In the face of some USD 130 bn in net capital outflows in 4Q08 and continued pressures in 1Q09, the Central Bank of Russia has finally abandoned its increasingly costly efforts to support the RUB. Over the course of the week, the central bank has permitted further controlled devaluation of the RUB against the dual-currency basket (55% USD and 45% EUR), with the official rate gaining for the fifth time this week (up another 1.5% to RUB 37.3). Both the USD and EUR set new records against the RUB, with the RUB/EUR rate gaining to more than RUB 43.0 and the RUB/USD rate advancing to more than RUB 32.6.

Versus the USD, the RUB has now retreated some 29% from its July 2008 high of RUB 23.13, or 17% since the CBR introduced more flexible currency controls on November 11, 2008. Despite the already substantial RUB weakening, the slide looks set to continue in the short term, with businesses bracing for support somewhere in the RUB 37-45 per USD corridor.

What does this mean for companies earning revenues in RUB?

While the rapid devaluation will provide support to the country's suffering commodities exporters, enterprises focused on the domestic market will see real revenues hampered at least through YE09 (and potentially much longer). The stocks of Russia's few liquid IT/Media players have already been pummeled on both domestic and foreign markets as participants price in the expected pressure on revenues.

* Note that RBC Information Systems remains pressured by both macroeconomic forces and the company's approaching insolvency. While RBC undoubtedly still holds value, the looming legal firefight is likely to be dirty; investors unfortunate enough to be holding the company's securities would be well advised to flee while they still can.

Across Russia, companies have reacted to the RUB devaluation by converting as much cash as possible into foreign currencies and rapidly switching from RUB- to USD-denominated sales. Companies with long-term, RUB-denominated contracts will inevitably get stuck holding the ball as they see the real value of those contracts dwindle. However, with expenses largely RUB-denominated, profit margins should remain resilient.

Certain sectors of the economy will be particularly hard hit, most notably developers and consumer creditors (if they still exist). Middle- and upper-class Russians who took out foreign-currency loans and mortgages during the boom times will be hard pressed to meet their obligations, as an effective salary freeze will remain in place even as another 15-30% of the RUB's value goes down the drain. The resulting fallout in property prices will be widespread and particularly toxic.

Impact on Russian IT

The hardware divisions of Russia's IT providers, which depend on domestic sales of foreign-manufactured equipment, should be relatively immune to the RUB's tumble; however, while hardware sales continue to contribute the lion's share of revenues for Armada and IBS Group, their profit margins (and thus equity value) have long been minimized. As in the past, price increases will be borne by end consumers. The crisis will inevitably bring about a prolonged slump in hardware sales, the beginning of which was already felt in 4Q08. This combined with a fundamental shift in the cost of equity will result in moderate erosion of what little equity value Russian hardware sellers have. However, no meltdown is to be expected in the segment.

The IT services and software development segments of Russia's IT sector are far less sheltered from the effects of the crisis. Purely domestic players like Armada (which is heavily dependent on revenues from government tenders and state-owned companies) are naturally exposed to the combined effects of a general slump in IT spending combined with the shrinking USD-equivalent value of their contracts. More diversified players like IBS Group and Sitronics are little better off, as the bulk of their revenues are still generated domestically. Sitronics' de facto status as a strategic asset has already provided the company with protection from default, but the long-term impact on shareholders' equity is uncertain. Needless to say, shareholder value is in dangerous and uncharted waters.

IBS Group, with its relatively lower profit margins and uncertain debt position, looks particularly vulnerable. The group has not published financial results since October 2008, and has given no indication about when it next intends to. As such, the group's capacity to remain solvent through the crisis is unknown, while news of management's efforts to raise capital have circulated particularly fervently in the past few days.

Impact on Russian Media

In times of crisis, television operators (especially large FTA broadcasters) have historically been the most insulated from advertising market contractions. Even so, following the 1998 crisis, Russia's aggregate television advertising market shrunk 65% in the span of two years (from USD 550 mn in 1997 to USD 190 mn in 1999). The contraction in 2009 won't be nearly as drastic, but the current RUB devaluation could still cut broadcasters' USD-denominated revenues by 20-30% y-o-y. Russia's FTA advertising revenues have shown somewhat versatile performance so far in 2009, with initial figures suggesting that nominal RUB-denominated market volume should remain stable or grow slightly from the levels seen in 2008. But advertisers remain wary of making long-term commitments; many have so far signed on only for three- or six-month contracts, with advertising budgets set to be reviewed on a quarterly basis. Furthermore, as CTC Media's experience in 4Q08 shows, advertisers always retain the option of canceling their preexisting contracts if market conditions worsen (though such withdrawal carries heavy sanctions).

With the exception of online advertising, other segments of Russia's advertising market are unlikely to fare as well as the television segment. 2H08 already brought a notable contraction in print media advertising, and similar 10-20% real declines can be expected in the outdoor and radio advertising segments. Online advertising looks poised to match or slightly exceed 2008's advertising volume, which would imply a major slowdown from the 50% y-o-y real growth seen in 2008

CTC Media still looks best poised to ride out the storm, though servicing the company's USD 135 mn credit facility (attracted in July 2008 to fund the purchase of the DTV network) will prove costly as USD-denominated revenues fall. Despite these difficulties, the crisis has at no point threatened CTC Media's capacity to operate as a going concern.

At the other end of the spectrum, Rambler Media remains about as liquid as an ice cube in Antarctica in July. The run up to the new year brought a stunning two-day combined trading volume of nearly USD 25 000, but activity since then has been decidedly muted. While one day in the future Rambler may present an attractive investment play, that day is unlikely to dawn any time soon. Meanwhile, both RBC Information Systems and O2TV appear likely to default in 2009.

Efficient markets?

After factoring in the most pessimistic scenarios imaginable (short of a full scale simultaneous invasion of Russia proper by both NATO and the People's Republic), both Armada and CTC Media appear heavily oversold. Even assuming a further 20-30% drop in the value of the RUB in 2009, followed by gradual appreciation in 2010 and beyond, as well as a 20% decrease in the USD volume of Russia's television advertising market in 2009, CTC Media's current stock price still implies a WACC of some 25% (and a corresponding COE of well over 30%). While today that may well be the case, such high premiums are unlikely to persist. At some point, capital will return to Russian equities.

The case for Armada is more clear cut (though the company's current USD 10 mn market cap will continue to scare off even the most risk tolerant investors until the macroeconomic environment grows calmer; for reference, the market cap of Armada is now roughly equivalent to the cost of 30 standard apartments in Moscow). Despite the stock's 95% nosedive over the past 12 months, Armada retains a healthy business model and an immaculate balance sheet, with minimal debt (the company did attract USD 16 mn in credit in 2008 in anticipation of M&A activity).

At the end of 2007, Armada had cash on its balance sheet of RUB 572 mn and can be reasonably expected to have earned net profit of at least RUB 300 mn in 2008. By even the most conservative calculations, Armada's YE08 book value should be at least RUB 800 mn (even after writing down the company's intangibles by 50% and assuming a 100% loss on RUB 575 mn in marketable securities owned at YE07). By these assumptions, Armada is now trading at a P/B of no more than 0.4x (the actual figure is likely closer to 0.25x).

More monsters in the shadows?

While both Armada and CTC Media look attractive, in the short term volatility in equities will continue to reign supreme. Only the truly masochistic would approach either until commodity prices (especially crude oil) show signs of recovery. Until this happens, the RUB will remain vulnerable to downward pressures, with resulting effects on the prices of both stocks (more so on CTC Media, which is traded in USD). The current stockpiling of oil reserves and other commodities is likely to make downward pressure on the RUB prolonged.

Nevertheless, we're long-term bullish on the RUB for a variety of reasons:

• Despite statements of independence on this issue, Russia is likely to work with OPEC to support oil prices, as well as further its interests in establishing a gas cartel.
• The current lapse in extraction capex will inevitably result in a capacity shortfall when aggregate demand returns. With Chinese GDP almost certain to continue growing in 2009 despite the crisis, the return of aggregate demand is apt to come sooner than later.
• Russia's equity and foreign-currency bond markets are among the cheapest in the world, discounted substantially to markets of more questionable stability like Argentina, India, and Turkey. If nothing else, raw capitalist greed will bring foreign money back.

Armada remains acutely sensitive to government IT spending, and it's not beyond the realm of possibility that the Russian government could revise downward its budget for 2009 in response to the plunge in commodities. To date, however, the government has implemented a pro-active and pragmatic approach to dealing with the financial crisis. Both Minister of Finance Alexei Kudrin and Presidential Aide Arkady Dvorkovich have underscored the government's willingness to fund deficit spending in 2009 and 2010 to support the real sector.

Even at a budget deficit of 5% of GDP (about USD 65 bn), the current USD 420 bn in foreign currency reserves held in the reserve fund would provide ample protection for a deep and protracted crisis. Though Armada is certain to see some downward pressure on revenues as various current and previous clients encounter financial difficulties, the company has reacted quickly to focus itself on government tenders and state-owned companies, and looks well positioned to ride out the crisis with few disruptions.