Research Notes

VimpelCom: Upside Potential Still Looks Strong

Recommendation on common shares:	Buy
Recommendation on ADRs:	Buy
Target price per common share:	$189.48
Target price per ADR:	$47.37
Upside potential:	38%

Reason: assigning recommendation

RTS ticker	VIMP
NYSE ticker	VIP
Market cap, $ mln	7,044
Company value (EV), $ mln	8,600
Number of common shares	51,281,022
Number of preferred shares	6,426,600
Ratio ADR/common share	4/1
ADR Price range per year	25.00-42.90
Comm share price range per year	100.00-171.6

Financials, .$ mln   2004 2005E 2006E Revenue 2,147 3,014 3,847 Operating profit 674 859 1,327 EBITDA 1,027 1,322 1,918 Net profit 350 524 839		Margins, %   2004 2005E 2006E Operating margin 31% 24% 29% EBITDA margin 48% 44% 50% Net profit margin 16% 17% 22%
Multiples   2004 2005E 2006E EV/S 4.0 2.9 2.2 EV/EBITDA 8.4 6.5 4.5 P/E 20.1 13.4 8.4		Dividends, $ / share 2002 2003 2004 Common shares - - - ADR - - -

We assign a fair price of $189.48 to VimpelCom common shares ($47.37 per ADR) and assign a Buy recommendation to ADRs and common shares.

• According to our estimates, VimpleCom’s ADRs trade at a 38% discount to fair price.

• We have estimated the fair value of shares using the DCF model and comparative analysis.

• We assign a Buy recommendation to VimpelCom ADRs based on the company’s strong fundamentals, good market position, clear outlook, high transparency for investors and appealing fair value.

• Our financial model has been built on VimpelCom’s forecast results based on the company’s current structure. We have not taken into account the company’s eventual entry into the Ukrainian market. We have also not factored in possible changes in the company’ equity.

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The Russian cellular market is still growing but has already been split up

Recently, the mobile industry has displayed huge growth rates: in 2004 the subscriber base doubled reaching 78 mln users by early February 2005 (twice as high as in February 2004). Cellular penetration (number of users/number of population ratio) reached 45%. Since early 2004, subscriber base of cellular operators has exceeded that of fixed-line telecom companies.

Òable1. Number of cellular users

	1999	2000	2001	2002	2003	2004
Number of subscribers in Russia, mln	1.35	3.45	8.00	18.00	36.20	73.86
Upside y-o-y		156%	132%	125%	101%	104%

Source: ACM-Consulting, www.beeline.ru

The market has largely been formed by the Big Three companies – MTS, VimpelCom and Megafon. They account for over 90% of the Russian cellular market.

Òable 2. Subscriber base of major mobile operators in Russia at the end of April 2005

	Company	Total	Russia
1	ÌÒS	42,084,667	31,933,608
2	VimpelCom	31,809,000	30,614,000
3	Ìågafon	16,269,861	16,218,532
4	Uralsvyazinform	2,480,000	2,480,000
5	Smarts	2,150,000	2,150,000
6	Òåëå2	1,590,000	1,590,000
7	Siberia Telecom	1,267,622	1,267,622
8	Nizhny Novgorod Cellular Communications	826,556	826,556
9	Yekaterinburg Cellular Communication Motive	537,665	537,665
10	New Telephone Company	345,67	345,67
	Total	99,361,041	87,963,653

Source: ACM-Consulting

Chart 1. Operator breakdown on the Russian cellular market

Source: ACM-Consulting

Cellular penetration in Moscow has already topped 100% and nearly reached this level in St. Petersburg.

We forecast the following figures of cellular penetration in Russia for 2005-2012:

Òable 3. Cellular penetration in Russia

	2003	2004	2005E	2006E	2007E	2008E	2009E	2010E	2011E	2012E
Total population, mln	144.62	143.90	143.20	142.54	141.90	141.28	140.66	140.03	139.38	138.72
Cellular penetration in the country	25%	51%	68%	78%	80%	81%	82%	83%	84%	85%
Cellular subscribers	36.20	73.86	97.01	110.97	113.52	114.44	115.34	116.22	117.08	117.92

Source: un.org and ACM-Consulting data, Finam estimates

VimpelCom: Business Overview

VimpelCom is Russia’s second largest wireless operator in Russia which operates under the Beeline trademark. License coverage is 94% of the Russian territory of (with a population of 136 mln people).

The company was founded by Dmitry Zimin in 1992. At that time it was a small nucleus of career scientists and engineers engaged in radio electronics. In 1993, a pilot project was launched (capacity of 300 user stations) on building an AMPS network in Moscow. In 1994, the contract for equipment supply was signed with Ericsson, the network was reconstructed for DAMPS standard which is of higher quality and the subscriber base topped 5,000. In 1996, the company launched an IPO on the New York Stock Exchange (NYSE) which was the first IPO by a Russian company in the US since 1903. In April 1998, the license coverage of GSM-1800 standard topped 100 mln users. In October, the pre-paid Bee+ program was launched.

At present, nearly 99% of VimpleCom’s subscribers run on the GSM standard. The company does not use the outmoded DAMPS analog standard DAMPS.

In 2004, the company acquired 100% in Kazakhstan’s second largest cellular operator Kar-Tel which owns brands K-mobile and Excess.

The company’s headline market and operating results are as follows:

• Share of the Russian market: 34.8%
• subscriber base in Russia: 27.3 mln, including 7.8 mln in Moscow;
• subscriber base in Kazakhstan: 995,000;
• roaming agreements with companies in 171 countries around the world (including GPRS roaming in 55 countries)
• contract subscribers account for 14%of the company’s revenues while prepaid customers comprise 86%
• ARPU: $9.1
• MoU: 97.3 minutes
• Churn rate: 5,7%
• SAC: $12.3

Òable 4. Equity breakdown

Name	Common shares, %	Preferred shares, %	Share in equity, %
Telenor	29.90%		26.60%
Alfa Group holding	24.50%	100.00%	32.90%
Free float	44.40%		39.40%
Shares to exercise options for company managers	0.30%		0.20%
Others (largely management)	1.00%		0.90%

Source: company data

In line with the company’s charter, preferred shares enable its owners to vote at the general shareholders’ meeting and entitle them to a fixed dividend payout. All shares in free float have been issued as ADRs. One ADR is equal to 0.25 common shares.

Shareholder conflict is tense, but has no impact on VimpelCom’s business

We have been witnessing a conflict of core shareholders for some time. The reasons behind it include a clash of opinions over the wireless operator’s development, in particular, entry into the Ukrainian market. Telenor opposes VimpelCom’s bid to break onto one of the most promising cellular markets in CIS, while Alfa is trying by hook or by crook to gain access to the Ukrainian market, for instance through mobile operator WellCOM or through a minority shareholder’s court claim in the Krasnodar region to amend the company’s charter, since this is a prerequisite for the acquisition of WellCOM.

In our opinion, the conflict has yet to produce any tangible impact on the company’s operations.

Tax risks: more about politics than economics

In December 2004, VImpelCom was hit with preliminary 2001 tax claims which totaled Rub 4.4 bln ($153.31 mln). But in the end, the final payment turned out to be 9 times less than the original claim, i.e. 489.9 mln ($17.07 bln)

On February 25, 2005 the company was hit with the final report on the 2002 tax audit. In line with this document, the final amount of tax claims was Rub 344.9 mln ($12.01 mln) plus Rub 129.1 mln ($4.49 mln) in fines and penalties.

On June 1, 2005 the Moscow Arbitration Court upheld the company’s appeal in terms of 2002 tax claims. VimpelCom has to receive all amounts paid as fines, penalties and compensations.

We view tax claims as a lever of political influence by the state on the company and its shareholders.

Operating results: the company has been fighting for client loyalty, but ARPU is still in decline

The company’s 2003-2004 US GAAP operating results are given below ($ th):

Òable 5. The company’s 2003/2004 financials

Line item	2004	2003	Change, %
Earnings	2,146,629	1,335,598	60.72%
Opex	1,472,463	919,201	60.19%
including depreciation and amortization	345,201	196,833	75.38%
including SG&A	720,127	467,655	53.99%
Pre-tax income and minority share	585,625	358,295	63.45%
Pre-tax profit margin before minority share	27.28%	26.83%
Net profit	350,396	228,809	53.14%
Net profit margin, %	16.32%	17.13%

Source: company data, Finam estimates

In early June, the company released its US GAAP Q105 financials. The headline indicators are summarized in the table below:

Òable 6. The company’s Q104/Q105 financials

	Q105	Q404	Change Q105/Q404	Q104	Change Q105/Q104
Subscriber base, th	30,748.40	26,583.30	15.7%	13,371.50	130.0%
Churn rate, %	5.9%	5.7%	0.2%	8.6%	-2.7%
ARPU, USD	7.3	9.1	-19.8%	10.9	-33.0%
Revenue, $ th	640,636	635,671	0.8%	413,772	54.8%
OIBDA,$ th	306,107	284,339	7.7%	202,025	51.5%
OIBDA margin, %	48%	45%		49%
Net profit	109,664	83,742	31.0%	75,602	45.1%
Net profit margin, %	17%	13%		18%

Source: Company data, Finam estimates

Overall, the figures underscore the following trends:

• Churn rate is gradually declining which points to increased customer loyalty;
• ARPU is in decline but the rate points to possible cessation of this trend;
• The company’s net profit displays a positive upward trend and its profit margin is quite strong;
• OIBDA profit margin declined insignificantly but the level itself is still quite robust.

The company’s earnings breakdown is as follows (in line with US GAAP financials):

Òable 7. The company’s revenue mix

Company earnings	Share
Subscriber payments and connection fee	94.80%
Sales of equipment and accessories	4.90%
Other earnings	0.30%

Source: Company data

Chart 2. VimpelCom’s cost breakdown


Source: Company data, Finam estimates

Company valuation

To estimate the fair value of VimpelCom’s ADRs we have used the discounted cash flow method. In building our model, we have forecast the number of users in Russia (separately for regions and the Moscow license zone which geographically consists of Moscow and the Moscow region) and Kazakhstan and VimpelCom’s ARPU and share on these markets, as the sources for the company’s earnings in 2005-2012. In these forecasts we proceeded from the assumption that cellular penetration in Russia will go to 80%, reach this figure by year-end 2007 and further stabilize around this level.

Òable 8. Cellular penetration in Russia

	2003	2004	2005E	2006E	2007E	2008E	2009E	2010E	2011E	2012E
Moscow license zone, mln, including	17.01	17.40	17.85	18.46	19.06	19.67	20.26	20.85	21.44	22.01
Moscow, mln	10.39	10.40	10.93	11.46	12.00	12.53	13.05	13.57	14.08	14.59
Moscow region. mln	6.62	7.00	6.92	6.99	7.06	7.14	7.21	7.28	7.35	7.42
Regions, mln	127.61	126.50	125.36	124.08	122.84	121.61	120.40	119.17	117.95	116.71
Population total, mln	144.62	143.90	143.20	142.54	141.90	141.28	140.66	140.03	139.38	138.72
Penetration	25%	51%	68%	78%	80%	81%	82%	83%	84%	85%
Cellular users	36.20	73.86	97.01	110.97	113.52	114.44	115.34	116.22	117.08	117.92

Source: un.org, ACM-Consulting data, Finam estimates

Òable 9. Cellular penetration in Kazakhstan

	2003	2004	2005E	2006E	2007E	2008E	2009E	2010E	2011E	2012E
Population, mln	14.86	14.84	14.83	14.81	14.80	14.80	14.80	14.80	14.81	14.83
Penetration	9%	18%	45%	60%	72%	74%	76%	78%	79%	80%
Cellular users	1.34	2.72	6.68	8.93	10.60	10.92	11.21	11.51	11.67	11.83

Source: un.org, ACM-Consulting data, Finam estimates

We estimated VimpelCom’s market share in the Moscow license zone at 40% in 2012 vs. 44% at present due to tough competition for customers among three major companies operating in this region. In addition, the company is expected to gain 35% of the market in the regions vs. 32% in 2004 due to a rise in subscriber base. In Kazakhstan, the operator will account for 40% of the local market in 2012 vs. 32% in 2004 due to efficient marketing measures implemented in Russia and the “territory effect” (in particular, lower equipment purchasing prices and broader marketing and financial opportunities).

ARPU forecast is based on prerequisites of a decline in this indicator by year-end 2005 on all Russian markets. After that, the Moscow license zone will see a rise in revenue per user by 5% pa within three years as a result of VAS implementation. This valuation is conservative and includes rather serious price pressure resulting from competition. After 2008, we expect the ARPU level to stabilize due to the final “split” of the market among three operators.

The situation is slightly different in regions: we expect a decline in ARPU by 10% in 2005 and further it is forecast to remain unchanged for two years. In 2007-2008, revenue per user will grow by 5% per year, while it is forecast to start stabilizing in 2009 on the back of the same factors as in the Moscow license zone.

Our analysis has underscored that ARPU in Kazakhstan is on the same level as it was in the Russian regions 2-2.5 years ago. For this reason, we forecast ARPU in Kazakhstan on the basis of mixed data in Russia for 2.5 years.

Chart. 3. VimpelCom’s APRU

Source: Finam estimates

We have also analyzed VimpelCom’s cost breakdown and on the basis of regressive analysis a forecast model has been developed for service costs, equipment costs and SG&A. Capex forecast has been made on the basis of SAC analysis in recent years. We expect a rise in net cash flow by 3% pa in the post-forecast period.

The resulting financial model is built on the forecast of VimpelCom’s performance, as a company with the current organization structure. We have not taken into account its possible entry into the Ukrainian market. We have not considered changes in the company’s equity either.

Òable 10. VimpelCom’s valuation

			Forecast period								Post-forecast period
		2004	2005	2006	2007	2008	2009	2010	2011	2012
Operating income	$ mln	2,147	3,014	3,847	4,29	4,594	4,7	4,78	4,846	4,895
Opex	$ mln	1,472	2,154	2,521	2,633	2,697	2,731	2,76	2,787	2,81
Other costs	$ mln	-89	-151	-192	-214	-230	-235	-239	-242	-245
Pre-tax profit	$ mln	586	709	1,134	1,442	1,667	1,734	1,781	1,817	1,84
Income tax	$ mln	152	184	295	375	433	451	463	472	478
Depreciation and amortization	$ mln	345	463	591	659	706	722	734	744	752
Capex	$ mln	1,517	1,337	762	833	776	792	794	803	827
Change in net capital outflow	$ mln	-29	-276	-165	-87	-60	-21	-16	-13	-10
Cash flow	$ mln	-793	-73	833	980	1,223	1,235	1,274	1,299	1,296
Weighted average cost of capital	%	10.96%
DCF	$ mln		-66.2	677	717	807	734	683	627
DCF amount	$ mln	4,179
Final growth rate	$ mln	3%
Final market cap	$ mln	16,294
Adjusted final market cap	$ mln	7,093
Market cap	$ mln	11,273
Net debt	$ mln	1,556
Cash available to shareholders	$ mln	9,717
Price per common share	$	189.48
Price per ADR	$	47.37

Source: Finam estimates

In line with our model, the fair value of VimpelCom’s common share is $189.48 and $47.37 per ADR. This implies 38% upside potential of ADRs and common shares.

For the purpose of comparative analysis, we have analyzed the following metrics of cellular peers on developed and emerging markets: P/E, EV/S, EV/EBITDA and EBITDA margin (EBITDA/S).

Òable 11. Comparable companies

Company	Country	P/E (2005)	EV/S (2005)	EV/EBITDA (2005)	EBITDA margin
Emerging markets
China Mobile	China	12.8	2.6	4.8	56%
China Unicom	China	17.1	1.5	4.3	34%
Telefonica Moviles	Spain / Latin America	18.2	3.1	8.4	40%
America Movil	South America	16.4	2.5	7.8	31%
Turkcell Iletisi	Turkey	11.1	2.5	5.9	38%
Sk Telecom	South Korea	9.4	1.8	4.2	44%
Advanced Info	Thailand	13.0	3.0	5.7	52%
Hutchison telecom	Hong Kong / FEA	70.7	2.1	9.0	36%
KT Freetel	South Korea	10.0	1.4	4.3	31%
MTN Group Ltd.	Africa	12.1	2.6	6.3	41%
Chunghwa Telecom	Taiwan	12.6	3.1	5.8	55%
Far EasTone	Taiwan	11.5	2.6	5.6	25%
Maxis Communications	Malaysia	14.0	3.6	6.5	57%
Taiwan Cellular Corporation	Taiwan	9.9	3.2	6.9	50%
MobiNIL	Egypt	12.8	3.0	6.1	53%
Partner	Israel	12.3	1.5	4.7	32%
Sonaecom	Poland	33.0	1.2	5.1	23%
NII Holdings, Inc.	North and South America	21.2	2.8	9.7	18%
Average for EM:		15.2	2.6	6.3	40%
Developed markets
Cosmote Mobile Telecommunications	Greece	14.8	2.9	6.8	42%
KPN	Holland	13.4	2.0	5.3	38%
Mobistar	Belgium	14.9	2.8	6.9	40%
Nextel Communication Inc.	USA	15.6	2.7	7.2	38%
Ntt DOCOMO Inc.	Japan	15.3	1.6	4.8	34%
O2 Plc.	Europe	20.6	1.5	5.4	27%
Tele2	Europe	11.5	0.7	5.5	13%
Telenor	Scandinavia	11.8	1.6	4.8	35%
TeliaSonera	Scandinavia	12.6	2.0	5.6	36%
US Cellular Corp.	USA	43.3	1.7	7.4	24%
Average for EM markets:		15,6	2.0	5.6	33%
VimpelCom	Russia / Kazakhstan	13.4	2.9	6.5	48%
Discount/(premium) on EM:		12%	-10%	-3%
Discount/(premium) on developed markets:		14%	-46%	-15%

Source: Bloomberg, IBES, company data, Finam estimates

As the above table show, VimpelCom trades at a minor discount in terms of P/E both on EM and developed markets. This underscores that the company is undervalued in terms of this indicator and VimpelCom posts higher net profit in relation to market cap than peer companies.

In terms of EBITDA margin, VimpelCom looks like an extremely appealing investment vehicle. For this reason, the company is overvalued by 3-10% vs. EM in terms EV/S è EV/EBITDA and by 15-46% vs. developed markets, since investors prefer, first and foremost, a more profitable business.

Overall, we can conclude that in terms of fundamentals VimpelCom has a strong competitive edge over other industry peers worldwide.

Summary

At present, the Russian cellular market is close to reaching the saturation point, since connection has already peaked in many regions and we expect gradual stabilization of penetration by year-end 2007. In line with our estimates, the company’s market share will remain unchanged during the entire forecast period at 40% for Moscow and 36% for Russia. This means that VimpelCom’s positions look unshakable in terms of its market share.

In addition, the company’s financials look attractive, since OIBDA margin is 48%, while net profit margin is over 17% and net debt/EV ratio is 18%.

In line with our forecast, the company will more than double its revenue within the next seven years, while net cash flow will be some $1.3 bln in 2007 (vs. the negative net cash flow of $-793 mln in 2004). Growth will be achieved largely on the back of a growing subscriber base, both in Russia and Kazakhstan.

According to our estimates, VimpelCom’s common shares and ADRs have 38% upside potential and the target price is $47.37 per ADR and $189.48 per common share. We assign a Buy recommendation to VimpelCom common shares and ADRs.

Ivan Kobulaev

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Sector: Telecommunications, IT
Company: VimpelCom

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