Rostelecom 20-F 2005
Filed with the Securities and Exchange Commission on June 29, 2005
TABLE OF CONTENTS
As used in this annual report, Rostelecom, the company, the group we, us or our refers to Open Joint Stock Company Long-Distance and International Telecommunications Rostelecom and its consolidated subsidiaries.
We publish our consolidated financial statements in Russian rubles. In this annual report, (i) references to RUR and rubles are to Russian rubles; (ii) references to US$ and U.S. dollars are to United States dollars; (iii) references to JPY are to Japanese yen; (iv) references to DEM are to German marks; and (v) references to EUR and euro are to the common currency of the European Economic and Monetary Union. Unless otherwise indicated, all RUR figures as of and for the years ended of December 31, 2000, 2001 and 2002 have been restated in terms of the ruble purchasing power current as of December 31, 2002.
For convenience only (except where noted otherwise), certain RUR figures for 2004 have been converted into U.S. dollars at the rate of RUR 27.7487 = US$1.00, which was the exchange rate published by the Central Bank of the Russian Federation, or the Central Bank, for December 31, 2004. These conversions should not be construed as a representation that the RUR amounts actually represent such U.S. dollar amounts or could be converted into U.S. dollars at the rate indicated. The ruble is not a convertible currency outside the territory of the Russian Federation. For more information, see Item 10. Additional Information - D. Exchange Controls.
LEGEND OF INDUSTRY-RELATED TERMS
The abbreviations of certain terms set forth below relate to the telecommunications industry and appear throughout this document.
ASN: Automatic switching node
ATE: Automatic truck exchange
DLD: Domestic long-distance
DRRL: Digital radio-relay line
DWDM: Dense wavelength division multiplexing
FOL: Fiber optic line
IRC: Interregional company
IFS: International free service
ILD: International long-distance
ISC: International switching center
ISDN: Integrated services digital network
ISR: Integral Settlement Rate
ITE: International trunk exchange
ITU: International Telecommunications Union
LSR: Linear Settlement Rate
LTO: Local Telephone Operator
PSTN: Public switched telephone network
MPLS: Multi-Protocol Label Switching
SDH: Synchronous Digital Hierarchy
TSR: Termination Settlement Rate
UIFN: Unified International Free Numbers
VoIP: Voice over Internet Protocol
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Matters discussed in this document may constitute forward-looking statements within the meaning of Section 27A of the U.S. Securities Act of 1933 (the U.S. Securities Act) and Section 21E of the U.S. Securities Exchange Act of 1934 (the U.S. Exchange Act). The Private Securities Litigation Reform Act of 1995 provides safe harbor protections for forward-looking statements in order to encourage companies to provide prospective information about their businesses. Forward-looking statements include statements concerning plans, objectives, goals, strategies, future events or performance, and underlying assumptions and other statements, which are other than statements of historical facts.
We desire to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 and are including this cautionary statement in connection with this safe harbor legislation and other relevant law. This document and any other written or oral statements made by us or on our behalf may include forward-looking statements, which reflect our current views with respect to future events and financial performance. The words believe, expect, anticipate, intend, estimate, forecast, project, predict, plan, will, may, should, could and similar expressions identify forward-looking statements. Forward-looking statements appear in a number of places including, without limitation, Item 3. Key Information - D. Risk Factors, Item 4. Information on the Company - B. Business Overview and Item 5. Operating and Financial Review and Prospects, and include statements regarding:
The forward-looking statements in this document are based upon various assumptions, many of which are based, in turn, upon further assumptions, including without limitation, managements examination of historical operating trends, data contained in our records and other data available from third parties. Although we believe that these assumptions were reasonable when made, because these assumptions are inherently subject to significant uncertainties and contingencies which are difficult or impossible to predict and are beyond our control, we cannot assure you that we will achieve or accomplish these expectations, beliefs or projections. In addition to these important factors and matters discussed elsewhere herein and in the documents incorporated by reference herein, important factors that, in our view, could cause actual results to differ materially from those discussed in the forward-looking statements include the achievement of the anticipated levels of profitability and growth, the development and impact of regulatory initiatives, the timely development and acceptance of new services and products, the impact of competitive pricing, the ability to obtain necessary regulatory approvals, the condition of the economies of Russia and certain other CIS countries, political stability in Russia and certain other CIS countries, the impact of general business and global economic conditions and other important factors described herein and from time to time in the reports filed by us with the U.S. Securities and Exchange Commission, or the SEC.
Except to the extent required by law, neither we, nor any of our respective agents, employees or advisors intends or has any duty or obligation to supplement, amend, update or revise any of the forward-looking statements contained in this document.
The selected financial data as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002 presented below have been derived from, and are qualified by reference to, the consolidated financial statements, including the notes thereto, included elsewhere in this annual report. Selected financial data as of December 31, 2002, 2001 and 2000 and for the years ended December 31, 2001 and 2000 have been derived from our previously published consolidated financial statements not included in this annual report. Our consolidated financial statements have been prepared in accordance with International Financial Reporting Standards, or IFRS. The information below should be read in conjunction with Item 5. Operating and Financial Review and Prospects and the consolidated financial statements and notes included elsewhere in this annual report.
The selected financial data set forth below reflects the impact of the restatements of our historical financial statements for periods ending on or prior to December 31, 2003 related to the recognition of certain revenue and related expenses, pension benefits and to earnings per share due to our early adoption of IAS 33. For more information on these restatements, see Item 5. Operating and Financial Review and Prospects - A. Operating Results - Restatement of Historical Financial Statements and Note 2 to our consolidated financial statements included elsewhere in this annual report. All referenced amounts for prior periods in this annual report are presented on a restated basis.
IFRS differs in certain significant respects from accounting principles generally accepted in the United States, or U.S. GAAP. For a discussion of the principal differences between IFRS and U.S. GAAP inasmuch as they relate to us, see Note 36 to the consolidated financial statements included elsewhere in this annual report.
Unless otherwise indicated, the following selected financial data as of and for the years ended December 31, 2004 and 2003 are presented in millions of rubles and the selected financial data as of and for the years ended December 31, 2002, 2001 and 2000 are presented in millions of rubles, restated in terms of the ruble purchasing power current as of December 31, 2002. Per share amounts are expressed in rubles.
Effective August 1, 2003, the government anti-monopoly authority implemented a new system for settlements between us, on the one hand, and regional operators of the Svyazinvest Group and alternative operators, on the other hand, under which we began to bill operators originating domestic long distance, or DLD, calls using one settlement rate and to pay to operators terminating the calls a termination fee based on another settlement rate. Before this change, we made no payments for termination and recognized revenue for processing traffic originating in networks of other operators on the basis of a single settlement rate, on a net basis. See Item 4. Information on the Company - B. Business Overview - Services - Domestic Tariffs and Note 20 to the consolidated financial statements for additional information.
The pro-forma information calculated on the basis of the new settlement system as if it was applied effective January 1, 2000 is presented below in millions of rubles.
The table below sets forth, for the periods and dates indicated, high, low, average, and period-end rates of the Central Bank for the purchase of U.S. dollars, expressed in Russian rubles per one U.S. dollar. No representation is made that the Russian ruble or U.S. dollar amounts referred to herein could have been or could be converted into U.S. dollars or Russian rubles, as the case may be, at any particular rate. The Russian ruble is not a convertible currency outside the territory of the Russian Federation and is subject to significant restrictions on trading within the territory of Russia. See also Item 10. Additional Information - D. Exchange Controls.
The following table sets forth, for the period of December 1, 2004 to June 27, 2005, the monthly high and low exchange rates of the Central Bank for the purchase of U.S. dollars.
An investment in our shares and ADSs involves a high degree of risk. You should carefully consider the following information about these risks, together with the information contained in this annual report, before you decide to buy our shares or ADSs. If any of the following risks actually occurs, our business, prospects, financial condition or results of operations could be materially and adversely affected. In that case, the value of our shares and ADSs could also decline and you could lose all or part of your investment.
The risks and uncertainties that our management believes are material are described below, but these risks and uncertainties may not be the only ones we face. Additional risks and uncertainties, including those our management currently is not aware of or deems immaterial, may also result in decreased revenues, increased expenses or other events that could result in a decline in the value of our shares and ADSs.
Risks Relating to Our Business
Implementation of the new Federal Law on Communications, or the Communications Law, will cause us to lose our monopoly position in the Russian long distance telecommunications market and impose an additional financial burden on us which may materially and adversely affect our business, financial condition and results of operations
Reform of the Russian telecommunications industry began with the introduction of the new Communications Law in 2004 and has intensified as implementing regulations have been enacted thereunder. In particular, several regulations have taken effect in 2005 that directly impact the DLD/ILD telecommunications services market in Russia and are ultimately expected to lead to the restructuring and liberalization of this market. For example, regulations enacted pursuant to the Communications Law allow telecommunications operators to apply for DLD/ILD telecommunications services licenses. Several operators are reported to have already applied for such licenses, and DLD/ILD licenses were awarded to three telecommunications providers pursuant to the new regulations in May 2005. If these and other alternative operators begin to provide nationwide DLD/ILD telecommunications services, we will lose our monopoly position in the fixed line DLD/ILD telecommunications sector and our market share in the fixed line DLD/ILD services market may erode.
In addition, other regulations enacted pursuant to the Communications Law contemplate a major restructuring of the DLD/ILD interconnection system and government regulation of operators with a significant position in the market. Among the most significant gaps in the new regulatory regime is how or whether the new regulations will modify the governments regulation of DLD/ILD tariffs charged by licensed operators.
As we currently hold a monopoly position in the Russian DLD/ILD telecommunications services market, these regulatory changes, if implemented, are certain to have a significant impact on our business. However, given the substantial gaps that remain in the legislative framework and lack of interpretive guidance from the regulatory authority regarding certain ambiguous provisions in the new regulations, we are unable to predict with any certainty how the new regulatory regime will impact our business, financial condition and results of operations.
The Communications Law also provides for the establishment of a universal services reserve fund for the purpose of supporting communications companies operating in less developed regions of Russia by subsidizing their construction and
maintenance of telecommunications networks in such regions. This reserve fund will be funded by a levy imposed on all communication services providers, including us. According to a government decree enacted on April 21, 2005, such providers must make quarterly payments in the amount of 1.2% of the difference between their total revenues and revenues generated by interconnection and traffic transit services. However, the procedures for its collection and subsequent distribution have not yet been established. This additional levy, the amount of which may be changed by the Russian government at its own discretion, will increase our costs and may materially and adversely affect our financial condition and results of operations.
See Item 4. Information on the Company - B. Business Overview - The Telecommunications Industry in Russia - Liberalization of the Russian Telecommunications Market for a description of the regulatory reform of the DLD/ILD telecommunications services market and the uncertainties regarding how the liberalization program will impact our business, financial condition and results of operations.
We face increasing competition from alternative operators that may result in reduced operating margins and loss of market share
Alternative operators are particularly active in the more profitable segments of the Russian telecommunications market, including mobile services, data transmission services and long-distance and international telecommunications services. In 2004, alternative operators continued to expand their presence in the telecommunications services market, and the Russian ILD market is becoming increasingly competitive. Moreover, the ongoing liberalization of the DLD/ILD telecommunications market will likely increase competition within this market as alternative operators granted licenses in 2005 begin to provide services and, thereby, erode our monopoly position. Increased competition may result in reduced operating margins and loss of market share. See Item 4. Information on the Company - B. Business Overview - Competition for information regarding our competitors and new DLD/ILD license holders.
In addition, the rapid development of mobile communications is allowing mobile operators greater access to the end-users of telephone services nationwide. Mobile operators have the technical capability and legal right to transit DLD traffic to public switched telephone networks, or PSTNs, through the mobile transit operator OJSC Multiregional Transit Telecom, or MTT. Mobile operators also have the legal and technical capability to directly exchange mobile-to-mobile traffic. Due to the mobile operators ability to bypass our network when transmitting DLD/ILD traffic, we carried an insignificant amount of mobile traffic during 2004, and we may be unable to increase or maintain our share of mobile traffic in the future.
Our independent registered public accounting firm reported a material weakness in our internal control over financial reporting and we may not be able to remedy this material weakness or prevent future material weaknesses. If we fail to do so there is a more than remote likelihood that a material misstatement of the annual or interim statements will not be prevented or detected
In connection with their audit of our consolidated financial statements for the year ended December 31, 2004, our independent registered public accounting firm identified a material weakness in our internal control over financial reporting as defined in the standards established by the Public Company Accounting Oversight Boards Auditing Standard No. 2. Specifically, our independent registered public accounting firm reported that given the size of our company and our consolidated subsidiaries, complexity of business transactions, number of locations, increasing requirements from the regulatory bodies (including those introduced by the Sarbanes-Oxley Act), the absence of a sufficiently integrated information system to support the process for IFRS financial reporting and lack of effective communications, the number of appropriately qualified and skilled employees within our IFRS financial reporting department is not adequate to fully meet the IFRS, U.S. GAAP and SEC reporting requirements.
Notwithstanding the steps we have taken and continue to take that are designed to remediate this material weakness, we may not be successful in remediating this material weakness in the near or long term and we may not be able to prevent other material weaknesses in the future. Any failure to maintain or implement required new or improved internal control over financial reporting, or any difficulties we encounter in their implementation, could result in significant deficiencies or additional material weaknesses, cause us to fail to meet our periodic reporting obligations or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding the effectiveness of our internal control over financial reporting that will be required when the SECs rules under Section 404 of the Sarbanes-Oxley Act of 2002 become applicable to us beginning with our annual report for the year ending December 31, 2006, to be filed in 2007. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in the price of our ADRs. See Item 15. Controls and Procedures for additional information.
To comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002, we will have to divert significant moneys and resources, including senior management time, from our operating businesses, which could materially adversely affect our business, results of operations and prospects
Section 404 of the Sarbanes-Oxley Act and the SECs and the Public Company Accounting Oversight Boards regulations thereunder currently are scheduled to become applicable to us for the fiscal year ending December 31, 2006. These regulations include a requirement that our management evaluate the effectiveness of our internal control over financial reporting on an annual basis and disclose any material weaknesses in our internal control over financial reporting. Our independent registered public accounting firm will be required to audit managements evaluation of our internal control over financial reporting. We believe that significant expenditures and resources, as well as the time of senior management, will be required to design, maintain and evaluate internal control over financial reporting under these new rules. In particular, senior management time will be diverted from running our business. For these reasons, the costs involved in attempting to achieve Section 404 compliance could have a material adverse effect on our business, results of operation and prospects.
We face risks related to our end-user business in Moscow
Moscow is currently the only region in Russia where we deal directly with end-users, providing DLD and ILD services and billing subscribers directly. The Moscow telecommunications market is highly competitive, particularly in the corporate customer segment. Our share in the Moscow DLD and ILD services market has declined in the last few years, particularly in the corporate customer segment. Because competing operators are smaller and tend to be more flexible in their tariff policy, as their activities are not subject to anti-monopoly regulation, our market share in Moscow may continue to decline, thereby limiting the growth of our revenues from Moscow end-user subscribers and potentially having a material adverse effect on our financial condition and results of operations.
If the demand for certain communications services we have recently introduced or are developing does not increase, our ability to achieve further revenue growth from these services will be limited
We have recently introduced or are developing new products and services, including (1) our Intelligent Network, which provides toll-free and mass-calling inquiry services, (2) our Televoting service, which provides a mass-calling service for TV, radio and other press events involving a high call volume and (3) our Communications Card, a pre-paid telephone card service. If the markets for these services do not grow as expected, our ability to achieve further revenue growth may be impaired. Furthermore, we may be unable to take advantage of any growth in demand for these services if we fail to develop and market our own services on a timely basis.
In addition, we are entering the transit market between Europe and Asia. However, even if we successfully enter the market, the demand for Europe-Asia transit services may decline due to economic conditions as well as increasing competition from other telecommunications operators, the commissioning of new cable systems and the rapid expansion of new services. Our inability to gain market share in the Europe-Asia traffic transit market will limit our ability to increase our revenues and may preclude us from achieving a favorable return on our investments in this segment.
We face risks resulting from significant delays in the collection of receivables
We bill end-users at set tariffs and IRCs and other local telecommunications operators for domestic long-distance and international traffic at either an agreed proportion of the receipts that the IRCs collect from subscribers or an agreed rate based upon minutes of traffic for the use of our network. As with many other Russian companies, we have in the past experienced, and continue to experience, significant delays in payment from certain government-funded entities and ministries, and some international operators. The incidence of delayed payments and bad debt may increase in the future if we begin to provide services directly to end-users nationwide. Delays in payments by our customers, including IRCs, as well as any significant level of bad debt, may have a material adverse effect on our business, financial conditions and results of operations.
We are dependent on certain key suppliers for our equipment
The operation of our network depends upon our ability to obtain adequate supplies of switching and other network equipment on a timely basis. At present, we purchase component parts for switching and certain network equipment from Siemens AG, NEC Corporation, Alcatel, Fujitsu Ltd., Huawei Technologies Co, Ltd. and Ericsson Nikola Tesla. Our business could be adversely affected if we are unable to obtain adequate component parts or equipment in a timely manner from our current suppliers or any alternative supplier, or if there were significant increases in the costs of such equipment.
We, our principal shareholders and their affiliates have engaged and may continue to engage in transactions among ourselves that may present conflicts of interest, and may be subject to challenge by minority shareholders
We, our principal shareholders and their affiliates have engaged and may continue to engage in numerous significant transactions among ourselves, potentially resulting in the conclusion of transactions on terms not determined by market forces. These transactions may be considered interested party transactions under Russian law, requiring approval by disinterested directors, disinterested independent directors or disinterested shareholders. See Item 10. Additional Information - B. Description of Charter Capital and Certain Requirements of Russian Legislation for additional information regarding interested party transaction approvals. These transactions have not always been properly approved
and, therefore, may be challenged by minority shareholders. In addition, Russian law requires a three-quarters majority vote of the holders of voting stock present at a shareholders meeting to approve certain actions, including, for example, charter amendments, major transactions involving assets in excess of 50% of the assets of the company, repurchase by the company of shares and share issuances. In some cases, minority shareholders may not approve interested party transactions requiring their approval or other transactions requiring supermajority approval. In the event that these minority shareholders were to successfully challenge past interested party transactions, or do not approve interested party or other transactions in the future, we could be limited in our operational flexibility and our results of operations could be materially and adversely affected.
Failure of network and systems equipment could significantly interrupt our operations
Our network is subject to a number or risks, including, among others:
Many of these risks are outside of our control.
Any failure in our network or other systems or hardware that causes significant interruptions in our operations could have a material adverse effect on our business, financial condition and results of operations. Our operations are also dependent upon our ability to integrate successfully new and emerging technologies and equipment into our network, which could increase the risk of a systems failure and cause a further strain on our network. Prolonged or significant system failures, or customer difficulty in accessing and maintaining a connection with our network, could seriously damage our reputation, result in the attrition of our customer base and have a material advise effect on our business, financial condition and results of operations.
Infringement by other telecommunications operators of our rights relating to transit of DLD and ILD traffic may have a material adverse effect on our financial condition and results of operations
Insufficient action by governmental authorities in ensuring compliance with applicable laws allows certain companies to infringe our rights in respect of DLD and ILD traffic transit and termination of incoming traffic. The absence of social and cross-subsidies burdens on these companies may allow these companies to offer substantially lower tariffs than we do. This, in turn, negatively impacts our revenues by causing our market share to decrease and forcing us to reduce our tariffs in order to remain competitive. Our inability to maintain our monopoly position coupled with the maintenance of cross-subsidies may have a material adverse effect on our financial condition and results of operations.
Computer viruses may harm or disrupt our telecommunications and IT networks
As telecommunications and IT networks increase in size and complexity, they are becoming increasingly susceptible to computer viruses. These viruses can potentially spread throughout a network system, slowing the network and disrupting service. In the event that any of our telecommunications or IT networks are the target of a virus, we may be unable to maintain the integrity of such networks and software operations, which could have a material adverse effect on our business and results of operations.
Our business operations could be significantly disrupted if we lost key members of our management
We are dependent on our senior management for the implementation of our strategy and operation of our day-to-day activities. In addition, the professional experience of members of senior management is important to the conduct of our business. No assurance can be given that management will continue to make their services available to us, and we are not insured against the detrimental effects to our business resulting from the loss or dismissal of key personnel.
We are also dependent on our qualified personnel required for financial reporting in accordance with IFRS, U.S. GAAP and SEC requirements. In Russia, there is only a limited number of individuals with adequate IFRS, U.S. GAAP and SEC reporting expertise and there is increasing demand and intense competition for such personnel as more Russian companies are beginning to prepare financial statements on the basis of IFRS or U.S. GAAP. Such competition makes it difficult for us to hire and retain such personnel, and there is a risk that we will not have sufficient qualified personnel to meet our needs. The loss of such key personnel could have a material adverse effect on our business, financial condition and results of operations. See also Our independent registered public accounting firm reported a material weakness in our internal control over financial reporting and we may not be able to remedy this material weakness or prevent future material weaknesses. If we fail to do so there is a more than remote likelihood that a material misstatement of the annual or interim statements will not be prevented or detected.
Our existing arrangements with trade unions may not be renewable on terms favorable to us, and our operations could be adversely affected by strikes and lockouts.
Over half of our employees are represented by the Telecommunications Union of Russia. Large union representation subjects our business to the risks of interruptions through strikes, lockouts or delays in renegotiations of labor contracts. Our existing collective bargaining agreement also may not be renewed on terms favorable to us. In such events, our business, financial condition and results of operations could be materially and adversely affected.
We do not maintain insurance coverage for all of our assets
We do not maintain third party insurance for all of our assets. Currently, our insurance policies cover approximately 43% of our cable and transmission devices and approximately 37% of our total property, plant and equipment. At present, however, we do not carry insurance for business interruption or liability to third parties for damage to property or the environment resulting from or connected with our property or activities. Any significant damage to our facilities and networks, whether as a result of fire, flooding, earthquake or other causes, could have a material adverse effect on our business, financial condition and results of operations.
The continued practice of cross-subsidies and the resulting tariff imbalances could cause our customers to obtain services from our competitors
IRCs provide local telephony service to their customers at below market rates and are subsidized from DLD and ILD operations. In particular, IRCs receive payments from us for traffic termination on their network at a termination settlement rate which exceeds their costs and a market rate profit, and thereby subsidize their loss-making local communications business.
Alternative operators who compete with us are not regulated by the FAS, do not subsidize the IRCs and are thus able to set their DLD/ILD tariffs at rates that are lower than our rates. Thus, our ability to maintain our leading position in the Russian long-distance telecommunications market will largely depend on our ability to improve our tariff policy and on the Russian governments adoption of laws and regulations to stimulate competition, eliminate cross-subsidies and provide for fair and equal application of regulations to all telecommunications operators.
We are subject to the regulation and control of the FST and FAS and our failure to comply with these regulations could have a material adverse effect on us
Under Russian law, the state has authority to regulate, to a certain extent, activities of natural monopolies. As we are considered by law to be a natural monopoly, we are subject to regulation by the Federal Service on Tariffs, or the FST. In addition, as an entity controlling more than 35% of the DLD and ILD telecommunications market in Russia, we are also subject to regulation by the FAS.
The Natural Monopolies Law provides a legal basis for the federal regulation of telecommunications providers and provides for state control over the setting of tariffs for publicly-accessible telecommunications services, mail services and other activities. This law significantly impacts our ability to set tariffs independently. The Natural Monopolies Law also governs the types of transactions into which a regulated entity, such as us, may enter. Any failure to comply with such regulation could materially and adversely affect our business. The Russian government, through the FST, regulates end-user DLD tariffs and DLD transit tariffs and may require us to enter into specified contracts with state-owned entities. Although we are permitted to petition the FST to change the tariffs based on such criteria as inflation and increased costs, such requests may not be granted and the FST may not adequately take such factors into account in setting tariffs. In addition, as a regulated entity, we are not permitted to refuse to enter into contracts with particular consumers if the FAS so requires. Any of the above circumstances could have a material adverse effect on our business, financial conditions and results of operations.
Failure to renew our licenses or receive renewed licenses with similar terms to our existing licenses could have a material adverse effect on our business and results of operations
All of our activities in the telecommunications industry are subject to licensing requirements. Our licenses expire periodically and may be renewed upon application to the Federal Service for Oversight of the Communications Sector. Officials of the Ministry of Information Technologies and Communications have broad discretion in deciding whether to renew a license.
The Communications Law also contains a broad list of grounds for the suspension and cancellation of licenses issued to communications operators. If we fail to comply with the requirements of applicable Russian legislation or fail to meet any terms of our licenses, our licenses and other authorizations necessary for our telecommunications operations may be suspended or terminated.
Failure to renew our licenses or receive renewed licenses with similar terms to our existing licenses, or the suspension or termination of licenses or other necessary governmental authorizations, could have a material adverse effect on our business and results of operations.
In addition, almost all telecommunications equipment used by us is subject to certification requirements. Failure to renew these certifications as necessary could result in our inability to import and use such equipment, which could have a material adverse effect on our business and results of operations.
Risks Relating to Our Financial Condition
The actual amount and timing of our future capital requirements may differ materially from our current estimates due to various factors, many of which are beyond our control
The actual amount and timing of our future capital requirements may differ materially from our current estimates due to various factors, many of which are beyond our control. Additional financing may be required in the event of departures from our current business plans and projections, including those caused by (i) unforeseen delays, (ii) cost overruns, (iii) changes to engineering designs, (iv) demand for new services, (v) adverse regulatory, technological or competitive developments and/or (vi) major changes in market conditions. Our capital requirements have and may continue to deviate materially from our estimates of such requirements.
We face risks related to fluctuations in the Russian rate of inflation and ruble exchange rates
Until recently, the ruble has fluctuated dramatically against certain foreign currencies, including the U.S. dollar, the euro and the Japanese yen, in the great majority of instances falling in value. In 2004, approximately 88% of our revenues and 80% of our expenses were denominated in rubles, and 100% of our total debt was denominated in currencies other than the ruble. We are not engaged in any active hedging of the foreign exchange risk arising out of our operating activities. As a result, a devaluation of the ruble against foreign currencies may adversely affect our ability to repay our foreign-currency denominated indebtedness, and increase our expenses in ruble terms. The devaluation of the ruble also results in losses in the value of our ruble-denominated assets, such as ruble deposits.
In addition, the Russian economy has been characterized by high rates of inflation. In 2004, the inflation rate of 11.7%, combined with the nominal appreciation of the ruble, resulted in the appreciation of the ruble against the U.S. dollar in real terms. As we tend to experience inflation-driven increases in certain of our costs, including salaries and rents, which are sensitive to rises in the general price level in Russia, our costs in U.S. dollar terms will rise. In this situation, due to competitive pressures and regulation of our tariffs, we may not be able to raise the prices we charge for our products and services sufficiently to preserve operating margins. Accordingly, high rates of inflation in Russia could increase our costs, decrease our operating margins and have a material adverse effect on our financial condition and results of operations.
Russian currency control regulations hinder our ability to conduct our business
The Central Bank has from time to time imposed various currency control regulations in attempts to control the U.S. dollar/ruble exchange rate, and may take further actions in the future. Furthermore, the government and the Central Bank may impose additional requirements on cash inflows and outflows into and out of Russia or on the use of foreign currency in Russia, which could prevent us from carrying on necessary business transactions or from successfully implementing our business strategy.
A new framework law on exchange controls took effect on June 18, 2004. This law empowers the government and the Central Bank to further regulate and restrict currency control matters, including operations involving foreign securities and foreign currency borrowings by Russian companies. The new law also abolishes the need for companies to obtain transaction-specific licenses from the Central Bank, envisaging instead the implementation of generally applicable restrictions on currency operations. As the evolving regulatory regime is new and untested, it is unclear whether it will be more or less restrictive than the prior laws and regulations it has replaced.
Limitations on the conversion of rubles to other currencies in Russia could increase our costs when making payments in other currencies to suppliers and creditors and could cause us to default on our obligations to them
As of December 31, 2004, we had US$156.7 million of indebtedness denominated and payable in various foreign currencies, including the U.S. dollar, the Japanese yen and the euro. Russian legislation currently permits the conversion of ruble revenues into foreign currency. However, the market in Russia for the conversion of rubles into foreign currencies is limited. The scarcity of foreign currencies may tend to inflate their values relative to the ruble, and such a market may not continue to exist, which could increase our costs when making payments in foreign currencies to suppliers and creditors.
Additionally, any delay or other difficulty in converting rubles into a foreign currency to make a payment or delay or restriction in the transfer of foreign currency could limit our ability to meet our payment and debt obligations, which could result in the loss of suppliers, acceleration of debt obligations and cross-defaults and, consequently, have a material adverse effect on our business, financial condition and results of operations.
Government regulation over foreign investments could hinder our access to foreign equity markets
Russian legislation on foreign investments does not prohibit or restrict foreign investment in the telecommunications industry. However, there is a lack of consensus on the methods and scope of government control over the
telecommunications industry. While draft legislation protecting the rights of foreign investors specifically in the telecommunications industry has been considered at various times, the Law on Foreign Investment in the Russian Federation does not provide any specific protections in this regard. Since the telecommunications industry is widely viewed as strategically important to the Russian Federation, governmental control over the telecommunications industry might increase, and foreign investment in the industry might be limited in the future. Any such increase in governmental control or limitation on foreign investment could impair the value of foreign investments in us and hinder our access to additional capital in foreign equity markets.
Risks Relating to the Control of us by Svyazinvest and the Government of the Russian Federation
We could be influenced by the government of the Russian Federation
The government, through the Russian Ministry of Property Relations and the Russian Federal Property Fund, holds a 50% interest (plus one share) and a 25% interest (less two shares), respectively, in OJSC Svyazinvest, or Svyazinvest, and effectively controls Svyazinvest and its group of companies, or the Svyazinvest Group. Svyazinvest holds 50.67% of our voting shares. Thus, the government of the Russian Federation has the ability to control matters submitted to a vote by our shareholders, including, but not limited to, the approval of the annual financial statements, declaration of dividends, capital increases in connection with acquisitions, take-over offers, investments, the election and removal of members of our Board of Directors and Management Board and other policy decisions. Moreover, three government representatives were elected to our Board of Directors at our annual shareholders meeting on June 25, 2005. The interests of the government of the Russian Federation and the factors it considers when exercising its votes could conflict with the interests of our other shareholders and holders of the ADSs, and it may make decisions that materially and adversely affect your investment in the shares or ADSs.
Our business operations could be significantly disrupted if our major shareholder undergoes a change in control or reduces its control over us
We are effectively controlled by Svyazinvest, which holds 50.67% of our voting shares. In turn, the government has a controlling interest in Svyazinvest. The Ministry of Information Technologies and Communications has indicated its support for selling the governments stake in Svyazinvest by the end of 2005. Any such change in control in Svyazinvest may have a material adverse impact on our business activities due to the following factors:
Currently, Svyazinvest is viewed as a strategic asset by the government mainly due to our vital role in providing telecommunications services to certain state agencies. The government may therefore elect to maintain a certain measure of control over Svyazinvests subsidiaries, including us, through the maintenance of a golden share or other means.
Risks Relating to the Russian Federation
Political and Social Risks
Since 1991, Russia has sought to transform itself from a one-party state with a centrally-planned economy to a democracy with a market economy. As a result of the sweeping nature of the reforms, and the failure of some of them, the Russian political system remains vulnerable to popular dissatisfaction, including dissatisfaction with the results of privatizations in the 1990s, as well as to demands for autonomy from particular regional and ethnic groups. Moreover, the composition of the Russian government, the prime minister and the other heads of federal ministries has, at times, been highly unstable. For example, six different prime ministers headed governments between March 1998 and May 2000. On December 31, 1999, President Yeltsin unexpectedly resigned. Vladimir Putin was subsequently elected president on March 26, 2000 and re-elected for a second term on March 14, 2004. Throughout his first term in office, President Putin maintained governmental stability. However, in February 2004, President Putin dismissed his entire cabinet, including the prime minister. This was followed in March 2004 by President Putins announcement of a far-reaching restructuring of the Russian government, with the stated aim of making the government more transparent and efficient. The changes included,
for example, reducing the number of ministries from 30 to 14 and dividing the government into three levels: ministries, services and agencies. In addition to the restructuring of the Russian federal government, the Russian parliament adopted legislation proposed by President Putin whereby the executives of sub-federal political units will no longer be directly elected by the population and will instead be nominated by the President of the Russian Federation and confirmed by the legislature of the sub-federal political unit. Further, President Putin has proposed to eliminate individual races in State Duma elections, so that voters would only cast ballots for political parties.
These and future changes in government, major policy shifts or lack of consensus between various branches of the government and powerful economic groups could disrupt or reverse economic and regulatory reforms. Any disruption or reversal of the reform policies, recurrence of political or governmental instability or occurrence of conflicts with powerful economic groups could have a material adverse effect on our business and the value of investments in Russia, and the value of our ADSs could decline.
Recent changes in the structure of the Russian federal executive authorities may lead to uncertainty in the regulation of our activities
As part of the broader administrative reform of the Russian federal executive authorities, the Russian government has designated new regulatory authorities to oversee the Russian telecommunications and securities markets. In the area of telecommunications, the Russian government has abolished the role of the Ministry of Information Technologies and Communications as the sole direct regulator of the Russian telecommunications sector and has established the following new bodies: the Federal Service for the Oversight of the Communications Sector, the Federal Agency of Communications and the Federal Agency of Information Technologies, each subordinated to the Ministry of Information Technologies and Communications. In the event these regulatory and supervisory bodies adopt and enforce new or more rigorous regulatory policies, we may face increased regulatory scrutiny and may be subjected to increased administrative costs.
Additionally, in March 2004, the Russian government abolished the former regulatory agency charged with regulating the Russian securities markets, the Federal Commission for the Securities Market, or FCSM, and established the Federal Service for the Financial Markets, or the FSFM, giving the new agency wider-ranging powers to regulate the Russian securities market than its predecessor. Any change in policy by the FSFM may lead to changes in the regulatory framework for the circulation of our securities, including the shares underlying the ADSs, which may affect the rights of ADS holders, including voting rights.
Conflict between federal and regional authorities and other conflicts could create an uncertain operating environment that would hinder our long term-planning ability and could materially and adversely affect the value of investments in Russia and consequently, the value of our securities
The Russian Federation is a federation of 88 sub-federal political units, consisting of republics, territories, regions, cities of federal importance and autonomous regions and districts. The delineation of authority and jurisdiction among the members of the Russian Federation and the federal government is, in many instances, unclear and remains contested. Lack of consensus between the federal government and local or regional authorities often results in the enactment of conflicting legislation at various levels and may lead to further political instability. In particular, conflicting laws have been enacted in the areas of privatization, land legislation and licensing. Some of these laws and governmental and administrative decisions implementing them, as well as certain transactions consummated pursuant to them, have in the past been challenged in the courts, and such challenges may occur in the future. This lack of consensus hinders our long-term planning efforts and creates uncertainties in its operating environment, both of which may prevent us from effectively and efficiently implementing our business strategy.
Additionally, ethnic, religious, historical and other divisions have given rise to tensions and, in certain cases, military conflict, such as the continuing conflict in Chechnya, which has brought normal economic activity within Chechnya to a halt and disrupted the economies of neighboring regions. Various armed groups in Chechnya have regularly engaged in guerrilla attacks in that area, and other parts of Russia also have experienced violence related to the Chechen conflict. Violence and attacks relating to this conflict have also spread to other parts of Russia, and several terrorist attacks have been carried out throughout Russia, including in Moscow. The further intensification of violence, including terrorist attacks and suicide bombings, or its spread to other parts of Russia, could have significant political consequences, including the imposition of a state of emergency in some or all of Russia. Moreover, any terrorist attacks and the resulting heightened security measures are likely to cause disruptions to domestic commerce and exports from Russia, and could materially and adversely affect our business and the value of investments in Russia, including the value of the ADSs.
Selective or arbitrary government action may have a material adverse effect on our business, financial condition and results of operations or prospects
We operate in an uncertain regulatory environment. Governmental authorities in Russia have a high degree of discretion and, at times, act selectively or arbitrarily, without hearing or prior notice, and sometimes in a manner that is inconsistent with legislation or influenced by political or commercial considerations. Selective or arbitrary governmental actions have reportedly included the denial or withdrawal of licenses, sudden and unexpected tax audits, criminal prosecutions and civil
actions. Federal and local government entities have also used ordinary defects in matters surrounding share issuances and registration as pretexts for court claims and other demands to invalidate such issuances and registrations or to void transactions, often for political purposes. Moreover, the government also has the power in certain circumstances, by regulation or government act, to interfere with the performance of, nullify or terminate contracts. Standard & Poors has expressed concerns that Russian companies and their investors can be subjected to government pressure through selective implementation of regulations and legislation that is either politically motivated or triggered by competing business groups. In this environment, our competitors may receive preferential treatment from the government, potentially giving them a competitive advantage over us.
In addition, in 2003 and 2004, the Ministry for Taxes and Levies aggressively brought tax evasion claims on certain Russian companies use of tax-optimization schemes, and press reports have speculated that these enforcement actions have been selective and politically motivated. Selective or arbitrary government action, if directed at us, could have a material adverse effect on our business, financial condition and results of operations or prospects.
Labor unrest in Russia may materially and adversely affect us
The failure of the government and many private enterprises to pay full salaries on a regular basis and the failure of salaries and benefits generally to keep pace with the rapidly increasing cost of living have led in the past, and could lead in the future, to labor and social unrest. Such labor and social unrest may have political, social and economic consequences, such as increased support for a renewal of centralized authority; increased nationalism, with restrictions on foreign involvement in the economy of Russia; and increased violence. An occurrence of any of the foregoing events could restrict our operations and materially and adversely affect our operations.
Crime, corruption and negative publicity could disrupt our ability to conduct our business and could materially and adversely affect our business, financial condition and results of operations or prospects
The political and economic changes in Russia in recent years have resulted in significant dislocations of authority. The local and international press has reported that significant criminal activity, including organized crime, has arisen, particularly in large metropolitan centers. Property crime in large cities has increased substantially. In addition, the local press and international press have reported high levels of official corruption in the locations where we conduct our business, including the bribing of officials for the purpose of initiating investigations by government agencies. Press reports have also described instances in which government officials engaged in selective investigations and prosecutions to further the commercial interests of certain government officials or certain companies or individuals. Additionally, published reports indicate that a significant number of Russian media regularly publish disparaging articles in return for payment. The depredations of organized or other crime, demands of corrupt officials, claims that we have been involved in official corruption or engaged in improper transactions or slanted articles, press speculation and negative publicity could disrupt our ability to conduct our business and could materially and adversely affect our business, financial condition and results of operations or prospects.
The Russian government may not be able to implement its policies of economic reforms and stabilization
Since the dissolution of the Soviet Union, the Russian economy has experienced at various times:
The Russian economy has been subject to abrupt downturns. In particular, on August 17, 1998, in the face of a rapidly deteriorating economic situation, the Russian government defaulted on its ruble-denominated securities, the Central Bank of Russia stopped its support of the ruble and a temporary moratorium was imposed on certain payments in other currencies. These actions resulted in an immediate and severe devaluation of the ruble and a sharp increase in the rate of inflation; a dramatic decline in the prices of Russian debt and equity securities; and an inability of Russian issuers to raise funds in the international capital markets.
These problems were aggravated by the near collapse of the Russian banking sector after the events of August 17, 1998, as evidenced by the termination of the banking licenses of a number of major Russian banks. This further impaired the ability of the banking sector to act as a consistent source of liquidity to Russian companies and resulted in the losses of bank deposits in some cases.
Recently, the Russian economy has experienced positive trends, such as the increase in the gross domestic product, a relatively stable national currency, strong domestic demand, rising real wages and a reduced rate of inflation; however, these trends may not continue or may be abruptly reversed. In particular, economic development within the different regions of Russia is still very uneven, which results in maintaining the practice of subsidies to dependent regions at the expense of donor regions that are economically better off. Moreover, there is a lack of consensus as to the scope, content and pace of economic and political reform. No assurance can be given that reform policies will continue to be implemented and, if implemented, will be successful, that Russia will remain receptive to foreign trade and investment, or that the economy in Russia will improve. Any failure of the current policies of economic reform and stabilization could have a material adverse effect on our business, financial condition and results of operations. In addition, the recoverability of the value of our assets, including collection of debt and receivables, and our ability to pay our debts as they mature, depend on the effectiveness of the fiscal measures and other economic reforms, which have been or may be undertaken by the Russian government.
Fluctuations in the global economy may adversely affect Russias economy and our business
The Russian economy is vulnerable to market downturns and economic slowdowns elsewhere in the world. As has happened in the past, financial problems or an increase in the perceived risks associated with investing in emerging economies could dampen foreign investment in Russia and Russian businesses could face severe liquidity constraints, materially and adversely affecting their economies. Additionally, because Russia produces and exports large amounts of oil, the Russian economy is especially vulnerable to the price of oil on the world market and a decline in the price of oil could slow or disrupt the Russian economy. Recent military conflicts and international terrorist activity have also significantly impacted oil and gas prices, and pose additional risks to the Russian economy. Russia is also a major producer and exporter of metal products and its economy is vulnerable to world commodity prices and the imposition of tariffs and/or antidumping measures by principal export markets. A slowdown in the Russian economy may have a material adverse effect on our business, financial condition and results of operations.
The physical infrastructure in Russia is in very poor condition, which could disrupt normal business activity
The physical infrastructure in Russia largely dates back to Soviet times and has not been adequately funded and maintained over the past decade. Particularly affected are the rail and road networks; power generation and transmission; communication systems; and building stock. For instance, in May 2005, a fire and explosion in one of the Moscow power substations built in 1963 caused a major outage in a large section of Moscow and some surrounding regions, which resulted in a halt of half of the Moscow metro lines leaving thousands of people blocked underground for a long time. The blackout also hit the ground electric transport, led to road traffic accidents and massive traffic congestion, disrupted electricity and water supply in office and residential buildings and affected mobile communications. The trading on exchanges and the operation of many stores and markets were also halted. Road conditions throughout Russia are poor, with many roads not meeting minimum quality requirements. The Russian government is actively considering plans to reorganize the nations rail and electricity systems. Any such reorganization may result in increased charges and tariffs while failing to generate the anticipated capital investment needed to repair, maintain and improve these systems.
The deterioration of physical infrastructure in Russia harms the national economy, disrupts the transportation of goods and supplies, adds costs to doing business and can interrupt business operations. Further deterioration in the physical infrastructure could have a material adverse effect on our business and the value of our securities.
The Russian banking system remains underdeveloped, and another banking crisis could place severe liquidity constraints on us
Russias banking and other financial systems are not well developed or regulated, and Russian legislation relating to banks and bank accounts is subject to varying interpretations and inconsistent applications. The August 1998 financial crisis resulted in the bankruptcy and liquidation of many Russian banks and almost entirely eliminated the developing market for commercial bank loans at that time. Although the Central Bank has the mandate and authority to suspend banking licenses of insolvent banks, many insolvent banks still operate. Most Russian banks also do not meet international banking standards, and the transparency of the Russian banking sector still lags far behind internationally accepted norms. Aided by
inadequate supervision by the regulators, many banks do not follow existing Central Bank regulations with respect to lending criteria, credit quality, loan loss reserves or diversification of exposure.
Recently, there has been a rapid increase in lending by Russian banks, which many believe has been accompanied by deterioration in the credit quality of the borrowers. In addition, a robust domestic corporate debt market is leading Russian banks increasingly to hold large amounts of Russian corporate ruble bonds in their portfolios, which is further deteriorating the risk profile of Russian bank assets. The serious deficiencies in the Russian banking sector, combined with the deterioration in the credit portfolios of Russian banks, may result in the banking sector being more susceptible to market downturns or economic slowdowns, including due to Russian corporate defaults that may occur during any such market downturn or economic slowdown. In addition, the Central Bank revoked the licenses of certain Russian banks during 2004, which resulted in market rumors about additional bank closures and many depositors withdrawing their savings. If a banking crisis were to occur, Russian companies would be subject to severe liquidity constraints due to the limited supply of domestic savings and the withdrawal of foreign funding sources that would occur during such a crisis.
There is currently a limited number of creditworthy Russian banks, most of which are located in Moscow. We have tried to reduce our risk by receiving and holding funds in a number of Russian banks, including subsidiaries of foreign banks. Nonetheless, the bulk of our excess ruble and foreign currency cash are held in Russian banks, including subsidiaries of foreign banks, in part, because Central Bank regulations so require and because the ruble is not transferable or convertible outside of Russia. There are few, if any, safe ruble-denominated instruments in which we may invest our excess ruble cash. Another banking crisis or the bankruptcy or insolvency of the banks from which we receive or with which we hold funds could result in the loss of our deposits or affect our ability to complete banking transactions in Russia, which could have a material adverse effect on our business, financial conditions and results of operations.
Lack of reliability of official data from the Russian government and agencies may affect our plans and strategy
Most of the market data and certain other information contained in this annual report were derived from publicly available information and we have relied on the accuracy of this information without independent investigation.
In addition, some of the information contained in this annual report has been derived from the official data of Russian government agencies. The official data published by Russian federal, regional and local governments are substantially less complete or well researched than those of Western countries. Official statistics may also be produced on different bases than those used in Western countries. Any discussion of matters relating to Russia in this document must, therefore, be subject to uncertainty due to concerns about the completeness or reliability of available official and public information. The veracity of some official data released by the Russian government may be questionable. In the summer of 1998, for example, the Director of the Russian State Committee on Statistics and a number of his subordinates were arrested and charged with manipulating economic data to hide the actual output of various companies. In addition, the lack of reliable statistics relating to trends in the Russian economy may have a negative impact on our long-term plans.
Weaknesses relating to the legal system and legislation create an uncertain environment for investment and business activity, which could have a material adverse effect on the value of the ADSs
Russia is still developing the legal framework required to support a market economy. The following risk factors relating to the Russian legal system create uncertainty with respect to the legal and business decisions made by us, many of which uncertainties do not exist in countries with more developed market economies:
Furthermore, several fundamental laws have only recently become effective. The recent nature of much of Russian legislation, the lack of consensus about the scope, content and pace of economic and political reform and the rapid evolution of the Russian legal system in ways that may not always coincide with market developments place the enforceability and underlying constitutionality of laws in doubt and results in ambiguities, inconsistencies and anomalies. In addition, Russian legislation often contemplates implementing regulations that have not yet been promulgated, leaving substantial gaps in the regulatory infrastructure. All of these weaknesses could affect our ability to enforce our rights under our licenses and contracts, or to defend ourselves against claims by others, and could affect enforcement in Russia of any rights of the holders of ADSs against us. Furthermore, there is no assurance that regulators, judicial authorities or third parties will not challenge our internal procedures and by-laws or our compliance with applicable laws, decrees and regulations.
These uncertainties also extend to property rights. During Russias transformation from a centrally planned economy to a market economy, legislation was enacted to protect private property against expropriation and nationalization. However, it is possible that due to the lack of experience in enforcing these provisions and due to potential political changes, these protections would not be enforced in the event of an attempted expropriation or nationalization. Some government entities have tried to re-nationalize privatized businesses. Expropriation or nationalization of any of our assets without equivalent compensation would have a material adverse effect on our activities.
In addition, many Russian laws are structured in a way that provides for significant administrative discretion in their application and enforcement. Reliable texts of laws and regulations at the regional and local levels may not be available, and usually are not updated or catalogued. As a result, applicable law is often difficult to ascertain and apply. In addition, the laws are subject to different and changing interpretations. As a result of these factors, even the best efforts to comply with applicable laws may not always result in full compliance.
Failure to comply with existing laws and regulations or the findings of government inspections, or increased governmental regulation of our operations, could result in substantial additional compliance costs or various sanctions which could materially and adversely affect our business, financial condition and results of operations
Our operations and properties are subject to regulation by various government entities and agencies in connection with obtaining and renewing various licenses and permits, as well as with ongoing compliance with existing laws, regulations and standards. Regulatory authorities exercise considerable discretion in matters of enforcement and interpretation of applicable laws, regulations and standards, the issuance and renewal of licenses and permits and in monitoring licensees compliance with the terms thereof. Russian authorities have the right to, and frequently do, conduct periodic inspections of our operations and properties throughout the year. Any such future inspections may conclude that we or any one of our particular subsidiaries have violated laws, decrees or regulations and we may be unable to refute such conclusions or remedy the violations.
Our failure to comply with existing laws and regulations or the findings of government inspections may result in the imposition of fines or penalties or more severe sanctions including the suspension, amendment or termination of licenses and permits, or in requirements that we cease certain of our business activities, or in criminal and administrative penalties applicable to officers of our companies. Any such decisions, requirements or sanctions, or any increase in governmental regulation of our operations, could increase costs and materially and adversely affect our business, financial condition and results of operations.
The judiciarys lack of independence and overall inexperience, the difficulty of enforcing court decisions and governmental discretion in enforcing claims could prevent us or you from obtaining effective redress in a court proceeding, materially and adversely affecting the value of the ADSs
The independence of the judicial system and its immunity from economic, political and nationalistic influences in Russia remain largely untested. The court system in Russia is understaffed and underfunded. Judges and courts are generally inexperienced in the area of business and corporate law. Judicial precedents generally have no binding effect on subsequent decisions. Not all Russian legislation and court decisions are readily available to the public or organized in a manner that facilitates understanding. The Russian judicial system can be slow or unjustifiably swift. Enforcement of court orders can, in practice, be very difficult in Russia. All of these factors make judicial decisions in Russia difficult to predict and effective redress uncertain. Additionally, court claims are often used in furtherance of political aims or infighting. We may be subject to such claims and may not be able to receive a fair hearing. Additionally, court orders are not always enforced or followed by law enforcement agencies, and the government may attempt to invalidate court decisions by backdating or retroactively applying relevant legislative changes.
Changes in the Russian tax system could materially and adversely affect an investment in the ADSs
Generally, taxes payable by Russian companies are substantial and numerous. These taxes include, among others:
The tax environment in Russia historically has been complicated by the fact that the tax laws are often unclear, allowing authorities broad discretion for interpretation. For example, tax laws are unclear with respect to the deductibility of certain expenses and, consequently, deductions taken by us which we believe to be consistent with the law may be subject to challenge. This uncertainty potentially exposes us to significant fines and penalties and enforcement measures despite our best efforts at compliance, and could result in a greater than expected tax burden.
Because of the political changes that have occurred in Russia over the past several years, there have been significant changes to the Russian taxation system. Global tax reforms commenced in 1999 with the introduction of Part One of the Tax Code of the Russian Federation, or the Tax Code, which sets general taxation guidelines. Since then, Russia has been in the process of replacing legislation regulating the application of major taxes such as corporate income tax, VAT and property tax with new chapters of the Tax Code.
In practice, the Russian tax authorities often interpret the tax laws in a way that rarely favors taxpayers, who often have to resort to court proceedings to defend their position against the tax authorities. Differing interpretations of tax regulations exist both among and within government ministries and organizations at the federal, regional and local levels, creating uncertainties and inconsistent enforcement. Tax declarations, together with related documentation such as customs declarations, are subject to review and investigation by a number of authorities, each of which may impose fines, penalties and interest charges. Generally, taxpayers are subject to inspection for the three calendar years of their activities that immediately proceeded the year in which the audit is carried out. As previous audits do not exclude subsequent claims relating to the audited period, the statute of limitations is not entirely effective. In addition, in some instances, new tax regulations have been given retroactive effect. Recently, the Constitutional Court of the Russian Federation ruled that, in some instances, VAT paid on a commercial enterprises purchases, or input VAT, cannot be offset against VAT collected from sales to the extent that the input VAT was incurred on items purchased with borrowed funds.
Moreover, financial results of Russian companies cannot be consolidated for tax purposes. Therefore, each of our Russian subsidiaries pays its own Russian taxes and may not offset its profit or loss against the loss or profit of any of our other subsidiaries. In addition, intercompany dividends are subject to a withholding tax of 9% to 15%, though this tax does not apply to dividends paid out higher up the ownership chain once they have already been taxed at the lower level. These tax requirements impose additional burdens and costs on our operations, including management resources.
The foregoing conditions create tax risks in Russia that are more significant than typically found in countries with more developed tax systems, imposing additional burdens and costs on our operations. In addition to our substantial tax burden, these risks and uncertainties complicate our tax planning and related business decisions, potentially exposing us to significant fines and penalties and enforcement measures despite our best efforts at compliance, and could materially and adversely affect our business and the value of the ADSs.
Minority shareholders may be limited in their ability to pursue legal action against our management
Although Russian law provides some protection of rights of minority shareholders, corporate governance standards for many Russian companies have proven to be inefficient.
In general, minority shareholder protection under Russian law derives from supermajority shareholder approval requirements for certain corporate actions, as well as from the ability of a shareholder to demand that the company purchase the shares held by that shareholder if that shareholder voted against or did not participate in voting on certain types of actions. Companies are also required by Russian law to obtain the approval of disinterested shareholders for certain transactions with interested parties. See Item 10. Additional Information - B. Description of Charter Capital and Certain Requirements of Russian Legislation - Description of Charter Capital for a more detailed description of some of these protections. While these protections are similar to the types of protections available to minority shareholders in U.S. corporations, in practice, corporate governance standards for many Russian companies have proven to be poor, and minority shareholders in Russian companies have suffered losses due to abusive share dilutions, asset transfers and transfer pricing practices. Shareholder meetings have been irregularly conducted, and shareholder resolutions have not always been respected by our management. Shareholders of some companies also suffered as a result of fraudulent bankruptcies initiated by hostile creditors.
In addition, the supermajority shareholder approval requirement is met by a vote of 75% of all voting shares that are present at a shareholders meeting. Thus, controlling shareholders owning slightly less than 75% of outstanding shares of a company may have a 75% or more voting power if certain minority shareholders are not present at the meeting. In situations where controlling shareholders effectively have 75% or more of the voting power at a shareholders meeting, they are in a position to approve amendments to the charter of the company or significant transactions including asset transfers, which could be prejudicial to the interests of minority shareholders. It is possible that our current majority shareholders and our management in the future may not run us for the benefit of minority shareholders, and this could materially and adversely affect the value of the ADSs.
Disclosure and reporting requirements, as well as anti-fraud legislation, have only recently been enacted in Russia. Most Russian companies and managers are not accustomed to restrictions on their activities arising from these requirements. The concept of fiduciary duties of our management or directors to their companies and shareholders is also relatively new and is not well developed. Violations of disclosure and reporting requirements or breaches of fiduciary duties to us and our subsidiaries or to our shareholders could materially and adversely affect the value of the ADSs.
The Russian Law on Joint Stock Companies of December 26, 1995 (as amended), or the Joint Stock Companies Law, provides that shareholders owning not less than 1% of a companys ordinary shares may bring an action for damages against the management of the company on the grounds of breach of fiduciary duties.
However, Russian courts are still inexperienced with respect to such cases. Russian law does not contemplate class action litigation. Accordingly, the practical ability of minority shareholders to pursue legal action against our management may be limited.
The lack of a central and rigorously regulated share registration system in Russia may result in improper record ownership of our shares, including the shares underlying your ADSs
Ownership of Russian joint stock company shares (or, if the shares are held through a nominee or custodian, the holdings of such nominee or custodian) is determined by entries in a share register and is evidenced by extracts from that register. Currently, there is no central registration system in Russia. Share registers are maintained by the companies themselves or, if a company has more than 50 shareholders (as we do) or so elects, by licensed registrars located throughout Russia. Regulations have been issued regarding the licensing conditions for such registrars, as well as the procedures to be followed by both companies maintaining their own registers and licensed registrars when performing the functions of registrar. In practice, however, these regulations have not been strictly enforced, and registrars generally have relatively low levels of capitalization and inadequate insurance coverage. Moreover, registrars are not necessarily subject to effective governmental supervision. Due to the lack of a central and rigorously regulated share registration system in Russia, transactions in respect of a companys shares could be improperly or inaccurately recorded, and share registration could be lost through fraud, negligence, official and unofficial governmental actions or oversight by registrars incapable of compensating shareholders for their misconduct. This creates risks of loss not normally associated with investments in other securities markets.
Shareholder rights provisions under Russian law may impose additional costs on us, which could materially and adversely affect our financial condition
Russian law provides that shareholders that vote against or abstain from voting on certain matters have the right to sell their shares to the company at market value in accordance with Russian law. The decisions that trigger this right to sell shares include:
Our obligation to purchase shares in these circumstances, which is limited to 10% of our net assets calculated in accordance with Russian accounting standards at the time the matter at issue is voted upon could have a material adverse effect on our financial condition.
Russian legislation treating our depositary bank as the beneficial holder of the shares underlying the ADRs and lack of participation of ADR holders in shareholder votes hinder our ability to take corporate actions requiring a supermajority vote, including amending our charter
For two consecutive years, we have been unable to approve amendments to our charter. In accordance with the Joint Stock Companies Law, charter amendments must be adopted by a three-fourths majority of shareholders taking part in a general shareholders meeting.
In accordance with Russian legislation, our depositary bank, JPMorgan Chase Bank, is treated as the beneficial holder of the ordinary shares underlying our ADRs. Our bank-custodian, ING Bank (Eurasia), serving as a nominal holder for our depositary bank after receiving voting instructions from the depositary bank, is registered at our general shareholders meeting as the holder of the ordinary shares underlying the ADRs, which currently comprise approximately 25% of our total outstanding ordinary shares. However, historically, holders of only 2-5% of our ordinary shares represented by ADRs exercise their voting rights at our general shareholders meetings. As a result, approximately 25% of total shares eligible to be voted at our annual shareholders meeting in 2005 and 2004 were not voted, making it nearly impossible to reach the 75% threshold required to approve the amendments to our charter.
Our inability to amend our charter limits our flexibility in introducing changes to our corporate governance practices required by new regulations, listing rules and supervising authorities, and may have a material and adverse effect on our business, financial condition and results of operations.
We may be jointly and severally liable for obligations of certain of our subsidiaries
The Russian Civil Code and the Joint Stock Companies Law generally provide that the shareholders in a Russian joint stock company are not liable for the obligations of the joint stock company and bear only the risk of loss of their investment. An exception to this rule, however, is when the shareholder of a joint stock company is capable of determining decisions for such company. The person or entity capable of determining such decisions is deemed an effective parent. The person whose decisions are capable of being so determined is deemed an effective subsidiary.
Under the Joint Stock Companies Law, an effective parent bears joint and several responsibility for transactions concluded by the effective subsidiary in carrying out these decisions if:
In addition, an effective parent is secondarily liable for an effective subsidiarys debts if an effective subsidiary becomes insolvent or bankrupt resulting from the action or inaction of an effective parent. An effective parent is also secondarily liable for an effective subsidiarys debts if an effective subsidiary is declared insolvent or bankrupt resulting from the action or inaction of an effective parent. Accordingly, we could be liable in some cases for the debts of our consolidated subsidiaries. This liability could have a material adverse effect on our business, results of operations and financial condition.
Vaguely drafted Russian transfer pricing rules and lack of reliable pricing information may impact our results of operations
Russian transfer pricing rules entered into force in 1999, giving Russian tax authorities the right to control prices for transactions between related entities and certain other types of transactions between independent parties, such as foreign trade transactions or transactions with significant price fluctuations. The Russian transfer pricing rules are vaguely drafted, leaving wide scope for interpretation by Russian tax authorities and arbitration courts and their use in politically motivated investigations and prosecutions. We believe that the prices used by us are market prices and, therefore, comply with the requirements of Russian tax law on transfer pricing. However, due to the uncertainties in interpretation of transfer pricing legislation, the tax authorities may challenge our prices and propose adjustments. If such price adjustments are upheld by the Russian arbitration courts and implemented, our results of operations could be materially and adversely affected. In addition, we could face significant losses associated with the assessed amount of prior tax underpaid and related interest and penalties, which would have a material adverse effect on our financial condition and results of operations.
If transactions of members of our group and their predecessors-in-interest were to be challenged on the basis of non-compliance with applicable legal requirements, the remedies in the event of any successful challenge could include the invalidation of such transactions or the imposition of other liabilities on such group members
Members of our group, or their predecessors-in-interest at different times, took a variety of actions relating to share issuances, share disposals and acquisitions, valuation of property, interested party transactions, major transactions and anti-monopoly issues that, if successfully challenged on the basis of non-compliance with applicable legal requirements by competent state authorities, counterparties in such transactions or shareholders of the relevant group members or their predecessors-in-interest, could result in the invalidation of such transactions or the imposition of other liabilities. Because applicable provisions of Russian law are subject to many different interpretations, we may not be able to successfully defend any challenge brought against such transactions, and the invalidation of any such transactions or imposition of any such liability may, individually or in the aggregate, have a material adverse effect on our business, financial condition and results of operations.
Risks Relating to the ADSs
Because the depositary may be considered the beneficial holder of the shares underlying the ADSs, these shares may be arrested or seized in legal proceedings in Russia against the depositary
Because Russian law may not recognize ADS holders as beneficial owners of the underlying shares, it is possible that you could lose all your rights to those shares if the depositarys assets in Russia are seized or arrested. In that case, you would lose all the money you invested.
Russian law may treat the depositary as the beneficial owner of the shares underlying the ADSs. This is different from the way other jurisdictions treat ADSs. In the United States, although shares may be held in the depositarys name or to its order, making it a legal owner of the shares, the ADS holders are the beneficial, or real owners. In U.S. courts, an action against the depositary, the legal owner of the shares, would not result in the beneficial owners losing their shares. Russian law may not make the same distinction between legal and beneficial ownership, and it may only recognize the rights of the depositary in whose name the shares are held, not the rights of ADS holders, to the underlying shares. Thus, in proceedings brought against a depositary, whether or not related to shares underlying ADSs, Russian courts may treat those underlying shares as the assets of the depositary, open to seizure or arrest. In the past, a lawsuit was filed against a depositary bank other than our depositary seeking the seizure of various Russian companies shares represented by ADSs issued by that depositary. In the event that this type of suit were to be successful in the future against our depositary, and the shares underlying our ADSs were to be seized or arrested, the ADS holders would lose their rights to the underlying shares.
A challenge to the privatization of us, if successful, could result in ADS holders losing their ownership in our shares underlying the ADSs
Our privatization began in 1992 and continued through 1997. Because privatization legislation often is vague, inconsistent or in conflict with other legislation, including conflicts between federal and local privatization legislation, many privatizations are arguably deficient and, therefore, vulnerable to challenge, including selective challenges. For instance, a series of presidential decrees issued in 1991 and 1992 that granted to the Moscow city government the right to adopt its own privatization procedures were subsequently held to be invalid by the Constitutional Court of the Russian Federation, which ruled, in part, that the presidential decrees addressed issues that were the subject of federal law. While this court ruling, in theory, did not require any implementing actions, the presidential decrees were not officially annulled by another presidential decree until 2000. Currently, there are no pending challenges to our privatization. In the event that our privatization is subject to challenge as having been improper and shareholders are unable to defeat such claims, the holders of the ADSs may lose their ownership interests in our shares underlying the ADSs.
ADS holders may be restricted in their ability to exercise their voting rights and influence our governance
As an ADS holder, you have no direct voting rights with respect to the shares represented by the ADSs. You may exercise voting rights with respect to the shares represented by ADSs only in accordance with the provisions of the deposit agreement relating to the ADSs and relevant requirements of Russian law.
However, there are practical limitations on the ability of ADS holders to exercise voting rights due to the additional procedural steps involved in our process of communication with them. For example, the Joint Stock Companies Law and our charter require us to notify our shareholders of any general shareholders meeting at least 30 days or, in certain cases, 50 days in advance of such meeting. Our shareholders will be notified directly by us, and will be able to exercise their voting rights by either attending a general shareholders meeting in person, through a representative, or by sending a completed voting ballot.
In contrast, ADS holders will not receive notice of a general shareholders meeting directly from us. In accordance with the deposit agreement, the depositary will be notified by us of a general shareholders meeting. In turn, the depositary is required, as soon as practicable thereafter but not later than 30 calendar days prior to the date of the meeting, to mail the notice of such meeting, voting instruction forms and a statement as to the manner in which instructions may be given, to the ADS holders. To exercise their voting rights, ADS holders must instruct the depositary on how to vote. Due to this additional procedural step involving the depositary, the process for exercising voting rights may take longer for ADS holders than for shareholders. As a result, holders of ADSs may have less ability to influence our governance than direct holders of our shares. ADSs in respect of which the depositary does not receive voting instructions in time will not be counted in any vote at any general shareholders meeting.
In addition, although Russian securities regulations expressly permit the depositary to split the votes with respect to the shares underlying the ADSs in accordance with instructions from ADS holders, such regulations remain untested, and the depositary may choose to refrain from voting at all unless it receives instructions from all ADS holders to vote the shares in the same manner. You may thus have significant difficulty in exercising voting rights with respect to the shares underlying the ADSs. There can be no assurance that holders and beneficial owners of ADSs will (i) receive notice of shareholders meetings to enable the timely return of voting instructions to the depositary, (ii) receive notice to enable the timely cancellation of ADSs in respect of shareholder actions or (iii) be given the benefit of dissenting or minority shareholders rights in respect of an event or action in which the holder or beneficial owner has voted against, abstained from voting or not given voting instructions.
You may not be able to deposit shares in the ADS program
Russian companies are limited in their ability to issue shares in the form of ADSs or other depository shares due to Russian securities regulations that came into force in 2003 providing that no more than 40% of a Russian companys shares may be circulated abroad through sponsored depositary receipt programs. Our ADS program accounted for approximately 25% of our outstanding ordinary shares as of December 31, 2004. As our existing shareholders may deposit their shares in to the ADS program in the future and/or the Russian regulatory authority may reduce the 40% limit in the future, our ability to raise equity financing through the issue of ADSs and the ability of holders of ordinary shares to deposit their shares into the ADS facility and receive ADRs may be limited.
You may have limited recourse against us and our directors and executive officers because they generally conduct their operations outside the United States and all of the directors and executive officers reside outside the United States
Our presence outside the United States may limit your legal recourse against us. We are incorporated under the laws of the Russian Federation. All of our directors and executive officers reside outside the United States, principally in the Russian Federation. All or a substantial portion of our assets and the assets of our directors and executive officers are located outside the United States, principally in the Russian Federation. As a result, you may not be able to effect service of process within the United States upon us or our directors and executive officers or to enforce U.S. court judgments obtained against us or our directors and executive officers in jurisdictions outside the United States, including actions under the civil liability provisions of U.S. securities laws. In addition, it may be difficult for you to enforce, in original actions brought in courts in jurisdictions outside the United States, liabilities predicated upon U.S. securities laws.
There is no treaty between the United States and the Russian Federation providing for reciprocal recognition and enforcement of foreign court judgments in civil and commercial matters. These limitations may deprive you of effective legal recourse for claims related to your investment in the ADSs. The deposit agreement provides for actions brought by any party thereto against us to be settled by arbitration in accordance with the rules of the London Court of International Arbitration. The Russian Federation is a party to the United Nations (New York) Convention on the Recognition and Enforcement of Foreign Arbitral Awards, but it may be difficult to enforce arbitral awards in the Russian Federation due to a number of factors, including the inexperience of Russian courts in international commercial transactions, official and unofficial political resistance to enforcement of awards against Russian companies in favor of foreign investors and Russian courts inability to enforce such orders and corruption.
There is less publicly available information about us than about public companies in the United States and certain other jurisdictions
Our corporate governance is regulated by Russian laws and by the charters and by-laws of companies comprising the group, as well as by recommendations outlined in the corporate conduct code issued by the FCSM. The rights of shareholders and the responsibilities of members of the Board of Directors and the Management Board under Russian law are different from, and may be subject to certain requirements not generally applicable to, corporations organized in the United States or other jurisdictions. Although we are subject to the reporting requirements of the U.S. Exchange Act, the periodic disclosure required of non-U.S. companies under the U.S. Exchange Act is more limited than the disclosure required of U.S. companies. Therefore, there may be less publicly available information about us than is regularly published by or about other public companies in the United States.
You may be unable to repatriate your earnings from distributions made on the ADSs
Russian legislation currently requires dividends on ordinary shares to be paid in rubles and permits such ruble funds to be converted into U.S. dollars by the depositary without restriction. Also, ADSs may be sold by non-residents of Russia for U.S. dollars outside Russia without regard to Russian currency control laws as long as the buyer is not a Russian resident for currency control purposes.
The ability to convert rubles into U.S. dollars is subject to the availability of U.S. dollars in Russias currency markets. Although there is an existing market within Russia for the conversion of rubles into U.S. dollars, including the interbank currency exchange and over-the-counter and currency futures markets, the further development of this market is uncertain. At present, there is no market for the conversion of rubles into foreign currencies outside of Russia and no viable market in which to hedge rubles and ruble-denominated investments.
Developing corporate and securities laws and regulations in Russia may limit our ability to attract future investment and may affect the price of our ADSs
The regulation and supervision of the securities market, financial intermediaries and issuers are considerably less developed in Russia than in the United States and Western Europe. Securities laws, including those relating to corporate governance, disclosure and reporting requirements, have only recently been adopted, whereas laws relating to anti-fraud safeguards, insider trading restrictions and fiduciary duties are rudimentary. In addition, the Russian securities market is regulated by several different authorities which are often in competition with each other. These include:
The regulations of these various authorities are not always coordinated and may be contradictory.
In addition, Russian corporate and securities rules and regulations can change rapidly, which may materially and adversely affect our ability to conduct securities-related transactions. While some important areas are subject to virtually no oversight, the regulatory requirements imposed on Russian issuers in other areas result in delays in conducting securities offerings and in accessing the capital markets. It is often unclear whether or how regulations, decisions and letters issued by the various regulatory authorities apply to us. As a result, we may be subject to fines or other enforcement measures despite our best efforts at compliance.
Sales of our equity securities may adversely affect the price of our equity shares and the ADSs
Any future offering of a substantial number of our shares in the public market could have an adverse effect on the market price of the ADSs. Furthermore, such equity offerings may dilute the shareholding of our current shareholders. If we issue additional preferred shares, such preferred shares may have rights, preferences or privileges senior to those of existing preferred shares and/or ordinary shares.
The price of the ADSs may be highly volatile
The liquidity of a securities market is often a function of the volume of the underlying shares that are publicly held by unrelated parties. Although our ADS holders are entitled to withdraw the equity shares underlying the ADSs from the depositary at any time, there may be a limited public market for our shares. This, in turn, may affect the liquidity of the ADSs and their trading price.
The price of our ADSs has been extremely volatile and may continue to be so. Although our ADSs are currently listed on the New York Stock Exchange, and traded on the London Stock Exchange and the Frankfurt Stock Exchange, it is possible that an active public market for the ADSs will not be sustained. Furthermore, the price at which the ADSs trade could be subject to significant fluctuations caused by a wide variety of factors, including:
In addition, the public markets for the stock of telecommunication companies have experienced extreme price and volume fluctuations in recent years. These fluctuations have often been unrelated or disproportionate to the operating performance of such companies. These market and industry factors may materially and adversely affect the price of the ADSs, regardless of our operating performance. In the past, securities class action litigation has been instituted against companies following periods of volatility in the market price of their securities. This type of litigation, if initiated against us, could result in substantial costs and a diversion of our managements attention and resources.
An investor in our ADSs may not be able to exercise preemptive rights for additional shares and may therefore suffer dilution in his or her equity interests in us
Under the Joint Stock Companies Law, existing shareholders of a joint stock company enjoy preemptive rights to subscribe and pay for a proportionate number of shares to maintain their existing ownership percentages prior to the issuance of any new equity shares. Holders of ADSs may be unable to exercise preemptive rights for equity shares underlying the ADSs unless a registration statement under the U.S. Securities Act is effective with respect to such rights or an exemption from the registration requirements under the U.S. Securities Act is available. We are not obligated to prepare or file such a registration statement and our decision to do so would depend on the costs and potential liabilities associated with any such registration statement, as well as the perceived benefits of allowing ADS holders to exercise their preemptive rights, and any other factors we consider at that time. No assurance can be given that we will file a registration statement under these circumstances. If we issue any such securities in the future, such securities may be issued to the depositary, which may sell the securities for the benefit of the ADS holders. There can be no assurances as to the value the depositary would receive, if any, upon the sale of such securities. To the extent that the ADS holders are unable to exercise preemptive rights granted in respect of equity securities represented by their ADSs, their proportional interest in us will be reduced.
You may not be able to benefit from double tax treaties
In accordance with Russian legislation, dividends paid to a nonresident holder generally will be subject to Russian withholding at a rate of 15% for legal entities and organizations and at a rate of 30% for individuals. This tax may be reduced to 5% or 10% for legal entities and organizations and to 10% for individuals under the United States-Russia double tax treaty for U.S. holders.
However, the Russian tax rules applicable to ADS holders are characterized by significant uncertainties and by an absence of interpretive guidance. The Russian tax or financial authorities have not provided any public guidance regarding the treatment of ADS arrangements, and it is unclear how the Russian tax authorities will ultimately treat those arrangements. Thus, we may be obliged to withhold tax at higher rates when paying out dividends to U.S. holders, and U.S. holders may be unable to benefit from these treaties.
Capital gains from the sale of ADSs may be subject to Russian income tax
Under Russian tax legislation, gains arising from the disposition of Russian shares and securities, such as our ordinary shares, as well as financial instruments derived from such shares, such as our ADSs, may be subject to Russian income or withholding taxes. However, no procedural mechanism currently exists to withhold any capital gains or for subsequent remittance of such amounts to the Russian tax authorities with respect to sales made between non-residents or sales of ADSs on the New York Stock Exchange.
Open Joint Stock Company Long-Distance and International Telecommunications Rostelecom was organized as an open joint stock company under the laws of the Russian Federation on September 23, 1993. Our principal executive offices are located at 14, 1st Tverskaya-Yamskaya St., Moscow 125047, Russia, our telephone number is +7 095 972 8283, our facsimile number is +7 095 787 2850 and our e-mail address is email@example.com. We maintain a website at http://www.rostelecom.ru. The information on our website is not a part of this report.
Our charter capital is currently comprised of 728,696,320 ordinary shares, par value 0.0025 rubles per share, and 242,831,469 preferred shares, par value 0.0025 rubles per share.
In accordance with the Registration Statement on Form F-6 under the U.S. Securities Act relating to the registration of our ADSs, we appointed Puglisi & Associates, 850 Library Avenue, Suite 204, Newark, Delaware 19715, as our authorized representative in the United States in connection with the ADSs.
We have appointed CT Corporation System, 111 Eighth Avenue, New York, New York 10011, as our authorized agent for service of process for any suit or proceeding arising out of or relating to our shares, ADSs, or the Deposit Agreement.
Listing of Our Shares
Our American Depositary Receipts, or ADRs, have been listed on the New York Stock Exchange (ticker ROS) since February 17, 1998. Our common and preferred shares (tickers RTKM and RTKMP, respectively) have been listed on the RTS Stock Exchange, or the RTS, and the MICEX Stock Exchange, or the MICEX, since October 27, 1997 and February 27, 1997, respectively.
On December 21, 2004, the Board of Directors voted to establish an Audit Committee comprised of three independent directors and one non-executive director. The non-executive director is a representative of Svyazinvest and is a non-voting member with observer status. Establishment of the Audit Committee is an important step in enhancing and developing our corporate practices following the creation of the Strategic Planning Committee and Nominations and Remuneration Committee of the Board of Directors.
At the same meeting, the Board of Directors approved the Audit Committee Regulations as the principal terms under which the committee will operate. According to the Regulations, the principal purpose of the Audit Committee shall be to assist the Board of Directors in overseeing:
For a further description of our Audit Committee and its composition, see Item 6. Directors, Senior Management and Employees - C. Board Practices - Corporate Governance Developments.
Automation of Business Processes
In 2004, we and Svyazinvests IRCs began to implement a unified billing system, or UBS, to enhance operating efficiency. IBM Business Consulting Services is the lead implementer and consultant on the UBS project, which is based on Amdocs software. The lead implementer and software supplier were chosen by a tender committee consisting of Svyazinvest, us and IRC representatives.
Implementation of the UBS project is planned over the course of 2005-2007. The process consists of analyzing existing billing systems and related business processes, purchasing and implementing Amdocs Billing Suite software, data transfer from existing billing systems and an overall transition to settlements within the UBS.
The UBS is expected to enable us to enhance our overall performance and strengthen our competitive position due to the optimization of business processes, improvement of transparency and precision of settlements between operators. It will also facilitate the introduction of a more flexible tariff policy and support the rapid launch of new services.
In addition, in order to increase the quality of the services we provide, reduce the cost of traffic, re-route traffic expeditiously and increase the effectiveness of labor and our competitiveness, we have begun to automate the traffic routing processes.
In 2004, we also implemented the MBS Axapta enterprise resource planning system. Axapta integrates all of the accounting and financial information from our different divisions, combining it together into a single, integrated database so that the various departments can more easily share information and communicate with each other. The system allows for instant access to complex information, the streamlining of financial reporting and contributes to more effective decision making by management.
Investment Policy Highlights
The main objective of our investment program is to further develop and modernize our integrated digital telecommunications network in order to strengthen our position in all segments of Russias long-distance telecommunications market.
The investment program focuses on the following major areas:
To achieve our strategic objectives, in the mid-1990s we began construction of a modern telecommunications infrastructure and expansion of our primary network and implemented new technologies which enabled us to enlarge the scope of services we provided to various customers. We financed these investments through internal sources, including cash from operations, as well as through external debt financing.
Capital construction and investments in 2002
In 2002, we invested approximately RUR 2,696 million in our property, plant and equipment. The most significant investment projects implemented in 2002 were as follows:
Capital construction and investments in 2003
In 2003, we invested approximately RUR 3,579 million in our property, plant and equipment. The most significant investment projects implemented in 2003 were as follows:
Capital construction and investments in 2004
In 2004, we invested approximately RUR 4,773 million in our property, plant and equipment. The most significant investment projects implemented in 2004 were as follows:
Main directions of development in 2005 and beyond
We plan to invest approximately RUR 7,000 million annually for projects from 2005 to 2007 using cash from operations and external financing sources. The investment program for 2005 and subsequent years includes the following major projects:
We made the following material acquisitions during 2004 and 2005 (as of the date of this annual report):
In January 2004, we finalized the acquisition from RTC-Leasing of the title to the telecommunications equipment previously leased by us from RTC-Leasing. For additional detail see Item 10. Additional Information - C. Material Contracts.
In April 2004, we and Westelcom, our subsidiary, entered into a substitution agreement in relation to the Black Sea Fiber Optic Cable System (BSFOCS) whereby Westelcom was replaced by us as a participant in the BSFOCS. In accordance with the agreement, we paid Westelcom RUR 160 million.
In April 2004, we and Westelcom entered into a substitution agreement in relation to the underwater Russia to Georgia FOL whereby Westelcom was replaced by us as a participant in the FOL. In accordance with the agreement, we paid Westelcom RUR 134 million.
In April 2004, we and Westelcom entered into an agreement for the sale of two ITEs in Moscow and St. Petersburg. In accordance with the agreement, we paid Westelcom RUR 54.9 million.
In April 2004, we and Westelcom entered into an agreement for the sale of telecommunications equipment consisting of a data transfer node. In accordance with agreement, we paid Westelcom RUR 17.7 million.
In December 2004, we and LLC IBM Eastern Europe/Asia entered into an agreement for our purchase of Amdocs billing system software. In accordance with the agreement, we will pay LLC IBM Eastern Europe/Asia US$39.8 million in 18 installments over 2005-2006.
We made the following material divestitures during 2004 and 2005 (as of the date of this annual report):
In July 2004, we and OJSC Svyaz of Komi Republic entered into a series of related agreements for our sale of radio-relay stations in the North-West region and related telecommunications equipment for total consideration of RUR 42.5 million.
In August 2004, we and CJSC GlobalTel entered into an agreement for our sale of a billing system and related computer equipment for total consideration of US$3.6 million.
In February 2005, we and JSFC Sistema entered into an agreement for the sale of our 20% stake in CJSC Telmos, a Moscow alternative fixed-line operator, for total consideration of RUR 235.4 million.
In February 2005, we and LLC Orbita-Telecom entered into an agreement for the sale of our 45% stake in CJSC Telecom-Center, a Moscow alternative fixed-line operator, for total consideration of RUR 67.7 million.
We are Russias national long-distance telecommunications operator. We own and operate a nationwide trunk telecommunications network and carry the bulk of Russias long-distance and international traffic. Throughout the country, we render international and domestic long-distance traffic throughput services to Russian operators, including each of Russias seven IRCs and alternative operators. We are currently the only nationwide carrier of wholesale long-distance and international traffic in Russia and, therefore, hold a monopolistic position in this market. Local operators, including IRCs, bill their own local customers for outgoing domestic long-distance and international calls, while we bill the operators for the traffic throughput. In Moscow, we provide domestic long-distance and international telecommunications services to end-users through the local access network of a local operator, and bill customers directly. In addition, we provide telecommunications services to various government-funded entities and government ministries across Russia and ensure the operation of the ground-based network of most television and radio broadcasting channels. We also have the exclusive right to terminate incoming international voice traffic from international operators.
Our trunk network, which transmits the majority of Russias domestic and international traffic, is comprised of nearly 200,000 kilometers of digital and analog lines. As of December 31, 2004, our digitalization level in terms of channel kilometers was 93% of our total network, and 100% of our switching equipment was digitalized. We have completed a major part of the construction of our domestic long-distance digital transit network based on eight ASNs. Today, 100% of our ATEs, which are stations that collect voice traffic and automatically sort and retransmit it to our ASNs and ISCs, are connected with them through two or more paths. For additional information, see Switches and Current Structure of the Russian Telecommunications Industry below.
We have completed the construction of a fully connected international digital network based on 13 ISCs and ITSs, ensuring the availability of international telecommunications services in most geographic locations in Russia. We have direct access to 70 countries and participate in 30 international cable systems. We also maintain relationships with more than 125 international operators and network administrations.
Russia is a member of the International Telecommunications Union, or ITU, a specialized intergovernmental organization under the United Nations which facilitates guidelines and agreements regulating telecommunications. The ITU is designed to coordinate, standardize and internationally regulate the telecommunications industry on a worldwide scale. Though established international standards are sufficiently effective to regulate communication services and settle disputes among international operators, we seek to strengthen our relations with international operators with which we have direct channels through written arrangements.
We have implemented and are developing a variety of services, largely complementing our existing international and domestic long-distance communications services. We also provide multimedia communications services, offer digital channels for lease and distribute television and radio programs through our network among broadcasters throughout Russia.
Our principal markets are as follows:
See Note 20 to the consolidated financial statements included elsewhere in this annual report for additional information regarding our revenues relating to each principal market.
Prior to December 1, 2003, we conducted certain leasing and banking and investments activities through RTC-Leasing and our subsidiaries. As part of our managements efforts to concentrate on our core business segment, as of December 1, 2003, we discontinued our leasing and banking and investing business segments. See Item 10. Additional Information - C. Material Contracts and the consolidated financial statements included elsewhere in this annual report.
Several regulations have taken effect in 2005 that directly impact the DLD/ILD telecommunications services market in Russia and are ultimately expected to lead to the restructuring and liberalization of this market. As we currently hold a monopoly position in the Russian DLD/ILD telecommunications services market, these regulatory changes, if implemented, are certain to have a significant impact on our business.
See Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - Implementation of the new Federal Law on Communications, or the Communications Law, will cause us to lose our monopoly position in the Russian long distance telecommunications market and impose an additional financial burden on us which may materially and adversely affect our business, financial condition and results of operations and Item 4. Information on the Company - B. Business Overview - The Telecommunications Industry in Russia - Liberalization of the Russian Telecommunications Market for a description of the regulatory reform of the DLD/ILD telecommunications services market and the uncertainties regarding how the liberalization program will impact our business, financial condition and results of operations.
The substantial gaps that remain in the legislative framework, coupled with a lack of interpretive guidance from the regulatory authority regarding certain ambiguous provisions in the new regulations, make it difficult for us to predict with any certainty how the new regulatory regime will impact our business, financial condition and results of operations. However, we have developed our strategy in light of these changes and uncertainties.
For 2005, our main objectives are as follows:
Our global goals in the Russian telecommunications market are to:
Our goals in the Russian regional and alternative operators market are to:
Our goals in the Russian VoIP and mobile operators market are to:
Our goals in the international market are to:
Our goals in the market for end-users of DLD and ILD services are to:
Our goals in the development of Intelligent Network-based services and prepaid cards are to:
The demand for our services can be characterized as stable, without any marked seasonal fluctuations. Notable fluctuations in demand for telecommunications services occur only on particular dates, such as public holidays and nationwide events. The range of our services minimizes any seasonal fluctuations.
Network and Facilities
We provide international and domestic long-distance telecommunications services through our ground and submarine cables, microwave lines and satellites. Our digital network based on Synchronous Digital Hierarchy, a European standard used for long-range data transmission, and DWDM technologies covers almost the entire territory of the Russian Federation.
Primary Communications Network
Our primary network consists of trunk cables linked to the IRCs networks and to our ISCs for connections with foreign operators, as well as a satellite communications network. As of December 31, 2004, our digital network comprised 39,948 kilometers, including 28,199 kilometers of FOLs and 11,749 kilometers of digital radio-relay lines. A fundamental component of the network are high-capacity FOLs between Moscow and Novorossiysk, Moscow and St. Petersburg, and Moscow and Khabarovsk, as well as a satellite communications network that includes three junction centers in Moscow, Novosibirsk and Khabarovsk and nine periphery switches in Barnaul, Kirov, Gorno-Altaysk, Kyzyl, Minusinsk, Yakutsk, Novokuznetsk, Yuzhno-Sakhalinsk and Salekhard.
We have installed international FOLs accessing Finland, Denmark, Turkey, Italy, Japan, Korea, China, Estonia, Kazakhstan, Ukraine and Belarus. Major foreign operators can now send their unswitched traffic through Russia. As new digital communication lines are built, we regularly phase-out our analog transmission lines. Thus, over 33,000 kilometers of analog lines have been phased-out during 2001 through 2004.
The following table describes the principal lines of communication that comprised our primary network as of December 31, 2004:
As of December 31, 2004, we owned 13 ISCs and ITEs, which allow for efficient ILD traffic management, including four in Moscow, two in St. Petersburg (Lyuban) and one each in Rostov-on-Don, Samara, Ekaterinburg, Novosibirsk, Khabarovsk, Kaliningrad and Murmansk. The combined capacity of these switches was 141,370 channels. In addition, we had eight ASNs, which allow for efficient DLD traffic management, and which are interconnected by digital channels and seven ATEs that provide access to DLD service to local users, including six in Moscow and one in Pavlov Posad. The ASNs and their connecting digital channels, constitute an integrated services digital network, or ISDN, with channel switches to which the networks of IRCs and alternative operators are connected. The ATEs of Moscow and Pavlov Posad route domestic long-distance traffic between switching centers, as well as directly to and from end-users.
As of December 31, 2004, our domestic long-distance trunk network consisted of 205,200 digital and 15,810 analog lines. Approximately 95.7% of all digital channels are connected through the SS-7. Approximately 96.8% of all Russian ATEs have access to our digital transit network.
Of the Russian ATEs, 70 are able to provide ISDN services through the domestic long-distance network. We have an open network of multimedia communications. Connected to this network are subscriber units in 77 Russian regions and nine retail outlets. Subscribers connected to our open network multimedia communications can participate in, and arrange both bilateral and multilateral video conferences, discuss and jointly edit textual and graphic documents, receive and send files, and receive and send various audio and video information.
As part of our program to expand and upgrade our international telecommunications capabilities, we utilize modern submarine cables to establish traffic links between Russia and other countries. We are the terminal party and a major capacity owner in five international fiber optic cable systems: Denmark-Russia 1, Russia-Japan-Korea, Italy-Turkey-Ukraine-Russia, Novorossiysk-Varna-Odessa, and Novorossiysk-Sochi-Poti (Russia-Georgia). Our ownership stakes in these cable systems range from 9% to 67%. The remainder is controlled by various international operators.
In addition, in order to provide access to these systems and to establish direct high-quality international lines to remote sites of the world, we participate in the construction of, and acquire capacity in, international cable systems. As of the date of this annual report, we had interests in, or an indefeasible right of use of, 30 cable systems, including global cable system projects such as Fiber Line Around the Globe (UK-Middle East-Japan), Asia-Pacific Cable, Canada-Transatlantic system, Trans-Pacific Cable (Japan-USA), South East Asia-Middle East-Western Europe system and Trans-Atlantic system.
We lease satellite channels from government-owned FSUE Space Communications, which operates earth satellite vehicle Express-A. We also rent international fixed satellite channels from FSUE Space Communications, which operates five satellites, and from CJSC Teleport TP, a Russian satellite telecommunications company which operates through three satellites in the Intelsat systems.
Our satellite communications network is operated by three nodal land-based stations and nine periphery land-based stations located in Russia. The composition and the locations of the land-based satellite communications stations were determined by us based on the secondary network requirements for, among other things, access to the trunk network through ASNs and trunk digital communications.
Cooperation with Mobile Communications Network Operators
Our cooperation with Russian operators of land-based mobile communications networks is aimed at expanding our high-quality network services, including the establishment of national and international roaming.
As of December 31, 2004, we provided international roaming for the major national and regional mobile communications operators, connecting them with 380 international mobile operators in 170 countries.
In order to broaden the spectrum of our communications services and to upgrade communications with Russias remote regions, we, in partnership with Globalstar, launched the Russian segment of the Globalstar Global System for Mobile Satellite Communications in order to provide mobile satellite communications services throughout Russia. To facilitate this project, we and Globalstar in 1996 established CJSC GlobalTel, a U.S.-Russian joint venture. We believe that the pooling of Globalstars modern global mobile satellite communications facilities with the capacity of our domestic long-distance trunk network creates additional opportunities for establishing national and international roaming and for selling communications services to Russian users. The Russian segment of the Globalstar system has been in commercial operation since the end of 2000.
We are the primary provider of international telecommunications services in Russia. Specifically, we provide the switching and transmission infrastructure that connects the Russian domestic telecommunications trunk network with foreign networks and, in coordination with foreign telecommunications operators, facilitate the transmission of global telecommunications traffic within Russia. According to our estimates, at the end of 2004 our market share in the international sector was as follows (measured by traffic minutes):
In 2004, our volume of outgoing ILD traffic amounted to 1,541 million minutes (including 308 million minutes from end-users and 1,233 million minutes from Russian operators), an increase of 16.4% from the previous year. The increase was primarily due to the further upgrade of our network, expansion of local access networks by the IRCs and the overall increase of per capita income in Russia.
In 2004, our volume of incoming ILD traffic from international operators amounted to 1,531 million minutes, an increase of 20.0% from the previous year.
In 2004, ILD revenue increased by 8.6% to RUR 13,101, or 35% of our revenues, compared to RUR 12,069 million, or 39% of our revenues in 2003 and to RUR 12,737 million, or 46% of our revenues in 2002.
The following tables set forth data on our incoming and outgoing international traffic for 2002, 2003 and 2004.
International traffic with foreign countries, excluding traffic to and from CIS countries and the Baltic
International traffic with the Baltic States (in millions, except percentages)
International traffic with CIS countries (in millions, except percentages)
Our largest international traffic routes are between Russia and Germany, the United States, the United Kingdom, France, Italy and Finland. The following table sets forth the total number of billed minutes of international incoming and outgoing calls for these countries for 2002, 2003 and 2004.
Minutes of international incoming and outgoing calls (in millions)
In 2004, approximately 27% and 6% of outgoing international traffic was initiated from Moscow and St. Petersburg, respectively. Accordingly, the traffic volume and the tariff rates for outgoing international calls in these two cities have a material impact on our results of operations.
We establish the tariffs for outgoing international calls based on the destination of the call and the day and the time of the call. For each outgoing call from IRCs, we receive 50% of the total amount that the relevant IRC charges the subscriber initiating the call. In order to bring our current billing policies for international traffic in line with standard practices, on October 1, 2004, we introduced new rates for alternative operators for outgoing international traffic that approximate the income received from IRCs.
For international calls made by Moscow subscribers using MGTS, we receive, on average, 88% of the tariff proceeds after settlement with MGTS. In turn, we pay an agreed termination charge to a foreign operator receiving the outgoing traffic. For incoming international calls, we charge foreign operators a pre-determined termination rate.
Since April 1, 2004, we have been using the following two types of tariffs for international calls:
In addition, tariffs for international calls made by Russian PSTN subscribers (other than MGTS subscribers in Moscow) were changed as follows:
The tables below illustrate the international tariffs effective as of December 31, 2004.
Tariffs for international telephone communications with CIS countries, Baltic States and other foreign countries
The following tables set forth special tariffs offered by us for calls to the Peoples Republic of China as of December 31, 2004:
Domestic Long-Distance Traffic
According to our estimates, in 2004, we carried over 66% of the DLD traffic in the Russian Federation, with our volume of DLD traffic amounting to 9,094 million minutes (including 1,331 million minutes from end-users and 7,763 million minutes from operators). The amount of DLD traffic carried by us in 2004 increased by 10.6% from the previous year, which increase was primarily due to the further upgrade of our network, our active cooperation with Russian operators, expansion of local access networks by the IRCs and the overall increase of per capita income in Russia.
In 2004, our DLD revenue grew by 40% to RUR 17,297million, or 46% of total revenue, compared to RUR 12,347 million, or 39% of total revenue in 2003 and RUR 9,372 million, or 34% of total revenue in 2002.
The table below sets forth data on our domestic long-distance traffic for 2002, 2003 and 2004.
Domestic Long-Distance Communications (in million minutes) for the last three years
In all regions of Russia except for Moscow, we are paid by IRCs and alternative operators for the throughput of outgoing DLD traffic at a specified settlement rate.
In Moscow, we own international and long-distance switches and render customer services through MGTS. We have an agreement with MGTS under which we pay to MGTS an average of 12% of the revenues collected from end-users in Moscow on a monthly basis for our right to use MGTS local access network while providing DLD and ILD services to its subscribers.
Historically, the linear settlement rate that we charged for the throughput of domestic long-distance traffic from IRCs was based on a fixed ruble amount for each 50 kilometers of distance. Our linear settlement rate was set in 1993 in compliance with directives of the Ministry of Communications. Prior to 1996, it was regularly indexed according to inflation. However, the rate remained unchanged during the period between July 1996 and July 2001 despite its reduction in real terms due to continuing inflation in Russia.
Prior to January 1, 1997, local telephone operators paid us for outgoing traffic at the linear settlement rate and for termination of such traffic by another local operator at the termination settlement rate, while we paid the terminating local operators for each minute of incoming traffic. Both the linear settlement rate and termination settlement rate were regulated and could only be changed through a procedure established by the regulatory authority.
On January 1, 1997, the Russian anti-monopoly authority introduced an integral settlement rate which took into account the linear charge for the throughput of traffic based on a rate of one minute per 50 kilometers and also a termination charge based on the balance between incoming and outgoing traffic of each local operator. The rate was calculated and approved by the government each year taking into account the balance of incoming and outgoing traffic for the previous year. Since January 1, 1999, the FAS has regulated domestic long-distance tariffs for all categories of customers, as well as settlement rates used by us and local operators for their settlement of domestic long-distance traffic transit and termination.
In order to reduce cross-subsidies in the communications sector, the FAS in June 2001 increased the integral settlement rate by 25%, effective July 1, 2001, and in October 2001 increased it by another 25%, effective January 2002. This was followed by the FASs abolishment of the integral settlement rate for settlements between us and regional operators in August 2003. In its place, the FAS introduced a new, more transparent direct payment settlement system for DLD traffic transit that prescribed the linear and termination settlement rates. Under the new settlements system, we bill the regional operators for the transit of DLD calls using the linear settlement rate and pay regional operators for the termination of DLD calls using the termination settlement rate.
There were only two changes in our DLD tariffs for end-users in 2004:
The table below illustrates the per-minute tariffs charged by us for 2002, 2003, 2004 and 2005 to government-funded organizations and other customers for domestic long-distance calls between Moscow and other territories divided into various zones. Our tariffs are set and charged in rubles.
Domestic long-distance tariffs in nominal rubles
Additional and New Services
While domestic long-distance and international telephone services remained the largest source of our revenues in 2004, we continued to expand the range of services we provide to both end-users and operators.
VoIP service: VoIP allows affiliated operators to provide voice traffic transit and termination through our high-quality IP/MPLS-based network. In 2004, we continued to expand our service area, and modernized our VoIP network in order to increase bandwith and improve quality. Connections to our VoIP network can currently be made through access points in the following cities: Moscow, St. Petersburg, Kazan, Samara, Ekaterinburg, Novosibirsk, Krasnoyarsk and Rostov-on-Don. By using our primary trunk network, connections to the VoIP network can be made at 400 access points.
ISDN Service: ISDN allows end-users to transfer voice and data traffic over the same phone line. In 2004, we continued to expand our ISDN services, connecting Bryansk, Kaliningrad, the Republic of Adygeya, Krasnoyarsk, Novokuznetsk and Naberezhnye Chelny. As a result, ISDN services are currently accessible in 74 regions in Russia. In addition, we launched international ISDN services in 2004 with several new operators, including Bulgaria Telecommunications Company (Bulgaria), Portugal Telecom (Portugal), Turk Telecom (Turkey) and in Luxemburg. Our international ISDN services are currently available in 37 countries to 43 operators.
Flexible Access Multiplexer Network Development: Due to the creation of a modern, flexible multiplexer network in 2002 and 2003, we are able to offer our customers digital channels with high throughput capacity. As of December 31, 2004, digital channels were available to customers in 110 Russian cities. Considering the high level of demand for this service in the Russian telecommunications market, we are actively working to expand our flexible access multiplier network.
Intelligent Network Services: Our Intelligent Network is a technological platform that allows us to provide certain value-added services such as Freephone or Premium Rate Calls.
We continue to actively promote our Intelligent Network services. In 2004, our revenues from this service increased by 195% to RUR 142 million from RUR 48 million in 2003. Due to the scope of our network, we are the only company in the Russian Federation able to support this service across the nation. We also expanded our International Free Phone Service, or IFS, which we established in 2002 between Turkey and Russia for several Russian customers. In 2003 and 2004, we worked to increase the number of countries from which this service is available, and as of December 31, 2004, 25 operators from 23 countries had signed agreements to provide IFSs for our customers in Russia.
In addition, we launched a new Intelligent Network service called Premium Rate Call in 2004. Through this service, we offer end-users certain chargeable services such as inquiry, reference and consulting services, phone quizzes and prepaid order services, among others.
In 2004, we received the new operators code 100 in addition to our existing 200 code. The new code, which we plan to put into operation in the second quarter of 2005, will increase the numbering capacity of our Intelligent Network.
International Roaming: We route international roaming signal messages to 170 countries (380 international mobile communications operators). Russias three largest mobile operators, Vimpelcom, Mobile TeleSystems and MegaFon use the services of our international signal network.
Televoting: In 2004, we continued to expand our Televoting service launched in 2003. Televoting is a mass-calling processing service for TV, radio and other press events which involve a high volume of calls. Televoting is provided through our Intelligent Network, which uses sophisticated equipment and computer software to process the high volume of calls and visually display the results. The advantage of our Televoting service, compared to similar services of other operators, is that calls to Televoting numbers are free for end-users of the PSTN.
Telephone Cards: In 2003, we integrated our existing card products and released a new pre-paid telephone Communications Card, which offers all the functions provided by our previous cards. We also executed supplementary agreements with IRCs to provide access for our pre-paid telephone card service from Russias PSTN. Communications Card services are available to card holders in 63 cities throughout Russia and in 44 countries.
The following chart lists the services we currently provide to end-users and operators:
We plan to offer the following services in 2005:
In 2004, our revenues from the provision of other services, excluding the transit of DLD and ILD traffic, amounted to RUR 6,920 million, or 19% of our revenue for the reporting period. In 2003 and 2002, our revenues from the provision of other services, excluding the transit of DLD and ILD traffic, amounted to RUR 6,851 million and RUR 5,744 million, or 22% and 20% of our revenue, respectively.
We currently are the only nationwide carrier of wholesale DLD and ILD traffic in the Russian Federation and therefore hold a monopoly position in this market. We own and operate a nationwide trunk telecommunications network in Russia. All operators of PSTNs, including IRCs, are obliged to use our trunk network (subject to technical availability of our network) for the throughput of domestic long-distance and international traffic from their local subscribers.
However, in addition to us, several operators are developing their own primary network resources:
In 2004, alternative operators had an increased presence in the Russian telecommunications market, competing with us in all of our segments, but primarily in the Moscow end-user and leased lines markets.
The operations of alternative operators have historically been confined to providing services within a limited territory or to a narrow segment of customers, and it was only within these territories or segments that such operators represented
full-scale competition to traditional operators such as us. However, several alternative operators are reported to have applied for DLD/ILD licenses in 2005 pursuant to new regulations enacted under the Communications Law, and DLD/ILD licenses were awarded to MTT, Golden Telecom and Centerinfocom, a company recently formed by five Moscow-area local telecommunications providers, in May 2005. Thus, the territorial reach of alternative operators may increase in the future as they are awarded DLD/ILD licenses and commence nationwide operations thereunder.
See Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - We face increasing competition from alternative operators that may result in reduced operating margins and loss of market share.
Currently, our network has greater territorial coverage than any of our competitors in Russia. By keeping our network well maintained and technically updated, we are able to keep the cost of our services comparatively low.
We review and conduct research on the competitive environment in the communications market for purposes of monitoring the impact of competitors on our activities. In the course of building our development strategy, we take into consideration the competitive situation and the dynamics of our development and the activities of alternative operators and operators of overlay networks. Currently, we consider the following alternative operators to be our main competitors:
TransTelecom was incorporated in 1997 for the purpose of upgrading the information and technology segments in the infrastructure of the Ministry of Railways of the Russian Federation by means of constructing a high-bandwidth telecommunications network in the railroad precinct, as well as exploiting the networks profit-making capabilities. Currently, TransTelecom is licensed to lease communications channels and provide telematic and data transmitting services (ATM, Frame Relay, IP, X.25).
Initially, TransTelecom planned to use part of its capacity to satisfy the need for telecommunications services by the Ministry of Railways and the remaining part of the capacity was to be used to provide telecommunications services to third parties on a commercial basis. However, TransTelecom does not currently possess a license to provide DLD/ILD communications services, though it reportedly applied for such license in April 2005.
JSFC Sistema provides services in several telecommunications market segments, including telephony, data transmission, Internet services, cellular communications, satellite communications and paging and trunking communications. Currently, some of the biggest alternative and mobile operators in Russia in terms of revenue and coverage, such as MTU-Intel, Comstar, MTU-Inform, Telmos, Sky-Link, MTT and MTS, are subsidiaries and affiliates of Sistema.
Multiregional Transit-Telecom was established in October 1994 with the objective of creating a transit telecommunications network capable of integrating the networks of mobile operators. MTTs network is based on seven transit nodes built in each federal region of the Russian Federation. MTT also has a number of local commutation centers allowing the interconnection with local mobile and fixed-line operators. MTT was granted a license to provide DLD/ILD communications services in May 2005.
Golden Telecom, Inc .
Golden Telecom, established in June 1999, is an operator offering integrated communications services and Internet access services in the major cities of Russia and the CIS. In December 2003, it acquired 100% of the equity capital of Comincom (which in turn owns the telecommunications operator Combellga). Since March 1, 2004, these operators have offered clients integrated communication services under the single brand Golden Telecom.
Golden Telecom currently offers local, domestic long-distance and international telephone communications services through an allocated network and through the PSTN, data transmission services, cellular communications services, Internet access, ISDN services, videoconferencing and other services. Golden Telecom was granted a license to provide DLD/ILD communications services in May 2005.
We currently own 11% of the charter capital of Golden Telecom and have the right to appoint two directors to Golden Telecoms ten-person board of directors.
The Telecommunications Industry in Russia
Generally, the Russian telecommunications market can be described as unsaturated and rapidly developing. According to the Ministry of Information Technology and Communications, the Russian market for telecommunications services
grew by 38% to US$18.3 billion in 2004 from US$13.3 billion in 2003. The sub-sectors that expanded most rapidly included mobile communications services and data transmission services.
In 2004, fixed telephone penetration in Russias regions continued to increase and reached 28.8 phone lines per 100 inhabitants. Additional automated telephone exchanges were built in urban areas, increasing the total capacity by 5 million phone numbers, which is a 25% increase over the level of capacity created in 2003. Rural automated telephone exchanges introduced in 2004 had a total capacity of 600,000 numbers, or 69% more than the total capacity created in 2003. The number of settlements in Russia not connected to the PSTN decreased from 50,000 to 46,000 in 2004.
Mobile telecommunications services continued to demonstrate impressive growth with the number of subscribers doubling in 2004 to reach 72 million. The penetration rate for mobile phones reached 51% in Russia, while in Moscow it reached 99%.
It is expected that further investment in, and capital expenditure on, fixed assets in the Russian telecommunications industry will generate increased market volume and sales in the future.
Current Structure of the Russian Telecommunications Industry
IRCs, which are territorial associations of Russias traditional local telephone operators, install and maintain local and zonal communications networks, access networks and subscriber lines, provide local switching and transmission services and interconnect subscribers with our domestic long-distance and international network.
Most ATEs in Russia belong to IRCs which switch traffic between their networks and the domestic long-distance trunk network operated by us. IRCs bill end-users for the services rendered and pay us for traffic transit based on the number of minutes passed through our network.
The international telephone switches connecting Russias telephone network with foreign networks are owned by us. Pursuant to Russian law, all the commercial operators that transmit phone traffic abroad use our facilities and networks.
In Moscow, we own long-distance switches and international switches and provide services directly to end-users through the local network of MGTS. We receive payments for our long-distance and international services directly from subscribers but have an agreement with MGTS whereby we make monthly payments to MGTS of approximately 12% of our Moscow revenues for the right to pass our international and long-distance traffic through the local MGTS network.
There are also a number of alternative operators in the Russian telecommunications market, as well as several major specialized operators. Recently, operators providing long-distance and international voice packet transmission services have been gaining market share. Generally, the operation of alternative operators is confined to the provision of services within a limited territory or to a narrow segment of customers. It is only within these territories or segments that such operators present full-scale competition to the traditional operators and to us.
We collaborate with many international telecommunications operators. This cooperation enables us to transmit international calls originating in Russia and to terminate incoming international calls via our network through the lines of IRCs and alternative operators.
Liberalization of the Russian Telecommunications Market
Reform of the Russian telecommunications industry began with the introduction of the new Communications Law in 2004 and has intensified as implementing regulations have been enacted thereunder. In particular, several regulations have taken effect in 2005 that directly impact the DLD/ILD telecommunications services market in Russia and are ultimately expected to lead to the restructuring and liberalization of this market. As we currently hold a monopoly position in the Russian DLD/ILD telecommunications services market, these regulatory changes, if implemented, are certain to have a significant impact on our business. However, given the substantial gaps that remain in the legislative framework and lack of interpretive guidance from the regulatory authority regarding certain ambiguous provisions in the new regulations, we are unable to predict with any certainty how the new regulatory regime will impact our business, financial condition and results of operations. The following discussion describes the current state of the liberalization process.
New regulations have been enacted allowing operators to apply for DLD/ILD telecommunications services licenses. In February 2005, the Russian government adopted a list of licensing requirements for telecommunications operators, including requirements for operators seeking a DLD/ILD telecommunication service license. Among other things, operators seeking to obtain such a license are required to have interconnection points in each of the 89 Russian regions and network capacity to offer DLD services throughout the entire territory of Russia. In May 2005, the Federal Service on Oversight in the Sector of Communications approved the DLD/ILD license applications of MTT, Golden Telecom and Centerinfocom. Other companies have also reportedly applied for DLD/ILD licenses.
Additionally, a new set of regulations has been enacted that endeavors to restructure the interconnection system. In March 2005, the Russian government approved the Rules of Interconnection and Interaction of Communication Networks, or the Interconnection Rules. The Interconnection Rules indicate that we (and other DLD/ILD service
providers) may be required in the future to switch to a new interconnection and settlement system for DLD/ILD traffic transit with regional and local operators whereby we will provide DLD/ILD services directly to end-users in all regions with regional and local operators acting as our intermediaries. Under this new system, end-users will be able to choose their DLD/ILD provider by dialling an additional prefix when initiating a call (carrier selection system) or by signing an agreement to set a default DLD/ILD provider (pre-selection system). Regulations setting forth the complete terms and conditions of the new interconnection and settlement system have not yet been implemented.
In addition, the Interconnection Rules impose certain restrictions on operators occupying a significant position in the DLD/ILD market, which is defined by the Communications Law as an operator holding, together with affiliates, more than 25% of the numbering capacity or throughput capacity in a particular geographic numbering zone or throughout Russia. Interconnection tariffs for operators occupying a significant position, which will likely include us, will be subject to government regulation even if such operators are not otherwise regulated as natural monopolies. However, as additional regulations regarding these restrictions have not yet been adopted, the specific terms and restrictions that may be imposed on operators occupying a significant position remain unclear.
Among the most significant gaps in the new regulatory regime is how or whether the new regulations will modify the governments regulation of DLD/ILD tariffs charged by licensed operators. Failure by the government to substantially modify or abolish the cross-subsidization of IRCs through our DLD/ILD tariffs would inhibit the flexibility of our tariff policy in the sphere of DLD/ILD services and prevent us from becoming more competitive as the DLD/ILD telecommunications services market opens up to competition.
The substantial gaps that remain in the new regulatory regime, coupled with an absence of interpretive guidance relating to the new regulations, make it difficult to assess how the liberalization program will impact our business, financial condition and results of operations. However, apart from intensifying the competition in the DLD/ILD services market, we expect that liberalization will create new opportunities for the development of our business and access to new markets. In particular, we expect that the market reforms will eventually enable us to provide our services directly to end-users throughout Russia.
For additional information regarding the risks we face, see Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - Implementation of the new Federal Law on Communications, or the Communications Law, will cause us to lose our monopoly position in the Russian long distance telecommunications market and impose an additional financial burden on us which may materially and adversely affect our business, financial condition and results of operations.
Regulation of the Russian Telecommunications Industry
The provision of telecommunications services in Russia is governed by federal legislation, which includes codes, federal laws, presidential and governmental decrees, government regulations and orders, procedures, letters and instructions issued by ministries and other federal executive authorities.
Our business operates in an uncertain regulatory environment. The principal legal acts regulating telecommunications in Russia are the Communications Law and the Federal Law on Natural Monopolies of August 17, 1995, as amended, or the Natural Monopolies Law.
The Communications Law establishes the legal basis for state supervision and development of the communications industry, including granting licenses to provide telecommunications services, allocation of radio frequencies, certification of equipment compatibility, development of comprehensive public networks and supervision of fair competition among telecommunications providers. The Communications Law provides for equal rights of individuals and legal entities to participate in certain categories of telecommunications operations and does not currently contain any special restrictions with regard to participation in the Russian telecommunications market by foreign persons. All users and operators, in compliance with the terms of the licenses issued to them, have the right to access and interconnect their networks with the PSTN of Russia.
The Natural Monopolies Law establishes the legal basis for the federal regulation of natural monopolies (such as us) and provides for state control over tariffs and other activities of natural monopolies. The FAS and the Federal Service on Tariffs oversee the implementation of this law, which may significantly impact the ability of certain categories of telecommunications providers to set tariffs. The Natural Monopolies Law also controls the types of transactions into which a regulated entity may enter. Regulated entities are subject to continuous reporting requirements, which include the submission of plans for capital investments. In addition, regulated entities may not refuse to enter into contracts with particular consumers if required by the regulatory authority.
As the primary provider of long-distance telecommunications in Russia, we have been, and will continue to be, subject to regulation under these laws.
The regulatory framework of the telecommunications industry in Russia has changed in recent years, and the authorities regulating the telecommunications industry often have vaguely defined powers.
In March 2004, the Ministry of Communications was briefly merged with the Ministry of Transportation into the Ministry of Transportation and Communications which was granted authority over the telecommunications industry. In May 2004, the government reversed this decision and granted the newly-formed Ministry of Information Technologies and Communications the authority to regulate the Russian telecommunications industry.
The Ministry of Information Technologies and Communications is currently responsible for determining governmental policy for telecommunications, adopting rules and regulations on the basis of federal laws and proposing the allocation of the federal budget for the telecommunications industry.
The Federal Service on the Oversight in the Sector of Communications, or FSOSC, supervises the licensing of all telecommunications operators in Russia.
The Federal Agency on Communications, or FAC, is responsible for the development and implementation of a long-term policy for frequency allocation. The FAC also manages state property relating to the telecommunications industry.
The State Radio Frequencies Commission is an inter-agency coordination body acting under the Ministry of Information Technologies and Communications which is responsible for the regulation of radio frequency spectrum and develops a long-term policy for frequency allocation in Russia.
The Federal Service on Tariffs regulates certain tariffs in the sphere of telecommunications, including the tariffs on local and DLD calls by subscribers of PSTN, installation and subscription fees and telephone line access tariffs.
The FAS supervises competition regulations and enforces the Natural Monopolies Law and the regulations enacted thereunder. The FAS and the Federal Service on Tariffs would automatically cease to have jurisdiction over the Russian telecommunications industry if it was no longer deemed to be a natural monopoly.
Licensing to Provide Services
The Communications Law generally requires that any provider of telecommunications services must obtain a license prior to commencing such services, unless such services are essentially for internal use (such as within an automobile, on a vessel, in an airplane or in another means of transportation), are for internal production or technological purposes, or are used solely to service public administration, defense, security and law enforcement authorities.
The Communications Law expressly allows any entity, foreign or domestic, to own and operate communications facilities in Russia, although it also allows for the enactment of legislation specifying certain communications networks and facilities that can only be owned by the federal government. Such legislation has not yet been enacted.
Licenses to provide telecommunications services are issued by the FSOSC in accordance with the Regulation on Licensing in the Field of Telecommunications in Russia, or the Licensing Regulation.
Telecommunications licenses are issued and renewed for periods ranging from three to twenty-five years and several different licenses to provide varying communications services may be issued to one entity. Currently, renewals may be obtained upon application to the FSOSC and upon verification by appropriate governmental authorities that the licensee has conducted its activities in accordance with the licenses. The FSOSC has fairly broad discretion with respect to both issuance and renewal procedures. Both the Communications Law and the Licensing Regulation provide that a license may not be transferred or assigned.
If the terms of a license are not fulfilled or the service provider violates applicable legislation, the license may be suspended or terminated. Licenses may be suspended for various reasons, including:
In addition, licenses may be terminated for various reasons by the court, including:
The license may also be terminated in a number of cases, including liquidation of a license holder or failure to pay a license fee on time.
Fees for issuing licenses are determined as follows:
While these fees are nominal, telecommunications licenses traditionally also require financial contributions to the development of the PSTN of Russia.
Licenses generally contain detailed conditions regarding the date by which services must begin, technical standards, the number of lines that must be in service and the percentage capacity, which must be operative by specified dates. Failure by us to satisfy any such requirements could lead to the revocation of one or more of our licenses, which could have a material adverse effect on our business. See Item 5. Operating and Financial Review and Prospects - C. Research and Development, Patents and Licenses.
Radio Frequency Allocation
Regulation of the use of radio frequencies and spectrum allocation are under the exclusive control of the Ministry of Information Technologies and Communications through its subordinated bodies. The FAC allocates radio frequencies based on decisions of the State Radio Frequencies Commission. A frequency allocation is necessary to receive a license to provide telecommunications services from the FSOSC.
Certain telecommunications equipment used in Russia is subject to periodic mandatory certification in order to confirm its compliance with established standards and technical requirements. Certificates of compliance are issued to the supplier by the FAC on the basis of the FACs review. Moreover, certain high-frequency equipment, a list of which is set forth in Government Resolution No. 539 of October 12, 2004, manufactured or used in, or imported into, Russia requires special permission from the FSOSC. Special permissions are specific to the entity that receives them and are non-transferable. Failure to receive such certification could result in the mandatory cessation of the use of such equipment. To date, we have not experienced significant problems as a result of the failure of any of our equipment suppliers to obtain necessary certifications.
In addition, the Federal Security Service is empowered to certify and issue licenses for the designing, production, selling, using and importing of encryption devises, including telecommunication equipment with encryption capabilities.
Universal Services Fund
The Communications Law provides for the establishment of a universal services reserve fund for the purpose of supporting communications companies operating in less developed regions of Russia through the financing, construction and maintenance of telecommunications networks in low-profit and unprofitable sectors. This reserve fund is aimed at eliminating the practice of cross-subsidies by compensating operators for certain mandatory, loss-making local services in rural and sparsely populated areas. The universal service fund concept has been used in some developed countries and in Eastern Europe. It will be funded by a levy imposed on all communication services providers, including us. The Russian government set the levy at 1.2% of the difference between an operators total revenues and revenues generated by interconnection and traffic transit services. The levy is payable on a quarterly basis starting from the second quarter of 2005. The Russian government may, in its discretion, change the rate of the levy or the basis for its calculation. See Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - Implementation of the new Federal Law on Communications, or the Communications Law, will cause us to lose our monopoly position in the Russian long distance telecommunications market and impose an additional financial burden on us which may materially and adversely affect our financial condition and results of operations.
Competition and Pricing
The Ministry of Information Technologies and Communications and the FAS are the two principal executive authorities regulating our activities. In particular, the Ministry of Information Technologies and Communications, as the principal governmental agency for the industry, determines the level and principal features of competition in the telecommunications market, while the FAS is responsible for setting the tariffs on which our profitability, in significant part, depends.
The Communications Law requires federal regulatory authorities to encourage and promote fair competition in the provision of communications services and prohibits abuse of a dominant position to hinder, limit or eliminate competition. The Communications Law provides that tariffs for telecommunications services may be established on a contractual basis between the provider and the user of telecommunications services, thus confirming the policy of liberalization of prices for telecommunications services initially introduced by presidential decree in 1991. However, the Communications Law also provides that tariffs may be regulated by the state for specific types of communications services.
Presidential Decree No. 221 on Measures for Streamlining State Regulation of Prices (Tariffs) of February 28, 1995, and Government Resolution No. 239 of March 7, 1995, as amended, provide that prices and tariffs for certain telecommunications services are subject to state regulation. Government Resolution No. 715 of October 11, 2001, delegates tariff control over certain types of telecommunications services provided in the domestic market to the FAS. To encourage fair competition, the supervising authorities have reduced their control over international tariffs.
Thus, Order of the State Communications Committee No. 142 on Tariffs On International Telephone Services of August 19, 1998, allows telecommunications operators, and specifically us, to freely determine tariffs for the international telephone services they provide. Government Decree No. 332, dated June 30, 2004, authorized the Federal Tariffs Service to set the following tariffs for the natural monopolies in the communication market:
Tariffs for other services are determined by us, taking into account the cost of service and market prices. As a result, our tariffs for certain services, such as digital trunk line leases, are used by other operators as a benchmark to set prices for their own services.
In accordance with the Communications Law, the FAS is responsible for the encouragement and support of fair competition in the telecommunications industry. As we have a dominant position in the telecommunications market, we are subject to anti-monopoly laws and regulations. In the event we are found to be in violation of any such law or regulation, sanctions could include confiscation for the federal budget of profits derived from anti-competitive practices and the imposition of fines on us and our executive officers amounting to 5,000 and 200 times the minimum monthly wage, respectively. The minimum monthly wage established by federal law for the purpose of calculation of administrative fines currently constitutes 100 rubles (which is an equivalent of approximately US$3.60). Civil or criminal actions could also be brought against our executive officers.
As of the date of this annual report, we are not aware of any violation of anti-monopoly laws and regulations which could lead to any such penalty.
Under the existing practice of cross-subsidies, IRCs, which provide local telephony service to their customers at below market rates, are subsidized by DLD and ILD operations, for which IRCs are able to set above market rate tariffs. IRCs also receive payments from us for traffic termination on their network at a termination settlement rate which exceeds costs and market rate profit, and which provides IRCs with additional profit to subsidize loss-making local communications.
Several regulations have taken effect in 2005 that directly impact the DLD/ILD telecommunications services market in Russia and are ultimately expected to lead to the restructuring and liberalization of this market. However, among the most significant gaps in the new regulatory regime is how or whether the new regulations will modify the governments regulation of DLD/ILD tariffs charged by licensed operators. Failure by the government to substantially modify or abolish the cross-subsidization of IRCs through our DLD/ILD tariffs would inhibit the flexibility of our tariff policy in the sphere of DLD/ILD services and prevent us from becoming more competitive as the DLD/ILD telecommunications services market opens up to competition. See Item 4. Information on the Company - B. Business Overview - The Telecommunications Industry in Russia - Liberalization of the Russian Telecommunications Market for a description of the regulatory reform of the DLD/ILD telecommunications services market and the uncertainties regarding how the liberalization program will impact our business, financial condition and results of operations.
We are a member of the Svyazinvest Group. As of December 31, 2004, Svyazinvest, a telecommunications holding company created by the Russian government in 1995, held a 50.67% interest in us. In turn, the Russian Ministry of Property Relations and the Russian Federal Property Fund held a 50% interest (plus one share) and a 25% interest (less two shares), respectively, and Mustcom Ltd. held a 25% interest (plus one share) in Svyazinvest. See Item 3. Key Information - D. Risk Factors - Risks Relating to the Control of us by Svyazinvest and the Government of the Russian Federation for a description of certain risks relating to our ownership structure.
Svyazinvest has at least a 50% interest in the following Russian entities:
Svyazinvest has less than a 50% interest in the following Russian entities:
As of the date of this annual report, the group comprised us and our consolidated subsidiary, Westelcom; principal associates RTComm.RU, GlobalTel, Golden Telecom, Inc. and MMTS-9, each accounted for under the equity method of accounting and thus not consolidated in our financial statements. In addition, we held interests in 56 additional associates and subsidiaries, which were accounted for using the equity method or at cost since the aggregate effect of the results of operations and financial position of these companies is not material for our consolidated financial statements taken as a whole. For information regarding changes in our associates during the first half of 2005, see Item 8. Financial Information - B. Significant Changes.
We operate through branches located throughout Russia and, as of December 31, 2004, had nine branches in Russia. Most of our branches are responsible for performing operations with the IRCs and other operators, particularly with respect to providing telecommunications services to the IRCs, and participating in our joint projects in areas where our facilities connect with relevant regional communications networks. Our branches are also responsible for settling bills with the IRCs.
Under Russian law, a branch functions as a division within the corporate structure of a company. Although not a legal entity distinct from the company, a branch may generally own assets, incur liability and enter into contractual relationships. Our branches operate pursuant to internal regulations approved by our General Director, while we bear full liability for their operations.
In order to expand our presence in the area of international organizations, we joined the International Telecommunications Union, or ITU, and opened a representative office in Geneva, Switzerland in August 1999 in order to secure our position with international authorities and organizations, as well as promote international trade and research cooperation. In April 2002, we registered our representative office in Yerevan, Republic of Armenia, in order to research the market and the possibilities for introducing high-level telecommunications technology into the Armenian market.
Westelcom, a joint venture with the Russian Telecommunications Development Corporation, registered in the Russian Federation, was established in December 1992 to contribute to the development, introduction, operation and management of the Russian telecommunications infrastructure. We acquired a 50% interest in Westelcom in 1992. In October 2002, we purchased the remaining 50% interest in Westelcom from the Russian Telecommunications Development Corporation for US$15 million. We own 100% of the voting shares in Westelcom.
Westelcom provides communications channel and telecommunications equipment lease services and processes incoming traffic information via international telephone exchanges. Westelcom has two Russian subsidiaries, OJSC A-Svyaz and OJSC InfoTeX Taganrog Telecom.
Westelcom owns 81.9% of the charter capital of OJSC A-Svyaz, which provides access to the PSTN, as well as local telephone network services, ISDN services, Internet access services and IP telephony services. Westelcom owns 74.0% of the charter capital of OJSC InfoTeX Taganrog Telecom, which provides access in the Russian city of Taganrog to the PSTN, as well as local telephone network services, Internet access services, lease of communication channels and long-distance payphones.
RTComm.RU is a company registered in the Russian Federation providing integrated Internet technology solutions. RTComm.RU currently has licenses to lease communications channels, provide telematic and data transmission services, and to engage in the technical protection of confidential information. RTComm.RUs target customers are Internet service providers, corporate customers and government entities. We own 31.1% of the voting shares in RTComm.RU and began accounting for the results of operations and financial position of RTComm.RU under the equity method as of January 1, 2004. Prior to that, we consolidated RTComm.RU in our financial statements on the basis of our control over the financial and operating policy decisions of RTComm.RU through December 31, 2003. We ceased consolidating the results of RTComm.RU following our disposal of RTC-Leasing, which held a 49% interest in RTComm.RU.
One of the principal services that RTComm.RU has been providing since 2001 is dedicated access, which provides a 24-hour connection of the customers router to a port of the RTComm.RU network node and permanent access to Internet resources. RTComm.RU also provides data center services, including registration of domain names, post-office services, news server services, virtual hosting, co-location, dedicated hosting and others.
RTComm.RU owns 100% of CJSC RTComm-Sibir and LLC RTComm-Yug and 51% of LLC BASHRTCOMM, each of which is a regional Internet access provider. It also owns nodes in London and Stockholm and data centers in Moscow and Novosibirsk. In the domestic market, RTComm.RU provides services to more than 1,000 business customers, including to communications operators, national corporations and federal ministries and agencies located in the more than 130 large cities in Russia where RTComm.RUs principal access nodes are located.
CJSC GlobalTel, a joint venture with GlobalStar LP, is a company registered in the Russian Federation established in 1996. We own 51% of the voting shares in GlobalTel. As GlobalTels minority shareholder enjoyed substantive participation rights in 2004, we have been accounting for GlobalTel under the equity method. However, in April 2005, a new version of GlobalTels charter was approved by shareholders providing us with certain preferred rights and eliminating certain rights of the minority shareholder. We are currently assessing the potential impact of these changes and our future method of accounting for GlobalTel.
GlobalStars satellite communications system is designed for the provision of mobile and fixed satellite communications services mainly in remote and hard-to-reach areas where cellular and wireless communications are otherwise unavailable or underdeveloped. Its services are currently available in over 100 countries. The Russian segment of this network is operated by GlobalTel, which provides communication services in the territories of all 89 entities in the Russian Federation. Subscribers are offered a variety of communications services and over a dozen models of satellite subscriber terminals. Most of the terminals are handsets capable of operating in and automatically switching to GSM 900 or AMPS 800 modes.
Golden Telecom Inc.
We own 11% of the voting shares in Golden Telecom. Two board members nominated by us currently sit on the Board of Directors of Golden Telecom.
Golden Telecom was incorporated as a Delaware corporation on June 10, 1999 and is listed on the Nasdaq National Market under the symbol GLDN. Golden Telecom is a facilities-based provider of integrated telecommunications and Internet services to businesses and other high-usage customers and telecommunications operators in Moscow, Kiev, St. Petersburg, Nizhny Novgorod and other major population centers throughout Russia and other CIS countries. Its operations are organized into the five customer groups below:
Golden Telecoms facilities in Moscow are fully integrated with its domestic and international networks, as well as with our networks and those of MGTS. In May 2005, Golden Telecom was granted a license to provide nationwide DLD/ILD communications services.
MMTS-9 is a company registered in the Russian Federation. Its business consists primarily of renting out premises to mobile and fixed-line telecommunications providers for the installation of their telecommunication equipment, and the provision of interconnection services and call center services. We own 49.1% of the voting shares in MMTS-9. The majority of Russian Internet web-sites are hosted on servers located on the premises of MMTS-9.
Our principal facilities and properties consist of buildings, sites and telecommunications facilities such as switches of various capacities, cable and transmission devices, television and radio broadcasting equipment, transportation vehicles and various other equipment located throughout Russia. There are no major encumbrances on the properties owned by us. See Item 4. Information on the Company - B. Business Overview - Network and Facilities for additional information.
We own the building in which our principal executive and administrative offices are located at 14, 1st Tverskaya-Yamskaya St., 125047 Moscow, Russia. Under Russian law, any transfer by us of our title to this property is subject to prior governmental approval. We also own and lease offices and operational facilities throughout Russia related to the operation of our business. The location of our principal property, plant and equipment are described in Item 4. Information on the Company - A. History and Development and B. Business Overview. Our major offices are located in the destination cities of our primary network in Russia, including in Moscow, St. Petersburg, Novosibirsk, Ekaterinburg, Samara, Rostov-on-Don and Khabarovsk.
Our management believes that our facilities are adequate for our present needs.
The table below shows the value of fixed assets owned by us as of December 31, 2004, 2003 and 2002. Values are expressed in millions of rubles, according to net book values under IFRS. See Notes 7 and 36 to the consolidated financial statements included elsewhere in this annual report for a description of the differences in the valuation of property, plant and equipment under IFRS and U.S. GAAP.
Our capital expenditures approved by the Board of Directors for 2005 are expected to be RUR 7,283 million. See Item 4. Information on the Company - A. History and Development.
Construction in progress as of December 31, 2004, 2003 and 2002 amounted to RUR 4,313 million, RUR 5,345 million and RUR 3,872 million, respectively.
We believe that we are in compliance with all material requirements relating to environmental protection. Under various construction agreements to which we are a party, we assume obligations to the state and/or local authorities to effect payments to cover costs for the regeneration of forests, agricultural lands and other properties. In the absence of specific regulations requiring us to separately account for such expenses and as long as the amounts of such payments established in our construction agreements significantly differ from each other, neither the exact, nor the average,
amount of such costs can be definitively determined and we have not set aside any contingency amounts in our financial statements for environmental compliance costs.
The following discussion of our financial position and results of operations should be read in conjunction with our consolidated financial statements and the notes to the consolidated financial statements included elsewhere in this annual report.
The accompanying consolidated financial statements have been prepared in accordance and comply with IFRS, which differs in certain respects from U.S. GAAP. For a discussion of the differences between IFRS and U.S. GAAP insofar as they relate to us, see Note 36 to the consolidated financial statements included elsewhere in this annual report.
In 2004, we reviewed the bases on which certain revenues from local operators and related expenses were recognized and determined that not all conditions necessary for revenue and related expenses to be recognized had been met. As a result, management considered it appropriate to correct revenues and expenses and respective accounts receivable and payable as of December 31, 2003 and the two years then ended. In addition, during 2004, we changed retrospectively the method of accounting for certain pension benefits which previously were accounted for as termination benefits. Due to our early adoption of IAS 33, we have also restated earnings per share previously reported for the years ended December 31, 2003 and 2002.
Our principal sources of income are revenues generated from the provision of domestic long-distance and international telecommunications services. We render DLD and ILD traffic throughput services to Russian operators throughout Russia, including to each of Russias seven IRCs, as well as to alternative operators and mobile operators. We currently are the only nationwide carrier of wholesale DLD and ILD traffic in the Russian Federation and therefore hold a monopolistic position in this market. We also have the exclusive right to terminate the incoming international voice traffic to Russia from international operators. International operators pay us for termination of the incoming ILD traffic to Russia at a pre-agreed rate per minute of traffic. Local operators, including IRCs, bill their own local customers for outgoing DLD and ILD calls, while we bill the operators for the traffic throughput. In Moscow, however, we provide DLD and ILD services directly to end-users through the local access network of a local operator and bill customers directly. In addition, we provide DLD services to various government-funded entities and government ministries across Russia.
We own and operate our network and the international gateways through which the majority of Russias DLD and ILD traffic passes. Our network connects all of the IRCs in Russia which, in turn, own and operate local telephone networks in their respective areas. Consequently, we do not bill the majority of telephone users directly, except in Moscow and certain business customers and government agencies located elsewhere in Russia. Instead, we receive payments from the IRCs or other entities, which bill their own local customers for outgoing domestic long-distance and international calls. Historically, growth in the volume of international traffic was limited as a result of Soviet-era capacity constraints on the Russian telecommunications network. However, in recent years, we have made significant investments to improve channel capacity for international calls and to enhance interconnections with international operators. While these improvements have increased the capacity for incoming international calls, the need for further development of our long-distance trunk network and the IRCs networks and the general state of the Russian economy have continued to limit outgoing international traffic.
For a description of our DLD and ILD tariffs, see Item 4. Information on the Company - B. Business Overview - Services.
We have in the past experienced, and continue to experience, significant delays in payment from subscribers located in Moscow, certain government-funded entities and government bodies and agencies, and some international operators. Our management believes that appropriate allowances for doubtful accounts receivable were established to cover our potential exposure. See Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - We face risks resulting from significant delays in the collection of receivables.
The large-scale reform of the Russian telecommunications industry that began with the introduction of the Communications Law in 2004 is continuing, and several regulations have taken effect in 2005 that directly impact the DLD/ILD telecommunications services market in Russia and are ultimately expected to lead to the restructuring and liberalization of this market. For example, regulations enacted pursuant to the Communications Law allow telecommunications operators to apply for DLD/ILD telecommunications services licenses. Several operators are reported to have already applied for such licenses, and DLD/ILD licenses were awarded to MTT, Golden Telecom and Centerinfocom in May 2005. In addition, other regulations enacted pursuant to the Communications Law contemplate a major restructuring of the DLD/ILD interconnection system and government regulation of operators with a significant position in the market.
Among the most significant gaps in the new regulatory regime is how or whether the new regulations will modify the governments regulation of DLD/ILD tariffs charged by licensed operators.
As we currently hold a monopoly position in the Russian DLD/ILD telecommunications services market, these regulatory changes, if implemented, are certain to have a significant impact on our business. However, given the substantial gaps that remain in the legislative framework and lack of interpretive guidance from the regulatory authority regarding certain ambiguous provisions in the new regulations, we are unable to predict with any certainty how the new regulatory regime will impact our business, financial condition and results of operations.
See Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - Implementation of the new Federal Law on Communications, or the Communications Law, will cause us to lose our monopoly position in the Russian long distance telecommunications market and impose an additional financial burden on us which may materially and adversely affect our business, financial condition and results of operations and Item 4. Information on the Company - B. Business Overview - The Telecommunications Industry in Russia - Liberalization of the Russian Telecommunications Market for a description of the regulatory reform of the DLD/ILD telecommunications services market and the uncertainties regarding how the liberalization program will impact our business, financial condition and results of operations.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements prepared in accordance with IFRS. Our reported financial condition and results of operations are sensitive to the accounting methods, assumptions and estimates generally underlying the preparation of financial statements. Our management has identified certain critical accounting policies which require them to make significant estimates and assumptions. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. These results and assumptions form the basis for making judgments about the carrying values of assets and liabilities not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
Accounting for the effects of inflation and changes in foreign exchange rates has also been included by management as a critical accounting policy because of the material impact on our financial statements for the years 2000-2002. Management believes that some of the most critical accounting policies currently affecting our financial condition and results of operations are as follows:
Principles of Consolidation
Our group is comprised of Rostelecom and its subsidiaries. Transactions and balances between Rostelecom and its subsidiaries are eliminated, and accounting policies of the subsidiaries are adjusted to conform to Rostelecoms accounting policies.
A consolidated subsidiary is an entity that is controlled by us, either through ownership, directly or indirectly, of more than 50% of the voting share capital of such entity, or by other means. Companies where we own more than 50% of the voting share capital but the minority shareholder enjoys substantive participation rights and has effective veto rights that would prevent us from taking decisions that are significant in the ordinary course of business, i.e., we are unable to exercise control, are accounted for under the equity method.
As of December 31, 2004, the group comprised Rostelecom and its consolidated subsidiary, Westelcom. Prior to December 1, 2003, the group comprised Rostelecom and its then consolidated subsidiaries: RTC-Leasing; RTCL (Cyprus); RTCL, S.A.; RTDC; RIB; AKOS; Spetzautoleasing; RTComm.RU; and Westelcom.
For more information see Item 4. Information on the Company - A. History and Development, Item 10. Additional Information - C. Material Contracts and the consolidated financial statements included elsewhere in this annual report.
Associates in which we have significant influence but not a controlling interest are accounted for using the equity method of accounting. Significant influence is usually demonstrated by our ownership, directly or indirectly, of between 20% and 50% of the voting share capital of such company or by exerting significant influence through other means. Our share of the net income or losses of associates is included in the consolidated statement of operations, and our share of the net assets of associates is included in the consolidated balance sheet.
An assessment of investments in associates is performed when there is an indication that the asset has been impaired or the impairment losses recognized in prior years no longer exist. Our management must exercise judgment in determining whether a potential impairment of an investment has occurred. For the purposes of such assessment, management uses information relating to the fair value of the investment rather than to its carrying value, information relating to the financial condition of the investee company as well as other known factors which may have an impact on the carrying value of the investment in the near future.
If our interest in an entity is between 20% to 50% and such interest is acquired with the intention to sell it in the foreseeable future, such investment is accounted for as investment available-for-sale and is stated at the fair value. Determination of the fair value of assets is subjective by nature and often involves the use of significant estimates and assumptions. Management has, in the past, engaged independent appraisers to assist in the determination of the fair value of certain available-for-sale investments. The most significant estimates and assumptions used to determine fair value relate, among others, to the estimation of the amount and timing of future cash flows and then discount rates and perpetual growth rates. Most of the assumptions are based on available historical and market information.
Prior to October 2003, we owned 27.13% of the voting shares of RTC-Leasing. However, as management believed that it exercised control over the management, policies and day-to-day operations of RTC-Leasing, including the right to appoint a majority of the Board of Directors of RTC-Leasing, we continued to consolidate the results of operations and financial position of RTC-Leasing. In October 2003, we sold our remaining equity interest in RTC-Leasing and effectively lost control as of December 1, 2003. As a result, RTC-Leasing, together with its subsidiaries, ceased to be treated as a consolidated entity for the purposes of our financial statements. For additional information see Item 10. Additional Information - C. Material Contracts.
As of December 31, 2004, we held 31.1% of the voting shares of RTComm.RU. We consolidated RTComm.RU in our financial statements on the basis of our control over the financial and operating policy decisions of RTComm.RU through December 31, 2003. However, following our disposal of RTC-Leasing, which held a 49% interest in RTComm.RU, we ceased consolidating the results of RTComm.RU and began accounting for the results of operations and financial position of RTComm.RU under the equity method as of January 1, 2004.
In addition, we held 51% of the voting shares of GlobalTel as of December 31, 2004. As GlobalTel is a joint venture under common control, and its minority shareholder has substantive participation rights which enables them to veto decisions by the majority shareholder, we account for GlobalTel under the equity method.
For additional information, see Note 9 to the consolidated financial statements included elsewhere in this annual report.
Property, Plant and Equipment
Cost or valuation of the network comprises all the expenditures up to and including the cabling and wiring to the local telephone operators intercity exchange, and includes contractors charges and payments on account, materials, direct labor, and interest costs on specific project financing up to the date of commissioning of the relevant assets.
Subsequent expenditures are capitalized if it can be clearly demonstrated that they extend the life of the asset or significantly increase its revenue generating capacity beyond its originally assessed standard of performance. Expenditures for ongoing repairs and maintenance are charged to the statement of operations as incurred. Assets acquired to satisfy the basic needs of our employees (for example, in remote districts) are expensed upon acquisition.
Items of property, plant and equipment that are retired or otherwise disposed of are eliminated from the balance sheet along with the corresponding accumulated depreciation. Any gain or loss resulting from such retirement or disposal is included in the determination of net income.
Depreciation of property, plant and equipment is calculated on a straight-line basis from the time the assets are available for use over their estimated useful lives (for details see Note 7 to the consolidated financial statements). The determination of the useful life of an asset involves a subjective judgment by management with respect to the estimated periods of its business use. Changes in our intended period of use of certain assets as well as changes in technology may cause the estimated useful life of an asset to change. The useful lives and depreciation methods are reviewed periodically to ensure that the methods and the periods of depreciation are consistent with the expected pattern of economic benefits from items of property, plant and equipment.
At each balance sheet date, an assessment is made as to whether there is any indication that our assets may be impaired. If any such indication exists, an assessment is made to establish whether the recoverable amount of the assets has declined below the carrying amount of those assets as disclosed in the financial statements. Where such a decline has occurred, the carrying amount of an asset is reduced to the recoverable amount. The amount of any such reduction is recognized immediately as an expense in the statement of operations. Any subsequent increase in the recoverable amount of an asset would be written back when the circumstances that led to the write-down or write-off cease to exist and there is persuasive evidence that the new circumstances and events will persist for the foreseeable future.
Determination of fixed assets impairment involves the use of estimates which include, but are not limited to, the cause, the timing and the amount of the impairment. In evaluating impaired fixed assets, we typically consider technological obsolescence, suspension of services and other changes in circumstances. The recoverable amount is determined as the
higher of the assets net selling price and value in use. The value in use of assets is estimated based on forecast future cash inflows and outflows to be derived from continued use of the assets and from the estimated net proceeds on disposal, discounted to present value using an appropriate discount rate. Management makes judgments and estimates regarding the amount and timing of the future cash flows and the discount rate to be used. Management uses estimates as to future revenue streams, effects of liberalization of the Russian telecommunications industry, discount rates and others. Our managements use of different estimates could have resulted in the need to recognize an impairment charge. Recognition of an impairment charge would reduce the carrying value of property, plant and equipment as of December 31, 2004, increase operating expenses and decrease the net income for the year ended December 31, 2004.
For the purpose of evaluating impairment, we reviewed property, plant and equipment to be held and used, and based on this analysis, we believe that the carrying value of property, plant and equipment reflected in the consolidated financial statements as of December 31, 2004 does not exceed their recoverable value.
For the purpose of determining the opening balance sheet on the first application of IFRS on January 1, 1994, we performed a valuation of our property, plant and equipment, as reliable historical cost information and information regarding their acquisition dates was not available. A brief description of the methodology applied in performing this valuation is set out below for each major asset category:
Effects of Inflation and Changes in Foreign Exchange Rates
Prior to December 31, 2002, the Russian Federation met the definition of a hyperinflationary economy as defined by International Accounting Standard 29 (IAS 29), Financial Reporting in Hyperinflationary Economies. Although the cumulative inflation index for the three-year period ended December 31, 2002 was less than 100%, it was considered that the remaining criteria set forth by IAS 29 indicated that during 2002, the Russian Federation continued to experience conditions that met the definition of a hyperinflationary economy.
Effective January 1, 2003, the International Task Force of the American Institute of Certified Public Accountants determined that the Russian Federation no longer meets the criteria of a hyperinflationary economy. Beginning in 2003, we ceased applying IAS 29 and only recognize the cumulative impact of inflation indexing through December 31, 2002 on non-monetary elements of the consolidated financial statements. Transactions undertaken subsequent to December 31, 2002 are reported at actual, nominal amounts except for those involving non-monetary assets and liabilities acquired prior to January 1, 2003. Results of operations (including gains and losses on disposal) involving such assets and liabilities are recognized based on the restated cost, which was calculated by applying to the carrying values of these assets and liabilities the change in the general price index through December 31, 2002. Comparative financial information for the year ended December 31, 2002 is presented in terms of the measuring unit current as of December 31, 2002.
IAS 29 requires that financial statements prepared by companies in hyperinflationary economies on a historical cost basis be adjusted to take account of the effects of inflation. The consolidated financial statements for the years ended December 31, 2000, 2001 and 2002, have been restated in terms of the purchasing power of the measuring unit as of December 31, 2002, and the net gains or losses arising on the net monetary position of assets and liabilities during the periods presented have been included in the statement of operations and disclosed separately. We have utilized the General Price Index (GPI) as issued by the Federal Service of Public Statistics, in the application of IAS 29.
Substantially all of our revenue is denominated in rubles, except for revenue from international operators, which is denominated in U.S. dollars or other foreign currencies. Most of our costs, other than payments to other international operators and certain domestic service providers, telecommunications equipment purchases and interest paid on foreign denominated debt, are denominated in rubles. Therefore, our performance results from international traffic and, accordingly, year-to-year comparisons of our incoming international traffic revenues, are significantly affected by the relative movements of domestic inflation and ruble exchange rates. For example, if foreign currency international incoming traffic revenues for any periods being compared remain at the same level but between the periods the rate of devaluation of the ruble is slower than the rate of Russian inflation, the related revenues expressed in constant rubles decline from one period to the next. Conversely, if the rate of devaluation exceeds the rate of inflation, such revenues expressed in constant rubles increase from one period to the next. During 1998, the ruble devaluation rate exceeded the rate of inflation, while in the period from 1999 to 2002, it was less than the rate of inflation. Currently, we do not use nor plan to use hedging to insure against such foreign currency fluctuations.
The following table illustrates the effects from 1998 to 2002 of both exchange rate changes and the indexation of historical amounts to adjust for Russian inflation on a fixed amount of U.S. dollar revenues:
The following table summarizes the annual rate of inflation for the years ended December 31, 2004, 2003, 2002, 2001 and 2000:
Source: Federal Service of Public Statistics.
Revenue and Operating Costs Recognition
Revenue and operating costs for all services supplied and received are recognized at the time the services are rendered. Revenue is recognized when it is probable that the economic benefits associated with the transaction will flow to the enterprise and the amount of revenue can be reliably measured. Revenue recognition requires managements judgment as to the probability of the inflow of economic benefits to us, i.e., the expected conversion of revenue streams to cash collected. Use of such judgment for the purpose of establishing revenue recognition policy is widely used in the telecommunications industry in connection with settlements with long-distance telecommunications operators.
We charge regional telephone operators and other telecommunications service providers in Russia either an agreed proportion of the amounts they collect from subscribers or an agreed settlement rate per minute of traffic. For outgoing telephone traffic originating in Moscow, subscribers are charged directly by us.
We charge fees to foreign network operators for incoming calls and other traffic that originate outside Russia. We are charged by foreign operators for the termination of international calls from Russia.
These revenues and costs are shown in gross amounts in the accompanying consolidated financial statements, and exclude value added tax. Amounts payable to and receivable from the same operators are shown net in the balance sheet where a legal right of offset exists.
Our primary business area is the provision of telecommunications services, including international and domestic long-distance phone calls and Internet-related services.
Approximately 96% of our revenues are derived from telecommunications services. Revenues from telecommunications services are reported according to the types of customers and the types of services provided. In the opinion of management, this is the most relevant presentation of revenues generated from our telecommunications services. We determined the following types of customers to be reported separately: local operators, subscribers, and foreign operators. For each type of customer, we report the following types of material services provided:
All other types of revenues are reported as other revenue.
Allowance for doubtful accounts
We analyze our accounts receivable for recoverability on a regular basis. The allowance estimation process requires management to make assumptions based on the historical results, future expectations, assessment of the general economic environment and changes in the creditworthiness of our debtors. Such estimates and assumptions may have a significant impact on the carrying value of the accounts receivable and on the amount of bad debt expense. The percentage of general allowance is based on types of customers, history of debt collection per customer type and age of debt. Specific allowance is established based on the analysis of significant debtors on an individual basis. Historically, the major part of allowance for doubtful accounts relates to accounts receivable from subscribers in Moscow.
We use the same pattern to record the allowance for doubtful accounts as of December 31, 2004 as was used for doubtful accounts as of December 31, 2003. The allowance for doubtful accounts decreased significantly during the year ended December 31, 2004, primarily as a result of a write-off of bad debts of subscribers from Moscow.
Related Party Transactions
We have entered into a number of related party transactions. See Note 29 to the consolidated financial statements and in Item 7. Major Shareholders and Related Party Transactions - B. Related Party Transactions. For a description of weaknesses identified by our independent auditors relating to our procedure for the identification of related parties and related party transactions, see Item 3. Key Information - D. Risk Factors - Risks Relating to Our Business - If we fail to maintain effective internal control, we may not be able to accurately report our financial results or prevent fraud. As a result, investors could lose confidence in our financial reporting, which would harm our business and the trading price of our securities.
As part of our effort to concentrate on our core business segment, we completed a series of transactions through which we divested our remaining interest in our former consolidated subsidiary, RTC-Leasing. RTC-Leasing and its subsidiaries conducted operations in the Russian leasing, banking and investing business segments.
Based on this development, the results of operations of RTC-Leasing have been reported separately as discontinued operations in our consolidated financial statements for the year ended December 31, 2003. See Note 22 to the consolidated financial statements included elsewhere in this annual report.
The statements of income for the years ended December 31, 2004, 2003 and 2002 included as discontinued operations the post-tax results of operations carried out by RTC-Leasing and its subsidiaries, which are comprised of the following:
Our loss recognized on the disposal of shares of RTC-Leasing in 2003 and the respective discontinuance of operations in the leasing, banking and investing segments consisted of the following:
Financial Results for the Years Ended December 31, 2004 and 2003
Restatement of Historical Financial Statements
In 2004, we reviewed the bases on which certain revenues from local operators and related expenses were recognized and determined that not all conditions necessary for revenue and related expenses to be recognized had been met.
Pursuant to regulations established in the telecommunications industry for settlements between local network operators, operators, including us, bill for transit of traffic on a monthly basis based on traffic information for the previous month. For the purposes of our IFRS consolidated financial statements, in prior years, at the end of each year, we made an accrual whereby we recognized revenues and expenses related to intercity and international telephone services based on the difference between actual billings and actual traffic. This adjustment resulted in a build-up of an unbilled receivable at the end of each financial year, the realizability of which could not be assured at the time and in the absence of clear regulatory and contractual guidelines. Accordingly, we believe revenues and associated expenses as reported in the IFRS consolidated financial statements for 2003 and prior years should be adjusted to reflect our revenues based on actual billings rather than on actual traffic. As a result, our financial position and results of operations as of December 31, 2003 and for each of the two years ended December 31, 2003, were restated accordingly to reflect the above facts.
During 2004, we retrospectively changed our method of accounting for certain post-employment benefits. Previously, we accounted for them as termination benefits. They are now accounted for as a defined benefit plan and the estimated benefits are determined using an actuarial method. Our consolidated financial statements for the year ended December 31, 2003 and 2002, as restated, reflect the effects of this change.
In December 2003, the IASB published revised International Accounting Standard No. 33 (IAS No. 33), Earnings per share. As revised, IAS No. 33 requires the application of the two-class method to determine earnings applicable to ordinary shareholders, the amount of which is used as a nominator to calculate earnings per ordinary share. The application of the two-class method requires that the profit or loss after deducting preferred dividends is allocated to ordinary shares and other participating equity instruments to the extent that each instrument shares in earnings as if all of the profit or loss for the period had been distributed. The total profit or loss allocated to each class of equity instrument is determined by adding together the amount allocated for dividends and the amount allocated for a participation feature. We have adopted the provisions of IAS No. 33 early and applied them to the financial statements for the year ended December 31, 2004, and retrospectively restated the amounts reported earlier for 2003 and 2002.
The reconciliation of earnings per share, as restated, and earnings per share previously reported for the years ended December 31, 2003 and 2002 is as follows:
The discussion below is based on the restated figures and, therefore, is different from the discussion included in our last annual report on Form 20-F filed on June 30, 2004.
In 2004, total revenues increased by 19.4% to RUR 37,318 million from RUR 31,267 million in 2003. The growth in total revenues was largely due to the introduction of the new settlement system between us and local operators. Revenue from the new settlement system accounted for RUR 5,980 million of our total revenues in 2004.
Revenues from local operators represented 60.7% and 50.5% of total revenues in 2004 and 2003, respectively.
Revenues from local operators for DLD traffic transit increased by 54.7% to RUR 13,411 million in 2004 compared to RUR 8,669 million in 2003 due to the introduction of the new settlement system between us and local operators for DLD traffic transit in 2003 as well as 12% DLD traffic growth. The principal reason behind the traffic growth was Russias continued economic development coupled with higher fixed-line and mobile penetration, as well as our active marketing efforts to strengthen our positions in the regional markets. Effective August 1, 2003, the government anti-monopoly authority implemented a new settlement system for domestic long-distance traffic transit between us, on the one hand, and regional operators of the Svyazinvest Group and alternative operators, on the other hand. According to this new system we began to bill local operators originating DLD calls for DLD traffic transit using a Linear Settlement Rate and pay local operators for DLD traffic termination using a Termination Settlement Rate. Previously, we collected revenue from local operators for DLD traffic transit using an Integral Settlement Rate and made no payments for DLD traffic termination. See Item 4. Information on the Company - B. Business Overview - Services - Domestic Tariffs and Note 20 to the consolidated financial statements for additional information.
Revenues from local operators for outgoing ILD traffic transit increased by 19.1% to RUR 6,160 million in 2004 from RUR 5,171 million in 2003 as we took active measures to both gain additional traffic volume on our network and rebalance tariffs. Outgoing ILD traffic volume from local operators grew by 25% in 2004. This was primarily due to a doubling of traffic volume carried on our network by alternative operators. ILD tariff rebalancing for subscribers across Russia (excluding our subscribers in Moscow) contributed to the positive revenue dynamics for outgoing ILD traffic transit.
Other income from local operators increased by 57.6% to RUR 3,077 million in 2004 compared to RUR 1,952 million in 2003. Other income from local operators represents revenue from leased line services, repair and maintenance services as well as other services. The growth in revenue was largely due to an increase in the volume of leased line services offered to local operators.
Revenues from our subscribers, mainly representing our subscribers in Moscow, include revenues from domestic and international long-distance calls as well as other services. In 2004, revenues from subscribers represented 23.4% of total revenues compared to 29.8% in 2003. In 2004, revenues from subscribers decreased by 6.2% to RUR 8,740 million from RUR 9,319 million in 2003. This decrease was principally due to a change in the accounting treatment of RTComm.RU, which accounted for 100% of our Internet access revenues in prior years, and disposal of our interest in AKOS, which accounted for 100% of our cellular services revenues in prior years. We ceased to consolidate AKOS effective December 1, 2003 and RTComm.RU effective January 1, 2004, respectively. Net of revenues of RTComm.RU and AKOS, revenues from our subscribers increased from RUR 8,142 million in 2003 to RUR 8,740 million in 2004, a 7% growth year-on-year.
Revenues from subscribers for international long-distance services decreased by 4.2% to RUR 2,900 million in 2004 from RUR 3,027 million in 2003. The negative revenue dynamic was due to a 9% decrease in outgoing ILD traffic volume from subscribers, reflecting the intense competition in the Moscow market, and partly offset by a higher effective tariff rate for international calls.
Revenues from Moscow subscribers for domestic long-distance services increased by 5.7% to RUR 3,886 million in 2004 from RUR 3,678 million in 2003 due to our more effective pricing policy, the provision of additional services to Moscow subscribers and other marketing efforts. The 2% rise in DLD traffic volume from subscribers compared to 2003 also contributed to the growth in revenue.
In 2004, revenues from the lease of channels to subscribers increased by 58.5% to RUR 1,352 million from RUR 853 million in 2003 due to a solid growth in the volume of lease services. In 2004, revenues from television and radio transmission amounted to RUR 602 million, an increase of 3% compared to 2003.
In 2004, revenues from foreign operators represented 12.2% of our total revenues compared to 14.3% in 2003. The 1.7% increase in revenues from foreign operators from RUR 4,483 million in 2003 to RUR 4,560 million in 2004 was due to incoming international traffic growth. The incoming international traffic grew by 20% compared to 2003, reflecting our growing market share. Revenues from telex, telegraph and other services offered to international operators decreased by 24% to RUR 327 million in 2004 from RUR 431 million in 2003 due to the continued weakening demand for these services.
Total operating expenses grew by 11.1% to RUR 32,313 million in 2004 from RUR 29,082 million in 2003, mainly due to higher charges by local operators due to the introduction of the new settlement system as well as scheduled increases
in wages and salaries. The growth in operating expenses was partly offset by lower depreciation charges, loss on sale of property, plant and equipment and administration and other costs.
Charges by local network operators increased by 88.8% to RUR 8,178 million in 2004 from RUR 4,331 million in 2003 as a result of the introduction of the new settlement system and growth in DLD traffic volumes.
Charges by international network operators for outgoing international calls termination increased by 9.7% to RUR 6,484 million in 2004 from RUR 5,913 million in 2003. The increase was driven by the growth in outgoing ILD traffic volumes.
Wages, salaries and other staff costs increased by 29.5% to RUR 5,109 million in 2004 from RUR 3,946 million in 2003. The growth in wages, salaries and other staff costs was mainly due to planned average salary increases while the number of employees was reduced by 5.4% to 25,285 as of December 31, 2004 compared to 26,742 as of December 31, 2003. The introduction of the Management By Objectives system, or MBO, in May 2004 for our top and mid-level managers also contributed to the growth in wages, salaries and other staff costs. See Item 6. Directors, Senior Management and Employees - D. Employees for a description of MBO.
Depreciation of property, plant and equipment decreased by 9.1% to RUR 7,498 million in 2004 from RUR 8,252 million in 2003. The latter included an additional RUR 210 million depreciation expense on certain satellite channels, which we discontinued using in 2003. The decrease in depreciation charges in 2004 was also due to the fact some property, plant and equipment were disposed of or fully depreciated in 2003.
The loss on sale of property, plant and equipment decreased by 82.1% to RUR 217 million in 2004 from RUR 1,214 million in 2003 as we decommissioned a larger number of analog cable systems in 2003.
Administration and other expenses decreased by 19.1% to RUR 3,058 million in 2004 from RUR 3,782 million in 2003, as the latter included an additional RUR 446 million expense incurred by RTComm.RU in connection with the governmental program Electronic Russia, which is aimed at enhancing the technical capabilities of governmental organizations in various regions in Russia.
Taxes (other than on income) increased by 15.8% to RUR 587 million in 2004 as compared to RUR 507 million in 2003 mainly driven by the application of a higher property tax rate due to changes in tax legislation.
Bad debt expense increased by 9.5% to RUR 369 million in 2004 from RUR 337 million in 2003. The increase resulted from uncollected receivables in the amount of RUR 253 million due for satellite channels disposed of, which was partly offset by the effect of better debt collection in 2004.
In 2004, operating profit increased by RUR 2,820 million, or 129.1%, to RUR 5,005 million from RUR 2,185 million in 2003. As a result, the operating margin grew from 7.0% in 2003 to 13.4% in 2004.
Net interest expense and other non-operating items decreased from a RUR 1,516 million net gain in 2003 to a RUR 682 million net gain in 2004 mainly due to the fact we received an additional RUR 752 million gain from debt restructuring and a RUR 316 million contribution in 2003. The decrease in net interest expense and other non-operating items compared to 2003 was partly offset by lower interest expense and higher interest income, which resulted from reduced total debt and increased financial investments, respectively.
Income Tax Expense
Our 2004 income tax expense amounted to RUR 1,507 million compared to RUR 331 million in 2003. The increase was primarily due to an increase in our operating profit. In addition, as a result of the RTC-Leasing disposal and subsequent changes of temporary differences in accounting and tax bases of some assets and liabilities, we had a one-off deferred income tax benefit in the total amount of RUR 620 million in 2003.
Results From Discontinued Operations
Discontinued operations resulted from the disposal of our stake in RTC-Leasing on December 1, 2003. We did not record a loss from discontinued operations in 2004, while in 2003 net loss from discontinued operations amounted to RUR 3,109 million.
Financial Results for the Years Ended December 31, 2003 and 2002
Restatement of Historical Financial Statements
Our consolidated financial statements for the years ended December 31, 2003 and 2002 have been restated. See Financial Results for the Years Ended December 31, 2004 and 2003 - Restatement of Historical Financial Statements and Note 2 to the consolidated financial statements included elsewhere in this annual report for information regarding the restatement.
In 2003, total revenues increased by 12.3% to RUR 31,267 million from RUR 27,853 million in 2002. The growth in total revenues was largely due to the introduction of a new settlement system between us and local operators in Russia. The impact of the introduction of the new settlement system on our total revenue for 2003 amounted to RUR 2,966 million.
Revenues from local operators represented 50.5% and 45.7% of total revenues in 2003 and 2002, respectively.
Revenues from local operators for DLD traffic increased by 48.0% to RUR 8,669 million in 2003 as compared to RUR 5,859 million in 2002. The increase in revenue from local operators for DLD traffic transit was due to a 15% growth in traffic and a 49% increase in the level of tariffs. The principal reason behind the growth in traffic was the continued growth of the Russian economy and greater penetration of fixed and mobile telephony in the Russian market. With respect to tariffs, on August 1, 2003, the Anti-Monopoly Ministry (currently, the FAS) abolished the ISR for settlements between us, on the one hand, and regional operators, the Svyazinvest Group and alternative operators, on the other. Under the new settlements system, we began to bill the regional and alternative operators for the origination of DLD calls calculated using the Linear Settlement Rate and to pay regional and alternative operators for the termination of DLD calls calculated using the Termination Settlement Rate. Previously, we made no payments for termination and recognized revenue for processing traffic originating in the networks of other operators on the basis of the ISR.
Revenues from local operators for outgoing ILD traffic increased by 2.9% to RUR 5,171 million in 2003 from RUR 5,025 million in 2002. In 2003, outgoing international traffic from local operators grew by 10% as compared to 2002. In 2003, tariffs were largely unchanged as compared to 2002.
Other income from local operators increased by 6.2% to RUR 1,952 million in 2003 compared to RUR 1,838 million in 2002. Income from local operators consists of revenues from leased lines services and other services rendered to local operators including equipment rent and maintenance. The growth in revenue is due to higher leased lines prices charged.
Revenues from our subscribers, which consist mainly of subscribers in Moscow, include revenues from national and international calls. In 2003, revenues from subscribers represented 29.8% of total revenues compared to 32.9% in 2002. In 2003, revenues from subscribers increased by 1.6% to RUR 9,319 million from RUR 9,171 million in 2002. Such growth was principally due to an increase in subscriber DLD revenues, increased Internet access revenues and rental fees for telecommunications channels, partly offset by a decrease in subscriber ILD revenues.
Revenues from subscribers in Moscow for international telecommunications services decreased by 12.6% to RUR 3,027 million in 2003 from RUR 3,462 million in 2002 partially as a result of a slight decrease in outgoing international traffic, caused by continued intense competition in Moscow, a 4% decrease in the tariff level from the previous year and the impact of inflation.
Revenues from subscribers in Moscow for DLD telecommunications services increased by 4.7% to RUR 3,678 million in 2003 from RUR 3,513 million in 2002 due to our more effective pricing policy, the provision of additional services to Moscow subscribers and other marketing efforts.
In 2002, revenues from subscribers also included revenues from our Internet and mobile telecommunications businesses, representing the activities of RTComm.RU and AKOS, respectively, which we started consolidating from January 2002 and April 2002, respectively. The revenues of RTComm.RU were consolidated in our results through December 31, 2003, although the revenues of AKOS were consolidated through December 1, 2003. Internet access revenues in 2003 increased by 24.9% to RUR 1,060 million from RUR 849 million in 2002 due to the growth in RTComm.RUs business. Revenues from mobile subscribers in 2003 increased by 31.5% to RUR 117 million from RUR 89 million in 2002 due to the general growth in demand for cellular services in Russia. We disposed of our holding in AKOS together with the sale of our remaining holding in RTC-Leasing in late 2003.
In 2003, revenues from the lease of channels to subscribers increased by 19.8% to RUR 853 million from RUR 712 million in 2002 due to an increase in tariff levels for leasing channels. In 2003, revenues from television and radio transmission amounted to RUR 584 million, an increase of 7.0% from 2002.
In 2003, revenues from foreign operators represented 14.3% of total revenues compared to 18.3% in 2002. Revenues from foreign operators decreased by 12.1% to RUR 4,483 million in 2003 from RUR 5,100 million in 2002. Incoming international traffic increased by 24% in 2003 as compared to 2002. In 2003, tariff levels decreased by 23% from the previous year. Revenues from other services such as telex and telegraph decreased by 30.7% to RUR 431 million from RUR 622 million in 2002 due to continued weakening demand for these services.
Total operating expenses increased by 12.0% to RUR 29,082 million in 2003 from RUR 25,955 million in 2002, mainly due to an increase in charges by international and local network operators, wages and salaries, administration and other costs. This increase in expenses was partly offset by decreasing depreciation, lower taxes (other than on income) and lower bad debt expense.
Charges by local network operators increased by 153.7% to RUR 4,331 million in 2003 from RUR 1,707 million in 2002. The impact of the introduction of the new settlement system on our total operating expenses for 2003 amounted to RUR 2,136 million.
Charges by international network operators for termination of outgoing international calls increased by 2.3% to RUR 5,913 million in 2003 from RUR 5,779 million in 2002. The increase was principally due to the increase of outgoing international traffic.
Wages, salaries and other staff costs increased by 13.5% to RUR 3,946 million in 2003 from RUR 3,476 million in 2002. However, as of December 31, 2003 the number of employees decreased by 15.7% to 26,742 from 31,729 as of December 31, 2002. The increase in wages, salaries and other staff costs was due to an increase in average salaries of 31% in 2003 as compared to 2002.
Depreciation of property, plant and equipment decreased by 9.2% to RUR 8,252 million in 2003 from RUR 9,089 million in 2002. During 2002, we formalized a plan to discontinue using certain satellite channels which resulted in additional depreciation expenses of RUR 897 million and RUR 210 million being recognized in 2002 and 2003, respectively. The remaining decrease in depreciation in 2003 relates to property, plant and equipment disposed of in 2002. During 2003, we ceased using certain analog cable systems with the result that related losses increased by 170.0% to RUR 1,214 million in 2003 from RUR 449 million in 2002.
Administration and other expenses increased by 13.3% to RUR 3,782 million in 2003 from RUR 3,336 million in 2002. This increase relates primarily to expenses incurred by RTComm.RU in connection with the governmental program Electronic Russia, which is aimed at enhancing the technical capabilities of the government