Research Notes

Mosenergo, Lenenergo and Irkutskenergo - Three Sides of the Reform Story

	Target price, $	Current price, $	Upside potential	Recommendation
Mosenergo	0.061	0.0925	-34%	Sell
Irkutskenergo	0.27	0.227	19%	Buy
Lenenergo, common	0.471	0.57	-17%	Sell
Lenenergo, pref	0.3014	0.431	-30%	Sell

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

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Introduction

This Desk Note addresses the prospects, opportunities and threats associated with portfolio investments in three high-cap utility companies, whose major stakes are in the hands of strategic investors and whose shares are the most liquid on the Russian equity market: Mosenergo, Lenenergo and Irkutskenergo.

It is noteworthy that these companies are currently at different stages of the restructuring process. For example, Moscow utility was unbundled on April 1, while the spin-off of entities from Lenenergo by business activities is slated for October 2005. As for Irkutskenergo, this utility is beyond the reach of UES and the power reform to a lesser extent affects the interest of its minority shareholders, since at present the reorganization of regional energos within the electricity sector reform does not concern Irkutskenergo.

Overall, portfolio investors in the Russian utility sector will need to a choice either to invest in (1) shares of already spun off entities, most of which are only distribution and grid assets, (2) shares of companies to be split up in order to obtain stakes in all entities that will be established as a result of restructuring or (3) channel funds into shares of isolated and independent energy systems in an attempt to make portfolio investments lesser exposed to risks associated with the reform process.

In addition, we provide a brief description of methods used to assess the value of shares in these utilities which are traded on the Russian stock market and assign recommendations to them.

Changing landscape in the industry

As part of the power industry reform regional energos are to be spun off by business activities. In mid-April 135 new entities established as a result of the reorganization of 35 of 60 regional energos, whose restructuring projects were approved by UES BoD, passed state registration. It should be noted that six of these 135 companies have finalizalized their restructuring. All reorganization projects are slated for completion by the end of 2005.

We would like to remind our online readers that the final structure of the utility industry is projected for formation by 2007, by which time the power holding will cease to exist. Upon completion of the restructuring, there will be a holding of guaranteed suppliers and isolated energy systems controlled by the state.

By the time UES is liquidated, the power holding's capitalization will be far below its current market cap and shareholders of UES and regional energos will hold shares in the newly established entities - WGC, TGC, IRDC, IRLGC, etc.

To date, all wholesale generating companies have been registered and the configuration of 12 territorial generating entities, except for TGC #11 and TGC #12, has been approved. Five TGCs have already been registered. The power holding's BoD approved the configuration of four IRDCs at its meeting in April 2004, with three of them having already passed state registration.

Admittedly, the state's share in territorial generating companies (TGCs) spun off from UES will be no higher than a blocking interest, while its holding in wholesale generating companies (WGCs) established on the basis of thermal power plants will be below a controlling stake. Hydro-WGC will remain under state control.

According to information presented in the preliminary action plan for power industry reform, UES finds it necessary to determine the exact number of generating companies which can be put up for sale on the basis of market conditions and also after their formation is completed. Nonetheless, the power monopoly finds it possible to sell off some thermal WGCs and TGCs at auctions for shares and cash even before their restructuring is finalized.

According to the forecast by UES, WGC #5 and WGC #3 could be prepared for sale in 4Q2005, while TGC #3, set up on the basis of Mosenergo's TPP should be auctioned off in 3Q 2005. The other thermal WGCs and TGC #5, 6, 8, 9 could be put up for sale in 2H 2006.

We maintain that the privatization of gencos before the completion of UES restructuring, i.e. by 2007, could be a positive signal for the power holding's stocks and, consequently, for the whole market of utility shares, since UES is considered to be a driving force behind the power sector and demand for UES shares largely determines demand for the stocks of other utility companies.

Given the power monopoly's expectations that all utility entities established in the course of reforms will enter international capital markets no later than 2008, shares of these companies will be an attractive investment vehicle not only for Russian investors, but also for major foreign investment funds and investment companies.

We are of the opinion that the ongoing reforms will contribute to the formation of a more efficient model of the power market and a subsequent increase in market capitalization of utility concerns.

Mosenergo

Both before and after the breakup Mosenergo will remain one of the largest regional energy companies in Russia. According to 2003 data, the installed capacity of Mosenergo's power plants amounted to 15,000 megawatts. After the Moscow utility's April 1 split-up by business activities, installed capacity of the company's generating assets which are currently traded under the Mosenergo ticker stands at 10,700 megawatts.

UES' interest in Mosenergo's equity equals 50.87%. The Moscow utility company's largest minority shareholder is Gazprom Group which holds a blocking stake. At present, the energy company's free float is a mere 2-3% and its stock quotes are largely determined by speculative sentiment on the market.

In 2004 the electricity concern generated 72.7 bln kWh of electric power, a decrease of 3.2% on 2003, and sold 70.5 Gcal of thermal power to consumers, also down 3.8%. Meanwhile, we would like to note a 28% surge in revenues to $3.11 bln mainly due to a sharp rise in the effective electric power tariff. It is noteworthy that Mosenergo has posted record growth in revenues. FY2003 sales climbed 31% compared to 2002, when topside growth amounted to 22%.

In addition, we would like to note robust growth in sales revenues and gross profit - over 100% on the year. The utility's FY2004 net profit rose 18% to $56.29 mln. Thus, net profit margin stood at 2% year-on-year.

The Moscow-based energy system has already passed the peak of its reorganization after being carved up into 14 entities on April 1, 2005. The Mosenergo brand will be retained by the generating assets of 17 power plants, whose book value accounts for about 47% of Mosenergo's total assets. TGC #3, the largest among 14 territorial generating companies to be established on the basis of generating assets of restructured regional energos, will be formed at a later time.

It should be noted that of the 13 entities spun off from Mosenergo, four are generating concerns, three are engaged in power distribution, one specializes in electricity marketing and the last one is a power grid. Shares of these (13) entities will be transferred to shareholders' accounts based on data available on the cut-off date, April 1, 2005.

As of April 1 the regional energo's registrar received the shareholders register of the spun off company to transfer shares of new entities to shareholders' accounts. Following the registration of share issues, which takes two months at longest, shares will be transferred to custody accounts with depositaries. Thus, Mosenergo's shareholders will be able to trade shares of spun off utilities on the OTC market as early as the second half of May. Later on, provided that the Moscow utility's management adopts a decision to register share prospectuses of newly formed companies, their shares will be traded on exchanges in September 2005 at the earliest.

We maintain that the current market price of Mosenergo's shares is substantially higher than the company's fair value. The steep rise in stock prices seen last year was fueled by rising interest of the company's main minority shareholder Gazprom in consolidating a blocking stake in Mosenergo. As a result, the company's valuation reached levels inadequate in terms of fundamentals. Even now with lower stock quotes 1 kWh of Mosenergo's installed capacity is worth $244/kW, while the market average is $111/kW.

Irkutskenergo

Since the breakup of Mosenergo, the Irkutsk-based energy system with installed capacity of 12,882 megawatts has been the largest power system in Russia. The regional electricity concern has both excess capacity and power output. Irkutskenergo consists of three hydropower plants and 12 thermal power plants.

Irkutskenergo's ownership structure is as follows: 40% is owned by the Russian Property Ministry, 30% is in the hands of structures affiliated with Basic Element (RusAl) and 10% is held by companies affiliated with Sual Group.

In early December 2004 Irkutskenergo released its 3Q 2004 RAS financials. During the reporting period the company's revenues climbed by $87 mln from $361 mln to $448 mln, while 9m 2004 net profit calculated in accordance with the Russian Accounting Standards reached $31.2 mln, which is by far a stronger result compared to the loss of $8.3 mln in the year-earlier period. We would like to note that Irkutskenergo's COGS also rose by 7%, but in comparison with a 24.15% increase in revenues during the reporting period this is an extremely robust indicator which underscores the company's successful cost containment efforts. As for balance sheet data, we would like to note an 8% slide in long-term accounts receivable, a 5% drop in short-term accounts receivable and a 7% decrease in accounts payable.

According to the company's interim results for 2004, net profit amounted to $32.41 mln. It is noteworthy that net profit generated by Irkutskenergo in 2004 is slightly above that in 2001 when the utility company generated $28.28 mln of net profit. Net profit margin reached 8% in 2001, then dropped to 2% in 2002 and nearly reached the zero point in 2003.

We believe that FY2004 net profit margin will be at least 9%. Overall, Irkutskenergo's RAS financials should be greeted by investors with enthusiasm. Nonetheless, we are not of the opinion that this indicator cannot serve as an upside driver for shares of Irkutskenergo.

As for the impact the power industry reform is having on Irkutskenergo's structure, we would like to note that notwithstanding the company's operations on the local market, its restructuring will be carried out in accordance with the established procedure.

However, an important distinctive feature in the restructuring of a company which is an energy system independent of UES, is the fact that while restructuring and breaking up Irkutskenergo by business activities newly established entities will not be folded into consolidated structures (WGC, TGC, IRDC, etc.), as is the case with power entities controlled by the power holding. Thus, the risks associated with the company's reorganization are lower and its shares can serve as a hedging instrument to cut risks associated with the utility reform's impact on the company's investment appeal.

It is important to note that the company is undervalued on such a ratio as P/IC (the company's capitalization divided by installed capacity of power plants) compared to the market average. And while generating assets of regional energos are estimated at $111, Irkutskenergo's figure is $80 per kW.

In our opinion, the prospects for a higher valuation of Irkutskenergo's capacities are quite good, since as the reform moves forward conditions under which utility concerns operate will even out and the accompanying decrease in liquidity of restructured companies will encourage investors to pay more attention to independent energy companies, including Irkutskenergo.

It should also be noted that in the event that the market value of HPPs continues to rise, which is the most likely scenario, in our view (see our Desk Note dated March 2 - “Formation of Hydro-WGC - Prospects for Investors”), keen interest should be focused on regional energos which own substantial hydropower assets, which is also the case of Irkutskenergo.

We would now like to say a few words about the mid-term risks for the Irkutsk energy system which are associated with the roll-out of the 5-15 free electricity market in Siberia.

According to the power holding's reform strategy, building a single market space in the territory of European Russia, Siberia and the Urals is a target model for the wholesale power market. A special model which factors in all the specific features of Siberia is being framed for the electricity market of this region. Siberia has no excess generating capacities, as is the case in European Russia, and it is harder to generate electricity for sale on the free market to various groups of buyers. It should also be noted that initially major Siberian power plants were designed to generate power for specific consumers and owing to the vast territory of Siberia long-distance grid companies are not as developed as those in the Urals and the European part of Russia.

In all likelihood, the bulk of electric power will be sold in Siberia through direct contracts and at regulated tariffs. At the initial stage Siberian power companies will be able to market up to 5% of electricity generated at competitive prices, whereas buyers will be able to purchase up to 15% of the amounts they need.

We maintain that the extension of the 5-15 market to Siberia could exert an adverse impact on Irkutskenergo's financials. The point is that the Irkutsk energy system has one of the lowest power tariffs nationwide. With electricity tariffs leveled off in Siberia, both Irkutskenergo and its consumers could end up in trouble due to rising tariffs for electric power generated by Irkutskenergo.

Lenenergo

Lenenergo is the largest energy system in the north-west of Russia and one of the largest ones in the Baltic region. The company services an area of 85,300 sq km and a population of over 6.2 mln people, including St. Petersburg with 4.5 mln people (an area of 1,400 sq km) and the Leningrad region with 1.7 mln people (an area of 83,900 sq km).

The installed electric capacity of power plants run by Lenenergo is 3,253 MWt and thermal capacity is 11,880 GKal/h. An important competitive advantage of Lenenergo is a high proportion of hydro power plants which account for 12% of the overall installed capacity of the energy system. Another important advantage is the company's strategic location, as the utility has direct access to electricity exports to Finland and Estonia.

Lenenergo's restructuring and formation of TGC-1 where Lenenergo's charter capital share will stand at 63%, was hampered by disagreements between UES and Fortum (Lenenergo's core minority shareholder) concerning formation of this utility to which generating assets of Lenenergo, Kolenergo and Karelenergo will be assigned. The major reason behind disagreements was that Lenenergo's shareholders had clashing opinions on the advisability of creating TGC on a lease basis. Fortum insisted on the base scheme for creating this TGC with assigning assets as property, while UES offered to establish the company on a lease basis.

In early 2005, the conflict came to a head when the government of the Republic of Karelia opposed the decision by UES BoD to create a TGC on the basis of generating assets of Lenenergo, Karelenergo and Kolenenergo. According to Head of the Republic of Karelia Sergey Katanandov, it would be efficient to merge two generating systems - the Murmansk and Karelian ones which possess unique opportunities and isolated capacities.

However, all issues were resolved in 1Q 2005 and TGC-1 was registered on March 30, 2005. Founders of TGC-1 were Karelenergogeneratsiya (12%), Kolenenergo (25%) and Lenergo (63%). The installed capacity of TGC-1 will be roughly 6,087 MWt.

In line with the preliminary schedule, TGC-1 will launch operations as a company established on a lease basis effective July 1, 2005. The formation of the company is to be completed by merging three regional generating companies in 3Q 2006. This means that all the corporate procedures for merging RGCs spun off from Kolenergo, Karelenergo and Lenenergo should be finalized in April 2007.

According to the company's preliminary financials, Lenenergo's RAS revenue jumped by 21% to $1.06 bln in 2004, while net profit sky-rocketed to $29.37 mln, up 4-fold y-o-y.

We would like to point out to an increase in the company's efficiency ratios, as sales profit margins jumped from 5.1% to 5.7% in 2004, ROTA was 1.85% against 0.9% in 2003 and ROE surged to 2.07% from 0.5% in the year-earlier period. A total of $8.04 mln is to be paid out as FY2004 dividend payouts which is nearly twice as much as in 2003 ($4.15 mln).

Admittedly, a rise in dividend payouts is a short-term positive for investors. Meanwhile, we would like to note that the company's dividend payout ratio is 27% for 2004, only about half as much as 58% in 2003. The company's financial trend in 2004 is lower than in 2001. In addition, looking at the utility's financial indicators beginning 2001, its FY2004 performance is even softer than in 2001.

It's noteworthy that Lenenergo is overvalued on a number of fundamentals. In addition, the company is in the process of restructuring, which is the reason for the major risks which prevent an increase in its market cap.

Valuation

The fair price was determined using the comparative method in two variations which we view as the most acceptable - determining regression dependence in terms of several significant parameters and by assigning weightages to various multiples of the company value and subsequently determining the potential for upside or downside.

We view the proposed scheme as the best at present, since other valuation methods require too many assumptions and free interpretations. As a result, this leads to the fact that final results could turn out to be polar opposites depending on the appraiser's opinion.

We would also like to point out such difficulties in determining the fair value of each business segment represented in regional energos as uncertainty over electricity transmission and distribution and a lack of benchmarks for determining the value of the electricity sales business. As a result, the electricity generation segment is the most valuable one in a utility company.

At the same time, considerable value at regional energos is concentrated in distribution and transmission assets. The above valuation methodology is the best way to capture major value metrics of regional energos aside from being more indicative and less dependent on a large number of hard-to-forecast factors.

Valuation of the fair price of Lenenergo and Irkutskenergo shares.

Valuation of the fair price of shares of the Leningrad and Irkutsk utilities was assessed using data as of late March 2005. In the course of the work, data were analyzed on 32 regional energos which are traded on RTS or MICEX. Shares of companies in which less than 10 transactions during the last 12 months were executed, were removed from the sample collection. Major valuation ratios for the companies under analysis and average industry values are given in the table below:

Indicator	P/S	P/output	P/IC	EV/IC	P/book
Average for regional energos	0.63	14.87	111.54	154.25	0.55
Irkutskenergo	2.14	19.17	79.90	91.00	0.61
Lenenergo	0.69	22.24	184.96	244.70	0.44

In our opinion, these ratios could serve as a tentative framework for determining prospects of the utilities industry on the basis of market parameters.

For instance, in terms of P/IC (market price of 1 kW of installed capacity), EV/IC (adjusted for net debt market value per kW of installed capacity), Irkutskenergo is undervalued. However, in terms of P/S (relation of market cap to sales), P/output (relation of capitalization to electricity output) and P/book (relation of capitalization to balance sheet value of the charter capital) the company is overvalued by the market.

Lenenergo is undervalued in terms of the P/book coefficient, while it is overvalued by the market compared to the industry.

In the course of research, we analyzed a number of regression models, the basic statistical characteristics of which we have summarized in the table below:

	Multiple R	R-square	Normed R-square
Correlation between P and electricity output	0.89	0.79	0.76
Correlation between EV and revenue	0.72	0.52	0.51
Correlation between EV and electricity output	0.74	0.54	0.53
Correlation between EV and installed capacity	0.88	0.77	0.74
Correlation between EV and installed capacity, length of trunk grids and length of distribution grids	0.86	0.73	0.68
Correlation between P and installed capacity, length of trunk grids and length of distribution grids	0.85	0.73	0.67

The target market cap of companies was determined by comparing recommendations obtained on the basis of three models with the most important statistical parameters:

• Correlation between EV and installed capacity;

• Correlation between EV and installed capacity, length of trunk grids and length of distribution grids (three factor model)

• Correlation between P and installed capacity, length of trunk grids and length of distribution grids (three factor model);

In addition we have factored in the recommendations on regional energos analyzed on the basis of these three models and presented as precentages of potential upside/downside of the target price. We see that this correlation is significant and only one company has a discrepancy - #16 in the chart below. This is Altaienergo and the discrepancy is caused by considerable capital leverage which is only recorded in terms of the EV indicator and not recorded in terms of the company market cap indicator (P).

The most interesting development is the three factor model for estimating the company's value using the following variables:

• installed capacity of power plants (x1);
• length of distribution grids (x2);
• length of trunk grids (x3).

When developing this model, we assumed that the company's value consists of three major components - value of generating assets reflected by variable (x1), value of distribution grid assets (x2) and value of trunk grid assets (x3).

We believe that the proposed segments of the total company value are the main factor of investment appeal of industry entities. For this reason, the proposed model should yield reliable results.

	Ratios	Standard Error	t Stat	P-value	Lower 95%	Upper 95%
Intercept	0
X1	77,697.77	10,141.77	7.661163	1.9E-08	56,955.51	98,440.04
X2	18,813.23	17,660.88	1.065249	0.295553	-17,307.3	54,933.8
X3	1,403.605	848.9702	1.653303	0.109056	-332.735	3,139.945

Thus, we obtained the following variable ratios:
x1: 1 kWt of installed capacity is valued at $78;
x2: 1 km of trunk power transmission lines is valued at $18,800;
x3: 1 km of distribution grids is valued at $1,400.

In our opinion, the results obtained for x1 and x3 fairly estimate the value of these assets. Data obtained for value of trunk grid assets are somewhat higher than the industry consensus for the possible value of trunk grid assets including the future structure of the Russian energy market.

We would like to point out that using the proposed model for analysis of factors of the company's value we obtained the following average results for the companies under analysis:

Here we can see that the generation segment accounts for 62% of the company's value, with 24% for distribution grid assets and 14% for trunk grids.

We maintain that despite a number of assumptions, the results we obtained are quite accurate given the model used to calculate the company's fair value. The graph of selection by x1 variable is given below. As we can see from the graph, dispersion of the company's EV multiples is attributable to the relationship which we have identified.

The 67% R-square statistical ratio is also an upbeat development for this model, which means that in 67 cases out of 100 dispersion the market cap is explained by the identified relationship.

We used a 36% discount, which is the industry average for valuation of the fair price of Lenenergo prefs. At the date of this report, the market price of Lenergo preferred shares was 34% lower than that of common shares. At present, due to the ongoing restructuring the fate of preferred share remains undecided and we view the discount of preferred shares to common shares observed on the market as largely fair.

Valuation of Mosenergo shares

We estimated the fair price of shares of the unbundled company, which is currently trading under the Mosenergo ticker and which includes the generating assets to be assigned to TGC-3 in the future:

Our valuation of the fair price of Mosenergo's generating assets is underpinned by determined regression relationship between capitalization (P) and company value (EV) on the following indicators:

• Balance-sheet value of assets (book);
• Installed capacity of power plants (IC);
• Electric power generated (output).

The model was created on the basis of data on five federal power plants whose shares are trading on the stock market: the Konakovskaya HPP, the Kostromskaya HPP, the Pechorskaya HPP, the Stavropolskaya HPP and the Cherepetskaya HPP.

As a result, the fair price was determined as weighted average between three unifactor regression models in which the most significant characteristics of statistical relationship - relationship of the company's market cap on electricity output (P-output), of the company's market cap on generating capacity (EV - IC) and the company's market cap on balance-sheet value of equity capital (EV-book).

Average values of ratios by analyzed companies are given below:

Indicator	P/S	P/output	P/IC	EV/IC	P/book
Average value for HPPs	1.80	28.76	83.37	106.68	2.44

It's noteworthy that the cost per kWt of installed capacity for federal HPPs is $80. This indicator is higher than a similar indicator of cost per kWt of installed capacity of regional energos which we estimated at $78 by our regression model.

We viewed as unreasonable a discount for valuation of generating capacities of Mosenergo compared to the generating segment of federal power plants due to the fact that generating capacities of the Moscow utility, despite their high depreciation and lower efficiency are of significant interest to a strategic investor representing the Gazprom group which is prepared to pay a premium to boost its stake in Mosenergo's charter capital.

A more detailed description of the valuation methodology used for utilities companies and a target price for all utilities companies trading on the Russian stock market will be given in our next power industry Desk Note.

Summary

The proposed approach valuation approach which involves peer comparison is the best presently available given the lack of information on a number of important industry metrics until after the restructuring is complete. By using this model to perform a valuation of the fair price of Mosenergo, Lenergo and Irkutskenergo shares, the following results were obtained:

	Ticker	Fair price	Current price	Upside potential
Mosenergo	MSNG	0.061	0.0925	-34%
Irkutskenergo	IRGZ	0.27	0.227	19%
Lenenergo, common	LSNG	0.471	0.57	-17%
Lenenergo, preferred	LSNGP	0.3014	0.431	-30%

Thus, we expect to see a decline in Mosenergo and Lenergo shares and an upside in Irkutskenergo stocks and assign the following recommendations:

• Sell Mosenergo common shares with a fair price of $0.06 per share;
• Sell Irkutskenergo common shares with a fair price $0.27 per share;
• Sell Lenenergo common shares with a fair price of $0.47 per share;
• Sell Lenenrgo preferred shares with a fair price of $0.30 per share.

Simon Birg

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Sectors: Power Utilities, Regional Energos, Heat Generation
Company: Irkutskenergo, Mosenergo

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