Rostelecom: From an outsider to a true Big 4 name

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1 RESEARCH DEPARTMENT TELECOMMUNICATIONS, MEDIA & IT Rostelecom: From an outsider to a true Big 4 name Texelart Fotolia.com Anna Kurbatova +7 (495)

2 EQUITY RESEARCH: TELECOMMUNICATIONS RESEARCH DEPARTMENT Rostelecom: From an outsider to a true Big 4 name Rostelecom Ordinary Preferred Ticker RTKM RX RTKMP RX Recommendation Overweight Overweight Target price, RUB Current price* Upside, % 31% 35% Shares outstanding, mln 2, Market capitalization, RUB bln Company description Rostelecom is Russia s national telecommunications operator. The company provides traditional fixed-line voice, mobile, data, TV and value-added services to residential, corporate and governmental subscribers. Rostelecom has the largest domestic backbone network of 5, km and last-mile connections to approximately 43 mln households in Russia. The company is present on almost the entire territory of the Russian Federation. Rostelecom common shares vs. RTS Index, YTD 3% 2% 1% % -1% -2% -3% -4% Jan 12 Feb 12 Mar 12 RTKM RX Apr 12 May 12 Jun 12 Jul 12 Aug 12 RTS Index Source: Bloomberg Shareholder structure as of July 27, 212 (ordinary shares) Mobitel (treasury shares) 4.64% VEB 2.45% Rosimuschestvo 7.43% Svyazinvest 45.28% Free float 4.2% Source: company *All pricing and/or valuation data in this report is based on the market closing prices as of August 7, 212. **All USD-denominated values, where applicable, have been converted from rubles based on the official CBR exchange rate as of August 7, 212. We initiate coverage of Rostelecom with OVERWEIGHT rating and 12-month target price of RUB 153 ($4.8**) per ordinary share. We think that the current weakness of the share price offers a good opportunity to play on a combination of the company s defensive nature, state support, as well as the ongoing transformation into a true Big 4 name. Russia s second-largest telecom company by revenue. Rostelecom is currently Russia s second-largest telecommunications company after MTS. It is a powerful integrated incumbent player, controlling the amplest telecom infrastructure in the country and providing full range of telecom services. The company s telecom market share by revenue is 22%. Building a new landmark on the Russian telecom landscape. Rostelecom has strong fixed-line background, which ensures robust cash flow generation and the ability to finance aggressive development beyond its traditional business. The company is set to explore growth opportunities in fixed and mobile data, pay-tv, as well as new services on the edge of telecom, IT and media. We expect Rostelecom to leverage its unique infrastructural resource and substantially improve subscriber monetization in the medium term. We project Rostelecom s consolidated top line in rubles to grow at a CAGR of 4.3% in , which would secure it the second position among the Russian Big 4. Solid fundamental profile. Despite a significantly lower exposure to mobile business, Rostelecom s EBITDA margin is comparable with its Big 3 competitors. We anticipate Rostelecom s consolidated EBITDA margin in a healthy % range in the medium term. Besides, according to our DCF model estimates, Rostelecom is likely to remain in the positive free cash flow zone over the entire forecasting period, despite its aggressive investment plans. The company s leverage should peak at a safe level of 1.5x by Net debt/ebitda in 212. Key risks include rising competition and local loop unbundling on the industry side, as well as poor strategy execution, potential new obligations associated with the function of the main government s agent on the telecom market, and unfavorable M&A activity on the company side. Attractive valuation. Rostelecom s stock is cheap, offering a good entry point to play on the company s transformation into a true Big 4 peer. The company s common shares have strongly underperformed the Russian market since the beginning of 212 without any negative developments on the operating front. Rostelecom s stock currently trades at EV/EBITDA 212E of 4.1x and P/E 212E of 9.9x, which implies heavy 23% and 3% discounts to emerging market peers. We initiate analytical coverage of Rostelecom with OVERWEIGHT rating and 12M target price of RUB 153 per common share. Our TP offers a solid 31% upside potential from the current market price of the stock. We see Rostelecom s current market price of RUB 117 per one common share as an attractive entry opportunity to play on the company s transformation into a leading integrated Russian telecom provider and a strong competitor to the Big 3. The stock offers an attractive combination of defensive nature, growth, state support and cheap valuation. Rostelecom IFRS financials, RUB bln E 213E 214E 215E 216E 217E Revenue EBITDA EBITDA margin 36.8% 39.8% 4.2% 38.5% 38.9% 39.3% 39.4% 39.3% Net profit Net margin 11.4% 15.6% 11.1% 8.1% 8.3% 9.1% 9.7% 9.5% Net debt EPS (RUB) DPS (RUB) N/A EV/EBITDA (x) P/E (x) P/BV (x) Source: company, Bloomberg, Gazprombank Anna Kurbatova +7 (495) Copyright «Gazprombank» (Open Joint-Stock Company) 1

3 CONTENTS Investment summary 3 Company overview 5 Key facts about the company 5 Rostelecom on the Russian telecommunications landscape 7 Business overview 9 Brief top-line overview 9 Traditional voice to continue declining as % of the top line 11 Exploring growth opportunities beyond traditional voice 14 Fixed broadband 14 Pay-TV 17 Mobile: Big 4 ambitions 19 New services: rapid expansion from low base 26 M&A plans 28 Real estate: a long term play 29 Corporate issues 3 Dividend policy 3 International listing delayed, SPO unlikely 3 Treasury shares 3 Option programs 31 Share buyback 31 Reorganization 32 Privatization: very unlikely before Financial forecast 37 Valuation 41 Appendix. Financial model 44 2 Rostelecom: From an outsider to a true Big 4 name

4 Investment summary We initiate coverage of Rostelecom with OVERWEIGHT rating and 12-month target price of RUB 153 ($4.8) per ordinary share. We think that the current share price weakness offers a good opportunity to play on a combination of the company s defensive nature, state support, as well as the ongoing transformation into a true Big 4 name. Investment case The second-largest Russian telecom company by revenue. Rostelecom, which was formed by the merger of telecom assets of the state-owned Svyazinvest holding in 211, is Russia s second-largest telecommunications company by revenue after MTS. Rostelecom is an integrated service provider and the owner of the amplest telecommunications infrastructure in the country, present in all market segments and rendering services to households, corporate clients and government entities, as well as operators. The company has a 22% telecom market share by revenue. Building a new landmark on the Russian telecom landscape. As an incumbent telecom operator, Rostelecom has a strong fixed-line background (traditional fixed-line business constituted 52% of the consolidated top line in 211), which ensures robust cash flow generation and the ability to finance aggressive development strategy beyond its traditional business. In the medium term, Rostelecom is set to become a new landmark on the Russian telecommunications landscape by exploring growth opportunities in fixed and mobile data, pay-tv, as well as new services on the edge of telecom, IT and media. In other words, we expect the company to leverage its unique infrastructural resource to substantially improve monetization of the subscriber base. We conservatively project Rostelecom s consolidated top line in ruble terms to grow at a CAGR of 4.3% in , which would secure its firm second position among the Russian Big 4. Solid fundamental profile. Despite a significantly lower exposure to mobile business, Rostelecom operates at margins, which are comparable to those of MTS, Vimpelcom and Megafon. We forecast the consolidated EBITDA margin in a healthy % range over the entire forecasting period, as gross margin erosion associated with the company s aggressive growth strategy in highly competitive market segments should be largely offset by internal cost-saving capabilities. The latter should be based on the synergy from consolidation of formerly separate telecom assets. Besides, according to our DCF model estimates, Rostelecom is likely to remain in the positive free cash flow zone over the entire forecasting period, despite its aggressive investment plans. The company s leverage should peak at a safe level of 1.5x by Net debt/ebitda in 212. Risks Macroeconomic We see the main macroeconomic risk in softening overall economic environment and slower-than-expected pace of personal income growth and consumer spending, which could hinder the company s growth prospects in mobile, broadband, pay-tv and new services. As the company s top line, operating expenses and debt obligations are almost entirely denominated in rubles, the risk on the currency front to our financial forecast is quite limited. Industry-specific Stronger competition on the back of new network construction and further expansion of the main rivals to the most lucrative segments of the fixed-line market (broadband, digital TV). Local loop unbundling, which has recently returned to the Communications ministry s agenda, could erode the historical advantage of Rostelecom as the largest owner of fixed-line infrastructure in the country. Rostelecom: From an outsider to a true Big 4 name 3

5 Company-specific Strategy execution. Rostelecom s strategy plans, as well as our forecasts, are subject to proper execution by the company s management. This is even more important given the significant competition in broadband and mobile markets, which should become the main source of Rostelecom s incremental revenues over the medium term. Accordingly, poor execution conceals the risks of slower-than-expected top line expansion, weaker profitability and higher capex requirements and leverage. The status of the government s main agent on the telecom market makes Rostelecom vulnerable to the risk of participating in large infrastructural projects with low ROI and long payback period, which could be negative for the company s cash flow. We also do not rule out that in the longer term Rostelecom could become the consolidation center for state-owned and private assets in telecommunications, media and IT, resulting in a certain risk of unreasonable transactions and/or unfair asset valuation. Unfavorable M&A activity (high asset valuation, unnecessary acquisitions) could negatively affect the company s cash flow and dividend payouts. Lower-than-expected government spending on modernization and infrastructure in telecoms and IT. With new services likely to deliver 4% of Rostelecom s incremental revenue in , we view more conservative state spending on modernization projects (resulting from the growing budget deficit, changes in the government s investment priorities etc.) as a risk to our top line forecast. 4 Rostelecom: From an outsider to a true Big 4 name Valuation We derive the fair value of Rostelecom using the DCF approach. We discounted the company s future cash flows using WACC of 11.5%. Our DCF model indicates RUB 438 bln equity value of Rostelecom or RUB 153 ($4.8) per one common share and RUB 17 ($3.4) per one preferred share. We also note that there is a single-digit percentage upside potential to our estimated fair value of Rostelecom from reorganization, as the number of the company s shares outstanding is likely to decrease after elimination of cross ownership with Svyazinvest. We expect this upside to be realized within the next 12 months. In our view, Rostelecom s stock is currently cheap and offers a good entry point to play on the company s transformation into a true Big 4 peer. Rostelecom s common shares have underperformed the Russian market by significant 28 pps since the beginning of 212 without any negative developments on the operating front. Rostelecom now trades at EV/EBITDA 212E of 4.1x and P/E 212E of 9.9x, which implies heavy 23% and 3% discounts to emerging market peers. The way the market has been treating Rostelecom over the last six months seems unjustified to us, given the company s solid fundamental profile and clear growth opportunities. Rostelecom is a large-scale mature telecommunications business with ongoing mid-single-digit growth in the top line and EBITDA, moderate leverage and proven cash flow generation ability. Coverage initiation with OVERWEIGHT rating We initiate analytical coverage of Rostelecom with 12M target price of RUB 153 ($4.8) per common share. Our TP offers a solid 31% upside potential from the current market price of the stock. We see Rostelecom s current market price of RUB 117 per one common share as an attractive entry opportunity to play on the company s transformation into a leading integrated Russian telecom provider and a strong competitor to the Big 3. In our view, the stock offers an attractive combination of defensive nature, growth, state support, and cheap valuation. We assign OVERWEIGHT rating to Rostelecom s preferred shares. We see a 35% fundamental upside potential in the stock to our DCF-based 12M target price of RUB 17 ($3.4). Rostelecom s preferred share story would be largely driven by reorganization, which would open an attractive exit opportunity to holders of this type of stock, in our view. We view 1Q13 as the most realistic time for a shareholder meeting on reorganization and mandatory share repurchase.

6 Company overview Rostelecom is one of the largest telecom providers in Russia. A large-scale integrated telecommunications business. Key facts about the company Rostelecom is Russia s national telecommunications operator, which was formed by merger of telecommunications assets of the state holding Svyazinvest (long-distance provider Rostelecom, seven regional telecommunication operators (RTOs), and Dagsvyazinform) in April 211. The company provides traditional fixed-line voice, mobile, data, TV and value-added services to residential, corporate and governmental subscribers. Rostelecom has the largest domestic backbone network and last-mile connections to approximately 43 million households in Russia. The company is present on almost the entire territory of the Russian Federation. As of the end of 1Q12, the company s customer base included 28.1 mln fixed-line voice, 8.4 mln broadband, 12.7 mln mobile (the number for 1Q12 does not include SkyLink operations) and 6. mln pay-tv subscribers. Together with its subsidiaries, Rostelecom employs approximately 181, people. Rostelecom s shareholder equity consists of 2,943.3 mln ordinary and mln preferred shares with the par value of RUB 25 ($8) each. Ordinary shares constitute 92.38% of the company s equity capital, while 7.62% belong to preferred stock. Rostelecom s ordinary and preferred shares are traded on RTS/MICEX under respective tickers RTKM and RTKMP. The company s depository receipts are traded OTC in the USA on the OTCQX under the symbol ROSYY. Charter capital and ownership structure. Rostelecom s common equity is split 25/75 between the common equity of the former long-distance operator Rostelecom and the equity (common and preferred) of regional assets seven regional telecoms and Dagsvyazinform. Among the seven RTOs, the shareholders of the former CenterTelecom gained the biggest stake in the enlarged company (17.5%). The Russian government controls 55.16% of Rostelecom s ordinary shares via Svyazinvest holding, Federal Agency for State Property Management (Rosimuschestvo) and Vnesheconombank (VEB). Rostelecom s 99.9% subsidiary Mobitel holds 4.64% of ordinary shares. 4.2% of the ordinary shares outstanding constitute the free float. As much as 28.9% (7.2 mln) of Rostelecom s preferred shares outstanding represent treasury stock (12.55%) as well as the shares reserved for the management option program. The remaining 71.1% are the free float. The total current market capitalization of Rostelecom s ordinary and preferred shares is $11.4 bln, which is comparable with that of MTS ($19.6 bln) and Vimpelcom ($14.6 bln). Shareholder structure as of July 27, 212 (ordinary shares) Shareholder structure as of the end of 2Q12 (preferred shares) Mobitel (treasury shares) 4.64% Free float 4.2% Mobitel 12.55% Rosimuschestvo 7.43% Option program 16.35% VEB 2.45% Free float 71.1% Svyazinvest 45.28% Source: company Source: company Rostelecom: From an outsider to a true Big 4 name 5

7 Rostelecom ownership structure Russian Federation (Rosimuschestvo) 1% 75%-1 VEB Svyazinvest 7.4% 2.4% 45.3% 25%+1 Rostelecom 4.2% 99.9% 4.6% Free float Mobitel Source: company Board of directors composition The company s board of directors consists of eleven members. Three of them represent governmental entities (Rosimuschestvo, Svyazinvest, VEB) and eight are independent. Top executives Alexander Provotorov, President, Chairman of the Management Board Gazprom-Media, chief legal officer, member of the management Board; 23 Sputnik group, vice-president, investment department; Marshall Capital, CEO; Svyazinvest, first deputy CEO; July 21 - present time Rostelecom, CEO; In April 212, the Board prolonged the contract with Mr. Provotorov as CEO until July 215. Anton Khozyainov, CFO Itera, financial controller; various investment funds, CFO; 29 MC NTT (Rostelecom 1% subsidiary), advisor to CEO; April 29 until present time Rostelecom, deputy CEO, CFO. 6 Rostelecom: From an outsider to a true Big 4 name

8 Rostelecom on the Russian telecommunications landscape Rostelecom is one of Russia s largest integrated telecom operators, present in all key market segments and comparable with the mobile Big 3 players by the scale of business and profitability. Rostelecom is the second-largest telecom provider in Russia by revenue after MTS; No. 1 traditional fixedline and broadband operator. Based on its financial results for 211, Rostelecom was the second-largest Russian telecom company by revenue after MTS. The company has the most extensive terrestrial network infrastructure with approximately 5, km backbone capacity (the nearest rival MTS has 117, km backbone), as well as 28.1 mln out of Russia s total 41.4 mln copper lastmile lines, which makes it No. 1 provider of traditional fixed-line voice services and broadband Internet in the country. After the acquisition of National Telecommunications (NTK) in February 211, the company advanced to the second place on the pay-tv market in terms of subscriber base and became number one by revenue. With its 12.9 mln mobile subscribers as of 2Q12 (market share 5.7%, SkyLink not included) Rostelecom is the fifth largest mobile operator after the Big 3 and Tele2. Unlike MTS, Vimpelcom and Megafon, the company has no nationwide mobile market presence, which makes it inferior to the Big 3 competitors in terms of revenue market share, ARPU and mobile revenue growth rates. Rostelecom presence in Moscow Rostelecom has historically had limited exposure to Moscow, the largest local market, as MGTS (a part of MTS group) is the incumbent operator in the city. Before the merger with regional telecoms, Rostelecom only used to provide traditional long-distance telephony to Moscow customers and had certain B2B business. The company became a significant broadband and pay-tv player in Moscow after the acquisition of NTK in early 211. At the end of July 212, Rostelecom acquired CDMA operator SkyLink gaining access to the metropolitan mobile market (SkyLink has approximately 2% market share in Moscow license area by subscriber number). Rostelecom operations map Source: company Rostelecom: From an outsider to a true Big 4 name 7

9 Big 4: revenue and EBITDA margin (211) % % 266 Rostelecom market positions and principal competitors by segment, end-1q12 Market Market share position Principal competitors Operational indicators Backbone, km 5 N/A 1 MTS, Vimpelcom, Megafon, Transtelecom, Mobile subscribers, (2Q12*) 12,94 5.7% 5 MTS, Vimpelcom, Megafon, Tele2 Fixed-line voice subscribers, 28,13 68% 1 MTS (MGTS), Vimpelcom Fixed-line broadband subscribers, 8,43 4% 1 MTS, Vimpelcom, ER-Telecom, AKADO Pay-TV subscribers, 6, 23% 2 Tricolor-TV, MTS, ER-Telecom 211 financial indicators, RUB bln Telecom revenue % 2 MTS, Vimpelcom, Megafon, Transtelecom Mobile revenue 36 5% 5 MTS, Vimpelcom, Megafon, Tele2 Fixed-line revenue 26 35% 1 MTS (MGTS), Vimpelcom, Megafon, Transtelecom Fixed-line broadband revenue 47 52% 1 MTS, Vimpelcom, ER-Telecom, AKADO Pay-TV revenue 7 16% 1 Tricolor-TV, MTS, ER-Telecom *2Q12 number does not include SkyLink operations Source: company, ACM-Consulting, Communications Ministry, Gazprombank Rostelecom comparison with the Big 3 Rostelecom MTS Vimpelcom Megafon Backbone, km Total households passed, mln N/A N/A Fixed-line subs, mln N/A N/A Broadband subs, mln Mobile subs, mln (2Q12) Pay-TV subs, mln N/A Sales points incl. franchise, Number of employees, Source: company, ACM-Consulting, Gazprombank 4.1% 241 MTS Rostelecom Vimpelcom Megafon Revenue, RUB bln 41.4% 55% 5% 45% 4% 35% 3% 25% 2% EBITDA margin (RHS) Source: companies Mobile market breakdown by subscribers (2Q12) Other 2% Rostelecom 6% Tele2 9% MTS 31% Vimpelcom 25% Megafon 27% Source: company, ACM-Consulting Broadband market breakdown by subscribers (end-211) Pay-TV market breakdown by subscribers (end-211) Megafon 3% AKADO 4% ER-Telecom 9% Other 23% Vimpelcom 1% MTS 11% Rostelecom 4% Akado 4% ER-Telecom 7% MTS 12% Other 26% Rostelecom 22% Tricolor-TV 29% Source: company, ACM-Consulting Source: company, iks-consulting 8 Rostelecom: From an outsider to a true Big 4 name

10 Traditional fixed-line telephony dominates the top line, regulated services constitute 45% of the total revenue. Business overview Traditional voice business stagnates but is likely to remain an important contributor to the top line; Solid growth opportunities on fixed-line territory remain in broadband and pay-tv; Aggressive mobile strategy; Strong upside potential in new services. Brief top line overview Despite its solid exposure to mobile business and new market segments, Rostelecom remains predominantly a traditional fixed-line provider, as fixed-line voice telephony (local, intra-regional and long-distance) and wholesale operations constitute 52% of its consolidated revenue (according to 211 financials). At the same time, the share of fixed-line business of Rostelecom s main competitors (the Big 3) varies from 6% (Megafon) to 19% (MTS). Besides, Rostelecom remains heavily dependent on regulated business. The government directly sets prices for local, intra-regional and domestic long-distance services, which together contributed 45% to the company s top line in 211. We estimate the respective number for MTS at 11% (the regulated business of MGTS), while Vimpelcom s and Megafon s operations are presumed to be 1% non-regulated. Rostelecom s excessive exposure to regulated fixed-line business over the last several years has caused slower organic growth of the company s top line as compared to its main competitors. Rostelecom demonstrated low single-digit organic growth in rubles in versus 5-1% delivered by the Big 3 players. Rostelecom s comparison with the Big 3 by revenue structure (211) 1% 8% 8% 8% 3% 3% 17% 19% 6% 6% 4% 8% 73% 8% 9% 2% Broadband and local services are the main top line drivers; long-distance telephony still suffers a doubledigit decline. % 12% Rostelecom MTS Vimpelcom Megafon Other Fixed-line Mobile Fixed-line broadband services, which grew at a CAGR of 27% in versus 4% CAGR of the total Rostelecom s revenue, has been the main contributor to the company s top line growth over the past three years. Accordingly, the contribution of broadband services in the top line grew from 9% in 28 to 16% in 211. Although the fixed-line voice customer base of Rostelecom is shrinking, traditional local voice telephony remains the biggest revenue item (3% of the total in 211) and an important contributor to the top line growth. In other words, the annual local tariff indexation, which traditionally takes place in the first quarter and is in line with inflation, remains a significant driver of Rostelecom s revenue. Intra-zonal and long-distance segments is where Rostelecom has been suffering from the sharpest revenue outflow over the last several years, as intra-regional and international traffic is still rapidly migrating to mobile and IP networks. Revenues from intra-zonal and DLD/ILD services dropped by 39% in , and their share in Rostelecom s consolidated top line declined from 29% to 15% in 211. Rostelecom: From an outsider to a true Big 4 name 9

11 Revenue breakdown by region (21) Revenue breakdown by service (211) NTK 3% Center 13% North-West 9% Rostelecom old 23% Volga 11% Far East 6% Former regional telecoms generate 74% of new Rostelecom s top line. As much as 54% of revenues come from residential subscribers. South 8% Siberia 13% Urals 14% Rent of channels 3% Interconnect 7% Pay-TV 2% Other 8% Data 6% Intra-Zonal 7% DLD/ILD 8% Mobile 12% Local 3% Broadband 16% Source: company Rostelecom SWOT analysis by market segment Market segment Share in top line (211) Opportunities/Advantages Risks/Disadvantages Monopoly operator; Local voice 3% Low competition from other players in the residential segment; Solid exposure to the SME and B2G segments; Subscriber outflow on mobile cannibalization; Sharp competition in the B2B segment (large and middle). Annual tariff indexation supports revenue growth. Intra-zonal, DLD/ILD Broadband 16% Mobile 12% Pay-TV 2% Interconnect, traffic transit 15% Extensive own transit infrastructure. 7% Unique local loop access with 28.1 mln out of 41 mln copper fixed lines; No. 1 player, 4% share; No. 1 by new subscriber additions; Substantial growth points in middle and small cities, rural areas. Present in 54 regions (former RTO operations and SkyLink); Solid license portfolio (GSM, CDMA, UMTS, federal 4G license allocated in July 212); No. 2-4 player in local markets; Acquisition/market alliance with Tele2 reportedly under discussion. Rapid traffic migration to mobile and IP networks; Price competition from mobile operators is increasing as cheaper LD tariffs are implemented; Direct tariff regulation for IZ and DLD calls. Broadband services are largely based on ADSL technology; High competition from federal and local operators in large cities; Substantial capex required to deploy FTTx networks to increase connection speeds. No federal 2G and 3G coverage, low current market share (~6% including SkyLink); Only CDMA presence in Moscow - through SkyLink; Separated mobile assets with no unique brand, only regional brand recognition; Tele2 is an aggressive discounter. IPTV deployment plans along with broadband network expansion; Solid cable-tv exposure; Mostly cable TV subscriber with low ARPU; Up-selling social tariff customers to higher-arpu basic and premium Substantial capex required to deploy IPTV. tariff plans. Most extensive terrestrial network capacity; LTE network rollout will raise transit capacity demand in the market; The Big 3 players substitute their trunk network capacity Revenue growth opportunities on new international transit routes demand by own construction. (Europe Asia, Northern Europe Central Asia). According to our estimates, the company s regional units, former regional telecoms, generate 74% of Rostelecom s top line; historical long-distance operations contribute 23% and NTK provides 3% of consolidated revenues. Central and Urals business units (former CenterTelecom and Uralsvyazinform) are the two largest regional revenue contributors with estimated 13-14% share of each in Rostelecom s top line. CenterTelecom used to be the largest of seven regional telcos providing fixed-line services to 6.6 mln subscribers (23% of the current subscriber base of Rostelecom). At the same time, Uralsvyazinform had the most developed mobile operations among RTOs and currently constitutes 37% of Rostelecom s mobile subscriber base. Rostelecom generates 54% of its consolidated revenue from residential customers, 24% from corporate customers, 11% from other operators and the remaining 11% from governmental entities (based on 211 data). 1 Rostelecom: From an outsider to a true Big 4 name

12 Traditional voice to continue declining as % of the top line Traditional voice services, which include local, intra-regional (or intra-zonal) and long-distance connections, remain the principal part of Rostelecom s business, comprising 45% of the company s consolidated top line in 211, as compared to the aggregated 3% contributed by broadband, mobile and pay-tv services. The traditional landline voice business has been shrinking on cannibalization from mobile and IP telephony. The traditional voice revenue declined at the average rate of 3.9% a year in versus the consolidated top line CAGR of 4.6%. The share of traditional voice services declined from 58% of the top line in 28. We project this share to go down further to around 3% by 217. Local revenue is shrinking Traditional local voice telephony remains the biggest contributor to Rostelecom s top line with 26% share in 1Q12. Rostelecom provided services to 28.1 mln fixedline telephony subscribers as of the end of 1Q12, including 24.1 mln households and 4. mln corporate customers. Rostelecom is de facto a monopoly local telephony provider to households in Russia, except for few regions, where incumbents were not part of Svyazinvest holding after the privatization in early 9s (the cities of Moscow, Pskov, Kostroma, the republics of Tatarstan, Bashkortostan, as well as Tuva, Chukotka, Chechnya, and Ingushetia). The competition is traditionally higher in the B2B segment, as fixed-line units of federal operators and local players approach businesses with fixed-line service packages. According to our estimates, Rostelecom s share on the local voice market in 211 stood at 68% by the number of lines (including 76% in the residential and 48% in the corporate segments) and at 57% by revenue. Although the competitive pressure in the residential fixed-line voice segment is low, Rostelecom has been experiencing a notable subscriber outflow over the last several years with the ongoing mobile cannibalization and the general change in customer behavior being the main reasons behind this trend. Subscriber outflow accelerated from.2 mln in 29 to.9 mln in 211. Although the company addresses subscriber migration by implementing promotional fixed-line service packages, we expect the local subscriber base to continue shrinking by 3% a year over the next three years, as we see room for further voice tariff decreases by mobile operators on the back of the expanding revenue from data services. According to our projections, by the end of 217 the local subscriber base of Rostelecom is likely to decline to 25.3 mln, down 11% from end-211 results. Rostelecom local fixed-line subscriber base, mln subs 35-6% Q12 Corporate Households Source: company Local fixed-line subscriber outflow by region in 211, subs North-West Center Volga South Urals Siberia Far East Rostelecom: From an outsider to a true Big 4 name 11

13 Still, local revenues continue growing by low single-digit percentage in rubles as regulated annual tariff indexation rate outpaces subscriber outflow rate. The average local tariff grew by 9-1% in rubles over the last two years slightly ahead of inflation rate and has risen by 6% so far in 212. We project Rostelecom local tariff rates to increase by 3-5% per annum in the medium term, which would be in line with inflation. We note that the persistent risk of subscribers outflow is likely to restrain the company from increasing prices ahead of CPI in coming years. As a result, our DCF model envisages Rostelecom s local revenue growing at a CAGR of 2.3% in rubles. Average local tariff indexation rate vs. CPI Rostelecom local revenue and ARPL forecast E 214E 215E 216E 217E E 213E 214E 215E 216E 217E Average local tariff increase CPI Local revenue, RUB bln ARPL, RUB/month (RHS) Source: Federal Tariff Service, Rosstat, Gazprombank Intra-zonal and long-distance revenues vanish on mobile and IP substitution The share of intra-zonal and long-distance services in Rostelecom s top line almost halved over the last three years (from 29% in 28 to 15% in 4Q11) as the company has been losing its traffic and revenue market share. Similar to other traditional fixed-line providers, Rostelecom has been suffering from traffic migration to mobile and IP networks since the middle of 2s, when alternative technologies became widely available on the mass market. The substitution of long-distance fixed-line voice services by mobile and IP traffic sped up after 28, when mobile operators shifted to the fixed-line segment (Vimpelcom was the first company out of the Big 3 to acquire Golden Telecom in early 28) and simultaneously increased investments into own trunk network infrastructure to support rapid 3G traffic growth. Besides, the price competition in the long-distance segment increased as mobile operators began implementing promotional tariffs to stimulate voice traffic growth after the crisis (long-distance traffic is predominantly built by corporate clients). At the same time, traditional operators had limited room for maneuver as intra-zonal and domestic LD tariffs, which are subject to regulation by the government, remained flat over the last three years. As a result, mobile operators managed to bite off a heavy share of intraregional and long-distance market from traditional fixed-line operators, first of all regional operators of Svyazinvest, which are now united under Rostelecom. According to the data of the Communications ministry, the total intra-zonal and long-distance market volume shrank from its peak of 28 (RUB mln, or $5. bln) to RUB 93.5 bln ($3.2 bln) in 211 a decrease by a quarter in three years. We estimate that Rostelecom s revenue from non-local voice connections plunged 38% over the same period (including a 22% decline in IZ and 48% in DLD/ILD revenue). In other words, the company (seven regional telecoms and Rostelecom before the merger) lost 1 pps revenue share on the shrinking market after 28 (down from 59% to 49%). Rostelecom s intra-regional traffic fell 23%, domestic LD traffic was 38% lower and international LD traffic declined by 48% over the three years from 28. Traffic migration from Rostelecom s network and non-local voice revenue decline accelerated in 211. The results for 1Q12 showed a 1-11% YoY reduction in IZ and DLD traffic volumes. 12 Rostelecom: From an outsider to a true Big 4 name

14 Intra-zonal and long-distance market, traditional operators, RUB bln Rostelecom IZ and LD revenue and market share % % % % % % 6% 4% 2% % Reside ntial Corporate Revenue, RUB bln Market share (RHS) Source: Communications Ministry, Gazprombank Source: company, Communications Ministry, Gazprombank Average price per minute of the Big 3 mobile operators, RUB Intra-zonal and DLD tariff indexation rate vs. CPI in , pps MTS Vimpelcom Megafon Source: company Intra-zonal Domestic LD CPI Source: Federal Tariff Service, Rosstat, Gazprombank Rostelecom intra-zonal and long distance traffic dynamic, min bln E 213E 214E 215E 216E 217E Rostelecom intra-zonal and LD revenue forecast, RUB bln E 213E 214E 215E 216E 217E Intra-zonal DLD ILD (RHS) DLD/ILD Intra-zonal We expect Rostelecom to continue losing intra-regional and LD market in the medium term, given that the competitive pressure from mobile operators is unlikely to ease as long as their mobile-fix convergent offers advance. Our DCF model envisages revenue CAGR of minus 14% in the intra-regional segment and minus 2% in the long-distance segment in The combined share of these two segments in Rostelecom s consolidated top line is set to shrink to just 4% in 217. Rostelecom: From an outsider to a true Big 4 name 13

15 Fixed broadband is an important top line driver. Exploring growth opportunities beyond traditional voice Fixed broadband A significant portion of Rostelecom s revenues comes from fixed-line broadband Internet access business. With its 16% input to the consolidated revenue in 211, broadband access was the second most important contributor to Rostelecom s top line after local connections. The share of the broadband in the top line almost doubled over the last three years from 9% in 28 as a result of the impressive growth in demand for rapid Internet access across Russian regions. Rostelecom s revenue from fixed broadband connections grew at a CAGR of 27% in , as compared to the consolidated revenue CAGR of just 4%. According to our estimates, the broadband delivered 86% of Rostelecom s organic top line growth over the last three years and 66% in 211 alone. Brief market overview The number of residential fixed-line broadband subscribers in Russia reached 19.2 mln by the end of 211, according to ACM-Consulting. As many as 37% of households had broadband Internet access in 211 as compared to 3% a year before. Broadband penetration remains highly uneven with almost quarter of all subscribers concentrated in the two biggest cities Moscow and St. Petersburg, which represent only 11% of households. Broadband penetration was 86% in Moscow, 75% in St. Petersburg and only 31% in the rest of Russia at the end of the last year. Due to the below-average penetration ratios, Russian regions are the main source of subscriber inflow. The regions delivered 91% of all new broadband users last year. We note that the broadband growth is slowing down, as the market is gradually approaching the maturity point. Russian broadband subscriber base grew 25% YoY in 211 as compared to 36% in 21. Russian residential fixed broadband subscribers 25 5% 37% 2 4% 3% 15 3% 22% 1 17% 2% 9% % % Subscribers, mln Penetration (RHS) Source: ACM-Consulting Broadband penetration, end-211 1% 86% 8% 75% 6% 4% 31% 37% 2% % Moscow St. Petersburg Regions Russia Source: ACM-Consulting, Gazprombank What is next? Subscriber growth to slow down to single digits in two years We forecast the overall number of broadband subscribers in Russia to grow 16% YoY in 212 to 22.4 mln with the service penetration increasing to 43% of households. The double-digit subscriber growth will continue in 213 (we project 1% YoY) and is likely to slow down to single digits in the following years. Given that the service penetration in large cities (2,+) is already high (5-7%), the new demand would largely come from middle and small cities (<1,) and rural areas, which account for 5% of the total Russian population. We note that the broadband growth outside cities would be limited by low PC penetration. At the same time, we expect moderate growth of subscriber base to continue in large cities, including Moscow and St. Petersburg, driven by the ongoing residential construction. 14 Rostelecom: From an outsider to a true Big 4 name

16 According to our estimates, the broadband penetration in 217 would reach 9% of households in Moscow, 8% in St. Petersburg and 48% in regions, with all-russian penetration coming up to 52% (from 37% in late 211). Thus, the overall number of broadband subscribers is set to grow by substantial 49% from the current level (meaning estimated 9.3 mln in net subscriber additions in ) to 28.5 mln in 217. Apparently, the growing penetration of 3G and WiFi-based mobile broadband services has not impacted the fixed broadband growth. We believe the two market segments would continue developing separately due to the natural difference in service patterns and user needs. Russian broadband subscriber forecast Broadband penetration forecast 1% 86% 9% 75% 8% 6% 4% 2% 8% 48% 31% 37% 52% E 213E 214E 215E 216E 217E Regions Moscow & St. Petersburg Source: ACM-Consulting, Gazprombank % Moscow St. Petersburg Regions Russia Source: ACM-Consulting, Gazprombank Broadband connection rates on the downside With broadband service penetration already high in large cities and rapidly growing in the regions, we believe the competition between operators is likely to shift further towards better price/speed rates to users. That said, large operators, who have cheaper access to transit infrastructure, are better positioned to win the game. As a common practice, providers aim to secure their subscriber base by increasing connection speeds but keeping monthly tariff rates unchanged (fixed broadband subscribers mainly use unlimited monthly packages). Roughly two thirds of future new broadband subscribers will come from middle and small cities and rural areas and thus, mainly bring low-income users to the market. This is another ARPL-dilutive factor in the medium term. Active market consolidation to continue in In our view, gradual saturation of the broadband market and ongoing price competition would support industry consolidation both in large cities and periphery. We expect 212 and 213 to become the last years of large-scale M&A activity, as the market growth is likely to slow down to single digits in the years to come. By 2Q13, Rostelecom is set to consolidate the Moscow-based operator Central Telegraph as part of the second stage of Svyazinvest assets reorganization. Megafon, which lags far behind its main rivals by exposure to the fixed broadband, is considering acquisition of the Top-5 provider AKADO. The acquisition of the last large independent regional asset ER-Telecom by one of the Big 3 operators is only a matter of time, in our view. At the same time, the Big 4 would continue acquiring small- and middle-sized local broadband providers over the medium term. We believe that the four federal players could raise their overall broadband market share from 65% in 211 to 8-85% over the next two to three years, which is comparable with the current mobile market structure. Rostelecom: From an outsider to a true Big 4 name 15

17 Rostelecom is Russia s largest fixed broadband provider With 8.2 mln subscribers (7.6 mln of them are residential) by the end of 211, Rostelecom is Russia s leading fixed broadband provider. The company has 4% residential market share, while its main competitors MTS and Vimpelcom lag far behind with 11% share each. Two Independent providers ER-Telecom and AKADO follow the leaders with respective 1% and 4% market shares. Megafon s current broadband market share is tiny about 1.5%. However, the acquisition of AKADO, which is under discussion now, would place the company closer to the leaders. Rostelecom s positions are particularly strong in the regions. According to ACM- Consulting data, the company has 47% residential subscriber market share outside Moscow and St. Petersburg, which is several times more than the subscriber base of the next rival ER-Telecom (13%) and Big 3 mobile competitors (MTS and Vimpelcom have 8% share each). At the same time, Rostelecom is lagging behind its key rivals in Moscow. The company s 1% subsidiary National Telecommunications has 9% subscriber share in the capital city (MTS 27%, Vimpelcom and AKADO 21% each). Consolidation of Central Telegraph, which has another 7% share of the metropolitan market (as part of the planned Svyazinvest merger expected by 2Q13) would promote Rostelecom to the fourth-largest fixed broadband provider in Moscow. Rostelecom s unique last-mile access to households in regions underpins its market leadership by net subscriber additions. Rostelecom gained 23% of all new fixed broadband subscribers in 211 as compared to 18% by Vimpelcom, 14% by ER-Telecom and 9% by MTS. Moscow broadband market breakdown (end-211) Regional broadband market breakdown (end-211) MTS 27% ER-Telecom 13% Other 24% Other 5% GorCom 2% Qwerty 7% Vimpelcom 21% Vimpelcom 8% MTS 8% Megafon 8% Rostelecom 9% AKADO 21% Rostelecom 47% Source: ACM-Consulting Source: ACM-Consulting 16 Rostelecom: From an outsider to a true Big 4 name Rostelecom market share forecast We expect Rostelecom to strengthen its positions in the broadband market over the medium term. Despite the rising competition, the company is positioned to secure its current market share in large and middle cities and win most of new demand in smaller cities and rural areas. Under its broadband strategy, Rostelecom will roll out fiber optic networks and fully replace xdsl in large and middle cities (64 cities with 3,+ citizens, the total population is 44 mln) by 215, which would provide better speeds to subscribers and raise customer loyalty. According to the company s data, 2. mln of the total 8.2 mln broadband connections were FTTxbased by the end of 211. Besides, Rostelecom s share in net subscriber additions would increase as long as the broadband growth shifts further to small cities and rural areas, where the national champion is facing substantially lower competition from other market players. Overall, we expect the company to gain additional 3.5 pps share of the maturing market over the next five years (46% share projected in 217), which would translate into 5. mln new subscribers (a substantial 6% increase from the current level to estimated 13.2 mln in 217).

18 However, this growth is likely to be dilutive for ARPL. We expect the blended broadband ARPL to decline by 25% from the level of 211 to RUB 366/month ($11.9/month) in 217. As a result, we project Rostelecom s broadband revenue to grow with a moderate CAGR of 5.3% in Still, the broadband is likely to generate solid 2% of the company s incremental revenues over this period. Rostelecom broadband subscriber and ARPL forecast E 213E 214E 215E 216E 217E 2 Subscribers, mln ARPL, RUB (RHS) Pay-TV Brief market overview Pay-TV is currently one of the most rapidly growing segments of the Russian telecom market. The number of pay-tv subscribers soared by 59% in three years since 28 to total 26 mln last year, according to iks-consulting. Pay-TV penetration reached 49% of households in 211 as compared to 31% three years ago. In , the market expanded by 75% in revenue terms (to total RUB 4 bln or $1.36 bln last year), posting 2% CAGR as compared to the overall telecom market CAGR of only 4.3%. The robust market expansion continued in 212, as iks-consulting registered a 5% YTD growth in pay-tv subscribers in 1Q12 to total 27.4 mln (up 26% YoY). We note that pay-tv penetration is highly uneven by territory and varies from 7% of households in Central Russia to only 24% in Siberia. Such difference is explained by two main factors: i) satellite TV broadcasting is mainly limited to the European part of the country, and ii) the degree of cable infrastructure development in different cities varies from one city to another. The bulk (6%) of Russian pay-tv users are subscribed to the relatively cheap cable TV service, and they mainly use this option as an alternative to the analogue free-toair TV (although Russia is characterized by high FTA TV penetration some 99% of population the quality of analogue FTA signal is often poor). This explains the low level of pay-tv ARPU as compared to other telecom services. The average ARPU of pay-tv was RUB 14 ($4.8) a month in 211 compared to $17 for the broadband, $1 for mobile and $8 for fixed-line voice services. The share of cable TV in the total subscriber base has substantially declined over the last three years (from 75% in 28), as subscriber growth was mainly driven by satellite TV operators. Satellite services delivered 54% of the total pay-tv net ads in vs. 34% by cable and 12% by IPTV. This growth mainly reflects higher demand for quality and price-attractive TV services in small cities and rural areas. As a result, the share of satellite TV grew by 12 pps from 28 to 35% of all pay-tv subs last year. At the same time, the share of IPTV remains fairly low 5% of the market (1.5 mln subscribers representing less that 3% household penetration). Given that IPTV is a premium TV service (IPTV is 2-4% more expensive than cable and satellite Rostelecom: From an outsider to a true Big 4 name 17

19 services) it is mainly in demand in large cities where the high quality of FTA TV signal is complemented by the wide choice of channels. Accordingly, low broadband penetration and purchasing power have been serious obstacles for IPTV expansion outside large cities. The Russian pay-tv market is expected to grow by 35% by subscriber count over the next four years, according to iks-consulting. The total number of subscribers is likely to reach 35 mln (66% household penetration). As for technology, satellite and IPTV are likely to increase their shares to 37% and 11% of the market with cable losing 8 pps more in share. Overall, the share of digital TV services is likely to reach 51% of all subscriptions in 215 as compared to 44% in 211. We believe that the average pay-tv ARPU is likely to demonstrate a moderate single-digit growth in the medium term, as higher demand for IPTV as well as gradual migration of cable-tv subscribers from cheap social to base and premium packages would be partly offset by large inflow of low-arpu satellite TV users. As a result, we project pay-tv market to grow by a half in money terms over the next four years (11% CAGR) and reach RUB 6 bln ($2. bln) in 215. Pay-TV subscribers and penetration Pay-TV subscriber base by technology 4 66% 8% 1% 2% 2% 3% 5% 11% % 36% 41% 49% 6% 4% 8% 6% 4% 23% 27% 3% 35% 75% 71% 67% 6% 37% 52% % 2% E % % E Subscribers, mln Pay-TV penetration (RHS) IPTV Satellite TV cable TV Source: iks-consulting, Gazprombank Source: iks-consulting, Gazprombank Rostelecom s pay-tv market prospects With its 6. mln subscribers in 1Q12, Rostelecom is the second-largest pay-tv player in Russia after National Satellite Company (satellite TV operator, Tricolor-TV brand). Rostelecom has 22% market share by subscribers versus 29% with NSC. At the same time, Rostelecom is the market leader in money terms, generating 18% of the industry-wide revenue as compared to estimated 13% by MTS and 12% by each of Tricolor-TV and NTV Plus. Rostelecom is present in the cable and IPTV market segments, which have higher ARPUs than the satellite, which explains its higher market share in money terms as compared to the subscribers share. As of 1Q12, 85% of Rostelecom s pay-tv subscribers were users of cable TV and the remaining 15% used IPTV. The company is largely present in the cable segment through its 1% subsidiary National Telecommunications (NTK), which was acquired in 211. NTK operates in Moscow, St. Petersburg, Ekaterinburg, Novosibirsk and Kurgan. Rostelecom provides IPTV services in regions on the base of IP infrastructure of former regional telecoms. Pay-TV currently constitutes tiny 2.5% of Rostelecom s consolidated top line. We believe the company is in position to substantially raise its revenues from this service in the medium term through both expanding subscriber base and increasing ARPUs. According to our estimates, only 15% of Rostelecom s residential broadband subscribers use IPTV option, which has substantial room for growth to 25-3%. Given that IPTV has been determined the priority technological platform, Rostelecom's plans in pay-tv are part of its comprehensive broadband 18 Rostelecom: From an outsider to a true Big 4 name

20 development strategy. In one to two years, the company aims to substantially increase IPTV usage rate by up-selling this option to broadband subscribers in large and middle cities, where it would substitute xdsl networks by fiber optic routes. In a longer term, there are also plans of shifting cable TV users (predominantly subscribers of NTK) to IPTV, which would be positive for ARPU. In the meantime, monetization of NTK s customer base would be raised by up-selling basic and premium service packages to the current subscribers of cheap social TV service. As TV is the principal channel of entertainment of inhabitants outside large urban areas, in the long term Rostelecom s gradual expansion with the broadband to small cities should give an additional impetus to pay-tv development, we believe. We project 29% pay-tv service penetration among Rostelecom s broadband users by 217, which translates into 8.1 mln subscriber base (up 36% from the current level). Our forecast envisages that Rostelecom would keep its share of pay-tv market (by subscribers) largely unchanged over the medium term (we expect satellite operators to grow at a comparable pace). At the same time, Rostelecom s average pay-tv ARPU has 5% upside potential in the medium term (from RUB 15 to RUB 15 per month), according to our estimates. In other words, the company s revenue market share is set to advance by 2 pps to 2%. We project Rostelecom's pay-tv revenue to expand at 12% CAGR over the forecasting period and reach 4% of the consolidated top line in 217. Pay-TV market breakdown by subscribers (end-211) Rostelecom pay-tv subscribers and ARPL forecast 1 2 Akado 4% Other 26% ER-Telecom 7% Tricolor-TV 29% 4 8 MTS 12% Rostelecom 22% E 213E 214E 215E 216E 217E 4 Subscribers, mln ARPL, RUB (RHS) Source: company, iks-consulting Mobile: Big 4 ambitions With its 12% share in the consolidated revenues in 211, the mobile segment was the third most important contributor to Rostelecom s top line after local services and the broadband. Rostelecom provides mobile services directly (mostly in Urals) and through its subsidiaries. Brief market overview: data drives growth, voice is stagnating With 48% of the total telecom industry revenues in 211, mobile communications remain the principal telecom market segment. According to the Communications ministry data, the mobile constituted 5% of the total incremental telecom revenue in although the segment s growth slowed from the average 25% per annum before the crisis to around 5% after 28. The demand for mobile services increased by 14% in rubles over the last three years (by RUB 78 bln or $2.6 bln in absolute terms) and reached RUB 623 bln ($21.1 bln) in 211. Non-voice services (VAS), and particularly mobile data, have been the main market growth catalysts over the last several years. The demand for mobile VAS almost doubled from 28 to total RUB 185 bln ($6.3 bln) last year, according to ACM- Consulting. At the same time, mobile data revenue soared 2.3 times to RUB 76 bln ($2.6 bln) and contributed 6% to incremental mobile VAS revenue. Rostelecom: From an outsider to a true Big 4 name 19

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