Research Notes

We begin our coverage of Inter-Regional Distribution Network Company Center shares (Russian acronym: MRSK Center / English acronym: IDGC of Center).

Reduction in the uncertainty surrounding the tariff-setting principles has enhanced the investment attractiveness of the power distribution grid segment. Among the Inter-Regional Distribution Network Companies (Russian acronym: MRSK), MRSK Center is distinguished by high corporate governance standards and a skilled management.

In our view, the market does not currently take into account the potential premium to the price of the company which was set at a time when its formation had not yet been completed and its value was determined as the total price of the Regional Power Distribution Grid Companies (RSK) that were incorporated into the company. The premium was to reflect the expected increase in the liquidity of MRSK Center shares, improved management of the company, its expansion and elimination of the previous ‘expenses plus’ tariff-setting system. As of year-end 2007, the RSKs that were to be merged into MRSK Center had a total market cap of USD 2.42 billion, while the combined company’s market cap equaled USD 1.79 billion, implying a 26% discount to its actual price.

The company is, to a large extent, immune to instability on global markets, due to its focus on meeting domestic demand.

Adoption of a modern internationally-accepted tariff-setting methodology, called Return on Regulatory Asset Base, or RAB, is expected to enhance investor interest in the sector. As cash flows in the sector become more predictable, large investments get easier to draw and financial incentives are in place to improve operating activities.

The corporate governance and information disclosure standards of MRSK Center are higher than those of other MRSKs, thanks to the adoption of IFRS, an executive incentive program, and the availability of long-term investors, capable of defending their rights among minority shareholders.

The possible upward revision of the originally invested capital, in view of the position adopted by the management on this issue, may enable the company to considerably increase its tariffs in upcoming years, which should have a positive impact on its cash flows.

The main risk faced by the company is the possible understatement of its original capital by the regulator prior to the regulation of its tariffs under the RAB method. If approved, the undervaluation could hurt the company’s tariffs and, therefore, its cash flows.

Following our estimate of the fair value of MRSK Center shares under a DCF method, we assign a BUY recommendation to the company’s stock, with a target price for the shares of USD 0.068 per share as of year-end 2009.

Konstantin Reily

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