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. Last Updated: 07/27/2016

Making the Right Call on Restructuring

A lot of big calls were made in the early years of privatization, but few were bigger than the one the government made in 1993 to sell 49 percent of nearly all of its more than 80 regional telephone companies. It was a wake-up call for an entire industry, and it is still being paid for.

Two years later, a holding company, Svyazinvest, was set up to manage the state's stakes in those companies and to lure foreign investment into the vital, vast and crumbling sector.

The ploy worked in 1997 when billionaire George Soros, together with other members of his Mustcom consortium, doled out more than $1.8 billion for 25 percent plus one share of the holding, in what remains Russia's largest-ever privatization tender.

But then the economy imploded, reforms and investment plans were shelved, and Svyazinvest's value plummeted, prompting Soros to call the deal the worst he ever made.

Vladimir Putin soon took over the country and put fellow St. Petersburgers Valery Yashin and Leonid Reiman in charge of Svyazinvest and the Communications Ministry, respectively, and an ambitious restructuring project was launched to create seven super-regional holdings under Svyazinvest's umbrella.

Two years on, things are looking up --the first stage of that restructuring is finished and Svyazinvest's value has risen about 80 percent in the last year to roughly what Soros originally paid for a quarter of the company.

Neither Soros nor his partners in Mustcom could be reached for comment on the developments at Svyazinvest. But analysts say one thing is clear: Svyazinvest, once maligned for low liquidity and obscure financials, is now the government's best-performing reform project, and once-weary investors are giving the fixed-line telephone industry another look.

The Seven Sisters

Using a single blueprint to forge the creation of seven super-regional holdings out of dozens of networks strung across 11 time zones is the stuff of corporate nightmares.

For the plan to work, Svyazinvest had to sell a single idea to scores of shareholders and dozens of companies from all over the nation -- swapping their shares in local operators for shares in the largest telephone company in their region.

It required crisscrossing the country countless times and spending untold hours in negotiations, but the company's managers pulled it off. It took nearly 17 months from the shareholders' meeting approving the merger of Dalsvyaz in the Far East in June 2001 for the "seven Svyazinvest sisters" to be officially formed. The mergers creating Center Telecom, Sibir Telecom and Volga Telecom were completed in November 2002.

The seven sisters may have been established, their management teams elected and financial flows consolidated -- but that's only the first phase of a radical corporate overhaul designed to end on the New York Stock Exchange, Svyazinvest chief Yashin said in a recent interview.

Stage two, he said, is creating synergy among the siblings, which should take between three to five years.

"Every super-regional company has to function as a unified mechanism," said Yashin, adding that between one year and 18 months from now, the new companies will be completely integrated.

Afterward a modernization push crafted to lure investors will begin, he said.

"We urgently need to modernize the management and business process of the companies so that they become way more competitive and attractive for investors."

Yashin said that although Svyazinvest's valuation has grown rapidly since reorganization began, it has been mainly due to its super-regional subsidiaries, and the potential value of the parent company is much higher.

Two years ago, the seven sisters accounted for little more than half of Svyazinvest's value. Now that figure is closer to two-thirds.

The company's other holdings include a 38 percent stake (and a voting majority) in long-distance monopoly Rostelecom, 23 percent of Moscow fixed-line monopoly MGTS, which is not one of the seven sisters, and minority stakes in several second-tier operators.

It's All About Tariffs

Even with the notable progress, however, Svyazinvest can't come close to matching the performance of its emerging market peers -- despite having 32 million lines, or 32 million customers, its value pales to those of much smaller analogs in Eastern Europe.

The Czech Republic's relatively tiny Cesky Telecom, for example, has a market capitalization of nearly $3 billion, while Poland's TPSA is worth more than $4.5 billion.

So why has Svyazinvest's value shrunk by three-fourths while the value of comparable companies has risen dramatically?

Yashin believes the answer is simple: tariffs.

Yashin said that before the government defaulted on its domestic debt and devalued the ruble in 1998, the average monthly phone bill in Russia was $5. But now individuals pay on average just 96 rubles ($3.05) a month, while businesses pay 142 rubles, compared to an average of $10 in Poland and Hungary.

"Therefore, companies in those countries have a higher market capitalization," Yashin said.

The Anti-Monopoly Ministry, which is responsible for setting telephone tariffs, hiked prices 27 percent last year, but that was far short of the 200 percent increase Svyazinvest says is needed for the "normal development" of the industry.

Indeed, Anti-Monopoly Minister Ilya Yuzhanov admitted earlier this year that under the current tariff regime, 30 percent of all fixed-line operators are losing money.

Although Yashin is expecting a rise of no more than 30 percent again this year, it could be higher if Svyazinvest could reach a compromise with the Anti-Monopoly Ministry on a long-term method of calculating tariffs. But the two sides are divided.

Alexander Sysoyev, general director of Northwest Telecom, one of the seven sisters, says the ministry is being unreasonable. "If the ministry would finally approve Svyazinvest's sensible tariff policy, which would allow operators to cover their costs and improve their networks, the average monthly fee could grow to 240 rubles," Sysoyev said.

The ministry, however, faced with political and economic concerns in other areas, is taking a more cautious approach.

Even so, analysts say Yuzhanov has not done enough for the industry.

"Despite two years of above-inflation tariff hikes, residential tariffs still remain below the underlying cost of providing the service," said Alexei Yakovitsky of United Financial Group. "And the government has yet to deliver a comprehensive tariff reform program that involves a major overhaul of the entire tariff-setting system."

Analysts also say tariffs should be rebalanced -- regional operators should pay Rostelecom more for handling their customers' domestic long-distance calls, and customers should pay the regional operators more for local calls.

If this isn't done soon, fixed-line operators will face increasingly stiff competition from mobile operators.

As it stands now, the top two national mobile companies -- MTS and Vimpelcom -- earn average monthly revenues per customer of $13.60, while regional fixed-lined operators earn $9.40, according to a report by Renaissance Capital.

The narrowing gap means that regional operators only have another year or two before the window of opportunity closes, said Alex Kazbegi, a telecoms analyst at the investment bank.

"[Fixed-line operators] need to move fast to show revenue growth while the window is open," Kazbegi said.

"Tariff reform, however, is a key ingredient to revenue growth that companies do not control," he said. "Given the history of tariff re-balancing, the potential for disappointment is high."

Fixed-Line Telecoms in 2002
CompanyMarket Capitalization, $ mln Number of Lines, mlnDigitalization Rate, %Number of Employees Waiting List, mln
Sibir Telecom4043.304550,0000.70
Volga Telecom4594.244151,0000.75
South Telecom2993.213942,9700.72
Center Telecom5186.003570,0001.2
Northwest Telecom3143.624030,4000.4
*data for 2001
Sources: United Financial Group, company data

Every Minute Counts

A key part of tariff reform is the much-anticipated move to widespread per-minute billing.

"Per-minute billing is objectively necessary for a fixed-line operator to function normally," said Northwest Telecom's Sysoyev.

He said there were two main reasons to make the switch.

First, it would decrease traffic, which would free up capacity and increase service quality. "Old networks are overloaded and it's hard to get through during peak hours, not because a user's number is busy, but because equipment doesn't function properly," he said.

Second, it is fair to charge people based on how much they use a product: "With monthly fees, users who rarely talk on the phone pay for those who work as operators for various services using their home phone numbers or dial-up Internet services for hours," said Sysoyev.

Sysoyev's company is one of the few that has implemented per-minute billing, although on a limited basis. He said customers in the Karelia and Murmansk regions are already being charged by the minute, as are some parts of the Leningrad region.

In all, customers in more than 220 cities and towns nationwide are paying by the minute, including Kazan, Krasnoyarsk, Nizhny Novgorod and Yaroslavl.

A favorite election tool of many populist politicians is to rail against attempts to institute per-minute billing, saying low-income people would not be able to afford to make telephone calls.

Yashin notes, however, that the transition has been smooth in the regions where the system has been introduced.

He even advocates giving pensioners and other low-income groups toll-free calls to hospitals, pharmacies and other providers of basic services.

"We are willing to compromise in this question," he said.

The Anti-Monopoly Ministry is resisting the change unless its plan is agreed to.

The ministry wants fees cut 40 percent, which would lower the average monthly bill for individuals to 57.6 rubles at current rates. The difference between the old and new rates would then be divided by the average amount of time people spend talking on the phone each month, which varies from 300 minutes to 450 minutes, depending on the region. The result would be a per-minute charge of between 8.5 and 12.8 kopeks.

But before these changes can be introduced, operators will have to wait for the new law on communications, which establishes the legal mechanisms of the switchover and has already passed the State Duma in a first reading.

"Technologically, the networks are ready for per-minute billing to be introduced," said Ruben Amaryan of Center Telecom, which covers the super-region that surrounds, but does not include, Moscow. "But the determining factor will be the new law on communications."

Analysts doubt, however, that the equation the ministry is advocating will result in higher revenues for operators.

"The suggested time-based tariff schemes per se are in no way designed to increase the average monthly revenue of a fixed-line operator," said Alexei Yakovitsky of UFG.

"Rather, they are aimed at a 'fairer' distribution of costs between low- and high-use customers and, in the longer-term, higher capital expenditures efficiency for regional telecoms."

Going Mobile

A major reason that Soros' Mustcom paid such a premium for its stake in Svyazinvest was because the Communications Ministry had promised the fixed-line monopoly a license to operate a national GSM network, the most popular cellular standard.

But that license never came, and MTS, Vimpelcom and more recently Megafon have been scrambling over each other to roll out their networks and snap up smaller players in the regions.

Now, nearly everyone agrees, there is no room for a fourth player, which puts Svyazinvest in a quandary, as its subsidiaries have nearly 1.5 million mobile subscribers, or about 7.5 percent of the national market.

Some Svyazinvest mobile operators use the outdated DAMPS standard, while 26 use the non-digital NMT standard and need a costly upgrade to IMT-MC-450 to stay competitive.

But of the seven sisters, three boast more or less significant exposure to the cellular market.

Uralsvyazinform, which covers the Urals region, including Perm and Yekaterinburg, owns five mobile operators with a total of nearly 500,000 subscribers.

Sibir Telecom owns two mobile operators -- Krasnoyarsk's Yeniseitelecom with 102,000 subscribers and Irkutsk's Baikalvestcom with 75,000 subscribers, according to ACM Consulting.

And Volga Telecom owns Nizhny Novgorod Cellular Communications, which has nearly 200,000 subscribers. It also has stakes ranging from 15 percent to 100 percent in 12 other companies with 200,000 subscribers between them. It holds 2.95 percent of SMARTS, which is Russia's fourth-largest operator with 630,000 subscribers.

"Super-regional companies are rather powerful financially, and in our opinion, they are capable of developing the cellular operators they control," Yashin said. "Given the effect of consolidation within the regions, we hope that in the short-term they will be able to compete with federal operators."

Most analysts, however, say that short-term is the only kind of growth a cellular operator controlled by one of the seven sisters can count on.

Kazbegi of Renaissance Capital said the "Big Three" -- MTS, Vimpelcom and Megafon -- are growing so fast that regional mobile penetration will reach its saturation point within one to two years.

"Eighty-five percent of the Russian population will, in the long-run, be served by one of the three national mobile operators," he said.

Kazbegi says the best Svyazinvest's subsidiaries can hope for is to sell their mobile operations while there are still buyers -- "or before mid-2004 at the latest."

Adding Value

With the fixed-line giant's cellular prospects bleak, the company is looking at other ways to grow its business, including new, so-called value-added services, or VAS, such as Internet and data transfer.

VAS only accounted for between 1.6 percent and 3 percent of sales for the seven super-regionals last year, according to Renaissance Capital estimates.

But several of the seven sisters are paying more attention to non-core activities.

Sibir Telecom, for example, is developing a multi-service network that would offer access to both cable television and the Internet, said Anatoly Nikulin, the company's general director.

And South Telecom, which serves Rostov and Krasnodar, is looking at developing ISDN networks, videotelephony, IP-telephony and opening public Internet access points for data transfer customers.

But here, as in the cellular market, growth potential is limited, analysts say.

"Data is the domain of business customers, who typically choose an alternative operator to provide them with a full package of data, Internet and VAS," Renaissance's Kazbegi said.

As for the Internet, he said, residential service is still in its infancy, and the low penetration of personal computers in the regions is prohibitively low.

Cutting Costs

With the biggest potential revenue gains dependent upon the government and its tariff policy, and the potential gains in non-core activities limited, Svyazinvest is looking for other ways to improve the profitability of its subsidiaries -- and that means cutting costs.

The three main operating expenditures are wages, maintenance and interconnect fees to Rostelecom for long-distance traffic.

The first two are to a certain degree interdependent -- the more updated a network, the fewer people needed to support it.

Interconnect fees to Rostelecom will largely depend on the new law on communications and on the individual relationships between Rostelecom and the super-regionals, Yakovitsky of UFG said.

Maintaining a single analog line requires the support of 24 people at various locations along its route, while for a digital line that figure is three, according to the Renaissance report.

On average, Svyazinvest says its seven super-regionals average 78 employees per line and have a network digitalization level ranging from 34 percent in the Far East to 52 percent in the Northwest.

By comparison, Hungary's MATAV has over 300 lines per worker and is 85 percent digital, Poland's TPSA is also 85 percent digital and has over 200 lines per employee, and Cesky Telecom is 100 percent digital and operates 250 lines per worker.

Yashin said job cuts are taken "very seriously" by the company, "but we have to reach the figure of 100 lines per employee."

The seven sisters and Rostelecom have a combined workforce of 364,400, down from 391,800 at the beginning of 2001.

With the number of lines exceeding 32 million, that means over 40,000 people need to be let go, although some 2 million lines are being added each year.

"Cutting personnel was not the major goal of reorganization," Yashin said. "But when making cuts, we first lay off managers whose skills are universal enough to help them find a job outside the company."

But reducing staff won't solve the cost problem by itself, as analysts say wages will need to be raised by 25 percent to 50 percent by the end of 2004 to keep pace with inflation and maintain social commitments.

Investing in the Future

In many ways Russia is a third-world country -- a third of its towns and villages have no connection with the outside world, and the waiting list for a phone line is 5 million names long.

The government wants Svyazinvest to remedy the situation and has tasked it and its subsidiaries with having 45 million fixed lines in service by 2010, meaning it would have to install 4 million phones and upgrades per year for the next eight years.

Yashin said the goal is achievable -- but not without more money.

"The waiting list exists not because we are working slowly," Yashin said. "It all comes down to under-valuing telecommunications. The current tariff policy does not allow us to make such large investments."

The company's investment plan is just 30.4 billion rubles ($968 million) this year, but meeting the target would cost at least $1.5 billion annually, he said.

"We are capable of such results, but only with radical changes to the current tariff policy."

To Sell or Not to Sell

So is the government ready to try its luck at selling another chunk of Svyazinvest?

Yashin says it's too early -- any stake would be worth much more in a couple of years.

But the Property Ministry has been floating the idea of selling another 25 percent stake in the giant before the end of the year, and hinting that it may just go ahead and sell its whole 75 percent stake.

Alexander Borodin, head of the ministry's industry, construction, transport and communications department, told Expert magazine recently that even the "sale of 75 percent minus one share is possible."

He added that a federal law would have to be established that would ensure that the government retains control over Svyazinvest's subsidiaries.

Borodin's boss, Property Minister Alexander Braverman, suggested the same thing earlier this month when he said the plan to sell 25 percent minus two shares "is not the only option."

Communications Minister Leonid Reiman supported the idea of selling the government's remaining stake in Svyazinvest all at once, but like Yashin, he said it should only be done when the reorganization of the company is finished.

"Currently, the valuation of Svyazinvest is significantly lower than what it could be once the reorganization of the company's management is finished," Reiman said.

"You can't sell the company in its present state."

Analysts said it was unlikely that the Kremlin would allow such a significant sale until after the 2004 presidential elections are out of the way.

"The Kremlin is very unlikely to have any interest in having its grip over the wire-line sector loosened ahead of the presidential elections," UFG's Yakovitsky said.

"Svyazinvest is worth more than the current prices of its underlying assets suggest," Yakovitsky said.

"But realizing this hidden value requires timely and convincing progress on corporate restructuring and tariff reform, including long-awaited clarity on both the magnitude of tariff growth and the new tariff-setting methodology."