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Mobile TeleSystems (NYSE:MBT)

Q2 2007 Earnings Call

September 4, 2007 11:00 am ET

Executives

Andrei Terebenin - IR

Leonid Melamed – President & CEO

Vsevolod Rozanov – VP & CFO

Mikhail Shamolin - VP, Head of MTS Russia

Pavel Pavlovsky – Head of Business Unit, Ukraine

Analysts

Alex Kuznetsov – Bear Stearns

Herve Drouet – HSBC

Eric Muller – IRM

Nadejda Golubeva - Aton

Will Milner – Arete Research

Dalibor Vavruska

Konstantin Chernyshev - URALSIB

Olga Bystrova - Credit Suisse

Stephen Pettyfer - Merrill Lynch

Alexander Valatmin

William Kirbing

Andrei Bogdanov - Alfa Bank

Yagislav Sholin

Presentation

Operator

Ladies and gentlemen, thank you for standing by and welcome to the second quarter 2007 financial and operating results conference call. (Operator Instructions) I now turn the conference to your host, Andrei Terebenin with MTS. Please go ahead.

Andrei Terebenin

Hello, ladies and gentlemen and welcome to MTS conference call to discuss the company’s second quarter 2007 financial operating results. Before beginning our discussion, I would like to remind everyone that except for historical information, comments made during this call may constitute forward-looking statements and involve certain risk. These statements may relate to one of the following issues: the strategic development of MTS business activities both in Russia and abroad; revenue and or subscriber growth; syndicated loan facilities and their usage; legal actions or proceeding directed at the company or its representatives; regulatory changes and the impact on the company operations or the markets in which we operate; financial indicators such as operating income before depreciation and amortization, average revenue per user, cash flow projection and or return on invested capital; technical matters as they pertain to our mobile communication network, including equipment, licensing or network technologies; and, capital expenditures and operating expenses.

Important factors that could cause actual results to differ materially from those contained in our projections or forward-looking statements. These statements may include company press releases, earnings presentations, MTS annual report and Form 20-F, as well as other public filings made by the company with the United States Securities and Exchange Commission, all of which are available on the company website, www1.mtsgsm.com or that of the United States Securities and Exchange Commission.

MTS disavows any obligations to update and any previously made forward-looking statements after the completion of this conference call or make any adjustment to previously made statements to reflect changes in risks. Copies of the presentation and materials used in reference to this conference call are available on our company website.

Participating in the call today are Leonid Melamed, President and Chief Executive Officer; Vsevolod Rozanov, Chief Financial Officer; Mikhail Shamolin, Head of Business Unit, Russia; Pavel Pavlovsky, Head of Business Unit, MTS Ukraine.

Now, I will now give the floor to Mr. Leonid Melamed.

Leonid Melamed

Thank you, Andrei. Ladies and gentlemen, thank you for joining our 2007 second quarter conference call, an occasion to mark another quarter of strong growth in all our markets of operation. For the period, we witnessed group revenue growth to $1.969 billion, a 32% gain year over year, while OIBDA grew over the same period by 39%.

Our Russian operations constitute the greatest driver to our growth. Revenues increased 37% year-on-year to $1.481 billion while OIBDA in Russia grew at the rate of 50% over the same period. Most intriguing now is what is happening in Russia. In contrast to other markets, growth is coming at a time when we are reaching effectively full penetration in our home market. Virtually all developed mobile markets see significant slowing of growth as penetration levels reach 70% to 90%. In Russia, on the contrary, we have seen an acceleration of growth. Revenues for the first half of the year were up 39% from last year as penetration levels reached 110%.

Many issues about the Russian market factor into this development, such as the favorable macro economic climate, the markets’ regional dynamics and a positive regulatory environment. However, it is really usage that is the driving power. Total growth in usage reached 13% this year whereas in the same period last year we only saw an 8% rise. At the same time, we have also maintained our APPM level. This is strong evidence of our ability to generate more revenues from our network at prices satisfying to the end consumer.

Overall, spending in Russia on a per capita basis matched other markets, both developed and emerging around the world. The percentage of GDP Russian mobile spending is roughly 1.5% which is comparable to Germany, France, UK; stable developed markets that show little growth. On the other hand, emerging markets like China, South Africa or even Eastern Europe routinely show wireless spend that is 2% or even 3% GDP. This parity is a clear sign that an opportunity exists to grow this market. We discussed on this call previously raising the share or capturing the wallet is one of the primary factors that led us to adopt revenue stimulation as a key cornerstone of our company’s strategies and have led to significant growth in our Russian operation.

In Ukraine, in spite of the increased competition in the market, our operations turned in 12% quarter-on-quarter growth as the competitive pricing environment somewhat stabilized in Q2. As we discussed on our last call, we initiated campaigns at the end of Q2 in anticipation of our rebranding which we launched in July after the close of the reporting period. Though it’s too early to disclose any indicators, initial responses to the introduction of the Interbrand, have been overwhelmingly positive and we anticipate a positive impact looking ahead.

At the same time, we continue to rollout our networks and maintain our market leadership in both Uzbekistan and Turkmenistan. In Uzbekistan, revenue doubled for the first six months year on year to $106 million, driven largely by a 14% increase in our subscriber base as we maintained our market share of 56%. Penetration stood at 13% at the end of the period. With a compelling brand and a strong market position, we feel confident in our ability to manage the pending high growth phase of the market development and entrance into the mass market segment.

Turkmenistan, penetration remains low in the single-digit range due to the limited network rollout but the market share is stable at 83%. Local import regulations restrict our ability to develop our network, but we remain committed to serving this market.

Now, I pass the call to Vsevolod to elaborate more on our results.

Vsevolod Rozanov

Thank you, Leonid. The rise in group revenue has been complemented by substantial gains in group profitability. OIBDA grew even faster than revenues. At the group level, OIBDA grew 45% for the first half of 2007, which is 33% growth in revenue. In Russia, the difference was little more pronounced. The revenues increased 39% for the first half of the year, OIBDA grew 53%. A double-digit revenue growth rate at this stage of the market is unusual, such OIBDA growth is even less common in a maturing markets like Russia.

For the fourth quarter in a row, MTS delivered OIBDA margin in excess of [inaudible]. Our efforts over the past year to improve our bottom line are clearly evident in the results for this quarter. Net income in Q2 improved 72% year on year, and 100% improvement versus the first half of 2006. Strong financial management, more stable currency environment in Russia for the period and lower interest payments are all contributing to the bottom line improvement, with net income margin exceeding 25%; much higher than our developed market peers and in fact, 5 percentage points higher than the aggregate average net income margins for our emerging market peers as well.

Commenting on the balance sheet items for the first half of the year, our free cash flow totaled $825 million. We increased our cash position in anticipation of a dividend payout beginning in early September, in addition to an anticipated [inaudible] payment.

Our net debt to OIBDA ratio fell to 0.5 and our total amount of debt is decreasing while OIBDA increases. As we do have outstanding notes and bonds maturing in January 2008, we will examine the various ways of refinancing with a potential issuance this year depending on market conditions.

With that I would like to pass over to Leonid.

Leonid Melamed

Thanks Vsevolod. This past summer we convened a series of meetings involving senior and middle level management from throughout the group in each of our markets of operation. These strategic sessions enabled us to marshal the full resources of our company and map our future in what are demographically, economically and technologically changing markets. From the many positive ideas and initiatives generated in these sessions, we have amended our key corporate strategies to reflect our changing markets and meet the challenges that lie ahead.

We’ll begin with the core values of MTS: (1) delivering always more for our customers, (2) striving to be the leading communications brand, (3) creating exceptional shareholder value. To this end, three plus two constitute the core elements in acting on these values. Our first priority is to capture the full growth potential in our core market. As mentioned before, driving revenue stimulation is our focus, but we also must complement our attractive product with comparable service. Likewise, providing a unique customer experience will differentiate us from other operators in our markets, something increasingly important as our markets mature.

Our next priority is value creation in developing markets. With a market portfolio ranging from maturing to single-digit penetration, we have a unique opportunity to leverage our institutional experience and drive growth throughout our home base in CIS. At the same time, we are keen on enlarging our footprint in CIS so as to gain better scale throughout the organization.

Our third priority is the development of the wireless broadband. As we have discussed on this call previously, a combination of factors, including the proliferation of devices, equipment prices and broadband execution makes our 3G network rollout more attractive than other market providers. As our markets mature, that has become increasingly important to sustain growth and capture growth is key to our long-term future.

Growth can’t come at any cost; this is why organizational efficiency has to be a part of our outlook. The group is constantly focused on improving processes and efficiencies throughout our business. As scale is critical to our future development, developing synergies within our regional markets becomes more important in ensuring that we are extracting the greatest amount of value from our operation.

We have to expect that our customers will embrace the most innovative mobile products and services, we need to equally embrace developing technologies; hosting the latest technologies has become a priority for the group.

Last, development of the overall group is the method by which we add greater value to our business operations. The experience we’ve gained in our markets and ensuring skills throughout the group is critical. We are not only maximizing our business performance, but also in building up our overall capabilities in providing a rewarding work environment to address and retain best-in-class employees.

In sum, 3+1 to 3+2 is an evolution of the 3+1 strategies that had been approved last year. Since that time our business has changed, our markets have changed and the company has changed also. New competitive environment, new regulatory environment and new technologies shape and reshape our business. No matter what, our goals have and will remain the same: providing more for our customers, more for our shareholders and more for employees.

Thank you for you time. Now I ask you to open the call for questions.

Question-and-Answer Session

Operator

Your first question comes from Alex Kuznetsov – Bear Stearns.

Alex Kuznetsov – Bear Stearns

Good afternoon. Let me congratulate you on the strong ARPU expansion in the Ukraine. Could you let me know if the trend is expected to continue in the second half of 2007? Could you elaborate on the major reasons behind the Ukraine ARPU expansion, apart from the additional seasonality? Have you seen significant improvement in the competitive landscape in the second quarter and do you expect the improvement to continue throughout the year?

My second question is regarding the announcement you made earlier today. There was a comment that Mobile TeleSystems is going to increase leverage by borrowing $1 billion, which is quite an interesting development given the increased cost of debt and the current cash flow generation we’ve seen in the last quarter. Could you comment on how you are going to use the debt please?

Leonid Melamed

Thank you for your question. Good afternoon. Let me pass it over to Pavel Pavlovsky, the Head of Business in Ukraine, to comment on ARPU development there.

Pavel Pavlovsky

Thanks, Leonid. Good evening everyone, it’s evening in Moscow. Talking about ARPU dynamics in Ukraine, yes indeed we saw some noticeable growth in ARPU which resulted from higher usage, impacted by the seasonality. But also in Q2 and even more in Q3 have been introducing the new brand which has stimulated the usage. We will also see the [inaudible] participation is cooling down a little bit and even here more in Q3. Again, after the introduction of the new brand and our new tariff we saw little response from the competitors which gives us a good sign. So, we do hope that this trend will continue although we should not be over optimistic. Thank you.

Let me pass to Vsevolod Rozanov

Vsevolod Rozanov

Thank you Pavel. I will take the second question on the potential debt increase. As it was previously announced, we are likely to register the new bond issuance with the federal service or financial markets later this year for the sum of up to 50 billion Rubles. The sum is by no means the exact number and the exact number will depend on the general corporate needs. Another reason for the Ruble bonds is the refinancing of the Euro bonds which is due to mature in January 2008. At this stage, and I would like to reemphasize it, we are not aiming to attract $1 billion. We are registering the prospectus for this sum, if there is a general corporate need over the course of the next year. Thank you.

Operator

Your next question comes from Herve Drouet - HSBC.

Herve Drouet - HSBC

Your CapEx looks relatively low as a percentage of revenues, especially compared with previous year. On the other side, we see usage increasing very fast on your network. I was wondering, do you experience any congestion of traffic in some cities or in some countries and how do you see CapEx evolving looking forward, especially in the second half? Do you have any guidance or any change in guidance regarding CapEx for the end of the year?

The second question is regarding 3G, I was wondering if you have any detailed plan or a bit more of a detailed plan or your roll out plan for third generation, do you have any dates or quarter in mind in terms of commercially launching operations with 3G in Russia?

Leonid Melamed

Thank you for the question. Regarding the CapEx numbers, for the year 2007 our guidance that we gave in the beginning of this year was that we’re going to spend about $2 billion, including the 3G roll out plan which remains unchanged and we have observed the consequences of our special procurement policy we have introduced this year and as long as our CapEx numbers reflects not in accrued but in cash, we don’t see the full reflection of our expenditures, let’s say in the numbers for Q1 and Q2. But, in Q3 and Q4 we believe that they will be fully reflected in accordance with the agreement signed with the vendors and construction companies. We are full on the way to adjust our network to the increasing requirements of our customer base.

I can state that we don’t allow any reduction in degrees of quality on the network in the majority of the regions of our operation and we measure them on a daily, weekly, and monthly basis. All of the parameters are inline with the standards applied for MTS Group due to the serious capacity that our network still has due to the previous development and due to the reasonable planning of the network development that's been applied in the company through years and for the year 2007 in particular.

Our 3G rollout, we proceed with development right now. There is a long list of activities that we have to undertake before the commercial launch, including the planning of the network, including the construction activities and deployment of the equipment, including preparation of the marketing and advertisements and all special functional activities due to such kind of a plan. All of that is under development right now in MTS Group. As you know, we have already chosen the vendor for 3G equipment for the Moscow region and actually for the last couple of days they made the first successful test on the initial part of the network deployed in the Moscow region and very soon we believe we will accomplish the tender to choose the vendors for the other parts of the Russian Federation to deploy our network in the end of this year and the year 2008.

With frequency clearance, we understand that the majority of regions where we plan our operations in the year 2008 will be able to operate and to launch the commercial usage of the 3G network in the first half of the next year. Moscow is of course of a primary interest to us, the operation is still less clear than in the other territories but we also believe that due to the special efforts of the government and from all operators here, we will be able to also start commercial usage in the first half of the next year.

So, in general terms we can state that our deployment plans are developing in accordance to our initial plans and we don’t anticipate big delays on starting the commercial use of the 3G network.

Operator

The next question comes from the line of [inaudible].

Unidentified Analyst

Good afternoon, everyone. There was a headline earlier on today that MTS was thinking of buying back approximately 10% of its ADRs. Could you please comment on that and if this is something that you do consider, how do you see your funding needs changing with this respect? Thank you.

Leonid Melamed

Thank you for the question. The Board of Directors of MTS actually just finished an hour ago and one of decisions of the Board of Directors was to proceed with the ADR buyback program exactly in the way it has been approved last year for another year in a row. So, there will be no changes in this program in the next coming 12 months.

Unidentified Analyst

And so you see your company being able to utilize its own cash reserves, not tapping the markets for additional borrowings?

Leonid Melamed

We understand that we have now a lot of specific tasks in the developing of our company to use the free cash flow that we have in order to finance our organic growth, and potential inorganic, let’s say, solutions and development. But we also consider quite seriously the opportunity to buy back our stocks if the price would be reasonable, exactly in the way we approach this task through the last 12 months.

Operator

Your next question comes from Eric Muller.

Eric Muller – IRM

Hi, gentlemen. Congratulations on strong 2Q results . I have a question for you on the locals. We are a shareholder and the locals carry the same economic and voting rights yet they trade at an 18% discount to the ADR. Now, I am willing to acknowledge that the ADR program is full and there is probably not any fungibility, but I just wanted to ask what is the company undertaking right now to hopefully narrow that discount to the ADR?

Leonid Melamed

Thank you. Our activity in this area is concentrated on the presentation of the company results and the presentation of investment opportunities, local stocks of MTS for the local investor and this autumn we plan to undertake a road show to tour the company among the local investors to attract more interest and increase the liquidity of our stocks in the local market. That’s actually the first step in this direction from our side and based on the result, we will see what else we should do to somehow change the situation that we understand is uncomfortable for the investors of the local stock.

Operator

Our next question comes from Nadejda Golubeva - Aton.

Nadejda Golubeva - Aton

Good afternoon. Congratulations on the strong results. First of all, could you please comment on the decision regarding your strategy by your board? So, as I understand now are you going to be less stricter on the return on the project you are going to undertake, so I am particularly interested in how much of the return are you going to sacrifice now? If you see that a certain investment is strategically important, as you are saying here, and whether the return on investment is considered at all and whether there is still a floor level below which you won’t undertake a project in any case? This is some sort of strategic question.

Several specific questions I have. First of all, I wonder whether you could disclose interconnect revenue in Russia and also can you give us the advertising expenses in Russia in the second quarter and possibly comment on the increase of SG&A as a percentage of revenue compared to the first quarter?

Leonid Melamed

Well, thank you, and thank you for the compliment on our results. It’s a very good question and we really would like to be very clear here. Our 3+1 strategy showed our very strict, as we call it, a [inaudible] approach to the main initiatives and activities inside MTS Group. What is very important to state is that our 3+2 strategy is an upgrade of our 3+1 strategy and we in no way would like to change or alter any of the main statements that have been done by the company with the 3+1 strategy. So, we would like to play a very thorough, diligent approach to all kinds of investments that we make in the future.

What is also important we stay very much devoted to show the financial results for our shareholders at the levels that had been announced a year ago. So, our task to create ROIC of 25% in the five year prospectus for our shareholders is still on the agenda.

But, let me turn your attention that our current ROIC is 43% and it’s also because we’ve applied very strict regulations on the investment projects that we have been undertaking. Now what we say is that keeping on the way of very diligent studying of each project and defining strict criteria on each project, we are prepared to consider the projects that would be a bit longer paybacks than before, and still keeping ourselves able to provide very attractive paybacks higher than 25% in this five year prospectus to our investors.

We are sure we can do that because on the one hand the market showed quite a different, much more positive behavior than we anticipated it to a year ago, and as long as we the eventual forecast of 142% growth in the Russian Federation in the next coming five years in the mobile sector. We understand that we have room for, let’s say, more aggressive investments that would still give us excellent return.

As an example of this approach, a comment on the plan that we are going into investment into Uzbekistan where we have planned to develop the 3G network and we’re planning further development next year where we are sure that the payback period will be a bit longer than is usual for our other operations, but we as long as our 3+2 strategy, wireless broadband is the strategic goal for the company and as long as we believe that this investment would really bring a lot of returns to our investors with a longer perspective than we used to think before, we will most likely go and invest into this project quite soon.

So, this is the example of how we, in favor of our strategic targets, under very strict control or numbers and KPIs are prepared to let’s say invest into the projects with a different financial perspective than we had been ready to invest a year ago. But we are absolutely sure that this trend will allow us to provide to the shareholders the returns in the short-term and long-term perspective.

Nadejda Golubeva - Aton

Thank you. And my other questions?

Mikhail Shamolin

Interconnect revenues in Russia were up to $170 million which is 15% growth to the first quarter. Increase of G&A as a percentage of revenue, we had a very slight increase from 6.8% of revenue to 7.2% of revenue and that was mainly due to increased cost of advertising expenses because we had more active advertising in the second quarter than we had in the first.

Nadejda Golubeva - Aton

Should we expect less advertising in the third quarter or should we expect approximately the same level of advertising as a percentage of revenue?

Mikhail Shamolin

In terms of advertising spend, we expect pretty similar levels but, we will not be giving guidance now of what percentage of revenue that will be.

Nadejda Golubeva - Aton

On interconnect revenue, in Russia your interconnect was a $100 million, correct? When I look at interconnect revenue in Russia I see $203 million. Given that you have roughly a similar size subscriber base, I would assume that your interconnect should be equal, but still your interconnect is 16% less compared to [inaudible].

The explanation I could give that your subscriber base is a bit inflated – sorry if you don’t like this word -- but it should be a bit higher compared to [inaudible]. Could you give some possible other explanation on why your interconnect revenue with Russia would be less compared to [inaudible] by a pretty sizeable 16%?

Leonid Melamed

Well, we don’t really comment on the competitors, so I wouldn’t be explaining why their interconnect revenue is at the level that it is. I could only assume it relates to the tracking patterns in the particular areas, marketing problems, for instance. I know that in the market there certain price plans stimulate incoming calls, interconnect calls and where customers are being given a bonus for receiving incoming calls and that is essentially the difference in the interconnect revenue.

Nadejda Golubeva - Aton

Can you disclose the advertising expenses in Russia? Could you give us the number for advertising expenses in Russia?

Leonid Melamed

I am not sure we are disclosing this information.

Operator

The next question comes from Will Milner – Arete Research.

Will Milner – Arete Research . Just a few questions on usage in Russia following on from the last question, really. Can you just confirm that the usage figure that you quote in Russia includes both outgoing and incoming minutes?

Secondly, can you confirm whether you have established any new interconnect agreements in the second quarter with either fixed or mobile operators?

Thirdly, can you just confirm or let us know what percentage of your Russian traffic is on net, and I guess how that trend has evolved over time?

Leonid Melamed

Usage in Russia includes all minutes. The interconnect agreements, we did not have any interconnect agreements in Q2, and as a percentage of traffic, the on net is around 60%, above 60%, roughly.

Will Milner – Arete Research

Without the establishment of new interconnect agreements, could you maybe just outline what some of the products and services are that you've launched that have stimulated the usage in the quarter?

Leonid Melamed

We have multiple initiatives. First of all, we have products that are targeted for group usage. Those are two groups of products, one basic product which stimulates usage within a network of friends or relatives and this is to mainly a youth audience. Then, we have a second line of tariffs called WE, and this clearly a family tariff where a family of five could talk, again on-net, within this tariff plan cheaply and that stimulated a lot of traffic.

We also have so-called options, which we add onto our tariff plan, basically any tariff plan. This includes things like unlimited weekend calls for a fee, unlimited calls at night for a fee, and other activities of that nature.

In the second quarter, we have also launched a credit program for the mass segment, which is something which we did not have before in the market and that also stimulated usage because it allowed people to essentially not limit their conversations by being switched off while their balance is zero.

Will Milner – Arete Research

That’s really helpful.

Leonid Melamed

An additional initiative is try and buy on the value-added services.

Will Milner – Arete Research

Just as a quick follow-up, looking at the pricing and usage trends you are seeing now in Russia, you are seeing relatively flat ruble pricing quarter over quarter but a big 13%, 18% increase in usage year over year. Is there any reason to suppose that those trends won’t carry through into the second half of this year? How do you think about those?

Leonid Melamed

One of the basic explanations I could give you is presented on Page 31 of our presentation which is MOU figures on the prepaid and the postpaid segment, which is 510 minutes on the postpaid and 110 on the prepaid. As you probably know, in Russia the postpaid is not a classical credit post-paid, it is subscribers that have contracts, but essentially most of them keep their balance above zero, so they are effectively prepaid from that perspective. The only difference between them in this classification is the level of ARPU and the level of income, which basically tells you that as the level of income is going to be increasing, the usage is going to be increasing as well and therefore that sort of gives you range of where usage could go and that’s why we believe that the Russian market does have quite a significant potential for growth.

Operator

Your next question comes from Dalibor Vavruska.

Dalibor Vavruska

Good evening. I have two questions basically following up on the initiatives that you have in the second quarter. It seemed like a [good usage]. I’m just wondering, VympelKom talked about their initiatives where basically they are giving some sort of free minutes after, or very cheap discounted minutes after a certain number of minutes a call and they explain the increase of usage pretty much based on, or they said these initiatives helped. I’m just wondering whether that was the case for MTS as well, and if that is the case, what is roughly the proportion of these free or heavily discounted minutes in your traffic as a result of this promotion?

Secondly, maybe this is not significant and I might be wrong, but I heard that for the high-end customers with direct numbers, there were some additional charges introduced at some stage. I’m wondering if that was in the second quarter and if this was significant in any sense in terms of revenue for the company. Thank you.

Mikhail Shamolin

Okay, first on the usage; we have two basic tariff lines which comprise the majority of our sales and both of those tariff lines center around usage. The basic tariff, which we launched last year right after the rebranding, was tariff plan First, and the essence of this tariff plan, the first two minutes were say at $0.10 and the third and other minutes are $0.05, for example, and therefore the longer you talk, the less you pay. That stimulates usage by itself.

The second line of tariffs is called Freely, or [Strabod] in Russian, and that tariff stimulates a lot of short calls during the day, because we have a usage pattern in which people, especially in the mass segment, tend to call five, 10, 20 times a day but have very short conversations, like less than a minute. Essentially, this tariff plan stimulates people with a lower price per minute after four minutes of total use during the day. So if they make four calls and the fifth call already is much cheaper, and that stimulates usage by itself because people do buy those particular tariff plans to talk more and they get a value for having longer conversations or more calls.

It also works for us because if you look at the APPM figures, they have not really changes, so basically our APPM is stable. We are not cutting down on prices heavily and we are therefore not reducing our revenues while creating value for clients.

As far as the high-end customers are concerned, we had one step change last year with the introduction of the CPP when we introduced certain charges on the certain fee on the direct numbers, and that fee was only to compensate that fact that after CPP had been introduced, calls from fixed networks to direct numbers were not, did not fall under the interconnection deals. In other words, they would have been free for customers if this fee wasn’t introduced and basically the whole market has done something similar. Since then, we have not really introduced any charges.

Unidentified Analyst

Okay, well, that’s very clear. If I can ask maybe on the first question, just one more detail; has there been any unlimited or quasi-unlimited offers that MTS offered that basically customers would pay after a certain number of minutes zero, or that they can prepay per month and then whatever? Any sort of unlimited offers with an unlimited nature?

Mikhail Shamolin

Of course we have, and we have had those tariffs for a number of years, when actually you pay I think in Moscow it’s $130 and you have unlimited local traffic for that --

Unidentified Analyst

But no promotion or nothing new on that in the second quarter?

Mikhail Shamolin

No, not really. We’ll introduce a couple of tariffs which also have some benefits on the inter-city connections, like inside the MTS network, our customers can make inter-city calls for the price of a local call.

Unidentified Analyst

Okay. Thank you.

Operator

The next question comes from Konstantin Chernyshev. Please go ahead.

Konstantin Chernyshev - URALSIB

Good evening. I have a question regarding slide number 31. According to the slide, value-added services as a percentage of ARPU declined from 17% in Q206 to 11% in Q207. Can you please comment on that?

And one additional question; what is the share of SMS in value-added services?

Mikhail Shamolin

First of all, on the percentage of VAS and ARPU decline, the primary reason is because growth in usage happens mostly in the mass segment. These are the people who have owned mobile phones for a year or so and they are sort of getting used to the device. It is becoming a part of their life and they start using more and more minutes, and therefore voice usage grows. Of course, the VAS usage is lagging behind because the level of sophistication of those customers sort of increased gradually and we expect that we will see the value-added services as a percentage of this revenue catching up in mid-term.

As far as the SMS are concerned, it comprises approximately 55% of the total value-added service revenue.

Konstantin Chernyshev - URALSIB

Thank you.

Operator

The next question comes from Olga Bystrova. Please go ahead.

Olga Bystrova - Credit Suisse

Good evening. Olga Bystrova from Credit Suisse. Congratulations on the strong results. I have a few questions. One is a follow-up on the ARPU and ARPU driver dynamics in Russia. Basically, given that you’ve introduced a few promotions and new tariff plans in July/August, how do you think -- basically how do you think elasticity could look like in the third quarter because of that?

The second question is regarding the extension of the buy-back program. In general, you haven’t really executed on that program heavily in the past 12 months. Why do you think you will be interested in doing it now and completing it maybe over the next 12 months? And what is your preference for dividends versus repurchases?

And the final question is on Uzbekistan, because Uzbekistan I think the situation was a little bit less, in my view, successful but I could be wrong. Could you explain what is your strategy now? Because pricing has been going down quite significantly for you in that country. Thank you very much.

Mikhail Shamolin

On the ARPU, we have essentially introduced three programs in July and August. The first one was a triple bonus program, which effectively gives our customers a bonus every two months for the period of six months for staying within the MTS network. Therefore, in the third quarter we will not see any negative effect of this program and overall, we believe this program is quite positive because it helps increase loyalty and retain customers and reduce churn.

The second program was promoting inter-city calls, inter-city calls within the MTS network at the price of a local call. And this is essentially giving our customers a true alternative to fixed because the pricing there is quite similar. Therefore, we don’t expect any sort of affect on APPM and maybe a positive effect on ARPU because we’ve had this pricing in the past and now we are just promoting it.

And the third initiative was a special tariff for school children, school kids, and launched before the first of September and this is in Russia, a very good date to launch something like this. And again, APPM on this tariff plan is at the average level of APPM and we hope it’s going to be successful.

So in other words, we have not launched any initiatives which would lead to an ARPU decrease and as far as an ARPU increase, I don’t think we are guiding at the third quarter today but certainly we don’t see reasons for why it would decrease.

Olga Bystrova - Credit Suisse

Okay, and I think maybe just a quick follow-up; I think there was one tariff plan where you have 15 kopecks per minute after the third minute, or something like, that, if I’m not mistaken. Is that correct and what do you see on the tariff currently happening for usage and ARPU development?

Mikhail Shamolin

Yes, this is a tariff plan which is called Super First, and it hasn’t been advertised heavily and the sales on that tariff plan are fairly limited at this point but we are planning to promote it further on. This is a continuation of the first line of tariffs. It promotes a very attractive price point to our customers but this tariff differs in its structure from region to region and the difference is in the number of minutes after which it becomes 15 kopecks. Like in Moscow, it is I think after four minutes and in some of the regions where competition is high and therefore APPM is lower, it may be after the second minute or even after the first minute. It depends on the local competitive landscape.

Olga Bystrova - Credit Suisse

Okay, great, and the other two questions.

Leonid Melamed

On buy-back, we understand that in the set of priorities now, capital expenditures, buy-back is one of them but not the one. I believe it is well communicated by us to the investment community. It is going to be like that, as far as I understand, the next coming 12 months.

We see different developments in the stock market and at some stages, it would be quite useful from a commercial viewpoint to get an instrument to allow us to buy back our stock and to have good returns on this operations in the mid-term perspective.

We are not planning to cancel the stock and the goals of those acquisitions are still the same as we declared before, is to use them in the future M&A deals or to use them in the management incentive programs. But on the other hand, as long as this is a related question, we have to confirm that there have been no changes in our dividend policy recently. I believe it is important for the investors to be aware of this.

Regarding Uzbekistan, the situation there is quite interesting. On one hand, you have a significant increase of customers. We have reached the level of two million customers in Uzbekistan in Q2. The penetration level doesn’t grow very quick but we believe soon it is going to become really a mass market boom and we’ll have to play an important role in this development.

What is also important is that we have really face some tested consumption growth in Uzbekistan. Our MOU there is growing from quarter to quarter and it is now in the level of 549 [minutes]. And the ARPU decrease is relatively small, actually, on the year terms and in Q2 our ARPU happened to be even higher than in Q1. And this result we achieved with very low APPM, so we have to be very accurate with the situation on pricing there. We have to catch up the trend of increase in usage and let’s say prepare ourselves with the full knowledge we have throughout the group to the significant increase in penetration level.

Olga Bystrova - Credit Suisse

Okay, great. Thank you very much.

Operator

And the next question comes from Stephen Pettyfer. Please go ahead.

Stephen Pettyfer - Merrill Lynch

Thanks. Good afternoon. Stephen Pettyfer, Merrill Lynch. Just a few questions on the costs side of things, please. Firstly, in the past you’ve provided a breakdown of your costs as a percentage of sales. I wonder if you could do that again for us this quarter, in Russia specifically.

Secondly, in your presentation or in the slides, you mentioned for Ukraine that the margin benefited from a lower advertising and marketing ahead of the rebranding, and I wonder if you could confirm that thus you are effectively saying there that you think the margin could come down in Q3.

In Turkmenistan, you also made a comment there about an additional licensing expense in the reason for the change in margin there. I wonder if you could comment on whether that’s going to continue.

And then on a separate matter, coming back to the share buy-back, given your fairly ambitious or large objectives there in terms of numbers of shares to buy back, can you foresee any time when you would change your thought about potentially canceling those shares? Thanks.

Vsevolod Rozanov

Thank you, Stephen. We’ll just start with the cost structure discussions. Speaking about the group, we had 8.2% of sales and marketing expenses as a percent of revenue, and for G&A it was 15.6%. Those are G&A expenses, 15.6.

It was a slight increase in sales and marketing expenses from Q1, from 8% and there was also an increase in G&A expenses from Q1, when the percentage of sales was 14.5%. The key reason for that increase in G&A expenses was actually this one-time charge in Turkmenistan where we paid in tax arrears basically in the sum of approximately or just about $10 million. We consider this to be a one-time effect.

Speaking about the developments in Russia, there was a slight increase in sales and marketing expenses from 6.9% to 7.6% in Q2, and that was the reason which we discussed actually during the Q1 call when we said that the sales and marketing expenses was unusually lower, due to the reason of the fact that we first changed from the dollar enumerated tariffs to ruble enumerated tariffs during that time and we didn’t promote any new initiatives in that period.

Speaking about Ukraine, I would say that we do not expect a significant change in the sales and marketing costs as a percentage of revenue and basically we think that, as we discussed, the image costs were decreased and they were substituting and are substituting now with the new rebranding costs. It might be a slight increase but nothing exceptional is expected.

And the second question was on the --

Stephen Pettyfer - Merrill Lynch

Turkmenistan.

Vsevolod Rozanov

On Turkmenistan, yes. I mentioned that it probably was a miscommunication. It’s not through licensing but it’s tax charges, one-time tax charges in Turkmenistan that caused the significant decrease in the OIBDA margin in Q2.

Speaking about share consolidation, we believe that at this stage, the key goals of the share buy-back are mainly the same. If there is a change in the goals of the share buy-back or in any parameters of the program, there definitely will be information about that.

Stephen Pettyfer - Merrill Lynch

Thanks. Could I just come back to the Russian costs again? Could you tell us what G&A was a percentage of sales in Russia?

Vsevolod Rozanov

It was 15.7% in Q2 and 14.9% in Q1.

Stephen Pettyfer - Merrill Lynch

Thank you.

Operator

Your next question comes from the line of Alexander [Valatmin]. Please go ahead.

Alexander Valatmin

Good evening. My question is a follow-up on your local ADR discount. Will you probably consider a local share buy-back to eliminate it? Thanks.

Leonid Melamed

We’ve studied this issue thoroughly under the special request of the Board of Directors of the company and there have been of course some pros and cons in doing that and the main reason why the Board of Directors did not support this idea was that we can really decrease the liquidity on the Russian market because we want to buy back our stocks, our local stocks. And among all of the potential advantages, this was chosen to be the main factor not to go for this initiative, so the answer is now the Board of Directors do not support it. In the next coming year, we are not in the position to do that.

Alexander Valatmin

And on your ADR acquisition program, according to your financials, you spent roughly $40 million for the repurchasing. Should we anticipate the acceleration of the repurchasing, or it will depend on market situations?

Leonid Melamed

Thank you. The situation is -- the technology of this buy-back is that we are, in accordance to the American regulations, we issue instructions to our broker every quarter and once we do that, we take into consideration the current fiscal position of the company, the market development, our forecast of those developments and our own understanding of what is the set price for the stock of MTS. So we have four times a year to make up our mind on this.

Currently, through the previous year, our behavior was quite stable. There were no changes in our approach to this program. We observed the current trends from the market quite attentively and if there would be some changes, we would have to react in accordance. If the situation would stay the way it was like a year before, we would I believe keep on the policy and buy-back we’ve been promoting through the whole year.

Alexander Valatmin

Thank you. Can I ask a third question on the Ukrainian pricing? Considering very tough competition in the Ukrainian market in the past and very low current yields per minute, do you think it is possible to increase prices in the Ukraine, or it is completely impossible?

Pavel Pavlovsky

Obviously we introduced a new brand to support the new price offering in July of this year. We don’t see, as I said, any I would say unreasonable response from our competitors so that goes well. But at this time, I don’t see any opportunity to increase prices and I don’t think it would be well-received by the market. I have to remind you that the Ukraine is even more price-sensitive and a very price-oriented culture as a whole, even compared to Russia.

But I have to stress that our strategy is to position us as a premium operator in the Ukraine, therefore next year we believe we will be well-positioned, given all the investments we made this year into quality and service, et cetera, to be positioned as a premium to the overall level in the Ukraine. Thank you.

Operator

Our next question comes from William [Kirbing]. Please go ahead.

William Kirbing

Hello. I have three questions. Firstly, your sales expense was low in both Q1 and Q2, despite high advertising inflation. A previous caller brought up changes in the general and administrative line so I just want to clarify what is in sales versus what is in general and administrative and then also what will be driving the sales line in the future.

My second question is similar on tax rates. They were lower in H107 than in the same period in ’06. Is this due to the for-ex gains and what else will be driving this line?

Finally, on your gross margin, we had expected maybe that your gross margin would trend upwards -- sorry, would trend downwards because of rising interconnects. How have you managed to keep it where it is?

Vsevolod Rozanov

Thank you. First of all, I would kindly ask you to repeat the first question.

William Kirbing

My question was on sales expense in Russia, the sales and marketing line. Despite high advertising inflation in Russia, this has remained low. How have you managed to achieve this and what do you expect in the near future?

Vsevolod Rozanov

Well, we have it more in line with our forecast to keep it below 10% of the revenues and I think that going forward, this number is likely to remain the same. In spite of the price inflation, we make a sort of a management decision on that in each particular country.

Speaking about the tax rate, you are definitely right. This is the main reported development which drives the tax rate and this is exactly the case for the difference between the Q2 of this year and the Q3 of this -- of last year.

Speaking about the gross margin development, we’ve seen a decrease of sales in the handsets and other accessories this quarter. That basically led to improvement of our gross margin.

William Kirbing

Okay, sure. Thank you for the information on taxes. Is there anything else that you foresee impacting your tax rate in future years, or is it mostly just due to fluctuations in foreign exchange?

Vsevolod Rozanov

Well, I don’t see any other major factor which might be influencing the tax rate.

William Kirbing

Okay. Thank you.

Leonid Melamed

I just wanted to add something to the marketing expenses. The inflation, the media inflation is typically accounted during the negotiation for the year contract, which typically happens in the fall of the year before. In other words, all the media inflation has been negotiated and put in the budget already in the fall of 2006 and the difference in media costs between quarters is driven not by inflation but by the level of advertising activity, which is tied to the marketing plan and tied to seasonality, so it is purely related to how we structure our marketing activity.

William Kirbing

Okay, so what can we expect for next year? We see rising advertising costs coming in to the Russian market now. Does that mean they will feed through next year or will you be reducing advertising spend?

Leonid Melamed

We will not be giving guidance on this now. I can tell you that we will see further media inflation in Russia for sure, with regard to TV and some other major advertising channels. But we are in the process of formulating exactly what our marketing plan is going to be and therefore what advertising support is going to be needed as we speak.

William Kirbing

Okay. Thank you.

Operator

Our next question comes from Andrei Bogdanov. Please go ahead.

Andrei Bogdanov - Alfa Bank

Yes, a few questions, if I may. First one, a short one, with regard to Belarussia, are there any developments there with regard to your plans to increase your stake in the joint venture and consolidate the financials into your numbers?

The second question is more kind of a long-term question. Given the success of your business, the strong cash flow generation, you already have $750 million on your balance sheet in cash at the end of the first half. Going forward, it will be more than this and obviously there are not many expensive projects you can be involved in. 3G is let’s say $1 million and potentially a few acquisitions in CIS but given your cash flow generation is not so big. So the question is going forward, what do you think you will be doing with your cash? Obviously we won’t have anything significant outside of [inaudible] union. Will you increase your dividend payments or whatever? What should be your plans with that regard?

And the real last question is you also mentioned today in the conference call that wireless broadband is one of your strategic goals going forward. As you probably know, another company, Sky Link, just last week said that they are going to five-fold raise their market share revenues from 2% to 10% of the whole Russian mobile market. Obviously it is capitalizing on their wireless broadband CDMA service they are offering. Any kind of view on that from your side? Do you have any DPIs or commitment from Sistema with regard to distribution of the market between you and Sky Link? I know you are different companies but any insight on that would be helpful. Thank you.

Leonid Melamed

Thank you very much for the question. On Belarussia, the situation for us is we are moving forward. We have an open proposal for our partner. In case they would like to sell the asset, we are prepared to buy it. The fact that recently they have sold the control of the second-largest operator in Belarussia, Valcom, gives us a sign that probably we will be able to negotiate our acquisition of the control in the company in a more effective way than we managed to do it for the time being.

About the usage of free cash flow, we don’t have any special strategy on that for the time being. We understand that we have to finance our organic growth, including 2 and 2.5G development in the countries of our presence, and including 3G development. We will finance the extensive growth, like acquisitions, mostly we believe in the territory of the CIS in the mobile sector in the next coming period of time, if it will be available for us. So this is like the second course of investments from our side.

We will invest into the improvement of quality or increase the quality of all major areas of our operations in accordance to the 3-plus-2 strategy, where the quality-centric and value-centric approach is announced to be the main conceptual idea.

And on top of this, we’ll have the dividend policy of the company approved by the Board of Directors in Q2 actually of this year. We are going to implement it.

Also, we’ll have a buy-back program. That’s actually the set of directions of cap expenditures and where the priorities are, the fulfillment of our 3-plus-2 strategy and of course, following the dividend policy approved by the Board of Directors.

Regarding the wireless broadband, we are very optimistic to the development of this market and CIS in general and in the Russian Federation in particular. The preconditions to that are we’ve already discussed as far as the low penetration of the fixed line Internet access, with the favorable prices for the equipment, the growth of wealth and distributed income among the population, and the growing demand for broadband Internet access, plus an increase of services and -- the services that people and organizations can extract by using the broadband access.

From that, we believe that only in Russia in the next coming five years, the mobile broadband would grow from almost let’s say very small numbers that we have now, especially the majority of those numbers are driven by Sky Link and the GPRS niche of activities of the current operators, to the number of $3.4 billion in 2012.

We as a company would like to play an important role in the distribution of this revenue pack and we also hope that Sky Link will also be effective in gaining its market share. Of course, we don’t receive any instruction from Sistema on the competitive behavior for MTS and I believe that goes without saying. Thank you.

Operator

(Operator Instructions) We have a follow-up question from Alex Kuznetsov. Please go ahead.

Alex Kuznetsov - Bear Stearns

Good afternoon. I have a few follow-up questions. There were some comments regarding the potential acquisition of the second Armenia operator. Your competitive board, Armentel, at the beginning of this year. I believe it may make sense for you to enter the market but could you comment on the financial parameters of the Armenian operator currently considered for an acquisition, please? Would you be in a position to comment on the EBITDA margin and ARPU?

The second question is regarding 3G deployment in Ukraine and Uzbekistan. Could you share with us your outlook on the license allocation and the licensing requirements in those countries?

Finally, could you let us know your target capital structure and the amount of bonds maturing at the beginning of next year? You pointed out previously that one of the reasons you have registered the bond issue is that you have to finance bonds maturing at the beginning of 2008. Thank you very much.

Leonid Melamed

Thank you, Alex. Well, the first question is quite an easy one. We definitely have interest in the Armenian market. We have interest in the acquisition of K-Tel. We are not in the position to comment on anything about this company. We believe that the market is attractive, especially for MTS, due to the synergies we have in the group and as long as it totally corresponds with the 3-plus-2 strategy that we’ve announced today. So if we will be successful to step into this market, we will give a full explanation on the details and we will try to make you share with us the reason of the price and all the steps.

Ukraine and Uzbekistan 3G -- on Uzbekistan, we are like the owners of the 3G license, and the WiMAX license by the way, as well. We plan to start deployment of the net upgrade in the end of this year and it will take us another two-and-a-half years, almost three years to cover the main cities in Uzbekistan. We plan to go for commercial launch of the network in the first half of the next year. We understand it is still a very attractive business case, although the pay-backs are not like extremely short. We hope it will also assist us in the development as long as the penetration level would grow in Uzbekistan.

In the Ukraine, we don’t have a license. There was only one license issued by the regulator to UkrTelecom. We received signs from the regulator that we could potentially, the same as the other operators, apply for the MTS licenses but due to some recent changes in the, let’s say regulatory environment, this approach has unfortunately been stopped and now we -- let’s say wait until the clearance with the situation will come and then we will knock at the door of the regulator once again to receive this license.

And your third question, Alex, I will pass to Vsevolod.

Vsevolod Rozanov

Thank you, Leonid. Speaking about the amount of bonds maturing at the end of 2008, it is $400 million. And speaking about target capital structure, I would say that we do not have a targeted capital structure as such. Of course, we understand that we have room for increasing our debt. However, at this stage we are able to finance our strategy from the cash flow of the existing business, and in case there is attractive opportunity to go outside of the existing businesses in the CIS or outside of CIS, we will be able to finance it from the increase of debt.

From the discussion of the credit rating agencies, the level of the debt to OIBDA, which of course will be discussed later on, specifically with those agencies but at this stage sort of leaves our credit agencies comfortable with this 2, 2.2 times debt-to-OIBDA. Thank you.

Alex Kuznetsov - Bear Stearns

Thank you very much. May I ask you for some clarification on the Uzbek license? You mentioned that it is a WiMAX license but do you have UMTS license as well?

Leonid Melamed

Sorry, I was unclear. Of course we have a 3G license, UMTS license and we will also have a license for the frequencies in 2.5 megahertz applicable for WiMAX.

Alex Kuznetsov - Bear Stearns

Thank you very much.

Operator

And the next question comes from the line of Olga Bystrova. Please go ahead.

Olga Bystrova - Credit Suisse

For a follow-up question, although some of them are already answered, do you provide numbers, outgoing versus incoming calls in Russia and the Ukraine? A breakdown of usage, I mean?

Leonid Melamed

No, I don’t believe we disclose this.

Olga Bystrova - Credit Suisse

Okay, great. Thank you very much.

Operator

And the next question comes from the line of [Yagislav Sholin]. Please go ahead.

Yagislav Sholin

Just a follow-up question on your M&As; are you currently holding any negotiations that require non-CIS assets? And if yes, do any of the potential projects overlap with the Sistema or mobile stemming from extension plans, if any? Meaning them entering new markets directly by besting MTS? Thank you.

Leonid Melamed

I’m sorry, do I understand your question correctly that you are asking us whether our M&A policy can come in conflict with Sistema’s activities?

Yagislav Sholin

Yes, and also if there are any current negotiations on you acquiring non-CIS assets as well.

Leonid Melamed

I don’t believe actually that that can happen and I don’t see the reason for that. Sistema has announced a number of times that they are very much committed in the development of MTS and I’ve witnessed through my presence in the group, especially in the MTS, no signs of potential conflicts in this kind of activity. So I don’t think this is the case.

Other way around, I’ve let’s say witnessed discussions on the Board of Directors, first of all, where Sistema expressed its desire to support us in fulfillment of our strategy at full speed and is looking for opportunities to help us in the areas where they can.

Yagislav Sholin

So basically you don’t see any reason for them to even want to acquire mobile telecom assets, international assets not by MTS?

Leonid Melamed

Well, as you know, in accordance to our policy, we don’t comment on the activities of our shareholders. That’s why I would, if I may, recommend you to address this question to them directly.

Yagislav Sholin

Okay, and what about your current negotiations, if any?

Leonid Melamed

With --

Yagislav Sholin

-- CIS companies, mobile companies.

Leonid Melamed

Well, actually, even if we would be in such, we would probably be prepared to comment but I would say that our strategy is very much CIS-centric and it was announced in the previous version, in the 3-plus-1 version, and we just confirmed it in our 3-plus-2 version that we are, at the MTS group, we are very much devoted to our whole market. This is CIS and this is exactly where we study let’s say all possibilities, whilst our potential activities outside CIS is something of a secondary or third level of importance to us.

Yagislav Sholin

Thank you.

Andrei Terebenin

Last question, please.

Operator

(Operator Instructions)

Andrei Terebenin

Okay. Thank you very much, ladies and gentlemen, for your patience and for your interest in MTS. We welcome you at any time to contact our investor relations department for further questions. A webcast of this discussion will be available on our website if you wish to replay the call. In the meantime, we appreciate your interest and wish you a very pleasant day. Goodbye.

Operator

Ladies and gentlemen, that does conclude our conference for today. We thank you for your participation. You may now disconnect.

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