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  • 1. The Re-Rating of Russia by William F. Browder Managing Director, Hermitage Capital Management February 2002
  • 2. Agenda 1. Catalysts for Re-rating 2. Macroeconomics 3. Fixed Income vs. Equity 4. Microeconomics 5. Risks to Re-rating 6. Hermitage’s Investment Approach 7. Case Studies 8. Hermitage Performance
  • 3. Re-rating of Russia Catalysts for Re-rating Economic Reforms Solid Macro-Economics Improved Corporate Governance Good fundamentals + Cheap valuations + Trigger = Re-rating Political Stability Cheap Valuations relative to GEM* September 11 Good Fundamentals Crackdown on Corruption Re-rating
  • 4. September 11th as a Trigger
    • Official end of “Cold War”
    • Key non-Middle East oil supplier
    • Russian WTO entry
    • Better terms at the Paris Club
    • Better terms with the IMF
    • No more condemnation on Chechnya Lower global interest rates
    • Emerging markets’ bailout “across the board” (Turkey and Pakistan)
    • Lower oil prices
    V Russia is a clear winner of world’s re-shaping after Sept.11th Positive Effects Negative Effects
  • 5. Economic Reforms Tax Reform Banking Reform Business De-regulation Judicial Reform Pension Reform Natural Monopolies Bankruptcy Reform Labor Code Land Code For the first time in the history of modern Russia, significant reforms are being implemented 2000 2001 2002
  • 6. Tax Reform Tax rates are coming down and tax collection is going up Source: ING Barings, Alfa-Bank, Russian Ministry of Tax Collections, December 2001 Tax Rate Collection Tax Rate Collection Individuals Corporations
  • 7. Labor Code Tremendous improvement of Labor Code should stimulate more flexible and efficient relationships between businesses and employees
    • Old Labor Code
    • (primary goal is to protect an employee*)
    • Number of working hours can not exceed 40 hours per week
    • Virtual impossibility to fire an employee without a prior consent from a trade union
    • A person may take three year maternity leave and have salary and position sustained upon return
    • New Labor Code
    • (more realistic in the current economic environment)
    • Number of working hours is not limited to 40 hours per week and is subject to agreement between a firm and an employee
    • No consent from a trade union is needed to fire an employee
    • Launching a strike requires approval from 2/3 of employees ( vs. minority)
    * Under the old Labor Code 78% of all layoff cases considered by Russian courts were won by employees
  • 8. Economic Reforms
    • Pension Reform
    • Introduction of fully funded individual pension accounts instead of unsustainable pay-as-you-go system
    • Transparent and open asset management process instead of existing “shadow” allocation among local banks
    The other reforms in progress are:
    • Banking Reform
    • Opening a banking market to foreign financial institutions
    • Introduction of government deposit insurance scheme in 2004
    • Government to sell its stakes in a number of banks
    • International accounting and reporting standards are to be adopted in 2004
    • Bankruptcy Reform
    • The main goal is to create a simplified bankruptcy procedure
    • Elimination of loopholes, which currently allow to use a bankruptcy procedure as a tool in hostile takeovers
    • Judicial Reform
    • Judges can be fired or imprisoned for accepting bribes
    • Local courts to be more independent from local authorities
    • Introduction of jury trials in criminal cases and improved pay for judges
    • Increased pay for judges
  • 9. Crackdown on Corruption Organization Name Accusations Consequences Date Aeroflot Gazprom Railway Ministry Berezovsky Goldovsky, Koshits Aksenenko Diversion of cash via offshore firms Massive asset stripping via Sibur Mis-spending of US$70 million of Ministry’s cash Currently in exile, former associates are in prison Both are arrested, charged and currently in prison Resignation from government. On-going investigation 2000-2001 January 2002 December 2001 Presidential Administration Voloshin No formal accusations Currently under investigation launched at request of Duma January 2002
  • 10. Crackdown on Corruption Organization Name Accusations Consequences Date Duma Defense Ministry Ministry of Justice Golovlev Oleinik Kovalev Stealing of US$600 million while running a regional property fund Stealing of US$200 million and accepting bribes Currently under investigation, immunity stripped Faces imprisonment for 10 years Sentence of 9 years in prison 2000-2001 2000-2001 1999-2001 Ministry of Finance Vavilov Stealing of S$330 million Currently under investigation; can’t leave the country June 2001 Mis-spending of US$440 million
  • 11. Crackdown on Corruption Ministry of Emergency Situations Ministry of Finance Ministry of Railways Committee of Statistics Defense Ministry Ministry of Justice Committee of Fishing Customs Committee Ministries State Committees Under investigation by General Prosecutor’s Office (2001-2002) In addition, 5 Ministries and 3 Government Committees are under investigation by the General Prosecutor’s Office Source: General Prosecutor’s Office, January 2002
  • 12. Improved Corporate Governance Government Actions Owners Self-Interest Shareholder Activism + Firing Gazprom CEO Vyakhirev + Throwing out Chubais’ UES asset stripping plan + Challenging Norilsk Nickel in court + A new law on joint stock companies + Corporate Governance Code + Minority shareholders have appointed representatives to more than 20 corporate boards + Minority shareholder revolt at UES + More than 15 lawsuits filed against issuers by minority shareholders + Elimination of transfer pricing + Payment of significant dividends + Introduction of corporate governance charters Corporate Governance has also significantly improved on many fronts
  • 13. Solid Macroeconomics GDP Growth (%), 2002E Current Balance (% of GDP), 2002E Trade Balance (% of GDP), 2002E Fiscal Budget (%), 2002E Russian macroeconomic indicators remain very attractive relative to other economies (in spite of lower prices) Source: Deutsche Bank, Alfa-Bank, Morgan Stanley, JP Morgan, Merrill Lynch, December 2001
  • 14. Fixed Income vs. Equity Low domestic interest rates and relatively high inflation mean Russia now has negative real interest rates Source: Renaissance Capital. Interest rate is given for a benchmark GKO26003 maturing in March 15, 2003 Domestic Interest Rate vs. Inflation Real Interest Rate
  • 15. Fixed Income vs. Equity Russian sovereign debt is already trading at lower yields than Global Emerging Markets Source: Bloomberg Russia vs. Global Emerging Markets, Spread (in basis points)
  • 16. Fixed Income vs. Equity The fixed income re-rating is being closely matched by the Credit rating agencies Sources: JP Morgan, Standard & Poor’s, January 2002 Changes in S&P Rating on Russia B+ B B- BB BB- BB+ Non Investment Grade Lower Non- Investment Grade S&P’s Rating Scale Current S&P’s Rating for Russia
  • 17. Fixed Income vs. Equity Despite the recent rally, Russia remains the cheapest emerging equity market in the world Source: Merrill Lynch. Data as of January 9, 2002. Price/Earnings Ratios of Emerging Markets, 2002E
  • 18. Microeconomics Even with a decline in world oil prices, Russian companies will continue to have strong earnings Source: Troika Dialog, Brunswick Warburg, Renaissance Capital, Aton, January 2002 Net Income (US$ million)
  • 19. Microeconomics Dividend yield has been reaching Western standards Source: Alfa-Bank,Troika Dialog, Brunswick Warburg, Renaissance Capital, Aton, Bloomberg. Data as of January 18, 2002. Dividend Yield, 2000-2001E Dividend Yield (1.4%), S&P 500 Index
  • 20. Microeconomics But the dividend payout ratio is still lagging Western benchmarks and leaves much room for higher dividends in the future Source: Renaissance Capital, Federal Reserve Bank of Cleveland, December 2001 Dividend Payout Ratios, 2001 Dividend Payout Ratio (34%), S&P 500 Index
  • 21. Microeconomics At the same time Russian oil companies keep a huge amount of cash to finance their investment programs. Why? Source: Alfa-Bank, January 23, 2002; Based on financial statements as of 1H2001 - 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 Yukos SurgutNG LUKoil US$ Billion Cash on a balance sheet for selected Russian companies (US$ Billion) 1.7 3.8 3.8
  • 22. Microeconomics Among the three sources of financing generally available, Russian companies only had an access to retained earnings in the past Global debt markets closed 1998-2001 Russian companies X Retained Earnings Equity Markets at 5x PE too expensive for Companies X
  • 23. Microeconomics Therefore, Russian companies are extremely underleveraged compared to their Western peers * Cash includes Cash and Marketable Securities, Debt includes Short- and Long-term Debt Common-size balance sheet* as of January 1, 2001 Assets (%) Equity & Liabilities (%) Equity Debt Cash Equity Fixed Assets Other Assets Fixed Assets Other Assets A/P Debt A/R A/P A/R Cash Surgutneftegas Exxon Mobil
  • 24. Microeconomics Access to capital markets means that there will no more need for Russian companies to hold such piles of cash Upcoming debt issue issues in 2002 Sibneft, Debt, US$250 m Gazprom, Debt, US$700 m Magnitogorsk Steel, Debt, US$150 m Alrosa, Debt, US$500 m TNK, Debt, US$500 m Russian Federation, Debt, US$2,000 m Lukoil, Convertible, US$300 m Tatneft, Debt, US$200 m Debt issues in 2001 Yukos, Convertible, US$250 m MTS, Debt, US$250 m Rosneft, Debt, US$150 m Sibneft, Debt, US$175 m Tatneft, Debt, US$325 m Source: Brunswick Warburg, January 2002 Total = US$1.2 Billion Total = US$4.7 Billion Greater dividends in future
  • 25. Source: Troika Dialog, Brunswick Warburg, Renaissance Capital, Aton, January 20, 2002 Price/Earnings Ratio, 2002E (as of January 20, 2002) Microeconomics In spite of growing dividends in future, Russian stocks are still cheap
  • 26. Risks to Russia’s Re-rating Global Financial Markets Meltdown Collapse of Oil Price Loss of Putin / Government Crisis Refinancing Crisis in 2003 What are the major risks to Russia’s re-rating? Re-rating of Russia
  • 27. Risks: Collapse of Oil Price Fiscal Surplus (% of GDP) Source: Goldman Sachs, October 2001 Although oil generates important tax revenues for the government, the budget will only go into deficit at below US$15 per barrel And economy will grow in almost any oil price scenario GDP Growth (%) Break-even
  • 28. Source: Alfa Bank, January 2002 Russian companies should be profitable even if oil price is US$15 per barrel Break-even for Russian Oil Companies (US$ per Barrel) Risks: Collapse of Oil Price
  • 29. Risks: Collapse of Oil Price Over the last 10 years oil price has never traded below US$15 per barrel for more than 14 months Source: Reuters, Morgan Stanley, December 2001 Oil Price (Brent, US$ per barrel) Break-even for Russian budget Median Price (US$ 19 per barrel) Break-even for Russian oil companies
  • 30. Risks: Loss of Putin Source: ROMIR, December 2001 Putin is the most likely winner of the next presidential election in 2004 Age of World Leaders UK Russia USA Germany Japan France China
  • 31. Risks: Refinancing Crisis in 2003 Russia reduced the outstanding sovereign debt due in 2003 by US$5 Billion Debt Repayment (US$ Billion) Reserves of Russia (US$ Billion) vs . Central Bank Reserves Reserves of Russian Government Buyback and early repayment to IMF 14.0 X Sources: Alfa-Bank, Troika Dialogue, January 2002
  • 32. Risks: Global Markets Meltdown Russian equities correlate strongly with global markets only in time of extreme volatility (long-term correlation* over last 6 months is 45%) Source: Reuters, Bloomberg January 23, 2001 * Correlation between RTS Index and Dow Jones Industrial ** Correlation between RTS Index and Dow Jones Industrial is calculated for the following periods - Sept. 3 - Oct. 1, 2001 and Dec. 23 - Jan. 23, 2001 Russia vs. Global Markets RTS Index Nasdaq Dow Jones DAX Correlation =83%** Correlation = -50% “ September 11” Value of indices is rebased to 100 on August 15, 2001
  • 33. Risks: Summary Global Financial Markets Meltdown Long-term Collapse of Oil Price Loss of Putin / Government Crisis Refinancing Crisis in 2003 Only dramatic and long-term fall of oil price (for more than a year) presents a major danger to Russia’s fundamentals. Russia has enough momentum and reserves to survive a short-term fall in price of oil Risk Probability of event LOW ? VERY LOW VERY LOW The only real risks are global
  • 34. Hermitage’s Investment Approach
    • In-house data-driven research
    • Small number of large positions
    • Regular and frequent visits to portfolio companies
    • Shareholder activism (Board representation, Russian courts, publicity)
    • Work with the government, Russian SEC and other shareholders to fight corruption
    • Long-term investments vs. short term-trading
    • No use of leverage
    • Ignoring advice from sell-side analysts and stockbrokers
  • 35. Case Studies Gazprom Sberbank Unified Energy Hermitage
  • 36. Case Study: Sberbank Very Cheap Valuations Very Negative Market Perception New Law as a Trigger P/E of 1.5 P/BV of 0.5 Bad management History of dilutions On-going threat of a new dilution Preemptive rights on shares issue in new Law on January 1, 2002 Shareholders Activism
    • EGM to fire CEO
    • Lawsuit
    • Publicity
    • Board appointment
    SBERBANK What do you need for a share price to triple?
  • 37. Case Study: Sberbank Very Cheap Valuations at the time of dilution of Major World Banks of Major World Banks Source:: Morgan Stanley, Troika Dialogue, December 2000
  • 38.
    • In December 2000, Sberbank announced it wanted to sell 68% discount to book value in a new issue without granting rights to existing investors
    Case Study: Sberbank Source: Central Bank web-site, January 2001 Before New Issue Proposed New Issue
  • 39. Case Study: Sberbank The equity analysts hated the stock:
    • “ The issuance underscores the management’s short-sightedness and illustrates its total disregard for shareholder value. We recommend that investors who do not hold Sberbank look elsewhere in the Russian equity market for more attractive opportunities ”, Kim Iskyan, Renaissance Capital, January 30, 2001
    • “ While the bank is fundamentally undervalued, we believe that negative perceptions about unfair treatment of minority shareholders and the possible dilution of their stake should keep the share price depressed. We have downgraded our recommendation to Neutral ”, Andrei Ivanov, Troika Dialog, January 24, 2001
  • 40. Case Study: Sberbank
    • What Hermitage did to stop the dilutive issue:
    • Organized Shareholders
    • Combined efforts with minority shareholders owning 10% of share capital to call EGM to oust CEO Kazmin and change charter of the company
    • Legal actions
    • Filed a lawsuit to uphold EGM
    • Filed a lawsuit against Central Bank to annul registration of new issue and against Sberbank to cancel Supervisory Board decision on the new issue
    • Filed appeals with the Moscow Arbitration Court
    • Public Relations Campaign
    • Organized a PR campaign against new issue in Russian and Western media : more than 70 articles appeared during 2001 in Financial Times, Wall Street Journal, Bloomberg, Reuters, Moscow Times, Kommersant, Economist
    • Board of Directors
    • Gained support from minority shareholders and became a member of the Board of Directors after an election fight
  • 41. Case Study: Sberbank
    • The Sberbank fight highlighted dilution problems, which helped create a new law guaranteeing proportional rights in all new share issues
    As of January 1, 2001 any new issue now has to be sold pro-rata to existing shareholders Distribution of ownership New Issue Central Bank Central Bank Sources: Alfa-Bank, Troika Dialogue, January 2002 Foreign Investors Foreign Investors Local Investors Local Investors
  • 42. Case Study: Sberbank Source: RTS - Medium-term downtrend - The stock gets “very boring” Sberbank dilutes minority shareholders Since Sept. 25th Sberbank’s share price tripled (!) Market starts to realize that Sberbank can not issue new shares without granting pre-emptive rights to shareholders Hermitage fights Sberbank and puts member on board to block future issues Sberbank’s share price (US$) 2 equity analysts issue BUY recommendations for the first time +350% return (%) since May 1999
  • 43. Case Study: Unified Energy Bad Restructuring Plan Very Negative Market Sentiment New Restructuring Plan as a Trigger Management wanted to give away company assets to local oligarchs Share prices loses 66% of its value after announcement of its restructuring plan No asset sales Shareholders Activism Lobbying Government to stop asset sale UNIFIED ENERGY What do you need for a share price to rise by 145%? Proportional distribution of assets Board oversight A major PR campaign Formulation of a new restructuring plan
  • 44. Case Study: Unified Energy Bad restructuring plan Unified Energy Systems 72 Regional Power Company 24 Thermal Power Stations 11 Hydro Power Stations Oligarchs Management of UES Local Governors Friends Liquidation sale of all assets via non-transparent Regional Auctions Electricity Grid
  • 45. Case Study: Unified Energy Negative market sentiment: Share price drops by 66% after UES announced its restructuring plan UES’ announcement Share Price of UES (US$)
  • 46. Case Study: Unified Energy Shareholder Activism
    • Call for EGM to fire Chubais and change charter of UES
    • Investor letter to Putin and PR campaign with all international media
    • Alternative restructuring plan by Hermitage and Government Officials
    New Restructuring Plan
    • Convinced the Presidential Administration to change the charter
    • The new restructuring plan fixed a bad management plan and eventually was approved by Putin on July 11, 2001
    C Shareholder activism to improve the restructuring plan Outsiders Shareholders Old Plan New Plan Sales Pro-rata distribution C C
  • 47. Case Study: Unified Energy Market changes its sentiment towards UES a result of new restructuring plan Share Price of UES (US$) Source: RTS
  • 48. Case Study: Gazprom Very Cheap Valuation Huge Difference between Perception and Reality Resolution of Situation Market assumes 99% theft TRIGGER Disclosure of asset theft Gazprom Call for external fraud Audit Analysis suggest 9% theft 25% of world’s natural gas reserves for US$13.8 Billion Government reclaimes lost assets What do you need for a share price to go up tenfold? US$0.12 per barrel of reserve Government fires CEO 2001E P/E
  • 49. Case Study: Gazprom Gazprom is the cheapest oil and gas company in the world because market believes that 99% of its assets are stolen
  • 50. Case Study: Gazprom What exactly was stolen from Gazprom?
  • 51. Case Study: Gazprom _______Perception versus Reality_______ Market Perception Hermitage’s Analysis 99% Stolen Assets 9.65% Stolen Assets 90.35% Assets in place vs. 1% Assets in place
  • 52. Case Study: Gazprom What Hermitage did to unlock the value of Gazprom:
    • Research
    • Hermitage was the first financial institution to research and make public numerous examples of asset stripping at Zapsibgasprom, Purgas, Rospan, Sibneftegas, Tarkosaleneftegas, Sibur and Vostokgas
    • Public Relations
    • Organized a PR campaign with all international media: more than 200 articles appeared from October 15, 2000 to August 30, 2001 in Financial Times, Wall Street Journal, New York Times, Business Week, Vedomosti, Reuters, Kommersant, Washington Post, Business Week and Bloomberg, exposing all the asset stripping
    • EBRD
    • Presented finding of research to Jean Lemierre at the EBRD, who then declined to lend US$250 million to Gazrpom unless it disclosed relationship with Itera and Stroytransgaz
    • Appealed to Market Regulators
    • Together with other minority shareholders filed complaints with the Russian Federal Securities Market Commission
    • Organized Shareholders to demand independent audit of the asset stripping
    • transactions
    • Combined efforts with UFG and other minority shareholders with a total stake of 10% and demanded an independent audit of Gazprom by Deloitte & Touche.
  • 53. Case Study: Gazprom +140% Gazprom has started its way to US$6 per share
  • 54. Hermitage Performance Since inception 1 Year 2 Years 3 Years 4 Years 5 Years Hermitage Fund CSFB ROS Index 80% 57% 502% -28% 62% 57% 17% 350% -14% 13% 355% 161% Performance of Hermitage Fund vs. CSFB ROS Index Hermitage CSFB ROS Index Total Return* * Total returns for each period are calculated using the last bid as of January 18, 2001
  • 55. Hermitage Performance * Since inception Total Return *
  • 56. Hermitage Performance Source: Nelson’s Investment Management Database Hermitage Fund has outperformed all other emerging market funds in the world over the last 5 years ending March 31, 2001 % Annualized Return Annualized performance of emerging markets funds
  • 57. Hermitage Composition of Portfolio* Fund Strategy Sector Allocation * As of December 31, 2001
  • 58. Disclaimer This material is for information purposes only and is not an invitation to subscribe for units or shares in the Hermitage Fund. Subscriptions will only be received and units or shares issued on the basis of the current prospectus for the Fund, and prospective investors should carefully consider the risk warnings and disclosures for the Fund set out therein. Investors should also consider any other factors that may be relevant to their circumstances, including tax considerations, before making an investment. The information is based on data obtained from publicly available sources, which have not been verified by Hermitage Capital Management Limited, or any of its respective associates or affiliates. As a result of the difficulty in obtaining reliable data in Russia, we do not represent this information to be accurate and complete and we do not accept any responsibility for the reasonableness of any conclusions based upon such information. Past performance is not necessarily indicative of the likely future performance of an investment. The price of units or shares can go down as well as up and may be affected by changes in rates of exchange. The Hermitage Fund has been authorised by the Guernsey Financial Services Commission as a Class B Collective Investment Scheme under the Protection of Investors (Bailiwick of Guernsey) Law 1987 and the Collective Investment Schemes (Class B) Rules 1990. It must be understood that in giving this authorisation the Commission does not vouch for the financial soundness or correctness of any of the statements made or opinions expressed with regard to The Hermitage Fund. Investors in The Hermitage Fund are not eligible for the payment of any compensation under the Collective Investment Schemes (Compensation of Investors) Rules 1998 made under the Law.