Insights from Our Meetings with Russian Energy Firms Gazprom and Novatek

Over the past few years, emerging market equities have delivered lackluster performance. As negative headlines come to the fore, the focus tends to be less on individual companies and their fundamentals and more on fears of a deteriorating macroeconomic environment. We believe that at precisely these times—when concerns over geopolitical events swamp considerations at the company-specific level—that potentially compelling entry points may emerge. On March 17–18, 2014, we participated in HSBC’s CEEMEA¹ Investor Forum in New York and met with a variety of Russian companies. It was a great opportunity to hear directly from Russian managers what they thought of their operating environment, as well as their geopolitical picture. In this blog post, we will highlight our meetings with Gazprom² and Novatek³. Major focal points of those meetings include: For Gazprom: • Gazprom’s outlook for natural gas demand and important weather-related concerns • Unique aspects of Gazprom’s dividend policy • Potential risks to Gazprom from the Ukraine situation For Novatek: • Novatek’s share buyback program • Unique aspects of Novatek’s ownership structure and dividend policy • Potential risks to Novatek from the Ukraine situation   Europe and Asia Need Natural Gas, and Gazprom Is a Significant Supplier According to Gazprom, the company currently supplies approximately 30% of Europe’s natural gas. This means Russia’s decision to annex Crimea creates a tricky political calculus for the European Union. If the EU responds with any sanctions, it could potentially cut off its own energy supplies.   Potential Deal Between China and Gazprom Gazprom representatives believe there is potential of engaging China in a long-term resource partnership. President Vladimir Putin, as of the time of our meeting, was scheduled for a trip to China in May to discuss a potential treaty with China National Petroleum Corporation (CNPC). China has been using recent commodity price weaknesses to help secure its long-term goals of acquiring resources. China has also used the political disruption between Europe, the U.S. and Russia as an opportunity to step in and fill the void, given its own resource needs.   Weather: A factor that could impact European Political outcomes As Europe’s demand for natural gas increases, the political appeal of Russian sanctions will likely decrease. According to Gazprom, the current political turmoil could last until the end of summer—once fall hits and temperatures start going down again, the need for natural gas will rise. Gazprom does not see any easy way for Europe to replace its gas supplies in mere months.   A Potential Catalyst for Gazprom’s Dividend Growth: Changing Accounting Standards A potential switch to International Financial Reporting Standards (IFRS)⁴ from Russian Accounting Standards could critically impact Gazprom’s dividend levels. A switch to IFRS could mean almost doubling Gazprom’s dividends if and when it happens, according to stock analysts we follow⁵. Gazprom has many subsidiaries in which it holds stakes ranging from less than 1% ownership to 100% ownership. At present, Gazprom reports its financials for purposes of its dividend payout using Russian Accounting Standards, which inhibit the consolidation of results from all of the different subsidiaries into the results of the parent company. Should the government approve this accounting change—and it is a government-level decision—the 25% mandated payout ratio for state-owned enterprises (such as Gazprom) could potentially be applied to the results of the entire set of businesses in which Gazprom owns a stake. Gazprom was unable to give specific guidance on the potential impact of this new set of accounting standards on future dividends, or exactly if and when the government would approve the change.   Gazprom’s Current Dividend Picture The latest results of Gazprom stock trading in Russia show an annual dividend of approximately 6 rubles per share, with an ex-date of May 14, 2013. With a price of 127.00 rubles per share on March 18, 2014, the approximate dividend yield equals 4.7%. If the dividend were to double as some expect with the changeover to IFRS accounting standards, at the same price that could mean an almost double-digit dividend yield. Thinking from a risk/return perspective, this higher income level could make Gazprom more attractive to income-oriented investors as the yield may compensate for the increased headline risk levels of Russian companies.   The Ukraine Risk Is Significant for Gazprom Gazprom supplies much of its natural gas through Ukraine, including almost half the company’s exports to Europe. This makes Gazprom vulnerable to economic sanctions against Russia for its annexation of Crimea. On a fundamental basis, the stock was already one of the most inexpensive stocks on a price-to-earnings (P/E) ratio basis before tensions between Russia and Ukraine began, trading at below three times earnings. As of our meeting, there were no forecasts for significant declines in earnings. Catalysts are always hard to see in advance, but these very depressed valuations make Gazprom an interesting opportunity for income strategies such as the WisdomTree Emerging Markets Equity Income Fund, DEM. The specific index DEM tracks caps its top holdings at 5% at each annual rebalance; as a result, Gazprom is unlikely to see its weight increase at the 2014 rebalance. That said, it could see its weight drift up between rebalances with positive performance turns compared to other holdings.   Meeting with Novatek: Starting with a Share Buyback Announcement As of March 14, 2014 (the last business day before our meetings), Novatek’s year-to-date share price was down approximately 25%, a significant drop before the end of the first quarter.⁶ Generally speaking, the Russian energy sector⁷ was down a similar amount over this same period and traded at below five times earnings.⁸ If a company believes its share price is undervalued, one effective use of corporate cash is to initiate a share buyback program, such as the one Novatek announced on March 17, 2014. The company’s buyback program began on June 7, 2012. Novatek tends to initiate share buybacks at varying amounts over 3- to 4-day intervals, according to a study on the company’s investor relations website. At no single point between June 7, 2012, and March 11, 2014, did Novatek repurchase an amount greater than one million shares during one of these 3- to 4-day intervals . However, according to the March 17 announcement, from March 11 to March 14, Novatek bought back 2,476,250 shares.⁹ The share buyback program and especially its relative size reflect the confidence of Novatek’s board of directors in the fundamental value of the firm.   Surprise! Novatek Has No Direct Government Ownership Many Russian firms have large, direct state ownership stakes, but Novatek actually has no Russian government ownership¹⁰—a big contrast to Gazprom, which is majority-owned by the Russian government. Novatek’s dividend policy is a function of the company’s own judgment and not determined by a majority government shareholder.   Novatek’s Dividend History Looking at Novatek’s dividend history, the cash dividend, measured in rubles, has increased over the course of each calendar year since 2009. During our meeting, the company representative expressed his view that the dividend is important—it has been growing, and he didn’t see a reason at this time why that trend couldn’t continue.   Conclusion: Any Risk to Novatek’s Ongoing Operations? The development of new fields as sources of oil and natural gas and the construction of facilities to improve the efficiency of the firm’s existing fields generated the greatest excitement during the meeting with Novatek. Each aspect of the presentation was designed to emphasize that natural gas sells for approximately $4.50 per 10,000 British thermal units (BTUs),¹¹ whereas oil sells for approximately $106 per barrel.¹² The more that can be done with the liquid elements that are, in essence, somewhere between gas and oil, the higher the profit margin that Novatek is able to earn and the more cash the company is able to generate. The big point was that Novatek’s expansion plans are much more focused on liquids than on gas. A critical question, today, is what the company views as the main risks relating to its ongoing business. Share buybacks and dividends are all well and good, but keeping the firm running is first and foremost. The Novatek representative emphasized that he’d been living in Russia for 20 years, and his view was that things like this current disruption tend to happen, but that in the past, they’ve tended to represent significant buying opportunities where share prices of otherwise strong businesses are depressed. A factor that was cited as a potential risk was the fact that European banks were definitely involved in the financing of Novatek’s new projects, so, depending on the nature of any EU sanctions, these financing channels could potentially face delays. However, he did mention the potential for China to step in and offer funding, should this occur. All in all, Novatek was confident as of March 17, 2014, that business would be able to continue.   A Great Time to Meet with Individual Russian Firms We appreciate HSBC’s allowing us to attend their CEEMEA Investor Forum in New York. We learned a lot and look forward to participating in similar future events that can help us better understand some of the constituents of our Indexes.     Unless otherwise noted, source is Bloomberg, as of 3/19/2014. ¹Central & Eastern Europe, Middle East & Africa. ²Gazprom’s weight equaled 5.25% of the WisdomTree Emerging Markets Equity Income Fund (DEM) as of 3/19/2014. ³Novatek’s weight equaled 1.40% of the WisdomTree Emerging Markets Dividend Growth Fund (DGRE) as of 3/19/2014. ⁴International Financial Reporting Standards (IFRS): A set of accounting standards, developed by the International Accounting Standards Board (IASB), that are becoming the global standard for the preparation of public company financial statements. ⁵Source: Moshkov, Maxim & Constantine Cherapanov, CFA. “Gazprom: Conservative DPS Outlook Despite Record Earnings,” UBS Global Research, 3/4/14. ⁶Source: Bloomberg, from 12/31/2013 to 3/14/2014. ⁷Refers to the MSCI Russia Energy Index. ⁸Refers to the P/E ratio of the MSCI Russia Energy Index as of 3/19/2014. ⁹Source: “Novatek Resumes Share Buyback Program” news release, dated 3/17/2014, and Share Repurchase Program history available on company’s investor relations website. ¹⁰Source: 3/17/2014 meeting, confirmed by Bloomberg as of 3/19/2014. ¹¹Refers to the price of a futures contract, which is an agreement where parties agree to deliver or purchase a set amount of natural gas at a date specified in the future. ¹²Refers to the price of a futures contract on specifically Brent crude, where parties agree to deliver or purchase a set amount of natural gas at a date specified in the future.