Research Notes

At present, active trading covers 48 distribution grids (DGs) which appeared following the restructuring of regional energos. The consolidation of DGs and IRDGs will be finalized in Q108 and as early as Q208 DG stocks will get listed on the stock market. According to our estimates, right now DG stocks are the most attractive vehicle in the utility sector. Distribution concerns have exhibited strong financial showings, strategic investors have taken concerted efforts to lobby the interests of DGs and a new tariff formation mechanism is expected to be introduced by 2009, driving up investors' interest in the segment. In the short-term outlook, DGs will also take center stage, as ratios for converting regional DG stocks into those of IRDGs will be announced in Q407.

As part of this desk note we analyzed DG stocks. Analysis of the market valuation of operating indicators of Russian DGs shows that they are drastically undervalued compared to their foreign peers. What's more, assuming that grid facilities are 80% deteriorated, the replacement price is $16,500 per km or virtually 3 times higher than the current valuation of grid companies in the DG segment. Thus, we believe that most DG stocks hold upside potential. Be that as it may, as part of this research note we identified the most undervalued concerns among Russian DGs, offering them as the best point to enter the segment. We find reasonable to rely on the comparative figures of Russian distribution grids in terms of operating and financial indicators and use data relative to useful electricity output, the length of grids with their breakdown by classes, revenue, assets and liabilities of grid companies.

Based on our valuation, we assign a Buy recommendation to most issuers in the segment. Distribution grids are attractive investment vehicles when it comes to revenue only. In 2007 aggregate revenue of DGs is projected to jump 54% and 14% in 2008. Starting 2009 the plan is to introduce a RAB-based tariff formation mechanism which will result in stronger financial figures at DGs and growth in adequately invested funds. We consider the stocks of the companies that make up IDGC Center, IDGC North West and IDGC North Caucasus as the most undervalued, while the most promising investment options in the DG segment are shown below:

We advise investors to add DG stocks to their investment portfolios before the publication of DG/IDGC stock conversion ratios. In the mid term, the integration of grid assets, keener attention of strategic investors in DG shares and changes in corporate tariff formation procedures will serve as upside drivers for DG stocks.

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Simon Birg

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