Research Notes

Baltika: Still in the Vanguard

Recommendation on common shares Buy Target price: 29 Current price: 23.9 Upside/downside: 21.3%   Recommendation on preferred shares Buy Target price: 20 Current price: 17 Upside/downside: 17.6%

Reason: upgrade of target price

RTS ticker	PKBA, PKBAP
Market capitalization, $ mln	2,800.1
EV	3,227.7
Number of common shares	117,158,530
Number of preferred shares	13,545,150
Year-end target for common shares, $	11.05 – 25.8
Year-end target for preferred shares, $	10 - 17

Financial indicators, $ mln   2003 2004 2005F Revenue 737.2 994 1,235.5 Operating profit 168.5 172.5 240.7 EBITDA 226.81 252.6 330.3 Net profit 123.1 131.9 184.4		Multiples   2003 2004 2005F P/S 3.5 2.6 2.1 P/E 23.7 22.6 17.1 EV/EBITDA 14.2 12.8 9.8 EV/S 4.0 2.9 2.4
Profit margins, %   2003 2004 2005F Operating profit margin 22.9 17.4 19.5 EBITDA margin 30.8 25.4 26.7 Net profit margin 16.7 13.3 14.9		Dividends, $/sh   2002 2003 2004 Common shares 0.3 0.38 0.48 Preferred shares 0.39 0.49 0.63

We are upgrading the fair price of Baltika’s shares to $29 per common share and setting the target price of $20 for preferred shares. Our recommendation on Baltika’s shares is a Buy.

• According to our calculations, the brewery’s common and preferred shares are traded at discounts of 21.3% and 17.6%, respectively, to their fair price.

• We have valued the fair price of shares using the DCF model and the comparative method.

• We assign a Buy recommendation to Baltika’s shares on the back of the company’s strong fundamentals, its leadership status and attractive estimated value.

• The company’s financial model hinges on forecasts for Baltika’s performance as an independent business unit. We take no account of the upcoming merger of Baltika, Vienna and Pikra, since perspectives and the timeframe for the legal merger remain unknown. However, we have priced into our model a gradual decline in the proportion of costs in Baltika’s revenue thanks to the positive effect from the consolidation of the marketing and distribution departments of these companies.

---

The Russian beer market continues to expand

For a number of years the Russian beer market has been considered to be one of the world’s most dynamically expanding markets. Beginning in 1996, the Russian beer sector has posted record growth rates – output volumes surged by 20-30% a year. Even despite the 1998 economic crisis, beer producers brewed 28% more and 1999 witnessed peak production – almost up 32% on the year. However, after that growth rates slowed down and the trendline underwent changes in 2001.

The bulk of beer brewed in Russia – over 60% - is produced by companies with foreign participation (Baltika, Interbrew, Heineken, Efes and SÀBMiller). The market of beer manufactured under Western licenses began to expand in 2002 with the launch of such brands as Staropramen and Kozel.

Baltic Beverages Holding AB (BBH) is the largest beer producer in Russia, accounting for 35% of total national production. BBH’s key producing unit is Baltika brewery. In addition, the holding has controlling stakes in the Yarpivo Group of companies, the Vienna-Golden Urals Group and Pikra. The holding’s Russian assets are to be consolidated over the next few years. Sun Interbrew ranks second in terms of production. More than 300 beer companies operate on the Russian beer market, but no more than 20 of them can be classified as large.

Growth of beer market

	2000	2001	2002	2003	2004
Per capita consumption, liter	37.9	43.6	48.6	53.0	56.8
Growth, y-o-y	23.8%	15.0%	11.5%	9.1%	7.1%
Production in Russia, mln decaliter	554.5	636.3	702.5	757.3	851.96
Growth, y-o-y	22.7	14.7	10.4	7.8	12.5

Source: data from Business Analitika

Last year was favorable for the domestic beer industry following a downturn in growth rates, which had been observed for the three previous years. In September 2004 a new law took effect imposing serious restrictions on beer advertising and fears emerged that this would deal a crushing blow to beer producers. Legislative restrictions exerted no serious impact on the beer market’s 2004 performance. According to forecasts by the Russian Union of Brewers, the market is expected to grow by around 8% in Q105. These results lead us to believe that the market environment will improve further down the road. According to our forecasts, in 2005 the Russian beer market could grow by at least 8-9%.

Among the primary trends which become entrenched on the Russian beer market in recent years, we would like to note a jump in the proportion of licensed and value beer, rising sales of beer in PET and aluminum cans and a drop in the share of bottled beer. As regards licensed beer, producers’ interest in this segment is easily explained by much higher profit margins from sales of licensed beer when compared to other beer segments.

Over the past several months, breweries have been active in launching new beer brands. The leaders in this race are as follows: Heineken (Guinness and Amstel), Sun Interbrew (Hoegaarden and Brahma), Ivan Taranov Breweries (Coors Light) and Moscow-Efes Brewery (Zlatopramen). Last year Baltika began to brew Foster’s, while Vienna represented its new brand, Kroneburg 1664.

Market leaders

The year 2004 saw hardly any changes in the market share among key market players. Baltika is still the leader on the Russian beer market, trailed by Sun Interbrew. We maintain that during the next few years Baltika will retain its status as Russia’s number 1 beer company in terms of production, although market shares of both companies could undergo changes.

Baltika – Business overview

Baltika has been the leader of the Russian beer market since 1996. The company was incorporated in 1990, with Baltic Beverages Holdings AB its major shareholder which holds a 75.4% interest. Baltika consists of five breweries located in St. Petersburg, Tula, Rostov-on-Don, Samara and Khabarovsk, owns 30% of a St. Petersburg-based malthouse, new malting facilities in Tula and 32 distribution centers. The company’s products are exported to 36 countries of the world. Marketing, distribution and sales units of Baltika, Pikra and Vienna (all these entities are controlled by BBH) should merge by January 1, 2006 and the legal merger will be executed at a later time. Yarpivo is also planned to join the merged company.

Baltika brewery is the owner of two well-known beer brands: Baltika and Arsenalnoye. International brands Carlsberg and Foster’s are manufactured under the license. The company has also a number of other brands: Samara, DV, Don, Parnas, Medovoye, Leningradskoye and Zhigulevskoye.

President of Baltika Taimuraz Bolloyev, who has headed the company for 13 years, decided to resign in mid-December 2004. Currently, the brewery’s president is Anton Artemiev.

Equity and dividend

Shares

Baltika’s charter capital is split into 117,158,530 common and 13,545,150 preferred shares with Rub 1 ($0.03) par value each. The company’s shares obtained a listing and are trading on RTS and MICEX.

Dividend payout policy

Baltika’s dividend payout policy is characterized by a continuous increase in the amount of dividend payouts on the company’s shares. Dividends on common and preferred shares have jumped by over 4-fold in 5 years.

Dividend period	Dividend payouts per common share, Rub	Dividend payouts per preferred share, Rub
2000	3.16	4.11
2001	8.5	11
2002	9.32	12.12
2003	11.64	15.13
2004	13.94	18.12

Bonds

In 2004, Baltika launched its first bond issue placing on the secondary market 3-year bonds valued at Rub 1 bln ($35.6 mln). Average yield is 8.99%.

FY2004 results

The year 2004 was successful for Baltika as output surged by 23% to 199 mln decaliters, while the market as a whole expanded by nearly 12%. Baltika’s market share was 22.8% vs. 20.5% as of year-end 2003. Thus, the company managed to overcome difficulties of 2003 and restore its market share. In Q1 2005, the company’s sales jumped by 23% on the year earlier period to 41.5 mln decaliters.

* in kind vs. the same period in 2003

Baltika’s sales breakdown by type of packaging reflects common trends on the market: rising sales of beer in plastic bottles and aluminum cans and declining share of beer in glass bottles.

Among all Baltika’s brands, the year 2004 was the most successful for Carlsberg, Samara and DV.

Risisng sales of the company’s leading brands in 2004

Baltika	13%
Baltika # 3	21%
Baltika # 7	21%
Arsenalnoye traditional	6%
Samara	158%
DV	214%
Carlsberg	129%

In 2004, the Baltika brewery boosted its presence on the draft beer market and sales in this segment rose by 37%.

The company’s exports were up 14% y-o-y to 11 mln decalitres of beer. A total of 6% of cumulative sales were exported and exports revenue surged by 32%. Baltika exports its products to 36 countries.

Financial results

$ mln	2003	2004	Chng.
Net revenue	737.25	994.02	34.8%
COGS	397.30	549.18	38.2%
SG&A	171.41	272.33	58.9%
EBITDA	226.82	252.60	11.4%
Operating profit	168.53	172.51	2.4%
Net profit	123.14	131.95	7.2%
Operating profit margin	22.9%	17.4%
EBITDA margin	30.8%	25.4%
Net profit margin	16.7%	13.3%

Source: Company data, Finam estimates

Baltika’s revenue jumped by 34.8% in 2004, however, net profit soared a mere 7.2% due to faster cost growth rates. The company’s margins softened against the 2003 level due to rising costs caused by ongoing restructuring: the company launched a new distribution system, new market strategy and created a logistics system in which $25 mln was invested.

In 2004, the company pursued an active investment policy and annual investments totaled $119.3 mln.

Valuation

We used the DCF model to estimate the fair value of Baltika’s shares. Our model is underpinned by the following key assumptions: a gradual slowdown in growth rates of beer output in Russia, with further stabilization at the level of 3%, outstripping growth of Baltika’s output and reaching a 25% market share by year-end 2007.

Our model treats Baltika as a standalone company as the precise timeframe and procedure for the legal merger of Baltika with breweries Vienna and Pikra have yet to be unveiled. We have made provisions for a gradual decrease in share of expenses in the company’s revenue as a result of the upcoming operating merger.

			Forecast period							Post-forecast period
		2004	2005	2006	2007	2008	2009	2010	2011	2012
EBIT	$ mln	172.5	240.6	302.6	362.8	420.2	470.5	526.5	583.1	639.3
EBIT tax	$ mln	41.4	57.8	72.6	87.1	100.8	112.9	126.4	139.9	153.4
Depreciation	$ mln	80.1	89.7	98.6	107.5	115.6	121.4	127.4	133.8	139.2
Capital investment	$ mln	126.9	135.8	145.4	150.9	149.1	139.6	152.4	137.4	147.1
ChWC	$ mln	30.1	27.9	27.1	28.5	25.5	20.6	22.5	21.7	20.5
Cash flow	$ mln	54.2	108.9	156.1	203.8	260.3	318.8	352.7	417.9	457.4
Discount rate	%	11
DCF	$ mln		98.1	126.7	149.0	171.5	189.2	188.6	201.3
Total DCF	$ mln	1,124.3
Final growth rate	%	3
Final value	$ mln	5,717.3
Estimated terminal value	$ mln	2,480.9
Market cap	$ mln	3,605.2
Net debt	$ mln	197.3
Cash available to shareholders	$ mln	3,407.8
Price per common share	$	29
Price per preferred share	$	20

In line with our estimates, the fair value of Baltika’s common share is $29 and per preferred share - $20. Thus, upside potential for common shares is 21.3% and for preferred 17.6%.

We used the comparative model as an auxiliary one. Baltika’s indicators were compared to the performance of its peers from different countries.

	P/E	P/S	EV/EBITDA	Net profit margin
Baltika	22.6	2.5	12.3	13.3
SUN Interbrew	59.6	4.3	23.3	7.3
Kirin Brewery (Japan)	24.8	1.0	13.1	4.2
Anadolu Efes Biracilic (Turkey)	12.8	2.2	7.8	17.3
Nigerian Breweries (Nigeria)	32.0	4.2	17.2	13.0
Hite Brewery (Korea)	18.3	2.0	9.6	10.8
Browary Zywiec (Poland)	21.3	1.6	10.6	7.6
East African Breweries (South Africa)	33.6	5.4	19.6	16.1
Grupo Modelo (Mexico)	15.7	2.2	6.6	13.8
Average for EM	27.2	2.9	13.5	11.3
SABMiller	17.3	1.8	8.4	6.9
Heineken	23.17	1.25	7.7	5.4
Anheuser-Busch	17.2	2.5	10.4	15.0
Scottish & Newcastle	29.8	1.0	16.2	3.2
Foster's	10.3	2.1	11.0	20.6
Cia Cervecerias Unidas	19.2	2.06	10.18	10.8
Average for developed markets	19.5	1.8	10.6	10.2
Discount/premium of Baltika to EM	-17.1%	-12.8%	-8.7%
Discount/premium of Baltika to developed markets	15.9%	41.7%	15.6%

Source: Bloomberg, Company data, Finam estimates

Baltika in undervalued on all key indicators compared with EM peers. The discount ranges from 8.7% to 17.1%. Compared with companies which operate on developed markets, Baltika’s premium ranges from 15.6% to 41.7%. However, Baltika has stronger margins than the average value for its rivals. In addition, the Russian beer market has stronger potential than developed markets. For this reason, we view Baltika’s premium as justified.

Summary

According to our estimate, Baltika’s common shares have upside potential of 21.3% and target price of $29. Preferred shares are undervalued by 17.6% and the target price is $20. We have upgraded the fair price of the company’s shares based on the following factors: market leadership status, upside potential of sales and market share, and anticipated rise in Baltika’s margins as a result of cost-containment after merging with other breweries controlled by Baltik Beverage Holding AB. We assign a Buy recommendation to Baltika shares.

Olga Samarets

* 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.

Sector: Consumer, Food
Company: Baltika

All Research Notes >>