Evgeny Shago of Trust -

In 2006, air transport in Russia grew at a much higher rate than GDP, with the main driver of the airlines' revenue being the growing disposable income of the population. Not all Russian airlines can benefit from the rise in this disposable income, but there are some that will retain and expand their market share through organic growth as well as mergers and acquisitions.

Investment summary

Despite some overall problems, the air transportation sector grew in 2006 much faster than the GDP rate and has continued to rise this year. The main driver is the rising disposable income of people in the Russian regions, which allows people to use an expensive form of transport like airlines more often. We believe that GDP and disposable income will continue to grow and thus keep the sector very attractive.

We see the following factors positively affecting sector valuation:

--Continuing GDP and disposable income growth that allows people to fly more often, which keeps the airline revenue growth rate higher than most other sectors;

--A possible drop in fuel price makes airlines more profitable.

On the negative side, we view the following factors: --Problems with safety due to a lack of new airplanes and experienced pilots make Russian airlines risky for investing in (and flying in);

--Any new conflict in the Middle East could bring the price of oil to $100 per barrel, meaning that the jet fuel price comes to $1,000, which will make all the airlines completely unprofitable.

We keep a 'Perform' rating for Aeroflot with a fair price of $2.58 and an 'Outperform' rating for UTair with a fair price of $0.79, implying an upside potential of 51.1%.

Our valuation does not include the possible acquisition of Alitalia by Aeroflot, which we feel would have a negative influence on the company's value. And our valuation does not include the possible loss from the catastrophe in Samara Region experienced by UTair's Tu-134 airplane. The total amount of compensation to passengers could be around $500,000.

Sector overview

According to 2006 results, air transport has maintained a much higher growth rate than that of GDP, despite a couple of catastrophes and other troubles like fuel price increases and a lack of new airplanes.

Transportation, in particular air transport, is one of the sectors that can substantially benefit from the growth of personal incomes and increased domestic demand. People fly most often in countries with the highest per capita income.

The absolute leader is the US, where on average each resident flies more than two times per year. Europeans fly a bit less on average, but only thanks to small distances, as destinations can be reached by ground transport. Generally, the leaders in passenger volumes are countries with large territories, such as the US, Australia and Canada.

The substantial distances in Russia preordain the development of air transportion, or rather, its reestablishment, since in Soviet times the population used this kind of transport no less frequently than in the US.

However, currently Russia's phase of air transportation development is similar to that of Asian countries, where per capita income is significantly lower, or to Eastern Europe, where distances are substantially less. As the following chart shows, even in Moscow, a major transportation hub in Eastern Europe, the population uses air transportation less frequently than in the US and Australia. In other Russian regions, the use of air transportation remains at the level of the poorest Asian countries.

Nevertheless, the high rate of GDP growth and increasing personal income will overcome the current situation. Beginning with 2001, the rate of passenger turnover growth has noticeably been exceeding GDP growth. The exception was 2005, when jet fuel prices almost doubled, which created great difficulties for airlines. However, currently the majority of Russian airlines are able to optimize their fleets, having replaced their planes with more fuel-efficient Boeing and Airbus airliners, which permit a decrease in fuel expenses.

The results of 2006 show passenger turnover growing by 9.5%a year. The growth rates of the leaders were significantly higher than the average; several companies grew by 30-50% and are retaining these rates in the beginning of 2007, substantially increasing their market share. Among these airlines are Transaero, UTair, and S7.

Aeroflot's low growth rates prevented it from increasing its market share, but in the next few years with the successful replacement of its long range fleet with Airbus planes, the company can show very high growth rates and return from its trailing position.

Apart from transport growth rates is the consolidation process occurring in the sector due to the acquisition of smaller players by the larger and more efficient airlines, as well as the exclusion from the market of outsiders. After consolidation we can expect that between 5 to 10 major airlines will share the market, and they will possess sufficient economic potential for operating in such a capital intensive business.

Evgeny Shago is an analyst with the brokerage Trust in Moscow

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