Research Notes

LUKOIL: FY2004 financials – In Line With Expectations

Recommendation	Buy
Current price	34.6$
Target price	38.74 $
Upside potential	12%

• Lukoil's Q404 and FY2004 financials released on May 25 were in line with the most upbeat expectations.

• Compared to the same periods of 2003, the company's net revenue was up 49% in 2004. In addition, cost growth in terms of the dollar equivalent was in line with that of net revenue. Net profit was up 78% in the reporting period not including the sale of the stake in the Azeri-Chirag-Guneshli project and the effect of changes in accounting policy.

• The reasons behind such stellar operating and financial performance include sky-high high crude and oil products prices in the reporting period, tough budgeting, asset consolidation, as well as the company's aspiration to achieve organic production and refining growth.

• However, the brilliant performance posted by Lukoil in 2004 has no impact on our valuation of fair share price, since the company's capex also took a jump in 2004 coupled with rising net profit over our target value.

• At present, Lukoil is the only private oil major in the sector and the company is characterized by a combination of considerable upside potential and low political risks.

• We reiterate our fair price of $38.74 per Lukoil share and a Buy recommendation.

Reason: FY2004 financials

RTS ticker LKOH Market cap, $ mln 29,756.7 Company value (EV), $ mln 32,224.7 Number of common shares 850,563,255 Free float 60%		Financial indicators, $ mln Indicator 2003 2004 2005E Revenue 22,299 34,058 45,817 Operating profit 3,457 6,034 7,047 EBITDA 4,377 7,109 8,139 Net profit 2,571 4,248 5,536
Margins, % Indicator 2003 2004 2005E Oper profit margin 17.9% 20.9% 20.1% EBITDA margin 22.6% 24.7% 23.2% Net profit margin 12.3% 14.7% 15.8%	Multiples Indicator 2003 2004 2005E P/S 1.5 1.0 0.8 P/E 12.5 7.0 5.4 P/ EBITDA 6.8 4.5 3.7 EV/EBITDA 7.4 4.5 4.0

Lukoil stock quotes and benchmark RTS trends

On May 25, Lukoil released its FY2004 audited consolidated report under US GAAP and again posted the strongest results in the industry not only in terms of the date of releasing the results but likely also in terms of performance. The company's actual results even slightly exceeded the company's guidance, although performance in Q4 (which we calculated on the basis of the company's 9m04 interim financials) looks somewhat softer than in Q3:

• Lukoil's net revenue surged by 49% in 2004 and was up 50.5% in Q4 y-o-y;
• cost-side growth in 2004 was in line with that of net revenue;
• profit from core activities jumped by 65.5% in Q4 and by 74.5% in 2004;

• Lukoil's net profit under US GAAP was $4.2 bln in 2004, up 78% on the year-earlier period, not including profit from the sale of a stake in the Azeri-Chirag-Guneshli project and the effect of changes in accounting policy

Òable 1. Lukoil's headline financial indicators

Indicator	Q4 2003	Q4 2004	Q4 2004/ Q4 2003	2003	2004	2004/ 2003
Revenue	6,025	9,627	59.78%	22 299	34 058	52.73%
For reference:
Excises and export duties	849	1,836	116.25%	2,954	5,248	77.66%
Net revenue	5,176	7,791	50.52%	19,345	28,81	48.93%
Opex	492	779	58.33%	2,546	2,88	13.12%
Cost of oil, oil products and petrochemicals purchased	1,609	2,789	73.34%	5,909	10,124	71.33%
Transportation costs	569	704	23.73%	2,052	2,784	35.67%
SG&A	569	579	1.76%	1,8	2,024	12.44%
Depreciation and amortization	235	269	14.47%	920	1,075	16.85%
Taxes (other than profit tax)	680	990	45.59%	2,456	3,505	42.71%
Exploration costs	59	46	-22.03%	136	171	25.74%
Excise and export duties	849	1,836	116.25%	2,954	5,248	77.66%
(Loss) profit from asset retirement, devaluation	2	45		69	213
Total costs	5,064	8,037	58.71%	18,842	28,024	48.73%
Profit from core activities	961	1,59	65.45%	3,457	6,034	74.54%
EBITDA	1,196	1,859	55.43%	4,377	7,109	62.42%
EBIT	942	1,564	66.03%	3,446	6,008	74.35%
Profit tax	306	516	68.63%	1,007	1,76	74.78%
Net profit	451	1,153	155.7%	2,386	4,248	78.0%

Revenue

Analyzing the rise in net revenue (up $9.5 bln or 49% on the year-earlier period) we can single out the following major factors behind the major's upbeat financial performance:

1) An increase in volumes of crude production and refining, selling oil and oil products.

As reported earlier, consolidated crude output of the Lukoil group rose by 7.4% to 86.2 mln tons in 2004. A 5.3% organic increment of crude output was achieved due to production optimization techniques and launching new oilfields, including locations in the Nenets Autonomous District and the Republic of Komi. Undoubtedly, asset consolidation, including increased stakes in Tabukneft, Ukhtaneft, Lukoil-AIK and acquisition of stake in RKM-Oil in 2003, produced a considerable positive impact. In the refining segment oil products output was up 4.1% on the year-earlier period, largely due to commissioning the company's Romanian refinery after reconstruction.

2) Unprecedented high crude prices both on the domestic and international markets of crude and oil products.

In particular, according to the company's financials, average price growth for crude Urals on global markets was about 27.6% (from $27/bbl to $34.5/bbl) and prices for high-octane gasoline were up 35.2% (from $296.13/ton to $400.33/ton);

3) Optimization of sales logistic chains by the company by restructuring and rerouting the sales of crude and products

The company has estimated the effect from these measures at $5.6 bln (export of oil and oil products was up 21.9% in 2004 in terms of volume amidst an overall decrease in sales volumes on the domestic market), also due to the commissioning of the first stage of the Vysotsk oil terminal in Q204.

Trend of revenue indicators per barrel of produced oil are as follows:

Chart 2. Lukoil's revenue indicators

Costs

By and large, cost breakdown and trends (Table 1) for the last two reporting periods underscore Lukoil's efficient cost-containment efforts and tough opex budgeting. However, we could say that Q4 was a step back compared to the strong 9m04 performance in this area. Cost growth rate, including opex, was nearly 58% in Q404 and outstripped net revenue growth. As a result, total costs rose 48.7% in 2005, while opex grew by 13% against 2003, although opex rose by a mere 2.3% in 9m04 while total costs were up 45%. We are hopeful that this trend is caused by objective reasons, not just inflationary processes and commissioning the Romanian refinery after reconstruction. We view objective reasons for rising opex for the company, which has been implementing tough cost-containing measures for nine months and generated windfall profit, as partial rejection of such tough steps concerning production costs, including capital and temporary repairs of assets as was the case with Lukoil during 9 months.

Thee major factor had a negative impact on Lukoil's annual financials as was the case in the interim financials:

• transportation costs spiked by 35.7% in 2004;

• rising tax burden on the Russian oil industry (tax payments, except for profit tax, surged by 42.7%, while excises and export duties shot up by 77.7%).

• costs for purchase of oil, oil products and petrochemicals rose by 71.3%.

Lukoil is capable of controlling transportation costs only in part, tax burden is impossible to control, while the cost line for purchase of crude and products remains totally opaque.

By and large, the fact that costs grew in line with net revenue's growth is an upbeat factor. However, we have already mentioned that Q4 showed a slight deterioration

Profit margins

In line with expectations, all Lukoil's margins posted an upsurge in the range of 2-3.1% both in Q4 and 2004 (Table 2).

Table 2. Lukoil's margins

Indicator	Q403	Q404	Q4 2004/ Q4 2003	2003	2004	2004/ 2003
Operating profit margin	18.6%	20.4%	1.8%	17.9%	20.9%	3.1%
EBITDA margin	23.1%	23.9%	0.8%	22.6%	24.7%	2.0%
EBIT margin	18.2%	20.1%	1.9%	17.8%	20.9%	3.0%
Net profit margin	8.7%	14.8%	6.1%	12.3%	14.7%	2.4%

Source: Company data, Finam estimates

Capital investments

The total amount of capital investments considerably outstripped our expectations in 2004 and came in at $3.2 bln minus asset sales and $3.74 bln – including acquisition and sale of fixed assets and other assets. According to company data, capex will be $3.54 bln in 2005 and will be maintained at the same level which is caused by the need to develop capital intensive projects in the Caspian region, the Timan-Pechora oil and gas province as upgrade and development of the company's international refineries. The company has announced plans to increase gas production to 30% of total hydrocarbon output.

Cash flows

Lukoil's cash flow became negative in the reporting period (chart 2), although operating cash flow soared by 42.3% to $4.2 bln. However, a rise in investment flow (not including asset sales of $3.2 bln, and including asset acquisitions of $3.74 bln) and negative cash flow used in financial activities and exchange rate ranges offset the increase in operating flow.

Chart 2. Lukoil's cash flows in 2003 and 2004 $ mln

By and large, there's nothing wrong the major taking advantage of favorable price trends or investing in the upstream. Lukoil's 2004 dividend yield is expected to be roughly 3%, which is a rather high figure for the industry at present.

Risks

In our opinion, in addition to general industry-wide risks Lukoil's risk exposure is related to the oil major's international operations and largely to the fact that the bulk of Lukoil's drilling projects are capital intensive exploration projects situated in politically unstable regions. Recently Lukoil pulled out of two projects in Azerbaijan and recently news broke that after drilling the pilot well on the Yalam block no industrial oil flow was received (another project in Azerbaijan). Thus, the likelihood that the strategic production target will not be achieved still remains, although we view it as unlikely. At present, Lukoil is one of the largest private companies in the industry. The company offers a unique combination of considerable upside potential and low political risks.

Ksenia Samartsieva

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Sector: O&G
Company: Lukoil

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