RED OCTOBER

INVESTMENT HIGHLIGHTS
Red October increased produciton by 37% y-o-y in Jan-May 2002, outperforming the confectionery industrys average 10.7% over the same period. The new management team has highly ambitious plans for the companys further expansion, including increasing the holdings share of the domestic confectionery market and listing on Western stock markets. Highly positive operational results in 2001 and in H1 2002 are not priced in the companys stocks. The new owners plans for an ADR issue in the next 18 months-2 years is a good sign, showing managements readiness to conduct open investor friendly business. The growth of Russian households real income creates a good base for the further expansion of the industry in the mid-term perspective. We beleive that the companys stocks are currently undervalued. Yet, in the short-term an increase in the companys share price seems highly unlikely. We, therefore, recommend Red October as a long-term investment.
300 270 240 210 180 150 120 90 60 Bid Ask RTS index

July, 2002

July, 2002

Common share price Preferred share price Number of common shares Number of preferred shares Market Capitalisation Ticker Recommendation: Short-term Long-term

$8.0 $4.7 8,773,564 1,474,549 $70.19m KROT

Accumulate Market Outperformer

KROT performance vs RTS index (01.01.2000=100%)

30 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-19 Oct-01 Jan-02 May-02

Financials, $m. Sales EBIT EAT Operations, % EBIT margin

99
88.18 13.36 8.05

00
80.31 13.82 6.76

01
94.46 12.99 9.19

02F

Price Ratios

99
0.55 3.61 586

00
0.60 3.49 658

01
0.74 5.40 856

02F
0.57 4.41 669

122.80 P/S 15.92 P/E 11.26 MC/Output, $/t

Production
15.15% 17.21% 13.75% 12.96% Output, 000 tons 9.17% Rev/output, $/t 82.280 162.37 73.284 188.58 82.005 158.41 104.966 151.67

9.13% 8.42% 9.73% EAT margin R E S E A RC H D E P A R T M E NT O F P R O S P E C T I N V E S T M E N T

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We consider Red October stocks among the most undervalued on the stock market. Both the companys price ratios and poor share price dynamic support this view. The positive developments that have taken place at the company over the last 6 months are not reflected in the share price. The 36% y-o-y growth in net dollar profits in 2001 has not affected the companys valuation quotes now stand at $4.85/$8.00 against $5.35/$8.00 at the beginning of 2002. Our conservative estimate of the companys value, calculated according to the DCF model, gives us a fair price of $120m or $13.67 per share. This is 71% above the current asking price. Investment case In line with the general performance of the food sector, the confectionery industry has shown remarkable growth and proved to be one of the best performing industries in the Russian economy. During the first five months of 2002 food production enterprises increased output by 8.1% y-o-y against 3.0% y-o-y industrial growth and 3.7% y-o-y economic growth in general.
Food Industry Index Performance in 2001-May 2002 (Dec 2000=100)
118 114 110 106 102 98 94 90
M ar -0 1 M ay -0 1 N ov -0 1 Ja n02 M ar -0 2 M ay -0 2 Ja n01 Ju l-0 1 Se p01

strated by the food industry as a whole. Red October, in its turn, managed to increase output by 37% in Jan-May 2002 compared with Jan-May 2001, far above the industry average. Although the performance of the confectionery industry correlates with the dynamic of industrial production, output is subject to different fluctuations. As we can see from the chart the dynamic of food production is far more volatile compared with other industries. Producing consumer goods, most of which could not be called essential, confectionery enterprises appear to be highly dependent on consumer demand, which is, in turn, subject to sizeable fluctuations. In addition to this Russian confectioners face serious competition from foreign rivals. Taking the economy in general, the situation appears to be the same. The growth of real disposable incomes does not necessarily lead to an increase in demand for domestic produce, as more consumers start buying imported goods.
Wholesale Trade Index Performance in 2001-May 2002 (Dec 2000=100)
115 110 105 100 95 90 85
Ja n01 Ju l -0 1 Se p01 01 Ja n02 ar -0 1 ar -0 2 M -0 1 M ay ov M ay -0 2

Real disposable incomes

W holes ale trade

Source: Goskomstat

Industrial production

Food industry

Source: Goskomstat Confectionery Industry Performance in 2002 (th tons)

140 120 100 80 60 40 20 0 Jul May Aug Sep Nov Jan Mar Jun Apr Dec Feb Oct

That said, the dynamic of consumer demand, as represented by wholesale performance, appears to have had a positive trend since the beginning of the year, which creates all the right prerequisites for the expansion of the food industry. However, going by this reasoning, we should be careful to draw a direct correlation between the expected wholesale figure dynamics and the performance of the food industry. The history of the last few years clearly demonstrates that the state of a confectionery enterprise, in many ways, depends not only on the condition and capacity of its production base, but also on an effective marketing policy.

Source: Goskomstat

In the same period domestic confectionery enterprises increased outputs by 10.7% y-o-y, which looks quite impressive even against the outperforming results demon-

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Russian Chocolate Market (%)

Rot Front Cadbury Sladko Babyevsky Red October Mars Nestle Kraft Foods
0 3 6 9 12 15 18

allows them to debit a much higher share of advertising expenses on operational expenses.
London Exchange Raw Sugar (cif) ($ per ton)

210 195 180 165 150 135 Jan Jan Feb Mar Apr May Jun

Source: Prospect

The overall volume of the Russian confectionery market is estimated at 1.65 million tons a year. Of this, about 20% is chocolate products, 55% - flour-based confectionery and about 25% - sweets/candy. Meanwhile, the average production capacity of domestic confectionery plants is 3 million tons a year, which suggests that the growth potential of confectionery enterprises is very high. The main players on the domestic market include Babaevsky confectionery concern, Rot Front, Red October, Sladko, Nestle, Mars, Cadbury and Stollwerck Rus. Except for Nestle, which in 1995 bought a Samara confectionery plant and reorganized the Rossiya Confectionery Association, other foreign companies, which have entered the Russian market, have preferred to build their own production capacities in Russia. In the beginning of 2002 Stollwerck sold its Pokrov-based chocolate plant to US Krafts Foods. Even taking into account the impressive growth of the domestic confectionery market that took place over the last few years the market still seems along way from saturation. As the experience of other Eastern European markets shows the domestic demand for confectionery is closely linked to household income. Currently, per capita consumption in Russia is about 10kg, which is far below the 1993 figure of 19kg and 20kg average in Europe. At the same time the rate of product utilization capacities in the Russian confectionery industry is very low. In 2000 it stood at 48.6%, while in 2001 it fell to 41.8%. The market, thus, has very high growth potential and the domestic confectionery industry has many of the prerequisites for meeting this increased demand. Red Octobers new management team seems to have some understanding of the link between satisfying demand and increasing marketing. According to Artem Kuznetsov, the head of Gosinkor Holding, which holds controlling stakes in Red October and Rot Front confectioneries, this year the advertising budget of the new holding would be doubled compared to the previous year - $10m in 2002 against $5m in 2001. The new tax legislation, which came into effect this year, provides Russian companies with substantial benefits in this respect as it

Source: Bloomberg International Cocoa Organization Bean Cash Price ($ per ton)

1900 1800 1700 1600 1500 1400 1300 Jan Jan Feb Mar Apr May Jun

Source: Bloomberg

Another factor that needs to be taken into account is the high dependence on the price of raw materials and ingredients. According to data from the Center for Macroeconomic Analysis and Short-term Forecasting, every percent growth of raw material prices leads to an average profit reduction of 0.60 percent in the food industry. This is the highest figure in all industries of the economy. It indicates one of the weakest point of the food industry, which consumes a lot of raw material items, which are either not produced domestically (e.g. coffee) or produced in small volumes (e.g. sugar). Meanwhile, price dynamics for these items do not give producers much cause for optimism. At the same time the food industry demonstrated the lowest dependence of profit margins on energy and fuel prices: each percent growth of energy and fuel tariffs mean only 0.05 percent contraction of profitability figures. This is the second lowest (after the oil industry) figure in the Russian economy. This represents another advantage of the industry considering the forthcoming large-scale increase of prices of natural energy monopolies prices in the future.

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Red October Company overview Red October is one of the leaders in the Russian confectionery industry, holding 5% of the national, and about 30% of the Moscow, market. In the 4-year period following the 1998 crisis Red October gradually reduced production, thus effectively wasting the opportunity opened up on the domestic market following sharp ruble devaluation, losing market share to foreign producers. In 2000 the volume of production at the enterprises of the Red October group decreased by 21% y-o-y, mostly due to the reduction of caramel output in the wake of increased competition from Ukrainian confectionery producers. 2001 was the first year, when Red October raised output by 11.9% y-o-y to 82,000 tons. Consolidating the positive tendencies of the last year in Q1 of this year the company increased output by 28% y-o-y to 20,500 tons, while in the first half of the year production increased by 35% y-o-y to 41,700 tons. The Red October group consists of 9 confectionery enterprises located in different parts of the country. The company has a huge production capacity, which is operating well below potential. According to company data, the total production capacity of the Moscow factories is 65,000-70,000 tons, while the same figure for the regional factories is 120,000 tons. Production reaches 70% of capacity at the Moscow production facilities and about 30% at the regional factories. The dynamic of the companys production suggests that the new owners of the company seem to have chosen proper marketing policy, which is not yet priced in the stocks of the company. Shareholder structure
Red Octobers Shareholder Structure

Front. The new owners have already announced ambitious plans, which include raising domestic confectionery market share and entering Western stock markets. The Moscow city administration holds 23.6% stake in the company. At the May extraordinary shareholders meeting the shareholders elected a new Board of Directors. Gosinkor received 8 out of 11 seats on the Board. The new owners left Anatoly Daursky at the post of company CEO, which indicates that Gosinkor does not want to upset relations with the Moscow government, which previously said that it did not want to change the management of the confectionery producer. Location Most of the production facilities of the Red October group are located in the Moscow area. Moscow and the Moscow region represents one of the most capacious and sound regional markets. It accounts for about one third of the overall sales of the Red October group. This give the company certain advantages in comparison with competitors. Seven of the other eight confectionery plants are located in the European part of the Russian Federation, while only one is located in the Russian Far East, in Birobidjan. The company also has one of the most recognized brand names on the market. Export is negligible about 3.5% of the companys output. Competition from imports Red October, like all Russian confectionery producers, faces severe competition from Ukrainian and Belorussian caramel producers, which have certain advantages in terms of cheaper sugar and ingredients and, according to inter-governmental agreements, can import caramel without paying VAT. The issue became a subject of a special investigation carried out by the Economy Development and Trade Ministry, which resulted in the introduction of special protective duties on the import of caramel at 21% of the customs value. In response Ukraine confectioners started to add cocoa to caramel, thus, effectively exempting it from customs duties. Recently a government commission on protective measures in the economy reported it had started a second investigation into imports of Ukrainian caramel to Russia. The probe will likely end with the introduction of similar customs duties on the import of cocoa-containing candies in some 1-1.5 months. Trade alliances In March 2002 Gosinkor holding reported it had bought a 51% stake in Red October and 52% stake in Rot Front. Most of the Red Octobers stocks were bought from foreign institutional investors, such as Templeton (6%), Invesco (16-18%) and Pioneer First (6%), and from minority shareholders on the secondary markets.

Moscow gov-t 23.75% Other 11.05%

Brunswick Warburg 14.20%

Gosinkor Holding 51.00%

Source: NAUFOR, Prospect

In March 2002 Gosinkor Holding reported it has accumulated 51% shares of Red October and 52% of shares of another Moscow confectionery market leader - Rot

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The new owners of Red October confectionery company, which also holds a controlling stake in Rot Front, another leader of the Moscow market, said they plan to create a holding on the base of the two companies. The two confectioneries would have a common strategy of market expansion and coordinate marketing and advertising policy. The holding plans to economize on purchasing and transport expenditures. Gosinkors initial plans also include the affiliation of Babayevsky confectionery concern. In June 2002 there were reports of Gosinkor buying the debts of Babayebsky, which raises suspicion that Gosinkor is likely to undertake a hostile takeover of the factory. Sales policy A distinctive feature of Red Octobers distribution policy is that it tries to sell most of its output through its own regional retail network. In addition to the retail centers Red October has a number of its own outlets in the main cities and holds its own departments in the big food stores. This policy is equally employed by almost all Russian confectionery producers. High expenses on the outlets are believed to be the main reason for high distribution costs. In contrast to domestic producers foreign confectioners set up regional representative offices in the regions and distribute their products through major regional wholesalers. Another feature of Russian producers is that they produce a huge number of different goods, which reduces the opportunity for effective marketing policy. Currently Red October produces up to 400 different items of confectionery. Foreigners, instead, focus on a few brand names, which are actively advertised in the mass media. We believe that Red October would be better of if it considerably reduced the number of product lines. Finally, the success of foreign companies on the Russian market could be partly explained by the low margins they charge on the products. This helps them a lot in expanding their market share at the expense of Russian producers. Price is one of the most important factors determining demand for confectionery, which is not considered as an item of prime necessity. Consolidation of Red October and Rot Front help to reduce production costs and cut retail prices. Most of the benefits are expected to come from centralized purchasing of cocoa beans, which are the main ingredient of chocolate and top-of-the-range candies. The prices for cocoa beans are highly dependent on the volume purchased. Consolidation would also have a positive effect on reducing management expenses, distribution and advertising costs. Therefore, we believe the merger of the two confectioneries will have highly positive effect on the fi-

nancial position of both. As we said earlier, indications appear to suggest that Gosinkor is interested in the acquisition of the Babayevsky confectionery concern. Gosinkor reportedly wants to unite all three confectioneries into the Moscow Food Corporation. Should that take place it would positively affect the valuation of all incorporated companies. Costs The main factor affecting the costs of confectionery production are the prices of cocoa beans and sugar, the main ingredients of chocolates and caramel. Since cocoa beans are not produced in Russia domestic chocolate producers have to import from abroad, which makes production of chocolate highly sensitive to world cocoa prices, as cocoa accounts for up to 90% of the costs. Meanwhile, over the last few months the world price for cocoa beans appeared to be on the up. From the beginning of 2002 the exchange price for cocoa beans went up by more than a third, which is likely to have negative effect on the profitability of chocolate production. Yet, since confectioners usually conclude long term contracts on cocoa bean supplies the recent price hike would likely to have had effect only at the end of the year. Russia is also a large importer of sugar. Although it has its own sugar production, the volume of sugar produced covers only one third of domestic consumption. On average Russia imports about 4 million tons of sugar a year, which makes it the largest sugar importer in the world. Besides, Russian sugar producers make white sugar from beet, which substantially increases the costs of sugar production. To protect domestic sugar producers the government introduced both quotas and customs duties on the import of white and raw cane sugar. These two factors would undoubtedly affect the profitability of Red Octobers production. But this will likely be mitigated by the unification of purchasing capacities of the two companies. Dividend policy Red October has always appeared to be a poor dividend payer. Although the company almost always pays dividends to its shareholder, their volumes are too small. As we can see from the table the dividend payout ratio was just above 5% last year and less than 4% this year. That is far below international standards and the new levels of payments set by the leaders of the Russian stock market in the last few years. 1999 0.041 0.96% 2000 0.039 5.08% 2001 0.041 3.93%

Dividend (common), USD Dividend payout ratio Investment plans

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According to the head of Gosinkor Artem Kuznetsov, the Holding plans to invest up to $20m in the confectioneries and bring the market share of the new Holding up to 25%. The latter seems to be an overly optimistic target, as it means that the Holding needs to double its production capacities. In the future Gosinkor plans to transfer both enterprises to a single share. Over the next 18 months it also plans to list on international capital markets through ADR issue. Gosinkor hopes to raise some $100m through the sale of its shares in the West. We reckon that the ADR issue would be the main driver of Red October stocks in the next 1-1.5 years, as it would force the owners to undertake actions, which aimed at raising market valuation. Strategies for the future Russias confectionery sector has huge growth potential. As the experience of the Eastern European markets shows, consumer demand shifts towards higher-priced confectionery goods, such as chocolates and luxury candies, as household income grows. These are also the products which generate the highest profits. In our view Red October needs to take account of changes in demand structure, which would allow the company to reap the

most benefits from the emerging opportunities. Another point that needs to be addressed is advertising strategy. Currently Red Octobers advertisements call upon consumers to remember the tastes they knew from childhood. Although this slogan effectively exploits the main market advantage of the company, its well-known brand name, it seems to miss the young generation of customers, which are just developing their preferences. Liquidity of shares Red Octobers stocks are highly illiquid. Over the first six months of this year there were only 20 deals with Red Octobers stocks registered on RTS. The overall volume of trades totaled just $122,000. The bid/ask spread equals about 45% of the mid price which makes them highly attractive assets for short term investments. The figure reached about 60% in April when the quotes on the stocks of the company started to climb up on the back on the news that Gosinkor consolidates the confectionery enterprises. Yet, we believe that in the long-term perspective the stocks have huge growth potential as the recent financial achievements of the company were basically not priced in the stocks.

Summary: On the basis of what we said above we can see that Red October is undervalued. Meanwhile, due to certain objective reasons, the short-term appreciation of confectionery stocks is unlikely. As we believe that Red October stocks have very good growth potential, we recommend them for long-term investments.

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RESEARCH Alexander Korchagin, Head of Research Strategy / Macroeconomics Telecommunications / Transport Retail / Consumer Goods / Banks Editor Alexander Korchagin korchagin@prospect.com.ru Alexey Zaitsev zaitsev@prospect.com.ru Marat Ibragimov mibragim@prospect.com.ru Adam Smith adam.smith@prospect.com.ru TRADING Andrey Galperin, Managing Director Vadim Verhovski, Vice-President Igor Lossavio Nikolai Gusev Anton Kashtanov Andrey Usachev Alexander Lobanov PROSPECT INVESTMENT Address: phone: fax: e-mail: Internet: Vrubel street 12, Moscow, Russia, 125080 7 - (095) - 937 - 3363 7 - (095) - 937 - 3360 research@prospect.com.ru http://www.prospect.com.ru BLOOMBERG: PSPR <GO> Oil&Gas Utilities Engineering / Autos / Metals Dmitry Druzhinin druzhinin@prospect.com.ru Vitaly Natarov vnatarov@prospect.com.ru Nikolai Ivanov ivanov@prospect.com.ru

The information presented herein was obtained from sources to be reliable. Nevertheless, the contents of this report should be used for informational purposes only, and PROSPECT INVESTMENT cannot be held responsible for its accuracy. This document is neither an offer nor a solicitation to buy or sell any securities, and is specifically not a recommendation to buy or sell the securities described herein. We and our officers, including persons involved in the preparation of this material may have positions in, and sell or buy, the securities of the mentioned companies. Investing in the CIS is inherently risky, and all investors should perform their own due diligence prior to investment. All rights reserved. No reproduction is permitted in whole or part without the written consent of PROSPECT INVESTMENT.

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