OPINION: Svyazinvest privatization, why is market exuberant?

Contributed by Alexander Kazbegi, telecoms analyst at Renaissance Capital

The news that the Interior Ministry agreed to the long-delayed and long-awaited privatization of Svyazinvest was taken by the market as exuberantly as one could possibly only imagine — the shares of Regional Telecom Companies (RTOs) were up 6.3% on average in two days and the shares of Rostelecom were up by 8.2% in the same time.

We don’t share the markets’ and some of our competitors’ hurray response to the news. You may call us pessimists, but we’d rather refer to ourselves as realists. Firstly, there is absolutely no detail to why and on which exact terms the Interior Ministry agreed to the privatization. It is to naive to assume that after not giving a go ahead for such a long time the Ministry was just persuaded by the proponents’ argumentation and yielded to obvious. We suspect the Ministry may have put its own preconditions in the privatization terms.

Secondly, the government — or rather Prime Minister Fradkov, the final entity on the way to paving way to privatization — may still come up with somewhat less exciting scheme: for instance, they may decide to privatize another 25% of Svyazinvest (which will be a joke), or 50% but not the entire 75%-1 share. As for the Ministry of Interior, their argument was based on the view that by privatizing Svyazinvest the government would be jeopardizing Russia’s national security. The cornerstone to their argument was that as Rostelecom (more then others) and RTOs (to a lesser degree) provide communication to the bulk of the Interior Ministry units (and pretty much for free), these companies cannot be held privately. Thus one possible sacrifice to getting their agreement is to leave Rostelecom outside of the privatization scope or to oblige the company to continue serving the interests of the power Ministries and depriving it from conducting business commercially.

Maybe we are wrong and as often times happens in Russia there was some sort of behind-the-curtain deal which allows for a no-obligation privatization of all companies in Svyazinvest. That would still not explain why Rostelecom shares were so strong over the last days, as the company is facing a tough future no matter what.

Consider this: RTO’s upside stems from two main items: (1) growing their revenues through a more efficient tariff structures and new services, and (2) cutting costs. There is hardly a consensus in terms of how much of these costs can be cut and frankly nobody can really put a number before it is known who the new owners of these companies are and what sort of new management they are going to bring in. But all brokers have some assumptions and all have factored improvements in revenue and considerable cost cutting. It’s the latter which mostly creates the type of upsides we are talking about (from 30% to more than 100% between various brokers) as the EBITDA margin is assumed to expand by between 6 to 12 percentage points, depending on the company. This by far drives most of the value creation rather then the revenue increase.

Rostelecom, on the other hand, already undertook drastic cost cutting — and successfully — and while it ran an EBITDA margin at 40% for the past year, there are signs of costs creeping in. Thus it is not going to be the costs that can drive Rostelecom’s revaluation and it has to be only revenues. In the telecom market that is about to be opened to competition it is hard to find a combination of tariff resiliency, traffics growth and market-share preservation that would make Rostelecom’s revenues look good.

Even if there was an overall growth in total long-distance revenues through positive price elasticity, while Rostelecom will at best preserve its market share (we don’t think they can as the company managed to lose 15% of domestic market and 30% of international market in what was considered to be their monopoly position), the RTOs will see all of the benefits of increased revenues. The telecommunication law allows hardly any competition on the local level and hence all the upside from increased total revenues will be far more visible at the RTO level than at Rostelecom’s.

Maybe the market is betting that there will be no liberalization? A highly unlikely scenario as licenses have already been issued and the only real missing part is interconnect. Then again, before the terms of privatization are announced why would the Ministry of Telecommunications rush to determine interconnect? It’s wiser to see what the terms are and how the prospective buyers, which we think are Telecominvest jointly with Access and Sistema, agree to carve up the assets before finally defining rules. However, liberalization is only postponed till January 1, 2006, until which time Svyazinvest is unlikely to be privatized anyway, and if Russia wants WTO membership giving up the already de facto lost monopoly of the long-distance market sounds such an obvious proposition.

We deliberately don’t want to put numbers here; we just want to show that Rostelecom’s current business model will not create value. Will they get new revenues from a carrier pre-selection rule or possible access to end-users, as some of other brokers suggest? We very much doubt that. Rostelecom had announced its entry into the corporate market about three years ago and we have seen nothing since. Major clients are already split between the stronger players, Golden Telecom, Comstar UTS, Equant etc. Getting into their domain is extremely difficult because these companies offer not just a dial tone but a complex array of telecom services which Rostelecom is simply unable to match.

None of the carrier of carriers in the world has ever made a good investment. The largest of them all, AT&T, has posted a 7% compound annual growth rate (CAGR) return over the 20 years since it was made a long-distance carrier, only underperforming the S&P index by 2.5 percentage points and finally biting the dust in 2005. We would avoid Rostelecom, as even if the omens turn out positive for them, their upside potential if far inferior to the RTOs as the latter are exposed to much of the same upside for revenues as Rostelecom but additionally have enormous cost-cutting potential.

As for RTOs, the market also seems to think that the sky is the limit. We just want to warn not to get carried away — you don’t want to hold companies at 6x EBITDA if privatization terms are not generous, if privatization is delayed or the buyers turn to be not as aggressive cost-cutters as we all wanted them to be. In any case, if we are correct that two ‘winning’ consortia will be Telecominvest and Sistema then we would strongly advise positioning oneself as close as possible to the buyers, i.e. in the companies which they are likely to use/make their flagships: North-West Telecom and MGTS.

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