Research Notes

Liquidity Risks for Utility Stocks
In the Course of Restructuring Regional Power Companies

Semen Birg
Birg@finam.ru
(095) 204-8098

Alexander Chikunov, UES board member and head of the center in charge of restructuring regional energos, took part in the meeting.

During the meeting, the participants focused on the following issues:

1. current status and plans for restructuring the regional energos which comprise UES power holding;

2. ways, means and timeframe for distribution of shares of companies to be spun off from regional energy entities;

3. liquidity of reorganized entities’ stocks and obtaining a listing for shares of spun off companies.

The reason for holding this meeting is that the changes currently under way in the utilities sector have started to produce a serious affect on the market price of regional energy companies’ shares tradable on domestic bourses and have also raised the uncertainty associated with risks which accompany the restructuring process.

In addition, timely consideration of changes that are taking place in the power industry will help shareholders of restructured regional companies avoid situations where additional investment risks emerge.

In addition to the results of the roundtable meeting and analysis of Mr Chikunov’s report, we hereby highlight some issues that are necessary to gain a clear understanding of the entire reform process, such as the ways, means and timeframe for restructuring and further objectives which UES is striving to achieve.

Restructuring of regional power entities

The reorganization of regional energy systems is the centerpiece of reform in the Russian power sector, which provides for their breakup by business activities.

It should be noted that 72 regional energy systems are planned to be broken up during the reform process. Out of the 72 regional energos that form UES, over 50 are currently under reorganization. By the completion date of this research report, the power holding’s BoD has endorsed 52 reorganization blueprints for regional utilities companies, 48 of which stipulate reorganization under the base scenario.

The scenario for reorganization of regional energos, adopted by UES as the base one, implies their restructuring by spinning off new entities by business activities – generation, transmission and sales of electric power while retaining the mirror ownership structure where all shares are distributed among regional energos’ shareholders on a pro rata basis.

For more details on the reform structure, see our Desk Note dated December 16, 2004 “Power Industry: Sector, Reforms and Investments”.

Earlier, the base scenario for reorganization of a regional power company meant the establishment of a management company, to which the functions of a sole executive body of the generating and power sales entities, as well as those of the regional power system itself, were to have been assigned.

Management companies were to have been involved in performing organizational functions and liquidated after the industry reforms are completed.

But at its last meeting, UES’ Strategy and Restructuring Committee adopted a decision to scrap the idea of establishing management companies. They are of no use, since the restructuring plan for the next two years has been determined and all companies spun off in the course of reforms will fold into larger entities within a short period of time.

In addition, according to the base scenario, in 92% of the cases, the parent company that holds the brand of a regional energo will include grid assets (grids with voltage below 110 kW).

In breaking up regional energy entities, the mirror ownership structure will ensure equal rights for common and preferred shareholders. During the roundtable meeting Mr Chikunov once again persuaded analysts that regional energy systems’ stocks will be converted into those of newly established entities in strict observance of the rights of all shareholders.

Despite the fact that earlier UES management addressed the option not to issue preferred shares, a decision was adopted to retain the structure of spun-off entities’ charter capital similar to that of the company under reorganization.

While new entities are spun off from regional energy systems, the number of shares outstanding in the new entities will be equal to that of regional power companies. The scope of rights provided by stocks of spun off companies and regional energos is equal.

Non-standard reform option

In view of the specific nature of some regional power companies, they are restructured under the non-standard scenario. These companies are as follows: Samaraenergo, Saratovenergo, Ulyanovskenergo and Pskovenergo.

As opposed to the traditional reform option whereby regional energos are restructured under the spin-off scheme and new entities’ shares are distributed among shareholders of regional power companies, the application of the non-standard option to the above companies call for another spin-off scheme.

For example, the following companies will be spun off from Pskovenergo:

• Pskovenergosbyt;
• Pskovenergoagent;
• Pskovenergoservice;
• Pskovenergoavto

The generating assets of Pskovenergo, which are classifiable as non-core assets, will not be folded into a TGC or WGC, but be put up for sale.

Entities to be spun off from all regional energos reorganized under the non-standard scenario will be their 100% subsidiaries and, in contrast to the base scenario, the brand of the regional energo will include all its assets even after its restructuring is completed.

How to secure shareholders rights

Shareholders that voted against the restructuring or did not participate in the voting on this issue are entitled to have their shares in regional energos bought out. The buyout price is set by the company’s BoD on the basis of an independent valuation report. Shares are to be bought back using in-house funds of the company. In the event that internal financial resources are insufficient, the company raises loans.

According to previously announced concepts for restructuring regional energos and as confirmed by a report delivered by Alexander Chikunov, shareholders, whose rights are confirmed by the regional company’s shareholders registrar on the date of state registration of entities spun off from it, will obtain shares of newly established entities in proportion to their holdings in the regional energo.

Within two weeks after the date of state registration of the new legal entity, the regional power company’s BoD will appoint the registrar. Then, the registrar (e.g. the Moscow Central Depositary) receives the regional energy entity’s shareholders register valid on the breakup date of the new companies and transfers the regional power company’s shares to shareholders’ depositary accounts, whether they are de facto or nominal holders.

Thus, the cut-off date for obtaining shares of spun off companies is the date of the state registration of companies spun off from regional energos.

At the same time, all newly established companies submit documents to the Federal Securities Commission (FSC) for the state registration of their share issue. Before FSC assigns state registration codes to a share issue of companies spun off from regional energos, shares of these companies are illiquid. This phase could take from one to two months.

After the state registration of companies, spun off from regional energos, the distribution grid company, which has the regional energo’s brand and is trading under the same ticker, is no longer the same company. Par value and the number of shares, as well as the charter capital remain the same, while the market cap is lower, since the stake of distribution grids in reorganized companies varies from 90% to 40%. When shares of new companies are issued (1-2 months), only shareholders of the previous regional energo at the cut-off date will obtain shares in new companies.

Share prospects of spun off companies

We would like to point out that the breakup process will drive down liquidity of newly established companies and could cause shares of smaller companies, created on the basis of regional energos, to have modest market caps.

After newly established companies register their share prospectuses (in 1-2 months), these shares could be included in the non-listed stock segments. In the period between splitting regional energos and the registration of share prospectuses of newly established companies shares are not eligible for purchase or sale.

It’s noteworthy that the registration of share prospectuses of spun-off companies is not always advisable. Since sales companies possess relatively modest assets (except Pskovenergo, where energy sales are the core activity), it is economically unviable to bear significant losses incurred by the registration of issue prospectus, such as financial consultants’ fees, all the more because the companies spun off from regional energos, will eventually be merged with larger entities.

Moreover, it will take no less than 6 months to be assigned an RTS listing, since in accordance with the listing requirements on this stock exchange, half a year is the timeframe required for the physical existence of a stock, before RTS allows trading in shares of new companies.

Restructuring results

To date, UES’ 21 energy system have nearly been split by business activities.

In 2004, 4 regional energos were split using the basic scheme plus 1 regional energo (Pskovenergo) using the “non-standard” scheme, and 16 new companies were registered.

In January 2005, 16 regional energos were split and 49 new companies were registered.

Further restructuring timetable

According to Chikunov, in 2005 another 25 regional energos are slated for breakup and 144 new companies are to be registered.

It’s noteworthy that various delays in and amendments to the initial reform strategy emerged during the restructuring process. At present, basic reform guidelines and the timeframe for their implementation are set forth in the blueprint “UES’ Development Strategy for 2003-2008” (the 5+5 program). However, a number of its provisions are already out of date. In this regard Mr Chikunov said that by the end of 1Q 2005 UES management plans to submit the adjusted timeframe for utility sector reform measures for 2005-2006 to its BoD.

As part of the roundtable discussion, Chikunov clarified that adjustments were required due to procrastination in the restructuring timeframe and due to fine-tuning of certain provisions related in particular to the reorganization of regional energos and changes in the liberalization blueprint for the wholesale power market in Russia.

What next?

In accordance with their business activities, spun off assets will be merged to larger consolidated and horizontally integrated companies.

Before newly established companies merge with larger ones, the shares of these companies will have a low market cap and low liquidity. This period could last anywhere from 1 month to 1 year, depending on the company. This phase will be characterized by high uncertainty and for this reason implies additional risks for shareholders. At the same time, in the long term there is a chance to reap high rewards.

After small companies are included into merged companies, another 6 months should pass before shares of merged companies could be included into quote lists on the bourses. However, it should be borne in mind that UES’ management is in talks with stock exchanges over changing the procedure for shares to enter the trading system, as well as amending the current legislation in order to implement reform and minimize inconveniences for shareholders.

Generating companies, spun off from regional energos, will be merged into territorial generating companies (TGCs) and wholesale generating companies (WGCs). Distribution grids, which, as noted above, remain under the brand name of a regional energo, will become part of inter-regional grid distribution companies (IRGDC). Trunk grid assets will become part of the single Federal Grid Company (FGC).

As soon as the reform process is complete, these consolidating companies will turn into large horizontally integrated structures. As a result, by 2008 there may be roughly 20 power companies on the market with high-liquidity shares.

Summary

To sum up, we would like to say that the ongoing restructuring process in the industry is having a tangible impact on the market cap and stock prospects of the reorganized companies.

Since a grid distribution company is essentially trading using the ticker of a reorganized regional energo, the market cap experiences a technical correction by the amount of spun-off assets. However, shareholders of regional energos become shareholders of spun off companies at the reorganization date and the total market cap of a regional energo and spun-off assets remains unaffected. This way, the rights of shareholders are observed.

However, in the short term, recent developments in the industry have depressed liquidity and market cap of some utilities companies. In the long term, investors who have opted to maintain power stocks in their portfolios, will capitalize on the increased efficiency of utilities companies, reduced restructuring risks and emerging synergetic effects as a result of the merger of numerous assets broken up into large companies.

Simon Birg

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