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Gazprom's low cash flow, high spending

Russia's gas behemoth continues to sink money into projects of dubious value

Gazprom seems hell-bent on focusing on "value-destructive" investment projects rather than complying with a Kremlin decree to raise dividends, investment analysts say.

The latest plan to cause dismay amongst investors is a $1bn expansion of the Sakhalin-Khabarovsk-Vladivostok (SKhV) gas pipeline. Gazprom built the original pipeline in 2011 to transport natural gas to China and other Asian markets via Vladivostok.

The company claims the expansion is required for the provision of future gas deliveries to customers in the Far East, deliveries for the planned Far East Petrochemical Complex (Fepco) and a fertilizer production plant near Vladivostok.

But analysts say the project will barely be used and that the money would be better spent raising dividends, which would help buttress the monopoly's flagging share price. To compound concerns, Stroytransneftegaz is to be appointed to build the extension without any competition, according to a report in Kommersant newspaper. The construction company, which is controlled by President Vladimir Putin's key ally Gennady Timchenko, has already been selected to build the $1.3bn Force of Siberia gas pipeline.

"We see no rationale for this project," says Dmitry Loukashov, an oil and gas analyst with VTB Capital. "We believe that this investment, which amounts to some 2% of the company's current market cap, is highly likely to become value-destructive for Gazprom and negative for the company's fundamentals and the stock."

In late April, the Kremlin decreed that state-owned companies must fork out half of their earnings in dividends, in a renewed bid to squeeze companies like Gazprom.

The windfall is intended to prop up the federal budget, which has been hit by recession, lower energy prices and sanctions imposed by the US and the European Union. In February, Russia's deputy economy minister Olga Dergunova said that increasing dividend payments could bring as much as 100bn rubles ($1.7bn) in additional income.

Gazprom, the world's largest gas producer, is the biggest contributor of dividends to Russia's federal budget. The company reported on April 27 that net profit had surged by 21% in 2016 to 951.6bn rubles, helped by the appreciation of the ruble on foreign exchanges.

The decree, which was signed by Prime Minister Dmitry Medvedev and approved by President Vladimir Putin, follows a similar order last year that was widely ignored. And there appears to be plenty of wiggle room this year for companies to offer dividends way below the mandated level—Deputy Prime Minister Arkady Dvorkovich has even admitted that exceptions are possible.

Last year, Gazprom agreed to pay a dividend of 7.89 rubles per share, or just 24% of its 2015 profits under International Financial Reporting Standards, having been granted a waiver by the government.

Profits on paper

Remarks by President Putin at a Beijing conference in mid-May suggest another waiver may be on the way. Putin said Gazprom's profits existed on paper, but that "there isn't a real cash flow", according to a Financial Times report. "So when the government makes a decision about this issue, it's going to take the real situation into account, and not the company's paper income," he said.

Meanwhile, Rosneft, Russia's largest oil producer, also plans to dodge its obligation by paying out 35% of its 2016 earnings in dividends.

Analysts believe Gazprom will use new investment projects, such as SKhV, as an argument not to increase dividends this year. Other strains on their capital expenditure include Power of Siberia, Nord Stream-2 and Turkish Stream, which analysts estimate could cumulatively cost the company $22bn-$24bn per year over the next few years.

Gazprom's capital expenditure programme, its size and sources of financing remains the key concern for investors. Given that Gazprom's free cash flow—operating cash flow less capital expenditure—for 2016 was just 202bn rubles, an increase in capital spending now could easily push annual free cash flow into negative territory for the first time in 11 years.

A €4.75bn ($5.25bn) financing deal signed with five European companies on 25 April to build the Nord Stream 2 pipeline provides some relief to Gazprom's massive investment burden. The deal, which secures 50% of the project's cost, was closed with Anglo-Dutch giant Shell, France's Engie, Germany's Uniper and Wintershall, and OMV of Austria each providing €0.95bn.

Gazprom, which is not subject to Western sanctions resulting from Russian interference in the Ukraine conflict, could try to borrow heavily on capital markets to pay the higher dividend payments.

But most investors think Gazprom will neither pay the higher dividend nor be prepared to rein in its ambitious capex programme. That's reflected in the company's share price, which has declined 12% over the past year, compared to a 9.5% rise for the broader Micex Index covering companies on the Moscow stock exchange.

In an earnings call with analysts on 27 April, Gazprom's management said its capex guidance for 2017 remained unchanged at 1.7 trillion rubles, while indicating dividends would remain in check.

"The question about the 50% dividend pushed by the government has been discussed with one variation or another from year to year," said Alexander Ivannikov, Gazprom's chief finance officer. "So, the best way to approach it is to open up newspapers from last year and see the scenario which followed."

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