#15
Washington Post
June 23, 2002
What the Soviets Created, Russia and Investors Must
Slay
By William F. Browder
MOSCOW
William Browder is the chief executive officer of Hermitage Capital Management.
On June 6, the U.S. Department of Commerce declared Russia a free-market economy. On the surface, that historic judgment seems reasonable. After all, only 12 percent of Russian enterprises are still owned entirely by the state. Russian government outlays as a percentage of GDP in 2000 stood at just 30 percent, the same as in the United States. Moreover, President Vladimir Putin has cracked down on greedy oligarchs and welcomed foreign trade and investment. Four years after the collapse of the ruble and Russian economy, investors are flocking back here in droves and the Russian stock market is up 90 percent in the past 12 months.
But there is another test of the character of Russia's economy: the fate of the country's largest company, the natural gas giant Gazprom. Monstrously mismanaged, unaccountable to shareholders and politically well connected, Gazprom remains a challenge to the integrity of Russia's free-market economy. Moreover, it poses a challenge to Russian democracy itself, which needs to foster independent public institutions -- like independent courts and regulatory agencies -- and a private sector that truly respects property and the rights of shareholders.
Shareholders like me. I manage the largest international fund in Russia, one with a significant investment in Gazprom. During the seven years I have lived in Russia, I have fought in many ways against corporate corruption and abuses, but nowhere are the stakes as high as they are in Gazprom. This year I decided to take my fight to a new level by running as a minority shareholder candidate for the board of Gazprom at the company's annual meeting on Friday. If successful, I believe I can advance not only my interests, but Russia's.
Why is Gazprom so important? Gazprom is not only Russia's biggest company, but also one of the largest companies in the world -- and its potential boggles the mind. It holds 25 percent of the world's natural gas reserves, which makes it as big as Saudi Arabia in terms of hydrocarbon holdings and 10 times the size of Exxon Corp., the largest publicly traded oil and gas company in the world. Gazprom brings in 20 percent of Russia's export income and pays 18 percent of its tax revenue. Yet in spite of its size and importance, the market capitalization of Gazprom is so small that it's a national embarrassment. The company currently has a market value of $25 billion, less than that of smaller firms such as AT&T Wireless or Fox Entertainment. Or to put it another way, the price of Gazprom's stock implies a value of 21 cents per barrel of oil reserves, 98 percent less than the value investors attach to Exxon's reserves. Exxon's stock price translates into $13 per barrel.
When something is cheap, it is usually cheap for a reason. In the case of Gazprom, there are several good reasons. The extremely low valuation of the company is the result of many years of asset stripping and lack of transparency. It is also a reflection of investors' uncertainty about government intentions to clean up the company or free the firm from costly regulations. If Russia cannot get its most valuable company in order, what about the rest of its economy?
Most of Gazprom's problems pre-date the Putin regime. First,past managers were allowed by the Kremlin to engage in what can only be called an orgy of stealing. Under President Boris Yeltsin, they transferred ownership of 18.4 billion cubic meters of gas reserves to a shadowy Florida-based company called Itera for little or no consideration. This allowed Itera to grow from scratch to something larger than Chevron Texaco in less than five years.
Second, Russia's heavily regulated system of selling gas to consumers -- at way below the market price -- has hobbled the company's profits. Despite liberalization in other areas, natural gas prices have remained firmly stuck under state control in a style reminiscent of the Soviet system. Gazprom has been forced to sell its gas to domestic customers for 89 percent less than German companies pay. This unrealistic discount distorts the Russian economy, and hurts Gazprom, which essentially subsidizes other Russian companies (including many grossly inefficient ones) at a cost of about $43 billion a year.
Finally, harsh and discriminatory ownership restrictions have been imposed on foreignersinvesting in Gazprom. Any foreign investor willing to buy Gazprom shares has had to pay a huge premium, effectively meaning nearly a 100 percent "penalty" for not being Russian. Rather than pay this discriminatory "tax," a lot of foreigners investing in Russia have chosen to avoid Gazprom altogether. Foreign investors own only $1 billion of Gazprom stock, which pales beside the $15 billion foreign ownership of Telmex, the Mexican phone company. This hurts Gazprom's, and Russia's, ability to attract needed capital from abroad.
Before Westerners grow smug about the integrity of their own companies and economies (if that's still possible after the recent corporate scandals in the United States), consider this: Gazprom management kept questionable transactions within the company a closely guarded secret with a bit of Western help. The esteemed U.S. accounting firm PricewaterhouseCoopers conveniently failed to mention any of the asset-stripping inits annual reports while working as Gazprom's auditor from 1996 to 2002. Its omissions included billions of dollars' worth of transactions to companies directly owned by family members of Gazprom management.
Putin entered the Gazprom fray last summer and made headlines in an effort to clean up the mess. He fired Rem Vyakhirev, the asset-stripping CEO, and replaced him with a loyal technocrat named Alexei Miller, who was given a mandate to recover lost assets and improve transparency. Putin also instructed the government to liberalize gas prices, and he set up a commission to change the rules so that foreign investors could buy Gazprom shares without any restrictions. The share price doubled over the next 12 months in anticipation of all the improvements.
Unfortunately, Putin couldn't micromanage the whole process, and what started out with the best of intentions ended up with mixed results. On the transparency front, it looked promising at first. As my fund filed lawsuits against PricewaterhouseCoopers for false and misleading audits and the Russian government launched two separate investigations into PricewaterhouseCoopers' auditing at Gazprom, the new Gazprom CEO held a competitive tender process to select a new auditor for the first time in history. But hopes dimmed when the board of Gazprom mysteriously chose to rehire PricewaterhouseCoopers, even though the auditing firm whitewashed the past management's misdeeds.
The asset recovery exercise also started out looking good. After about six months on the job, Miller announced that he had recovered two of the seven gas fields that were taken from Gazprom. He also organized the arrest and indictment of several former executives who had been involved in another asset-stripping scheme. However, Gazprom has been something akin to the mythical nine-headed Hydra. As soon as Hercules chopped off one of its heads, two others grew back. Just as Miller declared victory over two major asset recoveries, three more scams were discovered in Gazprom's gas distribution business. The scams were estimated to cost Gazprom between $1 billion and $2 billion annually.
On the domestic subsidy issue, the news has been likewise mixed. After lengthy debates, the government raised domestic natural gas tariffs 37.5 percent, from $13.30 to $18.30 per thousand cubic meters. This sounds like a decisive step until you look at how far prices still need to be raised. The 2001 tariff increase narrowed the Russian-German discount from 89 percent to 85 percent. At this pace, it will take six years for Russian gas prices to achieve parity with the West's.
The final disappointment came from the commission set up to liberalize foreign ownership of Gazprom shares. The commission started meeting last summer. But instead of eliminating the discriminatory ownership structure for foreigners, commission members ended up quarrelling over how to somehow divert the premium to themselves. In theory, there was as much as $4.5 billion just sitting there waiting for them. Their fight couldn't be resolved, so the commission sent four different proposals to Putin. Each recommended a different recipient of the foreigners' premium through complicated auction procedures, but none backed liberalizing the rules for foreign ownership of Gazprom. The problem remains and most foreigners continue to stay away from Gazprom shares.
To guarantee his place in the history books, Putin needs to ensure continued economic growth -- and nowhere can he make a bigger contribution than by increasing the value and effectiveness of Gazprom, and making it a model for Russia's market economy. He should re-visit his initial to-do list at Gazprom and implement real reform. He should instruct the government, which owns a 38 percent block of Gazprom stock, to use its shareholder votes in the June 28 annual meeting to fire PricewaterhouseCoopers and bring in a new independent auditor to do a comprehensive forensic audit of the company and identify where theft took place. Next, he should set up a special commission to retrieve all lost assets of Gazprom whatever the political connections of the new owners of those assets. Then, he should set a three-year schedule for raising gas prices to market levels. Finally, he should allow free trading of Gazprom shares regardless of the nationality of their owners.
If these steps were taken, I believe the value of Gazprom would rise between five-fold and ten-fold.The value of the government-owned 38 percent stake in Gazprom would also increase to nearly $100 billion, which could help erase much of Russia's sovereign debt burden and open up new channels for investment and growth.
Most important, the increased valuation and openness at Gazprom would also send a powerful signal to other Russian companies plagued with corporate governance problems and for whom asset-stripping, diluting stock issues and violations of shareholder rights have become the norm of doing business in Russia in the '90s. Both domestic and foreign investors would be encouraged, and it would reinforce the notion that companies, like Russian society at large, have many stakeholders, voices and responsibilities.
In his address to the nation, Putin said, "Nobody is going to help us. We have to fight for a place under the economic sun on our own." This is not entirely true. There are many non-Russians, including myself, who are interested in Russia's success. My interest is partly familial: My grandfather, Earl Browder, was head of the American Communist Party before being ousted by Stalin in 1945. What happens in Russia has long been important to my family.
Do I also have an economic interest in the outcome of the Gazprom story? You bet I do. But my economic interest is also Russia's. I believe that by properly implementing reform at Gazprom, Putin would personally help Russia achieve financial security and economic prosperity for the next generation.
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