UniCredit in Moscow -

We believe inflation fears are overblown. Accelerating inflation in Russia has raised fears that rapidly rising consumer prices would cut into the population's consumption bundle, which might lead to a slowing of the current consumer demand-led growth. The planned liberalization of gas and electricity tariffs, which are crucial for further reforms in the Russian energy sector and thus the valuations of leading Russian companies, have led to similar concerns in some quarters.

We admit that inflation remains one of the major challenges for Russian economic policy makers. However, we would also note that even with the dramatic acceleration of CPI inflation to 11.9% on year at the end of 2007, any measurements of inflation still lag - by far - nominal disposable income growth in Russia, which presently exceeds 22% on year. Such nominal income increases leave plenty of room for companies to transfer their rising costs onto customers and maintain tidy profit margins without a significant deceleration in real demand.

Moreover, the continued growth of nominal incomes leads to robust increases in wealth of increasingly deeper layers of the population, creating a rapidly expanding middle class. According to our estimates, the number of Russians with a disposable income over $1,000 per month has nearly tripled in just three years, from barely 10m in 2005, to exceed 28m in 2007. We expect this trend to continue in the future, due to a combination of strong economic growth and the Russian demographic squeeze. This in turn leads to radical changes in the quality of consumption, as more and more of the Russian population moves away from near-subsistence models of consumption, creating a boom in demand for high-quality and valued-added goods.

We believe that this process of real consumption growth and improvement should continue - despite considerable increases in food prices - as the story of the emerging Russian middle class remains in its early stages.

The beneficiaries

In our opinion, this situation is particularly beneficial for companies that are exposed to domestic consumer demand and that wield pricing power. We would include retailers such as X5 Retail Group, Magnit, and Dixy, among those set to benefit the most from the buoyant expansion of demand. The existing inflationary environment should enable such companies to transfer continued cost increases onto consumers without compromising profit margins.

According to our estimates, given the existing level and structure of costs of major Russian retailers, their total costs should rise by over 10% per year over the next five years, due to increases in wages, retail space rent, and product prices. On the other hand, total nominal retail turnover is expected to rise by almost twice as much over the same period. This leaves substantial room for further real sales growth and potentially even expanded profit margins, despite the existing inflationary pressures.

The same story holds for gas and electricity price increases, which is one of the major driving forces behind the valuations of such major companies as Gazprom, Novatek, UES and others. Thus, even under the most bullish assumptions for liberalization of domestic gas and electricity tariffs, the cumulative expected increases should still lag behind cumulative expected nominal increases in disposable income. Therefore, the share of total expenditures on gas and electricity out of total spending by the population is likely to remain at worst unchanged over the period, which should make the projected price increases more than sustainable.

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