Revenues 39,502 50,767 56,497 64,889 77, ,159 EBITDA 17,367 21,052 17,875 20,747 26,656 40,017

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1 INTERN ET FEB 14 MAR 14 APR 14 MAY 14 JUN 14 JUL 14 AUG 14 SEP 14 OCT 14 NOV 14 DEC 14 JAN 15 FEB 15 FEBRUARY 20, 2015 TARGET PRICE UPDATE Yandex In from the storm RUS SIA Sergey Vasin We reviewed our model and valuation of Yandex following the recent release of 4Q14 financials. We incorporated the effect from sharp devaluation of the ruble, as well as a weak economic outlook for We cut our target price for Yandex from $34.6 to $19.2 per share. In addition, we changed our recommendation on the stock from overweight to NEUTRAL Media market suffers from weak economy. Advertising markets are sensitive to economic cycles. We expect a 3.2% YoY decline (our estimate) in Russia s real GDP in 2015 to translate into a 13% YoY drop in the media advert market. Internet in better shape than other segments. Most of the traditional advert segments (TV, radio, outdoor advertising, etc) are set to demonstrate a drop in the range of 15-30% YoY in Meanwhile, internet advert is expected to grow at 9% YoY due to the migration of advertisers toward cost-efficient solutions offered by internet players. At the same time, text-based advertising (Yandex s core business) is expected to rise 15% YoY. Weakness looks temporary. We expect the media advert market in Russia to experience similar trends as in , when the Russian economy also experienced a downturn. At that time, a sharp recovery took place in 2010, while this time around we are looking for a recovery of the market in Robust 2014 results to be followed by a downswing in Although Yandex managed to deliver a strong top line in 2014, its EBITDA faced some pressure from rising USD costs. We are looking for a slowdown in the company s annual revenue growth from 29% in 2014 to 11% YoY in This compares to our original estimate of 27% for Earnings hit by a double whammy. At a time of slowing revenues, Yandex s EBITDA margin is affected by high operating leverage (70% of operating costs are fixed). Moreover, office rental costs are rising on the weak ruble, as the costs are in USD, while the salaries of some IT specialists should be raised to a competitive level globally. We thus revised down EBITDA margins for Expect market share to drop. Yandex has been losing its search market share since March Google started capturing the market from all players after a few years of stable market breakdown. The key reason behind this trend is Google s dominance on mobile platforms in Russia, about 86% of smartphones are powered by Android. Yandex has very limited ability to compete with Google and should thus see its market share erode from the current 59% to 56% by TICKER Closing price, $ 16.9 Target price, $ 19.2 Upside 14% Recommendation YNDX US NEUTRAL Source: Bloomberg, Gazprombank estimates SELECTED STOCK DATA MCap, $ mln 5,359 Net debt, $ mln 178 EV, $ mln 5, week high, $ week low, $ 14.9 Source: Bloomberg Yandex share price performance vs. RTS Index 110% 100% 90% 80% 70% 60% 50% 40% 30% YANDEX RTS INDEX Source: Bloomberg Key financials, RUB mln E 2016E 2017E 2018E Revenues 39,502 50,767 56,497 64,889 77, ,159 EBITDA 17,367 21,052 17,875 20,747 26,656 40,017 EBITDA margin 44.0% 41.5% 31.6% 32.0% 34.4% 40.0% Net income 13,474 17,020 10,821 12,271 16,267 25,666 EV/EBITDA, x P/E, x Source: company data, Gazprombank estimates Research Department 1 Copyright Gazprombank (Joint Stock Company)

2 Valuation multiples Balance sheet statement, RUB mln E 2016E 2017E P/E, x EV/EBITDA, x EV/Revenues, x Dividend yield 0.0% 0.0% 0.0% 0.0% FCF yield -3.9% 0.3% 0.9% 2.3% Income statement, RUB mln E 2016E 2017E Revenues 50,767 56,497 64,889 77,474 Operating costs -35,444-43,142-49,334-56,628 incl. SG&A -7,782-12,774-14,665-16,865 DD&A -4,484-4,520-5,191-5,811 EBITDA 21,052 17,875 20,747 26,656 Operating profit 15,323 13,355 15,556 20,846 Financial income net Pretax profit 22,475 14,238 16,146 21,404 Income tax -5,455-3,417-3,875-5,137 Net income 17,020 10,821 12,271 16,267 EPS Key margins E 2016E 2017E EBIT 30.2% 23.6% 24.0% 26.9% EBITDA 41.5% 31.6% 32.0% 34.4% Net income 33.5% 19.2% 18.9% 21.0% E 2016E 2017E Cash and equivalents 17,645 11,800 11,161 15,325 Accounts receivable 3,703 4,619 5,280 6,078 Inventories n/a n/a n/a n/a Total current assets 35,807 30,475 32,496 39,890 PP&E 17,107 25,017 32,803 40,163 Total assets 94,924 97, , ,755 Short-term debt Accounts payable 5,053 5,623 6,459 7,711 Total current liabilities 9,796 10,313 11,825 14,331 Long-term debt 26,325 22,825 19,325 15,825 Total non-current liabilities 29,392 25,518 22,248 19,251 Total shareholders equity 55,736 61,255 74,279 91,174 Minority interest Total liabilities and equity 94,924 97, , ,755 Cash flow statement, RUB mln E 2016E 2017E Operating cash flow 15,546 15,521 16,494 21,540 incl. changes of w/c -1, Investing cash flow -28,589-14,566-13,633-13,876 incl. CAPEX -7,615-12,429-12,978-13,171 Financing cash flow -11,707-6,800-3,500-3,500 Change in cash -15,749-5, ,164 Free cash flow -13, ,860 7,664 Key leverage data, RUB mln E 2016E 2017E Total debt 26,325 22,825 19,325 15,825 Net debt 8,680 11,025 8, Total debt/equity, x Net debt/ebitda, x Source: company data, Gazprombank estimates 2

3 CONTENTS 4Q14 financials good results, but the outlook raises concerns... 4 Russia media advertising is on the edge, except online... 6 The market looks depressed now, and the outlook is even worse... 6 but advert budgets to bounce back as they usually do... 7 TV and other media are stepping down in front of internet... 8 Text-based advert main growth driver for the whole segment... 9 Video advertising a rising star or supernova? Yandex in from the storm Mobile platforms create an issue a rather big one Online video testing fertile soil Yandex Market a grounded bird Changes in outlook Debt and share buybacks Valuation Summary DCF valuation Relative valuation

4 4Q14 FINANCIALS GOOD RESULTS, BUT THE OUTLOOK RAISES CONCERNS Yandex s revenues in 4Q14 highlighted the good dynamic in development of key areas, although the tough environment in Russia s media advert market took a heavy toll on display advertising. Notably, EBITDA margins came under pressure due to USD-related costs. This pressure looks set to intensify in The company also guided revenues only for 1Q15 as opposed to FY15, emphasising a challenging year ahead. Revenues grew 21% YoY to RUB 14.7 bln in 4Q14, matching our expectation, while EBITDA rose 18% YoY to RUB 6.1 bln, a touch ahead of our RUB 5.9 bln forecast. The EBITDA margin reached 41.4% vs. the previous year s 42.6%. Adjusted for FX gains, the net income of Russia s largest internet company increased 13% YoY to RUB 4.0 bln, slightly beneath our estimate of RUB 4.5 bln. We note, however, that net income was adjusted for a RUB 4.7 bln FX gain in 4Q14, so the reported figure was well above our forecast. The company s profitability has been declining since last year. The key reason for this was the sharp rise in product development costs, by 62% YoY in 4Q14 to RUB 2.7 bln. It appears that Yandex has been forced to raise salaries for its IT specialists in order to match international levels in USD terms. The company also has office rental costs denominated in dollars, meaning that the weak ruble in 4Q14 pushed down margins. At the same time, Yandex seems to have improved its bargaining power with partners, as Traffic Acquisition Costs (TAC) grew only 9% YoY to RUB 3.1 bln. This compares with a 21% rise in total revenues. Yandex 4Q14 and FY14 US GAAP results, RUB mln 4Q14 4Q13 YoY 4Q14E YoY YoY 2014E YoY Revenues 14,667 12, % 14, % 50,767 39, % 50, % Adj. EBITDA 6,078 5, % 5, % 21,052 17, % 20, % Adj. EBITDA margin 41.4% 42.6% -1.2% 40.4% -2.2% 41.5% 44.0% -2.5% 41.2% -2.8% Adj. net Income 3,967 3, % 4, % 13,751 13, % 13, % Source: company data, Gazprombank estimates Revenue breakdown analysis Context advertising revenues from Yandex s own websites grew 24% YoY in 4Q14 to RUB 9.9 bln, while those from partner websites increased 16% YoY to RUB 3.3 bln. The growth in context advertising was underpinned by organic growth shown by a number of advertisers, which reached 317,000, up 14% YoY. At the same time, the average cost per click in 4Q14 increased 3% YoY. This marks a slowdown vs. the 3Q14 CPC growth rate of 8% YoY. Yandex revenues breakdown, RUB mln 4Q14 4Q13 YoY 4Q14E YoY YoY 2014E YoY Text based 13,235 10, % 13, % 46,638 35, % 46, % Display 1,181 1, % 1, % 3,509 3, % 4, % Others % % % % Total 14,667 12, % 14, % 50,767 39, % 50, % Source: company data, Gazprombank estimates Overall, text-based advertising expanded 22% YoY to RUB 13.2 bln and accounted for 90% of total revenues in 4Q14, thus emphasizing the core role of this type of advertising for the company. It appears that the text-based advertising market is much 4

5 less sensitive to Russia s economic slowdown, while display advertising is showing very sluggish performance. On the negative side, revenues from display advertising increased only 3% YoY to RUB 1.2 bln, with own website display advertising down 2% YoY to RUB 997 mln. At the same time, we note that display advertising from partner networks is still rising at 34% YoY to RUB 184 mln. Still, this figure is too small to become a material factor for Yandex. The reason for the sharp growth is the recently arranged strategic partnership with Google on Real Time Bidding systems. This partnership, in our view, should provide another boost to display advertising. The 4Q14 revenue growth shows a slowdown due to the tough economic environment. We note that Yandex s revenues surged 28% YoY in 3Q14, with text-based advert booming at a rate of 29% YoY. We also note that Yandex s other revenues, which mainly consist of taxi services, are also rising sharply (+156% YoY to RUB 251 mln), compared with 84% YoY growth in the segment in 3Q14. These contributions are very small at this point, however. The company also provided revenue growth guidance for 1Q15 of 15% YoY, compared with the 28.5% YoY increase seen in We believe this short-term forecast (1Q instead of FY) underscores the likelihood of a challenging year ahead. 5

6 RUSSIA MEDIA ADVERTISING IS ON THE EDGE, EXCEPT ONLINE The market looks depressed now, and the outlook is even worse The Association of Communication Agencies of Russia (ACAR) recently published preliminary data for 9M14. As these data reveal, the Russia media advert market grew only 5% YoY to around RUB bln. That was the slowest rate since The main reason for such weak figures is the economic slowdown, which had already made its appearance in 9M14, as advertising budgets are highly sensitive to economic factors. Russian advertising market breakdown, 9M14 vs. 9M13, RUB bln M13 9M14 OTHER RADIO PRINT OUTDOOR INTERNET TV Source: ACAR, TV advert continues to play a pivotal role, with the market totaling RUB bln (46.5% of the total) and rising 4% YoY. Meanwhile, internet is rising sharply, with 20% growth YoY to around RUB bln acting as a key growth driver for the industry and already contributing 24% of the total. Text-based advertising was the fastest-growing segment with 28% growth YoY in 9M14 to RUB 46.6 bln (78% of internet advert and 19% of the total). Despite rather strong figures, text-based advertising is also slowing down, as in 9M13 the segment showed about 36% growth YoY, decreasing to RUB 35.7 bln. It is also worth noting, however, that display (banner) advertising showed marginal growth of 2% YoY to RUB 12.9 bln, accounting for 22% of internet ads but only for 5% of the total market. Radio and outdoor ads were rather resilient, with 5% and 2% YoY growth, respectively, while they are both losing market shares to internet advertising. The printed press segment struggled most of all in 9M14, down 10% YoY to RUB 23.9 bln, with magazines showing the biggest decline (-11% YoY to RUB 11.7 bln). We expect that during 4Q14 all of the negative trends in media segments only got worse due to an escalation of the economic slowdown over that period. Overall in 2014, we expect the total market to grow only 1% YoY to RUB 332 bln, as we expect most segments to show a drop in 4Q14 in the range of 4-30% YoY, with the exception being text-based online advertising, which we expect to expand 20% YoY in 4Q14. 6

7 In 2015, we expect outdoor and print advertising to be the major losers of advert budgets in Russia (-30% YoY), contracting by RUB 27 bln and RUB 22 bln, respectively. Meanwhile, we believe that TV, the largest media advert segment in Russia, should experience about a 15% YoY drop in 2015 to RUB 134 bln, slipping back to levels seen in Still, TV should remain the largest advert segment, accounting for 46% of the total market. Russia advert market YoY growth rate estimates by segment in 2014 and 2015, % Russia advert market estimates, 2014 vs. 2015, RUB bln 20% 15% 10% 5% 0% -5% -10% -15% -20% -25% -30% -35% 15% 9% 1% 2% -5% -7% -15% -15% -20% -25% -30% -30% TV ONLINE OUTDOOR PRINT RADIO OTHERS 2014E 2015E Source: ZenithOptimedia, Gazprombank estimates E 2015E OTHERS RADIO PRINT OUTDOOR ONLINE TV Source: ZenithOptimedia, Gazprombank estimates We are only looking for online advert to see growth in 2015 to the tune of 9% YoY to RUB 90 bln, being driven by text-based advertising. We expect advertisers to be looking for the most flexible and efficient audience-targeting methods in Online advert offers the best price/quality ratio in these terms. Thus, we expect advert budgets to switch from more traditional methods to an internet-based model. Overall, in 2015 we expect the total market to decline by 13% YoY to RUB bln. We note that the total market, excluding online advertising, should drop an estimated 20% YoY to RUB 200 bln. but advert budgets to bounce back as they usually do We expect the media advert market in Russia to experience similar trends as in , when the Russian economy also went through a downturn. In 2009, the overall media advert market dropped 27% YoY to RUB 186.4, with outdoor and print advert sustaining the heaviest losses (-44% YoY). Meanwhile, TV advert lost 18% YoY and radio declined 30% YoY. As it was sharply on the rise at that time, online advert showed 19% YoY growth in 2009 (compared to 38% in 2008 and 100% in 2007). Following the crash of 2009, the advertising market in Russia experienced a recovery already in 2010, when the overall market increased 17% YoY to RUB bln. The key driving factors were online (+51%), TV (+15%) and outdoor (+18%) advertising, while the radio and print segments lagged behind (+12% and +7%, respectively). The market managed to recover to the peak level of 2008 (RUB 257 bln) only in We also expect the Russian media market to start recovering in 2016 following the crash anticipated in We should note, however, that in 2009, in our view, advertisers overreacted to the upcoming crisis and cut their budgets excessively. Companies that refused to advertise their services in 2009 often lost their market shares to those who continued advertising. In 2015, we expect advertisers to behave more rationally and cut their budgets in a slightly smoother manner than six years ago. 7

8 E 2015E 2016E 2017E 2018E FEBRUARY 20, 2015 Russia advert market YoY growth rates by segment in 2009 and 2010, % 60% 40% TV ONLINE OUTDOOR PRINT RADIO OTHERS 51% 41% 20% 15% 19% 18% 7% 12% 0% -20% -18% -19% -40% -30% -44% -44% -60% Source: ACAR As of end 2008, the Russian media advertising market accounted for 0.62% of the country s GDP over the period, which we can compare to current levels seen in Canada and Germany (among the Top 10 markets). In 2009, advert spending in Russia dropped to 0.48% of GDP and despite some recovery it has never regained the levels seen before 2008 ( %). In 2014, Russia s media advertising market is estimated to equal 0.47% of the country s GDP, which is still comparable to the levels seen in China and France (also among the Top 10 markets) over the same period. Russian media advertising market estimates, RUB bln Media advertising market 2014E as % of GDP in Top 10 countries vs. Russia % 0.57% 0.52% 0.47% 0.42% 0.37% USA JAPAN AUSTRALIA S.KOREA UK BRAZIL GERMANY CANADA RUSSIA FRANCE 0.47% 0.45% 1.01% 0.93% 0.83% 0.81% 0.79% 0.74% 0.64% 0.62% CHINA 0.44% ADVERT MARKET % OF GDP 0.0% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% Source: ACAR, ZenithOptimedia, Gazprombank estimates Source: ACAR, ZenithOptimedia, Gazprombank estimates We are modeling the market in Russia to drop to 0.38% of GDP in 2015 or RUB bln, and recover to the level of 2014 (RUB 332 bln) by However, in terms of GDP percentage we do not expect full recovery within the above investment horizon and are only modeling to a level of 0.43% by TV and other media are stepping down in front of internet While the TV segment still accounts for the bulk of advertising revenues in Russia (47% in 2014 vs. the peak of 52% in 2009), internet is the fastest-growing segment. In 8

9 2014, total internet advertising continued to rise robustly at an estimated 15% YoY to RUB 82.5 bln, accounting for 25% of the total market. We note that in 2009 its share stood at only 10% and in 2005 just 2%. Internet is grabbing market share from other traditional segments, such as radio and printed press. The loss of share in the TV segment was not crucial, however, until mid-2012, when internet penetration exceeded the crucial 50% level and large internet companies became comparable with major TV channels in terms of audience reach. The importance of internet media became clear to advertisers in April 2012, when Yandex beat Russia s major Russian TV player (Channel One) in terms of audience, having reached 19.1 mln visits per day vs. Channel One s 18.2 mln. In 2013, Yandex s revenues also exceeded those of Channel One. Russian media advertising market estimates, % Internet advertising as % of total media advertising in select countries, 2015E 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 46% 52% 51% 50% 48% 48% 47% 46% 45% 44% 42% 6% 10% 12% 16% 19% 22% 25% 31% 32% 33% 35% 48% 39% 37% 34% 33% 30% 28% 23% 23% 23% 22% E2015E2016E2017E2018E OTHERS INTERNET TV AKAR, ZenithOptimedia, Gazprombank estimates UK 45% CHINA 32% RUSSIA 31% USA 28% GERMANY 25% FRANCE 25% SPAIN 23% ITALY 19% INDIA 11% BRAZIL 5% 0% 10% 20% 30% 40% 50% Source: Bloomberg, Reuters, Gazprombank estimates Going forward, we expect internet advertising to capture as much as 35% of the total media advertising market in Russia by 2018 at the expense of more traditional media TV, published press and radio. We note that in terms of the proportion of total internet advertising, Russia is very similar to the US and Chinese markets and we expect Russia to follow a similar trend going forward. Text-based advert main growth driver for the whole segment Due to the economic downturn in Russia, we revised down our estimates for the internet advertising market from RUB bln by 2018 to RUB 147.8, which should still account for 35% of Russia s total media market vs. the current 25%. The internet advert market is heavily consolidated, with only three players Yandex, Mail.ru Group and Google controlling about 97% of the market in revenue terms. The main driver for the whole internet advert segment should remain text-based advertising, in our view. This advert offers very flexible and focused advert campaigns and is therefore attracting an increasingly large number of advertisers from both traditional media (TV, press and outdoor) and display ads. We also anticipate an increase in the share of large advertisers in Russia s text-based advertising. As a result, we are looking for RUB124.9 bln to be spent on text-based advertising (85% of the total) in 2018, thus implying a CAGR of 19% over

10 CAGR = 33% FEBRUARY 20, 2015 Revised internet advertisement estimates, RUB bln Internet advertisement breakdown estimates, RUB bln E 2015E 2016E 2017E 2018E E 2015E 2016E 2017E 2018E NEW ESTIMATES OLD ESTIMATES TEXT-BASED DISPLAY Source: ACAR, ZenithOptimedia, Gazprombank estimates Source: ACAR, Gazprombank estimates Notably, we anticipate a decline in the popularity of display (banner) advertising. Despite some support coming from the recent introduction of Real-Time Bidding (real-time auctionbased pricing of banners) and the rising popularity of video ads (part of display advertising), we expect deterioration of the display advertising market in By 2017, we see the total display market being worth RUB 19.4 bln vs. RUB 20.1 bln in Video advertising a rising star or supernova? The online video market, which can also be called the OTT video services market, is booming in Russia due to the switch of audience interests from traditional TV channels to internet. According to J son & Partners management consulting estimates, the total online video market in Russia reached RUB 4.8 bln in 2014, having shown 50% growth YoY. By end 2017, the market should reach RUB 11.4 bln, while the CAGR over the period is estimated at 33%. The core monetization model in Russia for online video services is video ads shown prior to a video clip/movie. This model accounts for about 73% of the total market, while the rest comes from subscription fees and video on demand services. Meanwhile, the world average online video market is only 46% monetized with video ads. Russia online video market estimates, RUB bln* E 2017E Russia online video advert estimates, RUB bln and % of online display advertising % 2% 4% 7% % 22% 26% 29% % E 2015E 2016E 2017E 2018E ONLINE VIDEO ADVERT % OF DISPLAY 70% 60% 50% 40% 30% 20% 10% 0% * - including VAT Source: J son and partners Source: J son and partners, Higher School of Economics, Gazprombank estimates Materially important growth in Russia s online advertising began in 2010, when the market reached about RUB 230 mln and accounted for 3% of total online display ads 10

11 in Russia. The segment had been growing at a CAGR of 80% by 2014 and reached RUB 2.5 bln (14% of display advertising) estimated by end Online video ads appear to be a rising star in the internet advertising segment, which might challenge traditional TV advert budgets to a larger extent than other display and text-based ads have done. Yet, for the time being we prefer to model a rather conservative scenario. The underlying reasons for the phenomenon of sharp growth in the segment are the following: Internet penetration in Russia has exceeded the crucial 50% level and the internet audience reach has become comparable to traditional TV. A young, economically active and thus very lucrative audience is switching its free time spent from traditional TV channels to internet. This, in turn, has prompted some TV channels to refocus their efforts on rolling out online content offerings (CTC Media). Internet offers much much more interactive and easier-to-control contact with an audience. The future development of video advertising should be determined by the rising popularity of smartphones and smart TVs. According to IVI (a leading online cinema service in Russia), more than 60% of its movies are viewed on so-called second screens (smartphones and tablets) as opposed to conventional PCs. Overall, we expect the video advertising market in Russia to reach RUB 7.1 bln in 2018 (30% CAGR in local currency) and become the main driver for the display ad segment of the online advertising market in Russia. Video ads should contribute about 31% to the segment by 2018 vs. 14% in 2014E. 11

12 YANDEX IN FROM THE STORM Mobile platforms create an issue a rather big one Since March 2014 and until January 2015, Yandex has faced a moderate but rather constant decline in its market share in terms of search enquires. The company s efficient search engine, which uses own and proprietary algorithms to provide relevant results as well as high-quality localization of services, has been the main reasons for Yandex s longstanding leadership. But that seems to be changing now. Although the quality of Yandex s services remains high, we maintain that the primary reason for the decline is the rising popularity of mobile data and mobile devices, which are altering the way people go online. According to TNS, only 36% of users use conventional PCs as their sole means of internet access, while the remaining 74% use both PCs and all types of mobile devices (smartphones, tablet PCs, etc). Smartphone penetration in select countries, November 2014 S.KOREA 80% CHINA UK 70% 68% USA 58% ITALY GERMANY FRANCE JAPAN RUSSIA POLAND TURKEY 53% 50% 49% 46% 45% 41% 39% BRAZIL 29% INDIA 15% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% Source: InternetWorldstats, ITU, Google The current smartphone penetration rate in Russia is estimated at 45%, similar to Poland but still below levels seen in developed markets. Taking into account the incremental love of Russians for compact gadgets, we would expect smartphone penetration in the country to reach levels comparable to the UK and the US before long. Notably, about 61% of new mobile phone sales in Russia in 2014 were attributable to smartphones, according to J son & Partners. Online advert migrating from PC to mobile The popularity of mobile devices creates an environment conducive to the expansion of mobile online advert as opposed to conventional PC-based online advert. This, in turn, gives new players a chance to capture market share from the leaders. According to Interactive Advertising Bureau (IAB), mobile gadgets commanded 17% of global digital (online) ads as of 1H14. By 2017, according to emarketer, mobile 12

13 advertising in the world should reach $62.8 bln, accounting for 36% of the digital advertising market. In Russia, mobile ad expansion is still in its inception, since, according to emarketer estimates, it accounted for only about 5.7% of total digital advert in 2014 vs. 3.1% a year ago. J son & Partners estimates that mobile ads will account for 16% of total online advertising in Russia by Google is winning out in mobile platform competition Google s Android OS currently commands leadership in Russia s smartphone platform. As of end 2014, about 86% of smartphones were equipped with this operating system. This figure stands in stark contrast with the situation in 2010, when Nokia, with its Symbian, dominated the market (72% share), while Android was just a starter with 11%. Russia s smartphone users by operating system in 2014E vs Russia s internet users by browser, January % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 4% 10% 72% 86% 12% 5% 11% E SYMBIAN OTHERS IOS ANDROID Source: Json and Partners Consulting, 7.2% 10.6% 6.7% 6.3% 4.4% 14.4% 19.6% 30.8% CHROME ANDROID SAFARI OPERA YANDEX FIREFOX EXPLORER OTHERS Source: Liveinternet Google is winning out in the competition for means of internet access globally. On top of its Android solution for mobile devices, the company introduced its own internet browser Chrome around end The browser is the frontrunner in global competition and by January 2015 already accounted for 51% of the market (according to StatCounter). We note that before the introduction of Chrome, the market leader, Internet Explorer, was used by 80% of internet users. Russia faces trends similar to those in the rest of world, as internet browsing in the country is heavily dominated by Google applications. About 31% of internet views in January 2015 were routed through Google Chrome, while another 20% were executed via mobile gadgets equipped with Android (Google). ios-based Safari users come in third, with 14%. Meanwhile Yandex s in house browser holds only 7% of the market. Google s dominant position in internet browsing and mobile operating systems allows it to secure its positions in search enquires and thus in text-based advert. The company uses its search engine as a default option in all PC and mobile applications. No country for other apps Android is an open source platform and can be significantly adjusted to fit the needs of mobile device vendors. However, under the terms of its licence agreement, Google requires all vendors using the operating system in their mobile devices to have Google apps and search engines pre-installed as default user options. Alternative applications are not prohibited and can also be installed, but often only at the user s initiative. This is how Google secures its dominant position on the market, while making it difficult for players like Yandex to fight for market share on mobile devices. 13

14 In order to address the market share issue, Yandex introduced its own internet browser in October This browser had gained 7% of the Russian internet market by January The bulk of user search enquires on the Yandex browser go through the Yandex search engine. In addition, Yandex reached an agreement to become a default search engine in the Mozilla Firefox internet browser in Russia at the end of We note that Yandex had already been a default search engine in Firefox from 2009 through 2012, before it switched to Google. Two months after the new partnership agreement was signed, the share of Yandex-powered search enquires on Firefox gained 3 pps and reached 75%. Moreover, Yandex has been the default search engine in mobile browser Opera Mini in Russia since 2008 (holding 3% of the market) and executes about 78% of search enquires from this application. In order to support its market position, Yandex aims to further enhance its leadership position in search enquires on all mobile internet browsing platforms alternative to Android. Moreover, Yandex is now considering a new promotion strategy via mobile retail chains in order to boost the amount of installations of Yandex applications on Android-based smartphones on the day of a purchase with the help of retailers on a commission basis. On top of the above measures, Yandex has asked the Federal Anti-Monopoly Service to force Google to unbundle Android from Google search and other applications. The aim is to allow Yandex to agree with smartphone manufacturers on pre-installation of Yandex apps. The move is warranted, in our view, although we doubt that it will lead to quick success. Despite all of the measures taken, we expect Yandex to continue losing its market share in search enquires to Google. By December 2018, we model Yandex to command 56% of search enquires vs. 59% in January Runet search enquires market breakdown by search engine 70% 60% 60.6% 60.5% 61.9% 59.3% 58.9% 56.0% 50% 40% 32.1% 32.8% 39.0% 30% 25.5% 26.4% 26.5% 20% 10% 7.5% 8.6% 8.6% 6.5% 6.4% 4.0% 0% -10% 6.4% 4.5% 3.0% 2.1% 1.9% 1.0% DEC-11 DEC-12 DEC-13 DEC-14 JAN-15 DEC-18E YANDEX GOOGLE MAIL.RU OTHERS Source: Liveinternet, Gazprombank estimates Meanwhile, Google is estimated to have a 39% market share by 2018 vs. the current 33%. Google s market gains should take place at the expense of all market players and not just Yandex. 14

15 Online video testing fertile soil Yandex has tapped into all the prospects of the online video advert segment, as we described above. The company is set to become an active player in a market that offers a 33% CAGR over the next four years in 2015 after the launch of its online video service based on recently purchased Kinopoisk in cooperation with a leading online-cinema player. Yet, this is just the beginning and we do not expect the company to start generating sizable revenues within the next few years. We do not even expect the company to start disclosing the details of video advertising in its revenue breakdown, as it might account for only 0.7% of Yandex s total revenues by Yandex Market a grounded bird We were never overly bullish on the Yandex.Market service and consider it as promising, albeit only one of the company s multiple business lines. Following a reassessment of economic prospects and in anticipation of a severe drop in personal income and consumption, we are decreasing our estimates for revenues from Yandex.Market. We expected revenues to grow at a CAGR of 49% over to 15% of Yandex s total revenues by 2018, but instead have cut our CAGR to 25%, with the share of revenues dropping to 9%. Yandex faced some difficulties in persuading internet shops to move to the Yandex platform, while the cost-per-action (CPA) price still remained low at only 1% of revenues. To remind, the initial plan was to raise the CPA price toward 7-9%. We postpone an increase in the CPA price in our model from 2015 to 2017 and limit the top price at 5%, which is expected to be reached by 2020 vs. 7% by 2017 in line with the estimate given in our previous report. However, that might be considered a conservative approach. Changes in outlook Revenues slowing down, but only temporarily Based on the revised market outlook we are changing our financial model for Yandex. While we cut our revenue growth forecasts for 2015 from an originally estimated 27% to 11% YoY, we are still confident about the viability of Yandex s business model. We expect to see the company s revenues growth recover to a level of 15-29% in and to show CAGR of 20% vs. the originally estimated 27%. This is still well ahead of the overall media advertising market, which is estimated to grow at a CAGR of 5% over the same period. Earnings hit with a double whammy During a period of slowing revenues, Yandex s EBITDA margin is affected by high operating leverage (about 70% of operating costs are fixed). Moreover, Yandex s office rental cost is rising on the weak ruble, as the cost is USD-denominated. We estimate that rental expenses (mainly the head office) equaled about 10% of Yandex s total revenues in 4Q14. As of 4Q14, personnel costs were equivalent to 20% of Yandex s revenues, whereas product development personnel comprised 59% of these costs. Although salaries are not explicitly denominated in USD, the company is forced to raise salaries for its topnotch IT specialists in order to match international levels in USD terms. And while Yandex has a stock option program as a measure of non-monetary incentives for top executives, we believe the company will be hard pressed to avoid raising salaries. 15

16 EBITDA margin estimates comparison, % 70% 60% 50% 40% 30% 20% 41.5% 42.1% 43.6% 41.5% 31.6% 32.0% 45.0% 46.0% 46.0% 46.0% 46.0% 43.7% 45.6% 46.0% 40.0% 34.4% 10% 0% E 2016E 2017E 2018E 2019E 2020E 2021E OLD ESTIMATE NEW ESTIMATE Source: company data, Gazprombank estimates In order to account for all of the new factors mentioned above, we revised down our EBITDA margin estimate for 2015 from 42% to 30%. A recovery in margins is expected on the back of higher revenues due to high operational leverage (a high proportion of fixed costs). That said, we expect to see only a 40% EBITDA margin in 2018 vs, 46% estimated earlier. However, our long-term EBITDA margin estimate (beyond 2020) remains unchanged at 46%. Capex set to rise in response to the soft ruble Yandex has 100% of its capex denominated in USD, as the bulk of this amount is related to foreign equipment for data centers. Due to weakness in the ruble, we raised our cumulative capex program for Yandex over the period to RUB 60.9 bln (17% of revenues) vs. RUB 54.8 bln (13%) estimated earlier. 16

17 Yandex main changes in financials, RUB bln E 2015E 2016E 2017E 2018E 2019E Revenues old estimate % growth YoY 5.3% 28.6% 27.1% 26.3% 30.0% 23.1% 18.2% new estimate % growth YoY 5.3% 28.5% 11.3% 14.9% 19.4% 29.3% 25.6% EBITDA old estimate % growth YoY 8.2% 21.5% 28.7% 31.0% 34.1% 25.8% 18.2% new estimate % growth YoY 8.2% 21.2% -15.1% 16.1% 28.5% 50.1% 37.4% EBITDA margin old estimate 44.0% 41.5% 42.1% 43.6% 45.0% 46.0% 46.0% new estimate 44.0% 41.5% 31.6% 32.0% 34.4% 40.0% 43.7% Net income old estimate % growth YoY 169.3% 5.2% 27.1% 31.9% 36.2% 27.0% 19.1% new estimate % growth YoY 26.3% -36.4% 13.4% 32.6% 57.8% 41.1% Capex old estimate % of revenues 18.7% 15.0% 14.0% 12.0% 12.0% 12.0% 12.0% new estimate % of revenues 18.7% 15.0% 22.0% 20.0% 17.0% 14.7% 12.0% Source: Company data, Gazprombank estimates 17

18 DEBT AND SHARE BUYBACKS Yandex generated positive free cash flow of RUB 5.5 bln and held a net cash position of RUB bln as of end 4Q14. The company has no bank loans, but in 2014 it issued $690 mln in 1.125% convertible senior notes due in The bulk of the proceeds are currently located on long-term bank deposits in USD. In 4Q14, Yandex bought back $100 mln in principal of this notes for $85.6 mln, so as of end 4Q14 the remaining amount of Yandex convertible notes issued was equal to $540 mln. To remind, the company bought back $50 mln of these notes in 3Q14. The company confirmed that as of end 4Q14 it had repurchased 0.98 mln shares as part of its previously announced 3.0 mln share repurchase program. We would expect the company to continue the practice of buybacks and to use the shares in stock option programs for personnel. This should provide additional support to the company s shares in 2015, in our view. As of end 2014, Yandex held mln class A shares (tradable on NASDAQ) in treasury and has board approval to purchase another 2.02 mln from the market. The buyback program has no time limits, however. 18

19 VALUATION Summary As was the case during our initiation of Yandex coverage, we used a series of valuation methods for the company in order to derive a better-weighted target price. We used a DCF model and international peer EV/EBITDA and P/E multiples, while also performing a PEG-based valuation. None of these methods are perfectly suitable for the sake of internet company valuations. DCF reflects a company s long-term growth potential but fails to avoid the risks inherent in long-term forecasts. The international peer multiples method reflects market sentiment toward a stock better than DCF, but still does not address company-specific issues. Although the PEG ratio is widely used to value internet stocks, it also lacks company-specific issues and does not provide a long-term view. We pooled all of the abovementioned valuation methods and derived a target price for Yandex based upon their weighted average. We assigned a 50% weight to DCF, our favorite valuation method, as we prefer a longterm view on the company; 40% was equally distributed among EV/EBITDA and P/E; while our PEG ratio valuation was given a 10% weight. Overall, we derive an end-2015 target price for Yandex of $ per share, while the weighted-average target price is $19.2, implying 14% upside potential to the current price. This compares with our previous target price of $34.6 per share. We therefore change our recommendation on the stock from overweight to NEUTRAL. Yandex valuation summary by valuation method, $ per share % % % % % % 20% 200% 150% 100% 50% 16.5 PEG PE DCF WEIGHTED AVERAGE EV/EBITDA 0% TARGET PRICE WEIGHTS Source: Gazprombank estimates Details on the individual valuation methods are provided in a later section. DCF valuation Our favorite valuation methodology for Yandex is DCF. This method, in our view, makes it possible to capture the company s long-term potential in the Russian market, which is not fully comparable to other emerging or developed markets. There are also a limited number of international peers with a similar business model. WACC estimates One of the reasons for the downgrade in our target prices for Yandex was an increase in our WACC estimate by 2.3 pps, mainly due to a higher risk-free rate and equity-risk premium since our last valuations. 19

20 WACC calculation summary NEW OLD Risk-free rate 10.1% 7.1% Basic equity-risk premium 9.4% 9.0% Adjusted beta Cost of equity 17.2% 14.9% Cost of debt 1.1% 1.1% % equity 100% 100% % debt 0% 0% WACC 17.2% 14.9% Source: Bloomberg, Gazprombank estimates DCF model and valuation Yandex DCF valuation model summary, RUB mln E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E 2024E Revenues 50,767 56,497 64,889 77, , , , , , , ,318 % growth YoY 28.5% 11.3% 14.9% 19.4% 29.3% 25.6% 20.0% 17.2% 15.0% 15.0% 15.0% EBIT 15,323 13,355 15,556 20,846 33,005 46,789 59,771 70,759 82,787 96, ,438 % growth YoY 19.4% (12.8%) 16.5% 34.0% 58.3% 41.8% 27.7% 18.4% 17.0% 16.0% 15.0% Less taxes -5,455-3,417-3,875-5,137-8,133-11,530-14,729-17,437-20,401-23,665-27,215 Tax rate on EBIT -36% -26% -25% -25% -25% -25% -25% -25% -25% -25% -25% Depreciation and amortization 4,484 4,520 5,191 5,811 7,011 8,180 9,063 10,625 12,219 14,051 16,159 % of revenues 9% 8% 8% 8% 7% 7% 6% 6% 6% 6% 6% (Increase)/decrease in NWC -1, ,258-1,511 1,771 2,036 2,342 2,693 % of revenues -3.4% 0.3% -1.5% -0.7% -0.9% -1.0% -1.0% 1.0% 1.0% 1.0% 1.0% Capex -7,615-12,429-12,978-13,171-14,723-15,102-15,106-15,052-15,273-16,862-18,852 % of revenues -15% -22% -20% -17% -15% -12% -10% -9% -8% -7% -7% Net free cash flow 5,006 2,209 2,926 7,812 16,258 27,079 37,489 50,666 61,368 71,900 83,224 % growth YoY -3.3% -55.9% 32.5% 167.0% 108.1% 66.6% 38.4% 35.1% 21.1% 17.2% 15.7% Source: Company data, Gazprombank estimates 20

21 DCF valuation summary, RUB mln WACC 17.2% Terminal growth rate 5.0% Discounted cash flow 131,471 +Discounted terminal value 170,758 Estimated enterprise value 302,228 - Net debt (2015E) -19,668 Estimated equity value 321,896 Number of shares issued, mln 318 Fair value per share, RUB 1,013 Exchange rate, RUB/$ 53.2 Fair value per share, $ Current share price, $ Upside potential, % 13% Source: Bloomberg, Gazprombank estimates By means of DCF, we valued Yandex at RUB 1,013 per share. In order to assign dollarbased target prices, we used our estimated average RUB/USD rate for 2015 of 53.2, which we derived under the base scenario outlined in our 2015 Equity Strategy report. Our new DCF-based target price (as of end 2015) for Yandex is estimated at $19.05 per share, which implies 13% upside potential for the stock from current levels. Our previous DCF target price (as of end 2014) was $34.6 per share. Ruble devaluation and the reduction in our overall media advert market outlook were the key reasons for the cut. We note that DCF valuation is very sensitive to WACC and USD/RUB rate assumptions. A less conservative approach might have used a lower WACC of 14.0%. On the other hand, one can argue that our ruble exchange rate is overly optimistic and it would be better to use a higher rate of 65. Based on these assumptions, Yandex s DCF-based target price could end up at a level of $22.85 per share, offering 36% upside. We prefer to be conservative in our DCF approach, but leave it to the investor to decide on the appropriate assumption. For the sake of convenience, we provide a valuation sensitivity table below. DCF valuation sensitivity table, $ per share USD/RUB RATE WACC 13.0% 14.0% 15.0% 16.0% 17.2% 18.0% 19.0% 20.0% 21.0% Source: Gazprombank estimates 21

22 Relative valuation Yandex peer group multiples comparison MCAP, $ MLN EV/EBITDA (X) P/E (X) PEG* 2014E 2015E 2016E 2014E 2015E 2016E 14-17E Google 368, Baidu 72, Yahoo! 41, N/A Yahoo! Japan 20, N/A Sohu.com 2,059 N/A N/A N/A International average Yandex 5, Mail.ru 4, Russian average * Yandex net income adjusted for FX gains/ losses Source: Bloomberg, Gazprombank estimates Among listed companies, Mail.ru Group (Mail.ru), the second-largest internet holding in Russia after Yandex, is the company s only real peer in Russia. These two stocks are not comparable, however, as Yandex is essentially a pure play on the rapidly growing text-based advertising market, whereas Mail.ru is more of a diversified and slowergrowing asset. Moreover, Yandex offers lower EBITDA margins in a range of 42-44% (prior to 2015) vs. 52% at Mail.ru. Yandex trades at lower EV/EBITDA but higher P/E multiples than Mail.ru. The difference can be partially attributed to the difference in growth rates. International comparison For comparison purposes, there are also only a limited number of international market peers that operate in both emerging and developed markets and have similar business models. We performed a valuation based on an international comparison of 2015E EV/EBITDA and P/E ratios, as they reflect market sentiment and growth expectations from internet stocks and can be used to value Yandex regardless of the difference in the size and markets in which they operate. Yandex valuation based on international EV/EBITDA, RUB mln International EV/EBITDA, 2014E 18.9 Yandex EBITDA, 2015E 17,875 Estimated EV 338,320 Net debt, 2015E -19,668 Estimated equity value 357,988 Number of shares, mln Fair value per share, RUB 1,127 Fair value per share, USD % upside/downside 26% Source: Bloomberg, Gazprombank estimates Based on the international media EV/EBITDA multiple of 18.9x estimated for 2015 earnings, we would argue that Yandex should be valued at $21.2 per share by end 2015, implying upside potential of 26%. On the other hand, the same 2015 international P/E ratio of 28.5x would indicate a valuation for Yandex of only $18.26 per share, or 8% above its current market price. 22

23 Yandex valuation based on international P/E, RUB mln International P/E, 2014E 28.5 Yandex net income, 2015E 10,821 Estimated equity value 308,599 Number of shares, mln Fair value per share, RUB 972 Fair value per share, USD % upside/downside 8% Source: Bloomberg, Gazprombank estimates The difference in valuations derived from EV/EBITDA and P/E ratios stems mainly from the difference in debt levels among the companies. To remind, Yandex enjoys a net cash position that is beneficial relative to its leveraged international peers. PEG ratio-based valuation We estimated PEG ratios for our select international peers based on Bloomberg consensus earnings estimates. We would argue that Yandex should trade at an average level to the PEG ratios of its International peers and thus deserves upside. Yandex valuation based on PEG ratio, RUB mln International PEG 1.3 Estimated Yandex net income CAGR ( 14-17)* 21% Estimated P/E, Yandex net income, ,821 Estimated equity value 305,252 Number of shares, mln Fair value per share, RUB 961 Fair value per share, USD % upside/downside 7% * net income adjusted for FX gains/ losses Source: Bloomberg, Gazprombank estimates Based on a PEG ratio of 1.3x (blended Russian and International peers), we estimate that Yandex might trade at 28.2x the 2015E P/E ratio, which implies a valuation of $18.06 per share by end The implied upside potential of 7%. The reason for such a low valuation is the depressed earnings of Yandex modeled for 2015 due to the weak ruble. As noted above, we pooled and weighted all of the derived valuations of Yandex and came up with an end-2015 target price for Yandex of $19.22 per share, which implies 14% downside to the current price. This compares with our previous target price of $34.6 per share (end-2014). We therefore change our recommendation to the stock from Overweight to NEUTRAL. 23

24 HQ: 16/1 Nametkina St., Moscow , Russia. Office: 7 Koroviy val St. Research Department +7 (495) EQUITY SALES +7 (495) FIXED INCOME SALES +7 (495) EQUITY TRADING +7 (495) FIXED INCOME TRADING +7 (499) Copyright Gazprombank (Joint Stock Company). All rights reserved This report has been prepared by the analysts of Gazprombank (Joint Stock Company) (hereinafter Gazprombank) and is based on information obtained from public sources believed to be reliable, but is not guaranteed as necessarily being accurate. With the exception of information directly pertaining to Gazprombank, the latter shall not be liable for the accuracy or completeness of any information shown herein. All opinions and judgments herein represent solely analysts personal opinion regarding the events and situations described and analyzed in this report. They should not be regarded as Gazprombank s position and are subject to change without notice, also in connection with new corporate or market events that may transpire. Gazprombank shall be under no obligation to update, amend this report or otherwise notify anyone of any such changes. The financial instruments mentioned herein may be unsuitable for certain categories of investors. This report should not be the only basis used when adopting an investment decision. Investors should make investment decisions at their own discretion, inviting independent consultants, if necessary, for their specific interests and objectives. The authors shall not be liable for any actions resulting from the use of this report. Any information contained herein or in the appendices hereto shall not to be construed as a solicitation or an offer to buy or sell any securities or advertisement, unless otherwise expressly stated herein or in the appendices hereto. Gazprombank should in no way be viewed as soliciting, facilitating, brokering or causing any persons to invest in any instrument or otherwise engage in transactions that may be prohibited to those persons under applicable laws and regulations. Investors should independently evaluate whether any investment transactions undertaken after reviewing Gazprombank research materials are permitted under any applicable economic sanctions laws and regulations or other laws applicable to their investing activities.