Market Report Baltic Post Q3 Update January 3, 2008 Focus on sentiment, macro figures Analysts: Erki Kert, Sten Pisang, Henri Adams Contact: [email protected] Forward P/E 30.0 28.0 26.0 24.0 22.0 20.0 18.0 16.0 14.0 12.0 Jan/06 Apr/06 Jul/06 Oct/06 Jan/07 Apr/07 Jul/07 Oct/07 Estonia Latvia Lithuania Baltics The second half of 2007 was rather weak on all three Baltic markets. As a result, Vilnius was the only one to end the year on positive side (+4.4%), while the annual performance of Riga and Tallinn was -9.2% and -13.3%, respectively. Going forward, we expect the volatile trading in both directions to continue and we would not be surprised to see even lower levels in the coming months. Both, the uncertainty regarding the macro future of Baltic states as well as turmoil on global credit markets constitute to the rough trading environment. The macro environment is clearly cooling – the most in Estonia and the least in Lithuania. Retail sales growth and real estate prices are coming down in all three Baltic states and although the GDP growth is still hanging on in Lithuania (and also in Latvia), we expect them to soon follow the path of Estonia (GDP growth has dropped from 11.4% in Q1/06 to 6.4% in Q3/07). In spite of that, we are generally expecting a “soft landing” scenario in 2008 with GDP growth of 4.7% and inflation of 8.6% in Estonia. Our top picks from the Baltic markets are definitely the telecoms – Eesti Telekom (Accumulate) and TEO LT (Accumulate). Both companies are trading at a significant discount to the European peers, which we argue is unjustified in the long term, because telecoms should not suffer very much even if the hard landing scenario was to play out. Moreover, the decrease in share price has pushed the expected 2007 dividend yield up to 8.4% for both companies, which is just too much to miss. In addition to telecoms, we also like Norma (Accumulate). The company is trading at reasonable levels, while at the same time holding a significant amount of cash, which brings about many interesting future scenarios. Please see disclaimer at the end of this report 1 Market Report Baltic Post Q3 Update January 3, 2008 Table of contents Performance ...................................................................................................................................................... 3 Valuation ............................................................................................................................................................ 4 Macro overview ................................................................................................................................................. 5 Deviation............................................................................................................................................................ 8 Recommendation performance.......................................................................................................................... 9 Recommendation: Accumulate ........................................................................................................................ 10 Eesti Telekom (Accumulate) – Low risk, decend dividends....................................................................... 10 Norma (Accumulate) – Cash ready for action............................................................................................ 10 Tallinna Kaubamaja (Accumulate) – profitability still strong, but rough year ahead .................................... 11 Tallinna Vesi (Accumulate) – Stable future ahead...................................................................................... 12 TEO (Accumulate) – Attractive valuation, nice dividends .......................................................................... 13 Recommendation: Neutral ............................................................................................................................... 14 Apranga (Neutral) – negative macro trends have left their mark................................................................ 14 Arco Vara (Neutral) – difficult to forecast, but trend seems to be clear ..................................................... 14 City Service (Neutral) – Growth expected to slow to normal levels........................................................... 15 Ekspress Group (Neutral) – not expensive, but sentiment could be better................................................ 15 Eesti Ehitus (Neutral) – all eyes on Civil engineering segment.................................................................. 15 Grindeks (Neutral) – cheap but a bit too risky ........................................................................................... 16 Harju Elekter (Neutral) – business as usual............................................................................................... 16 Pieno Zvaigzdes (Neutral) – more milk needed, worldwide....................................................................... 17 Rokiskio Suris (Neutral) – strong sales, booming profitability .................................................................... 17 SAF Tehnika (Neutral) – Can they stay in profit? ....................................................................................... 17 Saku (Neutral) – Downgrade to Neutral due to alcohol sales restrictions .................................................. 18 Tallink (Neutral) – hard times are over?..................................................................................................... 18 Recommendation: Sell ..................................................................................................................................... 20 Baltika (Sell) – sales growth losing steam................................................................................................. 20 Merko Ehitus (Sell) – real estate party is coming to an end....................................................................... 20 Olympic Entertainment Group (Sell) – struggling with falling margins....................................................... 21 Please see disclaimer at the end of this report 2 Market Report Baltic Post Q3 Update January 3, 2008 Performance The second half of 2007 was tough for all three Baltic markets. Tallinn took the most serious hit and the index ended the year with a negative performance of 13.3%. Riga and Vilnius also came down from the peaks done in mid October and Vilnius was the only market to end the year on positive territory compared to the beginning of the year. Uncertainty regarding the Baltic macro situation coupled with the turmoil on world credit markets had its impact on the sentiment and index performance. Since neither of these problems has disappeared yet, we believe that the markets could see even lower levels than at the moment. At the same time, we do not forecast a crash scenario for the stock exchanges and expect the sentiment to improve again in the second half of 2008 (maybe even sooner). Baltic markets performance (ytd) 25% 20% 15% 10% 5% 0% -5% -10% -15% -20% Jan/07 Mar/07 May/07 Jul/07 Sep/07 Nov/07 Tallinn Riga Vilnius Please see disclaimer at the end of this report 3 Market Report Baltic Post Q3 Update January 3, 2008 Valuation Although we had to make some downward adjustments to our 2008 estimates after the Q3 reports, the valuation levels have still significantly decreased. This is due to the fact that the share prices have dropped even more than our estimates. As a result, the Baltic average 2008e P/E is now 14.5x, which can be considered relatively fair taking into account the risks and cooling macro picture. Among Baltics, Latvia is the cheapest with 2008e P/E of 11.8x. However, given that our sample of Latvian companies is quite small, the figure is not very informative. Estonia is trading at 12.9x P/E for 2008, while Lithuania is still close to 19x level. Estonia’s figure can be considered even quite attractive, while Lithuania has some more room for decline. Forward P/E 30 28 26 24 22 20 18 16 14 12 Jan/06 Apr/06 Jul/06 Oct/06 Jan/07 Apr/07 Jul/07 Oct/07 Estonia Latvia Lithuania Baltics Overall, although the P/E ratios suggest that there may be some interesting picks from the markets (especially in Estonia), the sentiment tells another story. As long as the Baltic macro future remains uncertain, we prefer to remain cautious and mostly suggest defensive picks like telecoms and Norma. Forecasted annual EPS growth 60% 50% 40% 30% 20% 10% 0% -10% Jan/06 Apr/06 Jul/06 Oct/06 Jan/07 Apr/07 Jul/07 Oct/07 Estonia Latvia Lithuania Baltics Please see disclaimer at the end of this report 4 Market Report Baltic Post Q3 Update January 3, 2008 Macro overview The macro picture of the Baltic economies in third quarter of 2007 can be summarized in 3 phrases: (1) cooling GDP growth, (2) slowing retail sales, and (3) increasing inflationary pressure. All of those point to the fact that the consumer-driven economic growth in the Baltics is cooling, which also translates into slower top and bottom line growth for most companies listed on the three Baltic exchanges. Although there are a lot of bears out there, who forecast a crash scenario for all three Baltic states, we prefer to remain a bit more bullish and favor the so-called “soft landing” scenario”. For this reason, we still expect moderate growth rates for the companies next year and remain more or less neutral regarding the overall market. The GDP growth saw a drop in Estonia (to 6.4% in Q3 from 7.6% in Q2), while Latvian growth was more or less flat