Moscow Exchange. A bet on reform based growth

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1 Initial Coverage Tuesday, March 12, 2013 Moscow Exchange A bet on reform based growth USD 1.96 MOEX RX RTS Feb 22 Feb 01 Mar 08 Mar We initiate coverage of the Moscow Exchange with a BUY recommendation and price target of RUB68/share. The Exchange has a strong diversified business model, offering a unique exposure to the reform based growth in Russia s financial markets with a substantial countercyclical component that protects revenue. The ongoing development and modernization of the financial infrastructure should help repatriate flows, while new public offerings via the domestic exchange should also support volume growth. The story has several major risks business model changes, competition and country risks that justify a discount to its peers on multiples at this stage. Share data & recommendation Ticker MOEX RX Last price, RUB 54 Target price, RUB 68 Upside, % 26% Recommendation BUY Market data MCap, USD mn Free float, % 30% Free float, USD mn EV, USD mn Equity performance 1W chg., % 2.5% Company's multiples 13E 14E EV/EBITDA, х P/E, х Beneficiary of internal change. The Moscow Exchange (Exchange, Company), being the #1 exchange in Russia, is perfectly positioned to benefit from the ongoing reform in financial regulation and financial infrastructure. The story offers an exposure to a vertically integrated company incorporating trading, settlement and clearing in a variety of products as well as counter cyclical elements that protect revenue. Market expansion is expected to be supported by: 1) repatriation of flows from foreign exchanges as the new financial infrastructure reduces risks and costs of participants; 2) a greater intermediation and breadth of financial services in the Russian economy; 3) general growth of the economy and 4) recovery of risk appetite. Key risks: business model changes, competition and country risks. The Exchange story carries several major risks that justify a discount to its peers on multiples at this stage. First, the Company is in the midst of transition to trading with central counterparty (CCP) on a T+2 settlement regime, establishment of Central Securities Depository (CSD), with the introduction of Euroclear and new tariff schemes, most of which could have a dual impact on the P&L. Another risk is competition with international exchanges and migration of trading abroad. In addition, Russia s macroeconomic policies have often lacked consistency and completeness, a leading country risk e EBITDA CAGR of 5%. The Moscow Exchange may deliver e EBITDA CAGR of 5% on the back of revenue growth at 5% CAGR, as we expect a moderate contraction in margins due to a moderation in interest revenue, which currently comprises 48% of total. The Exchange has historically showed superior growth rates, including the 28% expansion of 2012e EBITDA. However, the growth stemmed from an expansion of interest revenue, which we believe will no longer persist. Nevertheless, any evidence of success in Russia s financial infrastructure reform should help the stock to further re rate. 12MF target price of RUB68/share, discount to peers may narrow going forward. We have valued the fair 12M forward MCAP of the Exchange at RUB153bn (RUB68/share) (US$2.1/share). Our valuation is based on P/E and EV/EBITDA multiples and cross checked by a DCF valuation. The stock trades at 2013e P/E of 12.4 and 2013e EV/EBITDA of 6.3, which is a 22% and 38% discount, respectively, to emerging market peers. The discount is reasonable at this time, taking into account business model risks. Going forward, assuming the company shows a clear track record and given the strong potential for market growth, we believe the discount should narrow. Summary of valuation and recommendations Company Current, Target, Upside MC, EV, EV/EBITDA P/E Recommendation RUB RUB RUB bn RUB bn 2012E 2013E 2014E 2012E 2013E 2014E ME % BUY Peers median As of 7 March Source: Bloomberg, BCS estimates Research Department + 7 (495) Olga Naydenova, +7 (495) (4734), onaydenova@msk.bcs.ru

2 Table of Contents Investment case... 3 Catalysts... 6 Risks... 6 Market structure reforms... 6 CSD and Euroclear / Clearstream... 6 Migration to T+2 from T Establishment of the Central counterparty... 7 New tariff structure... 7 Reform of listing... 7 Government initiatives to support financial center... 8 Privatization plans... 8 Tax initiatives... 9 Revision of National Wealth Fund investment policy... 9 Liberalization of requirements for pension funds investments Company description Reasons for IPO Shareholder structure Free float and liquidity Corporate governance and management Interest income Fee income Securities Foreign exchange Money markets Derivatives Operating costs expenses Dividend policy

3 Investment case The Moscow Exchange (Exchange or Company) is a play on financial infrastructure reform, the success of which should help attract financial flows to the Russian market. The Exchange is in the midst of a transition to a more modern and competitive financial platform. The key changes include establishment of a Central Securities Depository, transition to trading with central counterparty via a T+2 settlement regime, better pricing schemes and more sensible listing. The changes to a more modern financial infrastructure should help repatriate flows from international exchanges trading Russian assets, reducing the risks of participants as well as their costs. The Exchange is also focused on development of new products, mostly of underpenetrated derivatives, which should also be supportive for revenue. The Exchange has a diversified model, which also includes countercyclical components. It incorporates clearing and settlement of trades in a variety of assets, including equity, fixed income and derivatives. The Company also trades in foreign exchange and money markets, which provide for countercyclical protection as the CBR uses them as a liquidity provision to the banking sector. The Exchange also derives strong interest revenue from the placement of participant s balances the revenue has supported the top line in tighter liquidity situations. The Moscow Exchange could benefit from government initiatives to establish Moscow as one the global financial centers. As part of this process, the government is developing tax incentives for households to participate in securities markets, liberalizing pension funds regulation, increasing the allocation of the National Wealth Fund to domestic markets, and implementing a privatization program with preference for placements on the Exchange. A tighter budget also stimulates government effort to elevate corporate governance, especially in state owned companies. The poor quality of institutions, especially regarding the rule of law, and growing role of the state in the economy, are undermining the investment climate. This is especially important for the Exchange, as revenue is dependent on the attractiveness of investing in domestic companies. The Exchange has a clear development strategy and a properly incentivized management through a combination of compensation and management option programs. However, the transition to a new financial infrastructure and technical platform, as well as the expected market liberalization, add uncertainty to the Company s revenue. In the near term, we believe revenue flows will be primarily determined by the macroeconomic environment and regulatory changes; however, we expect the changes in financial infrastructure to bear first fruits as soon as late 2013 when new flows should start to support the share price. Valuation Consensus 12M forward P/E, Russian banks v MSCI EM banks Exchange is in the midst of a transition to a more modern and competitive financial platform Exchange could benefit from government initiatives to establish Moscow as one the global financial centers We expect financial infrastructure reforms to bear first fruits as soon as late 2013 Avg. P/E (Sberbank &VTB) We value the Moscow Exchange using the arithmetic mean of three valuation approaches: applying the median of peers P/E and EV/EBITDA multiples, based on the broader universe of trading exchange stocks, and the DCF model. Since there is no other domestic exchange stock, we are using banks as a financial services sector proxy for determining market discounts for the Exchange to be applied against peers valuations. We apply the average of consensus 12M forward P/E for MSCI EM Banks index and for Sberbank and VTB. This discount has average 23% over the past year. MSCI EM Banks Russian banks discount on 12M forward P/E to MSCI EM banks 20% 10% 0% Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 10% 5 0 Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 20% 30% 40% Source: Bloomberg Source: Bloomberg 3

4 Meanwhile, the premium for exchanges to banks on the 12M forward P/E basis has recently expanded to 60% level. We believe this is justified with the quality of revenue, as, in the medium term, Basel III could make banks relatively less attractive in terms of earnings generation than capital markets thus, the relative increase in preference for exchanges. Consensus 12M forward P/E, EM banks vs exchanges Exchanges premium on 12M forward P/E over EM peers 21 80% Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Median Exchange P/E MSCI EM Banks 70% 60% 50% 40% 30% 20% 10% 0% Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Peers multiple valuation Source: Bloomberg Source: Bloomberg We use our forecasts for 2013E and 2014e as the key valuation years for peers multiples approaches. Regarding the cost of equity approach, we are using the yield on the 14 year ruble denominated OFZ bond as the risk free rate and a 6% equity risk premium. We also apply a beta =1 to achieve our COE assumption of 13.3% (the company has no debt). Our multiples valuation is based on e EV/EBITDA and P/E we used multiples of the Exchange s global peers. The Moscow Exchange trades at a 17 38% discount to the median of global peers. In our view, Russian financial sector stocks, both banks and exchanges, should close the gap to global peers once risk sentiment recovers; we expect this gap to narrow to roughly 20%. Name Country price, $ Mcap, $m P/E EV/EBITDA 2013e 2014e 2013e 2014e LONDON STOCK EXCHANGE GROUP GB , DEUTSCHE BOERSE AG GE , BOLSAS Y MERCADOS ESPANOLES SP , NYSE EURONEXT US , NASDAQ OMX GROUP/THE US , BOLSA MEXICANA DE VALORES SA MX 2.5 1, ASX LTD AU , HELLENIC EXCHANGES SA HOLDIN GR BM&FBOVESPA SA BZ , BURSA MALAYSIA BHD MA 2.2 1, IG GROUP HOLDINGS PLC GB 7.7 2, WARSAW STOCK EXCHANGE PD JSE LTD SA CME GROUP INC US , DM average EM average Median MOSCOW EXCHANGE MICEX RTS RU , Discount to median 22% 17% 38% 36% Source: Bloomberg, BCS estimates 4

5 We applied peers multiples to our earnings and EBITDA forecast for the Exchange to achieve our targets based on multiple valuation. On a P/E basis, the target comes to RUB60.9/share, on EV/EBITDA to RUB69.5/share. Multiples valuation summary P/E EV/EBITDA Implied range 2013E 2014E 2013E 2014E Fair multiple (peers median) Net income, Rb bn EBITDA, Rb bn Fair EV, Rb bn Net debt, Rb bn Current fair equity value, no discount, Rb bn Current fair equity value, 20% discount, Rb bn MF Target Value, Rb bn Per share Current fair price, Rb/share MF target price, Rb/share Source: BCS estimates DCF valuation: RUB73.5/share 12MF fair price. For our DCF valuation, we used a cost of equity of 13.3% with a terminal growth rate of 5.0%. Thus, on a 12 month forward basis, our DCF based target price is RUB73.5/share. At the same time, in current terms, the fair price is RUB69.4/share. DCF valuation summary, RUB E 2014E 2015E 2016E EBIT 12,406,897 13,339,885 14,484,695 15,457,408 Taxed EBIT 9,704,914 10,434,715 11,330,207 12,091,082 Capex 900, ,000 1,011,240 1,071,914 FCFF 8,804,914 9,480,715 10,318,967 11,019,168 Discount factor Discounted FCFF 8,804,914 8,367,798 8,038,526 7,576,333 Sum of PV 32,787,570 Risk free rate 7.3% Terminal value 95,845,178 Risk premium 6.0% Target mid 2013 EV 128,632,748 Beta 1.0 Net debt/(cash), end 2012E 33,960,339 Cost of equity 13.3% Target mid 2013 Equity 162,593,087 TGR 5.0% # of shares 2,248 Source: BCS estimates Share price, mid 2013, RUB 72.3 Share price, 12MF target price, RUB 73.5 To define our investment recommendation, we set our 12 month forward target price from today s fair price at the Company s cost of equity. Whenever the target price offers more than 10% excess return, the stock is assigned a Buy rating, whereas the excess return between 10% to 10% translates into a Hold, while returns of less than 10% suggest a Sell recommendation. Valuation summary, RUB Target P/E 60.9 Target EV/EBITDA 69.2 DCF 73.5 Average 68.0 Upside 26% Fair price 60.0 Excess return 11% Source: BCS estimates Thus, with a RUB68/share target price, we assign a BUY rating to the stock. 5

6 The Exchange story features an array of positive catalysts, which outweigh the risks over the long run Catalysts Recovery of economic growth; Improvement in corporate governance, especially in state owned companies; Liberalization of markets, improvement of financial infrastructure; IPOs/SPOs of the Russian companies, including privatization deals; Repatriation of trading due to modern financial infrastructure; and Possible inclusion in MSCI Russia index. Risks General economic and political risks have become an essential element in Russia s investment case, as weak institutions limit domestic economic growth drivers; Poor earnings visibility IPO conducted in the midst of company and market transformation (transition to T+2, establishment of NDS and CCP with introduction of Euroclear, new tariff schemes), which have a dual effect on profitability; Corporate governance no track record and no need for further equity injections; Integration of RTS costs and synergies uncertain; Low liquidity of the stock Placement only in Russia reduces investor base and may increase share price volatility due to lower share of long funding sources; Continuation of trading migration from Russian exchanges to the abroad, especially in light of possible abandoning limitations on DR programs; Re emergence of a domestic exchange competitor; and Technical glitches hamper reputation, transition to a new IT platform accelerates risks The reforms should help to repatriate flows from international exchanges trading Russian assets Market structure reforms The Moscow Exchange is in the midst of market and company transitions to a more modern and competitive financial platform. Below we discuss the key changes that affect the business model. The changes should help to repatriate flows from international exchanges trading Russian assets via establishment of a modern financial infrastructure, reducing the risks of participants as well as their costs. On the other hand, change also suggests risks. CSD and Euroclear / Clearstream A part of the MICEX RTS deal was the merger of their depositories. In November 2012, the National Settlement Depository, owned by the Moscow Exchange, became the first and only institution granted (by law) the status of a Central Securities Depository. This implies that it is now able to offer 1) the nominee holder arrangements for foreign investors, 2) lower risks, 3) shorter and simplified settlement and 4) reduced post trading costs, which altogether improve access to the Russian market for foreign investors. Additionally, this also put Russia in compliance with 17f 7 rule, which opens the way for traditional US asset managers to own Russian local shares. The establishment of the CSD has introduced multiple benefits for the Exchange and investors The establishment of the CSD has also opened way for the two major European CSDs Euroclear and Clearstream to Russian markets. This implies that foreign investors would be able to trade on Russian exchanges and conduct settlement via their accounts at Euroclear or Clearstream. Euroclear commenced direct settlement of ruble denominated government bonds (OFZs) in February 2013 with other bonds being delayed, while cash equities are expected to become clearable via Euroclear by mid The developments are clearly positive from an investors perspective. However, from the perspective of the Moscow Exchange, this might have a dual effect trading volumes could be increasing, but the Exchange could lose significant market share should the float migrate to the OTC and then settled by Euroclear. While we have seen a positive increase in OFZ volumes on the fixed income securities side, we do not expect a significant outflow to OTC markets, whereas this could be a possible scenario on the equity side. 6

7 For the Exchange, the transfer to T+2 settlement is the single most important change in the infrastructure The new set of tariffs imply an average decrease of 10% in pricing Migration to T+2 from T+0 Unlike most international exchanges, the Moscow Exchange operates on the basis of T+0 regime, wherein market participants are required to keep funds on deposit to have trading flexibility. For international investors, this scheme implies higher deal costs and, thus, the transition to the T+2 settlement in the 20 most liquid equities and OFZ government ruble bonds, which is planned for March 2013, should be positive for repatriation of flows related to Russian assets. The T+0 would be phased out by the end of 3Q13. Later stages suggest adding up to 50 of the most liquid stocks to T+2 before the transition to deferred settlement is complete. Transition to the single guarantee deposit for T+2, T+0 and REPO markets would also be supportive for investors. For the Exchange, the transfer to T+2 settlement is the single most important change in the infrastructure. However, it could imply some outflow of the balances that clients keep with the exchange, thus reducing the potential to earn interest income. Establishment of the Central counterparty The Central Counterparty (CCP) clearing system was established in , and was just extended to money markets for repos with stocks and bonds. This significantly reduces counterparty risks for market participants and, thus, supports usage of the Exchange infrastructure by a larger investor base, primarily attracting foreign participants. We also think that extension of CCP to REPOs could support utilization of this refinancing tool by banks as they look to manage risks. On the exchange side, however, this requires the establishment of a proper risk management system to cover the risk of default of clearing participants. New tariff structure To improve the competitiveness of the domestic infrastructure and attract a higher proportion of trading volumes primarily from London, the Moscow Exchange has developed a new set of tariffs that suggest volume based discounts, and market making incentives. On our estimates, this should imply an average 10% decrease in pricing, which would make Moscow more competitive in terms of pricing. The exchange is considering higher tariffs for specialized trading, such as iceberg orders. It is also looking at further changes in the tariff structure, splitting out clearing rate from the overall fee to make it more comparable to that at LSE and other exchanges, whereas current tariffs include fees for trading, clearing and IT services. The Exchange would be partially compensated for the tariff reduction with the abolishment of VAT on trading and clearing, which came into effect in January ME Tariff changes Instrument Equities 1 bp 5 tariff plans with fixed and variable parts ( bp) 50% cross agency rebates Bonds Main market % x maturity, but no more than 0.01% Negotiated trades % x maturity, but no more than 0.01% and no more than RUB2000 Placements % x maturity, but no more than 0.015% Placements, fixed amount RUB12.5m / 3 months Eurobonds 0.01% Derivatives For OFZ futures RUB 1 / contract (c. 0.01%) Other than main market and negotiated trades % x maturity, but no more than 0.015% REPO Basic % x maturity Economy % x maturity plus fixed part of RUB0.15m Leader % x maturity plus fixed part of RUB0.5m FX SPOT Basic % Advanced % plus RUB 1m Maximum 0.001% plus RUB 2m Additional fee for iceberg orders (0.25 bp) Main market % x maturity, but no more than 0.01% Negotiated trades % x maturity, but no more than 0.01% and no more than RUB1800 Placements % x maturity, but no more than % Placements, fixed amount RUB 11.2m / 3 months Eurobonds % x maturity, but for negotiated trades no more than 0.01% and no more than RUB1800 For OFZ futures RUB0.8 / contract (c %) 0.002% Basic % x maturity Economy % x maturity plus fixed part of RUB0.15m Leader % x maturity plus fixed part of RUB0.5m Basic % Advanced 0.001% plus RUB 1m Maximum % plus RUB 2m Source: Company data Reform of listing Another tool the Exchange is working on to improve competitiveness is the reform of listing. The new MICEX listing rules are designed to make more sensible quotation lists, which would suggest some links between indices and lists. Higher tier quotation lists would also require, among other things, better transparency, corporate governance and standards for independent directors. Directly, this should be helpful for non state pension funds that are only eligible to invest in top tier quotation lists, which currently does not include all of the most liquid names. However, a reformed listing would also be beneficial for other investors. More demanding disclosure, governance and compliance obligations for higher tier listing companies could also increase attractiveness of respective shares and, therefore, support repatriation. 7

8 Government initiatives to support financial center The government is also be interested in improving corporate governance In the long term, Basel III should enhance attractiveness of capital markets The Moscow Exchange is the major beneficiary of the government s plans to build an international financial center in Moscow. This strategic goal is driving the improvements in the regulatory environment and institutional modernization. In addition, the government has developed a privatization plan and is working to improve the tax regime to support non bank financials, simplify bond issuance procedures, diversify potential investments of pension savings and revise National Wealth Fund investment strategies. The government is also interested in improving corporate governance, especially in stateowned companies. This is coming on the back of a tighter fiscal situation, resulting in demand for better quality of management, higher dividend payouts and privatization. In turn, this could stimulate financial reporting on a consolidated basis, which is in line with international standards. Additional improvements in corporate governance could come on the back of the ME listing reform. In the long term, Basel III should enhance attractiveness of capital markets. Tighter capital and liquidity requirements are expected to be introduced. In particular, the adoption of Basel III should reduce banks ability to extend maturity of funding, thus increasing attractiveness of capital markets compared with pure bank funding for the corporate sector long term funding needs. We also believe that continued macro prudential tightening in the banking sector could add to the relative attractiveness of non bank financing, which could become beneficial for the Exchange s business. All of these initiatives are supportive of the development of the local financial market. However, depending on political will, implementation by the government could translate into a protracted period for example, Central depository legislation took about a decade. More importantly, the key problems are capital investment weakness and the lack of long term private savings in Russia. According to Rosstat, capital investment growth slowed to just 1.3% y/y in 4Q12, whereas Russia operates on historically low % unemployment levels, underscoring the need for investments. Even though Russia has sufficient resources and low debt levels, savings are not being transformed into investment due primarily to institutional weakness and expansion of the state in the economy. On the private savings side, despite strong retail deposits (32% of GDP), long term savings, i.e., the insurance sector and private pension savings are inconsequential at 2 3% GDP each. Hence, to address the issue, institutional reform is necessary and inflation rates need to decline from the current 6 7% to a lower single digit, which would suggest combating structural inflation. Also, macroeconomic policy of the Russian government has been quite inconsistent (this has been the case in a number of instances, such as procedures for budget allocations, tax reforms). In particular, we highlight plans to partially reverse pension reform of 10 years ago, as the allocation of pension contributions to the accumulative pensions is now planned to reduce to 2% from 6% for those who do not select a private pension fund or asset manager. Privatization plans We do not expect the government s privatization plan to be implemented without major delay The Russian government has developed an ambitious privatization plan that suggests it would be looking sell assets in the amount of almost $12 bn, according to our estimates. However, the privatization plans are unlikely to be realized at the pace the government has outlined. In 2012, the only privatization deal that succeeded was the placement of 7.6% shares in Sberbank by the CBR, while 8 placements were initially planned. We do not expect the government s privatization plan to be implemented without major delay. For example, the privatization of Russian Railways has already been delayed to , whereas UAC suggests delaying to In 2013, we expect a $2 3 bn SPO of VTB, coming in the form of an equity injection rather than a privatization deal. Other than that, we believe deals on NCSP and Alrosa are possible. Russian privatization plan Company Stake Planned price, $ bn Year TGK % VTB %

9 The government s goal to establish an international financial center in Moscow supports the use of the Exchange in the privatization deals Russian privatization plan (continued) Company Stake Planned price, $ bn Year Sovkomflot 25% Russian railways 5% n/a 2013 Sibir avia 25.5% NCSP 20% Alrosa 14% Transneft 25% Zarubezhneft 100% n/a Rushydro 59% Aeroflot 51% Sheremetievo 83% n/a UAC (OAK) 50% 1 n/a OSK 50% 1 n/a Rostelecom n/a n/a Rosagroleasing 100% n/a OZK 50% 1 n/a Uralvagonzavod 25% 1 n/a Russian Agri Bank 100% n/a Transcontainer 25% Total 11.6 Source: Interfax, BCS Estimates The government s goal to establish an international financial center in Moscow supports the use of the Exchange in the privatization deals. However, with the placement in Moscow, investors should require a discount, which would be negative for budget revenue and, thus, the final choice would not necessarily be solely the Exchange in every case. In addition, liberalization is being diluted. The government s privatization efforts, thus far, do not entail a change of controlling ownership at most companies slated for privatization control will remain in the hands of the state. Furthermore, state ownership is expanding: Most recently, Rosneft acquired TNK BP. Thus, privatization would neither trigger a change in governance in those companies nor sentiment towards investing in Russia. Tax initiatives Several initiatives are emerging to support individual investments in financial markets On the positive side, several initiatives are emerging to support individual investments in financial markets, albeit they are in an early stage of development. Authorities are developing tax incentives, including a tax reduction (possibly a 0% tax on securities holdings for over 3 years). Tax stimuli for pension savings and life insurance as well as a system similar to deposit insurance (but for non bank savings) are being developed. Russia s retail savings are a strong 32% of GDP. However, over 70% is allocated towards banks savings, whereas just 7% is invested in securities. Cutting the securities holding tax, although generally positive, would only deliver a moderate benefit and be achieved over a long term. The current composition of household assets reflects the existing risk/reward balance when retail deposit rates are positive in real terms and bank savings have deposit insurance coverage, whereas markets are volatile and growth trends are unstable. However, as the economy recovers over time, this balance could be shifted towards markets. Revision of National Wealth Fund investment policy The government is suggesting changes that would increase investments of the NWF in domestic securities The National Wealth Fund (NWF) was created as a part of the former Stabilization Fund and is designed to secure the long term stability of Russia s pension system. It is funded by a part of budget oil revenues and, thus, is a countercyclical instrument also helping to combat the Dutch disease. The fund is currently RUB2.7 tln ($88.6bn) strong, a quarter of which is placed in accounts with VEB, while the rest is managed by the CBR with its currency reserves. The government is suggesting changes that would increase investments of the NWF in domestic securities, including the possibility of investing in privatization deals. While the increase of NWF participation in the securities market would largely depend on the emergence of infrastructure bonds, we believe that the increase in allocation of the NWF funds to domestic assets would be rather moderate. Given the nature of the fund and the need to prevent bubbles in domestic markets related to oil money, we would not expect more than 40% of the NWF to be dedicated to domestic assets. That said, the overall allocation would be of about 0.7% GDP. 9

10 Liberalization of requirements for pension funds investments We believe the elimination of the break even requirement should be a positive Over the medium term, the government is also looking to liberalize the requirements for nonstate pension funds, namely, to: Abolish the requirement for at least break even profitability in each reporting period (currently one year), and / or possibly a ban on transfers of pension savings from one NPF to another more often than once in three five years. Expand the list of securities applicable for investments by NPFs, and Allow them to participate in IPOs/SPOs. We believe the elimination of the break even requirement should be a positive, given the longterm nature of these investments. Indeed, the need to compensate for each year s losses prevents pension fund managers from investing in equities, whereas the elimination of this requirement could help increase the proportion invested in this asset class from the current very low 2%. However, we are not sure this could get final approval in current environment, given the focus on social protection. That said, should mechanisms similar to deposit insurance practice be introduced in this market, the initiative could get more proponents. The expansion of securities lists and possibility to participate in IPOs would do little to support equity markets on its own The expansion of securities lists and possibility to participate in IPOs would do little to support equity markets on its own indeed, NPFs are currently allowed to invest in the most liquid equities, but they keep only 2% of AUM in this asset class. However, it could be supportive in the context of eliminating the break even requirement. From the exchange marketing perspective, a class of investors eligible to participate in IPOs only locally is also important. Meanwhile, the total of accumulative pension savings (held by VEB and the NPFs) is a very modest 3% of GDP as of 2011, additional 1.3% GDP are voluntary pension savings with NPFs. The voluntary pension system shows virtually a steady increase of c.rub70 bn ($2bn) per year, thus growing slightly slower than GDP. On the mandatory system, it has steadily increased over the past two years from 1.4% GDP at the end of 2009 to current 3.4% GDP. Furthermore, the migration of assets from state asset manager (VEB) to non state pension funds has also accelerated, and currently stands at 1.0% GDP. Therefore, the recent revision of the pension contribution scheme to direct to the accumulative pension component just 2% of wages vs 6% previously unless funds are transferred from VEB by the end of 2013 would diminish this gradually emerging system. From an NPF perspective, we would likely see a spike of funds transfer towards them in 2013, although later growth would be limited organically. Voluntary and mandatory pension savings with NPFs, % GDP 2.5% We will likely see a spike of funds transfer towards NPFs in % 1.5% 1.0% 0.5% 0.0% Dec 06 Mar 07 Jun 07 Sep 07 Dec 07 Mar 08 Jun 08 Sep 08 Dec 08 Mar 09 Jun 09 Sep 09 Dec 09 Mar 10 Jun 10 Sep 10 Dec 10 Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 12 Sep 12 Pension savings, % GDP Pension reserves, % GDP Sources: FCSM, Rossat, BCS Research 10

11 9M12 ME income structure Interest income 8% 6% 2%2% 1% 9% 9% 15% 48% Source: company data Securities market FX Money mkt Depository Derivatives Software sale Info service Other Company description The Moscow Exchange is a vertically integrated company that provides trading, clearing, settlement and depository services in a variety of listed and OTC securities (equities and bonds), FX, REPO and derivatives. Additional sources of commissions are selling of technologies and market data. Altogether, fees and commission income contributed 52% to the company s revenue flow in 9M12. The remaining 48% comes from interest income the company derives primarily from investing the balances its clients deposit with the exchange. The chart describes the income structure of the company. The company was formed via the merger in mid 2011 of MICEX with RTS, which contributed mostly to the company s strength in derivatives markets and supported the establishment of a company owned CSD, the National Settlement Depository (NSD). Upon the completion of the merger, in 2012, the Exchange has effectively become a monopoly in Russia with 34% market share in equity trading volume (including GDRs), 97% in bonds, 95% in money markets, 26% in foreign exchange (while the rest is being conducted OTC) and 96% in derivatives. Reasons for IPO Moscow Exchange: Pre IPO shareholder structure* 33.5% 25.0% 11.9% 6.3% 6.5% 6.2% 10.6% *treasury shares excluded; VEB stake includes shares that belong to its 100% subsidiary RDIF Post IPO shareholding structure* 34.7% 23.8% 13.3% 6.0% 6.1% 5.9% 10.1% CBR VEB Sberbank VTB EBRD CBR VEB Sberba VTB EBRD *treasury shares excluded; VEB stake includes shares that belong to its 100% subsidiary RDIF Source: company data The IPO conducted in February 2013 had both primary and secondary components to it. While the RUB9bn ($300m) secondary component was of interest to the selling shareholders, the RUB6 bn ($200m) primary component appears questionable. As of 3Q12, the Company held c.$1bn of net cash on its balance sheet and has generated positive cash flow, thus, we believe it did not have commercial needs for a capital injection. This view is further affirmed with the plan to increase the dividend payout to 30% for 2012, 40% for 2013, and 50% in 2015, implying that over RUB6bn i.e., more than the primary component of the IPO would be paid in the form of dividends in two years. That said, the main reason for the IPO was to pre empt execution of the put option of former RTS shareholders. As a part of the merger with RTS, the Moscow Exchange granted former RTS shareholders a put option, which suggested that the exchange should buy out these shareholders if the exchange does not conduct an IPO of at least a RUB9bn before 30 June The strike of the option was based on the $4.6bn valuation set during the merger and 12.5% p.a. interest rate and effectively suggested RUB81.2/share price by mid The number of shares that were subject to the option was 297 mn, or 13.5% of the total pre IPO issued shares. However, at least in part, we attribute the decision to conduct an IPO lay to the building of a financial center in Moscow and as a consequent a more transparent publicly traded exchange. Shareholder structure Even post IPO, a group of state owned shareholders (including CBR, VEB, Sberbank and VTB) control 50.2% in the Moscow Exchange total share count (or 53.1% if treasuries are excluded), whereas the remainder belongs to non state holders including the EBRD. Reportedly, the largest buyer in the $500m IPO was the Russian Direct Investments Fund (RDIF), a subsidiary of VEB, acquiring additional $80m. According to the press, RDIF has also attracted sizable coinvestors to the IPO jointly investing c.$200m included Chinese CIC, Blackrock and Oppenheimer. According to the company, the holders of the 60% stake (including CBR, VEB, Sberbank, EBRD, CentroCredit bank and others) have agreed not to sell their stakes within 6 months of the IPO. However, President Putin has also approved the CBR (which will also act as a mega regulator) plan to completely step out of the Moscow Exchange capital in two years horizon. CBR is the largest shareholder in the ME, and it might start selling its shares as early as in August. This implies that in the medium term state shareholders are looking to decrease their stakes to below control. The Moscow Exchange has also established a management option program (which was subjected to the IPO success) totaling 53.6mn shares (or 2.4% on top of outstanding shares) and split into three equal tranches: first could be exercised 180 days after the IPO, second in two years upon special purchase agreement (mostly in 2H12), and third in three years. The price at which the option program could be exercised is RUB 46.9/share, or 15% discount to the IPO price. 11

12 While the free float exceeds 30%, the actual liquidity in the stock is relatively low Free float and liquidity While the free float calculated as a proportion of shareholders having less than 5% in the company exceeds 30%, the actual liquidity in the stock is relatively low. To the date the trading volumes averaged at $3.8m; however, if first two trading days are excluded, the average volume is just $2.3m. Meanwhile, over time, after the lock up period is over, and also due to the dedication of the CBR to step out of the ME capital, the liquidity in the stock will likely improve. However, currently the liquidity in the stock compares with that of NOMOS Bank before the buyout (with $2.5 bn MCap and 21.6% free float, $2.5 mn daily trading volume) rather than Sberbank s c.$37 bn free float and $0.56bn daily trading or VTB s $2.7 bn free float and c.$50 mn daily trading volume. Also, the average daily trading volumes of the company s emerging market peers range at $1 mn (WSE) $72 mn (Bovespa). Nevertheless, with this level of liquidity, the Company has the chance to be included in MSCI Russia index. There are three criteria: market cap, free float adjusted market cap and annual traded value ratio (ATVR, which could be shortened to 3 months for newly traded equities). MSCI Russia includes Mechel, LSR and TMK, which have smaller market caps and free floats, however, in terms of ATVR, on our estimates, MOEX balances around the 0.5 minimum. Corporate governance and management Even though the Exchange is effectively controlled by state entities, they are not dominant on the Moscow Exchange Supervisory Board Even though the Company is effectively controlled by state entities, they are not dominant on the Moscow Exchange Supervisory Board. Out of 19 Supervisory Board members, state bank jointly have six seats. One seat is a Moscow Exchange representative, five are independents, while the remaining seven represent minorities. While we highlight risks to corporate governance due to the lack of need to raise funds, we also note that the structure of the Supervisory Board represents a good example for governing companies with large state presence. On the management side, we believe it is quite well incentivized through the option program (see above) and through bonus payments, which depend both on individual and Company performance. The Exchange is also attempting to improve performance via new hires, including those at the senior level. This includes the new CFO Evgeniy Fetisov, who joined the Exchange in February, and deputy Chairman Andrey Shemetov, who joined last November. Interest income The Moscow Exchange derives a substantial part of its revenue flow from interest income The Exchange is vulnerable to a heavy reliance on interest income. Unlike many other exchanges, the Moscow Exchange derives a substantial part of its revenue flow from interest income. The main source stems from the investment of the pre deposited funds that market participants hold on their balances with the exchange. As of 9M12, interest income contributed 48% to the company s revenue flow and was the source of 82% of total revenue growth vs proforma 9M11. The main reason was the growing interest rate environment RUONIA rate increased from 2.9% in 2010 to 3.9% in 2011 and to 5.5% in Money markets and CBR policy rates 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 RUONIA CBR deposit rate CBR REPO rate Source: CBR 12

13 In our view, interest income growth should turn negative ( 5%) in 2013 and post a moderate 5% CAGR in e, especially as the company is not looking to accept higher risks on its interest revenues. The reasons are two fold: The transition to T+2 from T+0 in 20 most liquid equities and OFZ government ruble bonds is planned for March 2013 Transition to T+2 from T+0: The transition to T+2 from T+0 in 20 most liquid equities and OFZ government ruble bonds is planned for March Under the T+0 regime, market participants are required to keep funds on deposits to have trading flexibility, thus we could expect an outflow from clients balances. Additionally, the exchange is planning to unite deposits that participants are using to trade in different markets, namely T+2, T0, and REPO, which could also support the reduction of this pool. According to the Company, as of 3Q12, the maximum risk to the client s balances as a result of shifting to T+2 would be an outflow of less than 20% of the investment portfolio, whereas 65% was attributable to the client funds per FX and derivatives trading, which already operated on T+n settlement, 11% are the group s own funds, while 5% is the required minimum margin on T+2. Thus, as long as we expect growth in both derivatives and FX segments, we forecast just a 4.5% net outflow of clients balances. Decrease in Russian interest rates: In 4Q12, Russian GDP slowed to just 2.2% y/y growth, with corporate lending portfolio growth barely exceeding inflation over the past several months. We also expect the Russian central bank to start reducing rates as early as spring, with a possible 50 75bp move lower by the year end. The decline in interest rates could be backed as the regulator is tightening requirements on unsecured retail lending, whereas other banks are already tight on the capital side to further leverage their balance sheets. However, in y/y terms, this should keep the Russian 2013e average interest rate virtually flat. Fee income Fee and commission income are the core revenue sources for the Exchange, which has declined since 2011 We model for 6% CAGR growth in fees in 2013e 2016e Fee and commission income are the core revenue sources for the Exchange, but the share of fee and commission income has decreased from 70% in 2010 and 59% in 2011 to just 52% in 9M12, reflecting the outperformance of interest income and growing interest rate environment. We model for 6% CAGR growth in fees in 2013e 2016e after a 7% increase in 9M12 on pro forma basis. Securities The trading and listing of securities is the largest source of commission income accounting for 15% of total revenue, or 28% of fees. In 9M12, segment revenue decreased 27% y/y along with the decrease in equity trading volume the highest margin product. Thus, the increase in bonds trading volumes was not able to compensate for the decrease in equities. In the equities market, velocity declined in 2012 across the globe, but the Moscow Exchange appears to have lost more owing to competition from international exchanges, primarily the LSE. According to our estimates, the share of the Moscow Exchange in the exchange traded volumes of six most liquid Russian stocks has decreased from 62% in 2010 to 53% in 2011 and 47% in Equity market velocity 250% 250% 200% 176% % 100% 50% 115% 118% 88% 92% 65% 70% 67% 70% 56% 48% 56% 42% 46% 37% 29% 28% In the near term, we think the macroeconomic environment will be the dominant factor governing trading volume 0% NASDAQ NYSE DB BM&FB LSE ME HKE WSE JSE Source: company data A number of components drive trading volume growth. In the near term, we think the macroeconomic environment will be the dominant factor governing trading volume in Russian securities. Although the economy has slowed, posting just 2.5% growth in 2H12 and 1.6% growth in January, as Russian economic growth gathers pace, trading volumes should also rise substantially. 13

14 Share of ME in trading of Russia s most liquid stocks 100% In late 2013, the Exchange may already start to see first fruits from the financial infrastructure and tariff reforms Initial Coverage Valuations should improve if a) structural reform is implemented to improve investment climate and support investment driven growth, b) corporate governance sees improvement, especially in a number of state owned companies that dominate Russian markets, c) the European economy a key trading partner of Russia shows signs of improvement, d) socalled advanced economies improve, bolstering both risk appetite generally and for Russian securities market growth. In late 2013, the Exchange may already start to see first fruits from the financial infrastructure and tariff reforms that it is currently conducting. Flows should start improving even without a substantial improvement in economic or political environment. We sight Bovespa as the only exchange in our sample to have managed to increase equity market velocity in At least in part, the success could be attributed to the proactive management position that over 2011 has been introducing market making incentives, launching pricing discounts for HFTs, upgrading systems and introducing new products. These are the similar to what ME is looking to do and, therefore we are positive on the outcome in Moscow. For 2014 and onwards, we expect revenue from the segment to recover with the help of a modernized financial infrastructure repatriating some equity flows. However, for 2013, we forecast a further 14% decline in fees from securities, owing to reduced trading volumes in equities, reduced tariffs and the Euroclear / Clearstream effect. ME Monthly trading volumes in equities and bonds, R trn % 60% 40% 20% % Average Gazprom Norilsk Lukoil Rosneft Sberbank VTB Source: Bloomberg, BCS estimates 0.0 Sep 11 Jan 12 May 12 Sep 12 Jan 13 Stocks Bonds Source: company data Foreign exchange We expect FX to deliver a smooth 7% CAGR in e, owing to the CBR s inflation targeting policy and higher participation of foreign investors in securities trading In 9M12, foreign exchange fees expanded by 42% y/y and were the second largest contributor to fee income growth. FX accounts for 9% of total revenue flow or 18% of fees and commissions. We expect this component to deliver a smooth 7% CAGR in e, owing to the CBR s inflation targeting policy, which suggests higher FX volatility. We also believe that the growth in FX volumes will be supported with higher participation of foreign investors in securities trading due to the ability to clear deals with Euroclear / Clearstream. Another source for improvement would be the increase of the Exchange s share in the market, which currently stands at just 26% while the rest is held OTC. FX monthly volumes, RUB tln Sep 11 Jan 12 May 12 Sep 12 Jan 13 FX spot FX swap Source: Company data 14

15 Money markets Money markets, which include REPOs with the CBR and between dealers, are counter cyclical, as volumes are increasing whilst the funding conditions are tight. The introduction of central counterparty, we believe, will further improve the attractiveness of the money market REPOs are the only product where a central counterparty (CCP) has been introduced, and we believe this will further improve attractiveness of this market due to reduced counterparty risks. The clearing house is also expanding the list of securities that could be used as collateral which could also enhance volumes. Money market revenue account for 8% of total revenue flow in 9M12, or 16% of fees and commissions, and were the main source of fee growth in 9M12, having more than doubled on a y/y basis. The main reason is the increase in demand for liquidity from the CBR. We believe tight liquidity in Russian banking system will persist, while CBR plans to continue increasing the liquidity provision and, consequently, we forecast revenues in this segment to continue growing at 19% CAGR in e before stabilizing. Margins in this segment are dependent on duration and thus the revenues of the Exchange are unlikely to be affected with the expected CBR transition to 7+ days REPO, which would clearly reduce volumes. Money markets monthly volumes, RUB tln 30 Total money markets CBR repo Sep 11 Jan 12 May 12 Sep 12 Jan 13 Sources: CBR, Company data The derivatives business better developed under the former RTS, given the quite liquid RTS index futures was one of the most important assets acquired in the merger Derivatives The derivatives business better developed under the former RTS, given the quite liquid RTS index futures was one of the most important assets acquired in the merger. Derivatives remain one of the most underdeveloped markets in Russia. With underdeveloped interest rates and fixed income derivatives, the segment offers the highest growth potential in the long run. In 9M12, derivatives contributed 11% of fees and commissions, or 6% of the revenue flow. Revenue from the segment has declined 5% y/y on the pro forma basis, but this is primarily because of the historically high volatilities in In the long run, we expect growth in new products, and the introduction of CCP to support the segment s CAGR at 17% in e. Operating costs expenses Below you can see the breakdown of the company s operating costs expense, which are more or less typical for a financial services company. In particular, 48% are comprised of personnel expenses, including salaries, taxes and share based compensation programs. Out of the remainder, the biggest contributor is non cash items depreciation and amortization (17% in total), followed by services (12%, includes marketing costs) and office costs (6%). Structure of Moscow Exchange s operating costs, 9M12 Option program 4% Staff related taxes 7% Staff expenses 38% Services 12% Other non stuff costs 8% Amortisation 11% Office 6% Depreciation 6% Market makers fees 4% Maintenance 4% Source: Company data 15

16 Our below inflation outlook reflects postmerger RTS cost synergies that we believe still exist Our cost growth outlook assumes 6% CAGR in for staff costs and 5% CAGR for other expenses. Our below inflation outlook reflects post merger RTS cost synergies that we believe still exist. Meanwhile, the exchange is looking to introduce a number of technological developments and new products, which should not allow for cost reductions. On staff costs, we expect zero growth in 2013e on the back of 6% staff cut at the end of 2012; additionally, the introduction of the management option program was largely a one off in the 3Q12. Ex staff operating cash costs declined 4.3% in 9M12 over pro forma 9M11, implying that certain synergies were already realized. We think that a transition to a single multi asset trading platform, integrating platforms for risk management and clearing would largely off set the remaining synergies on the cost side. Dividend policy The more generous dividend policy suggests 30% of 2012 net income, 40% of 2013 and 50% of 2014 Ahead of the IPO, the group approved a new dividend policy. The policy suggests 30% of 2012, 40% of 2013 and 50% of 2014 net profit would be paid in dividends. The more generous dividend policy is logical in our view, given that the company is net cash positive, and the yields it is able to earn on this cash are much lower than the cost of equity. However, despite the relatively generous payout, the dividend yield would not be splendid because of the high P/E valuation. That said, based on the current price, the company s dividend yield is expected at just 2%, which is in line with that of Sberbank and VTB and makes the dividend component a rather moderate sweetener in the Company s shares. The Company s dividend yield and payout are also at the lower end of its exchange peers. Partially, this could be justified with the extensive capital expenditure program needed to build the new trading platform. Additionally, as the payout increases, MOEX should become more attractive on dividend criteria. Exchange dividend yield and dividend payout Dividend yield, % Dividend payout, % (RHS) NDAQ US EXAE GA MOEX RX LSE LN 388 HK BVMF3 BZ NYX US JSE SJ GPW PW BOLSAA MM NZX NZ BURSA MK IGG LN DB1 GR ASX AU CME US BME SM Sources: BCS, Bloomberg 16

17 Financial Statements Balance sheet statement, RUB mn E 2013E 2014E 2015E 2016E Cash & equivalents Fin assets at fair value through P&L Fin assets available for sale Fin assets held to maturity Due from banks Intangible assets Goodwill Fixed assets Other assets Total assets Balances of market participants Put option Other liabilities Total liabilities Equity Inc. Put option deduction Equity attributable to parent Minority interest Total liabilities and equity Source: Company data, BCS estimates Income statement, RUB mn E 2013E 2014E 2015E 2016E Fee and commission income Interest income Interest expenses Net from FA thru P&L FX gain / loss Other operating income Operating revenue Operating expenses Staff costs Total operating costs EBITDA Operating profit Put option interest expense Other income/expense Profit before tax Taxes Net profit Non controlling interest Net profit attributable to parent Key profitability ratios, % EBITDA margin 69% 60% 58% 65% 64% 64% 64% 64% Operating margin 65% 56% 52% 58% 57% 57% 58% 58% EBT margin 65% 56% 49% 51% 57% 57% 58% 58% Net margin (attributable to parent) 46% 40% 38% 40% 45% 45% 45% 45% Other share data ROE 19% 24% 24% 15% 12% 12% 12% ROA 2.0% 2.6% 2.8% 3.3% 3.4% 3.4% 3.3% Dividend per share, Rb/share Source: Company data, BCS estimates 17

18 Cash flow statement, RUB mn E 2013E 2014E 2015E 2016E CASH FLOWS FROM OPERATING ACTIVITIES: Profit before tax Depreciation and amortization charge Adjustments Cash flows from operations before operating capital changes Changes in operating assets and liabilities: Due from financial institutions Financial assets at fair value through profit or loss Balances of market participants Other operating assets and liabilities Cash flows from/(used in) operating activities before taxation Income tax paid Cash flows from/(used in) operating activities CASH FLOWS USED IN INVESTING ACTIVITIES: Purchase of investments available for sale, net Acquisition of subsidiaries, net of cash acquired Purchase of investments held to maturity, net Purchase of property and equipment and intangible assets, net Other investment activities Cash flows used in investing activities CASH FLOWS USED IN FINANCING ACTIVITIES: Operations with own shares Dividends paid Loans payable Acquisition of non controlling interest in subsidiaries Cash flows used in financing activities Effect of changes in foreign exchange rates on cash and cash equivalents Net increase/(decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Source: Company data, BCS estimates 18