Rostelecom: From an outsider to a true Big 4 name

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Rostelecom: From an outsider

to a true Big 4 name

© Texelart – Fotolia.com

RESEARCH DEPARTMENT TELECOMMUNICATIONS, MEDIA & IT

Anna Kurbatova

+7 (495) 913 78 85

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Rostelecom Ordinary Preferred

Ticker RTKM RX RTKMP RX

Recommendation Overweight Overweight

Target price, RUB 153.0 107.0

Current price* 116.9 79.5

Upside, % 31% 35%

Shares outstanding, mln 2,943.3 242.8

Market capitalization, RUB bln 344.1 19.3

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 500,000 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

-40% -30% -20% -10% 0% 10% 20% 30% Ja n 12 Fe b 1 2 Ma r 1 2 Ap r 1 2 Ma y 1 2 Ju n 1 2 Ju l 12 Au g 12 RTKM RX RTS Index Source: Bloomberg

Shareholder structure as of July 27, 2012 (ordinary shares)

Svyazinvest 45.28% VEB 2.45% Rosimuschestvo 7.43% Mobitel (treasury shares) 4.64% Free float 40.20% Source: company

*All pricing and/or valuation data in this report is based on the market closing prices as of August 7, 2012.

**All USD-denominated values, where applicable, have been converted from rubles based on the official CBR exchange rate as of August 7, 2012.

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 2012-2017, 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 38.5-40% 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 2012.

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 2012 without any negative developments on the operating front. Rostelecom’s stock currently trades at EV/EBITDA 2012E of 4.1x and P/E 2012E of 9.9x, which implies heavy 23% and 30% 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

2010 2011 2012E 2013E 2014E 2015E 2016E 2017E

Revenue 275.7 296.0 315.0 313.4 326.7 347.0 366.4 380.2 EBITDA 101.4 117.7 126.5 120.7 127.0 136.2 144.4 149.5 EBITDA margin 36.8% 39.8% 40.2% 38.5% 38.9% 39.3% 39.4% 39.3% Net profit 31.3 46.1 34.9 25.5 27.2 31.4 35.4 36.1 Net margin 11.4% 15.6% 11.1% 8.1% 8.3% 9.1% 9.7% 9.5% Net debt 119.8 152.4 179.8 161.8 141.2 110.2 75.4 36.6 EPS (RUB) 10.65 15.65 11.85 8.66 9.24 10.67 12.04 12.26 DPS (RUB) N/A 4.70 3.56 2.60 3.70 4.27 4.82 4.90 EV/EBITDA (x) 5.3 4.6 4.1 4.3 4.1 4.0 3.7 3.6 P/E (x) 11.0 7.5 9.9 13.5 12.7 11.0 9.7 9.5 P/BV (x) 1.6 1.3 1.3 1.2 1.2 1.1 1.0 1.0

Source: company, Bloomberg, Gazprombank

Rostelecom: From an outsider to a true Big 4 name

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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

30

Dividend policy 30

International listing delayed, SPO unlikely 30

Treasury shares 30

Option programs 31

Share buyback 31

Reorganization 32

Privatization: very unlikely before 2014 36

Financial forecast

37

Valuation 41

Appendix. Financial model

44

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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 2011, 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 2011), 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 2012-2017, 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 38.5-40% 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 2012. 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.

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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 40% of Rostelecom’s incremental revenue in 2012-2017, 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.

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 107 ($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 2012 without any negative developments on the operating front. Rostelecom now trades at EV/EBITDA 2012E of 4.1x and P/E 2012E of 9.9x, which implies heavy 23% and 30% 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 107 ($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.

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Rostelecom is one of the largest telecom providers in Russia.

A large-scale integrated telecommunications business.

Charter capital and ownership structure.

Company overview

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 2011. 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 6.0 mln pay-TV subscribers. Together with its subsidiaries, Rostelecom employs approximately 181,000 people.

Rostelecom’s shareholder equity consists of 2,943.3 mln ordinary and 242.8 mln preferred shares with the par value of RUB 0.0025 ($0.00008) 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’.

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. 40.2% of the ordinary shares outstanding constitute the free float.

As much as 28.9% (70.2 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, 2012 (ordinary shares) Shareholder structure as of the end of 2Q12 (preferred shares)

Svyazinvest 45.28% VEB 2.45% Rosimuschestvo 7.43% Mobitel (treasury shares) 4.64% Free float 40.20% Mobitel12.55% Option program 16.35% Free float 71.10%

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Rostelecom ownership structure

Russian Federation (Rosimuschestvo)

VEB Svyazinvest Free float Rostelecom 75%-1 7.4% 99.9% 2.4% 100% 45.3% 25%+1 4.6% 40.2% 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

 2001-2003 – Gazprom-Media, chief legal officer, member of the management Board;  2003 – Sputnik group, vice-president, investment department;

 2005-2009 – Marshall Capital, CEO;

 2009-2010 Svyazinvest, first deputy CEO;

 July 2010 - present time – Rostelecom, CEO;

 In April 2012, the Board prolonged the contract with Mr. Provotorov as CEO until July 2015.

Anton Khozyainov, CFO

 1999-2002 – Itera, financial controller;

 2002-2008 – various investment funds, CFO;

 2009 – MC NTT (Rostelecom 100% subsidiary), advisor to CEO;

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Rostelecom is the second-largest telecom provider in Russia by revenue after MTS; No. 1 traditional fixed-line and broadband operator.

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.

 Based on its financial results for 2011, Rostelecom was the second-largest Russian telecom company by revenue after MTS.

 The company has the most extensive terrestrial network infrastructure with approximately 500,000 km backbone capacity (the nearest rival MTS has 117,000 km backbone), as well as 28.1 mln out of Russia’s total 41.4 mln copper last-mile 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 2011, 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 2011. At the end of July 2012, 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

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Rostelecom market positions and principal competitors by segment, end-1Q12

Market share

Market

position Principal competitors

Operational indicators

Backbone, ‘000 km 500 N/A 1 MTS, Vimpelcom, Megafon, Transtelecom,

Mobile subscribers, ‘000 (2Q12*) 12,940 5.7% 5 MTS, Vimpelcom, Megafon, Tele2 Fixed-line voice subscribers, ‘000 28,130 68% 1 MTS (MGTS), Vimpelcom Fixed-line broadband subscribers, ‘000 8,430 40% 1 MTS, Vimpelcom, ER-Telecom, AKADO

Pay-TV subscribers, ‘000 6,000 23% 2 Tricolor-TV, MTS, ER-Telecom

2011 financial indicators, RUB bln

Telecom revenue 296 22% 2 MTS, Vimpelcom, Megafon, Transtelecom

Mobile revenue 36 5% 5 MTS, Vimpelcom, Megafon, Tele2

Fixed-line revenue 260 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, ‘000 km 500 117 111 118

Total households passed, mln 43 10.4 N/A N/A

Fixed-line subs, mln 28.1 3.6 N/A N/A

Broadband subs, mln 8.4 2.0 1.7 0.5

Mobile subs, mln (2Q12) 12.9 69.6 55.7 62.1

Pay-TV subs, mln 6.0 2.7 0.1 N/A

Sales points incl. franchise, ‘000 2.5 2.3 2.9 3.4

Number of employees, ‘000 181.0 55.7 33.0 27.2

Source: company, ACM-Consulting, Gazprombank

Big 4: revenue and EBITDA margin (2011) Mobile market breakdown by subscribers (2Q12)

312 296 266 241 42.6% 39.8% 40.1% 41.4% 20% 25% 30% 35% 40% 45% 50% 55% 0 50 100 150 200 250 300 350

MTS Rostelecom Vimpelcom Megafon

Revenue, RUB bln EBITDA margin (RHS)

MTS 31% Megafon 27% Vimpelcom 25% Tele2 9% Rostelecom 6% Other 2%

Source: companies Source: company, ACM-Consulting

Broadband market breakdown by subscribers (end-2011) Pay-TV market breakdown by subscribers (end-2011)

Rostelecom 40% MTS 11% Vimpelcom 10% ER-Telecom 9% AKADO 4% Megafon 3% Other 23% Tricolor-TV 29% Rostelecom 22% MTS 12% ER-Telecom 7% Akado 4% Other 26%

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Traditional fixed-line telephony dominates the top line, regulated services constitute 45% of the total revenue.

Broadband and local services are the main top line drivers; long-distance telephony still suffers a double-digit decline.

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 2011 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 2011. 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 100% 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 2009-2011 versus 5-10% delivered by the Big 3 players.

Rostelecom’s comparison with the Big 3 by revenue structure (2011)

12% 73% 80% 90% 80% 19% 17% 6% 8% 8% 3% 3% 0% 20% 40% 60% 80% 100%

Rostelecom MTS Vimpelcom Megafon

Other Fixed-line Mobile

Source: company, Gazprombank

Fixed-line broadband services, which grew at a CAGR of 27% in 2008-2011 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 2008 to 16% in 2011. Although the fixed-line voice customer base of Rostelecom is shrinking, traditional local voice telephony remains the biggest revenue item (30% of the total in 2011) 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 2008-2011, and their share in Rostelecom’s consolidated top line declined from 29% to 15% in 2011.

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Revenue breakdown by region (2010) Revenue breakdown by service (2011)

Center 13% North-West 9% Volga 11% South 8% Urals 14% Siberia 13% Far East 6% Rostelecom old 23% NTK 3% Local 30% Broadband 16% Mobile 12% Interconnect 7% DLD/ILD 8% Intra-Zonal 7% Data 6% Rent of channels 3% Pay-TV 2% Other 8%

Source: company, Gazprombank Source: company

Rostelecom SWOT analysis by market segment

Source: company, Gazprombank

Former regional telecoms generate 74% of new Rostelecom’s top line.

As much as 54% of revenues come from residential subscribers.

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 2011 data).

Market segment Share in top line (2011) Opportunities/Advantages Risks/Disadvantages

Local voice 30%

 Monopoly operator;

 Low competition from other players in the residential segment;

 Solid exposure to the SME and B2G segments;

 Annual tariff indexation supports revenue growth.

 Subscriber outflow on mobile cannibalization;

 Sharp competition in the B2B segment (large and middle).

Intra-zonal,

DLD/ILD 15%  Extensive own transit infrastructure.

 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 16%

 Unique local loop access with 28.1 mln out of 41 mln copper fixed lines;

 No. 1 player, 40% share;

 No. 1 by new subscriber additions;

 Substantial growth points in middle and small cities, rural areas.

 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.

Mobile 12%

 Present in 54 regions (former RTO operations and SkyLink);

 Solid license portfolio (GSM, CDMA, UMTS, federal 4G license allocated in July 2012);

 No. 2-4 player in local markets;

 Acquisition/market alliance with Tele2 reportedly under discussion.

 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. Pay-TV 2%

 IPTV deployment plans along with broadband network expansion;

 Solid cable-TV exposure;

 Up-selling social tariff customers to higher-ARPU basic and premium tariff plans.

 Mostly cable TV subscriber with low ARPU;

 Substantial capex required to deploy IPTV.

Interconnect,

traffic transit 7%

 Most extensive terrestrial network capacity;

 LTE network rollout will raise transit capacity demand in the market;

 Revenue growth opportunities on new international transit routes (Europe – Asia, Northern Europe – Central Asia).

 The Big 3 players substitute their trunk network capacity demand by own construction.

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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 2011, as compared to the aggregated 30% 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 2009-2011 versus the consolidated top line CAGR of 4.6%. The share of traditional voice services declined from 58% of the top line in 2008. We project this share to go down further to around 30% by 2017.

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 fixed-line telephony subscribers as of the end of 1Q12, including 24.1 mln households and 4.0 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 90s (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 2011 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 0.2 mln in 2009 to 0.9 mln in 2011. 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 2017 the local subscriber base of Rostelecom is likely to decline to 25.3 mln, down 11% from end-2011 results.

Rostelecom local fixed-line subscriber base, mln subs Local fixed-line subscriber outflow by region in 2011, ‘000 subs

25.6 25.5 25.2 24.4 24.1 4.2 4.1 4.2 4.1 4.0 0 5 10 15 20 25 30 35 2008 2009 2010 2011 1Q12 Corporate Households -6 % -130 -79 -183 -105 -231 -110 -65 -280 -240 -200 -160 -120 -80 -40 0 40

North-West Center Volga South Urals Siberia Far East

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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 9-10% in rubles over the last two years – slightly ahead of inflation rate – and has risen by 6% so far in 2012. 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% 2012-2017 in rubles.

Average local tariff indexation rate vs. CPI Rostelecom local revenue and ARPL forecast

107 110 109 106 105 105 104 104 103 109 109 106 106 105 104 104 103 103 100 103 106 109 112

2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E Average local tariff increase CPI

100 150 200 250 300 350 400 0 20 40 60 80 100 120

2008 2009 2010 2011 2012E 2013E 2014E 2015E 2016E 2017E Local revenue, RUB bln ARPL, RUB/month (RHS)

Source: Federal Tariff Service, Rosstat, Gazprombank Source: company, 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 2008 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 2000s, 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 2008, 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 2008) 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 intra-regional 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 2008 (RUB 125.5 mln, or $5.0 bln) to RUB 93.5 bln ($3.2 bln) in 2011 – 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 10 pps revenue share on the shrinking market after 2008 (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 2008. Traffic migration from Rostelecom’s network and non-local voice revenue decline accelerated in 2011. The results for 1Q12 showed a 10-11% YoY reduction in IZ and DLD traffic volumes.

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Intra-zonal and long-distance market, traditional operators, RUB bln Rostelecom IZ and LD revenue and market share 42 44 45 59 70 84 76 73 62 30 35 34 38 43 42 39 36 31 0 20 40 60 80 100 120 140 2003 2004 2005 2006 2007 2008 2009 2010 2011 Residential Corporate -25% 74.1 68.1 61.5 45.5 59% 59% 56% 49% 0% 20% 40% 60% 80% 0 20 40 60 80 2008 2009 2010 2011

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 2008-2011, pps

0.5 1.0 1.5 2.0 2.5 3.0 3.5 2004 2005 2006 2007 2008 2009 2010 2011 MTS Vimpelcom Megafon 100.0 99.4 99.3 100.0 100.0 90.6 100.0 100.0 100.0 100.0 113.3 108.8 108.8 106.1 105.7 80 90 100 110 120 2008 2009 2010 2011 2012

Intra-zonal Domestic LD CPI

Source: company Source: Federal Tariff Service, Rosstat, Gazprombank

Rostelecom intra-zonal and long distance traffic dynamic, min bln Rostelecom intra-zonal and LD revenue forecast, RUB bln

0.00 0.15 0.30 0.45 0.60 0.75 0.90 1.05 1.20 0 2 4 6 8 10 12 14 16

2008 2009 2010 2011 2012E 2013E 2014E 2015E 2016E 2017E

Intra-zonal DLD ILD (RHS) 0 10 20 30 40 50

2008 2009 2010 2011 2012E 2013E 2014E 2015E 2016E 2017E DLD/ILD Intra-zonal

Source: company, Gazprombank Source: company, Gazprombank

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 20% in the long-distance segment in 2012-2017. The combined share of these two segments in Rostelecom’s consolidated top line is set to shrink to just 4% in 2017.

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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 2011, 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 2008 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 2009-2011, 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 2011 alone.

Brief market overview

The number of residential fixed-line broadband subscribers in Russia reached 19.2 mln by the end of 2011, according to ACM-Consulting. As many as 37% of households had broadband Internet access in 2011 as compared to 30% 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 2011 as compared to 36% in 2010.

Russian residential fixed broadband subscribers Broadband penetration, end-2011

4.9 8.8 11.3 15.4 19.2 9% 17% 22% 30% 37% 0% 10% 20% 30% 40% 50% 0 5 10 15 20 25 2007 2008 2009 2010 2011 Subscribers, mln Penetration (RHS) 86% 75% 31% 37% 0% 20% 40% 60% 80% 100%

Moscow St. Petersburg Regions Russia

Source: ACM-Consulting 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 2012 to 22.4 mln with the service penetration increasing to 43% of households. The double-digit subscriber growth will continue in 2013 (we project 10% YoY) and is likely to slow down to single digits in the following years.

Given that the service penetration in large cities (200,000+) is already high (50-70%), the new demand would largely come from middle and small cities (<100,000) and rural areas, which account for 50% 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.

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According to our estimates, the broadband penetration in 2017 would reach 90% of households in Moscow, 80% in St. Petersburg and 48% in regions, with all-Russian penetration coming up to 52% (from 37% in late 2011). 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 2012-2017) to 28.5 mln in 2017. 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

11.0 14.5 17.4 19.5 20.9 21.8 22.4 22.9 4.3 4.7 5.0 5.2 5.3 5.4 5.5 5.6 0 5 10 15 20 25 30

2010 2011 2012E 2013E 2014E 2015E 2016E 2017E

Regions Moscow & St. Petersburg

86% 75% 31% 37% 90% 80% 48% 52% 0% 20% 40% 60% 80% 100%

Moscow St. Petersburg Regions Russia

Source: ACM-Consulting, Gazprombank 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 2012-2013

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 2012 and 2013 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 2011 to 80-85% over the next two to three years, which is comparable with the current mobile market structure.

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Rostelecom is Russia’s largest fixed broadband provider

With 8.2 mln subscribers (7.6 mln of them are residential) by the end of 2011, Rostelecom is Russia’s leading fixed broadband provider. The company has 40% 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 10% 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 100% 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 2011 as compared to 18% by Vimpelcom, 14% by ER-Telecom and 9% by MTS.

Moscow broadband market breakdown (end-2011) Regional broadband market breakdown (end-2011)

MTS 27% Vimpelcom 21% AKADO 21% Rostelecom 9% Megafon 8% Qwerty 7% GorCom 2% Other 5% Rostelecom 47% MTS 8% Vimpelcom 8% ER-Telecom 13% Other 24%

Source: ACM-Consulting Source: ACM-Consulting

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 300,000+ citizens, the total population is 44 mln) by 2015, which would provide better speeds to subscribers and raise customer loyalty. According to the company’s data, 2.0 mln of the total 8.2 mln broadband connections were FTTx-based by the end of 2011. 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 2017), which would translate into 5.0 mln new subscribers (a substantial 60% increase from the current level to estimated 13.2 mln in 2017).

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However, this growth is likely to be dilutive for ARPL. We expect the blended broadband ARPL to decline by 25% from the level of 2011 to RUB 366/month ($11.9/month) in 2017. As a result, we project Rostelecom’s broadband revenue to grow with a moderate CAGR of 5.3% in 2012-2017. Still, the broadband is likely to generate solid 20% of the company’s incremental revenues over this period.

Rostelecom broadband subscriber and ARPL forecast

200 300 400 500 600 0 4 8 12 16

2010 2011 2012E 2013E 2014E 2015E 2016E 2017E

Subscribers, mln ARPL, RUB (RHS)

Source: company, Gazprombank 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 2008 to total 26 mln last year, according to iKS-Consulting. Pay-TV penetration reached 49% of households in 2011 as compared to 31% three years ago. In 2008-2011, the market expanded by 75% in revenue terms (to total RUB 40 bln or $1.36 bln last year), posting 20% CAGR as compared to the overall telecom market CAGR of only 4.3%. The robust market expansion continued in 2012, 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 70% 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 (60%) 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-to-air 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 140 ($4.8) a month in 2011 compared to $17 for the broadband, $10 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 2008), as subscriber growth was mainly driven by satellite TV operators. Satellite services delivered 54% of the total pay-TV net ads in 2008-2011 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 2008 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 20-40% more expensive than cable and satellite

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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 2015 as compared to 44% in 2011.

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 60 bln ($2.0 bln) in 2015.

Pay-TV subscribers and penetration Pay-TV subscriber base by technology

16 19 21 26 35 31% 36% 41% 49% 66% 0% 20% 40% 60% 80% 0 10 20 30 40 2008 2009 2010 2011 2015E

Subscribers, mln Pay-TV penetration (RHS)

75% 71% 67% 60% 52% 23% 27% 30% 35% 37% 2% 2% 3% 5% 11% 0% 20% 40% 60% 80% 100% 2008 2009 2010 2011 2015E

IPTV Satellite TV cable TV

Source: iKS-Consulting, Gazprombank Source: iKS-Consulting, Gazprombank

Rostelecom’s pay-TV market prospects

With its 6.0 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 100% subsidiary National Telecommunications (NTK), which was acquired in 2011. 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 25-30%. Given that IPTV has been determined the priority technological platform, Rostelecom's plans in pay-TV are part of its comprehensive broadband

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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 2017, 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 50% upside potential in the medium term (from RUB 105 to RUB 150 per month), according to our estimates. In other words, the company’s revenue market share is set to advance by 2 pps to 20%. 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 2017.

Pay-TV market breakdown by subscribers (end-2011) Rostelecom pay-TV subscribers and ARPL forecast

Tricolor-TV 29% Rostelecom 22% MTS 12% ER-Telecom 7% Akado 4% Other 26% 0 40 80 120 160 200 0 2 4 6 8 10

2011 2012E 2013E 2014E 2015E 2016E 2017E

Subscribers, mln ARPL, RUB (RHS)

Source: company, iKS-Consulting Source: company, Gazprombank

Mobile: Big 4 ambitions

With its 12% share in the consolidated revenues in 2011, 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 2011, mobile communications remain the principal telecom market segment. According to the Communications ministry data, the mobile constituted 50% of the total incremental telecom revenue in 2008-2011 although the segment’s growth slowed from the average 25% per annum before the crisis to around 5% after 2008. 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 2011.

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 2008 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 60% to incremental mobile VAS revenue.

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Mobile data growth has been largely driven by 3G network rollout by the Big 3 operators, who are exclusive holders of nationwide UMTS licenses. At the end of 2011, Megafon’s 3G network included 26,000 base stations, followed by 23,000 with MTS and 15,000 operated by Vimpelcom. The share of the Big 3 in the industry’s VAS revenue increased from 86% at the beginning of 2008 to 93% in 1Q12, according to ACM-Consulting. Their share in the overall mobile data revenue grew from 89% to 95%.

High mobile data growth rates, which have been persistent over the last five years, prove that this market is far from saturation and has significant upside potential in the medium term. Mobile data surged by average 49% per annum in ruble terms in 2007-2011. The rapid growth continued in 2012 as the mobile data revenue surged 33% YoY in 1Q12, according to ACM-Consulting. We believe that the new demand for mobile data would be largely driven by new usage, rather than higher ARPUs from existing customers, as the overall mobile Internet penetration in Russia remains at relatively low levels as compared to other countries. Only 32% of all mobile subscribers used 3G-ready devices at the end of the last year, according to Mforum Analytics. Currently, smartphone penetration in Russia is estimated at 13% as compared to 50% in USA and average 16% in Eastern Europe.

However, smartphone penetration is rapidly growing from a low base. According to MTS retail network’s data, overall 14.4 mln smartphones were sold in Russia since the beginning of 2010. The share of smartphones in the total sales number of mobile devices increased from 8% in 1Q10 to 27% in 1Q12. We believe smartphone penetration would continue growing rapidly over the next three years driven by the increasing affordability of the devices to customers. The average sale price of smartphones decreased by 20% over the last two years to RUB 10,600 ($350) in 1Q12 and is likely to continue going down. As smartphones remain on average 4.3 times more expensive than feature phones and are still not affordable to many mobile subscribers, mobile operators launch smartphone subsidizing programs to stimulate data usage on their networks and raise ARPUs. According to Euroset data, users of premium smartphones ($500+ per device) generate $18-37 in monthly ARPU as compared to the current average of $7 by the Big 3.

The market forecast by Ericsson envisages 40% smartphone penetration in Russia in 2015. The average data traffic volume from each device is set to increase eight times over the next four years and the total data traffic in mobile broadband networks will likely rise 25 times, the company expects.

Mobile market dynamic in 2007-2011 Mobile data market forecast

0% 5% 10% 15% 20% 25% 200 300 400 500 600 700 2007 2008 2009 2010 2011

Mobile market, RUB bln % YoY (RHS)

0% 10% 20% 30% 40% 50% 60% 70% 0 30 60 90 120 150 180 210 2008 2009 2010 2011 2012F 2013F 2014F 2015F Mobile data market, RUB bln % YoY (RHS)

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3G-ready handset penetration in Russia Smartphone penetration by country 0.4% 1.7% 4.2% 8.3% 14.3% 23.2% 31.6% 0% 10% 20% 30% 40% 2005 2006 2007 2008 2009 2010 2011 0% 5% 10% 15% 20% 25% 30% 35% Slo ve ni a Tu rk ey Li thua ni a Ka za kh st an Cro at ia Cz ec h R epub lic Se rb ia Hu ng ar y Es to ni a Ru ss ia La tv ia Slo va ki a Uk ra in e Ro ma ni a

Source: Mforum Analytics, Gazprombank Source: GfK, Gazprombank

Smartphones offer a huge premium to monthly ARPU (RUB) Monthly mobile ARPU in rubles by handset price

0 300 600 900 1,200 1,500 MT S Vi m pe lc om Me gaf on Tel e2 Ro stel ec om OS W indo w s OS S ym bia n OS A ndr oi d OS B ad a iOS Smartphones actual ARPU 0 300 600 900 1,200 Bi g-3 av g. < 3, 000 3, 000 -5 ,0 00 5, 000 -7 ,0 00 7, 000 -10, 00 0 >1 0, 00 0

Source: company, Euroset Source: company, Euroset

Mobile voice market stagnates.

We project the mobile data market to grow 30% YoY this year (to total RUB 99 bln) and continue expanding by 20-25% over the next three years. This suggests the market would more than double in volume by 2015. We note that our current forecast does not include the potential upside from LTE-based 4G network rollout in Russia, which is scheduled for 2013-2019.

While mobile data revenues are rapidly expanding, the outlook for mobile voice demand is not that bright. After many years of robust growth, it seems that the demand for mobile voice services is close to saturation and the room for improving voice traffic monetization is very limited in the current tough competitive environment. Despite steadily increasing mobile voice usage, Russian operators’ revenue from voice services demonstrated only moderate single-digit growth after the crisis. This is largely the result of operators implementing lower-APPM (average price per minute) tariffs to promote usage.

According to our estimates, the Big 3 companies have seen 9-22% decline in voice APPM in rubles since the beginning of 2010. APPM of Tele2, which is a niche discounter player in the regions, was down 7% over this period. We note that Vimpelcom showed the sharpest APPM erosion over the last two years (APPM erosion accelerated from 9% a year in 2009-2010 to 14% in 2011), as the company made an attempt to regain its market position by attracting new subscribers to its network. Although Vimpelcom attracted 5.2 mln new subscribers (+1.4 pps market share), its share in the total mobile voice revenue of Top-4 players declined by 0.6 pps, according to our estimates. This well illustrates that competing for higher mobile market share by reducing price is a risky way in a challenging market environment.

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In our view, the pressure on mobile APPM is likely to persist in the medium term, as federal majors’ focus would shift even more towards mobile data. We expect the Big 3 to continue implementing promotional voice tariffs to increase customer loyalty, while the revenue shortfall would be compensated by higher data revenues. Besides, voice APPM could be negatively impacted by external factors, including roaming rates reduction after regulatory rulings. On a bottom line, we believe that competing for pure mobile voice share with zero or a limited mobile broadband capability is unpromising in the medium-term perspective.

MOU growth (1Q12/2010) APPM erosion in rubles (1Q12/2010)

0% 5% 10% 15% 20% 25%

MTS Vimpelcom Megafon Tele2

-25% -20% -15% -10% -5% 0%

MTS Vimpelcom Megafon Tele2

Source: company, Gazprombank Source: company, Gazprombank

Rostelecom’s current market position

 No. 5 player in Russia by subscribers. Rostelecom has modest positions in the

mobile market. The company had 12.9 mln mobile subscribers as of the end of 2Q12, which suggests a 5.7% share and the fifth place after the Big 3 and Tele2. The company generated RUB 35.6 bln ($1.2 bln) in mobile revenues last year with its revenue market share estimated at 5%. The acquisition of SkyLink, closed at the end of July, added 1.3 mln subscribers to Rostelecom raising its total mobile subscriber base to 14.2 mln, still far behind Tele2 (21.6 mln).

 Spotty geographical coverage. Rostelecom, through mobile units of former

regional telecoms and SkyLink, currently provides mobile services based on GSM 900/1800 and/or CDMA-450 in 54 regions. Rostelecom’s exposure is only solid in Urals and Siberia, where its subscriber share is 22% and 13% respectively. In Volga region, South and Far East, Rostelecom has only single-digit subscriber market shares, according to our estimates. SkyLink has only 2% subscriber share in Moscow and 1% in St. Petersburg, according to ACM-Consulting. We also note that Rostelecom operates on the mobile market under different regional brands. The shift to the single brand is scheduled for the end of this year.

 Weak mobile data offer, which underpins Rostelecom’s low market share.

Rostelecom has been historically lagging far behind the Big 3 operators in the mobile data segment - back in 2007, three federal UMTS licenses were allocated to MTS, Vimpelcom and Megafon. At the same time, data services of Skylink are based on CDMA technology, which explains its inferior position on the market. According to the latest data by ACM-Consulting, the aggregated VAS revenue share of non-Big 3 operators was only 7% and mobile data share amounted to 5% in 1Q12.

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Mobile market breakdown by subscriber base (2Q12) Rostelecom’s mobile market share by region MTS 31% Megafon 27% Vimpelcom 25% Tele2 9% Rostelecom 6% Other 2% 0% 5% 10% 15% 20% 25% 0 1,000 2,000 3,000 4,000 5,000

Moscow N-West Center Volga South Urals Siberia F-East Subscribers, '000 Market share (RHS)

Source: ACM-Consulting Source: company, Communications Ministry, Gazprombank

Rostelecom mobile strategy – catching up with the mobile data train

Rostelecom has serious ambitions on the mobile market. The company aims to maintain its positions in the regions, where it has historically been present with voice services, and emerge into the forth nationwide mobile broadband player along with the Big 3. Rostelecom has no plans to compete with the Big 3 and Tele2 for additional voice market share, given bleak revenue growth outlook for this segment. At the same time, the company has an ambitious goal to catch up with the Big 3 by the quality of commercial mobile data offer over the next three to four years. Rostelecom’s mobile strategy relies on utilizing the available license resources and own network construction. CDMA operator SkyLink, recently acquired by Rostelecom from Svyazinvest, would play an important role in the game due to its extensive license portfolio and mobile data expertise. Rostelecom and SkyLink hold GSM and 3G/CDMA licenses, which on aggregate cover almost the entire territory of Russia. The consolidation of SkyLink has enriched Rostelecom’s mobile portfolio with a number of assets:

 Existing operations based on CDMA-450 in 27 regions, including Moscow

metropolitan area, St. Petersburg and ten other 750,000+ cities. SkyLink had 1.29 mln subscribers as of end of 2Q12, according to ACM-Consulting.

 UMTS-1900/2100 licenses for 65 regions, including Moscow and St. Petersburg, which cover 95% of the total Russian population.

 GSM 900/1800 licenses for 45 regions covering 36% of the total Russian

population, which overlap Rostelecom’s current GSM license area only in seven regions in Siberia with the total population of 9.7 mln people.

Rostelecom/SkyLink mobile license portfolio

Company Mobile standard generation Number of regions Population under coverage Operations Subscribers, mln GSM 900/1800 MHz Rostelecom 2G 30 51 mln Active 12.9

CDMA 450 MHz Rostelecom 2G 9 16 mln Active –

CDMA 450 MHz SkyLink 2G 27 76 mln Active 1.3

GSM 900/1800 MHz SkyLink 2G 45 51 mln Not utilized –

UMTS 1900/2100 MHz SkyLink 3G 65 135 mln

Network rollout

underway –

2300-2400 MHz

(LTE, WiMax applicable) Rostelecom 4G 39 46 mln Not utilized –

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By the end of 2012, Rostelecom aims to roll out 3G LTE-ready UMTS networks consisting of 8,000 base stations in big cities in 27 regions, where the company is already present with GSM and/or CDMA-based voice services. The targeted regions include Moscow and St. Petersburg and together cover 81 mln people (57% of the Russian population, 60% of all SIMs). The company would commence 3G operations on new networks in 2013. By that time, it should be operating under a single brand. Rostelecom plans to expand its 3G operations to approximately 70 regions by 2015 with its coverage increasing to 90-95% of the population.

While in the longer run Rostelecom’s main goal is to assail the Big 3 on the mobile data battleground, we believe that on the two- to three-year horizon the company would at least be able to capture some market share from Tele2, which has 21.6 mln subscribers in regions (with 40% of them being mobile data users). Tele2 provides mobile data services on the base of the EDGE technology (up to 474 kBit/s download speed as compared to 1-20 Mbit/s in 3G), which means its service quality would be strongly inferior to that of Rostelecom in a couple of years. According to our estimates, Rostelecom could win up to 1.0 mln subscribers in the four large regions where its coverage already overlaps with Tele2 (Tambov, Kemerovo, Chelyabinsk and Nizhny Novgorod) and plans to roll out 3G network before the end of this year.

We conservatively assume that Rostelecom would raise the subscriber share in its regions of presence from 9% to 15% and would gain 7% share in regions where it currently has no operations by 2016. If our assumption is true, the company’s mobile subscriber base is set to double to 25 mln. Under our optimistic scenario, Rostelecom would surpass the 30 mln mark in 2016 and thus advance to the fourth market place after the Big 3.

We forecast Rostelecom’s mobile ARPU to deteriorate by 15% in three years from the current level, given that the company has to compete for higher share in a very tight market and most likely would enter new regional markets with discount voice and data rates. Notably, according to industry sources, Tele2 has offered a 20% discount to average market voice price in new regions. As a result, our DCF forecast envisages an 11% CAGR of Rostelecom's mobile revenue in 2012-2017. We expect the mobile segment to grow to 17% of the consolidated top line in 2017.

Rostelecom mobile subscriber base scenario forecast, mln Rostelecom mobile revenue forecast, RUB bln

0 5 10 15 20 25 30 35 40

2011 2012E 2013E 2014E 2015E 2016E 2017E

Conservative Base case Optimistic

0 20 40 60 80

2011 2012E 2013E 2014E 2015E 2016E 2017E

Figure

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References

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