Are Russian Stocks Too Hot to Handle?

I recently returned from a trip to Russia, where I met with managers from several of the telecom firms I cover as a stock analyst at Morningstar. Many of these firms' stocks have surged in the past decade, coinciding with the country's positive transformation. While we don't currently see any compelling values in Russian telecom, we thought we'd take the opportunity to share some of our thoughts on Russia's transformation and discuss why a combination of strong growth prospects and an historically volatile market could create investing opportunities in this sector in the future.

Russia's Troubled Past
Historically, because of abundance of land, buildings in Russia have not been built tall. It's a different story today, and tall skyscrapers are actively under construction. In fact, the number of cranes I saw and the number of tall buildings going up reminded me of when I was in Bangkok in March 1997. Just over three months later, the Asian crisis began with Thailand devaluing the baht.

However, there are significant differences between the two countries. In 1997, Thailand was running a large current account deficit--similar to the U.S. today--with its currency fixed to the U.S. dollar. The two situations were incompatible but were being propped up by hot money from foreign investors wanting access to the Asian Tigers. As more people began to talk of the unstable situation, locals began moving money offshore or converting to hard currency based accounts. As investors began to flee, the country's reserves fell, creating a vicious cycle that ended in devaluation and spread throughout Asia.

As oil prices plummeted the following year, troubles spread to Russia, which not only devalued its currency but also defaulted on its debt--something that the Soviet Union, through more than 70 years of existence, had never done.

Skyrocketing Out of the Rubble
Since the start of the 21st century, Russia has been on a tear. Oil has gone from a low of $10 per barrel in 1998 to more than $75 today, which has inspired a dramatic increase in the infrastructure for transporting oil and natural gas from Russia and its former satellite countries to the West. Given the massive amounts of capital introduced into Russia, the country has been able to pay off all of its debt and is sitting on $406 billion in reserves, an amount that only trails the reserves of China and Japan.

With the rise of the price of oil, president Vladimir Putin has been able to once again exhibit Russia's global power. Twice he has cut off natural-gas flows to Western Europe, reminding the countries there how dependent they have become on Russian natural gas.

The Soviet Union was long referred to as "The Bear." In the wild, there aren't many more dangerous situations than getting between a large female bear and her cubs. Unfortunately, the West has gotten between Russia and her former satellite states--her cubs--and Russia has become angry and dangerous.

It's no wonder that with newfound strength, Russia is once again flexing its muscles. Russia has been reconsolidating its natural-resource assets, which it considers strategic and which Putin thinks were sold at ridiculously cheap prices. We might not agree with his tactics, such as claiming back taxes on Yukos for issues that were standard practice and not enforced elsewhere or claiming environmental problems with Sakhalin II that suddenly disappeared once  Shell (RDS.A) turned control of the project over to state-controlled Gazprom. However, it is understandable why Russia has done what it has.

Value in Russian Telecom?
Some of these same issues apply in the telecom world. On my visit, I met with representatives of  Rostelecom (ROS),  Golden Telecom ,  Mobile TeleSystems , Sistema, and Comstar. Below are my thoughts on the growth prospects for these firms, focusing on both long-distance operators and wireless providers.

The Effect of Deregulating Long-Distance Operators
Rostelecom is the incumbent long-distance operator (think  AT&T (T) after the break-up of the Bell system in 1984) and is 51% owned by Svyazinvest, which in turn is 75% owned by the government. There has been talk of privatizing Svyazinvest since 1998, but Russia's security department (formerly the KGB) thinks part of the phone network is a matter of national security and needs to be state-owned. Rather than resorting to some of the tactics used in the oil and gas industry, Gazprom's pension funds have been eagerly buying shares in Rostelecom to regain control, sending the price to absurd levels based on fundamentals. However, from an investor's point of view, this is surely better than Venezuelan president Hugo Chavez's recent nationalization of the incumbent telephone operator CANTV.

The Russian long-distance telephone market was deregulated at the beginning of 2006, but we think Rostelecom will hold up much better than AT&T did after deregulation in the U.S. Because of Russia's unique tariff structure, the majority of the cost of a long-distance call is paid to Svyazinvest, the local operator. This precludes other operators from cutting prices significantly to take market share.

Rostelecom's competitors in long-distance are alternative carriers Golden Telecom and Multiregional Transit-Telecom, which is partially owned by Comstar. Golden has become the largest provider of telephone services to businesses in Moscow, where it holds a 42% market share, and the firm is growing rapidly as its clients move from Moscow to St. Petersburg and beyond. The firm also recently acquired Corbina, a leader in high-speed Internet access. Golden is planning a major expansion into the retail Internet access market starting in Moscow, where about 65% of the population lives in apartment buildings (I don't doubt this statistic--from my hotel you could see row after row of apartment buildings extending for miles). The compact nature of the buildings also enables cheaper network construction, as much of the fiber can be strung from rooftop to rooftop instead of being buried in the ground.

The Wireless Market Still Has Room to Run
New areas, such as retail Internet, are unlikely to grow as fast as Russia's wireless market did. As you can see from the chart below, the growth has been phenomenal, going from 1.4 million subscribers, or less than 1% penetration of the population, in 1999 to 152 million subscribers, or 105% penetration, by the end of 2006. The two biggest beneficiaries of this growth have been Mobile TeleSystems and  VimpelCom (VIP), the two largest wireless providers in Russia. Both have shown tremendous growth in subscriber base, revenue, and profits over the past seven years. With penetration rates of more than 100%, one might think that the market is quite saturated. However, Russia counts this number by SIM cards rather than by the number of phones, as most western countries do, and many people have SIM cards from more than one operator. Because of the difference in accounting for penetration, we think there is still growth left in the Russian market.

Both Mobile TeleSystems and VimpelCom have also been expanding into other countries of the former Soviet Union, where Mobile TeleSystems has a first-mover advantage over VimpelCom. Mobile TeleSystems also owns the second-largest wireless operator in Ukraine, which, with a population of 48 million people, is the second-most-populous former Soviet country (after Russia). Ukraine's penetration levels are similar to Russia's, and Ukraine provides Mobile TeleSystems with about 23% of its total revenue. The other countries have smaller populations, but also have lower penetration levels, which will add additional growth opportunities for both firms.

Our Conclusions
Overall, we found Russia to have made great progress this decade, and we see more growth ahead. Unfortunately, at present, none of these telecom stocks are cheap, in our opinion. However, given the historical volatility of the country's stock market, we think opportunities could present themselves in the future.

We also think that the political risk of investing in the telecom sector is less than in the oil and gas sector. That said, political risk still makes these firms riskier bets than telecoms in other markets; Russia's penchant for disrespecting property rights warrants a speculative risk rating and a large margin of safety before investors should consider buying.