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Hi Caglar, welcome back from your trip! Many analysts are looking to Russia’s opening as a good model for how Iran might look after sanctions are lifted, do you think it’s a good template?
Frankly, I’m leery of the comparison. Yes, from the standpoint of having entrenched, vested interests like the Revolutionary guard that have influence on some key industries as well as the fact that they’re dealing with a totalizing ideology among hardliners, there are some parallels, but Iran has a dramatically different culture than Russia. Persian society has been much more open to the West over its history, with the last thirty years really an aberration. I met with some pharmaceutical companies during my stay that used to be the foreign subsidiaries of several prominent Western firms and continued operating despite the regime. They were initially nationalized then later privatized, but throughout they tried to perpetuate a culture of transparency and embrace technology and openness. I think these firms are an exemplar of the businesses I came across while travelling in Iran. I believe the country will open up faster and with less existential angst than Russia did in the late 90s, that said, the current regime is very aware of moving too fast and unleashing forces that they can’t control. The February elections will be a key barometer for the pace of change.
Could Iran be like Russia in that they allow capital to flow to the energy complex, but accept limited reform or involvement otherwise?
Possible, but consider this, starting in 2005 the government began to privatize SOEs and gave a target of maximum 20% government ownership by the end of the process. Due to its isolation, no foreign companies were allowed to bid because of the sanctions, so government pension funds, Revolutionary guard vehicles and the like bought up all the deals. The gist is that they tried to let market forces decide on the prices of these businesses and then allowed them the opportunity to modernize. This was actually a pragmatic move for financial reasons but also to throw a bone to voters clamoring for change. As it stands right now there are no internal restrictions on foreign investment in Iran, just measures imposed from the outside. A note of caution too; suspicion surrounding foreign investment goes all the way back to the 1908 formation of the Anglo-Persian Oil Company and even some events that happened around the Reuter concession in the 19th century! Memories are long in this part of the world.
On the flip side, what are the odds that Iran could look like Turkey from 2002-2007 with a banking sector recapitalization, shareholder activism and some social and economic reform?
It’s interesting that Rouhani is surrounding himself with PhDs educated in the U.S. — in greater quantity I’m told than any other emerging market country — which gives you an indication of the direction they are headed. Most of the cabinet has studied and lived abroad and the one thing that I heard consistently is that they feel they cannot continue with business as usual in Iran. Even if you’re pro-regime you need to satisfy the desires of a restless, youthful population and one major avenue is boosting the economy and accelerating employment. The policies pursued under Ahmadinejad were a disaster, as capping interest rates lead to severe inflation, which has been brought down from 45% in 2013 to around 10% today. As far as a bank recap, we’ll see what happens when frozen offshore cash gets repatriated. The banking system is very well developed with roughly 90% of Iranians holding accounts and 75% using debit cards, but the industry has a serious NPL issue on the order of 25% of loans in the extreme case. Iran could see around $40-50 billion flowing back to the country over the next twelve months so a mechanism for recap might be there, but it’s still a very fluid situation.
A surprise for many in the West is how balanced the Iranian economy is…
Yes, despite having the world’s largest natural gas reserves and the fourth largest oil reserves, these segments only represent about 15% of an economy that is the third largest in the region on PPP terms, after Saudi and Turkey. GDP per capita on the same measure is around $16K, which is close to Mexico. Service industries make up about 53% of GDP, the industrial base is well developed and they produce as much electricity as Turkey. Interestingly, at the brokerage firm we visited on our trip all the traders were women. And at the Tehran stock exchange about half the workforce consisted of women. So, unlike some GCC countries, Iran is not sacrificing productivity by limiting the participation of half the population. Despite being relatively progressive, women only constitute 20% of the workforce, so there is much progress still to come. Today, women edge men in tertiary degree programs in Iran and the country produces the 5th largest cohort of technical degree graduates in the world. The overall population is highly literate at 85%, and this shoots to 98% for 15-24-year-olds. Internet penetration is the highest in the region at 54% with the Iranian equivalent of Amazon, Uber and GroupOn all part of a broader consumption story. I mean, even the Supreme Leader tweets! There is an increasingly wired generation that is asserting itself and this will continue.
So, with 318 listed companies, a market value of around $100B and average turnover of $40-50M some investors are expecting portfolio inflows between $500M and $1B in 2016. With the market at 5x forward numbers and an eye popping 11% dividend, are valuations destined to go higher in the short to medium term?
Since the beginning of 2014 the market is down about 30%. Commodity-related stocks account for roughly half of the index, along with petrochemicals, metals and mining, and this group is suffering along with the rest of the world as prices collapse and demand slows. Combine these companies with financials at 17% of the market and you’ve got two-thirds of the companies under duress. Fiscal and monetary tightening has led to a liquidity squeeze in the broader economy and has also made equities less attractive than simple bank deposits that currently yield about 20%. While you will indeed see inflows from European and Asian investors over this year, you’ll have to be very careful where you’re investing. Stated dividends may not be close to actual, or they may pay with delay, and more importantly being able to discern the truly private firms from those under some form of control will require significant on-the-ground due diligence. This market has more Frontier-like governance issues with nonexistent minority rights, so the ability to comprehensively cross-check references and data across the financial system, between brokers, bankers, the stock exchange, management, offshore family offices, high net worth individuals and PE players will be the key to finding winners and losers.
As far as the types of long-run vectors that we like to talk about, Iran seems to be perfectly positioned…
Yes, valuations are low, corporate profitability has a lot of room to expand and debt is negligible, there are high real interest rates, youthful demographics overall with half the population under 30, a relatively high regulatory burden and low investment with low productivity of capital. As far as variables that can get better over time to surf the long investment wave, there are a lot of things to point to, no doubt. Cost of capital is a huge issue. Even the government can’t borrow at less than 20%.
Maybe that’s why government debt-to-gdp is around 15%…
If you’re a company and you want to invest in a project your cost of debt is at least 25%, so your cost of capital is going to be fairly high, assuming a 25-30% cost of equity. Over the next five years if the cost of debt comes down to 13-14%, it should have a profound effect, the market in my mind could double in that time.
Estimates for Iran’s expected oil output are all over the map and a lot will depend on how bad the underinvestment has been over the last thirty years, as well as the condition of those few, giant ageing fields. Did you gain any insight into this during your trip?
I believe the IEA is at 600-800bbd and most of the Street is a bit more skeptical at around 400-700bbd for 2016. Given reports that gas reinjection rates were roughly half what’s needed to augment recovery on fields that have natural decline rates of 8-12%, these figures could actually miss on the low side and take longer than expected to ramp too. Nothing will be clear until some independents get in there though. What’s pretty certain is that it will take about $170B to develop the infrastructure to get back to sizeable output, but with absurdly low costs of $15-17 per barrel to produce, Iran is probably one of the only countries in the world that can still benefit in the current environment.
A lot of the appeal of a market like Iran is the possibility of a resurgent middle class and meeting the needs of an incredibly underserved public in so many fundamental areas, could you give us some examples here?
Interesting story, Carrefour, the French international retailer opened a hypermarket in Tehran but eventually pulled its name from the project even though the location went live. It’s run by Carrefour’s franchisee in the Middle East, Dubai-based Majid al-Futtaim that uses the name “Hyperstar” with a logo similar to Carrefour and products like “Laughing Cow” cheese (La Vache Qui Rit) slightly altered in appearance. While the politics surrounding the decision are not crystal clear I think they did something similar in Pakistan and the results of the Tehran “rebranding” have been positive. I was informed that same-store-sales growth continues to be in the 20-30% range and that’s already five years into the project. There is no similar supermarket concept and obviously a lot of pent up demand. We visited the store well into the middle of the day and it was completely packed. While Tehran does have high-end malls and fashionable art galleries and restaurants there are still a lot of basic markets that are underserved. Pharmaceuticals and food distribution were isolated for so long under sanctions that many native firms have become competitively flabby operating as the only game in town. Some of these businesses might not be able to keep up in a new environment. It will be worth looking at companies benefitting from low cost resources, such as the petrochemical industry. They’ll have cheap feedstock and large export price differentials once the market opens up.
If you had to leave investors with one concluding thought on Iran what would it be?
Well, at the end of the day Persian culture is very different from nomadic, Bedouin culture. The complexity associated with a modern economy and the relative sophistication of the consumption-driven wants and needs have been allowed to develop for quite some time now. Iran is farther along the curve than many realize and is more of an emerging market story with frontier-like corporate governance and capital market characteristics. Iran is at the very beginning of a long opening-up process and is not a tactical allocation. Investors would be wise to approach it strategically for the long haul.
Thanks Caglar, very interesting as usual!
Alexander Schay is a Managing Director at Ultima Thule, an equity research company focused on developing markets and an equity partner at WK Associates, a boutique energy consulting firm with a specialization in emerging market oil and gas.
Alex holds both an MS in Risk Management and an MBA from the Stern School of Business at New York University.