Research Notes

Our take on Gazprom’s 3Q and 9M 2004 results

Maria Radina
radina@finam.ru
(095) 204-8275

Kseniya Samartsieva
samartsieva@finam.ru
(095) 204-8274

• the gas holding’s 9M04 net revenue surged 26% to $23.6 bln compared to the same period last year ($19.3 bln).

• an increase in revenue in 3Q04 outstripped the rise in operating expenses by 12%, although such stellar results are due to the settlement of $700 mln debt by Ukrainian Naftogaz. Disregarding this fact, we again see a jump in operating expenses that outstripped growth in revenues: by 2% in Q304 and by 10% in 9M04.

Revenues generated by Gazprom in the third quarter and nine months of 2004 surged 26% and 23% compared to the same period of 2003. This came largely on the back of rising gas deliveries to European countries, which totaled 34.6 bcm in the third quarter of 2004.

We are concerned by the fact that Gazprom’s cost cutting attempts failed. If we view the gas giant’s results without taking into account gas debts cleared by the Ukrainian company, it is plain to see that an increase in operating expenses overshot growth in revenues both based on the results of the nine months in general and those of the third quarter in particular. We are of the opinion that the uncontrolled rise in the gas monopoly’s cost side is one of the primary problems for Gazprom’s financial standing in the future.

Table 1 – Gazprom’s highlights, $ mln

The structure of operating expenses also underwent no radical changes if compared to the results in the gas holding’s 1H 2004 report.

Gazprom’s main 9M04 cost items (see Table 2), as was the case in quarterly results, turned out to be depreciation (17% of total operating expenses), gas transit expenses (19%) and payroll (15.5%).

The most substantial increase in absolute terms was in wages of the gas monopoly’s employees (by nearly $1 bln) compared to the same period last year.

On the basis of 9m 2004 results gas transit expenses and taxes, except for profit tax, also jumped considerably in relative terms.

Increased payroll was previously explained by the gas mammoth’s officials that their company has increased wages three times over past twelve months and also an increase in headcount, including the consolidation of entities that form petrochemical giant Sibur.

Statements were also made that no major wage hikes are planned this year, but payroll is forecast to be indexed in line with the inflation rate.

Changes in taxes, except for profit tax, are attributable, first and foremost, to those in the tax legislation and, as we see it, need no comments, since these expenses are uncontrollable and the gas giant is in no way able to influence their amount.

Table 2 – Gazprom’s operating expenses, $ mln

Gazprom’s profit margins in 3Q 2004 (with operating and net profit margins hovering at 30% and 23%, respectively) look reasonable only at first sight. The reason that these ratios are better than those in the year-earlier period and close to the “best season” in the gas giant’s sales (1Q and 2Q) is the above settlement of debts by the Ukrainian company.

If one looks at the gas monopoly’s profit margins without taking into account the debt cleared by Ukrainian Naftogaz, it becomes abundantly clear that Gazprom’s activities were not more effective in the third quarter of 2004.

Faster growth in the company’s operating expenses than in its revenues still continues to have a negative impact on the gas giant’s profit margins.

Figure 1 – Dynamics of Gazprom’s operating and net profit margins

Source: Company data, Finam estimates

Operating profit margin that characterizes the company’s sales efficiency dropped even if compared to the same period last year from 23% to 21%. It is important to note that this came on the back of substantial price hikes and a 1.5% increment in gas output.

What happened to the gas mammoth’s cash flows is also unclear. A $3.6 bln jump in working capital was explained by the company’s officials at a conference call arranged for investors Thursday evening by the advance payment of gas export duties, Gazprombank’s activities and losses associated with the write-off of Ukrainian debts. As a result, the gas monopoly posted negative results not only in its free cash flow but also in its operating cash flow (Figure 2)

Figure 2 – Breakdown of Gazprom’s cash flows by quarters

We therefore regretfully note that in 3Q 2004 Gazprom lost its ability to generate free cash flows.

However, taking into account the Houston court’s ruling to dismiss proceedings in the Yukos case in the United States and cancellation of EGMs at Rosneft’s subsidiaries to approve the attraction of loan facilities to pay the Yuganskneftegaz acquisition, which should remove some political risks over the Rosneft-Gazprom merger, which should pave the way for removal of the ring fence around the gas holding’s shares, we reiterate our Buy recommendation on the gas monopoly’s shares until Gazprom posts its annual results for 2004.

Maria Radina

* Short overviews of equity research reports and sector reports are posted on the website http://www.finamrus.com with a 1-day delay after their full versions are emailed to the company’s clients. To get overviews on the day of their release, please contact your manager at Finam to sign up for full versions of research reports.