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Capitalize On Russian Market Phobia With Mostotrest (MCX:MSTT)

It's considered that current political crisis over Ukraine showed how destructive the Vladimir Putin's regime can be for the business of Russian companies... Right?

Not for every business... At least this company is the example of the exact opposite.

Background:

Mostotrest (MSTT) is a Russian road construction company that generates 92% of its revenues from the state budget contracts. In 2010-2013 the company managed to increase its revenue by 260% on the back of extensive state investments in road infrastructure. As a result, its present share in the Russian transport infrastructure market is approximately 10%. Mostotrest's remarkable ability to win tenders under very lucrative conditions is its key revenue growth driver. Just to give you a hint of the company's lobbying power I would like to give two examples.

  1. In 2012 Mostotrest got the 2 bln USD contract for construction of all road infrastructure in Skolkovo (Russian innovation area strongly supported by the government) without even participating in the prior tender procedure (the explanation: urgent preparation for G8 summit).
  2. In 2011 life-cycle construction contracts were launched in Russia, under these agreements the contractor also maintains the infrastructure facilities that he constructed for a period of 20-30 years. Such contracts ensure a large stable revenue stream for the contractor in the long-term taking into consideration that overly frequent and intensive repair and maintenance road works are typical for Russia. The interesting thing is that it was Mostotrest that won all 4 life-cycle contracts that have yet been tendered (maintenance work is carried out through subsidiaries: NITP and UTS)

Lobbying power is especially important in construction sector in Russia where the largest contracts are awarded by the government and the costs of these contracts are surprisingly much larger than in other countries (for similar scopes of work).

Arkady Rotenberg, a former judo partner of president Vladimir Putin is one of the beneficiaries of Mostotrest (with share of 26,4%).

Other useful connections are:

Igor Levitin, former minister of Ministry of Transport, Deputy CEO of Mostotrest at the moment (helped the company to get the 40 bln USD contract for Moscow-Saint Petersburg road construction)

Sergey Sobyanin, Moscow mayor (Skolkovo contract)

Valery Dorgan, Mostotrest manager (former head of Russian Road Agency subsidiary responsible for maintenance tenders in Russia)

Industry:

If there is a sector in Russian economy that is consistent with its status of an emerging market it is the infrastructure segment (incl. transport infrastructure). Among BRIC countries its forecasted growth, according to industry experts, is higher than in India and Brazil.

This forecasted growth stems from very high relative saturation of current road infrastructure by vehicles and current poor quality of roads. The expenditures are strongly supported in the nearest future by the demands of the Football World Cup in 2018: not only stadiums are to be built but also roads, airports, hotels and other infrastructure.

The only public company in the market that is directly exposed to the amazing opportunities of Russian road construction market is Mostotrest.

And please do not worry about the risks of sanctions. The current situation is beneficial for Mostotrest that has all of its operations in Russia for two reasons:

  1. The devaluation of rouble increases the revenue from oil and oil-products export denominated in roubles thus increasing the budget inflows (through which the road construction projects are financed)
  2. "friends will be friends": A.Rotenberg is a person under sanctions. As a result, Visa and MA stopped the coverage of the bank under his control. In response, as a measure of support for A.Rotenberg, the largest Russian oil company Rosneft (ROSN) awarded apipeline construction project to Mostotrest (this project completely unrelated even to secondary focus of the company). If the pressure on some of Rotenberg's businesses will continue further support for other ones including Mostotrest might follow

Financials:

The company demonstrates high revenue growth due to high lobbying power. My impression is that the overflow of contracts prevents the company from getting the maximum value from them. Nowadays the company relies heavily on subcontractor services (36% share in revenue in 2012 and 44% in 2013). The subcontractors carry out the work that Mostotrest is not qualified for and help the company in fulfilling its contracts when it is unable to increase its own capacities quickly enough. The warning sign is that subcontractors are also used in construction industry as a hedging instrument when the management thinks that the current volume of work will not be very sustainable in the future.

EBITDA margin

As a result of contract overflow the revenue is generated at the high speed but the margins suffer. In the future it will be the following factors that will drive their improvement:

  1. Increase in vertical integration (increase the share of self-produced materials, currently at 30%)
  2. Decrease in the number of subcontractors (through expansion of own capacities, mitigation of not profile projects like pipelines(!), increase in number of contracts in the fields the company specializes in: bridges and complex road infrastructure)

The management promised to decrease the share of subcontractors.And the last unaudited financials for the 1st half of 2014 (available only in Russian GAAP) indicate a substantial increase in margins.

Mostotrest also has a lot of cash. Even if we assume that working cash should be 10% of revenue, there is still a lot of spare money on the balance sheet. Moreover the company pays stable dividends (dividend yield 8% in 2013) and is determined to sustain them in the future.

Another plus is that there is literally no debt on the balance sheet.

Value:

The multiples for Mostotrest are brutally low. The reason is its high exposure to the prosperity and sustainability of Putin regime, however until 2020s there are no obstacles for it to come to an end. Two weeks ago Mr.Putin's electoral ratings reached their historical maximum. In my opinion, the regime stability is currently undeniable and Mostotrest's loyalty to it should be considered as a very positive rather than a negative factor.

Comparables table

My DCF valuation uses information on current backlog of the company to forecast the revenue in 2014-2015. The revenue growth in 2016-2020 is taken from the Ministry of Finance planned investments in road infrastructure and real GDP growth forecast.

The capex forecast is taken from management guidance for 2014-2015 and grows further in line with revenue growth.

Other assumptions are the following:

WACC=20% (due to high political risk)
Effective tax rate = 30% (official tax rate in Russia is 20%)
Working cash share in revenue =10%
No FCF growth after 2020
EBITDA margin = 9,5%

In my opinion there is a big upside for EBITDA margin: the 10-15% levels are typical for road construction and 15%+ - for bridges construction. The tax rate is also very conservative.

Surprisingly, the upside of no less than 70% is present even if we eliminate any cash flows after 2018.

DCF main components

The downside risks:

  1. The absence of new contracts (most likely due to confrontation with friends)
  2. The problems with the client payments (see Sochi contractors problems)
  3. Dividend payment termination
  4. Macro scenarios of the second Cold War

P.S.

The analysts love this stock, DB which is usually super conservative, states that it has nearly 200% upside. Same for other analysts, just check out 4traders.

The 19,9% of shares is held by asset managing institutions (BNP Paribas, JPMorgan, East capital, Prosperity etc.) In total, 36% of shares are in free float (17% belonging to individual investors). This implies that the real value should really be presented in the share price.

As you can see, real value seems to be much higher than the market one. Strong buy, with upside of more than 100% and high dividend yield that lowers downside risks.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.