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Investment summary

Sentiment weighs despite positive fundamentals

We remain broadly constructive on the Russian utility sector. We believe Russia’s Gencos boast sustainable balance sheet strength, as we expect solid FCF generation during the upcoming modernisation period, with FCF yields averaging 20% in 2018-2022, on our estimates. However, market sentiment remains weak, and understandably so: the government is yet to approve the final modernisation plan, the regulator has not yet carried out the first round of modernisation and capacity auctions (KOM), and conservative dividend policies are still in place at InterRAO and Gazprom Gencos, and it is still not obvious to minority shareholders whether or not they have a claim on excess cash on the latter’s balance sheets.

Sustained underperformance…

We have seen sustained underperformance of Russian Gencos and main grid company (FGC and Rosseti) stocks vs the broader MOEX market over the past 12 months (Figure 1).

Figure 1: Gencos stock performance, %

1M 3M YtD YoY

20%

10%

0%

-10%

-20%

-30%

-40%

UPRO ENRU IRAO HYDR OGKB MSNG TGKA FEES RSTI RSTIP Moex index

Source: Bloomberg

The only stocks in positive territory YoY are InterRAO and Unipro (12% and 1% respectively), with InterRAO managing to outperform the index (9% YoY). The biggest underperformers have been the Gazprom Gencos (TGK-1 -33%, Mosenergo -24%, and OGK-2 -32%), RusHydro -35%, and Enel Russia -30%. They have stabilised somewhat over the past month and three months (though still underperforming MOEX, except for Mosenergo, which grew 9% over the month and 2% over the three-month period), except for RusHydro, which has continued its downtrend mainly due to its exclusion from the MSCI Index in November, and Enel, which is struggling to finalise the sale of Reftinskaya GRES.

Such underperformance resulted in an increase in discounts in terms of multiples for Russian Gencos vs international (developed and emerging market) peers. We note that the average 2019 EV/EBITDA for Russian Gencos is at an almost 63% discount to international peers, while in terms of 2019 P/E the discount is close to 61% (Figure 2). However, the discounts have been quite substantial historically, thus we believe that the multiples just indicate the potential for Russian utility stocks to recover in the future, rather than providing a reliable valuation for the stocks.

Renaissance Capital

9 January 2019

Utilities

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Renaissance Capital 9 January 2019

Utilities

Figure 2: Multiples valuation

	Russia Gencos		MktCap,		Net debt 2018E,			EV/EBITDA, x								P/E, x
			RUBmn		RUBmn	2016	2017		2018E		2019E		2020E	2016	2017	2018E		2019E		2020E
	Unipro		163,927		823	5.7	3.3		6.3		5.5		4.2	31.7	4.9	10.1		8.7		6.6
	Enel Russia	36,804		16,567		4.1	3.1	3.3		3.9		4.1		8.4	4.3	4.9	4.7		5.2
	InterRAO		414,468		-244,158	3.0	2.1		1.5		1.0		0.5	7.6	5.6	5.2		5.2		4.8
	RusHydro	209,777		87,172		2.8	3.0	2.7		3.3		3.1		4.5	9.3	4.4	7.3		7.7
	OGK2		35,728		43,693	4.5	3.0		2.8		2.3		2.1	11.7	5.0	4.1		3.2		3.3
	Mosenergo	81,725		-12,322		3.2	1.9	1.9		1.9		1.3		6.1	3.6	4.9	6.4		5.3
	TGK1		32,006		9,685	2.7	2.2		1.8		1.5		1.0	6.0	4.0	3.2		3.3		2.9
	Average					3.7	2.6	2.9		2.8		2.3		10.9	5.2	5.3	5.5		5.1
	International peers, average					7.3	7.2		8.0		7.5		6.4	13.6	14.9	16.5		14.1		11.9

Source: Company data, Renaissance Capital estimates

We note again that we consider DCF and/or DDM-based valuations as the most appropriate to value Russian Gencos given the phasing out of DPM contracts, new modernisation capacity payments which are to appear beyond 2022, and adjustments in the medium-term KOM capacity market.

In the MRSK space, almost all stocks have declined YoY, except Lenenergo, Lenenergo prefs, and MRSK North-West (up 11%, 13% and 4% YoY, respectively). Among the major underperformers were Kubanenergo (down 38% YoY), MRSK North Caucasus (down 26% YoY), and MSRS (down 26% YoY). However, over the shorter periods of one and three months, the performance has stabilised (apart from MRKS South (MRKY) and MRKS North-West (MRKZ)); the relatively strong 9M18 IFSR and RAS figures and expectation of 4Q18 impairment charges (which will influence FY18 figures and thus dividends) supported the shares.

Figure 3: MRSK stock performance

YoY YtD 3M 1M

MRKP

TORSP

TORS

KUBE

MRKZ

MRKC

MSRS

MRKK

MRKV

MRKU

MRKS

LSNGP

LSNG

MRKY

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

Source: Bloomberg

We believe that the performance in the grid segment is mostly driven by expected dividends. As 4Q18 is the quarter when most impairment charges are usually booked, significantly affecting possible dividends, the main share price moves are likely to happen when FY18 results are released in early 2019.

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Renaissance Capital 9 January 2019

Utilities

...as the market remains sceptical on modernisation

We believe the underperformance is partly related to delays in the modernisation and KOM auctions that should have been carried out in November and December, respectively, but have been pushed out to 1H19. We consider the results of the auctions to be one of the key triggers for Russian Genco stocks, as they should provide some transparency on investment programmes, modernisation tariffs and KOM prices in the long run. We believe that the market is not pricing in either the effects of modernisation on FCF (as it is too far in the future), or excess cash on some companies’ balance sheets, as it is still not obvious to minority shareholders whether they would have a claim on this excess cash.

We are more constructive…

Nevertheless, our main points about the sector stand:

▪The Gencos under coverage (excluding RusHydro as its modernisation programme is yet to be finalised) should have accumulated a net cash position of almost RUB115bn (as of end-2018), which we believe should continue to grow even during the modernisation programme.

▪The Gencos under our coverage (excluding RusHydro) should embark on their modernisation programmes with healthy balance sheets. We estimate they will generate close to RUB156bn in 2018, and more than RUB387bn in 2019-2021, with total investment programmes amounting to RUB476bn, on our estimates.

Moreover, we estimate average FCF reaching 17% during the modernisation period (2022-2029) (Figures 4 and 5).

Figure 4: FCF yield								Figure 5: Net debt, RUBmn
			2018-2022			2022-2028		500,000				2018E		2019E			2020E
45%
40%								400,000
								300,000
35%
								200,000
30%
								100,000
25%
								-
20%								(100,000)
15%								(200,000)
								(300,000)
10%
								(400,000)
5%									Enel	Unipro		Mosenergo	OGK2		TGK1		InterRAO	RusHydro	FGC	Rosseti
0%
	IRAO HYDR ENRU UPRO			OGKB TGKA MSNG FEES RSTI
						Source: Renaissance Capital estimates												Source: Renaissance Capital estimates

We believe the delay to the modernisation and KOM auctions was partly due to the government not wanting to approve an attractive rate of return for the entirety of the modernisation period (2022-2031). In our view, the government will instead seek to set a 14% rate of return (under an 8.5% base OFZ government bond yield assumption) for 2022-2024, while for the balance of the programme the rate could be lower (the government has previously discussed a 12% rate of return under a 7.5% base OFZ yield assumption). However, even if the spread between the modernisation rate of return and the OFZ return were cut by 1 ppt (which would imply a 5-6% lower modernisation tariff), the overall return would still be attractive, in our view.

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Renaissance Capital 9 January 2019

Utilities

As the modernisation decree is approved (likely in January 2019), we expect market sentiment to improve, though we still don’t believe that the market will start factoring the modernisation programme into valuations. However, in our view, the clarity on future cash flow could allow the companies to be more constructive on increases in the dividend payout ratio and/or more aggressive M&A strategy, which could also boost their bottom lines.

…though we acknowledge lack of clarity on dividends

Our main concern, and the main driver of future share price performance of the Gencos, is dividend policy or/and a more active stance on M&A – specifically, whether or not the Gencos (in particular InterRAO, Mosenergo, TGK-1, and OGK-2) opt to increase their payout ratios. We reiterate our previous position, which is that, in bringing more clarity on the Gencos’ investment needs, modernisation tariffs, and KOM prices, the auction results should in turn provide the Gencos themselves with greater visibility on their future cash flows, thereby enabling them to raise their payout ratios and/or to embark on more aggressive M&A, which could also boost their bottom lines.

But we do not assume this for all the companies we cover. For example, having previously incorporated higher dividend payout ratio assumptions in our models for the Gazprom Gencos (TGK-1 and Mosenergo), we are now reluctant to do so, as Gazprom’s strategy regarding its generating assets, as well as the structure of any potential deal between Gazpromenergoholding and T+, remains unclear. Thus, we reduce our payout ratio assumptions for these and employ a historical 25%. Nevertheless, we would point out that the Gazprom Gencos are fundamentally capable of increasing dividends, without having to increase leverage and despite their modernisation needs. For example, Mosenergo’s net cash position (on our estimates) by the end of 2019 could be close to 30% of its current market cap and continues to grow, while TGK-1 will likely pay all its debt by the end of next year. Only OGK-2 will likely carry debt till 2022, however we estimate its average FCF yield will amount to 47% over 2019-2022.

Figure 6: Dividend yield, %

Figure 7: Dividend growth, %

	2018		2019E		2020E

16.0%

14.0%

12.0%

10.0%

8.0%

6.0%

4.0%

2.0%

0.0%

Enel

Unipro

Mosenergo

OGK2

TGK1

InterRAO

RusHydro

FGC

Rosseti

	Div CAGR Y17-28E		Div CAGR Y17-21E

40.0%

35.0%

30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0% -5.0% -10.0% -15.0%

IRAO

HYDR

ENRU

UPRO

OGKB

TGKA

MSNG

FEES

RSTI

RSTIP

Source: Renaissance Capital estimates

Source: Renaissance Capital estimates

We note that management of FGC guided for FY18 dividends to be no lower than FY17 dividends, which stood at RUB20.3bn, thus the dividend yield for FY18 should be no less than 10.5% at current market prices according to this guidance. Moreover, despite the lack of transparency on its dividend calculations, we believe FGC could sustain a yield above 10% as we expect future revenue, costs and capex to evolve alongside current growth rates with no significant changes likely.

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Renaissance Capital 9 January 2019

Utilities

We also reduce our dividend yield assumption for Mosenergo, due to adjustments to our FY18 forecast and beyond based on its 9M18 figures. At the same time, dividend yields for InterRAO, and Gazprom Gencos (apart from Mosenergo, whose dividends reached an attractive level only in the medium term) become attractive (falling into a 10-15% range) if the payout ratio is raised to 50% (Figure 6). Moreover, we see dividends growing long term (Figure 7) for all companies despite their planned modernisation and possible ‘digitisation’ capex at Rosseti (the BoD of Rosseti approved the digitisation programme in December 2018, with no material guidance on possible capex and efficiency improvement. We expect the first details and numbers related to the programme to appear in 1Q19).

We forecast that Enel Russia will deliver the highest dividend yield of almost 13.3% for FY18, followed by RusHydro (11.5%), Unipro (8.5%), OGK-2 and TGK-1 (6.1% and 7.8% respectively). We expect InterRAO’s dividend yield to reach 6.2% for FY18, while

Mosenergo will follow with a 5.1% yield. We note that the dividend yields for InterRAO and GEH Gencos assume a 25% payout ratio, which could increase yields to a very attractive range (10-15%) if the payout is hiked to 50% (which is unlikely in the short term).

Valuation

We use a DCF-based approach to value utility stocks (except for preferred shares of Rosseti, where we use a DDM approach), which we still believe to be the most appropriate method given upcoming modernisation, the expected increase in competitive KOM tariffs and the phasing out of DPM contracts. We update our DCF models based on: recently published 9M18 IFRS figures; electricity market dynamics in 4Q18; changes to our macro assumptions for the sector (in particular, changes to WACC estimates due to a higher risk-free rate and country risk premium); one-year rolling forward of our DCF models; lower assumed dividend payout ratios for Mosenergo and TGK-1. We show our revised financials for 2018-2020 in Figure 8.

Figure 8: Changes in financials, RUBmn

	EBITDA, 2018E		Net income, 2018E		EBITDA, 2019E		Net income, 2019E		EBITDA, 2020E		Net income, 2020E
	New	Old	New	Old	New	Old	New	Old	New	Old	New	Old
Enel	16,256	16,256	7,499	7,614	16,066	16,249	7,751	8,095	16,970	17,403	7,128	7,764
Unipro	26,345	26,773	16,271	16,612	30,737	31,236	18,846	19,274	39,106	41,560	24,936	26,957
Mosenergo	36,587	39,456	16,638	19,956	30,662	32,281	12,688	15,627	34,806	37,407	15,480	19,246
OGK2	28,850	29,551	8,764	9,173	29,770	32,097	11,061	12,320	28,047	32,950	10,895	14,379
TGK1	22,740	22,740	10,036	10,036	22,384	22,887	9,827	10,228	23,776	24,876	11,175	12,035
InterRAO	113,088	108,984	73,684	71,733	111,176	109,585	79,145	77,783	112,110	114,603	80,206	82,114
RusHydro	110,703	110,703	47,825	46,413	99,772	104,020	28,783	32,961	103,842	108,332	27,261	45,444
FGC	125,600	125,600	80,573	80,573	128,067	128,067	80,855	80,855	132,226	132,226	79,057	79,057
Rosseti	332,037	332,037	134,622	134,622	321,138	321,138	118,786	118,060	329,845	329,845	112,123	111,463

Source: Renaissance Capital estimates

Mosenergo and TGKA were mostly affected by our assumption changes, while we have left financials almost unchanged for Rosseti and FGC. However, apart from the changes for all companies outlined in this report we also make the following changes for individual companies:

▪FGC: We increase corporate governance risk used in our WACC assumption to 5% (from 1%), bringing it in line with Rosseti (particularly due to the change in its accounting policy within IFRS, which worsened the prospects for higher dividends based on IFRS accounts and still very unclear dividend calculation based on RAS accounting). We have also slightly reduced revenue from technological connection in future years following the guidance from the FGC investor day held in December.

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Renaissance Capital 9 January 2019

Utilities

▪Rosseti: We reduce our terminal growth rate assumption from 3% to 1% (in line with FGC), as the company’s digitisation programme remains unclear and nontransparent, while this programme should result in higher growth in our view.

▪RusHydro: We increase our capex estimate for 2019 and beyond following company guidance given at the last conference call in December and lower our terminal growth rate assumption to 1% (from 3%) to reflect unclear modernisation prospects in the Far East. We have also adjusted our impairment charges assumptions for FY18, FY19, and FY20 based on resent estimates of project costs and their date of commissioning in the Far East.

The main changes to our ratings (Figure 9) are that we downgrade Mosenergo to HOLD and upgrade RusHydro to BUY (we address each rating change below).

Figure 9: Target prices and ratings

	Ticker	New TP,	Old TP,	Change	CP,	Upside	New	Old
		RUB/share	RUB/share		RUB/share	potential, %	rating	rating
	IRAO	7.98	7.85	1.7%	3.97	101%	BUY	Buy
	HYDR	0.77	0.77	0.4%	0.49	59%	BUY	Hold
	ENRU	1.67	1.70	-2.0%	1.04	60%	BUY	Buy
	UPRO	2.62	2.57	2.1%	2.6	1%	HOLD	Hold
	OGKB	0.52	0.54	-3.0%	0.32	62%	BUY	Buy
	TGKA	0.0134	0.0144	-7.3%	0.0083	61%	BUY	Buy
	MSNG	3.09	3.62	-14.8%	2.06	50%	HOLD	Buy
	FEES	0.197	0.192	2.8%	0.15	32%	BUY	Buy
	RSTI	0.73	0.74	-0.9%	0.79	-7%	HOLD	Hold
	RSTIP	1.40	1.31	6.7%	1.40	0%	HOLD	Hold

Source: Bloomberg, Renaissance Capital estimates

We now have six BUYs in Russian Genco space – InterRAO, RusHydro, TGK-1, OGK-2, Enel Russia, and FGC – and four HOLD ratings for Mosenergo, Rosseti common and preferred stocks, and Unipro.

We believe that while many uncertainties damage Umeme’s investment case, some of the uncertainties should be resolved in 2019 (see subsequent section). We maintain our TP and rating for the company (Figure 10).

Figure 10: Umeme TP and ratings

Ticker	TP, UGX/share	CP, UGX/share	Upside potential, %	Rating
UMEM	400	320	25%	HOLD

Source: Bloomberg, Renaissance Capital estimates

We have left other ratings unchanged. We believe that the performance of the grid segment is totally driven by expected dividends. As 4Q18 is the quarter when most impairment charges are usually booked, significantly affecting possible dividends, the main share price moves are likely to happen when FY18 results are released in early 2019. As there are no indication on possible impairment charges in the segment for FY18 we leave our TP and ratings unchanged (Figure 11).

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Renaissance Capital 9 January 2019

Utilities

Figure 11: MRSK TPs and ratings

	Ticker	CP,	TP,	Upside	Rating
		RUB/share	RUB/share	potential, %
MRSK Ural	MRKU RM	0.19	0.35	89%	HOLD
MRSK Volga	MRKV RM	0.10	0.15	47%	BUY
Lenenergo, pref	LSNGP RM	95.5	124	30%	BUY
Moscow United Distribution Co.	MSRS RM	0.66	0.72	9%	HOLD
MRSK Center	MRKC RM	0.29	0.44	54%	HOLD
MRSK Center & Volga	MRKP RM	0.27	0.24	-10%	HOLD
Tomsk Distribution Co. (pref)	TORSP RM	0.30	0.18	-38%	SELL
Lenenergo, comm	LSNG RM	5.42	2.74	-49%	SELL
Tomsk Distribution Co. (comm)	TORS RM	0.34	0.09	-74%	SELL
Kubanenergo	KUBE RM	48.60	9.20	-81%	SELL
MRSK North-West	MRKZ RM	0.05	0.005	-91%	SELL
MRSK South	MRKY RM	0.06	0.004	-93%	SELL
MRSK Siberia	MRKS RM	0.10	0.002	-98%	SELL
MRSK Caucasus	MRKK RM	14.10	0.00	-100%	SELL

Source: Bloomberg, Renaissance Capital estimates

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Risks

Though we remain constructive on the approval of attractive modernisation regulation and its influence on companies’ long-term cash flows, we see the following risks to our investment case for the Russian utility sector:

▪Delays in the modernisation programme could lead the market to question the government’s commitment to setting economically justifiable tariffs for the programme. Although we believe the delays are mostly bureaucratic in nature, we do see a risk of the government modifying the parameters of the modernisation auctions after the first planned modernisation cycle (2022-2024).

▪As most companies are aware of the possibility of lower returns being set for subsequent modernisation cycles, there could be significant competition for the first-cycle projects, as companies seek to frontload investment into the cycle that has the more attractive tariff parameters. This could, in our view, result in significant declines in the bid price, which could in turn negatively affect the modernisation project’s financials.

▪Further delays to modernisation and competitive capacity auctions could further dent investor sentiment and increase the risk of the government changing the modernisation rules.

▪Unclear government strategy vis-à-vis the grid segment could cause increased volatility in the relevant stocks. We believe that the government has yet to decide on differentiation of FGC tariffs, possible increases in grid tariffs (from – 1% inflation currently to – 0.1% in the future), and consumer payments for excess reserve capacity. Though the government previously declared it would solve these issues, delays in their approval could indicate a lack of government commitment to restructuring grid segment regulation.

▪There is still no clear indication as to whether impairment charges are going to abate, as we believe they will. The 9M18 figures give no hints, as the companies usually book impairment charges in 4Q. Lower impairment charges could boost the investment case, while an increase would weaken it.

▪The sale of Reftinskaya GRES by Enel Russia at a discounted price (to fulfil the strategy set by the mother company) is a key downside risk for Enel’s investment story.

▪As InterRAO and Gazprom Gencos are ‘quasi’ state companies, we could potentially see the delay in the use of their cash piles due to a lack of government strategy on dividends for state-controlled companies, as well as restrictions on the use of these cash piles (for example the cash could be directed towards short-term deposits in particular banks instead of towards more attractive medium-term government bonds). All these could damage the investment case for InterRAO and Gazprom Gencos.

▪The key potential upside risk we see is faster-than-expected dividend payout ratio increases at InterRAO and the Gazprom Gencos,

▪Approval of a new, more transparent and clearer dividend policy by Rosseti (the CEO of Rosseti mentioned the possibility in December 2018), as well as clarification of its digitisation capex and its costs (which should happen sometimes in 2019) could boost the investment case for the grid sector companies, we believe.

Renaissance Capital

9 January 2019

Utilities

10