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. Last Updated: 07/27/2016

STET: Money on the Line

It began with Hungary, then the Czech Republic, then came to Russia. As with mass privatization, now Russia is tackling another key area of reform of the former communist economies -- selling out a sizable stake in a national phone company in order to equip itself for the information age.

The Hungarian government sold 30 percent of Matav, the state phone operations, to the Magyarcom consortium of Deutsche Telekom and the American regional Baby Bell, Ameritech. The Czech government followed, auctioning 27 percent of phone company SPT to a grouping of the Dutch and Swiss PTTs.

Last Friday, the Russians followed suit. The State Property Committee announced that the top bidder -- the Italian state telecommunications company STET -- had in principle been chosen to buy a 25 percent stake in Svyazinvest, which does not own the entire Russian phone system, but has the lion's share of 85 regional operating companies.

The Italians offered $630 million, plus an investment commitment of $770 million, to trump a consortium of France Telecom, Deutsche Telekom, and the Russian holding company of US West. The Italians bid nearly 50 percent over the minimum $430 million asking price. The competition's total bid was $200 million less.

Money appears to have been the deciding factor: The opposing consortium was the clear favorite. US West has a number of ventures in Russia, notably in cellular communications, while the French have made an investment in the Kaliningrad enclave. The German firm has to date refrained from large-scale investment in Russia, having just a mobile-phone venture, but it possesses a wealth of experience from upgrading the East German telephone network after reunification. Germany is also the main European destination for Russian international telecommunications traffic.

The Italians, in contrast, have little direct experience relevant to the herculean task before them. Their consortium bids were rejected in both Hungary and the Czech Republic, although they offered a higher sum than the winner in both cases. STET's main experience with emerging markets has been in Latin America, having invested in telecoms in Argentina, Uruguay and Bolivia. Its activities in Russia have centered on a manufacturing operation in St. Petersburg, and participation in a fiber-optic link to the Black Sea and Mediterranean.

"Deutsche Telekom is involved in Hungary, in the Ukraine, it's a major partner in the fiber-optic links being established between Moscow and Frankfurt," said Stephan Herz, a telecommunications analyst at Kleinwort Benson in London. "STET really doesn't have anything in Eastern Europe yet. I guess at the end of the day it came down to who was going to pay the most money."

The opposing consortium was perhaps too confident, or conversely, one analyst believes, it may have bid low to bow out.

"Frankly, I think that this consortium withdrew -- or, let's say, they put an offer which was sufficiently low to be rejected," said William Laurent, a telecommunications analyst with the London bank Robert Fleming. Deutsche Telekom and STET were not available for comment Monday, and France Telecom declined to comment.

According to Laurent, STET can afford the deal: He said that while the company has a high debt-to-equity ratio, it is in the process of reducing its debt level very rapidly.

Another 24 percent block of Svyazinvest shares is to be sold separately at a special money auction next year. This auction is to be aimed at portfolio investors and banks rather than telecommunications operators. Again, Central Europe is the model. The Hungarians are considering selling off as much as a further 40 percent of Matav for $1 billion, while another chunk of the Czech SPT is being privatized to small investors.

However, while the Russian initiative is obviously similar, there are, upon closer inspection, key differences. First of all, investors have not jumped into Russian telecommunications as enthusiastically as they did in Central Europe. Both the Hungarian and Czech deals were hotly contested: The highest bid in the Czech Republic was over $1 billion, while Deutsche Telekom and Ameritech took Matav with a payment of $875 million.

In Russia, however, interest has been thin. This partly explains why the asking price for the Svyazinvest tender was lower than those in Hungary and the Czech Republic, even though its network is several times larger than any telecom company in Central Europe.

According to Herz and other analysts, the biggest worry is that it is not clear exactly what STET is buying. Svyazinvest has only existed since late 1994, and its ability to control the companies in which it has stakes is therefore not really tested. Most of the regional operating companies were privatized during the first phase of privatization, which required that 25 percent of the shares be handed over gratis to employees.

At best, STET has got its hands on the key company controlling the bulk of Russia's local communications. At worst, however, it has bought an unwieldy holding company which doesn't really control anything.

Even if it is effectively managed, the local phone business in Russia requires huge investments and at the moment promises virtually no returns: Local calls are free, while the lion's share of long-distance phone revenues go to the trunk network operator, Rostelekom, which is a separate company and not part of the deal. Svyazinvest does not even include holdings in the local networks in Moscow and St. Petersburg.

The government had to sweeten the pot substantially to get any bids at all. Despite the political unpopularity of such a move, the government has agreed in principle to introduce charges for local calls, though not surprisingly it has not actually introduced them during the current electoral campaign.

Centrally, Svyazinvest has already received a license to allow it win some of the long-distance and international traffic. It will have to build its own network, but at least there is some return in sight. This is a profitable and expanding business. Rostelecom, the current monopoly operator, is a profitable operation, having earned a $155 million operating profit in 1994 and $35 million after taxes, on revenues of $837 million. Internal long-distance traffic accounted for 53.5 percent of this.

Moreover, it is a business that is growing fast: Russia's international traffic has grown 60 percent since 1992. Creditanstalt Investment Bank in Vienna estimates that outbound international traffic is now growing at 44 percent per year, and incoming international traffic at 55 percent.

To get Svyazinvest's network up and running, the government appears to be handing over to it control of the 50x50 project, an ambitious government plan to link 50 Russian cities with 50,000 kilometers of fiber-optic links.

The project, which France Telecom, Deutsche Telekom and US West were previously eying, became bogged down by lack of agreement and uncertainty about who was going to participate on the Russian side. Much of the investment STET must make will apparently go into 50x50. This project requires as much as $34 billion in funding, according to some estimates.

This leaves a huge task in trying to do something about the parlous state of local networks.

According to Creditanstalt Investment Bank, there are 10 million Russians on the waiting list for telephone lines. The International Telecommunications Union puts the figure as high as 35 million.

While Svyazinvest already has its license, there are numerous points yet to be worked out on how it will operate with its new investor. A Svyazinvest official, who asked not to be named, said Monday that there are still some "differences of approach" between STET and the Russian side.

The final contract is due to signed by Christmas. One month after the signature, STET is to transfer 20 percent of the initial purchase sum. It should take four places on the nine-member Svyazinvest board.

Key areas for discussion in finalizing the contract will probably include setting up an independent and a reliable authority to adjudicate disputes between Rostelecom and Svyazinvest. There is not a lot of love lost between the long-distance and regional phone companies.

In addition, STET and Svyazinvest will probably want the freedom to invest in profit-making sectors as they choose. It will be necessary to establish the ground rules for universal service -- that is, the provision of phone lines to those in places where it is not economic to install a line.

Putting together such a regulatory regime, and maintaining its independence, is proving difficult in the most liberal of economies, and will certainly be no easier in Russia.

The telecommunications law passed in 1994 fails to answer these questions, according to a report by Professor Robert Campbell for PlanEcon in Washington, and will demand supplementary legislation, possibly by a parliament hostile to the very idea of foreign involvement in telecommunications.

A crucial supplementary question is whether, if Svyazinvest and Rostelecom are to be compete with each other, anyone else will be allowed to get in on the act. In Hungary and the Czech Republic the bid winners got an undertaking that they would maintain a monopoly in long-distance and international services for several years.

Some observers of the Russian telecommunications scene think that even competition between Rostelecom and Svyazinvest is likely to be stifled, and that some means will be found to bring them together. The situation is complicated by the fact that Rostelecom is also partially privatized, and as much as 45 percent is believed to be in foreign hands.

The argument for consolidation is that because the investment task in telecommunications is so huge, profit margins must be kept up to fund capital expenditures. Estimates of the needed capital go to $50 billion and well above. Certainly, the amount STET will be required to spend is a drop in the ocean, and it seems wasteful to spend it on a duplicate trunk network.

Alex Goodwin, chief executive officer of Sector Capital, said that given the huge capital requirements for telecommunications investment in Russia, the most important aspect of the investment tender is that it can act as a vehicle for further financing.

It is very important that the deal go through, he said, because it provides the three things that Russian telecommunications needs -- "capital, technology, and management."

The major players in the government, including communications minister Vladimir Bulgak, are said to embrace this line of thinking. That some opposition parties may not is no doubt a factor why the tender has been held before the parliamentary elections.

The loans-for-shares scheme is giving the cold shoulder to foreign investors, and there has been no serious mooting of a sell-off of part of Aeroflot to a foreign airline, or a big stake of the electricity-generating system to a foreign power utility.

Yet here is a management stake in the phone network, the nervous system of society, up for grabs. Soviet leaders, who carefully restricted the development of telecommunications because of its capacity to foment subversion, would turn in their graves. Maybe the country can make it in the information age after all.

-- Jonas Bernstein and Anton Zhigulsky contributed to this article.