September 18, 2012

Nick Cousyn
nick.cousyn@bdsec.mn
Chief Operating Offcer
DW^
d^>DW
We are initiating price targets for the
MSE Top 20, Mongolian Sovereign Debt
and the MNT in US, Euro, Yen and Yuan
terms, with 12-18 month price targets as
follows:
Phone/fax: (976) 11-323411
Our MSE Top 20 price target of 25,000, represents a total return of 32% over the
next 12 months. We view the selling to date as largely attributable to the ongoing
European Debt Crisis, with the Mongolian stock market being infuenced by a
larger selloff in Emerging/Frontier Markets. We think investors began to pare bets
on Mongolia ahead of a restrictive mining law passed in May and the Country's
general election in June, on fears the economy would slow. We would also note
that the implementation of the new settlement and clearing process have reduced
equity volumes considerably. These new rules require additional paperwork from
account holders before they can trade, limiting the number of participants in the
market. Combined, this has had a "Perfect Storm effect on Mongolian equity
prices, yet economic growth remains very strong, with GDP through 1Q 2012 at
+30.2% nominal, +16.7% real, vs. the frst quarter of 2011. These are staggering
numbers considering the slowdown in Emerging Markets, let alone recessionary
fears in Developed Markets. t is also worth mentioning that consumer borrowing
is basically non-existent in Mongolia at the moment, with few residential mort-
gages, offering considerable room for sustained increases in consumer spending.
Real Estate in UB is largely unencumbered, which will likely be a source of lever-
age for years to come. For these reasons and others we will discuss, we defne
the economic expansion in Mongolia as "secular, with the country only 2-3 years
into what will likely be a 10-20 year secular bull market. While the Mongolian
economy could slow in the second half of 2012, any slowdown would likely be
short lived, as virtually the entire world are now cutting rates in response to global
economic fears. The US, Europe and Japan are in the mode of outright moneti-
zation of their debt via various forms of Quantitative Easing (QE), with no end in
sight. Currency debasement and negative real rates historically result in strong
commodity prices, which combined are both the cause and effect of high infation.
Relatively speaking, a high infation world benefts the owners of hard assets, at
the expense of the consumers of those assets. This acts as a transfer of wealth
to commodity rich countries like Mongolia, which has only just begun to exploit its
vast mineral wealth.
We forecast a snapback in equity prices in Mongolia, predicated on world beat-
ing economic growth, which has been largely resistant to the global slowdown.
Many companies in Mongolia trade at a fraction of their replacement costs, which
in some cases are 3-4x's (or more) their current stock price. Ultimately, equity
markets are most closely correlated to the direction of earnings, which bodes well
for MSE companies, as most are seeing double, if not triple digit top and bottom
line growth. With the MSE Top 20 near 1 year lows at 18,887 and off 42% from its
2012 BDSec Sales & Research Team www.bdsec.mn August 2012 1
Mongolian Equities
Source: Mongolian Stock Exchange
0
5,000
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35,000
2007 2008 2009 2010 2011 2012
MSE Index
Figure 1
Asset Class Price Target
MSE Top 20 25,000
MNT/USD 1,200 MNT
MNT/EUR 1,400 MNT
MNT/CNY 180 MNT
MNT/JPY 13.75 MNT
2012 BDSec Sales & Research Team www.bdsec.mn September 2012 2
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2011 high of 32,575, we view current prices as extremely compelling. Our advice
to investors is to begin building positions now, taking advantage of rock bottom
prices. Those who wait for a recovery to take shape, will likely have to chase much
higher prices and limited liquidity. With a market cap for the MSE of just $1.45B,
the 200 listed companies in Mongolia are being valued at roughly the equivalent
of one US small cap stock. Having visited and researched many Mongolian com-
panies, it is our opinion that current asset values, let alone future revenues and
earnings, far exceed current valuations. State owned enterprises will continue
to be privatized, which will offer investors access to prime opportunities. At the
moment, the government owns a majority stake in four of the eight largest com-
panies on the MSE, including TavanTolgoi (Little TT), Baganuur, ShiveeOvoo and
Telecom Mongolia. Privatization of these assets will increase liquidity and foreign
investment on the MSE.
Should estimates for GDP growth come to pass, the Mongolian economy would
almost quadruple in size by 2017, likely offering equity returns of 500%-1000%,
or more. We will look at the performance of US economy & equity markets from
1980-2000 as a template for what may unfold in Mongolian capital markets. Total
US GDP in 1980 was $2.8T, increasing to nearly $10T in 2000, growing the size
of the economy roughly 3.5x. During the same period, the S&P 500 appreciated
from a price of 102 in 1980, to 1498 in 2000, a near 15 fold increase. The Prime
Rate in the US hit 20% in '81, which is not dissimilar to current borrowing costs
in Mongolia. The 1980-2000 period in the US also demonstrates the power of
"secular growth and the duration of such bull markets (20 years), which we sus-
pect is unfolding here in Mongolia. t is also important to recognize that the cycles
in secular bull markets and economic expansions are much longer compared with
more cyclical economies. Historically, normal economic cycles encounter reces-
sions every 3-5 years. The US encountered only two recessions during period of
1980-2000 ('81-'82, '90'-'91), as such, we expect the next recession for Mongolia
to be a long way off, perhaps not until 2020 or later.
Source: EconStats.com Source: United States Census Bureau
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S&P 500 Large Cap Index (SPX) Nominal GPD of the USA (US$ billion)
Figure 2 Figure 3
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2012 BDSec Sales & Research Team www.bdsec.mn 3
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September 2012
We expect the Mongolian Togrog to appreciate anywhere from 10-20% against
the world's major currencies over the next 12-18 months. As mentioned earlier,
the majority of the central banks worldwide are loosening monetary policy and in
most cases posting negative "real rates, which will likely result in higher infa-
tion over time. Mongolia is one of the few countries in the world where monetary
policy is tightening, with the central bank increasing reserve requirements in an
effort to reduce liquidity. The Mongolian Central Bank (MCB) is also increasing its
As you can see in the below chart, the Mongolian economy has the potential to
grow nearly 800% in less than 10 years, from 2009-2017. f the S&P 500 increased
1500% during a period where GDP grew 350% (1980-2000), we would suggest
"The Blue Sky is the Limit for Mongolian equities. nvestors should also consider
the possibility of even greater currency adjusted returns, especially those who live
in a USD, EUR, or JPN denominated world. We discuss our bullish view on the
Mongolian Togrog below.
Mining production forecast, by minerals type
Source: ACI Mongolia, The Financial Markets Association
Nominal GDP estimation (bil MNT)
Figure 4 Figure 5
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Other sector increase Mining
By Capacity GDP, bil USD
unit: mil USD
Mongolian Togrog
Source: Bloomberg
Monthly MNT/USD rate (x1000)
Figure 6
0.65
0.7
0.75
0.8
Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep
2012 BDSec Sales & Research Team www.bdsec.mn September 2012 4
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During its most recent bond auction, The Government of Mongolia (GOM) auc-
tioned 5yr notes at 5.75% and 12% USD and MNT denominated, respectfully.
We fnd Mongolian Sovereign debt very attractive for foreign investors, especially
denominated in MNT, given the excess yield and our favorable view on Mongolia's
currency. We forecast an improving credit rating for the GOM, given the country's
rapid growth and relatively low debt/GDP of ~45%. We expect The Mongolian
Central Bank will begin to focus on reducing infation from the current rate of
~14% to its target rate of 10%. Key to our assumption of an improving credit rating
is the necessity for the GOM to cease guaranteeing deposits in the local banking
system. This was an emergency measure in the crisis of '08-'09 and the crisis
for Mongolia has long since passed. The GOM also needs to make large and
intelligent investments in infrastructure, especially in Ulaanbaatar. Traffc, power
shortages and pollution are all potential restraints to future growth. Well planned
investment in these areas and others will contribute to GDP, while offering long
term solutions to current problems. t is estimated that the GOM will spend ~$40B
in infrastructure over the next 5-7 years. Should projected economic growth play
out, with sound fscal and tighter monetary policy (near term), Mongolian bonds
are likely to begin a long term bull market, not unlike the US from 1980-2000.
Mongolian Sovereign Bonds
ownership of gold bullion and recently announced total reserves of 113K ounces,
up from 65K ounces in January '11. nfation through the 1H of '12 is running at
14.5%, which compares to the MCB's target rate of 10%. We forecast tight mon-
etary policy and additional purchases of gold by the MCB, which will likely result
in a strong Togrog. Long term, we think Togrog appreciation vs. the money print-
ing nations of US, Europe and Japan is especially compelling. A stronger Togrog
may cool Mongolian exports somewhat, reducing GDP at the margin. That said,
we would view an infation rate near 10% as a positive and would happily accept
nominal GDP in the low/mid 20%, with real GDP in the mid-teens, vs. the 1st half
of '12 at 31.8% and 17.3%, respectively. Since the Mongolian economy has just
begun its secular growth trend, we think the Togrog will experience its own long
term bull market. Japan entered a secular economic expansion in the early '70's
and while they relied greatly on exports, the Yen saw a dramatic increase vs. the
$USD
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Weekly JPY/USD
Figure 7
Source: National Statistical Offce
2012 BDSec Sales & Research Team www.bdsec.mn 5
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September 2012
There has been only one corporate bond successfully issued in Mongolia in the
last two years, which was Just Agro ($4.4M, 1 year duration at 16.2%). With local
banks now capital constrained, we anticipate greater interest on behalf of corpo-
rations to test the corporate bond market in Mongolia. Should the GOM cease
to guarantee deposits, investors will likely shift their focus to the credit of well
capitalized corporations, offering superior collateral. n order for local corpora-
tions to grow with the Mongolian economy, they no doubt need greater access to
capital, with longer duration. We expect rapid growth in corporate borrowing via
the capital markets.
Mongolian Corporate Bonds
US 30-year treasury bond price
Figure 8
Source: Yahoo Finance
Long term, Mongolia's fortunes are tied to that of China's. Currently, China repre-
sents ~90% of Mongolia's total exports, which is unlikely to change in the coming
years. With China's recent slowdown, many would have expected Mongolia would
slow as well, which has not happened in the aggregate.
Mongolia and China
Source: National Statistical Offce
GDP growth at constant price
Figure 9
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2012 BDSec Sales & Research Team www.bdsec.mn September 2012 6
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While these trends are a near term negative, it is important to recognize that
Mongolia is the low cost producer and will continue to take a larger share of Chi-
nese demand. This trend will be especially painful for Australia and ndonesia, as
seaborne commodity shipments from these countries to China is 4-6 thousand
miles, versus hundreds of miles from Mongolia. Mongolia also has world class
deposits of gold, silver, uranium, rare earths and fuorspar, all of which having su-
perior supply/demand dynamics to Coal and ron Ore at the moment. Not only can
these minerals act as a countercyclical offset to their weaker counterparts, they
require signifcant CapEx to exploit and bring to market, contributing to growth.
We estimate that exclusive of OT & TT, total mining CapEx in Mongolia could ap-
proach $40B over the next 5 years.
Source: Indexmundi.com
100
120
140
160
180
200
Aug-11 Nov-11 Feb-12 May-12 Aug-12
Monthly iron ore price (US$ per metric ton)
Figure 12
Chinese high-cost capacity
n fact, Mongolia's GDP grew nominal and real GDP at 31.8% & 17.2%, respect-
fully, in the 1st six months of 2012. We think this is attributable to the high level of
capital expenditures (CapEx), primarily from that of OyuTolgoi(OT). Total CapEx
spent so far on OT is $7B, with estimates of a further $5B for the second phase
of development. OT is estimated to represent 30% of Mongolia's GDP for '12,
increasing to 35% in '13, as OT goes into production. Once OT is at full produc-
tion, it is estimated to produce $7B annually of copper and gold. TavanTolgoi(TT),
which is thought to be the world's largest coking coal deposit at 7B tons, has re-
cently begun production at 3M tons for 2012. Production and CapEx will increase
meaningfully once the TT PO comes to market, which is expected to raise $10B
(greater than the total GDP of Mongolia in 2011 of $8.6B). That said, the price
drop in coking and thermal coal, as well as iron ore are a concern. Current price
trends are as follows:
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Jan/08 Jan/09 Jan/10 Jan/11 Jan/12
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(Rmb/t)
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Australian premium hard coking coal FOB
Coking coal price Thermal coal price
Figure 10 Figure 11
500
650
800
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1,100
Jan/08 Jan/09 Jan/10 Jan/11 Jan/12
(Rmb/tonne)
Datong premium blend 5,800 kcal/kg
Datong thermal coal
Source: CLSA
2012 BDSec Sales & Research Team www.bdsec.mn 7
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September 2012
The Mining Law passed in May has had a negative impact on new mining invest-
ment in Mongolia. While we understand the need to protect strategic resources,
the language of the law is vague, redundant and damaging to investment. t is our
understanding that an effort to amend this law is underway, which we hope will
result in a more effcient, business friendly regulation, while protecting strategic
Mongolian resources. t is no secret that China is searching the world over for
resources to lockup for their future consumption.Mongolia has no intention of al-
lowing any country a controlling interest in its vast mineral wealth. We have heard
that the moratorium on the issuance of new mining licenses will soon be lifted, an
important step back in the right direction.
Recent Securities regulation has likewise been a mixed bag. The new Millen-
niumT trading system was launched in June, which was in partnership with the
LSE and designed to automate trading. So far it has had little effect largely due to
reduced trading volumes. While the framework for T+3 settlement has been es-
tablished, it has not yet been implemented. Clearing for equity and bond transac-
tions has now been transferred from the government to the local banks. This has
had a drastic negative effect on equity volumes, as all brokerage account holders
are now required to open a bank account for clearing purposes before they can
trade. We suspect this has had an artifcially adverse effect on recent stock prices.
Those who have been selling have been doing so in an even thinner market than
normal, having a greater effect on prices. That said, the eventual move to T+3
will be an important catalyst for future institutional investment, which many of our
clients have been waiting for.
Lastly, the FRC (Financial Regulatory Commission) has been slow to approve
requests for PO's and secondary offerings. So far in 2012, there has only been
one PO, E-Trans Logistics (underwritten by BDSec). This has had a damaging
effect on Mongolian corporations looking to access the capital markets and have
forced them into short term, high interest bank lending. t is not uncommon for a
corporation to have to borrow at rates in excess of 20% for as little as 6 months,
not knowing if their lender will roll over their loans when they come due. We think
the banking system is at its limits in providing capital to businesses as loan/de-
posits are now 100%. High interest rates and short duration may have an adverse
effect on future competitiveness of Mongolian corporations. Hence, we are in ac-
tive discussions with the FRC to allow corporations greater access to the capital
markets at more favorable and competitive rates.
Regulatory Impact on Investment,
The Good, The Bad & The Ugly
Following the collapse of the Soviet Union, Mongolia embraced capitalism (the
frst communist country to do so), led by a younger generation weary from 70
years of Russian infuence. Mongolian leaders went in search of the best political
and economic policies to serve as a basis for their constitution and economy. The
result was a pure form of democracy and capitalism and an openness to foreign
investment. Foreign entities are free to invest and own local businesses without
any legal requirement and enjoy the same rights and duties as local investors.
They can move funds in and out of the country without restriction. The only recent
amendment to foreign investment was a Mining Law passed in May, which allows
the GOM to designate large assets (land and large petroleum and mineral assets)
as strategic, requiring government approval for ownership and exploitation. While
this has impacted incremental investment in mining, it is our understanding there
is an effort underway to make critical amendments. Populist rhetoric occasionally
results in legislation that negatively effects investment. History has shown eco-
nomic growth usually wins in the end, as evidenced by the breakthrough agree-
ment for the development of OT.
Policy towards foreign investment
2012 BDSec Sales & Research Team www.bdsec.mn September 2012 8
DW^
Despite heated political battles every 4 years during parliamentary elections, ma-
jor political parties generally agree on the direction Mongolia should be headed.
The Mongolian People's Party (MPP), which governed Mongolia without opposi-
tion in the communist era, also won most of the post-Soviet era elections. Re-
garded as center-left, the MPP was responsible for key decisions related to the
economic development of Mongolia, including that of OT. The MPP also initiated
the partial sale of state owned assets, which included the future PO of TT and
many of Mongolia's largest corporations. The MPP have modernized their policies
and changed with the times, in an attempt to shed their communist label (includ-
ing its prior name which sounded somewhat communist). They've also distanced
themselves from more radical and less reputable members, including former pres-
ident NambarynEnkhbayar, who was recently convicted on corruption charges.
While MPP has played a strong role in Mongolia's growth, their policy of fnancial
giveaways to citizens has had a negative effect on Mongolia's already high rates
of infation.
The MPP's main opposition, the Democratic Party (DP) was a merger of several
democratic parties in 2000. The DP won its frst election this last June, having
been defeated by the MPP in the prior 3 elections. We view the DP's victory in a
very positive light, as they are center-right and regarded as more business friend-
ly. The DP will likely shun cash handouts, in favor of supporting heavy industry
and manufacturing, as well as focusing on badly needed infrastructure. They will
also emphasize value added commodity exports, which will create more jobs and
sustainable long term economic growth. One of the key DP members is Mr. Bat-
tulgaKhaltarmaa, who was formerly minister of construction, road, transportation
and urban development and is now the minister of industry and agriculture. He is
well known for supporting investment in critical railroads, as well as the develop-
ment of the Sainshand ndustrial Park. This industrial park would be located on
the border with China and consist of several processing factories, including cop-
per, iron ore, etc. The industrial park will be built in partnership with private invest-
ment at an expected cost of over $10B USD. This is all part of a major investment
program, approved by parliament this July, consisting of $50B USD supporting
manufacturing, infrastructure, mining and construction. 43% of the total invest-
ment will be made in partnership with private investment.
n conclusion, we think the opportunity to invest in Mongolian assets is compel-
ling, to say the least. A broad basket of equities, sovereign and corporate debt
(Denominated in MNT) will offer incredible wealth creation, at a time when most
of the world is more focused on wealth preservation. The infection point for the
Mongolian economy has already occurred and assets are incredibly cheap, both
on a relative and absolute basis. Please contact us for specifc ideas and a list of
our proprietary deal fow.
Finding the right balance:
Recent political changes and
their impact on the economy
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BDSec Headquarter BDSec Express Branch
Zaluuchuud Avenue 27-1
8th Khoroo, Sukhbaatar District
Ulaanbaatar, Mongolia
Phone/Fax: 976-11313108
Website: www.bdsec.mn
Express Tower
Peace Avenue
Ulaanbaatar, Mongolia
Phone/Fax: 976-11311128
Email: info@bdsec.mn
Institutional Sales & Research Department
phone/fax: 976-11323411 mail: research@bdsec.mn
Dagiijanchiv Chuluunbaatar
Research
email: dagiijanchiv@bdsec.mn
Odbayar Oyunbaatar
Research
email: od@bdsec.mn
Sainbayar Jadamba
nstitutional Sales
email: sainbayar@bdsec.mn
Munkhtulga Ganbold
Head of nstitutional Sales
email: mganbold@bdsec.mn
Nick Cousyn
Chief Operating Offcer
email: nick.cousyn@bdsec.mn
DW^