulated period, it would likely face a reduction in its tariffs during the next period because the local regulator is always interested in keeping tariffs as low as possible to satisfy the local authorities’ constituents. Thus, under the current framework, DisCos are unable to retain saving from reduced costs if they report their operating expenses properly. Therefore it does not come as a surprise that
RAB approach is being adopted by Russian electric utilities
Decisions on tariffs highly politicized, especially at regional level
“Cost plus” fails to encourage cost savings
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operating expenses for Russian DisCos (less depreciation) are currently exaggerated so much, which suggests decent upside potential on cost savings from cutting out the “operating fat”. Needless to say, that all these inefficiencies of DisCos are passed through their tariffs on to the end-user customers.
Another unfavorable peculiarity of the “cost plus” regulation system is the one-year term for tariffs. This system makes DisCo business less predictable as their prices may change dramatically from year to year without any relationship to the market. This consequently leads to a situation in which distribution companies in Russia are virtually unable to attract long-term loans as their creditors consider the one-year tariff terms as very risky because no one knows what tariff the company will receive in the next period due to political decisions.
RAB-based regulatory approach is free of virtually all the above-mentioned drawbacks of the “cost plus” mechanism and thus proved itself in many countries around the globe such as the Czech Republic, Hungary, Bulgaria, Romania, Ukraine, Lithuania and Latvia as very efficient and progressive way to regulate tariffs of natural monopolies.
Considering these problems and the large-scale investment needs of the power distribution segment, the government has decided to adopt the RAB-based regulatory approach for MRSKs (see the section below on the timeframe discussion). Below we provide a comparative analysis of “cost plus” and RAB.
Attractiveness for investors No mechanisms of regulation of return on investments Approved market return reflecting industrial risks - important part of regulation
Efficiency incentives 2 years after payback period of cost savings measures 5 years for cost saving fact
Reliability incentives No regulation of reliability Economic incentives and responsibility for reliability and quality of provided services
Reduction of regulatory risks One-year regulation period: risks are unacceptable bystrategic investors
5 year regulation period (3 year - for the first transitional period)
Reduction of macroeconomic risks Tariffs are indexed with inflationTariffs are indexed with factual inflation and change of federal factors, i.e. tariffs are irrelevant to the all non-
controlled factorsSource: Federal Grid Company, Alfa Bank Research
The comparison of RAB-based tariff setting and “cost plus” is additionally visualized by the below chart:
Figure 55: The evolution of tariff regulation
Operating expenses Depreciation of initial RAB Return on iRAB
Asset depreciation + Depreciation of newly invested capital (new RAB)
Return on newly invested capital
+CAPEX Operating expenses
Taxes and charges Controlled by Company Watched by Regulator
Encourages investments and operating efficiencyComposition of the tariff-based revenue:
Compensates for the incurred costsComposition of the tariff-based revenue:
"Cost plus" tariff approach
Net income
Reserved for reinvestment and
dividends
RAB-based regulatory approach
Source: Federal Grid Company, Alfa Research
The legislation for RAB-based tariff regulation was approved by the government and went into force with Decree #109 of June 18, 2008,
Legislation came in force, rules are clear
“Cost plus” prevents active borrowing restraining efficiency of MRSK business
RAB regulation is more progressive according to all criteria
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accompanied by an order by the Federal Tariff Service describing the methodology of tariff regulation. Decree #30 of January 19, 2010 sets the schedule of RAB-based tariff introduction in various regions across Russia for MRSKs and other distribution companies (discussed below).
The RAB-based regulation being applied to Russian companies in the meantime is illustrated in the figure below:
Figure 56: RAB regulation in Russia Network reliability and development requirements:- Reliability and quality standards- Forecasting of on-peak loads and new connections
Economic incentives for efficiency and reliability:
- Bonuses/penalties for reliability based on the benchmarking approach- Retention of costs cut for some period
Adjustments to impartial factors:- Adjustment to inflation- Reimbursement of costs not subject to company control- Adjustment to volume of electricity sales
Regulated gross revenue
Tariff
- Plans for improvement of service quality
Depreciation of Invested Capital + Return on Invested Capital + Operating expenses
CAPEX:Market cost of
capital (reflecting risks)
OPEX reimbursement:- Reconstruction plans - Level of historical costs- Network development plans - Order for reducing costs along with technical progress
Source: Federal Grid Company
The guiding principle behind RAB is its encouragement of private investment in the sector through guaranteed fair returns and efficiency incentives. As in most foreign countries that have adopted the system, RAB in Russia relies on several key assumptions:
• The establishment of a regulatory asset base (RAB) at the replacement cost of a company’s assets determined by independent appraisers and approved by regulators. New investments will increase this base while depreciation will diminish it;
• Inclusion into the tariff of a 12% post-tax rate of return from the RAB for the newly-built assets while using 6-9-12% rates of return for the first three years of the first regulatory period for the “old” assets included into initial RAB (iRAB);
• A five-year tariff-setting period (three years for the first transitional period) and an annual adjustment for inflation and changing national macroeconomic factors;
• Allowing companies to retain the benefits of operating cost savings within the five-year period while bearing the economic responsibility to fulfill the reliability and service requirements.
It is expected that in real terms the RAB tariff will decline in the future, primarily thanks to OPEX improvements and an increasing share of RAB depreciation and return on RAB components in the aggregate RAB-based tariff vs. the OPEX component.
The general decision-making system for RAB-based tariff setting for MRSKs and their branches is depicted in the below chart.
Assumptions behind RAB
Who are the decision makers?
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Russia’s Federal Tariff Service (FTS) plays a central role in this scheme, as it is responsible for general supervision of the process and development and adjustment of the methodology of tariff setting while also determining and estimating the key macroeconomic parameters that should be incorporated into the tariffs. In turn, the FTS works with the Ministry of Energy to set various industry standards and also with the Ministry of Economic Development, which is responsible for macro forecasts and therefore closely watches the tariffs of natural monopolies.
Every region of Russia has a Regional Energy Committee (REC), which is responsible for tariff setting at the regional level. Not surprisingly, RECs report directly to local authorities, which usually fight high tariff increases. RECs are the final decision-makers for MRSKs, since their tariffs are set at the regional level. RECs are in turn supervised by the FTS, which must approve their tariff decisions. MRSKs submit the required data, including operational reports and OPEX numbers, to RECs for tariff calculation.
Figure 57: Decision-making scheme for MRSK RAB-based tariffs Regional Authorities
Ministry of Energy Regional Energy Committee (REC) 1 DisCo (MRSK branch) 1
… …
Federal Tariff Service (FTS) Regional Energy Committee (REC) j DisCo (MRSK branch) k
… …
Ministry of Economic Development
Regional Energy Committee (REC) n DisCo (MRSK branch) m
Regional Authorities
Regional Authorities
Submissions of required data, e.g. OPEX
Submissions of required data, e.g. OPEX
Submissions of required data, e.g. OPEX
RAB-based tariff setting
RAB-based tariff setting
RAB-based tariff setting
Main macro parameters for tariff regulation; general supervision and methodology
Calculate tariffs and determine the expected tariff growth rates, submit to FTS for approval
Calculate tariffs and determine the expected tariff growth rates, submit to FTS for approval
Calculate tariffs and determine the expected tariff growth rates, submit to FTS for approval
Source: Alfa Research
RAB introduction timeframe RAB-based tariffs were introduced for the first time in 2008 for distribution companies in five regions: MRSK Center (Belgorod and Tver), MRSK South (Astrakhan), MRSK Volga (Orenburg) and MRSK Urals (Perm). In 2009 the list of RAB-based regulated regional branches of MRSKs was extended to include five more regions.
The official schedule for adoption of RAB-based tariffs by MRSKs approved by the government is presented below:
The gray cells show those branches of MRSKs which have RAB-based distribution tariffs over the respective periods. We calculated the percentage of RAB-based regulated branches as a simple ratio of the number of RAB-based regulated branches to the total number of branches in the respective distribution company.
As can be seen, all the regions covered by MRSK Holding must be RAB-based regulated as of the beginning of 2011. At the start of this year, only 29% (18 out of 63) of regional DisCos belonging to MRSK Holding had
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adopted RAB-based tariffs, while this number is expected to reach 62% (39 out of 63) as of July 1, 2010 according to the above schedule, followed by 100% on January 1, 2011.
All the “pilot” DisCos adopted a three-year period as their first regulatory period, which is expected to be followed by five-year periods thereafter. Federal Grid Company also adopted a three-year period as of the beginning of 2010. Meanwhile, all those MRSK branches with three-year periods, as well as FGC, are now allowed to extend their first regulatory period to five years, and many MRSKs have already expressed interest in doing so.
The principles of RAB-based tariff setting The regulators determine the base parameters at the beginning of each regulatory period. They are fixed and cannot be revised for the entire period (this list is not complete and contains only the most important parameters):
• Base OPEX: base regulatory level of operating expenses;
• X-factor: the index of OPEX efficiency, implying the prescribed percentage of annual OPEX reduction. The X-factor must be set within a range of 1.0% and 2.5%;
• iRAB: initial regulatory asset base set by regulators;
• NWC: net working capital determined by regulators for the entire regulatory period. NWC is determined within a range of 4% and 8% of the regulatory revenue for the previous year;
• RoR: rate-of-return on invested capital determined by the FTS together with the Ministry of Economic Development.
Under the RAB regulatory framework, revenue consists of three main components. The so-called “smoothing” mechanism is sometimes applied to revenues to avoid sharp tariff increases over the regulatory period:
where OPEXt is total regulatory OPEX of year t, RAB depreciationt – annual depreciation of the regulatory asset base including newly built assets, RAB returnt – regulatory return on RAB, while Smoothingt is a special adjustment applied to the revenue to smooth out tariff growth.
Below, we discuss each component of revenue in more detail.
The OPEX number consists of controllable and uncontrollable operating costs:
ttt OPEXableUncontrollOPEXleControllabOPEX +=
Controllable OPEX includes the following items:
• Raw materials;
• Repair and maintenance costs;
• Personnel expenses;
• Other OPEX.
Controllable OPEX does not include PP&E depreciation charge, interest expenses, lease payments and other costs, many of which are part of uncontrollable OPEX.
The annual controllable OPEX is calculated based on the following formula:
3-year period might be extended to 5-years, new branches will adopt 5-years period
Key base factors set for the entire regulatory period
Three components form RAB-based revenue
OPEX combines controllable and uncontrollable costs
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)1(
)1()""1(1
t
ttt
indexquantityAssetsElasticity
ifactorXOPEXleControllabOPEXleControllab
⋅+⋅
⋅+⋅−−⋅= −
Where the X-factor has already been described, it – inflation, Elasticity – the index of elasticity of OPEX to asset growth (0.75x for the first regulatory period) and Assets quantity indext – the increase of the regulated company’s assets measured in special units.
Uncontrollable OPEX comprises the following cost items which cannot be controlled by the regulated company and must be reimbursed by tariffs based on the actual numbers:
• Transmission charge – paid by MRSKs to the Federal Grid Company; the FGC’s tariffs are also set in accordance with RAB-based methodology as of 2010;
• Lease payments;
• Income tax;
• Other costs.
RAB depreciation is calculated every year by dividing the previous year-end full regulatory asset base (including depreciation) by 35 years, which is the prescribed depreciation period for RAB.
RAB return comprises return on “old” RAB, i.e. the assets owned by the DisCo prior to the first year of regulation under RAB and included into its iRAB by regulators, and return on newly-built assets, which form the so-called “new” RAB:
newtoldtt RoRNewRABRoROldRABreturnRAB ⋅+⋅= −− 11
In turn, the following formula determines “new” RAB performance:
∑=
+−=t
jtjt NWCRABofondepreciatidAccumulateCAPEXRABNew
1
where jCAPEX - annual CAPEX of year j, while the other components of the equation have already been described.
It is not difficult to notice that the RAB methodology concept is not different from the residual income valuation concept, whereby the equity value of a company is equal to its book value when and only when ROIC equals the company’s WACC. Therefore, the RAB-regulated company should be valued in line with its RAB when the return on RAB set by the regulator is in line with its actual WACC, applied to discount its future free cash flow.
The table below provides an example of a perfect hypothetical company whose return on RAB coincides with its WACC and actual OPEX does not differ from that prescribed by its regulator.
Line Unit 2009 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 1st regulatory period 2nd regulatory period 3rd regulatory periodPresent value of FCF c.u. -131 174 324 430 500 996 894 801 716 638 568 Terminal year cash flow c.u. 2,452 Terminal value c.u. 17,415 PV of TV (45) c.u. 3,584 Sum of PV of FCF (46) c.u. 6,415 Total EV (47)=(45)+(46) c.u. 10,000 iRAB (48)=(9) c.u. 10,000 EV/iRAB (49)=(47)/(48) x 1.0x * Note: c.u. – conditional unit Source: Alfa Research
Figure 60: Perfect RAB-based regulated company, key assumptions iRAB c.u. 10,000Depreciation of the assets reflected in iRAB % 47%Regulated rate-of-return % 14.1%WACC % 14.1%Years of return on invested capital years 35Annual X-factor for OPEX % 1.0%Assumed annual efficiency gain % 1.0%Base year OPEX: "Controllable" c.u. 1,000"Uncontrollable" c.u. 1,000Actual OPEX: "Controllable" c.u. 1,000"Uncontrollable" c.u. 1,000Net working capital c.u. 100Perpetual growth rate % 0%Income tax rate % 20%Source: Alfa Research
Figure 61: WACC of a perfect company WACC components: Share of equity 70.0%Share of debt 30.0%Risk free rate 7.0%Base equity risk premium 7.0%Liquidity premium 2.0%Cost of equity 16.0%Cost of debt (pre-tax) 12.0%Cost of debt (post-tax) 9.6%WACC 14.1%Source: Alfa Research
As can be seen, the DCF-based EV of the company (10,000) exactly matches its initial RAB (10,000) when the regulatory return on its assets (14.1%) matches its WACC (14.1%). When this condition does not hold, the company’s EV/RAB multiple differs from 1.0x depending on whether its regulatory return is higher or lower than its WACC.
Another factor that also contributes to a possible discrepancy between EV and RAB, and hence a deviation of EV/RAB from 1.0x, is OPEX, which might differ from those numbers set by the regulator. In other words, if the company exceeds its regulatory OPEX in a given regulatory period, its intrinsic value may be substantially higher than its RAB, and vice versa.
In sum, we stress that there are two main factors on which a company might out- or underperform and which then determine the EV/RAB multiple: out- or underperformance on WACC vs. rate-of-return and on actual OPEX vs. regulatory OPEX.
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The charts below demonstrate the sensitivity of our perfect company’s EV/RAB multiple to various combinations of WACC vs. return and actual OPEX vs. the regulatory one.
Figure 62: Sensitivity to return-WACC spread, ppts Figure 63: Sensitivity to OPEX spread*, ppts
(0.5)x
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
-14-12-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14
EV/RAB
(1.0)x
(0.5)x
0.0x
0.5x
1.0x
1.5x
-14-12-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14
EV/RAB
Source: Alfa Research * Note: OPEX spread is defined here as difference between actual efficiency gain and regulatory X-factor Source: Alfa Research
The charts depict the extent to which the EV/RAB multiple might deviate from 1.0x depending on the out- or underperformance of the regulated company on WACC and OPEX.
The EV/RAB multiples of some real-world companies regulated under RAB are provided in the table below:
Figure 64: EV/RAB of real-world companies Company Country EV/RABFederal Grid Company Russia 0.46x Transelectica SA Romania 0.78x National Grid UK 1.41x Terna Spa Italy 1.27x SP Ausnet Australia 1.01x Elia Belgium 1.16x Source: Bloomberg, Company data, Alfa Research
The table shows that some of the companies are trading at substantial discounts to their RAB, with EV/RAB multiples well below 1.0x (e.g. Russia’s Federal Grid Company, with 0.55x EV/RAB, mainly explained by the large discrepancy between its WACC and rate-of-return, as well as Romania’s Transelectrica), while others are trading at a large premium over their RAB (e.g. UK-based National Grid, valued at 1.42x EV/RAB).
Although WACC and OPEX are the two main factors affecting EV/RAB, there are a number of other factors that could also lead to EV and RAB discrepancies. Regarding our DCF-based fair EV/RAB multiples for the MRSKs covered in this report, see the discussion in the Valuation section.
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MRSK Holding Address: Tel: E-mail: Website: CEO CFO Investor Relations
Terminal year cash flow 596 Terminal value 4,708 PV of terminal value 1,347 Sum of PV of FCF 1,663 Total EV 3,010 Net debt, 2009 429 Fair equity value 2,581 # of shares: Common, mln 42,218 Fair value per share $0.061 Implied EV/RAB 0.76 Implied 2010E EV/EBITDA 5.6 Implied 2010E EV/S 1.7 Source: Alfa Research
Figure 123: WACC calculation Cost of debt Risk-free rate 6%Corporate debt spread 3%Debt rate implied 9%Statutory tax rate 20%After-tax cost of debt 7.2%Cost of equity Risk-free rate 6%Base equity risk premium 7%Company-specific adjustments: 2%IFRS standards 0%Transparency and disclosure 0%Presence of large institutional investor 0%Payment discipline in the region 1%Regulatory risk 0%Liquidity 1%Adjusted equity risk premium 9%Cost of equity 15%Share of equity: E/(D+E) 70%Share of debt: D/(D+E) 30%WACC 12.7%Source: Alfa Research
Figure 196: Distribution tariff evolution Figure 197: Distribution tariff vs. inflation
0
100
200
300
400
500
600
2009
2010
E
2011
E
2012
E
2013
E
2014
E
2015
E
-10%-5%0%5%10%15%20%25%30%35%
RUB/MWh
-10%-5%0%5%
10%15%20%25%30%35%
2010
E
2011
E
2012
E
2013
E
2014
E
2015
E
Distribution tarif f Ruble inflation
Source: Alfa Research Source: Alfa Research
Figure 198: Revenue breakdown, RUB mln Figure 199: MRSKs current EV/iRAB ranking
-2,000
8,000
18,000
28,000
38,000
48,000
58,000
68,000
2011 2012 2013 2014 2015
Smoothing OPEX RAB Depr. Return
0.
16x
0.29
x
0.32
x
0.38
x
0.39
x
0.39
x
0.40
x
0.44
x
0.45
x
0.47
x
0.51
x 0.81
x
0.0x0.2x0.4x0.6x0.8x1.0x1.2x
NC
Ura
ls
Tom
sk D
isC
o
Kuba
nene
rgo
Cen
ter&
Volg
a
Sibe
ria
Lene
nerg
o
Volg
a
Cen
ter
Sout
h
MO
ESK
Nor
thw
est
Source: Alfa Research Source: Alfa Research
Figure 200: Revenue breakdown by branch, RUB mln Figure 201: Throughput breakdown by branch, GWh
01000020000300004000050000600007000080000
2011 2012 2013 2014 2015Samara distribution grids Saratov distribution gridsUlyanovsk distribution grids M ordovenergoOrenburgenergo PenzaenergoChuvashenergo
Figure 219: WACC calculation Cost of debt Risk-free rate 6%Corporate debt spread 4%Debt rate implied 10%Statutory tax rate 20%After-tax cost of debt 8%Cost of equity Risk-free rate 6%Base equity risk premium 7%Company-specific adjustments: 8%IFRS standarts application 2%Transparency and Disclosure 1%Presence of large institutional investor 1%Payment discipline in the region 1%% of branches under RAB 1%Liquidity 2%Adjusted equity risk premium 15%Cost of equity 21%Share of equity: E/(D+E) 70%Share of debt: D/(D+E) 30%WACC 17.1%Source: Alfa Research
Terminal year cash flow 45 Terminal value 245 PV of terminal value 42 Sum of PV of FCF 37 Total EV 79 Net debt, 2009 (8)Fair equity value 87 # of shares: common 4,347 Fair value per share $0.02 Implied EV/RAB 0.42Implied 2010E EV/EBITDA 8.2 Implied 2010E EV/S 0.6Source: Alfa Research
Figure 249: WACC calculation Cost of debt Risk-free rate 6%Corporate debt spread 6%Debt rate implied 12%Statutory tax rate 20%After-tax cost of debt 9.6%Cost of equity Risk-free rate 6%Base equity risk premium 7%Company-specific adjustments: 9%IFRS standards 2%Transparency and Disclosure 1%Presence of large institutional investor 1%Payment discipline in the region 1%Regulatory risks 0%Liquidity 4%Adjusted equity risk premium 16%Cost of equity 22%Share of equity: E/(D+E) 70%Share of debt: D/(D+E) 30%WACC 18.3%Source: Alfa Research
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