Global food retail leaders leave it late to set up shop in Russia

Graham Stack for business new europe
With a downturn in the West but the big emerging market countries still booming, Wal-mart et al want desperately to get into Russia, but are finding they have left it late.

At the World Retail Conference in Barcelona on April 9-11, the global retail sector’s biggest annual bash, there was not much of a party atmosphere. Carrefour CEO Jose Luis Duran summed up the prevailing mood by saying, “we are facing the most significant challenge in a generation.”

The only light on the horizon, most participants agreed, were the emerging markets, particularly Brazil, Russia, India and China. Russia is the last of the BRIC countries still lacking one of the big three supermarkets – Tesco, Carrefour and Wal-mart – but participants agreed this wouldn’t likely be for long.

Speculation that one of the big three will set up shop soon in Russia has reached fever pitch in 2008. In January, Carrefour was reported to be looking for a site in Russia’s oil rich Tyumen region – and subsequently the company officially announced plans to open up two hypermarkets by the end of the year. Then in March it was reported that Tesco had been holding talks with Petersburg-based hypermarket chain Lenta. Finally, on April 14, in the immediate aftermath of the Barcelona conference, Wal-mart announced it had appointed the hypermarket-experienced Stefan Fanderl as president of Wal-Mart Emerging Markets-East to “explore retail business opportunities in Russia and neighbouring markets.”

A piece of it

In its recent Global Retail Development Index report, AT Kearney ranked the Russian food retail market as the second most attractive emerging market for investment (after India) for three consecutive years. According to UniCredit research, the Russian food retail market is currently the fifth largest in Europe with a turnover of $193m in 2007 after the UK, France, Germany, and Italy. UniCredit expects the Russian retail market to become the second largest in Europe after the UK as soon as 2011, and to pass the $1-trillion mark in 2013.

So, in view of the current downturn on developed markets, the question for potential foreign investors is not when, but how? And whether through green-field development or acquisition? This is where the head-scratching starts.

Traditionally, the Russian listed retailer segment has been regarded as an M&A play, but Russian analysts are saying – think again. With growth rates of 40-50% per year set to continue in the medium term at least, none of the leading local names are in any hurry to sell out. And with major Russian brands established and growing, and some foreign majors such as Metro and Auchan also in the top 10 and doing very well, for even a global giant such as Wal-mart starting from scratch won’t be easy. As one participant of the Barcelona congress was heard to say: “Is now the time for us to move into Russia? No. The time was five years ago.”

In the words of Andrei Nikitin of investment bank UralSib: “Foreign retailers – Carrefour, Tesco, Wal-Mart – missed the opportunity of large-scale, unobstructed entry into Russia’s retail in the 90s, and now face an uphill struggle to gain entry in a market where domestic players have a strong foothold at national and regional levels. This, coupled with Russia’s inadequate infrastructure, real-estate related challenges, and administrative red tape, makes multinational retailers hesitant of building their own networks from scratch.”

“It’s difficult now to set up on your own,” agrees Alfa Bank’s Vitaly Kupeev. “The market is hot and competition is tough. Magnit, Auchan, X5 – all operate upwards of 20 hypermarkets currently, and the number grows every year.”

The major bottleneck is simply getting the land to build hypermarkets on. And this is means a global giant like Wal-mart will have difficulties setting up large-scale operations straight off. “It’s basically a land grab, with chains trying to acquire as much real estate as possible, trying to grow as fast as they can manage,” says Brady Martin of Alfa Bank.

“Real estate is the major challenge in cities, especially Moscow and Petersburg,” confirms agrees Nikitin. “There’s a deficiency in every class of real estate. You’re not just competing with other retailers, you’re also competing with residential development and office space and hotels.”

Russian bureaucracy, corruption and lack of infrastructure also slow down store openings. Moreover, labour is becoming an increasingly scarce resource as well.

Metro and Auchan, the two global names present in Russia, have done very well, says Brady, but Ikea and Germany’s MediaMarket have had problems related to local conditions. Moreover, according to Alfa Bank research, although French retailer Auchan has exhibited the highest growth of the top -10 retailers at 80%, jumping to the fourth-largest player as of end-2007, many Russian players have demonstrated similar growth rates, and in absolute terms Russian players continue to dominate the growth of the market. Despite being the largest player in the market, X5 Retail Group had the highest growth rate of all the top-10 players 2007.

So Russian retailers are no walkover. Bu but neither are they are a sellout either. The gist of a slew of recent report is that, with cricket score growth rates set to continue, none of the Russian leaders are interested in selling in the immediate future. “Why would anyone sell when they are growing at 50% per year?” asks Alfa’s Kupeleev. An Alfa Bank report published April 16 found that, “in our view, sale to a strategic investor is probably top of the list on the long-term exit strategy for owners of Russia’s largest retail chains. However, as long as the companies are able to sustain growth in excess of 40%, we do not feel that the majority shareholders of these assets will be in a hurry to sell.”

The other drawback to acquisition is that the Russian food retail sector is still hugely under-consolidated – both in terms of traditional formats such a small shops, markets and kiosks still counting for 70-80% of the total market, as well as within the 20-30% supermarket segment, where even major chains do not have market shares of more than 1.5%. “High market fragmentation undermines the validity of acquisition for the sake of market share,” according to UralSib’s Nikitin. Basically, you don’t get much market share for your money.

The two companies most often touted as potential Wal-mart targets are market leader and listed company X5, and St Petersburg-based non-listed Lenta, According to Uralsib’s Maria Startseva, however, X5’s management stated recently that the company, owned by Alfa Bank, might indeed be sold to Wal-mart, “but at the earliest within 20 years.” Wal-mart have said they might take a minority stake in a Russian company, and in February the owners of a 21% stake in X5 said they were interested in selling it. But Kupeev argues the stake is too small to make much sense for Wal-mart, and the deal would need to be approved by majority shareholder Alfa Bank, “and that will never happen.”

Analysts, therefore, regard non-listed companies, especially Russia’s fifth largest Lenta, as being the most likely candidates for acquisition. Lenta is known to have held talks with both Wal-mart and Tesco.

However, the problem with such companies is lack of transparency, according to Kupeleev. “Lenta don’t even publish their IFRS figures.” Such lack of transparency deters potential investors. Even in the case of Lenta, which counts the European Bank of Reconstruction and Develolpment among its shareholders with an 11% stake, everything is far from sweetness and light. The company’s major shareholders, among whom bizarrely is a US deputy prosecutor from San Diego called August Meyer, are currently at each others’ throats about who has the right to appoint the CEO. A court in the British Virgin Island made a ruling April 15 that confirmed the present CEO, but the dispute looks set to continue – and to hinder any takeover deal.

It can get worse than that. In 2007, UK electronics retailer DSG International, formerly Dixons, called off at the last moment a $1.9m investment into Russia’ leading electronics chain, Eldorado, due to concerns about “political, economic and corporative risks.” They obviously did their due diligence well, because on March 4 Eldorado was raided by Russian police, and two days later presented with a $327m back tax claim. This episode followed a tax raid of leading cosmetics purveyor Arbat Prestige in January that led to the arrest of its owner, together with a notorious international mafia boss, Semyon Mogilevich, whose wife turned out to be a major shareholder in the company.

This succession of raids is no coincidence: Russia’s tax service have publicly stated they are launching a crackdown on the retail sector, which they see to be a major transgressor of tax and customs laws. Further such developments are expected – and potential investors are hardly amused. So that could mean another option gone for global retailers looking to move into Russia big-time.

The most likely remaining option for the big names is that which Carrefour is pursuing: patiently put together an extensive land bank, open hypermarkets one by one as you can, and play a long-term game. But such a long-term strategy is too late coming to counteract the downturn on developed markets.

Russians gobble up European companies

Graham Stack for business new europe

It is hard to get alarmed by investors buying into tour companies, however big, but Germany’s influential Der Spiegel nonetheless rang the alarm bells when Russian steel oligarch Alexey Mordashov recently bought 10% of tourism giant TUI. But while a spate of acquisitions in Germany and Switzerland by Russian oligarchs is triggering paranoia about attempted political influence, Russian firms are more focused on conquering their domestic market – by buying up Western expertise and technology.

“What do the Russians want? Profits or political influence?” screamed Der Spiegel, before going on to accuse Russian investors of running a “simple plundering scam.” Describing in lurid tones the “fairytale riches” of Mordashov and his colleagues, the magazine concluded that, “they cannot find any profitable investment opportunities in Russia, so they are coming to Germany. The ruble is rolling towards the West.”

Fears that the Kremlin might gain control over German summer holidays were reminiscent of the quip in 2007 that the Russians were claiming the North Pole to control Christmas. A sense of realism returned days later when TUI and Mordashov’s investment vehicle declared they were founding a joint venture in order to tap into the potentially vast and booming Russian and CIS tourist market. Russian firms, it seems, are interested in acquiring technology and expertise to conquer the booming Russian domestic market by importing best practices on a large scale, they’re not looking to create a fifth column in the West, despite what the headline writers say. So far from reflecting a lack of investment opportunity in Russia, as Der Spiegel alleges, the exact opposite is true: such acquisitions directly reflect the massive investment opportunities opening up in Russia, ranging from an underdeveloped service sector benefiting from booming consumption, to upgrading scanty and crumbling infrastructure through generously sponsored public-private partnerships.

Mordashov’s interest in tourism is a reflection of the potential size of the Russian tourism market, and its current fragmentation. While Western Europe’s tourism market is saturated, Russian outbound tourism is the fastest growing in the world. According to the Russian Federal Agency for Tourism, between January and June 2007 a staggering 13.7m Russians went abroad for their holidays, with destinations such as Croatia, Egypt, and Greece growing 130-150% in 2007. Moreover, Russians, with their two-week compulsory break in January when the rest of Europe is back to work, are a tour operator’s dream – and one that Mordashov’s investment in TUI hopes to turn into reality.

Only a few days before Mordashov became TUI’s largest single shareholder, fellow oligarch Len Blavatnik, valued at $7.2bn by Forbes magazine, snapped up a 19% stake in Air Berlin, Europe’s third-largest discount airline with a market capitalization of €506m. Air Berlin is the only one of Europe’s big three budget airlines currently present on the booming Russian aviation market, with flights from Germany to Moscow and St Petersburg. Budget airlines are in their infancy in Russia, but this is another market ripe for growth.

Retooling Russia with European tech

Outside the tourism sector, on March 26 the Russian holding company FLC West, linked to Russia’s state-owned United Aircraft-building Corporation, bought 70% of the Aker shipyards in the German Baltic town of Rostock for €292m. Again, there was nothing coincidental about this purchase. The Kremlin launched a programme to revive Russia’s moribund ship-construction industry in 2007 by uniting state-owned naval shipyards in a holding – the United Aircraft-building Corporation, sister of the United Shipbuilding Corporation. The declared aim of the United Shipbuilding is to refocus state-owned shipyards from naval to commercial shipbuilding. Hopes are pinned on the niche of ice-class shipping – to serve the Russian energy sector’s growing demand for oil tankers, LNG tankers, pipeline-laying ships and supply ships capable of plying the icebound waters of the Arctic.

The Kremlin wants Russian shipyards to corner this market and win what Putin called in his 2007 parliamentary address, “a decent niche on the global market.” And in February 2008, the then-presidential candidate Dmitry Medvedev called on Russian companies “to acquire foreign enterprises both directly and through participation in joint stock capital [and] help re-equip Russian enterprises, enhance their production, diversify investment and gain new markets.”

This is where the Aker shipyards come in: Russian shipyards lag far behind in commercial-use technologies. The Aker shipyards are already producing ice-class dry-bulk carriers for Russian corporations such as Norilsk Nickel, the world’s largest nickel producer. The shipyards produce double-acting cargo vessels, the sterns of which are designed to double up as ice-breaking bows. A pioneering technology specially developed for Arctic shipping – and one now in Russian hands.

The equation is the same when it comes to uber-oligarch Oleg Deripaska’s investment in German-Austrian construction giants Strabag and Hochtief. In 2007, Deripaska acquired 10% of Germany’s Hochtief and 30% of Austria’s Strabag, both construction and infrastructure giants, in anticipation of Russia transforming “into a gigantic building site,” in the words of Deutsche Bank. A state-sponsored infrastructure building programme will, according to First Deputy Prime Minister Sergei Ivanov, be worth a staggering $1 trillion over 10 years. “This country needs everything: roads, hospitals, schools, airports, cars, trains, airplanes,” Deripaska said in a November 10 interview about his European construction industry acquisitions. “There is huge demand, and supply is not coping.”

Russians not welcome – yet

On April 4, the same day Blavatnik announced his acquisition of a stake in Air Berlin, an old friend from his student days, billionaire Viktor Vekselberg, announced he was increasing his year-old stake in Swiss technology concern Oerlikon, in which he first invested in 2007. That year, Renova also bought into Sulzer, the major Swiss engineering company producing, among other things, state-of the-art equipment for the oil industry. Renova is an energy-focused conglomerate with stakes in oil major TNK-BP as well as power generation assets. In a January interview with Russian business daily Vedomosti, Vekselberg put the total investment in Switzerland at $3bn-4bn.

The unexpected double acquisition raised hackles in Switzerland and was challenged in court. When asked by Vedomosti what his motive for investing in Oerlikon was, Vekselberg answered: “to get access to technology that we don’t have in Russia,” especially in the sphere of alternative energies – wind, solar and biofuels. Vekselberg patiently talked down the hostile response to his investment. “No one anticipated the appearance of major Russian investors in one of the historic leaders of the Swiss economy. They asked: ‘and what do these Russians want?’ You have to laugh, but they saw the Kremlin’s hand behind it all. They’re just not used to us – but given time that will change.”

Hardly had the news of Russian oligarchs’ new business operations in Germany subsided, than a new rumour was doing the rounds on April 11: that Russia’s largest bank, Sberbank was poised to acquire Dresdner Bank’s investment banking arm, Dresdner Kleinwort. However, in this case there was hope rather than suspicion in the German reports: Dresdner Kleinwort has been badly hit by the global financial crisis, is wearing a “save me” sign, but has nevertheless been turned down by potential investors such as the Chinese Investment Corp. sovereign wealth fund.

The Russian side, however, was quick to dismiss the rumours. Renaissance Capital’s banking analyst David Nangle says that while it’s obvious that Dresdner Kleinwort is being touted for a sale and there may have been some contacts in this connection with Sberbank, “I’ve been talking with the Sberbank people and there’s simply nothing behind it.”

“Sberbank are looking to add on an investment-banking wing, that much is true, but it’s going to be in Russia where their corporate clients are, of course. Either they’ll buy into a Russian investment bank, or most likely they’ll do it organically,” he says. “Dresdner Kleinwort might be going cheap, but Sberbank is far from going on a European shopping spree without rationale or strategy.”

Mad March for Russian potash sector goes into extra time in April

Graham Stack for business new europe

As commodity prices soar across the board, now even the humble mineral used in fertilizer is having its day in the sun. Potash prices are set to double in 2008 and, yet again, Russia stands to gain big.

It was no April Fool’s joke when on April 1 the world’s major potash trader, Belarus Potash Company (BPC), said it would use the record potash price just negotiated with India of $625 per tonne as its benchmark in upcoming negotiations with the former potash price-maker China.

“We have just reached a price agreement with one of the major world markets, India, two months earlier than planned, because the Indians were so anxious to secure volumes on a deficit market,” boasted Vladislav Baumgertner, CFO of Russia’s leading potash producer, Uralkali, at the 2008 Global Fertiliser Conference in Toronto held on April 2. Uralkali are joint owners of BPC along with Belarussian state-owned Belaruskali. “India paid in 2008 more than double the 2007 price, exceeding even the spot market level.”

All attention is now fixed on China – the world’s largest potash consumer, accounting for 20% of world demand, and traditionally the price setter for Russian producers. No longer. The Chinese are stalling, and living from inventory, but Uralkali are scenting blood and gunning for a huge price increase over and above the price the Indians have just agreed to pay.

“We might not stop at the Indian price, the benchmark for China will be the spot market price,” said Baumgertner. “We are determined to eliminate the China discount,” referring to the pricing power that China has traditionally exerted. “There is only limited product left for China now that India has leapfrogged.”

China successfully employed stalling tactics in 2006, but 2008 is already a very different market. “In 2006, all the world waited for China to conclude; in 2008 no one is waiting,” said William Doyle, CEO of the world’s largest potash producer, Canada’s Potash Corporation, in a panel discussion at the Toronto conference. “China is risking going into 2009 negotiations with no inventory and with the world having no inventory. The Chinese government has missed the signal – current capacity utilization is extraordinary high in the industry. Everyone is running as hard and fast as they can.”

Given that Russia’s potash producers have traditionally been notorious for market dumping of potash, Doyle asked rhetorically why they are now so aggressive on pricing. “The difference is that until 2003 they had excess capacity, now they have full utilization.”

More food

Since 2000, demand for potash has grown by 5% on a yearly basis due to rapid economic growth in China and India. Income growth across wide swathes of these massive populations is causing an increase in food consumption, and specifically in meat consumption – paradoxically requiring a massive expansion of arable farming for animal feed, and also a push to increase yields. Music to the ears of fertilizer producers.

This expansion is going to even accelerate as wheat inventories run low and the wheat supply deficit grows. “The global wheat deficit has been supplied from global inventories for over a decade, and now the inventories are running out. Global grain stocks are at a critical low level. One hitch could be fatal,” warned Mike Wilson, CEO of Agrium, a leading global fertiliser trader, at the same conference.

Potash will be on the frontline of any struggle to increase production. “Chinese farmers have historically used too little potash in their fertilizer combination,” said Harry Yang, executive director of China’s fertilizer importer Sinofert Holdings. “They will have to increase this.”

But the growth rate of China’s potash demand, forecast to average around 4.6% per year through 2010, is now currently being outpaced by both India, where potash demand grew about 13.5% in 2007, and Brazil, where market growth was 11.5% in 2007. Indeed, according to Marina Alexeenkova of investment bank Renaissance Capital, “the fact that Uralkali can reallocate products to other markets in the current environment increases the chance that the new pricing level for China will be much higher than we expect.”

Just as demand for fertilizers seems to be expanding on all sides, the supply structure is uniquely concentrated and inflexible – with a structural supply deficit of approximately 1m tonnes over the next five years. Only three countries – Canada, Russia, and Belarus – hold 85% of the known world reserves. Just two international syndicates fix the trade price of most of the product – Canpotex for the North American producers and Belarus Potash Company (BPC) for Uralkali of Russia and Belaruskali of Belarus. There are no upcoming green-field developments and building a mine together with rail and port infrastructure is a hugely expensive and complex undertaking. “If you’re not in the business already, you’ll get nowhere,” said Doyle.

Moreover, as Baumgertner pointed out, potash is a unique product: “an absolutely must-have product with no known substitute.” Plants must have potassium, and there is no industrial manufacturing process for potash. So it is no exaggeration to say that the planet’s future food supply security depends on a handful of mines in Russia, Belarus and Canada.

Extra time

So the stage was set for high drama at the March 23 auction of licences to four potash deposit at the Verkherkamenskoe field in the Perm region, where’s Russia’s potash industry is located. It was billed as the largest-ever international auction of potash deposits. “We are offering 40% of the world’s proven and untapped potash deposits for sale,” Andrey Belokon, head of the Russian Federal Subsoil Agency’s branch for Perm region, told the press at the time. It will take a decade before mines are opened, but when they do the field could boost global potash supplies by 9m-10m tonnes per annum, about the total volume produced in 2007 by Russia’s leading producers – the Perm region’s Uralkali and Silvinit.

Five companies – Uralkali, Silvinit, Acron, EuroChem and UralChem – submitted 21 bids for the three lots on offer: the large Polovodovskoye site, the Talitsky deposit and the smaller Palashersky and Balakhonsevsky sites, sold as one lot. It would have surprised no one if Uralkali, the world’s second-largest potash producer by reserves, had made a clean sweep of the auctions, not least because, along with Silvinit, it already mines the Verkhakamenovoskoe field and has all necessary infrastructure in place. Uralkali is also flush with cash after an IPO of 14.2% on the London Stock Exchange in November 2007 raised over $1bn. But nobody expected that global player Uralkali – which through BPC is a global market setter – would walk away from the mega-auction empty handed.

Competition was intense, with licenses being sold for 20 times the starting price – and the overall winner was Silvinit, Russia’s second-largest producer. Silvinit, as 40% partner in a joint venture together with Lanta bank and state-owned titanium producer VSMPO Avisma, offered an enormous $1.4bn for the licence to the largest Polovodovskoe deposit. Uralkali refused to bid over $800m. Marina Alexeenkova explains Silvinit’s readiness to go to the wire by it being “a life or death” situation for the company. “Silvinit has a restricted reserve base, and is dependent on one mine. The 3bn tonnes would secure supply for the future and turn Silvnit into a growing company. The Polovodoskoe licence simply had crucial strategic value for Silvinit, more than for Uralkali,” she says.

Uralkali strikes back

The rivalry between Uralkali and Silvinit goes back to Soviet times when in the mid-1980s they were split up after being originally one company. Their mines are situated only 30 kilometres apart, but they have never been good neighbours.

Privatization in the first half of the 1990s resulted in a stalemate, with former local doctor Dmitry Rybolovlev taking control of Uralkali, but only securing a minority stake of around 20% in Silvinit, with his partner Yury Shvetsov securing just under 5%. Ever since, the two have been set on controlling Silvinit and eventually merging the two companies back together.

The ensuing fertilizer wars of the 1990s even saw Rybolovlev and Shvetsov sit out a year in pre-trial detention on charges of organizing a contract killing. They were subsequently cleared of the charges, and Rybolovlev claims the affair was an attempt to pressure him into selling Uralkali.

So Silvinit’s auction win in April might have tasted especially bitter for Uralkali, since the massive deposit could secure Silvinit’s future as an independent company. Uralkali initially put a brave face on it, saying it had demonstrated good financial discipline to its post-IPO investors in limiting the price it was prepared to bid. Then came the sting: Ryblovlev and Shvetsov declared that they would use their blocking stake at the upcoming Silvinit emergency general meeting on April 19 to block ratification of the huge loans that Silvinit needs to finance the licence purchases. If they succeed in doing so, the licences will automatically go to the runners-up at the auction, namely Uralkali.

As Baumgertner declared at the conference in Toronto: “If Silvinit is not able to pay, then the auction commission will decide second place Uralkali is the winner, so Uralkali will take the deposit.”

Beyond this point, the devil is in the details. Silvinit claims that the separate licences acquired at the auction constitute separate, smaller expenditures each to be ratified respectively by only 50% of shareholders. Uralkali are saying that 75% of the EGM should ratify, but won’t. Silvinit has offered to buyout Uralkali’s stake, but Rybolovlev is not selling. In questions following his presentation in Toronto, Uralkali’s Baumgertner even declared boldly that, “We are convinced that sooner or later all the Verkhoamenskoe deposits will come under our control.”

Potash may not have the cachet of gold or oil, but the money invoved is still huge so expect another vicious Russian corporate battle to control the mineral.

A Renault u-turn urgently needed as Russia outgrows Avtovaz

Graham Stack for business new europe

Four months after the sensational announcement that turnaround experts Renault would become strategic investors in Russia’s Soviet-era car giant Avtovaz, analysts are hoping the company will now unlock a new class of low-income car owner.

It had been a long time since the producer of Lada cars, traditionally associated with gangland slayings and financial manipulation, made positive headlines, but December’s news that Carlos Ghosn’s Renault would take a 25% stake in Avtovaz caused a stir. The match between Russia’s ailing un-restructured car giant and Renault’s legendary turnaround star Ghosn, the man who single-handedly rescued Japan’s Nissan from the verge of bankruptcy, seemed perfect. Could he do the same this time, or had he bitten off more than he could chew?

“I was absolutely astonished. I refused to believe the reports, thinking the story was just groundless rumours, until it was confirmed officially,” is how Trust investment bank’s automotive analyst Aleksandr Yakubov recalls his surprise.

The surprise was all the greater because Avtovaz had been effectively renationalized in 2005, in a quite bizarre form: Russia’s state-owned arms exporting monopoly Rosoboronexport (ROE) had taken control, dislodging the previous management who controlled the company through an opaque system of cross-ownership by subsidiaries, and sending in whole battalions of riot police to expel criminal gangs from the premises.

Since ROE favours a policy of consolidating companies in sectoral holdings under state ownership, there were suspicions that moves were afoot to set up some national automotive corporation together with truck producer Kamaz and other Russian producers – and call on state funding to re-launch the Russian car industry. So it was a welcome surprise when ROE saw the light and called in Renault – banking $1bn for a 25% stake that had cost them a fraction of that.

While the ROE decision was surprisingly enlightened, analysts wondered about whether the same was true of Renault’s involvement in the troubled car giant. With only a 25% stake, how could they hope to turn the company around? Renault simply referred to the fact that they had bought into the biggest brand on what will very soon be Europe’s biggest market. And that it was very much the “people’s car” brand they were interested in.

Europe’s largest car market

With the value of Russia’s car market growing 57% in 2007 to $53.5bn, making it set to overtake Germany to become Europe’s largest in 2008, Avtovaz, Russia’s dominant car producer with 24% of the market, should be looking up.

Purely in volume terms, the market increased 36% on year to 2.75m cars, according to European Intelligence Unit. And growth is set to continue, driven by surging disposable incomes, which have increased twofold since 2000, and are currently growing at 10% on year. And a new wave is already breaking, with a surge in auto loans facilitating car purchases. Over 2002-2006, the proportion of new cars purchased on credit exploded from 7% to 42%. According to Autostat estimates, in 2007 new car credit grew 89% on year to $17bn. “Already in the near future,” says Renaissance Capital’s transport analyst Eduard Faritov, “this proportion could reach the European level of 60-80%.”

But this will still be just the tip of the iceberg: car penetration in Russia, despite a two-fold increase since 1993, is still astonishingly low. Even after a decade of strong growth, there are only about 185 cars per thousand people in Russia, compared with 205 per thousand in Central Europe, and dwarfed by the 450-600 per thousand level common in Western countries. And, according to Faritov, half of that car fleet is older than 10 years and in urgent needing of replacement.

All this of course looks like great news for Avtovaz – only it isn’t. While Avtovaz initially capitalized on Russia’s rebound after 1998, boosting production substantially through 2001, subsequently its sales stagnated. Why?

The Russian market is simply outgrowing Avtovaz, say analysts. “The market structure has changed dramatically, and is continuing to change dramatically,” says Faritov. “The structure of demand has shifted away from cheap cars. The average car price is now $20,000 – twice that of 2002. Lada cannot capture this demand.”

Yakubov agrees. “Avtovaz is looking very vulnerable. Higher incomes in Russia combined with retail credit and car loans are paradoxically translating into lower sales for Russian-made passenger cars – and Avtovaz, in contrast to the other Russian automotive producers, is completely exposed to the passenger car market.”

According to Renaissance Capital, the largest price segment in value terms is now the premium car segment (over $40,000), amounting to $10.9bn, or 20%, of the total passenger car market. The value of the $20,000-plus market is now larger than that of the sub-$20,000 segment. The shift in market structure is exemplified by the shift from used-car imports to new imports as the main alternative to Russian production. The new imports segment has grown at almost 70% per year over the past five years, increasing to more than 61% of the total market in 2007, from 17% in 2001. In 2002, used-car imports formed the largest segment in value terms ($4.8bn), followed by Russian cars ($3.6bn) and new imports ($2.3bn). By 2007, the situation had reversed: new imports segment ($32.8bn) had become the leader, followed by Russian-made foreign brands ($7.62) and used imports ($4.9bn).

If this was not alarming enough for Avtovaz, a government programme to boost foreign-branded car production took off in 2002, causing foreign-branded production in Russia to rocket 24 times. By the end of 2007, there were nine plants either running or planned in Russia, with total investment at more than $3.7bn. Total foreign-brand production is slated to reach about 1.46m units per year by 2010.

In response to this flood, Avtovaz has taken its finger out – but only to stick it in the dyke: previous Soviet-era management under Vladimir Kadannikov mostly limited itself to upgrading existing models, laying a Western veneer over the Soviet soul. “Avtovaz basically has not produced a new model since the 1970s,” says CentreInvest’s Natalia Sorokina. “And if things go on like this, it’s future might well be just assembling components.”

Renault’s revolutionary sLogan: “cheap but not crap”

In the face of these changes that threaten to shunt Avtovaz’s “cheap and crap” cars to the scrapheap, what does Renault think it can change?

True, managerial guru Carlos Ghosn turned Nissan around spectacularly, but as he himself admits, Nissan was the complete opposite case to Avtovaz, being a company with solid engineering traditions whose costs had spiralled out of control during a domestic recession. The key to understanding Renault’s interest in Avtovaz is not Nissan, but Romania’s Dacia plant that Renault acquired in 1999 – and the Logan model launched there in 2004, of which 600,000 have already been sold. The new business model behind the Logan could be the lifeline Renault throws to Avtovaz.

The Boston Consulting Group highlighted the Logan in a report named, “Tapping into Central and Eastern Europe’s 200m Neglected Consumers.” Boston calculates that 200m of the region’s 350m people live on incomes above the poverty line and below median household income. Together they account for half the region’s disposable income, and conscientiously by multinationals – until Renault’s Logan came along.

Promoted as the €5,000 car, the Logan made car buyers of income groups that producers had not previously considered potential customers. In a region characterized by low levels of car penetration, the Logan significantly dropped the market entry level, creating a new class of low-earning car owners.

The secret of the Logan’s success is that, in contrast to Lada cars, it’s cheap, but not crap. The design has economized on electronics and soundproofing, making the ride and driving experience less comfortable, but not compromising reliability. Cutting out much of the electronics even boosts reliability and ease of servicing. The Logan is also better adapted to Eastern European roads, thanks to a high chassis, and its engine is adapted for poor quality fuel. Basically, the Logan cuts costs by cutting elements that are anyway dubious in the Eastern European context.

Costs are also kept down by low-tech assembly lines that demand little initial investment. The Romanian Dacia plant hardly uses robots, as the cars are pieced together largely by hand. Wages are low, but the workers of the former obsolete state-owned giant are happy that their jobs have been saved. This strategy is tailor-made for such obsolete socialist giants: because the margin on such a cheap model is so small, and investment to be kept minimal, the strategy demands pre-existing large production capacities, a pre-existing dense dealership network, and a pre-existing established “people’s car” brand. Dacia had all three of these – and Avtovaz all the more, boasting production capacity of 1m vehicles per year, a dealership chain stretching from Lvov to Vladivostok, and a brand that is folklore in Russia.

So what Renault offered Avtovaz was the managerial knowledge of how to create a Russian Logan at Avtovaz – and with it a whole new class of low-income car owners.
And in March 2008, the two sides agreed the appointment of four influential Renault top managers to Avtovaz: Yann Vincent, as managing director; Kristian Muller, as senior vice president and procurement manager; Hugh Demarchez, as vice president; and an unnamed financial control manager.

However, Renault will not just be providing philosophy lessons, but also supplying technology for implementation. As CEO Ghosn said in an interview with business daily Vedomosti in March: “Costs are not the main problem. Avtovaz’s main problem today is the medium-term and long-term attractiveness of its production line. The plant needs a new platform, engine and transmission. This is where we are ready to help. Our main task is to support the Lada brand and help it retain its leading role in Russia.”

The big secret is what Lada’s new budget car, planned to replace its Classic model in 2009 and the lynchpin of the strategy, is going to look like. Avtovaz CEO Boris Alyoshin let slip that it will have a Lada platform, but the power-train will probably be supplied by Renault. As such, the car will be distinguished from the Logan, of which a Moscow-based joint venture produces 70,000 a year, but have enough of Renault’s engineering to constitute a new word in quality for a Lada car. Alyoshin has said the details of Avtovaz’s new Renault-supported strategy will be finalized and made public in May or June. Only then will it become clear just how much influence Renault is going to exercise.

Analysts were mystified as to why Renault was ready to get involved when only a blocking stake was on offer. “I just don’t know why Renault bought a blocking stake that gives them so little influence,” says Faritov.

“Control was never an issue,” explains Sorokina. “It was always clear that Avtovaz would retain control; the issue was which European partner would be chosen.”

The answer may be that ROE’s crisis management at Avtovaz, which had taken the first long overdue steps towards controlling costs and initiated reshaping the ownership structure, was able to assure Renault of its commitment to reform. Immediately prior to the deal’s announcement in December, the ROE management’s political weight was upped a notch, with CEO Vladimir Artyakov being appointed governor of Samara region, and government heavyweight Boris Alyoshin, formerly head of the Federal Industry Agency, taking over himself as the new CEO at Avtovaz. This means that Avtovaz management has the authority to implement whatever strategy is decided upon – and if they buy into Renault’s strategy wholeheartedly, the chances of its successful implementation are good, even if Renault only has a minority stake.

However, one measure that Renault used to good effect at Dacia is unlikely to be replicated at Avtovaz – job shedding. “Avtovaz has a workforce of 104,000,” says Faritov, “and produces only twice the number of cars as Toyota does with a tenth of that number.” However, analysts are certain that no sweeping job cuts are on the cards. “Avtovaz basically employs all of Toliatti,” says Trusts’ Yakubov, “and now as a state-run company, the political costs of laying off large numbers of workers would be enormous.”

But there is a workaround solution that seems to be on Renault’s mind, and would leave everyone happy. “Sooner or later,” Ghosn told Vedomosti, “we will start using some of Avtovaz capacities for our own production.”

House hunt for Red October

Graham Stack for business new europe

The Red October Chocolate factory is an icon of the Soviet-era. For more than 30 years Russian children have grown up craving Alyonka chocolate bars, the factory’s flagship product, and the chubby face girl on the wrapper is one of the best known faces in the country. But at the end of the 2007, the owners of the factory caved into temptation: situated on one of the most desirable locations in Moscow, they decided to close its doors and redevelop it as top-end residential apartments that are sure to sell for millions of dollars a piece.

The landmark redbrick building is perched on the Bolotny Island in the middle of the river Moskva. It is a short walk from the Kremlin and overlooks the rebuilt Church of Christ the Saviour cathedral on the opposite bank. Locations in the poorly supplied heart of Russia’s capital don’t get better than this.

With property prices soaring to astronomical levels over the last five years, the factory owners, Russian conglomerate Guta, decided to move the chocolate operations to the city’s outskirts and convert buildings and grounds into a luxury residential complex where prices are rumoured to reach $32,000 per square metre (sqm). The three main redbrick buildings and the famous chimney will remain, while 30 other buildings that have accumulated on the territory over decades will be razed to make way for new developments.

Internationally renowned architects are contributing to the factory conversion, where the most prestigious properties will be loft apartments created from the spacious top-floor production halls: boasting huge windows that afford a magnificent view across the river and of the Kremlin. “After such a long time in coming,” says Ekaterina Thain, director of residential department at Knight Frank Moscow, a consultant to the Red October redevelopment project, “finally sales will be starting next year. There has been a lot development for the high end of the market, but these buildings will be a chance to buy a little bit of Soviet history too. They are unique in the city.”

Bottomless pit

Property prices have soared across all of Central and Eastern Europe in the last two years and were up by just under a quarter in Russia, one of the fastest growing markets in the region. While the Red October development makes the headlines, it’s the emerging middle class that’s the driving force behind a booming residential property market. “Growth in 2006 was simply astonishing,” says Renaissance Capital real estate analyst Alexei Yazykov. “We’re talking about more than 100% over the year in Moscow.

The capital has led the market, but in the last year the regions have joined the fray and prices in all the millionki – the 11 regional cities in Russia with populations of more than a million people – are now close on the capital’s heels. Prices in northwest Russia rose 76% in 2006 – St Petersburg, Russia’s “other” capital, also saw prices double – and homes in the Volga Region saw their value jump 84%, according to Renaissance Capital.

The leap in prices is being driven by powerful GDP growth and rapidly rising incomes. Between 2004 and 2007, Russia’s GDP growth averaged 7% per year and the growth is still accelerating: the Russian economy expanded by 7.6% in 2007, although the brouhaha on international credit markets is expected to the edge of growth in 2008, which is forecast at 6.7%. At the same time, real incomes have been increasing by an average of 12% over the same period and were up by 20% over 2007, according to official preliminary estimates. Put another way: when the late former president Boris Yeltsin stepped down in 1999, most Russians were earning $50 a month; after eight years under President Vladimir Putin they are earning $500. Since 2001, they have access to credit too, meaning whole swathes of the population have crossed the threshold where they can consider buying new apartments.

Counter-intuitively, the fact that 65-80% of the population already owned their own apartments, thanks to the free-of-charge privatization of the 1990s, simply fuelled the explosion in demand. “High level of home ownership has created seed capital allowing people to continuously trade up,” explains Alpha Bank’s real estate analyst Brady Martin.

The Soviet legacy of pitifully undersized apartments means that Russia’s housing stock is around 21 sqm per capita – lower than CEE peers such as Poland (23 sqm) and considerably lower than Western Europe (with an average of 36 sqm in the EU capitals). “It is hard to get your head around just how short the supply of accommodation in Russia is,” says Roland Nash, head of research at Renaissance Capital. “But to increase the average living space per person in Russia to just the average enjoyed in Moldova – an economic basket case – would require the construction of the equivalent of two cities the size of Moscow.”

And most people don’t want to buy many of the apartments that are already there. According to Jones Lang LaSalle, over two-thirds of Russia’s housing stock is over 30 years old, and an astonishing 60% requires renovation – 15% is in critical condition and 12% is officially considered uninhabitable. The upshot is that although the majority of Russians own their apartments, virtually no one is happy with them, creating a powerful upward draught that is fanning the flames.

This huge pent-up demand and lack of supply has sent the real estate market spiralling upwards since about 2003, when the mortgage industry really started to take hold. Price have increased 10-fold in the last decade, but the difficulty in obtaining mortgages eventually put a ceiling on the market 2006. “Prices simply rose to a level out of reach of all but the most wealthy citizens,” says Yazykov, “and so they could not go any higher.”

The meltdown of the US sub-prime market has also been a drag on price growth, which slowed sharply in 2007 – especially in Moscow. Many banks have been financing their mortgage programmes with international borrowing and securitizations of mortgages were just appearing. As liquidity on the international credit markets evaporated, Russian banks have been cut off from their favourite form of refinancing loans, which has put the squeeze on property prices, which plateaued in the second half of last year.

Supply splutters

Russia’s residential property market has paused for breath, but most analysts believe the stop will be temporary; continued upside in residential real estate is supported by a severely underserved market and supply side bottlenecks. “There’s definitely been a construction boom here, but even with this boom supply is far short of demand. To give you an idea of the extent to which the market is under-supplied, independent bodies such as the Institute of Urban Economics and the Institute of Urban Land Development estimate the demand for residential properties at 1.2bn sqm. This is a massive amount. At present construction rates, it would take 20 years to fulfill. In terms of just residential stock, this is five cities the size of Moscow,” says Yazykov of Renaissance Capital.

Paradoxically, for a country as vast as Russia, the chief bottleneck is lack of land plots, or rather of plots with sufficient infrastructure to permit development. Where there are no access roads, water or power supply, development becomes prohibitively expensive.

Supply has also been restricted by recent regulatory measures. In 2005, a new housing code came into force that toughened requirements for developers to raise funds from the population. “There’s been more control of residential construction, after local investors got ripped off,” explains Martin. “Previously, developments were funded by presales, even before development even started, and sometime even before obtaining planning permission. Now the new law says you have to start construction before you can start presales.”

However, the tightening of regulations benefits overall transparency and public confidence in the sector. The consolidation it stimulated in the sector also benefits foreign investors looking for respectable and stable partners to develop with or to invest in.

A second regulatory issue is currently deterring foreign investors from the massive Moscow real estate market: the total absence of freehold in Moscow. The city owns the land and makes it available only on long-term lease. This gives city hall enormous bargaining power, which it uses to claim the “the city share” of any development: developers must either transfer apartments to the city for social needs, or build infrastructure for free.

While it remains difficult for international developers to make headway in Russia, Russian developers have internationalized in a big way latterly and raised capital with a slew of IPOs in 2007. “Many companies own development rights,” explains Alfa’s Brady, “but still have no core portfolio yielding properties, so they cannot raise debt. That’s why they are so enthusiastic about equity.”

Russian real estate companies raised $8bn over 2006-2007, exploding from two or three traded companies to 15, including the CIS countries. Most of these companies trade on the London Stock Exchange’s Alternative Investment Market with mixed results.

Another round of real estate IPOs is on the cards for 2008, predicts Brady. Following the US’ sub-prime debacle, other channels of raising finance have closed. Debt for development appeared in 2006 and financing in euros was becoming available at single-digit rates, with amortization terms for 10-20 years. Now rates are back at 14-15% and the maximum loan-to-value available has dropped to 60%.

Moscow is the new London

“Luxury doesn’t care about anything. You know, they say many non-domiciles in London are currently looking for another location, because it is so expensive. The exception are the Russians, who are simply happy to live in a city less expensive than Moscow,” laughs Yazykov.

While it is an exaggeration to say Moscow is more expensive than London, Knight Frank calculates the super-prime property price growth in Moscow in 2007 reached 40.9% and is set to reach London levels within 10 years. “This will continue,” says Knight Frank’s Thain. “The real centre is very restricted in Moscow, and construction is getting smaller and smaller from year to year. There are no more Red Octobers out there. There is no doubt top end is soon going to be close to London prices.”

The recent Wealth Report published by Knight Frank and Citibank Private states baldly: “We forecast that within 10 years, Moscow will vie with London for the most expensive city in the world. While the prime area of the city will be much smaller, the prices achievable for new build prime developments will be comparable. There is huge demand for prime property in Moscow owing to little existing stock and a very small potential pipeline of additional prime property.”

In fact, the London and Moscow markets are already increasingly intertwined. “We have really, really strong connections with our London office,” explains Thain. “Russians are buying a lot of properties in London. In fact, we do not just sell luxury apartments and luxury housing in and around Moscow; we are famous here for also selling apartments and houses in London to Muscovites. Wealthy Russians want firstly an apartment in the centre of Moscow, where their business is; secondly a country house; and then their third location will be in London for sure. Their fourth and fifth locations are summer houses in Italy or France.”

Global real estate players have come in droves to Moscow over the last few years to cater to this burgeoning business. In 2006, Morgan Stanley real estate investment fund made their first investments in Russia, snapping up a 15% stake in RGI International, a developer of elite residential in Moscow, and a 10% stake in Moscow’s R.E.D, developing mostly commercial and some elite residential. In March 2007, Morgan Stanley took a 25% stake in St Petersburg-based RBI Holdings. Deutsche Bank’s real state investment arm RREEF is also involved in prime residential development, and a slew of other funds are following in their wake.

Cushman and Wakefield Residential has been present in Moscow since mid-2006, and is now starting to reap the rewards of the decision. “What we do is arrange investment deals, sometimes we are representing landowners, sometimes investors who want us to find something for them. It’s mostly foreign investors interested in new developments and redevelopments. Most investors we work with are international real estate funds,” Christer Lystad, head of Cushman and Wakefield Residential in Moscow, explains. “Most of these are joint ventures with Russian companies doing the development and international investors contributing the finance, with plans and designs done jointly.” Lystad says projects currently bring a return on investment of over 50%, and earn yields of 7-10%.

The biggest deal Lystad stitched together to date has been a luxury residential development based on the Otrada Equestrian Club in Moscow. Lystad persuaded Orco Group’s Endurance Residential Subfund to invest $200m in the development. Otrada Equestrian Club is home to some of the country’s pre-eminent polo events such as the Rolex Polo Cup, the Moscow Polo Cup and the Russian Polo Cup. The sporting theme is one dear to Lystad’s heart – he has himself been a professional sportsman in both his native Norway and in Moscow, where he played the outdoors form of ice hockey called bandy.

Lystad says a number of similar elite residential complexes are in the pipeline for 2008 – and, not coincidentally, they mostly come equipped with top grade leisure and sports facilities such as fitness studios. Cushman and Wakefield also facilitated the development of the Mayak yacht club in its picturesque riverside surroundings on the outskirts of Moscow.