Ben Aris in London -
Bill Browder, the manager of Hermitage Capital, dropped a bombshell on delegates attending an Adam Smith conference on private equity in Russia last month; the details of oil company Surgutneftegaz' spaghetti governance that suggest political risks are nearer the surface than most investors think.
There was standing room only at the London-based event where Browder joked that you used to be able to tell how much upside the market still has by the number of free seats at this sort of event. Certainly the investors were out in force to hear a series of presentations where speakers generally agreed that the "easy money is gone" and that while you have to work hard, "there is still plenty of opportunity left."
Browder had his Russian visa nixed in November 2005 by what he assumes was the irate management of one of the companies he invests into, which was tired of his very public corporate governance campaigns.
And never one to shy away from controversy, Browder laid into many of the investment fads of 2006 before revealing the make-up of Surgutneftegaz following a company restructuring, which omes straight out of Russia in the 1990s and bucks the trend towards improving corporate governance.
Browder began by painting a familiar picture: Russia has the second-best fiscal balance of any major country in the world, the second-best current account and the second-best GDP growth in the world. Even more important, the state has almost no debt, which gives it substantial wiggle room in the event of a global recession or a fall in oil prices.
"Russia has this unbelievably good macro-economic situation. And with this great situation there should be some great things to invest in," says Browder. "The answer is there are some great things to invest in. But there are also some really bad things to invest into."
Five years ago everything in Russia was cheap, but after the relentless rise of the RTS, Browder says a lot of Russian companies are starting to look expensive. With price/earnings ratios ranging from 5.2 to over 100, it's now possible to lose a lot of money if there's a sharp downturn.
Of all the asset classes that attracted attention in 2006, none have set investors alight like Russian banks, which are now the most expensive in the world, claims Browder.
"If you invest into an oil company and you do a bad deal then maybe you'll make five-times your money. If you do a good deal then you'll make maybe 15-times your money," says Browder. "But a bank is just a bunch of guys. If you do a bad deal you can lose all your money, but if you do a good deal you can make maybe 1,000-times your money. I don't think it makes sense to own banks at 5 - to 8-times book value. It doesn't matter how good their prospects are. This is another internet-type exuberance phenomena."
Next up were the retailers, which have been hot for several years as supermarkets and food processors experience heady growth on the back of double digit gains in disposable income and retail turnover. There are three big publicly traded retailers in Russia - Seventh Continent, Magnit and X5 - all of which are trading at 30-times earnings.
"How are you going to make money from a company that is trading at over 30-times earnings? I don't know," says Browder.
The third fad in Russia in 2006 has been the boom in IPOs, which attracted over $17bn of investment last year. But Browder says that the IPOs have been almost universally disappointing.
"Over the last year, about 75% of IPOs have underperformed the market," says Browder. "It's like the famous proverb: if you go to a poker game and you don't know who the sucker is, it's probably you. You have to be very, very careful buying IPOs.
Surgut spaghetti governance
Valuations have been rising, but as owners rev up to IPO or simply borrow more money from banks to pay for this expansion, there has been a widespread move towards better corporate governance and increasing transparency.
However, Browder went through recent changes to Russian oil major Surgutneftegaz' corporate structure that seem to have been motivated by the company's fear of an asset grab by the state.
Surgutneftegaz is one of Russia's biggest oil companies and its stock has performed well in recent years on the back of rising oil prices and the general enthusiasm for all things Russian. But while analysts' reports describe the company's performance and prospects, Browder says there is one key question that no one has a clear answer to.
"The defining question at Surgutneftegaz is: how many shares are outstanding?" asks Browder. "It sounds like a strange question, as shouldn't you know the answer to this, a publicly traded company."
There are three possible answers. Is it 35.7bn shares, which is the number of shares issued by the company? Is it 20.7bn shares, which is the number of issued shares minus the number of shares held by Surgutneftegaz via a company called Leasing Production? Or is it 13.6bn shares, which is the number of shares issued minus Leasing Production and other Surgutneftegaz subsidiaries?
The question is important, as depending on the answer the company is either a moderately valued company with a price ratio of 9.7-times earnings, a cheap company valued at 5.6-times earnings, or a dirt cheap company valued at 3.7-times earnings.
Until the end of last year, Surgutneftegaz held 91% of Leasing Production, which once you complete the circles (and include a few other subsidiary cross-holdings) means the oil company owned 62% of itself. This was publicly available information.
Then on January 18, it was reported that Leasing Production no longer held 42% (which together with some affiliates made 62%) of the oil company. There was another revelation a few weeks later that Surgutneftegaz was actually owned by 19 non-commercial limited partnerships.
"If you can't prove something, it is better to assume they don't own it so every analyst downgraded Surgutneftegaz stock. The share price fell 20%," says Browder.
The non-commercial partnerships don't disclose any detailed information, but they do disclose the aggregate value on their balance sheet.
"We noticed that the balance sheet increased exactly in line with the appreciation with the value of Surgutneftegaz shares, which suggests that this is where they hold the shares," says Browder.
Hermitage spent two months working through the new company structure following this reorganisation and came up with a classic spaghetti governance ownership chart (see below)
"The left side [of the company structure chart] boils down to the fact that Surgutneftegaz owns 100% of the non-commercial partnerships and the non-commercial partnerships own 51.6% of Surgutneftegaz," says Browder. "The right-hand side of the chart is more complicated, but boils down to the fact that Surgutneftegaz owns 24% of the non-commercial partnerships plus 500-individuals that brings the total to 35%. If you add it all up, then Surgutneftegaz owns 60% of itself."
Legally there is little difference between a non-commercial partnership and a joint stock company, so the company has the same economic rights as it had before, says Browder.
The question is why are owners bucking the corporate governance trend?
While almost all of Russia's leading companies are cleaning up their governance and restructuring their companies to improve transparency ahead of a possible IPO, why is Surgutneftegaz' management deliberately muddying the waters?
"The answer is very simple," says Browder. "If you look at what is happening in Russia over a period of time you have the situation where there has been a consolidation in the oil industry - there is a major consolidation going on. Imagine how hard it would be to consolidate Surgutneftegaz with this complicated structure. I believe this is a Russian poison pill and the fact they have done it means there is more of a risk of the company being taken over than ever before."
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