THE REPORT OF THE SUPERVISORY BOARD OF NETIA SA FOR THE FINANCIAL YEAR 2013

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1 THE REPORT OF THE SUPERVISORY BOARD OF NETIA SA FOR THE FINANCIAL YEAR 2013 I. Review and assessment of the work of the Supervisory Board In the financial year ended December 31, 2013, the Supervisory Board maintained permanent general supervision over the business activities of Netia SA. Pursuant to 17 of the Company s Statutes, the Supervisory Board held its meetings on a regular basis and took care of all the issues which, according to the binding law and the Company s Statutes, are within its competence. The Supervisory Board, within its activities, supported the Management Board in achieving the Company s goals set for the year 2013, reviewed the Management Board s motions regarding issues which, according to the Company s Statutes, required consent of the Supervisory Board, and also acquainted itself with other issues presented by the Management Board. In addition, on the grounds of 13.2 of the Company s Statute, as well as Code of Best Practices for WSE Listed Companies, the Supervisory Board gave opinions concerning the resolutions of the General Shareholders Meetings which were proposed by the Management Board. In the financial year 2013 the Supervisory Board held 12 meetings, including 9 attended in person and 3 conference calls, on the following dates: February 23 rd, February 26 th, March 13 th, March 27 th, April 26 th,, June 28 th,, October 18 th - 19 th, November 7 th, November 20 th, November 21 st, December 3 rd and December 30 th. The Supervisory Board may consist of up to nine members. As at December 31 st 2013, Supervisory Board comprised of: George Karaplis Chairperson, Jacek Czernuszenko Vice-Chairperson, Stan Abbeloos, Raimondo Eggink, Nicolas Maguin, Ewa Pawluczuk, Tadeusz Radzimiński and Jerome de Vitry. All members of the Supervisory Board are independent members as defined in 15.3 of the Company s Statutes. During 2013 there were following changes to the composition of the Supervisory Board: on June 28 th Jacek Czernuszenko was appointed to the Supervisory Board, on November 13 th Benjamin Duster, Chairman of the Supervisory Board, resigned from the Supervisory Board, on November 20 th George Karaplis was appointed as a Chairman and Jacek Czernuszenko as Vice Chairman of the Supervisory Board. The meetings of the Supervisory Board in 2013 were held with an average attendance of eight members. Details of which Supervisory Board Members were in attendance at each Supervisory Board meeting as well as details of compensation and shareholdings of each Supervisory Board member are published on the Company s Investor Relations website in the Corporate governance section. In 2013 the Supervisory Board performed its duties in an appropriate way, holding meetings with a frequency sufficient to deal with all issues that were within its competencies. Both the composition of the Supervisory Board, as well as the knowledge and experience of its individual members, ensured a proper and efficient functioning of the Supervisory Board and content-related supervision over the Company s business.

2 The annual report referring to the execution of the Rules of Remunerating the Supervisory Board Members is published on the Company s Investor Relations website in the Corporate governance section. II. Functioning and work of the Committees of the Supervisory Board Four standing committees, with the following membership at the end of 2013, were operating within the Supervisory Board throughout 2013: (i) Audit Committee consisting of Raimondo Eggink Chairperson, Tadeusz Radzimiński and Ewa Pawluczuk, (ii) Nomination and Remuneration Committee consisting of Jacek Czernuszenko, Nicolas Magiun and Tadeusz Radzimiński (changes to the composition of the Committee: on March 27 th Jerome de Vitry resigned from Committee effective as on April 30 th, 2013 and Nicolas Maguin was appointed to the Committee, on November 13 th Benjamin Duster resigned from the Supervisory Board, on December 3 rd Jacek Czernuszenko was appointed to that Committee) ), (iii) Capital Investment Committee consisting of Stan Abbeloos - Chairperson, George Karaplis, Jacek Czernuszenko, Nicolas Maguin and Jerome de Vitry (changes to the composition of the Committee: on March 27 th Stan Abbeloos was appointed Chairperson of the Committee, on October 18 th Jacek Czernuszenko was appointed), and (iv) Strategic Committee consisting of Jerome de Vitry Chairperson, Jacek Czernuszenko, George Karaplis i Raimondo Eggink (changes to the composition of the Committee: on October 18 th Benjamin Duster resigned from the Committee and Jacek Czernuszenko was appointed). Moreover on April 26 th, 2013 an ad hoc Product Development Committee was established with the following composition: George Karaplis Chairman, Ewa Pawluczuk and Tadeusz Radzimiński. The Audit Committee met on a regular basis and advised the Supervisory Board on financial reporting, the Company s and its Capital Group internal audit activities, as well as proceeded with a regular work plan including the overall and comprehensive review of the Company s annual and periodic financial statements, both unconsolidated and consolidated, analyzing the Company s external auditor s letters to the Management Board, monitoring the integrity of the financial information provided by the Company, monitoring external and internal auditors of the Company, as well as cooperating with the Company s departments responsible for audit and checking, reviewing internal control and risk management systems. During 2013 the Audit Committee paid special attention to implementation of the new distribution policy, supervising the Company s tender to select a new external auditor for the Group, the effectiveness of small Ethernet acquisitions, tax proceedings, tax planning and impairment tests. The Audit Committee regularly conducts a self-evaluation. This year it highlighted the need to improve the feedback provided by the Audit Committee to the full Supervisory Board about the wide range of complex issues covered by its agenda. 2

3 The Nomination and Remuneration Committee advises the Supervisory Board on the shape of the Company s management structure, including issues on remuneration policy and selection of personnel matching the qualifications necessary to build the Company s success, particularly regarding the Management Board members. During 2013 there was one change to the composition of the Company s Management Board: Tomasz Szopa was appointed to the Management Board on November 21, 2013 with effect on February 3, The Committee reviewed the management bonus objectives fulfillment for the previous year and set goals for the present year. The Committee made recommendations to the Supervisory Board on the annual bonus for management as well as the present year SOP allocations and business goal achievements for the adjustments for the previous year s SOP allocations. The Capital Investment Committee met as usual to review the key drivers of capital investment spending within the Netia group and reviewed Management s proposals for the 2014 annual capital investment budget. Increasing emphasis was given to stricter spending controls as the Company s revenue came under increasing pressure and to ensure that investment strategies were aligned across Dialog, Crowley and Netia networks. Next Generation Access ( NGA ) and TV related capital investments were carefully analyzed with the performance of each key project closely monitored and decision criteria for 2014 investments established. The Strategic Committee s provides the Supervisory Board with the support on, amongst others, the following issues: areas of future development for the Company, mergers and acquisitions, review of all other areas or matters which have a strategic dimension for the Company. III. Brief Review of the Company s Standing Committees Netia Supervisory Board s key activity areas in 2013 In 2013 the Supervisory Board worked with and advised Management in a number of key areas, including: (i) approval of a Management Board compensation plan and its ongoing implementation following extensive peer analysis and internal discussions, (ii) review of strategic alternatives for positioning Netia to improve its competitive position within its existing markets and explore opportunities to drive value creating expansion, (iii) intensive review and analysis of regulatory developments and development of opportunities to accelerate pursuit of value accretive NGA investment, (iv) towards the end of 2012, the Company began an intensive analysis of its organizational alignment relative to changing dynamics in the media and telecom industries and challenging realities of the Polish market. This work has continued into 2013 and Management and Supervisory Board are jointly considering material structural changes to the organization to facilitate more responsive and efficient execution of strategies targeted at the companies and market segments. 3

4 The Supervisory Board s Audit Committee has monitored and supported Management s implementation of its foreign currency hedging strategy. Up to 50% of foreign currency exposures in capital investments and operating expenses for rolling 12 month periods are dynamically hedged using forward contracts. Whilst this policy showed mark-to-market gains during 2010, 2011 and 2013, and losses in 2012, it achieves its prime objective of reducing cash-flow volatility from changes in exchanges rates. With the drawdowns of the senior debt facility to acquire Telefonia Dialog SA, the Company took out fixed interest rate swaps (IRS) to hedge 75% of the floating rate interest payments due under the terms of the loan. While this IRS contract produced in 2013 net fair value gains in other comprehensive income and net realized cash losses in income statement, it achieves its prime objective of reducing volatility of interest payments between periods. Net fair value gains on IRS contracts recognized in other comprehensive income in the year ended December 31, 2013 amounted to PLN 3,039 (PLN 2,462, net of tax). During the year ended December 31, 2013, PLN 4,366 of net realized cash losses on IRS contracts increased interest costs. (a) Key developments Major developments at the Netia Group during 2013 included the following: I n t e g r a t i o n o f N e t i a, D i a l o g G r o u p a n d C r o w l e y i n t o N e w N e t i a G r o u p. December 2013 saw the two year anniversary of Netia s acquisition of 100% stakes in Telefonia Dialog SA ( Dialog, currently Telefonia Dialog Sp. z o.o.) and Crowley Data Poland Sp. z o.o. ( Crowley, currently merged into Netia). Completed and on-going integration projects have delivered cumulative synergies over eight quarters in the amount of PLN 219.3m at the Adjusted EBITDA level and PLN 46.0m from capital investments through December 31, The cumulative synergies achieved during twelve months of 2013 reached PLN 143.2m and PLN 24.2m, respectively. This represents a surplus of PLN 28m over PLN 115m of operational synergies planned originally for From a total of well over 100 projects, 97 Adjusted EBITDA level synergy initiatives and 40 Capex synergy initiatives have been completed. The final projects, mainly related to IT platform migrations, are to be concluded at the beginning of Q Total reorganization costs recorded in the twelve months of 2013 amounted to PLN 13.1m (out of which PLN 3.6m related to the employment restructuring program and PLN 9.5m related to integration costs). N G A n e t w o r k d e v e l o p m e n t. In 2013 Netia continued to expand its NGA standard network, which allows for providing, among others, high speed broadband and 3play services including IPTV and streaming TV services adding 41k homes passed. As of December 31, 2013, Netia covered in total 1,281k households with its NGA networks, including approximately 897k homes passed with VDSL copper networks, approximately 148k homes passed with passive optical networks (PON) and approximately 236k homes passed with the fast Ethernet networks and fiber to the building (FTTB). Moreover, at December 31, 2013 Netia covered a further 172k TV ready HPs within its network coverage based on ADSL2+ technology. Combined with NGA ready HPs, all of which can deliver TV services, Netia had 1,453k TV ready HPs in its proprietary network coverage. 4

5 Netia has advanced plans to expand its NGA coverage by another 400k or more HPs inclusive of the 2013 acquisition of cable networks from UPC Polska. Once all upgrade projects are completed, Netia expects to cover in total approximately 1,720k NGA HPs which can be reached with 3play service bundles (TV + fixed NGA broadband + fixed voice). Furthermore, Netia has introduced smooth streaming technology, which expands the availability of its 3play bundle offer onto networks where line speeds are too slow to support IPTV (extra +240k on-net HPs) and, potentially in the future, to homes where Netia does not provide the broadband connection. Netia is focusing on optimizing sales, provisioning and maintenance processes around TV services in addition to constant development of the content offering and service functionalities in the course of T V a n d c o n t e n t s e r v i c e s. Netia offers its customers TV services branded as Telewizja Osobista (Personal Television). The offering includes a proprietary set-top box the Netia Player, which provides access to paid digital TV content provided over IP based protocols in multicast and unicast, quick and easy access to popular internet services or personal multimedia over the TV screen as well as video-on-demand (VOD) content libraries such as Ipla, Kinoplex and HBO GO. On November 4, 2013 Netia introduced an innovative offering of its TV services, which allows a customer to tailor freely his/her own Personal Television from more than a dozen thematic options available and over 170 channels, including 56 HD channels. During the first month, a customer has access to all TV packages at the minimum monthly fee of PLN 35. Thereafter, a customer may choose TV packages meeting his/her interest within one of five monthly fee plans ranging between PLN 35 and PLN 160. The newly launched TV offering is unified in terms of available packages and channels across the various TV transmission technologies deployed by Netia. The number of active TV services in Netia grew to 120k as at December 31, 2013 up by 52% from 79k as at December 31, A c q u i s i t i o n o f a p a r t o f f o r m e r A s t e r c a b l e o p e r a t o r s n e t w o r k. In May 2013 Netia acquired from UPC Polska a part of former Aster cable operator s network, which was classified for resale according to the decision of the President of the Office of Competition and Consumer Protection (UOKiK) as of September 5, 2011 approving the acquisition of Aster cable operator by UPC Polska. Netia purchased cable networks in Warsaw and Krakow reaching a total of 446k homes passed. The transaction has been treated as a purchase of network assets and related liabilities with a net valuation of PLN 5.8m. Simultaneously, UPC Polska concluded with Netia Group a 12-month network rental agreement in order to ensure service continuity to its customers during a transition period. Total consideration payable to Netia Group for this network rental amounts to PLN 4.5m. Moreover, Netia will receive discounts on certain ongoing commercial agreements between the Netia Group and UPC Polska. These discounts are estimated to amount to PLN 16.4m and will be recognized as they are received. Netia is not gaining any retail customers, but the transaction increases the reach of Netia s proprietary network by 18% to 2.9m households and allows the Company to strengthen its infrastructural market position in these regions of the Residential market segment where, until now, it did not hold a strong footprint. The acquisition is the next important step in the execution of Netia s strategy, which is based on developing on-line solutions focusing on the Company s own networks and may 5

6 prove an excellent base for extracting synergies from future consolidation activities, not pursued before by Netia in this market segment. Netia has begun works on connecting the cable network to its backbone network, defining the to-be service offering and procuring necessary network equipment and set-top boxes. The Group is targeting a commercial launch during N e t i a s p l i t s i t s o p e r a t i o n s i n t o B 2 B a n d B 2 C B u s i n e s s U n i t s ( N 2 P r o j e c t ). On January 24, 2014 Netia announced a divisional split of its operations between two distinct Business Units: Business to Business (B2B) and Business to Consumers (B2C), with a view to best support the needs of its business and residential customers and the Company s key strategic objectives. Netia s organizational structure will be aligned accordingly, with both Business Units owning full P&L responsibility for all their operations. The B2B and B2C Business Units will be responsible for providing new, innovative and user-friendly products to their customers and constant improvement of service delivery. This organizational change is expected to results in the maximal possible simplification of internal procedures and processes, clear accountability for execution of each of strategic targets and thus the further improvement of the Group s financial performance. Moreover, the change is expected to allow Netia, being the second largest fixed network operator in Poland, to take optimal advantage of its existing infrastructure, which in the medium and long term is expected to increasingly play an important role in Netia s financial performance. In addition, it is expected to provide the flexibility necessary to take advantage of possible consolidation scenarios in the Polish telecommunications market. This transformation was completed by the end of Q E x e r c i s e o f o p t i o n s u n d e r N e t i a s s t o c k o p t i o n p l a n. As at December 31, 2013, there were 7.3m options (net of cancellations) outstanding under the share-based compensation scheme for the Netia Group for the years (the Plan 2011 ), approved by the supervisory board on February 25, Strike prices under the Plan 2011 vary between PLN 4.54 and PLN 6.00 with earliest vesting dates in Of the 3.7m options awarded in 2013, 50% will be cancelled at the moment the shareholders accept the Group s 2013 financial statements, with the cancellation reflecting operational performance versus agreed growth objectives for N e t i a s h a r e s c o n t i n u e d t o b e a c o m p o s i t e o f t h e R E S P E C T I n d e x o f t h e W a r s a w S t o c k E x c h a n g e f o l l o w i n g i t s a n n u a l r e v i e w i n D e c e m b e r The RESPECT Index covers Polish and foreign companies listed on the Warsaw Stock Exchange s Main Market which follow the highest corporate governance, reporting and investor relations standards, and which also include environmental, social and governance factors. The participating companies are screened by the Warsaw Stock Exchange and the Association of Listed Companies (SEG) in a three-stage process of review of all these factors and additionally audited by the project partner since the first edition: Deloitte. Currently, the RESPECT Index comprises 23 companies. 6

7 (b) Guidance G u i d a n c e f o r i s a s f o l l o w s : Revenues (PLN m) 1,735 Adjusted EBITDA (PLN m) 505 Adjusted EBITDA margin (%) 29.1% Adjusted EBIT (PLN m) 75 Capital investments (excl. M&A and integration capex) (PLN m) 200 Capital investments (excl. M&A and integration capex) to sales (%) 11.5% Adjusted operating free cash flow (Adj. OpFCF) 1 (PLN m) Adjusted EBITDA less total capital investments excluding acquisitions and Dialog and Crowley integration related capex The above guidance excludes the impact of one-off integration costs and one-off integration capital investments, estimated at up to PLN 8 million and up to PLN 14 million, respectively. Netia expects 2014 to be a year of consolidation with a focus on providing the foundations for the newly established B2B and B2C Business Units to deliver accelerating performance in future periods. While the Company expects to continue growth in on-net services with broadband, TV and B2B services all registering growth, the short-term priority will be to add additional product features, improve processes and reduce the cost base in order to sell more effectively in subsequent years. Accordingly, guidance is being limited to key financial measures with no RGU guidance being provided. T h e m e d i u m - t e r m s t r a t e g i c f i n a n c i a l g o a l s ( u n t i l ) The Group s medium-term strategic financial guidance, which was put under review in November 2013 at the time of publishing Q results, was withdrawn in February Management will await the results of the next mid-term perspective planning round together with the Company s Supervisory Board and which will be undertaken with key input from the two new, more autonomous B2B and B2C Business Units before deciding on whether to once again issue such medium-term guidance. 7

8 (c) Share price performance Since announcement of the New Netia Strategy in April 2007 through to January 2, 2014, the Netia Group has outperformed the WIG index by 42 percentage points. During 2013, the Company s share price increased by 15.6% whilst the WIG index increased by 6.6%. Moreover, Netia s tender repurchase of 4.15% of its share capital during 2013 represented a further return to shareholders of 35 groszy per share. (d) Conclusion In the view of the Supervisory Board, 2013 was the year when the Netia Group has successfully delivered integration synergies from the Dialog group and Crowley inmarket acquisitions from late 2011 and introduced steps which are expected to provide firm foundations for more stable future performance while operating in an extremely challenging environment for the entire telecommunications market. The B2B segment, a highly resilient free cash flow generator, continued to grow in 2013 in terms of RGUs delivered. The B2C segment made big strides with TV services, which allow Netia to compete head-on with CATV competitors, increasing subscriptions by 52% to 120k by 2013 year end, with 31% of the on-net broadband client base taking TV service from Netia. In addition, the Company continued steady investment in NGA quality networks and can now offer NGA broadband speeds to nearly 1.3m homes passed, up 241k over 2013, with a launch of Netia HFC-based TV services over 400k homes passed in Warsaw and Krakow to come in the course of During 2013 Netia implemented various sales efficiency initiatives under the project 4Sales, including defining new B2B and B2C sales functions. For 2014 the Company has taken this new segmentation a step further with the creation of B2B and B2C Business Units, each comprising sales, marketing, product, customer care and service delivery capability dedicated to serving their target customers and supported by a single network, IT infrastructure and back-office. This new organizational configuration is expected to deliver improved commercial performance for Netia over the coming quarters. The key focus for 2014 will be organization, product, process and cost improvements to ready Netia for steady growth over the long term. With Adjusted Operating Free Cash Flow projections at PLN 305m or 18% of revenue and with leverage going into at just 0.53x Adjusted EBITDA, the Company concluded it can plan for annual distributions to its shareholders of PLN 146m (PLN 0.42 per share) from 2014 and beyond, subject to relevant corporate approvals. IV. Internal audit and risk management system The Supervisory Board continuously monitors the business environment and the management of the Group by the Management Board. The Supervisory Board is directly involved in all decisions of strategic importance to the Company. In order to perform its tasks more effectively, the Supervisory Board has established four standing committees: the Audit Committee, the Nominations and Remuneration Committee, the Capital Investment Committee and the Strategic Committee. 8

9 The duties of the Audit Committee include advising the Supervisory Board on issues of proper implementation of the budget and financial reporting standards and internal audit of the Company and the Netia Group, overall review of annual and interim financial statements, both standalone and consolidated, analysis of the Management letters submitted by the Company s auditors, monitoring of financial information presented by the Company, cooperation with the statutory auditors, internal auditors as well as other units of the Company responsible for controlling, audit, internal control review and risk management. The role of the Nominations and Remuneration Committee is to support the Company s achievement of its strategic objectives by presenting the Supervisory Board with opinions and motions related to the shaping of the management structure, including organization solutions, remuneration system and selection of personnel having the qualifications required to ensure the success of the Company. The duties of the Capital Investment Committee include advising the Supervisory Board on the annual capital investment budget, monitoring investment drivers and expenditure control processes, investment strategies and reviewing capital investment performance against budget. The task of the Strategic Committee is to provide the Supervisory Board with the support with respect to, amongst others, the following issues: areas of future development for the Company, mergers and acquisitions, review of all other areas or matters which have a strategic dimension for the Company. The Management Board generally meets on a weekly basis and closely monitors operational performance of the business and implementation of key projects. Expenditure and investment decisions and products offerings above pre-set thresholds are all taken at Management Board level. Operational authority is delegated to managers on the basis of financial procedures and all authority to represent the company externally is managed by powers of attorney and centrally controlled. The Management Board provides written principles for overall risk management, as well as written policies covering specific areas, such as use of derivative financial instruments, credit risk and pricing risk. The financial risks associated with the use of financial instruments as discussed in Note 4 Financial risk management of the consolidated financial statements as at and for the year ended December 31, 2013, are managed by the Treasury unit under policies approved by the Management and Supervisory Boards. These policies are established to identify and analyze the financial risks faced by the Netia Group, to set appropriate risk limits and controls, and to monitor adherence to those limits. The Risk Management Committee of the Finance Department approves hedging transactions that are subsequently concluded by the Treasury division in close cooperation with other finance and operating divisions/departments of the Company. The Audit Committee of the Supervisory Board receives regular reports about decisions made and hedging transactions concluded. The hedging activities are designed always to reduce the Company s exposure to earnings volatility through changes in exchange rates and interest rates and the Company does not speculate. 9

10 The Internal Audit function plays an important role in assessing the quality and effectiveness of the Netia Group s internal risk management and control system. The Internal Audit division conducted both systematic and ad hoc financial, IT and operational audits of certain divisions/departments within the Company according to the audit plan assigned for The internal audit findings are discussed with applicable management personnel and every quarter the main findings are reported to the Management Board and the Audit Committee. The Management Board is responsible for establishing and maintaining adequate internal control over financial reporting. Therefore the Netia Group has implemented controls to assure that financial reporting is reliable. Those controls are tested and assessed on effectiveness by internal audit, finance department managers and external auditors. For further information see Report relating to Netia S.A. s compliance with the corporate governance rules in 2013 filed together with our annual report. After evaluating the effectiveness of the Company s disclosure controls and procedures as of December 31, 2013, the Supervisory Board concluded that those disclosure controls and procedures were effective and that the Netia Group s risk management system ensured that business risks and opportunities were identified at an early stage and that the Netia Group was in a position to deal with them actively and effectively and the Supervisory Board did not identify any significant deficiencies or material weaknesses in the Company s internal controls requiring corrective actions. V. Evaluation of the financial reports The Supervisory Board of Netia SA, after examining the following documents: 1. the report of the Management Board of Netia SA on the activities of the Company and of the Netia Capital Group in the financial year ending December 31, 2013, and 2. the Company s financial statements 2013, which consist of: a) the statement of financial position with total assets of PLN 3,290,493 thousand; b) the income statement showing a net profit of PLN 30,724 thousand; c) the statement of comprehensive income showing total comprehensive income of PLN 34,409 thousand; d) statement of changes in equity representing a decrease of PLN 107,389 thousand; e) statement of cash flows representing a net increase of cash and cash equivalents of PLN 32,546 thousand, and f) notes to the financial statements concerning the adopted accounting policies, and other disclosures; and 3. the Netia Group s consolidated financial statements for 2013, which consist of: a) the consolidated statement of financial position with total assets of PLN 2,937,636 thousand; 10

11 b) the consolidated income statement representing a net profit of PLN 46,290 thousand; c) the consolidated statement of comprehensive income showing total comprehensive income of PLN 50,007 thousand; d) the consolidated statement of changes in equity representing a decrease of PLN 91,791 thousand; e) consolidated statement of cash flows representing a net decrease of cash and cash equivalents of PLN 30,548 thousand, and f) notes to the consolidated financial statements concerning the adopted accounting policies, and other disclosures; and 4. the opinions and reports of Ernst&Young Audit Sp. z o.o. auditor of the above financial statements, hereby resolves that on the basis of information reviewed by the Supervisory Board, the documents shown above have been prepared in conformity with the books and documents of Netia S.A. and the companies of the Netia Group and that they conform with the actual state of affairs. The Supervisory Board hereby recommends to the Ordinary General Shareholders Meeting to acknowledge the fulfillment of their duties to all persons who were members of the Management Board of the Company in