For years, Russia had the appearance of a low-yielding equity market – at least in the eyes of those who looked at it through the prism of the MSCI and similar indices. In reality and probably more so than in other market, the headline dividend yield masked a very different relative performance between the private and state sectors – whilst at the same time, state-owned enterprises accounted for a very large portion of the index and are slightly above half at present. Even this year, despite trading at lower earnings multiples than private companies and representing mature industries, state-controlled businesses had a dividend yield of around half the yield of their private peers. This gap was even larger in previous years.
Whilst private sector companies gradually increased their dividend payouts as their shareholders grew more professional, their businesses matured and the enthusiasm for expensive projects or acquisitions subsided, the state remained at the mercy of management teams who, naturally, wanted to re-invest earnings rather than send any meaningful percentage to shareholders. This, however, began changing several years ago and for a number of reasons.
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As time went by, it was only natural for the government to start looking in the direction of state- owned enterprises in search for additional revenues not just directly through increased dividend receipts, but also by means of greater privatization proceeds at higher prices that would be possible on the back of the former factor. In this regard, private sector performance served as a useful indicator for the government as to what might be achievable.
After Mr. Medvedev took up the office of the Prime Minister of Russia in 2012, he made a number of key appointments at the Ministry of Finance and the State Property Agency, bringing on board people with investment banking backgrounds and the experience to tackle the problem in a professional manner – not least Olga Dergunova at the State Property Agency and Alexei Moiseev at the Ministry of Finance alongside certain members of their respective teams.
The management teams of government companies also became more professional and, even if they did not always admit to it, proper corporate behaviour became more natural – at least for some of the managers.
Finally, there was constructive pressure from non-state shareholders in state-owned enterprises including from Prosperity.
The actual work consisted of several stages. In 2012, the government decided that state-owned enterprises would have a minimum twenty-five percent payout ratio. However, not everything was well thought through. For instance, the question of whether to use net profit calculated on Russian Accounting Standards (read: un-consolidated) or an IFRS basis (read: consolidated) was, effectively, left for the companies to decide upon, as the government only asked them to make a full transition to an IFRS-based dividend calculation within three years of their 201 2 reform. Likewise, the matter of how to treat non-cash gains and expenses was also left open. This decision allowed ample room for interpretation, which was used by most of those who could to reduce the amounts distributed to shareholders. However, some progress was anyway achieved.
Sadly, the State Property Agency then stated that as long as state-controlled companies complied with the general direction of the order, there was no need to try to squeeze them further and that any additional upgrade to the general rule would have to wait until 2017.
However, the next big step happened well before 20 1 7, triggered by a sharply decreased oil price and a GDP decline that hit government revenues from 2014. The Ministry of Finance, naturally, assumed the large responsibility of looking for additional revenues and, this time, were very determined to make it happen through dividend reform.
At first, a thirty-five percent payout ratio was suggested, but this number was quickly replaced with as much as a fifty percent payout ratio. It was first presented as an extraordinary measure to generate additional revenue for the government in 2016. In spring, the updated government resolution was published – barely in time for it to have effect during the 2016 AGM season. Crucially, the basis for the calculation was set to be the higher of Russian Accounting Standards and IFRS-based reported net profit numbers. Therefore, any risk of manipulation was removed. Still, the resolution continued to mention that the Board needed to take into consideration the respective company’s investment plans, debt position, etc. On one hand, such deliberations are reasonable, on the other, in cases of bad will, they still leave some wiggle room.
The lack of time ahead of the dividend decision deadlines, some managements’ unwillingness to comply fully and some technical reasons led to some companies paying less than the mandated fifty percent of reported net profit. For instance, Rosneft distributed thirty-five percent of last year’s net profit and Gazprom (taking a share buyback into account) fourty percent. However, the direction of travel is very clear and all companies have announced that they are ready to comply fully going forward. Clearly, some negotiation will take place in certain cases, but generally speaking, fifty percent payout is very likely to be the ‘new normal’ for the dividend distributions of Russian state-owned enterprises.
Once all decisions concerning this year’s dividends had been taken, the Ministry of Finance quickly moved forward in order to consolidate its achievements. It announced that it intends to include a fifty percent payoutratio into the 2017-2019 three year budget. It is much harder to fight the distributions if they already form part of the government’s revenue as per the state budget approved by parliament. Secondly, the Ministry’s officials began floating an idea of increasing payout levels to as much as seventy-five percent over time. Further, interim dividends for some of the companies that did not fully comply earlier have been suggested and work is currently underway to put this into practice.
Prosperity is happy to report that we have been actively involved in bringing all of this to fruition. In fact, Prosperity’s Chief Investment Advisor, Alexander Branis, delivered a detailed presentation to the State Property Agency in November 2013 explaining that it is absolutely normal for mature state-controlled companies in both developed and emerging markets to disburse between fifty and seventy-five percent of their profits as dividends. Prosperity also helped with drafting the model dividend policy for state-owned enterprises, with the wording of government resolutions and even with offering the Ministry of Finance analytical firepower when they worked on specific numbers with certain companies. The portfolio investor group, Association of Institutional Investors, has also written to the government about this matter on a number of occasions.
There are a few aspects of the new policy that remain partially resolved. For instance, Russian corporate law still prohibits the distribution of larger amounts than the unconsolidated Russian Accounting Standards based profit of the legal entity making the dividend and, as such, compliance with the government’s guidelines will take careful financial management by the Boards and by management teams. Ideally, we would like for this legal restriction to be replaced with standard solvency tests applied at the time of dividend decisions, as is the case in developed markets. Also, going forward, we will see how indirectly government-controlled companies are treated. On one hand, they fall within the definitions of the government order, but, on the other, we are not fully convinced that all such companies will be covered. In short, there is a lot of space here for the application of our research efforts!
As a result of these reforms, our expectations are that we will see the dividend yield for Russia’s largest state-controlled companies improving from 3.2 percent this year to 8 percent next year. The private sector will also see increased yields to 6.4 percent next year. This will bring the market’s dividend yield up from 4. 3 percent this year to as much as 7.2 percent next year (note: the forecasted ruble/oil price changes also play a role). With respect to dividend yields, Russia is already looking attractive against other large emerging markets this year, but the gap will increase further in 2017.
In response to the improving management-efficiency and corporate governance of state-controlled companies and in anticipation of higher dividends we have increased our exposure to this part of the market to as much as forty percent of our portfolios on average an all time high for the Prosperity funds. Specifically, we have established or increased our investments in Federal Grid Company (FSK) and Aeroflot, both of which have made strong contributions to our performance so far this year.
Generally speaking, Prosperity believes that we will see high single-digit to double-digit dividend yields for a number of large state-owned enterprises. Apart from the direct financial effect, there is an important signalling component; investors will find it far easier to trust Russian numbers when they receive large cheques from these companies.
The higher dividend payouts will also have important positive indirect effects. As the management of some companies seek to emphasize the importance of continued large capex, they will be challenged by their Boards and forced to justify high IRRs in relation to such investments. As a result, capital discipline will improve. There will also be a greater focus on efficient capital structures, boosting ROEs. Many companies, in our view, could carry substantially higher debt loads in numerous cases, debt/EBITDA is below 1.ox and sometimes as low as 0.5x.
The market at large remains rather skeptical to the concept of dividend improvements being sustained; generally holding the view that as soon as the Russian state budget is in better shape a few years from now, the rules will be relaxed again. However, Prosperity’s take is that once positive changes are put in place it is quite hard to reverse them.
Chief Investment Advisor