SECTOR UPDATE

DIGITAL MEDIA

RUSSIAN INTERNET NO LONGER TERRA INCOGNITA?

Runet Opportunity Impossible to Ignore
The Russian Internet audience has been growing at an annual rate of 57% and has already overtaken the UK by size (60m users vs. 51m in the UK). With an additional 47m users from the remaining countries of the CIS, the Russian speaking Internet audience (Runet) is one of the largest audiences in the world. It is also becoming increasingly monetised with e-commerce and online advertising markets estimated at $8bn and $810m respectively in 2010.

Ecosystem Offering Protection from Global Giants

A number of factors idiosyncratic to Runet have stalled foreign entry, resulting in the leadership of local players in some of the key established sectors, such as Yandex in search, Ozon in e-commerce and vKontakte in social networking. As the market is becoming increasingly attractive, foreign competition is also intensifying, adding to the complexity of this already intricate market.

Western Influence Emerging

The recent surge in foreign venture capital investment and the increasing focus of entrepreneurs with western business experience illustrates the growing attractiveness of Runet. Collaboration with local investors and businesses has enabled the transfer of western business models and management expertise.

Business Models Leapfrogging Western Progression

Runet, so far safeguarded from foreign competitors, has benefitted from the mistakes made by the western Internet businesses and selected the latest and most successful models, which are more applicable to Russia. The massive popularity of social networking in particular has boosted the growth of some of the newly established businesses.

Social Networking Source of New Business Models

Russian Internet users are more social online than in the West, both in social networks and blogs, as it has become a crucial source of unbiased information and opinions, in contrast to the more restricted traditional media. Harnessing this source of information and traffic is the key driver for success.

Important disclosures appear at the back of this report. GP Bullhound LLP is authorised and regulated by the Financial Services Authority in the United Kingdom

Rapidly Becoming the Largest European Online Audience

The speed of Internet growth in Russia is astonishing. Five years ago, the Russian Internet audience was behind the majority of European countries at just over 10m it was less than that of the Netherlands (11m), Spain (12m), Italy (16m) and less than half of the French audience (24m) . Since then, Russian Internet penetration has grown from 9% to 43%, with Internet users estimated at c.60m it is now the second largest audience in Europe after Germany (65m) (Exhibit 1) . An additional 47m users are in the remaining countries of the CIS, forecast to grow to 130m by 2013. As a result, the Russian-speaking Internet audience is one of the largest in the world.
EXHIBIT 1 - ONLINE AUDIENCE AND PENETRATION (2006A VS. 2010A)
Internet Penetration in 2010A
2 1

Internet Audience in 2006A Germany UK France Italy Spain Netherlands Russia

Internet Audience in 2010A 31m Germany 30m 24m Russia UK France Italy Spain Netherlands

65m 60m 51m 45m 30m 29m 15m

79%
43% 83% 69% 52% 63% 89%

16m 12m 11m 10m

Source: comScore World Metrix, January 2007; International Telecommunications Union, June 2010

Increasingly Active Online

In addition to online access, it is the daily use of the Internet that has been crucial for Runets development. By the beginning of 2011, 36m people accessed the Internet on a daily basis equivalent to 72% of the monthly audience (Exhibit 2). This is more than a fourfold growth from the 8m daily users in 2006.
EXHIBIT 2 - AUDIENCE ACTIVITY BY INTERNET ACCESS FREQUENCY IN RUSSIA (2003A 2010A)
100%
80% 60% 40% 71% 33% Monthly Weekly Daily 92%

89% 73%
37% 75% 40% 77% 42%

91%

82% 48%
63% 68% 72%

20%

0% 2003A

2004A

2005A

2006A

2007A

2008A

2009A

2010A

Source: FOM Report Internet in Russia #32 at www.fom.ru, March 2011; GP Bullhound
1 Source: comScore World Metrix, unique visitors age 15+ January 2006 2 Source: International Telecommunications Union, June 2010

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Millioniki Key Source of Growth

Furthermore, with continuous infrastructure expansion, the Russian online audience is forecast to grow to 93m by 2013, reaching a penetration of 67% similar to that of France today (Exhibit 3). The current contrast between Internet penetration in Moscow and St. Petersburg (67% and 65% respectively ) and the rest of Russia (39% penetration) indicates that growth will stem from the Russian Millionikis, the 10 cities with a population over 1m.
EXHIBIT 3 - INTERNET USERS AND PENETRATI ON EVOLUTION (2008A 2013E)
4 3

67%

55%
38% 31% 43% 76m 85m 60m

61%

93m

44m

53m

2008A

2009A 2010E Internet users in Russia

2011E 2012E 2013E Internet penetration in Russia

Source: JSon & Partners, September 201; GP Bullhound

Broadband Penetration Rapidly Advancing

With 43% online penetration, Russia is comparable to Western Europe five years ago in 2005, France was at 43%, Germany at 46% and Italy at 48% . On the other hand, quality of access is significantly higher: in terms of broadband penetration Russia is ahead of the curve with c.25% rate vs. 15% in France, 13% in Germany, and 12% in Italy back in 2005 . Furthermore, broadband penetration is forecast to grow to 36% by 2013 .
7 6 5

Sophisticated Audience
In addition to having one of the largest audiences in the world, Runet has also amassed one of the most sophisticated: Well educated: 28% of the employed Russian population have a higher education degree ; Highly engaged in social networking: Russian social networking audience, estimated at c.38m , spends an average of 10.8 hours per month social surfing versus 4.7 hours for USA and 4.6 hours globally ; Mobile Internet penetration: monthly mobile Internet audience in Russia reached 10.8m in February 2011, or 18% of the Internet audience just behind
3 Source: JSon & Partners, September 2010 4 Source: TNS Web Index, December 2010 5 Source: eMarketer, January 2007 6 Source: JSon & Partners, September 2010; Accenture, December 2005 7 Source: Screen Digest, June 2010 8 Source: Rosstat, 2008 9 Source: JSon & Partners, September 2010 10 Source: comScore, July 2010
10 9 8

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the 20% for the EU-5 average (France, Germany, Italy, Spain and the UK) . The number of active 3G users is expected to reach 71m by 2013, or 50% of the total population . Through this rapid development of the Russian Internet sector, there has also been some significant growth of spending online, both from the consumer and business segments.
12

11

Growing Consumer Spending Power

During the last decade, the Russian economy has witnessed an improvement in income both in terms of value and distribution across the population: Average GDP per capita, currently at $16k vs. $35k in the UK, is expected to grow by 6% per year between the end of 2010 and 2015 (Exhibit 4) ;
EXHIBIT 4 - GDP PER CAPITA IN RUSSIA BASED ON PURCHASING-POW ERPARITY (1992A 2015F)
$25k $20k $15k $10k
13

$5k
$0k

Source: IMF, 2010

Consumer Online Spend Reached Tipping Point

The improving Russian economy has been a contributing factor both to the growth of the online audience, as well as monetisation of the Internet segment. In fact, the rapid development of a number of online revenue streams has made it a market impossible to ignore.
11 Source: TNS Web Index Report, April 2011 12 Source: JSon & Partners, July 2010; MASMI Research Group, September 2010 13 Source: IMF, 2010 14 Gini Coefficient of 100 represents a perfectly unequal society where one individual has all the wealth, while 0 represents perfectly shared wealth. 15 Russia is measured at 42.3 vs. 45.0 for US, 46.9 for China, 53.5 for India and 57.0 for Brazil in 2008 Source: Central Intelligence Agency, World Factbook, 2011 16 Source: Troika Dialog, August 2010

1992A 1993A 1994A 1995A 1996A 1997A 1998A 1999A 2000A 2001A 2002A 2003A 2004A 2005A 2006A 2007A 2008A 2009A 2010E 2011E 2012E 2013E 2014E 2015E

It is estimated that the distribution of income has become more equitable: according to the Gini Coefficient method and the other BRICs ; Emergence of the Russian middle class now estimated at c.68% of the total population, vs. 31% in Brazil, 13% in China and 3% in India .
16 15 14

Russia is more equitable that the US,

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E-commerce reach of online users in Russia has grown to 59% from 43% in the year to January 2011 , with turnover estimated at $8bn (Exhibit 5) . This market, however, is still in its infancy as e-tail represents only 1.6% of total retail turnover, in comparison to 10.5% for the UK and 8.0% for Germany in 2010 .
19 17 18

Internet Value Added Services

In addition to online shopping, consumers have been increasingly paying for Internet value added services (IVAS), such as virtual goods and premium subscription features sold within online games and social networks. This market, worth $329m in 2009, is projected to grow to $990m by 2011 and $1.6bn by 2013 an annual growth rate of 49% . Furthermore, IVAS are behind 46% of Mail.ru revenues, its successful IPO and current $7.2bn valuation .
EXHIBIT 5 - E-COMMERCE MARKET IN RUSSIA (2008A 2015F)
21 20

$20bn

$8bn $5bn

$6bn

2008A

2009A

2010E

2015F

Source: Data Insight, December 2010

Internet Taking Share of Advertising Spend from Traditional Media

Russias online advertising market is still in early stages of development only 9% of advertising budgets are spent on this channel, in comparison to the UK, one of the most established advertising markets in the world, where 3bn online advertising spend is c.28% of total advertising budgets . In Russia, television remains the main mass medium that has nationwide reach, estimated to attract up to c.55% of total advertising spend . Online advertising spend, however, is on the rise, driven by the rapid growth of audience reach. In addition, the nature of online advertising makes it easier to track spending and its impact. As a result, the Internet is becoming a much more effective advertising channel in Russia, and accordingly, online spending as a proportion of advertising budgets is forecast to grow from the current 9% to 14% or c. $1.6bn by 2013 (Exhibit 6) .
17 Source: comScore Media Metrix, January 2011 18 Source: infox.ru, 2011 19 Source: Data Insight, 2010 20 Source: JSon & Partners, September 2010 21 Source: CapIQ, GP Bullhound as at 17 May 2011, Mail.ru FY2010 Annual Report 22 Source: Zenith Optimedia, July 2010 23 Source: ZenithOptimedia, July 2010 24 Source: GroupM, September 2010; Euromonitor, August 2010
24 23 22

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EXHIBIT 6 - ONLINE ADVERTISING MARKET IN RUSSIA (2007A 2013F)

Online advertising market Online advertising penetration 9% 5% $497m 6% $708m $810m $600m

13% 11% 12% $1,305m

14% $1,620m

$1,030m

2007A

2008A

2009A

2010E

2011F

2012F

2013F

Source: GroupM, September 2010; Euromonitor, August 2010 Note: online advertising penetration represents advertising spend online as percentage of total advertising spend

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Low Historical Penetration by Foreign Internet Giants

The rapid development of Runet, particularly in terms of monetisation, has received increasing attention from foreign companies. Yet it still remains largely dominated by local players. The three largest and six out of the top ten Internet sites in Russia are local. By contrast, the top three Internet properties in Germany all have a global presence and out of the top ten only four are local players (one local player in the UK) (Exhibit 7) . Furthermore, Russia remains a key geographic black spot for both Facebook and Google.
EXHIBIT 7 - TOP ONLINE SITES W ITH LOCAL PLAYERS IN RED
Russia Total Unique Visitors Reach (m) (%) Rank 38.0 37.7 33.0 29.8 18.9 17.7 16.2 15.5 14.4 12.6 82% 82% 72% 65% 41% 38% 35% 34% 31% 27% 1 2 3 4 5 6 7 8 9 10 Germany Total Unique Visitors Reach Site (m) (%) Rank Google Microsoft Facebook.com eBay ProSiebenSat1 Deutsche T Amazon Sites Wikimedia United Internet Axel Springer 49.5 35.2 39.8 27.9 26.1 25.7 25.6 25.2 24.1 21.6 91% 65% 55% 51% 48% 47% 47% 46% 44% 40% 1 2 3 4 5 6 7 8 9 10 UK Total Unique Visitors Reach (m) (%) 40.3 39.5 33.3 28.2 24.9 22.1 20.9 18.8 18.4 16.7 93% 91% 77% 65% 57% 51% 48% 43% 42% 38%

25

Rank 1 2 3 4 5 6 7 8 9 10

Site Mail.ru Group Yandex vKontakte Google RBC Wikimedia BitTorrent Rambler Media Microsoft SUP

Site Google Microsoft Facebook.com Yahoo! BBC eBay Amazon Wikimedia Glam Media Apple Inc.

Source: comScore, December 2010; GP Bullhound

Whilst Russian companies have the highest online overall reach, they also dominate the most mature categories, such as online classifieds (Avito), auctions (Molotok.ru), and electronics retail (Ozon.ru) (Exhibit 8).
EXHIBIT 8 LEADERS IN KEY DEVELOPED VERTICALS GLOBALLY AND IN RUSSIA
Global Leader Russian Leader

Category Search engine Online portal Social network Online classifieds Online auctions Electronics retail
Source: comScore, March 2011; GP Bullhound

To an extent, the emergence and dominance of local players has benefited from the relatively slow entry from the international giants. As the Russian market became more attractive, several international players attempted to enter but with little success. Examples include:

25 Source: comScore, December 2010

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Google: entered Russia in 2001 and ten years later the company controls less than 22% of the online search market, with Yandex, the local incumbent, at 65% ;
26

Yahoo: launched its Russian website in 2009 but current traffic is below 1m unique monthly
27

visitors

(less

than

Yahoos

properties

in

Sweden

or

Switzerland) ; Facebook: Russian website launched in 2008 and had 19% online reach in December 2010 vs. 72% for vKontakte .
28

Foreign Competition Catching Up

Despite the relatively slow emergence of foreign players in Runet, their presence is growing. While in the West, the more established Internet sectors such as online search and social networking have a dominant player, in Russia these sectors are still in flux with multiple platforms available to consumers. For example, Google holds over 90% of the search market share in France and Germany, while in Russia it has only a 34% market share and is in direct competition with Yandex, who holds 62% (Exhibit 9) . As a result, this fragmentation of platforms adds to the complexity for newly emerging Internet business models.
EXHIBIT 9 SEARCH ENGINE MARKET SHARE BY AUDIENCE (FY2009A)
Russia Others 2% Google 34%

29

China Others 11%

Rambler 2%

Sohu 5%

Google 33%

Yandex 62%

Baidu 52%
France Bing 2% Yahoo! 3% Others 4% Germany Others 3%

Bing 2% Yahoo! 5%

Google 91%

Google 90%

Source: Greenlight Marketing, 2010; GP Bullhound

Language Complexities
Similar to China, Japan and Korea, one of the key barriers to entry to the Runet market is the language: not only is it from a different family of languages to the major western

26 Source: LiveInternet.ru, February 2011 27 Source: comScore, March 2011 28 Source: comScore, December 2010 29 Source: Greenlight Marketing, 2010; GP Bullhound

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languages with a different morphology, it also uses the Cyrillic rather than Latin alphabet. Yandexs search technology was developed around the Russian language first, and overcame a lot of the morphology issues, which have slowed down Google. According to the company, their global search competitors did not begin to focus on the intricacies and nuances of Russian-language search until the mid-2000s , giving them sufficient time to solidify their market leading position.
30

Cultural differentiation
Since the transition to a market economy, certain consumer products and services have become status symbols in Russia such as foreign holidays. The Russian outbound tourism market has been growing at about 10% a year since 2000, with popular resorts in Egypt, Turkey, Dubai and others . The majority of Russian holiday makers select places well known and highly visited by their countrymen, rather than trying new destinations 2.4m or nearly one in five of international Russian tourists go to Turkey, the same proportion as was the case in 2006 . An anecdote from a Russian online travel agent illustrates this: his efforts to introduce packages to new travel destinations have been met with reluctance from the Russian customers who after reviewing a number of options continue to prefer Turkey and Egypt for their summer vacation. Similar prejudices exist in other consumer categories. High-end brand demand in particular has been driven by an erstwhile lack of access to luxury in countries of the former Soviet Union, now replaced with rife consumerism. Similarly, Russians behaviour online also varies from the West. Notably, online monetisation has been restricted by the users lack of trust in online retail and payments, preferring to use the Internet for reviews and price information and making purchases by visiting the store directly. Although this mentality is slowly waning with growing online sales, it is an important factor to consider when dealing with Russian consumers. On the other hand, the market of goods and services requiring smaller payments, particularly for IVAS such as virtual goods and social games, has been advancing rapidly. In addition to having lower payment barriers, this sector has also been aided by the availability of mobile payment solutions.
32 31

Cash on Delivery Remains Most Common Payment Method

The relatively delayed development of electronic payment methods and the prevalence of a cash economy in Russia continues to significantly hinder the development of the e-tailing sector. In 2008, Russia had 0.8 payment cards per inhabitant in comparison to 3.3 in the US and 2.7 in the UK . Instead, cash-based payment terminals are in widespread use (Exhibit 10). In addition, e-commerce companies have implemented the payment on delivery service, where couriers take the payment in cash as they drop off the ordered product. In 2010 it is estimated that 44% of online transactions were made in that way.
33

30 Source: Yandex SEC Form F1, 28 April 2011 31 Source: Financial Times, Thomas Cook invests in Intourist brand, 25th November 2010 32 Source: Federal Tourism Agency of Russia (Rosturism), 2010 33 Source: Bank of International Settlements, Central bank of Russia, Morgan Stanley Research, December 2010

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The issues arising from payment method constraints are not limited to e-commerce players. For instance, when Google first launched in Russia, it did not have alternative payment methods in place to cater for the many small businesses that did not have credit cards or online payments. The Russian counterparts, on the other hand, had developed ways to receive payment for Internet ads using traditional accounts at bricks-and-mortar banks , thus maintaining a competitive edge.
EXHIBIT 10 EXAMPLE OF A PAYMENT TERMINAL
34

Source: Qiwi Company website

Other Payments Methods Growing Fast

Despite the prevalence of payment upon delivery and other cash-based methods, electronic payment is increasingly being used. For instance bank card payment and transfer is estimated to have grown from 17% in 2008A to 27% by 2010E (Exhibit 11) .
EXHIBIT 11 PAYMENT METHODS IN E-COMMERCE IN RUSSIA (2008A 2010A)
35

2% 7% 8% 9% 16%

3% 12%

2% 13%

17%

10%
14% 15%

10%

27%
17% 12%

56% 44% 44%

2008A Cash on delivery Banking card Electronic currencies

2009A

2010E Paid at the post office upton receipt Bank transfer SMS

Source: Rumetrika, July 2010

34 Source: New York Times, New to Russia, Google Struggles to Find Its Footing, 18 December 2006 35 Source: Rumetrika, July 2010

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Logistics Impacting Profitability

Due to the vast size of the country and lack of fast, cheap and reliable last mile delivery in some of the rural areas, logistics is also challenging. Ozon, the leading online retailer with a similar business to Amazon, established its own delivery network in more than 80 cities, offering 14 different types of delivery. In addition, the company has to subsidise delivery as the cost is so high for the consumer. This causes profit margin pressure for many ecommerce players.

Concentrated Market Structures

Due to the relatively recent transition from a planned economy in Russia, the prevalence of government regulation or oligarch ownership has resulted in certain offline sectors being dominated by one or only a few players, reducing the bargaining power of new online entrants within the supply chain. An example of this is Video International, whose historic relationship with the government enabled them to dominate the advertising market for all the major channels, including state television. Its subsidiary, IMHO VI has over 60% of the online display advertising market. Conversely in France, the top four ad sellers have less than 40% in total (Exhibit 12).
EXHIBIT 12 ONLINE DISPLAY ADVERTISING MARKET BREAKDOW N (RUSSIA VS. FRANCE, 2009A)
Russian Display Advertising Market Breakdown
French Display Advertising Market Breakdown Orange Advert Network 13% Microsoft Advertising 11%

Other 20%

Other 18% Zefir Web 4%

Mail.ru Group 20%

IMHO VI 60%

Yahoo 5% Pagesjaunes 5% Lagardere Publicite TF1 Publicite 6% 6%

Hi Media 9% AOL Advertising 7%

Source: TNS Media Intelligence, 2009; GP Bullhound

Business Risk Perception

Russia is still perceived as high risk for conducting business due to the following factors: Volatile macroeconomic environment: highly volatile in comparison to the main western economies (Exhibit 13) and closely linked to the oil price due to Russias exposure to the energy and commodity sectors (80% of exports are energy related );
36

36 Source: Russian Federal Customs Service, 2010

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EXHIBIT 13 HISTORICAL GDP GROW TH (2001A 2010A YEAR ON YEAR QUARTERLY)

10%

8%
6% 4% 2%

0%
-2% -4% -6% -8% -10% USA Italy Russia UK Spain Germany France

-12% 2001A 2002A 2003A 2004A 2005A 2006A 2007A 2008A 2009A 2010A
Source: Capital IQ; GP Bullhound

Intellectual property: the standard of IP protection in Russia is not yet as sophisticated as in most western countries, as the recent cases against Mail.ru and vKontakte show: both sites are well known among Russian Internet users as sources of free copyrighted content, from Hollywood blockbusters to musical hits. On 15th March 2011, the Supreme Arbitration Court of the Russian Federation freed the administration of social networks from liability for content uploaded by their users, forming a bad precedent for the industry . Russia has also been listed as having one of the worst records of preventing copyright theft for the 14th straight year in the US Trade Representative's Special 301 Report . One of the issues frequently mentioned is the absence of a unified law or procedure in Russia, like the USs Digital Millennium, leading to conflicting interpretations by the courts. There is gradual progress such as the new complete copyright legislation is being drafted by the Ministry of Communication ;
39 38 37

Legal complexities: differences in laws may result in complications for foreign entities. For example, the Strategic Companies Law, adopted in May 2008, restricts foreign ownership of companies involved in certain strategically important activities. While the Internet is not an industry specifically covered by the law, companies holding licences to use encryption technologies are covered. As a result, Yandex, whose subsidiary YandexMoney holds an encryption technology licence, may be covered by the law and the acquisition of more than 25% of the voting power would require permission from a Russian government committee . Another example is the taxation system, which is less transparent creating difficulties for start-up businesses;
40

Corruption and political interference: whilst Russia is not alone in the protectionist behaviour of its strategic sectors, it comes alongside concerns of

37 Source: The Moscow Times, 16 March 2011 38 Source: Reuters, 2 May 2011 39 Source: Financial Times, 4 November 2010 40 Source: Yandex SEC Form F1, 28 April 2011

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corruption. There have been a number of high profile cases where western investors have lost all or part of their investments in Russia examples include, Hermitage Capital, British Petroleum and Yukos. In addition, the threat of state control over Internet, as with traditional media, is alarming. For instance, in April 2011 Yandex came forward to say it was forced to give Russias federal security service, FSB, personal information about Russians who had used a Yandex payment service to donate to a whistleblowing website, launched by Alexander Navalny. In addition, Russias security service had criticised encrypted communication providers like Skype, Gmail and Hotmail as they cannot be monitored by the security service ; Online security issues: Runet has been subject to cyber-crime ranging from malware to accessing bank accounts, to political cyber-attacks on leading websites, such as the April 2011 incidents resulting in the closure of LiveJournal, one of the most popular blogging platforms, and Novaya Gazeta, the website of an independent newspaper .
42 41

41 Source: Financial Times, 11 April 2011 42 Source: Financial Times, 8 April 2011

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Foreign Management Driving Development

Russias rapidly growing Internet market has become an increasingly attractive opportunity for western entrepreneurs. Yet due to the varied and diverse nature of the market and the new well-recognised importance of a local partner aiding navigation through this complex environment, foreign companies have taken on a more collaborative role, moving away from direct acquisitions as was their entry method in other markets. This in turn has contributed to the development of the sector through the transfer of business models and management expertise: Ex-patriot management teams: foreign managers moving to Russia as well as Russian expatriates who have been educated and worked abroad prior to moving back to found their businesses, bring to Russia their management experience. Examples include Bernard Lukey (CEO of Ozon), Annelies Van Den Belt (CEO of SUP), Oskar Hartman (CEO of KupiVIP) and Filip Engelbert (CEO of Avito); Sophisticated foreign investors: international venture capital funds and business angels, who have established similar business models in the West, are increasingly drawn to the scale and growth of the Russian Internet market, as evidenced by recent investments by Accel Partners, Balderton Capital, Bessemer Venture Partners, Tiger Global, General Atlantic, Investor IG, Direct Group, Ventech, Intel Capital, Mangrove and Kinnevik. In 2010, more than half of the venture capital investments in Runet had foreign participation (Exhibit 14) .
EXHIBIT 14 PRIVATE PLACEMENTS IN RUSSIAN INTERNET COMPANIES BY INVESTOR (VOLUME)
Russian investment Foreign investment
43

16

7
8 6 3 3 2008 7 1 2009 2010 9 5 3 2 2011YTD

Source: Capital IQ; GP Bullhound, April 2011 Note: foreign investment includes syndicates with at least one foreign investor

Incubators: due to the rapid development of the market, established enterprises and investors have founded management teams to test out and implement new business models in Russia examples include Yandex.Fabrik, DST Investment, Fast Lane Ventures, Kite Ventures and Digital October. Although many of these

43 Source: Capital IQ, GP Bullhound, April 2011

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seed investors are of Russian origin, they are backed by foreign investors. This investment strategy enables: 1) 2) 3) 4) Better risk diversification; Rapid implementation of numerous models, including copy-cats; Leveraging management skills and other resources between projects; Knowledge transfer particularly through management training schools within incubators. Given the rapid development and high quality innovation of Runet, exit opportunities are also emerging, with the Mail.ru IPO completed in November 2010, the Yandex IPO announced in April 2011, and the acquisition of 20% in Kaspersky Labs by General Atlantic.

Leapfrogging Western Progression

A number of online categories in the Russian market have been launched following in western markets footsteps: emergence of classifieds sites followed the launch of online auctions (Avito.ru following Molotok.ru); no-stock marketplaces, such as Wikimart, came after inventory-holding online retailers, such as Ozon. The recent surge of start-ups, however, has produced a number of business models which, while reproducing western prototypes, have leapfrogged the natural progression of the market (Exhibit 15).
EXHIBIT 15 DEVELOPMENT OF KEY CONSUMER INTERNET SEGMENTS IN RUSSIA
1994
Online portals / search engines Social networks Online consumer goods C2C e-commerce
No-stock private sales model pre-empts traditional online apparel retail Social networks as platforms for advertising and retail

1996

1998

2000

2002

2004

2006

2008

2010

Online apparel retail

Online travel

Flash sales model pre-empts online OTA

Online services

Daily deals model pre-empts online reservation services

E-commerce aggregator

Online marketplaces ahead of price comparison

Russian equivalent

Business models driven by social networks

Source: GP Bullhound

To an extent, the new business models are an evolution of the older models and an answer to some of their predecessors issues. For instance, many of the new successful models (group buying, private sales etc.) rely on targeted, limited offerings and thus avoid

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the heavy task of creating a large offering in a country where online penetration remains low among suppliers: Apparel e-commerce: straightforward e-tail models such as YOOX, ASOS and Net-a-Porter have been bypassed by a private sales site, KupiVIP. In particular, the stock build-up and more prudent consumer spending as a result of the crisis aided the expansion of this model in Russia. While in the US, the launch of niche shoe shop Zappos pre-empted private sales, in Russia this business model, Sapato, emerged after KupiVIP, once the logistics and payment methods had been proven; Online travel: the development of online travel properties has been hindered in Russia by: 1) a cumbersome visa application procedure for international travel, which necessitates physical delivery of the passport; 2) a tendency to pay large sums in cash, which negates the advantages of travel tickets and bookings online; 3) a low inherent rate of online connection for Russian hoteliers. As a result, online traditional models such as OTAs and meta-search engines have struggled, whereas private / flash sale sites, similar to Jetsetter and Voyage Priv, are growing fast and benefit from not having to maintain an exhaustive offering as well as targeting a more sophisticated audience that is more likely to pay electronically. One of the players in this sector mentioned that 90% of transactions on the OTA site are in still cash vs. 20% of transactions only on their new flash sales site; Online services: the daily deals model was quickly adopted by Darberry, which was then subsequently acquired by Groupon. The more long-standing model of restaurant reservations, on the other hand, did not take off as rapidly because the restaurants themselves do not have significant online presence. In addition, niche category group buying sites have also emerged such as KupiBonus (health and beauty products); E-commerce aggregators: as with online reservation services, price comparison websites require a critical mass of suppliers to operate online. Instead online marketplaces, which provide online stores for business both online and offline, are emerging first.

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The Age of Social Networks

One of the major drivers for recent business models has been social networking not just in Russia but worldwide. New business models that can be integrated within and

propagated through social networking have grown at a dramatic pace, powered by electronic word of mouth. As a result of this viral effect, businesses are able to reach scale without significant advertising cost outlay. While this has been a global phenomenon, the distinctive social networking environment in Russia will continue to drive the development of new dynamic business models. Drivers of the characteristic social networking audience in Russia include: 1) Convenience: as a result of adverse weather conditions, as well as slow traffic in urban areas, social networks provide a more convenient way to connect with friends. In addition, due to the occasionally poor landline quality or expensive mobile connection, instant messaging within social networks is proving more effective for communication. 2) Information: price-sensitive consumers, especially during the recent crisis, are turning to the Internet to seek reviews and good deals. This is particularly important in Russia, where consumer protection is poor. 3) Opinion: as a result of state control of the traditional media, social networks and blogs have become key arenas for political discussion.
EXHIBIT 16 SOCIAL NETW ORK USERS IN RUSSIA (2009A 2015E)
Number of social networks users (m) Social network users as percentage of Internet users

67%

70% 65m

73% 72m

77% 76m

55%

58%

62% 58m 50m

38m
31m

2009A

2010E

2011F

2012F

2013F

2014F

2015F

Source: JSon & Partners, September 2010

Advanced Social Networking Audience

Despite the relatively emerging stage of Runet, its audience displays a higher propensity to socialise on the web than in more developed markets, such as Europe and the US: Runets social networking audience is estimated at 38m users 58% of total Internet users , versus less than half in the main five European countries . Furthermore, as
44 Source: JSon & Partners Consulting, September 2010
44 45

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Internet reach continues to expand, the Russian social networking audience is projected to grow at an annual rate of 15% to 76m by 2015 (Exhibit 16) . The Russian social networking audience is also the most engaged in the world with over 35m users spending nearly 10 hours per month on social networks more than double the worldwide average (Exhibit 17) . Social countries tend to use more online services, such as online office applications and Internet telephony for instance c.40% of Internet users in India and Russia have made a phone call online with services such as Skype. That is nearly three times as many as in the US and almost six times as many as in Japan .
EXHIBIT 17 TOP 10 COUNTRIES FOR SOCIAL NETW ORKING RANKED BY TIME SPENT PER VISITOR
9.8hrs
48 47 46

9.2hrs 7.6hrs 7.3hrs 6.2hrs

5.8hrs

4.5hrs

5.3hrs 5.0hrs 5.0hrs 4.9hrs

Source: comScore, August 2010

Social Network Diversity

In Russia, there are several online communities catering for different demographic groups, while in more developed Internet markets, one single player dominates with Facebook often the leader (Exhibit 18).

45 Source: eMarketer, January 2011 46 Source: JSon & Partners Consulting, September 2010 47 Source: comScore, August 2010 48 Source: Harvard Business Review, July August 2010

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EXHIBIT 18 LEADING RUSSIAN SOCIAL NETW ORKS BY PERCENTAGE REACH OF ONLINE POPULATION
45%

24% 20%

5%

3%

3%

2%

1%

1%

1%

Source: comScore, May 2009

To an extent, diversity in social networking communities balances bargaining power amongst players down the supply chain. Furthermore, it also promotes a wider variety of monetisation tools. Similar to Asian communities, Runet users purchase a range of products and services including virtual goods, premium subscription services such as an invisible profile (where users can access other profiles without being detected, whereas with normal accounts they can be seen), additional services such as page design and group creation (Exhibit 19).
EXHIBIT 19 INTERNET VALUE ADDED SERVICES CATEGORY BREAKDOW N IN RUSSIA
Group creation, 4% Avatars, 5% Page design, 7% "Invisible status" option, 9% Other, 5% Virtual gifts, 31%

More photo / video uploads, 11%

Smiles in messages, 17% Higher photo rating / voting, 11%

Source: Romir; Bank of America Merrill Lynch, December 2010

Active Blogosphere Electronic Word of Mouth

The Russian blogosphere is also a critical characteristic of Runet: in spring 2009, there were over 7.4m Russian-speaking blogs more than twice as many as a year before. Although over 76% of active blogs are hosted on four services: LiveJournal.com, Blogs.Mail.ru, Ya.ru and LiveInternet.ru, there are over 100 services available . This user generated system has had a significant effect on improving transparency both online and in wider media, particularly through connections with outside sources. A large
49 Source: Yandex, Trends in the Russian Blogosphere, Spring 2009
49

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cluster of Russian bloggers focus on politics, writing predominantly in Russia but frequently linking to English-language news websites such as the New York Times, Washington Post, Wall Street Journal, The Guardian and the BBC .
50

Trust
Furthermore, Russian Internet users appear to trust the information from blogs more than other more official data sources, particularly as other mass media channels are increasingly dominated by the state. In turn, within the mass media, blogs information is increasingly used to reflect public opinion: in 2010 over six thousand blogs were referenced by other mass media
51

(Exhibit 20).

Reviews
In addition to public discourse, the blogosphere is also an important source of user reviews and recommendations. According to speakers at the WPP Stream Digital Conference, 45% trust official websites, while 85% trust opinions of people they are connected with via Internet but have not necessarily met in person.
EXHIBIT 20 NUMBER OF REFERENCES TO BLOGS BY MASS MEDIA IN RUSSIA (2005A 2010A)
6,208

3,555

2,144
1,303 225 2005A
Source: Public.ru, 2011

535

2006A

2007A

2008A

2009A

2010A

Blogger Community More Integrated than USA

The Russian blogosphere is also particularly interesting as there is more cross-over between groups of users, despite differences in political and other views. In the US, on the other hand, studies have found that users are more isolated within silos of like-minded bloggers and do not cross-over as much with other opinion groups . Exhibit 21 illustrates this difference: blogs are represented by dots of different colours depending on the theme of content and size to reflect the number of links to the blog, i.e. its prominence in the sphere. In the graphical representation of the Russian blogosphere, different coloured dots are mixed around the larger ones with little segregation, showing cross-over of themes. In
52

50 Source: Public Discourse in the Russian Blogosphere: Mapping RuNet Politics and Mobilization, October 2010 51 Source: Public.ru, 2011 52 Source: Public Discourse in the Russian Blogosphere: Mapping RuNet Politics and Mobilization, October 2010

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contrast, the US blogosphere representation has a distinctive separation of blue and purple dots or liberal and conservative bloggers.
EXHIBIT 21 BLOGOSPHERE STRUCTURE COMPARISON
Russian Blogosphere US Blogosphere

Source: Public Discourse in the Russian Blogosphere: Mapping Runet Politics and Mobilization, October 2010 Note: The colour of each dot represents different content, size of the dot reflects the number of links to the blog

One of the main reasons is the structure of the popular blogging systems in Russia, which are more like hybrids between blogs and Social Network Systems. For instance, the pioneering LiveJournal platform enables the connection of friends, groups and file sharing options, promoting links within the platform as well as to other online content, such as news websites.

Conclusion: Runets Success Lies in its Uniqueness

So far, the recent activity in Runet has been through the application of western business models. Amendment of these models in response to the local idiosyncrasies has resulted in a different market evolution. One differentiation in particular the social networking audience may lead to an even further divergence. Already emerged examples of this trend include: Yandex traffic tool: collects user generated data to collate a traffic congestion map for its users; eMegamall: a multi-channel e-commerce system that enables e-tailers to sell their products on multiple social networks, classifieds and other sites. We envisage even more socially focused business models to emerge in this rapidly developing market.

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Selected Private Placements

Announc. Date May-11 Apr-11 Apr-11 Jizo.ru

Company

Investor Fast Lane Ventures General Catalyst Partners; Kite Ventures Holtzbrinck Ventures Gmbh; Investment AB Kinnevik; Tengelmann Accel Management; Bessemer Venture Partners; Mangrove Capital Partners; Russia Partners Management; Balderton Capital Ventech; Mangrove Capital Partners; ABRT Venture Fund Baring Vostok Capital Partners Limited Runet Leader-Innovations Access Industries n.a. Angel investors Tiger Global Management Softline Venture Partners Angel investors ProfMedia Investment AB Kinnevik; Direct Group; eVenture Capital Partners; Fast Lane Ventures Northzone Ventures; Investment AB Kinnevik Mail.ru Group; Almaz Capital Partners RBC OJSC Mangrove Capital Partners; ABRT Venture Fund; Fast Lane Ventures Tiger Global Management Tiger Global Management Direct Group; eVenture Capital Partners Mangrove Capital Partners; Direct Group; ABRT Venture Fund Advance Capital Valery Krivenko and Alexey Kovsh Accel Management; Mangrove Capital Partners; Direct Group; Arlan Investment Company Mail.ru Group; 1C Company

Transaction Size ($m) -

Commentary Meta-search engine of flights Online flash sales offering travel packages Online retailer of shoes

Ostrovok.ru Lamoda.ru

Apr-11

KupiVIP

$55.0m

Online fashion private sales

Apr-11 Apr-11 Mar-11 Mar-11 Mar-11 Mar-11 Mar-11 Mar-11 Feb-11 Feb-11 Dec-10 Nov-10 Nov-10 Oct-10 Sep-10 Aug-10 Aug-10 Jul-10 Jul-10 Jul-10 Apr-10 Mar-10 Jan-10 Nov-09

Oktogo.ru Ozon.ru Biglion WebMediaGroup Vigoda.ru Tulp.ru BabyBoom.ru Wikimart Emegamall HipClub.ru ivi.ru Sapato.ru Avito.ru i-Jet Media iGlobe.ru KupiBonus Wikimart anydayanyway.com Sapato.ru KupiBonus Textone.ru Tulp.ru KupiVIP Nival Network

$5.0m $50.0m $3.0m $7.0m $0.5m $0.5m $3.3m $5.1m $26.2m $20.0m $6.4m $10.0m $1.0m $5.0m $20.0m $7.0m

Online hotel booking E-tailer selling a wide range of products including books, audio, CDs and DVDs, software, electronic goods Group discount site Online video service through Zoomby platform Group discount site Online community, providing information on urban city guide Online babycare specialist retailer Online shopping marketplace Sets up third party sites on leading social networks, classifieds and auction sites and blogs Online flash sales offering travel packages Online licensed video distribution Online retailer of shoes Online C2C classifieds Online social games distributor Online travel portal operator Group discount site offering health and beauty products Online shopping marketplace Online airline ticket retailer Online retailer of shoes Group discount site offering health and beauty products Online service providing newspaper downloads as audio files Online community, providing information on urban city guide Online fashion private sales Online games publisher

Source: Capital IQ, GP Bullhound

GP Bullhound LLP

GP Bullhound is a research-centric investment bank headquartered in London.

Per Roman Founder / Partner

Hugh Campbell Founder / Partner

Manish Madhvani Founder / Partner

Christian Lagerling Founder / Partner

Alec Dafferner Partner / Head of US

Andr Shortell Partner

Guillaume Bonneton Partner

Antony Northrop Senior Advisor

Frank Schmitt Director

Claudio Alvarez Vice President

Julien Oussadon Vice President

Carl Bergholtz Vice President

Sasha Afanasieva Associate

Amanjit Dhami Associate

Remy Valette Associate

Justine Chan Associate

Florent Roulet Analyst

Malcolm Ferguson Analyst

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