Ukrainian Crisis: Will Russian ADRs Take a Hit?

Ukrainian Crisis: Will Russian ADRs Take a Hit?

As you know, Ukraine is facing hard times, and this political turmoil is hammering its economy. Former president Viktor Yanukovych's refusal to enter into a free trade pact with the European Union in search of a closer relationship with Russia triggered a series of massive protests that ended with around 80 civilians killed by security forces. Guess what? Viktor Yanukovych fled the country and is no longer in power.

A new international military conflict
Now, with Russian forces operating inside Crimea, is when things get messy. No one knows what will happen next, and this situation is making markets around the world swoon. According to Bank of America Merrill Lynch economist Vladimir Osakovskiy, "Direct costs of war to Russia could reach at least 3% of GDP." Moreover, exports of gas from Russia to Europe are carried out through Ukraine and would most likely be disrupted in the case of a war.

The Russian ruble has declined to a five-year low. However, some analysts expect that the Central Bank of Russia might start a stronger intervention to keep things calm. The most likely way of doing this would be by raising market rates and selling hard currency, capturing liquidity, which would cool down the economy.

Three Russian ADRs
The picture is still very uncertain, but let's try to understand what scenarios are facing two companies involved in telecommunications and one in mining and steel.

The first company to watch is the leading broadband provider in Russia and the sixth-largest mobile operator in the world, VimpelCom . This telecom behemoth operates in roughly 18 countries.

Unfortunately, no good news is coming from the company recently. It announced a dividend reduction for this year of more than 50% (now $0.035 per share). VimpelCom will continue with the reductions until its leverage ratio drops below two times EBITDA. So the scenario is not especially tempting.

Despite the company's international exposure, Russia is still its most important market in terms of operational importance and investor sentiment, which right now only adds exposure. In fact, Russia accounts for 40% of operating revenue.

In better shape
The second company is Vimpelcom's archrival and market leader Mobile Telesystems OJSC . This company has a massive footprint in Russia and the Commonwealth of Independent States, or CIS, and is the leader in nearly all of the countries it serves.

As opposed to VimpelCom, Mobile Telesystems announced a dividend hike. In fact, it will be a cumulative payout in 2014 and 2015 of at least $2.6 billion due to its rise in free cash flow and strong operating results. This will probably make investors shift their positions in other telecoms to this company.

Mobile TeleSystems owns the most compelling investment case in the Russian telecom sector. It has a healthier balance sheet, a stronger network, and a stable dividend. For the past few years, the company has refocused on economic efficiency and margin expansion -- and it's paying off.

High debts
The third company is Mechel OAO , Russia's second-largest producer of specialty steel and long steel products -- and, after many acquisitions, one of the largest producers of coking coal.

Weak demand of coking coal was the main driver of the company's poor third-quarter results, which resulted in a sequential drop in sales. The picture is not good, as the company had an operating loss of $432 million, and revenue from external customers dropped 19% year over year.

Despite the performance, Mechel has some strong fundamentals. It is the only specialty steelmaker in the world capable of internally sourcing most of its raw materials. It can source 100% of coking coal, 30% of iron ore, and 89% of nickel requirements of its steel segment, adding a cost advantage. Plus, through the purchase of two strategic ports -- Port Kambarka, one of Russia's largest river ports, and another in the Sea of Japan -- the company is optimizing transportation expenses.

Nonetheless, Mechel's high debt and its substantial interest burden is risky, given the scenario. The company's debt on its books is roughly $9.3 billion -- nearly 10 times its market capitalization. So, given rising rates and credit crunching, things could get really tough.

The situation is still unstable and unpredictable. So what should you do? Be prepared. For reasons that go beyond the latest headlines out of Ukraine, investors already had a negative outlook on Russia, and this can be noticed in the weakening of its local currency and the performance of its stock market.

If you want exposure to Russian telecoms, Mobile Telesystems is certainly the most compelling investment case. The company is solid and will continue to do well, though in the near term its stock price could experience variability.

However, as telecoms depend on government approvals for license renewals and acquisitions, the political turmoil could raise risks. For example, the Russian government is rumored to have ties with MegaFon, a competitor. Plus, both companies have businesses in Ukraine, as VimpelCom, for example, operates a fiber-optic network at a national level there.

Mechel's fundamentals are strong, but its debt level is just too high for this scenario where rates can go up. The company needs to return to profitability and be able to generate cash to start paying back its debts.

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