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McDonald’s Russia: A Jewel in the McDonald’s Emerging Market Operations? McDonald's Corporation is one of the oldest chains of quick service restaurants in the world and the largest. It was started in the late 1930s by two brothers Richard and Maurice McDonald in California, the US. Within a few years, the chain had become quite popular and it started to grow in numbers. The founders started to franchise out the stores to other partners at a premium price. In 1967, it started its international expansion for the first time by entering Canada and subsequently ramped up its presence in other international markets. McDonald's opened its first outlet in Russia in 1990. It entered at a time when the country was still struggling to gain political and economic stability after reforms had been introduced. It started by developing the food processing unit and training the local suppliers. McDonald's became an instant hit in the country where the culture of fast food was as new as the burger. The company experienced many obstacles along the way but it continued its slow and steady growth in the country. As of 2010, Russia was one of its key markets in Europe and some experts considered it as the jewel in McDonald's system. The case details the difficulties McDonald's had in entering the country and discusses how it overcame various challenges to establish itself firmly in the market. It discusses in detail some of the strategies adopted by McDonald's in Russia, including HR strategies, procurement strategies, expansion strategies, etc. that helped it gain a strong footing in the Russian market - so much so that the company accounted for more than two-third of the fast food market in Russia.

McDonald’s Russia: A Jewel in the McDonald’s Emerging Market Operations? “We are not afraid of competition. The market is still in the making and one who takes right decisions at the right time will be the leader. We did it 20 years ago… When we saw the first queues that were lining up to our first restaurant in Moscow every day and night all year round, our success was predetermined and all we had to do was to develop as fast as possible.”1 -

Khamzat Khasbulatov2, McDonald’s Corporation, president for Russia and Eastern Europe, in December 2009.

“Of the 118 countries where McDonald’s Corp. does business, none can boast more activity than Russia. On average, each location serves about 850,000 diners annually -- more than twice the store traffic in McDonald’s other markets. That has presented the world’s largest restaurant chain with an unusual dilemma. Russia, with its burgeoning middle-class and consumer appetites for all things American, is a jewel in the McDonald’s system.”3 -

- The Wall Street Journal, October 16, 2007.

Introduction The year 2008 was considered a landmark year for the world‘s largest fast food chain, McDonald‘s Corporation (McDonald‘s). While many companies, cutting across industries, were caught in the grip of the global economic recession, the fast food chain registered record performance. ―[…] 2008 was a banner year for McDonald‘s. Revenues increased to a record $23.5 billion … global comparable sales increased 6.9 percent, and we marked our 68th consecutive monthly increase … operating income and earnings per share rose 17 and 15 percent, respectively (excluding the 2007 Latin America transaction) … and we returned $5.8 billion to shareholders through share repurchases and dividends paid. These financial results are among the best in our Company‘s history,‖4 said Jim Skinner, Vice Chairman and CEO, McDonald‘s. The company‘s European operations accounted for 42% of McDonald‘s total revenues. According to the company, McDonald‘s had registered sound growth in Europe in 2008, and this growth was spurred by performance in countries such as France, the UK, Russia, and Germany. The company also posed strong results in 2009, with these markets spurring the growth.5 McDonald‘s had started investing in

1

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4 5

Maria Kiselyova and Maria Plis, ―McDonald‘s to Target Stay-at-home Russians,‖ www.reuters.com, December 17, 2009. Khamzat Khasbulatov was one of the four managers for the first outlet of McDonald‘s in Russia. He was named to McDonald‘s top Russia position in 1999 and later took on the responsibility for the company‘s Eastern European restaurants. Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007. ―McDonald‘s Corporation, 2008 Annual Report,‖ www.mcdonalds.com ―McDonald‘s Delivers Another Year of Strong Results in 2009,‖ www.chainleader.com, January 25, 2010.

327

International Business Russia (then Soviet Union6) in the late 1980s and had ramped up its presence through the 1990s and early 2000s despite facing some serious challenges. Some experts felt that Russia was the company‘s best performing market in Europe and one of its best performing markets in the world in 2009.7 As of early 2010, McDonald‘s dominated the Russian fast food market with a 70 percent market share.8 ―Out of 10 people who enter a food court, six go to McDonald‘s,‖ 9 said Mikhail Goncharov (Goncharov), general director of the Teremok fast food chain. McDonald‘s came into being in the late 1930s as a hot dog stand set up by two brothers Richard McDonald and Maurice McDonald in California, the US. It started its international expansion in 1967. McDonald‘s opened its first outlet in Russia in 1990, more than a decade after it had planned to enter the country. The entry was led by George Cohon (Cohon), founder of McDonald‘s Canada operations, who had been striving to enter the country since 1976. The company faced several challenges in the country, primarily due to the bureaucratic set up, strict laws, inability to convert the Russian ruble10 into other currencies, and economic instability. According to analysts, McDonald‘s faced the challenges successfully and developed its own supply chain in Russia, bringing in experts from other countries. In order to standardize its services, it gave importance to the training and development of its work force. The number of stores kept on growing at a slow and steady pace in the 1990s and early 2000s. In 2005, McDonald‘s Russia emerged as the second largest among McDonald‘s markets in terms of average number of consumers per restaurant.11 From 127 stores in 2004, the company had opened multiple numbers of outlets each year. In 2007 and 2008, it also invested in overhauling the existing stores, with investment worth US$ 500,000 on each store.12 Khamzat Khasbulatov (Khasbulatov), McDonald‘s president for Russia and Eastern Europe, said that the company was interested in expanding its business in Russia. He said McDonald‘s was keen on growing convenient formats like express windows and drive-thru windows in the country. ―Russia is one of the most successfully developing markets of the McDonald‘s Corporation in Europe,‖13 said Khasbulatov. As of early 2010, it continued to be one the leading revenue contributors to the parent company. With 245 outlets already in Russia as of early 2010, McDonald‘s was gearing up to add another 45 outlets by the end of 2012.14 6

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8

9

10 11

12 13 14

Prior to 1991, Russia was the largest republic in the Soviet Union (or USSR). The troubled economic conditions together with political turmoil led to the dissolution of the Soviet Union in 1991 into fifteen separate countries. As a result, Russia together with Ukraine and Belarus formed the Commonwealth of Independent States which was later joined by other Soviet republics. Yuri Mumchur, ―Obama in Moscow: True Reset or Just Walking in Circles?‖ www.russiablog.org, July 8, 2008. Maria Kiselyova and Maria Plis, ―McDonald‘s to Target Stay-at-home Russians,‖ www.reuters.com, December 17, 2009. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010. Ruble is Russian currency. 1 US$=29.403 Ruble (As of January 2, 2009). Chris Mercer, ―McDonald‘s Plans to Double Russian Presence,‖ www.foodnavigator.com, February 3, 2005. ―McDonald‘s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. ―McDonald‘s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. Jenny Wiggins, ―Growing Taste for Quality Goods Lures Big Brands,‖ www.ft.com, January 20, 2010.

328

McDonald’s Russia: A Jewel in the McDonald’s Emerging…

Background Note McDonald‘s was started in the late 1930s by Richard and Maurice McDonald in California, after they failed to make profits from running a movie theater. The brothers were inspired by a hot dog stand nearby, which always did brisk business even when other businesses were struggling under the effects of the Great Depression15.16 In 1937, the McDonald brothers started a hot dog stand called Airdrome, situated at Arcadia in California. Later, in 1940, they opened a barbeque restaurant in San Bernardino17 and called it McDonald‘s Barbeque.18 The barbeque restaurant had about 25 items on its menu like barbequed beef and pork sandwiches. It employed 20 carhops19 to provide service to customers. It soon became a favorite hangout for the teenagers in the city.20 In, 1948, the brothers found it difficult to manage such a large scale business with its extensive menus, staff, and the huge crowds that thronged the restaurant. They realized that the need of the hour was quick service and mass production of food items. Richard analyzed their menu and found that about 80% of the restaurant‘s sales were generated by the sale of hamburgers. 21 In December, 1948, the McDonald brothers reopened the store after incorporating new strategies to enable provision of fast service at a low price. This, they believed, would help in selling larger volumes. Taking a cue from the automobile industry, they decided to adopt an assembly line kind of approach to preparing food at the new restaurant.22 This system was called the ‗Speedee System‘ and it greatly improved the efficiency of the restaurant. The new concept established the principles of McDonald‘s fast food restaurants, and these were later adopted by several fast food restaurants. After implementing the new system, McDonald‘s was able to sell a hamburger at 15 cents (it cost 30 cents earlier) and French Fries at 10 cents.23 Around the same time, the company‘s first mascot was conceptualized and was called ‗Speedee,‘24 primarily to signify its quick service. In 1953, the McDonald brothers decided to go in for franchising in order to expand their business. For a thousand dollars, franchisees would receive the McDonald‘s name, a basic description of its service system, and the services of Art Bender 25 (Bender) at the new restaurant for a week, to help them with the business. Bender trained the people at the franchise, supervised the installation of the equipment, made contact with the butchers and bakeries for the supplies, etc. McDonald‘s first franchisee was Neil Fox, who had a drive-in restaurant in Phoenix, Arizona. This 15 16 17 18 19

20 21 22 23 24 25

Great Depression in the US was a period of acute economic crisis that started in 1929 as a result of crash of the Wall Street stock market and lasted till around early 1940s. Jane McGrath ―How McDonald‘s Works,‖ http://money.howstuffworks.com San Bernardino is a county in California, USA. ―Dick and Mac McDonald,‖ www.nationmaster.com A carhop is a waiter or waitress who delivers food to customers in their cars at drive-in restaurants. Carhops originated in the 1940s when drive-in eateries became popular. ―McDonalds-Site History,‖ http://www.route-66.com. ―McDonalds-Site History,‖ www.route-66.com. ―A Brief History of McDonald‘s,‖ www.bbc.co.uk, April 18, 2005. www.mcdonalds.ca. ‗Speedee‘ looked like a man with a hamburger shaped head, wearing a hat. Art Bender was associated with the McDonald brothers and was credited with serving the first McDonald‘s hamburger at their San Bernardino store. He later became a franchisee of McDonald‘s.

329

International Business restaurant became the prototype for the McDonald‘s chain. The red & white building with a slanting roof and the ‗Golden Arches‘ on the sides became the model for McDonald‘s restaurants. In the years that followed, McDonald‘s grew from strength to strength and by the mid-1950s, the fast food chain‘s annual revenues were US$ 350,000.26 In 1954, Ray Kroc (Kroc), a salesman for a company that manufactured milkshake mixers, noticed that one of his largest customers was a California-based restaurant owned by the McDonald brothers. Kroc found out that they used an assembly line-like system for making hamburgers and sandwiches and that the restaurant already used eight milkshake machines. Sensing an opportunity for more business, he went to meet the McDonald brothers. One look at the orderly, efficient restaurant that served a huge customer base was enough to convince him that he could sell the milkshake mixers to every McDonald‘s store that opened. The purpose of the visit was to persuade the McDonald brothers to open more restaurants so that he could sell milkshake mixers to them. But the brothers were not interested in expanding the business further and seemed content with the existing operations. Kroc then expressed his willingness to become the franchising agent of McDonald‘s restaurants and he succeeded in convincing them. In 1955, the company was incorporated as McDonald‘s Corporation.27 The McDonald‘s bothers finally sold the business to Kroc in 1961. Over the years, as the business expanded, the company‘s operation was divided into four segments – the US, Europe, Asia Pacific, the Middle East & Africa (APMEA) and other countries including corporate sales (Refer to Exhibit I for Important Milestones in McDonald‘s Growth). In 2003, the company experienced a quarterly loss for the first time since it went public in 1965. This was mainly due to the decrease in sales as a result of a rising concern among people about the effects of fast food on health. Responding to the concern, McDonald‘s switched to healthier meals and introduced salads and fresh fruits on its menu.28 As of 2010, McDonald‘s was headquartered in Oak Brook, Illinois, with James A. Skinner (Skinner), as Chairman and CEO of the company. Experts felt that the company had negotiated the economic slowdown well and things were looking up for the fast food chain (Refer to Exhibit II for the financial summary of McDonald‘s Corporation: 2004-2008).

International Expansion McDonald‘s began its international expansion in 1967 with its first restaurant outside the US coming up in Richmond B.C, Canada on June 1. In July 1971, McDonald‘s began operating in Tokyo, Japan, in a joint venture with a local partner Den Fujita.29 In the same year, the first McDonald‘s in Europe came up in the Netherlands. Restaurants also opened in Munich, Germany; and Australia. In the early 1970s, McDonald‘s also entered France and England.

26 27 28 29

http://www.mcdonalds.ca ―McDonald‘s Corporation, Company History,‖ www.answers.com Geoffrey Jones, ―Multinationals and Global Capitalism,‖ Oxford University Press. Den Fujita owned an import company in Japan, specializing in handbags, shoes, and apparel, before opening McDonald‘s in Japan.

330

McDonald’s Russia: A Jewel in the McDonald’s Emerging…

Exhibit I Growth of McDonald’s Corporation 1950s 1954

Ray Kroc became the franchising agent of McDonald‘s. Kroc‘s vision was to expand the fast food chain in every American State and internationally as well. He wanted McDonald‘s fast food restaurants to serve quality food by adhering to standards and specifications

1955

Kroc started a new franchising company under the name McDonald‘s System, Inc. and in the same year opened his own McDonald‘s drive-in at Des Plaines, Illinois. McDonald‘s franchising agreement was that anyone who wished to become a franchisee would initially pay a sum of a thousand dollars. Later on, 1.9 percent of the annual profits of the restaurant were to be paid. Kroc would then pass 0.5 percent of the takings to the McDonald brothers, keeping the other 1.4 percent with him.

1956

By the end of this year, there were fourteen McDonald‘s restaurants that served nearly 50 million hamburgers. The company reported annual sales of US$1.2 million.

1960s 1960

Kroc was running the whole show by this time. He renamed the company as ‗McDonald's Corporation.‘ He wanted to put up a McDonald‘s restaurant in every state of America. He personally looked after the operations, measured every product, and tasted burgers in every outlet to ensure that the quality of food served was uniform in every McDonald‘s restaurant. In the same year, McDonald‘s started its advertising campaign ‗Look for the Golden Arches‘ which gave sales a big boost. The McDonald brothers were happy with the results and were not concerned about the company Kroc had formed. In 1960, there were 228 McDonald‘s restaurants that reported US$37.6 million in sales, and sold 400 million hamburgers.

1961

Ray Kroc began letting out more franchises. The revenues that the company received from the franchises made it easier for him to raise capital in the financial markets. He utilized some of the money to create an advertising campaign with the theme, ‗Look for the Golden Arches‘. The company‘s logo was changed from ‗Speedee‘ to a letter ‗M‘ symbolizing the Golden Arches. Kroc was not happy with the restrictive agreement he had been operating under and wanted to operate the franchising business on his own. So he offered to buy out McDonald‘s for US$ 2.7 million. He obtained a loan and took over the business from the McDonald brothers. That same year, he opened a Hamburger University in the basement of a restaurant in Elk Grove Village, Illinois. It was a training facility where new franchisees and store managers were taught how to manage a McDonald‘s restaurant using sophisticated training techniques and through high-level management courses.

1963

McDonald‘s sold one million hamburgers per day in the US. In the same year, the company introduced Ronald McDonald, a red-haired clown, to appeal to children.

1965

On July 5, McDonald‘s was listed on the New York Stock Exchange and sold its shares for US$ 22.50 each. 331

International Business 1968

McDonald‘s well known product Big Mac30 was created. Fred Turner became the company‘s president and chief administrative officer while Kroc became the chairman and remained CEO until 1973. McDonald‘s opened its 1000th restaurant in Des Plaines, Illinois.

1970s 1970

By 1970, McDonald‘s reported US$587 million in sales from almost 1,600 restaurants in all 50 states of the US.

1973

McDonald‘s introduced its first breakfast fast food ‗The Egg McMuffin‘31.

1975

McDonald‘s opened its first drive-thru restaurant in Oklahoma City.

1979

McDonald‘s Happy Meal32 was created and was popular with children as well as adults.

1980s 1980

By 1980, McDonald‘s reported sales of US$ 6.2 billion from its 6,263 restaurants in 27 countries and surpassed the 35 billion hamburger milestone. During the 1980s, McDonald‘s diversified its menu to suit the changing tastes of consumers.

1982

McDonald‘s received The American Marketing Association Achievement Award for excellence in marketing programs.

1983

Chicken McNuggets were introduced. By the end of the year, McDonald‘s had become the second largest retailer of chicken based products in the world.

1984

On January 14, Kroc died. That same year, McDonald‘s broke the US$ 10 billion sales barrier and served its 50 billionth hamburger.

1986

McDonald‘s opened its ten thousandth restaurant.

1988

Fortune Magazine listed McDonald‘s hamburgers among ‗the 100 products America makes best‘.

1990s 1990

By 1990, McDonald‘s sales had grown to US$ 18.7 billion with 11,800 restaurants in 54 countries. In 1990, Life Magazine named Kroc as one of the ‗100 Most Important Americans of the 20th Century‘.

1996

The fast food chain reached the 20,000-restaurant mark.

1997

By the end of the year, the total number of McDonald‘s restaurants reached the 23,000th mark.

1999

McDonald‘s acquired its first stake in a Colorado-based fast food chain, Chipotle Mexican Grill, by buying a minor share in the company. In 1999, McDonald‘s 25,000th unit opened.

30

31

32

332

The Big Mac is a hamburger consisting of two 1.6 oz (45.4 g) beef patties, iceberg lettuce, American cheese, pickles, onion, and special McDonald‘s Mac sauce served on a threepart sesame seed bun. The Egg McMuffin is the signature breakfast sandwich sold by McDonald‘s in various sizes and configurations. Happy Meal is a combo meal with a toy, specially tailored for children by McDonald‘s. The meal includes a burger or Chicken McNuggets, French fries, a drink and a toy.

McDonald’s Russia: A Jewel in the McDonald’s Emerging… 2000s 2000

In May, McDonald‘s bought the bankrupt Boston Market chain 33 for $173.5 million in cash and debt, the largest acquisition till date. In the 2000s, McDonald‘s introduced low-calorie menu items and switched to healthy cooking ways like using low fat oil.

2002

In October, McDonald‘s introduced its famous Dollar menu.

2003

In September, McDonald‘s launched its advertising campaign on MTV with the tag line, ‗I‘m lovin‘ it‘. This was McDonald‘s first global campaign to be advertised in more than 100 countries. This campaign was successful as store sales for the year 2003 increased by 2.4 percent after falling 2.1 percent in 2002.

Compiled from various sources

Exhibit II Financial Summary of McDonald’s Corporation (2004-2008) US Dollars in millions, except per share data Company-operated sales Franchised revenues

2008 16,561 6,961

2007

2006 16,611 6,176

2005

15,402 5,493

14,018 5,099

2004 13,055 4,834

23,522

22,787

20,895

19,117

17,889

6,443 4,313(1) 4,313(1)

3,879(2) 2,335(2,3) 2,395(2,3,4)

4,433(5) 2,866(5) 3,544(5,6)

3,984 2,578(7) 2,602(7)

3,554(8) 2,287(8) 2,279(8)

5,917 1,625 2,136

4,876 1,150 1,947

4,341 1,274 1,742

4,337 1,818 1,607

3,904 1,383 1,419

4,115 3,981 1,823

3,996 3,949 1,766

5,460 3,719 1,217

(442) 1,228 842

1,634 605 695

Total assets

28,462

29,392

28,974

29,989

27,838

Total debt

10,218

9,301

8,408

10,137

9,220

Total shareholder‘s equity

13,383

15,280

15,458

15,146

14,201

1,115

1,165

1,204

1,263

1,270

Total revenues Operating income Income from continuing operations Net income Cash provided by operations Cash used for investing activities Capital expenditures Cash used for (provided by) financing activities Treasury stock repurchased Common stock cash dividends Financial position at year end:

Shares outstanding in millions

33

At the time of acquisition, there were more than 850 Boston Market outlets, which specialized in home-styled meals like rotisserie chicken.

333

International Business Per common share: Income from continuing operations–diluted

3.76(1)

1.93(2,3)

2.29(5)

2.02(7)

1.80(8)

3.76(1)

1.98(2,3,4)

2.83(5,6)

2.04(7)

1.79(8)

1.63 62.19

1.50

1.00

.67

0.55

Market price at year end

58.91

44.33

33.72

32.06

Company-operated restaurants

6,502

6,906

8,166

8,173

8,179

Franchised restaurants

25,465

24,471

22,880

22,593

22,317

Total Systemwide restaurants

31,967

31,377

31,046

30,766

30,496

Franchised sales

54,132

46,943

41,380

38,913

37,052

Net income-diluted Dividends declared

(1) Includes income of $109.0 million ($0.09 per share) from the sale of the Company‘s minority ownership interest in U.K.- based Pret A Manger. (2) Includes pretax operating charges of $1.7 billion ($1.32 per share) related to impairment and other charges primarily as a result of the Company‘s sale of its businesses in 18 Latin American and Caribbean markets to a developmental licensee (see Latam transaction note to the consolidated financial statements for further details). (3) Includes a tax benefit of $316.4 million ($0.26 per share) resulting from the completion of an Internal Revenue Service (IRS) examination of the Company‘s 2003-2004 U.S. federal tax returns. (4) Includes income of $60.1 million ($0.05 per share) related to discontinued operations primarily from the sale of our investment in Boston Market. (5) Includes pretax operating charges of $134 million ($98 million after tax or $0.08 per share) related to impairment and other charges. (6) Includes income of $678 million ($0.54 per share) related to discontinued operations primarily resulting from the disposal of McDonald‘s investment in Chipotle. (7) Includes a net tax benefit of $73 million ($0.05 per share) comprised of $179 million ($0.14 per share) of income tax benefit resulting from the completion of an IRS examination of the Company‘s 2000-2002 U.S. tax returns, partly offset by $106 million ($0.09 per share) of incremental tax expense resulting from the decision to repatriate certain foreign earnings under the Homeland Investment Act (HIA). (8) Includes pretax operating charges of $130 million related to impairment and $121 million ($12 million related to 2004 and $109 million related to prior years) for a correction in the Company‘s lease accounting practices and policies, as well as a non-operating gain of $49 million related to the sale of the Company‘s interest in a U.S. real estate partnership, for a total pretax expense of $202 million ($148 million after tax or $0.12 per share). Source: 2008 Annual Report In 1990, McDonald‘s opened up in Russia by starting a restaurant in Moscow. This was the largest McDonald‘s restaurant at that time. During the year, McDonald‘s also opened in Shenzhen, China. This restaurant was even bigger than the Russian one and attracted a larger number of people (around 40,000) on the opening day. The store was spread over an area of 28,000 square feet and had 29 cash counters. The Chinese operation was a joint venture agreement between the General Corporation of Beijing Agriculture, Industry, and Commerce and McDonald‘s. 334

McDonald’s Russia: A Jewel in the McDonald’s Emerging… In 1992, two outlets were opened in Poland and each separately surpassed the records set earlier by Russia and China in terms of first day transactions. The year also witnessed McDonald‘s entry into Africa with the opening of a restaurant in Morocco. By the early 1990s, McDonald‘s had a presence in 58 countries worldwide. In October 1993, another important phase of the company‘s expansion came when it entered the Middle East market by starting a restaurant in Tel Aviv, Israel. Slowly, restaurants also came up in the Gulf region — in Saudi Arabia, Oman, Kuwait, Bahrain, the United Arab Emirates, and Qatar and Egypt. By 1995, there were about 7,033 McDonald‘s restaurants spread across 89 countries and they generated sales worth US$14 billion.34 In 1996, McDonald‘s entered India with a restaurant coming up in New Delhi. In India, it entered through a franchisee. By 2007, international sales were reported to be a major contributor to the company‘s annual revenue (Refer to Table I for the revenues of McDonald‘s Four Operational Regions: 2006-2009).

Table I: Revenues of McDonald’s Four Operational Regions: 2006-2009 (In US$ million)

2008

2007

2006

US

4,636

4,682

4,410

Europe

7,424

6,817

5,885

APMEA

3,660

3,134

2,674

841

1,978

2,433

16,561

16,611

15,402

US

3,442

3,224

3,054

Europe

2,499

2,109

1,753

APMEA

571

465

379

Other Countries and Corporate

449

378

307

6,961

6,176

5,493

US

8,078

7,909

7,464

Europe

9,923

8,962

7,638

APMEA

4,231

3,599

3,053

Other Countries and Corporate

1,290

2,356

2,740

23,522

22,787

20,896

Company operated sales:

Other Countries and Corporate Total Franchised and affiliated:

Total Total revenues:

Total

Source: McDonald’s Corporation, Annual Reports, www.mcdonalds.com

34

―McDonald‘s History,‖ www.mcdonalds.ca.

335

International Business By 2008, McDonald‘s had more than 31,000 restaurants spread over 121 countries and it was regarded as one of the most successful restaurant chains (Refer to Exhibit III for a list of countries where McDonald‘s was operational, as of 2008).35

Exhibit III List of Countries Where McDonald’s was Operational, as of 2008 Year of Opening Restaurant 1967

1971

1972 1973 1974

1975

1976 1977 1978 1979 1981

1982 1983 1984

1985

35

Country and Date of First Restaurant Opening Canada - June 1 Puerto Rico – November 10 Costa Rica –December 28 Guam- June 10 Australia-May 30 Japan - July 20 Netherlands-August 21 Panama -September 1 Germany (West)- November 22 France-May 30 El Salvador-July 20 Sweden-27 October Guatemala-June 6 United Kingdom-October 1 Netherlands Antilles-16 August Hong Kong-January 8 Nicaragua+ The Bahamas –August 4 New Zealand -June 7 Switzerland - October 20 Ireland - May 9 Austria - July 21 Belgium- March 21 Brazil-February 13 Singapore - October 20 Spain - March 10 Denmark - April 15 Philippines – September 27 Malaysia – April 29 Norway –November 18 Taiwan (Republic of China)-January 28 Andorra – June 29 Finland – December 14 Thailand –February 23 Luxembourg –July 17 Venezuela –August 31 Italy - October 15 Mexico- October 29

―McDonalds Corporation,‖ www.fortune500news.com.

336

McDonald’s Russia: A Jewel in the McDonald’s Emerging… Year of Opening Restaurant 1986

1987 1988

1990

1991

1992

1993

1994

1995

1996

Country and Date of First Restaurant Opening Cuba – April 24 Turkey – October 24 Argentina –November 24 Macau - April 11 Serbia - March 24 South Korea -March 29 Hungary –April 30 Union of Soviet Socialist Republics - 31 January (in Russian SFSR, now Russia) People‘s Republic of China - October 8 (in Shenzhen) Chile –November 19 Indonesia –February 23 Portugal - May 23 Greece-November 12 Uruguay – November 18 Czechoslovakia (Later became the Czech Republic and Slovakia) - March 20 Poland – June 17 Monaco - November 20 Brunei – December 12 Morocco –December 18 Northern Mariana Islands 18 March Iceland - September 3 Israel - October 14 Slovenia –December 2 Saudi Arabia –December 8 Kuwait –June 15 New Caledonia - July 26 Oman –July 30 Egypt –October 20 Bulgaria –December 10 Bahrain –December 15 Latvia –December 15 United Arab Emirates –December 21 Estonia –April 29 Romania –June 16 Malta – July 7 Colombia –July 14 Slovakia –October 13 South Africa –November 11 Qatar –December 13 Honduras –December 14 Croatia –February 2 Samoa –March 2 337

International Business Year of Opening Restaurant

1997

1998

1999

2000 2001 2003 2004

Country and Date of First Restaurant Opening Fiji –May 1 Liechtenstein –May 3 Lithuania - May 31 India –October 13 Peru –October 18 Jordan –November 7 Paraguay –November 21 Dominican Republic - November 30 Belarus – December 10 French Polynesia – December 10 Ukraine - May 28 Cyprus - June 12 Macedonia - September 6 Ecuador - October 9 Isle of Man - December 15 Suriname - December 18 Moldova - April 30 Lebanon –September 18 Pakistan -September 19 Sri Lanka -October 16 Georgia -February 5 San Marino - July 6 Gibraltar -August 13 Azerbaijan - November 6 American Samoa - 29 September Mauritius – July 4 Kazakhstan Montenegro - June

+ McDonald‘s outlets ceased operation during the Nicaraguan civil war and reestablished a presence on 11 July 1998 after an absence of two decades. # List not exhaustive Compiled from various sources In every country, McDonald‘s followed a few basic strategies of entry and expansion. In some places it opened stores as a joint venture with a local partner while in others it went in for franchise agreements or self-owned stores. However, it mainly in went for a franchise mode of operation and about 80% of its restaurants were franchised. McDonald‘s tried to maintain a standard menu in all countries. It followed standard practices of store operation, such as mostly hiring local people, maintaining the same look and feel to the stores, offering the same level of customer service in all its stores, the same methods of food preparation, etc. According to analysts, McDonald‘s key to international success was — ‗think global, act local‘. This helped the company to do well in every region in which it opened its fast food restaurants. It localized its operations depending on the country in which it 338

McDonald’s Russia: A Jewel in the McDonald’s Emerging… was operating. For instance, to make it easy for Japanese consumers to pronounce the chain‘s name, McDonald‘s was changed to Makudonaldo. Keeping in mind local sentiments, McDonald‘s restaurants in Arab countries, Malaysia, and Singapore maintained ‗halal‘ menus36 and did not serve pork, abiding by Islamic laws for food preparation. In Saudi Arabia, McDonald‘s did not display statues or posters of Ronald McDonald, since the display of idols was prohibited in Islam. In Israel, McDonald‘s outlets did not serve dairy products 37, and they were closed on Saturdays, the Jewish Sabbath Day38. In India, McDonald‘s restaurants served Vegetable McNuggets, to cater to the vegetarians and a mutton-based Maharaja Mac39 as in that country some communities considered the cow sacred and did not eat beef. In Ireland, the McDonald‘s promotions stated ―Our name may be American, but we‘re all Irish‖. McDonald‘s even altered the original menu to meet the needs of the customers in different countries. It adapted its product offerings to suit the tastes of the local people. In tropical countries, guava juice was added to the McDonald‘s menu. Beer in Germany, fired egg sandwiches in Malaysia, chilled yogurt drinks in Turkey, espresso and cold pasta in Italy, and vegetarian burgers in the Netherlands were some of the menu variations at the McDonald‘s restaurants. McDonald‘s offered choice and variety with locally suitable menus such as the Teriyaki Mac 40 in Japan and variations of the Filet-O-Fish41 in China. It also introduced McGriddles sandwiches in Japan. In Norway, McDonald‘s sold a grilled salmon sandwich called McLaks. It sold spaghetti noodles served in sweet tomato-based sauce, hot dogs and grated pasteurized cheese called McSpaghetti in Philippines. McHuevo, a poached egg hamburger, was available at McDonald‘s outlets in Uruguay. In Thailand, McDonald‘s introduced the Samurai Pork Burger with sweet sauce. Irrespective of variations and additions, the basic structure of the McDonald‘s menu remained uniform throughout the world comprising a main course of burger or sandwich, fries, and a Coca Cola drink. Even though the main course varied in some countries, the signature product of McDonald‘s – the fries — were present in all its menus worldwide. As for the prices, they were set in each country on the basis of the demand for the item. For instance, in the US, a Big Mac with fries was priced low as it was a common food item but in some other countries where it was perceived as a luxury, it was priced higher.

36

Halal is an Arabic term meaning ‗permissible.‘ It usually refers to food that is permissible according to Islamic law. McDonald‘s underwent rigorous inspections by Muslim clerics to ensure that its food was halal. The chain was then awarded the halal certificate indicating the total absence of pork products.

37

Jews do not eat or cook meat and dairy products together.

38

The Jewish Sabbath day, called Shabbat in Hebrew, begins on Friday evening and ends on Saturday evening. The Jewish refrain from doing any kind of activity on this day.

39

Maharaja Mac is another name for Big Mac, and is made with lamb instead of beef. Teriyaki Mac is a Japanese styled burger containing pork with mayonnaise, lettuce, and teriyaki sauce. The Filet-O-Fish is a fish sandwich containing fish patty made mostly from whitefish, half a slice of processed cheese, tartar sauce, and filet seasoning on a steamed bun.

40

41

339

International Business

Entering Russia McDonald‘s pre-entry plans for Russia started way back in 1976. Cohon, at the time of the Montreal Games42 in Canada, offered the services of the McDonald‘s company bus to some of the Olympic officials from the erstwhile Soviet Union. He took the officials to a local McDonald‘s restaurant and offered them some of its signature dishes. The group enjoyed the food at McDonald‘s. It immediately struck Cohon that the McDonald‘s experience could be taken to Russia. 43 Over the next four years, Cohon kept on persuading government officials to allow McDonald‘s to open its outlets in Russia during the 1980 Moscow Olympic Games. However, that did not materialize. For several years, Cohon‘s plans of entering Russia did not bear fruit. Cohon paid numerous visits to the Soviet Union, each time trying to convince the bureaucrats in that country. During some of his visits, he even carried along a video to show the bureaucrats the visuals of the restaurants, so that they could understand better what actually McDonald‘s was all about. But these efforts proved to be in vain due to the high level of bureaucracy in the country. According to Cohon, while he earnestly tried to strike a deal to open McDonald‘s outlets in Russia, some of the officials at the company‘s headquarters in the US criticized his efforts. According to analysts, McDonald‘s chairman Kroc himself had ruled out the idea of being able to open an outlet in Russia.44 In April 1988, after the reforms movements of perestroika45 led by Mikhail Gorbachev, liberalized the Soviet economy, the Soviet government allowed foreign companies to have 49% ownership in ventures in the country. McDonald‘s Canada entered into a US$ 50 million joint venture million with Glavobshchepit46, to open 20 restaurants in the country.47 The deal also allowed the company to purchase land to build a processing unit.48 The joint venture was called McDonald‘s Russia.49 McDonald‘s Canada agreed to reinvest all its profits in Moscow for a chain of

20 restaurants. The company brought out an employment advertisement in newspapers for 630 posts and received about 27,000 applications. One of the first managers to be recruited was Khasbulatov, who contributed significantly to the establishment and expansion of McDonald‘s in the country and later went on to become the managing director of the Russian Operations. The Russian junior managers were sent for training to McDonald‘s Canadian Institute of Hamburgerology.

42

43

44 45

46

47

48

49

Montreal Games referred to the 1976 Summer Olympics, or XXI Olympics, held in Montreal, Quebec, Canada. Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007. Alf Nucifora, ―Russians Learn to Smile-for Profit,‖ Business News, September 27, 1999. Perestroika is the Russian term, meaning restructuring, for the political and economic reforms introduced in June 1987 by the Soviet leader Mikhail Gorbachev. Glavobshchepit, a part of the government body, was the food services agency of the city of Moscow. It was later renamed as Mosobshchepit. Foster, P., ―McDonald‘s Excellent Soviet Venture?‖ Canadian Business, Vol. 64, Issue 5, May 1991. Tony Royle, ―The Union Recognition Dispute at McDonald‘s Moscow Food-Processing,‖ Industrial Relationship Journal, Blackwell Publishing Ltd., 2005. As of 2009, McDonald‘s owned all of its Russian operations.

340

McDonald’s Russia: A Jewel in the McDonald’s Emerging… According to Cohon, he had made good friends in the political circles of Russia, which turned out to be very valuable for the company as these people lent their support to the company‘s activities in the country. For instance, the Russian army helped to dig trenches when the processing unit, called McComplex, was being built. In 1989, a 100,000 square feet McComplex, built at an investment of US$ 45 million, was opened in Solntsevo, a suburb near Moscow. It manufactured buns, cheese, burger patties, as well as other items, not just for the Russia market but also for the company‘s other restaurants in 17 other countries.50 On January 31, 1990, McDonald‘s opened its first restaurant in Russia at Pushkin Square, Moscow. The opening was widely publicized not only by the Russian media but by the international media as well. It was the largest McDonald‘s restaurant till that time, spread over 23,680 square foot area on multi levels, had a seating space for 700 customers, and 27 cash registers. According to reports, around 40,000 people queued up and waited for two hours for the opening. 51 According to Khasbulatov, on the opening day, there were queues outside the store even at closing time at night and he had to unwillingly turn them away. On the opening day, the store first served orphans and children, before entertaining other guests, who included high ranked government officials as well as some celebrities. 52 The store broke the then existing records for the number of customers served on the opening day. This store marked the beginning of not just the first McDonald‘s in Russia but the first fast food restaurant to ever come up in Russia. With this beginning, McDonald‘s also became a symbol of the advent of American capitalism in the country, opined the analysts. In contrast to its standard procedure of going in for a franchising agreement or a joint venture, the McDonald‘s outlets in Russia were wholly owned without any partners.53 The company also did not use franchising in Russia despite it being a key factor for its international operations in other countries. According to Khasbulatov, this was due to the fact that there were some gaps in the existing legislations relating to franchising in Russia. In Russia, the law on commercial concession governed franchising, but franchisers often felt that the legislation lacked clarity.54 However, the company did not rule out the franchise option. Commenting on the company‘s franchise program, Khasbulatov said ―franchising will appear in Russia as soon as it becomes possible, but for now there is no motivation to sell franchised restaurants.‖55 Analysts felt that it was a wise decision for the company since the fast food industry was new in the country and it was difficult to find an efficient partner who would completely understand the operation and stand up to the quality standards set by the company. As Alexander Gragin, a partner at Deloitte 56, Moscow, put it, ―Regional restaurant franchises [in Russia] can really vary in the quality and service that they offer. The tricky part of selling franchises is finding reliable partners in the regions. Also the legal situation with franchises at the federal level is as yet unclear.‖ 57

50

51 52

53 54 55 56

57

―The Taste of Pace: Situating Fast Food Restaurants in Russia‘s Agrifood System,‖ http://ageconsearch.umn.edu, May 18, 2007. ―McDonald‘s Russia,‖ Brand Strategy, November 2005. ―McDonald‘s in Moscow,‖ http://goldenessays.com/free_essays/2/economics/mcdonalds-inmoscow.shtml ―McDonalds Set for 20% Expansion in Russia,‖ www.sptimes.ru, June 10, 2005. Maria Levitov, ―McDonald‘s to Invest $50 Million,‖ The Moscow Times, March 16, 2006. ―McDonald‘s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. Deloitte Touche Tohmatsu (Deloitte), founded in 1845, is one of the leading firms in the world, delivering professional services like auditing, consulting, financial advisory etc. It is headquartered in New York, USA. ―McDonalds Set for 20% Expansion in Russia,‖ www.sptimes.ru, June 10, 2005.

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International Business

Expansion in Russia Right from the early 1990s, McDonald‘s started to invest in real estate ventures by acquiring various properties in Russia. As there was some difficulty in the conversion of the Russian ruble into any other currency, the company thought of using it for buying farmland and for building an office tower and distribution center in the country. In 1993, McDonald‘s first corporate building in Russia came up near Moscow Kremlin58. The company also leased out office space to Coca-Cola Company59 and Upjohn60. McDonald‘s continued to purchase many restaurant properties over the years.61 In 1993, two restaurants came up in Gazetny Pereulok and Stary Arbat. 62 By the end of the year, three of its restaurants in Russia had begun to earn profits.63 In 1996, McDonald‘s introduced the drive-thru format in Russia. It was a new concept in the country. Initially, people bought the food from the drive-thru windows, then parked their cars around the store and went inside the restaurants to eat whatever they bought. Over the years, the Russians not only learnt to appreciate the convenience associated with the format, but also started to acknowledge the delivery speed. In 1998, 19 McDonald‘s restaurants opened in various parts of the country. However, due to the Russian financial crisis64 and weakening of the economy around the same time, the company decided to go slow with the expansion. By 1999, the company had made investments worth around US$ 134 million in the country since 1989. 65 However, the strong bureaucracy in the country continued to create hindrances. In 1999, Khasbulatov was made the head of the Russian venture of McDonald‘s. Things took a turn for the worse around 2000, as the condition of some of the restaurants deteriorated. Some items on the menu were also losing their appeal. According to Svetlana Polyakova, Public Relations Manager, McDonald‘s Russia, by 2001, the company had invested around US$ 215 million in Russia. There were about 6,000 employees at that time.66 As of 2001, McDonald‘s International held an 80% stake while the government held the remaining 20% in McDonald‘s Russia. By then, there were about 40 stores in Moscow and more than 32 in the rest of the country. 67 The Russian economy also started to improve around the same time in the early 58 59 60 61

62

63

64

65

66

67

Moscow Kremlin is the official residence of the President of Russia. Coco-Cola Company is a leading beverage company with a worldwide presence. Upjohn was a pharmaceutical company. Erin E. Arvedlund, ―McDonald‘s Gobbles up Russian Real Estate,‖ www.iht.com, March 18, 2005. Dmitry Dobrov, Kommersant Vlast ―Food Industry 1991-2000,‖ www.russiajournal.com, October 26, 2001. Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007. The Russian financial crisis started in August 1998, primarily due to a financial crisis in Asia. There was a decline in world commodity prices, which impacted countries that depended heavily on the export of raw materials. Russia, which depended a lot on the exports of petroleum, natural gas, metals, and timber, was also affected. Natalia Olynec, ―Big Mac Blues in Russia,‖ Bloomberg News, www.bellybuttonwindow.com, 1999. ―US Fast Food Firm Expanding in Russia,‖ Interfax, CDi Russia Weekly #136, www.cdi.org, January 05, 2001. Vladimir Kozlov, ―Fast-Food Profits Offer Food for Thought,‖ www.russiajournal.com, November 29, 2001.

342

McDonald’s Russia: A Jewel in the McDonald’s Emerging… 2000s, and this provided a boost to the company‘s growth plans (Refer to Exhibit IV for a brief note on Russia‘s economy in the early 2000s).

Exhibit IV A Brief Note on Russia’s Economy in the Early 2000s Since the early 2000s, the Russian economy had seen a steady growth, fueled by the rise of consumerism. According to analysts, the economy grew at 6.9% rate between 2003 and 2007. In 2007, there was an increase by 10.4% in the average Russian disposable income. In 2008, it was estimated that above 60% of the population had a disposable income of US$ 350 on an average, after regular household expenses. However, analysts suggested that there existed an income inequality in Russia, which was higher than that in any other European country but still lower than that in the US. Analysts said that about 80% of consumption came from the top 10% earners in the country. Therefore, they added, if the difference reduced in future and more people became wealthy, consumerism would further rise. In addition to the rise in disposable income, consumerism was also boosted by the availability of liquid money due to growth in the credit market. This gave the households added power to spend, which in turn propelled the retail sector. Thus, analysts suggested that the rise of retail trade turnover, consumer spending power, and increased visits to restaurants and other food joints had become the prime factors that boosted the Russian economy in the early 2000s. In 2007, Russia became a favorable place for foreign investment and witnessed about US$ 100 billion worth of investment, a record for any emerging country and more than what the world‘s top 15 leading economies could attract. Also, most of these investments were reported to be for a long time basis. The country witnessed an inflation rate of about 9% in 2007, with the FMCG section witnessing 13% inflation. Analysts feared that the rising inflation could impact the growing economy. They pointed out that the consumer prices had increased since there was an increase in salaries, pension, etc, that led to spending that was higher than the economic growth. As a result, the supply of money increased, leading to a decrease in the purchasing power of the ruble. The circulation of money was also higher, leading to erosion in the purchasing power of the currency. The average growth rate of Gross Domestic Product (GDP) in the period between 2000 and 2007 was about 6.5%. In the first half of 2008, the country witnessed a Gross Domestic Product (GDP) growth of 8%. However, toward the end of 2008, the Russian economy faced some challenges due to rising oil prices and the depreciating value of the ruble in the international market. Like other western countries, Russia‘s economy was affected by the credit crunch, thus reducing the liquidity in the country. The stock market also crashed. There was a reduction in industrial production as well, resulting in many lay-offs and job cuts. Analysts predicted that the crisis would continue in 2009. Some feared that the growth in the GDP might even reduce by 4% in 2009. Many also believed that Russia, with cash reserves amounting to US$ 595.9 billion, would be able to pull out its banking sector and industry from the crisis very soon. Compiled from various sources

343

International Business In 2002, there were around 79 Russian stores that together drew around 200,000 customers each day.68 By 2003, McDonald‘s had a major share of the Russian fast food market.69 (Refer to Exhibit V for market share of fast food retailers in Russia between 2003-2006 and to Exhibit VI for a brief note on the fast food market in Russia: 2006-2008).

Exhibit V Market Share of Fast Food Retailers in Russia between 2003-2006 Retailer

Global brand owner

2003

2004

2005

2006

McDonald‘s

McDonald‘s Corp

35.3

30

30.7

30.3

Rostik‘s

Rostik‘s International Inc

3.6

5

5.9

4.3

Sbarro

Sbarro Inc

2.8

2.9

3

3

Rostik‘s-KFC

Rostik‘s International Inc

-

-

-

2.8

Teremok

Teremok - Russkie Bliny

0.4

0.6

1.4

KroshkaKartoshka

Tekhnologiya & Pitanie Ltd

0.4

0.6

1

1.4

Chaynaya Lozhka

Solo OOO

0.5

1.2

1.3

1.4

Baskin-Robbins

Dunkin‘ Brands Inc

1.3

Others

57.4

56.9

57.5

54.1

Total, %

100

100

100

100

Source: “Russian Federation HRI Food Service Sector-2008,” www.fas.usda.gov, July 28, 2008.

Exhibit VI A Brief Note on the Fast Food Market in Russia: 2006-2008 According to some studies, the Russian fast food service market was one of the fastest growing segments in the economy of Russia, with a growth rate of between 20 and 30%. In 2005, Moscow's fast-food market alone was estimated to be worth between US$400 and US$700 million, and was projected to grow at a rate of 20 percent annually for the next few years. 70 Analysts considered a major section of fast food customers to be price sensitive and keen on new products. With the restaurants growing more sophisticated in Russia, there was an increased demand for different products. Analysts witnessed a new 68 69

70

Daniel Rogers, ―Can Mac Fight Back?‖ www.marketingmagazine.co.uk, October 17, 2002. Dmitry Babich, Yulia Ignatyeva ―Big Mac Does not Give Up,‖ Foreign Investment-CDI Russia Weekly, www.cdi.org, February 26-March 4, 2003. Chris Mercer, ―McDonald‘s Plans to Double Russian Presence,‖ www.foodnavigator.com, February 3, 2005.

344

McDonald’s Russia: A Jewel in the McDonald’s Emerging… trend among Russians who tended to spend more on food and dining out – more than any other country in Europe. Moreover, the increasing number of shopping centers and malls in the country were in a way propelling the fast food culture, as most of these places had ‗food courts‘ with various low priced fast food stalls and restaurants. According to research conducted by Euromonitor Plc.71, almost 50% of the Russian population in the age group of 16-50, bought fast food at least once a week. The studies showed that 64% of the customers considered location as the most important factor among the reasons that drove customers into the stores, followed by 54% of customers who focused on cost. 43% of customers regarded quality and 25% regarded cleanliness as the factors that made them visit any fast food store. According to analysts, one quarter of Russian restaurants were situated in Moscow itself, out of which 60% of the market share was held by low-priced restaurants, 14% by elite restaurants, and 11% by fast food outlets. The most popular catering formats in Russia were cafés that offered ‗lunch deals‘ with the buffet option. The European and Asian menus were considered as the most popular ones. As of 2007, the fastest development in the restaurant segment was the mid-range, low-priced category of outlets. The national fast food chains and stalls that were slowly gaining ground were ‗Stardog,‘ ‗Teremok,‘ ‗Russkie Blini‘ etc. Street food vendors like ‗Kroshka Kartoshka‘ were also very popular in Russia. However, in 2007, the Mayor of Moscow prohibited the street vendors from doing business, in a bid to clean up the city. Some of them were allowed to rent space in the malls and shopping centers, but analysts pointed out that not all the vendors would be able to afford these places because of high rentals. Further, analysts also said that the high rents paid by the vendors would lead to an increase in the prices of the food items. In order to bear the increasing operational costs, Kroshka Kartoshka, joined hands with Poland‘s AmRest Holding, a franchisee of Pizza Hut, KFC, Burger King, etc., in eastern Europe. Among the fast food chain operators, the food court format was slowly becoming popular as of 2008. People visited the food courts not just for the food but also to socialize with friends and families. Most of the leading chains such as Rostick‘sKFC, Chaynaya Lozhka, Sbarro, and Baskin-Robbins had outlets in many malls, shopping centers, and hypermarkets.72 For the foreign fast food chains, franchising was a popular option to enter the country. As of 2008, Baskin Robbins was one of the largest franchises, which capitalized on the Russians‘ fondness for ice-cream. Among the drive-in restaurants, Rostik‘s was considered the market leader. In popularity, it stood second to McDonald‘s, which was among the most popular fast food chains since 1990. One of the major challenges for the restaurant industry in Russia was underdeveloped distribution and logistics in most parts of the country, other than large urban cities. It was also difficult to find experienced and efficient distributors. Moreover, in Russia, restaurants offering traditional Russian cuisine were widely popular, while fast food joints were not. This was due to the fact that to Russians,

71 72

Euromonitor Plc is a London, UK-based provider of information services. ―Russian Federation HRI Food Service Sector-2008,‖ www.fas.usda.gov, July 28, 2008.

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International Business eating food was a ―lengthy‖ procedure, with people sitting at the table for long periods of time.73 Around the end of 2008, the Russian economy also experienced the effects of the global economic slowdown and credit crunch. The stock markets performed poorly and the ruble depreciated considerably against the US dollar. Industrial production suffered, leading to wage reductions, lay-offs etc. Retail sales also suffered a lot due to the reduction in spending as well as lack of availability of cheap loans and liquidity of money.74 However, some analysts opined that the fast food industry might not be impacted as much as high-end restaurants as people would look for value for money in these tougher times rather than opting for fine dining experiences. It was reported that in 2009, Russian consumer sentiment had indeed been hit dramatically by the economic crisis, and the overall restaurant industry was estimated to be down 7-8 percent.75 Denying that the crisis had been beneficial for cheap restaurants, Oleg Sukhotin, executive director of the Russian Association of Fast Food Enterprises, said, ―In the fourth quarter of 2009, most fast food operators' turnover fell by 20% to 45%, year-on-year, and an average bill has also plummeted. People no longer order pancakes with caviar that much.‖ 76 As of early 2010, companies like McDonald‘s, KFC, and Sbarro dominated the Russian fast food market.77 In late 2009, Andrey Petrakov, executive director of the Restcon company, said that this was the right time fast for food chains to expand into the Russian market as the market had enough room for new players, and rental prices had dropped. 78 Source: “Food & Drinks Industry Day Converting Opportunities to Business: Russian and Ukrainian,” www.bordbia.ie, 2008; and, “Top 10 Consumer Trends in Russia,” www.euromonitor.com, May 7, 2008. In 2005, the company invested about US$ 10,000 in each restaurant to start a new breakfast menu. According to Khasbulatov, the decision to launch the breakfast menu arose after research revealed that around 90% of the people did not have any opportunity to get breakfast when outside their homes. 79 The breakfast menu mainly targeted professionals in the big cities like Moscow, who left home very early to avoid the traffic and needed to have breakfast somewhere outside. By 2005, there were a total of 129 McDonald‘s restaurants in Russia, out of which 82 were in Moscow and 15 in St. Petersburg. According to analysts, the company spent about US$ 1.5 million to US$ 2 million on setting up each new restaurant.80 The company intended to spend around half of its marketing budget in promoting its breakfast menu. Around the same time, the Russian operation became the second 73

74

75

76

77

78

79 80

―McDonald‘s and Burger King Kill Russian Bistro,‖ http://english.pravda.ru, November 9, 2009. ―The Fast Deteriorating State of Russia‘s Economy,‖ www.economist.com, December 14, 2008 Maria Kiselyova and Maria Plis, ―McDonald‘s to Target Stay-at-home Russians,‖ www.reuters.com, December 17, 2009. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010. ―McDonald‘s and Burger King Kill Russian Bistro,‖ http://english.pravda.ru, November 9, 2009. “McDonalds Set for 20% Expansion in Russia,‖ www.sptimes.ru, June 10, 2005 ―McDonalds Set for 20% Expansion in Russia,‖ www.sptimes.ru, June 10, 2005

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McDonald’s Russia: A Jewel in the McDonald’s Emerging… largest among McDonald‘s markets in terms of average number of consumers per restaurant.81 In 2006, more than 20 new restaurants were added to the Russian operation. Even in 2006, after 16 years of operations, the first restaurant at Pushkin Square was the busiest McDonald‘s in the world.82 By the end of 2007, there were more than 180 McDonald‘s restaurants present in around 40 cities of Russia.83 The Russian venture was one of the most lucrative businesses for McDonald‘s, fueled by the ever increasing quest for American products and brands among the growing middle class in Russia. However, the company decided to concentrate on increasing the quality and to extract more sales from the existing stores, instead of going in for rapid expansion. Some analysts pointed out the high real estate prices of the prime locations was the main reason for McDonald‘s deciding to go slow on its expansion (Refer to Table II for new outlets opened in Russia: 2005-2009). ―We would like to open more restaurants in Russia, but, unfortunately, the procedure for receiving permission is not becoming any easier,‖84 said Khasbulatov. The company also intended to introduce new forms of accessibility to its products in Russia, such as the 24-hour express windows and drive-thru windows.

Table II: New McDonald’s Outlets Opened in Russia: 2005-2009 Restaurants opened

2009

2008

2007

2006

2005

33 (Planned)

22

21

23

18

Compiled from various sources. By mid-2009, McDonald‘s had more than 220 restaurants in over 50 cities in Russia and had served more than 2 billion customers.85

McDonald’s Strategies in Russia The company faced stiff operational hurdles from time to time because of the strong bureaucracy that was present in Russia. According to analysts, opening a single store required the sanction signatures from about 200 different officials. The government issued guidelines running into 40 pages instructing the restaurants on numerous dos and don‘ts, while operating in the country. Nevertheless, the company went ahead, implementing several strategies that eased its difficulties and paved the way for smooth operations. The menu was kept similar to the one in the US, with the addition of cabbage pie and a few popular Russian dishes.

The Human Factor McDonald‘s faced some difficulties in getting the right talent, especially in the bigger cities like Moscow and St.Petersburg, as there was a low rate of unemployment in these places. However, it gave the best training to the local recruits, who were familiar with neither customer service nor the hamburger. Moreover, molding them in the 81

82 83

84 85

Chris Mercer, ―McDonald‘s Plans to Double Russian Presence,‖ www.foodnavigator.com, February 3, 2005. ―Top 10 Consumer Trends in Russia,‖ www.euromonitor.com, May 7, 2008 Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007. ―McDonald‘s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. ―George Cohon, Founder of McDonald‘s Canada and McDonald‘s Russia, Honored in Washington, D.C.,‖ www.marketwire.com, October 6, 2009.

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International Business ―McDonald‘s way‖ was a challenge when most of the local recruits were not familiar with working under the capitalist system. Experts felt that they were victims of the inertia brought about by the old system of central planning for so long that productivity remained low. Hiring local employees was a challenge though McDonald‘s first recruitment ad drew 27,000 applications. The company selected a 630-member crew comprising hires of between 18 and 27 years. Craig Sopkowicz, who was McDonald‘s quality-control expert and in charge of the new employees, said, ―We looked for applicants who lived close to the restaurant, among other things, in order to control the timeliness of employees.‖ 86 For most of these new hires, this was their first job as labor laws in Russia protected teenagers from indulging in any activity that conflicted with schoolwork. Initially, the company provided a starting salary that was on a par with the industry average in Russia (1.5 rubles an hour) for new hires.87 Local employees required lengthy training. To be flexible when positions changed, the new crew was trained in all aspects of the restaurant‘s functions; the new staff logged in more than 15,000 training hours to ensure control similar to that in western operations. Before the opening of the first Russian store, a team of 30 newly recruited managers (including Khasbulatov) was sent to Europe and the Institute of Hamburgerology in Toronto for comprehensive training. These people in turn trained the other new employees on quality, customer service, general conduct, as well as the health and safety standards that were to be followed in the stores. According to an executive from McDonald‘s, at first it was difficult to teach the store employees to smile and look straight into the eyes of the people. To teach the trainees, the training manuals were translated into Russian and they were also shown videotapes about various chores, like the right way to wash the windows and clean the floors, as well as the correct way to arrange the ingredients in the Big Mac.88 Since the company had some concerns about the employees‘ appearance, it decided to construct an on-site laundry room so that the company‘s standards could be ensured.89 In 2006, McDonald‘s Russia was named as the ―Best Employer in Russia‖ by the Russian Chamber of Commerce and Industry. The award recognized the company as a responsible employer.90 It was also named as the Best Employer in Central Eastern Europe from 2007-2009 by Hewitt Associates91. As of end 2009, the company employed more than 24,500 Russians at its restaurants, processing facilities, and corporate offices, and there were more than 100,000 Russians employed by suppliers.92 The company executives were Russian and most of them had started their career as crew-members.

Pricing The company began its operations by transacting in rubles, so that the customers did not face any issues with the currency. A few analysts called it a shrewd strategy targeted at luring the locals who were always attracted to foreign goods but could not 86

87 88 89

90 91 92

Helen Deresky, International Management: Managing Across Borders and Cultures, (Pearson Prentice Hall, 2006). Ann Blackman, ―Moscow‘s Big Mak Attack,‖ www.time.com, February 5, 1990. Ann Blackman, ―Moscow‘s Big Mak Attack,‖ www.time.com, February 05, 1990. Helen Deresky, International Management: Managing Across Borders and Cultures, (Pearson Prentice Hall, 2006). ―McDonald‘s Russia Named Best Employer,‖ www.crmcdonalds.com, January 16, 2007. Hewitt Associates is a leading global human resources consulting and outsourcing company. ―George Cohon, Founder of McDonald‘s Canada and McDonald‘s Russia, Honored in Washington, D.C.,‖ www.marketwire.com, October 6, 2009.

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McDonald’s Russia: A Jewel in the McDonald’s Emerging… purchase them since these goods could usually be bought in foreign currencies only.93 However, at 5.5 rubles for a Big Mac, fries, and Coke, only the higher-income segment could afford it as this was twice the cost of a meal in state-run outlets. According to analysts, the company in Russia maintained the profit margins somewhere around the mid 20 percent range. It was considered to be much higher than the global average profit margins that the company earned. The same store sales94 were also considered to be higher than in other markets. In 2007, the prices of the food items in the menu were increased around four times in the year, in order to maintain the desired profit margins, keeping up with the rising inflation. However, the percentage increase was different for different items. For instance, the price of less expensive items like ice-cream cones, was raised at half the rate of the inflation at that time, whereas for more expensive items, like the Big tasty burger, the price rise was above the inflation rate. According to Khasbulatov, despite a 35 percent devaluation of the ruble against the dollar in late 2008 and early 2009, McDonald‘s had lowered some prices to gain from bigger turnover. The company‘s endeavor was to not increase prices above annual inflation rates of between 13 percent and 14 percent. However, in mid-2009, the price of the Big Mac in Russia grew by 13.5 percent to 67 rubles, but it became less expensive in dollar terms - US$0.5 (19.7 percent).95 ―Consumers in Russia are really price sensitive . . . we‘ve been very careful in managing our menu prices,‖96 said Khasbulatov.

Procurement Sourcing and quality control of food was a huge challenge for McDonald‘s in Russia. Right at the time of entry, the company realized that many of the ingredients that it required were not available in the country at all. Greg Steeves, former Chief Operating Officer of McDonald‘s Europe, explained, ―Russia is often plagued by shortages, and in some cases the ingredients we required, such as iceberg lettuce, didn‘t even exist in the country.‖97 Right from the very beginning, the company understood that importing food items from other countries would not be a viable option as the rubles earned in Russia would be unconvertible. In that case, it would have to divert some of the income from McDonald‘s Canada or from other international market to procure items for Russia. McDonald‘s therefore decided to source food items locally, instead of importing and started to build partnerships with the local suppliers by providing them with adequate training. The company had to resort to vertical integration for sourcing raw materials. In order to control the quality, distribution, and reliability of its ingredients, McDonald‘s built a US$40 million, 110,000 sqft plant in a Moscow suburb to process the required beef, milk, buns, vegetables, sauces, and potatoes.98 This facility also included laboratories for testing to ensure compliance with quality and consistency standards. The company also brought in Peter Frings, an agronomist with Mccain 93 94 95

96

97 98

Ann Blackman, ―Moscow‘s Big Mak Attack,‖ www.time.com, February 05, 1990. Same-store sales is defined as sales at stores open for at least 13 months. ―Russian Ruble 43 Percent Underestimated, According to Big Mac Index,‖ http://newsfromrussia.com, July 21, 2009. Jenny Wiggins, ―Growing Taste for Quality Goods Lures Big Brands,‖ www.ft.com, January 20, 2010. ―McDonald‘s Russia,‖ Brand Strategy, November 2005. Ann Blackman, ―Moscow‘s Big Mak Attack,‖ www.time.com, February 5, 1990.

349

International Business Foods Ltd., to introduce the Russian farmers to the non-native Russian Burbank potato used to make the company‘s fries. 99 Some selected farmers were educated on improving the quality as well as production volumes. Some Netherlands-based potato farmers and processors helped the local farmers to grow a specific variety of potato that was suitable for making frozen French fries. Bakers were also brought in not only from the US and Canada, but also from some European countries like Sweden and Germany, to develop baking systems for buns and pies. The pasteurization process, set up by dairy experts from Sweden, was a very significant step as the milk in Russia was highly contaminated compared to other countries in Europe and the US. Initially, there were problems in the procurement of beef as well, due to its shortage in Moscow. Even though European meat experts were brought in to start new feed programs for the Russian cattle, the local supply was unable to meet the huge demand of 1,500 tons of beef per year. Also the company was not allowed by the government to buy meat directly on its own, in spite of initiating such feed programs. It had to strike a deal with the government-run slaughter houses, but then, the company was also restricted from picking up its choice of meat. As a result, McDonald‘s installed different buyers at various slaughter houses who bought the beef for the company in limited quantities.100 By 1999, about 75-80% of the raw materials were being sourced from more than 100 local producers in Russia. ―Our main goal is to develop local suppliers. We check their production every three months to guarantee quality,‖ 101 commented Khasbulatov. But even in 2001, the company was importing chickens from France, cheese, fish, and apple segments from Poland, potatoes — cut and frozen – from the Netherlands. While McDonald‘s continued to select its own suppliers in Russia, in 2007, it handed over the company‘s logistics to Alfa Group affiliate Rulog102 in a bid to remove logistics from its own management. McDonald‘s also transferred chicken production to a plant in the Kaliningrad region, which was set up jointly with Brazil‘s Sadia. ―The production of beef patties will be handed over before the end of the year to an enterprise that Italy‘s Inalca is building in the Moscow region… Thus, more than 80% of the products for our chain will be produced on Russian territory. Only the production and processing of potatoes and fish products will remain abroad,‖ 103 said Khasbulatov.

Results McDonald‘s was a huge success in Russia right from the first day of its operations. Thousands of customers queued up for hours to experience it. The restaurant served over 30,000 customers on the opening day. By 1993, the company started making profits in Russia and did not look back after that. ―In a country where there was nothing available, McDonald‘s was everything,‖ 104 said Russian restaurant magnate Rostislav Ordovsky.

99

100

101

102

103 104

350

Helen Deresky, International Management: Managing Across Borders and Cultures, (Pearson Prentice Hall, 2006). Foster, P, ―McDonald‘s Excellent Soviet Venture?‖ Canadian Business, Vol. 64, Issue 5, May 1991. Anatoly Vereshchagin, ―McDonald‘s Rules Russian Fast Food Market,‖ www.cdi.org, October 29, 2001. Rulog had a distribution center in Moscow and was planning to open similar facilities in St. Petersburg, Kazan, the Urals, and in southern Russia. ―McDonald‘s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007.

McDonald’s Russia: A Jewel in the McDonald’s Emerging… In 2004, McDonald‘s sales growth of 18 percent in Russia was the first time that its sales growth was below 20 percent since the year of its launch, but it still emerged as McDonald‘s leading market in comparable sales and total sales growth. 105 By the time the company celebrated the 15th anniversary of the opening of its first restaurant in Russia in January 2005, it had served over one billion customers and was serving more than 500,000 customers every day. According to Mike Roberts, President and COO, McDonald‘s, Russia ranked second in the entire McDonald‘s system for average guest counts per restaurant. 106 The company was also credited with having made significant contributions to the development of Russia‘s foodservice and processing industries, agriculture, and business practices. ―Customers view McDonald‘s as a company that builds in Russia with a pioneer spirit. It is now viewed as an international brand, run by local people and supplied by local people. It‘s part of Russia‘s history,‖107 said Khasbulatov. In 2005, McDonald‘s turnover in Russia grew by 26 percent. According to Khasbulatov, with a growth rate of more than 20 percent per year, it was comparable to China. The Russian state backed Russian Bistro that was set up in 1995 to directly compete with McDonald‘s too could not match it, and in 2005, the government transferred the managerial tasks to Arpikom Company, which started leasing the snack shops out.108 In 2006, the direct investment in the development of the McDonald‘s chain was more than 1 billion rubles and the company said that this figure was set to rise in subsequent years.109 Analysts felt that few of McDonald‘s markets could boast of more activity than Russia, which, on an average, served 850,000 diners annually. The figure was twice the store traffic in McDonald's other markets. In 2007, McDonald‘s President Ralph Alvarez commented, ―It‘d be very easy today to go in and say, ‗Khamzat, you‘ve got to build 100 restaurants,‘ because we‘re getting phenomenal returns.‖ 110 By 2007, McDonald‘s turnover in Russia was growing 30% annually, and the rate of growth was the fastest in the world. It was also opening more stores in Russia annually than any other country with the exception of China. 111 In terms of turnover, it was among the top ten markets of McDonald‘s.112 According to analysts, the company‘s profit margins in Russia were in the mid-20% range, much higher than the global average of McDonald‘s.113

105

106

107 108

109

110

111

112 113

Chris Mercer, ―McDonald‘s Plans to Double Russian Presence,‖ www.foodnavigator.com, February 3, 2005. ―McDonald‘s Celebrates its 15th Anniversary in Russia,‖ www.prnewswire.co.uk, January 31 2005. ―McDonald‘s Russia,‖ Brand Strategy, November 2005. ―McDonald‘s and Burger King Kill Russian Bistro,‖ http://english.pravda.ru, November 9, 2009. ―Number of McDonald‘s Restaurants in Russia to Exceed 200 by End of 2007,‖ http://eng.investmarket.ru, March 27, 2007. Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007. ―McDonald‘s Turnover in Russia Growing 30% Annually,‖ Russia & CIS Business and Financial Newswire, October 24, 2007. ―McDonald‘s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007.

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International Business Experts felt that the company had done well in Russia despite facing some serious challenges. Although the political environment had been murky at times, the company had increased its investment in the country. In 2009, it planned to invest US$120 million on expanding its operations in Russia.114 Experts noted that other companies such as Coca-Cola too were investing generously in the country. 115 According to Douglas Helfer, a senior portfolio manager at the Halbis unit of HSBC Global Asset Management, ―They see that the opportunity outweighs the price of the risk.‖ 116 According to McDonald‘s, it had posted record-high comparable sales growth in Europe in 2008. It attributed this success to markets such as Russia, France, the UK, and Germany. According to McDonald‘s, this was partly due to the fact that the company created local customer relevance through a tiered menu approach, which had ‗an effective combination of premium selections, classic menu favorites, everyday value, and popular limited-time food promotions‘. Like other markets in the Europe such as France, Germany, and the UK, the company strove to improve operational efficiency in its restaurants in Russia and transparently communicated facts about its brand, the quality and nutrition of its food items, and about itself as an employer. According to the company, its European operation‘s constant currency increase in revenues in 2008 and 2007 was mainly due to strong comparable sales in Russia, France, and the UK.117 ―We have 25,000 employees in Russia, US$1 billion in sales, and net profits of US$200 million… We are in 130 countries and Russia is, by far, the best… We do 800,000 transactions a year, which is double the number in North America,‖118 said Cohon. Despite a tough environment, with the Russian consumer sentiment being dramatically hit by the economic crisis, McDonald‘s Russia continued its stellar performance in 2009. ―In 2009, we have seen positive dynamics in customer traffic and sales. The average bill was higher than in 2008 although it did not reach what we forecast. We have no fundamental concerns that the situation may turn for the worse,‖119 said Khasbulatov. Industry observers felt that in addition to obtaining a first mover advantage in Russia, McDonald‘s had also benefited from being a foreign brand. ―If we look at ads from pre-revolutionary Russia, we hardly see a Russian brand. It‘s all Bormann, Einem, Wolf, Marx, Singer, etc. So, on a genetic level, our people trust only Western companies,‖120 said Goncharov.

114

115

116

117

118

119

120

352

Benjamin Scent and Natallie Cai, ―To Russia with Love,‖ www.thestandard.com.hk, June 29, 2009. In February 2006, Coca-Cola announced that it would invest US$1.2 billion in Russia over the next three to five years as it felt that the sale of carbonated drink would increase during the economic crisis. Benjamin Scent and Natallie Cai, ―To Russia with Love,‖ www.thestandard.com.hk, June 29, 2009. ―Moscow Wants to Up Rent on its Two McDonald‘s,‖ www.dailyherald.com, July 10, 2009. Diane Francis, ―Russia Good for Business: McDonald‘s,‖ http://network.nationalpost.com, September 11, 2008. Maria Kiselyova and Maria Plis, ―McDonald‘s to Target Stay-at-home Russians,‖ www.reuters.com, December 17, 2009. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010.

McDonald’s Russia: A Jewel in the McDonald’s Emerging…

Overcoming Challenges Analysts felt that the biggest challenge before McDonald‘s Russia was dealing with the ministries. They felt that these regulators adhered to rigid regulations in doling out supplies. ―When we need more sand or gravel for building and go to the department in charge, they say, ‗Sorry, you‘re not in my five-year plan‘,‖ 121 said Cohon. The level of bureaucracy in the country was a big impediment to growth, according to Khasbulatov.

Catering to the local population was also challenging as their eating habits were quite different and many of them were unaccustomed to eating foods such as burgers. For instance, some people who were initially invited to test the Big Mac reportedly ate it layer by layer.122 Moreover, eating habits were different. Eating food in Russia was a ―lengthy‖ procedure, with people sitting at a table for long periods of time. 123 They were also not familiar with the drive-thru format. However, with the offerings at McDonald‘s being viewed as a novelty by customers, the company had to contend with long queues. Right from the first day, the company had to work differently to cater to this market. It took various initiatives to reduce long waiting lines by hiring private security people to keep order and by using public-address systems to tell patrons how to place orders. In some locations, employees took orders on handheld devices before customers reached the counter. In addition to verbal instructions, customers were given picturemenus to simplify the ordering process. To deal with black marketing and pilferage, the company maintained a one-door policy. In the initial days, there was a limit of ten Big Macs to each customer.124 To move things fast, the company also invested in new cooking equipment that helped serve customers faster. According to Khasbulatov, ―When I said I have too many customers, it's a nice problem to have… I would love to continue to have this problem.‖125 In addition to the political challenges that the company faced, the company also suffered a financial crisis during the economic turmoil in Russia around 1998. During that time, the ruble fell drastically in value, leading to high inflation and economic instability in the country. As a consequence, customer traffic decreased considerably in the McDonald‘s stores and sales suffered a serious setback. 126 In 1998, McDonald‘s also experienced a major labor dispute in its processing plant, the McComplex, when attempts by security personnel in the unit to form a union were reportedly blocked by the company time and again. According to analysts, many laborers accused the company of ill-treating them and of illegally holding them back from forming a union. At that time, the company, under the pressure of an economic slowdown, did lay off some employees and reduce salaries, which made the labor force think about unionization. However, McDonald‘s Russia denied having ill treated its employees and said that it was strictly abiding by the Russian laws. The incident led to legal proceedings as well and tainted the employee friendly image of the company not only in Russia but also in several other markets during that time.127 121 122 123 124 125 126 127

Ann Blackman, ―Moscow‘s Big Mak Attack,‖ www.time.com, February 5, 1990. Ann Blackman, ―Moscow‘s Big Mak Attack,‖ www.time.com, February 5, 1990. ―McDonald‘s and Burger King Kill Russian Bistro,‖ http://english.pravda.ru, November 9, 2009. Helen Deresky, International Management: Managing Across Borders and Cultures, (Pearson Prentice Hall, 2006). Janet Adamy, ―As Burgers Boom in Russia, McDonald‘s Touts Discipline,‖ http://online.wsj.com, October 16, 2007. Youngme Moon, Kerry Herman, ―McDonald‘s Russia: Managing a Crisis,‖ http://harvardbusinessonline.hbsp.harvard.edu, October 21, 2002. Angela Charlton, ―Natalya Gracheva is Giving McDonald‘s Heartburn,‖ www.mcspotlight.org, June 23, 1999.

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International Business On February 19, 2007, the McDonald‘s at St. Petersburg was bombed in a terrorist attack, injuring six people and damaging the store to a great extent. A similar explosion had earlier occurred in 2002, when a bomb went off in a car at a McDonald‘s restaurant in Moscow.128 In November 2007, McDonald‘s Russia was suspected of tax evasion and its offices were raided by tax inspectors, who later claimed US$ 6.5 million from the company. According to a newspaper, the Kommersant daily, the income tax department suspected that the company bought meat and packaging materials through the shell companies and availed of value-added tax redemption on milk and meat purchases without having proper documentation.129 The Russian Tax officials contended that by allegedly using unlicensed suppliers, McDonald‘s had posed a threat to Russian society. Analysts felt that the Russian tax law was very complicated and left foreign players at the mercy of regulators.130 Experts said that McDonald‘s Russia faced minimum competition as it was the pioneer in fast food chains in the country and enjoyed the first mover advantage. Over the years, many other retailers came up but none could attain the stature enjoyed by McDonald‘s (Refer to Exhibit VII for Leading Fast Food Chains in Russia). According to analysts, the fact that McDonald‘s locked the prime locations in the country well in advance helped it to beat competition later when other companies like Starbucks Corporation (Starbucks) 131 struggled against the rising real estate prices to gain a significant presence in the country. ―When they are paying 3,000 rubles a month for a 1,500 sq. meter outlet on Arbat, and we are paying $20,000 a month for a 60 sq. meter outlet, who do you think is going to have the upper hand? And that‘s not their only outlet with such rent conditions,‖ 132 said Goncharov. In mid-2009, McDonald‘s also had to deal with a lawsuit filed against it by the government that sought higher rental payments from its two restaurants (on Arbat and on Bolshoy Nikolopeskovsky Pereulok) in the center of Moscow. In the early 1990s, the company had signed a 49-year agreement with the city government at an annual rate of 1 ruble per square meter. The government sought to enforce a local law requiring a minimum annual rental rate of 1,000 rubles (US$30.67) per square meter and wanted McDonald‘s to pay this rent.133 In December 2009, Moscow's arbitration court upheld the city authorities‘ move.134

128

129

130 131

132

133

134

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―Explosion Hits McDonald‘s Restaurant in St. Petersburg; 6 injured,‖ www.iht.com, February 18, 2007 ―McDonalds Russia Fights $6.5 mln Tax Claim,‖ www.flex-news-food.com, December 5, 2007. Shaun Walker, ―McDonald‘s Faces 3m Back-tax Bill in Russia,‖ www.independent.co.uk, December 5, 2007. Starbucks Corporation was started in 1971, at Seattle, the US. It is regarded as one of the leading coffee chains in the world. As of 2008, it was present in 43 countries across the world with 7,087 company operated stores and 4,081 licensed stores. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010. ―Moscow Wants to Up Rent on its Two McDonald‘s,‖ www.dailyherald.com, July 10, 2009. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010.

McDonald’s Russia: A Jewel in the McDonald’s Emerging…

Exhibit VII Leading Fast Food Chains in Russia Name of the Chain

Country of Origin

KroshkaKartoshka

Russia (Moscow)

Stardog‘s

Year of Est. in Russia

No. of Outlets 2005

2006

2007

March 2008

1991

141

170

230

252

Russia (Moscow)

1993 (2003 as new brand)

186

197

224

234

McDonald‘s

USA

1990

137

157

174

190

Baskin Robbins

USA

1992

118

132

139

139

Teremok

Russia

1998

62

92

135

142

Rostik‘s KFC

Russia/USA

1993 (2005 as new brand)

87

97

135

141

Sbarro

USA

1997

52

83

111

114

Riksha I Van

Russia (Moscow)

1998 (2006 as new brand)

79

90

Chaynaya Lozhka

Russia (St.Petersburg)

2001

28

42

59

64

Eurasia

Russia (St.Petersburg)

2001

30

49

49

49

Moo - moo

Russia (Moscow)

2000

14

17

17

PrimeStar

Russia/USA

2007

13

14

Grabli

Russia (Moscow)

2003

4

5

1

3

Source: “Russian Federation HRI Food Service Sector-2008,” www.fas.usda.gov, July 28, 2008. In Old Arbat pedestrian Tourist Mall, McDonald‘s constructed side cafés and served a dessert menu. McDonald‘s also began to make stronger McCafes, 135 as a pre-emptive measure to face competition from Starbucks, much before it entered in Russia in 2007.136 McDonald‘s, however, faced some competition from a few local retailers like the Rostik‘s Group137 and Elki-Palki138 as well as from the US-based companies like Yum! Brands.139 Some of the local fast food stalls that served local dishes at very low prices also took away a lot of McDonald‘s customers and added to the competition. 135 136

137

138

139

McDonald‘s coffee house style cafés were first launched in Russia in 2002. ―McDonalds Becoming Largest Corporate Land Owner in Russia,‖ www.organicconsumers.org, March 22, 2005. Rostick‘s Group (Rostick‘s), started in 1993, in Russia, operated restaurants in different formats that included including Il Patio, Planetsushi, Friday‘s Moka Loka, and Siberian Crown. There were 174 stores under Rostick in 2004. As of 2007, it controlled 14% of the restaurant market. Rostick‘s was the second most popular fast food name in Russia, after McDonald‘s. Founded in 1996, this Russian chain specialized in Russian cuisine and was moderately priced. Yum! Brands, based in Kentucky, USA, operates around the world through 36,000 restaurants in 110 countries and territories. In 2007, it reported sales worth US$ 9,100

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International Business Despite many obstacles that included two bomb attacks on its stores, Russia‘s two wars in Chechnya,140 the economic crisis in 1998, and many other challenges, McDonald‘s Russia continued to grow at a slow and steady pace. Some analysts also pointed out that though McDonald‘s Russia faced a lot of challenges, it remained shielded from controversies related to the paying of low wages and health-related accusations that it suffered in the US and European countries. They said that obesity related controversies did not bother the company in Russia where people themselves asked for mayonnaise that had 40% fat content.141 This was despite some nutritionists raising concerns that the local population‘s love for a burger could lead to health issues in the country.142 McDonald‘s also said that though it encountered some problems in dealing with the regulators, it did not have any trouble in terms of corruption or harassment in Russia. According to Cohon, Russia was a great place to do business, if politics were not involved.143

Outlook With more than two-third of Russia‘s fast food business, McDonald‘s was a dominant player. In 2009, Russia was again one of the markets that spurred the company‘s growth as it was McDonald‘s fastest-growing market in Europe in terms of restaurant openings. Analysts said that McDonald‘s strong performance in Russia came at a time when the country was in the grip of an economic downturn and its competitors were struggling (Refer to Exhibit VIII for Comparison between McDonald‘s Comparable Sales in November 2008 and 2007). According to the company, the sales were driven by extended operational hours and more variety in the breakfast and regular menu. In the words of Skinner, ―McDonald‘s continued strong performance reflects the benefits of our multidimensional approach. Convenient locations, extended hours, and quality food at an outstanding value are all reasons why people are choosing McDonald‘s.‖ 144 However, Khasbulatov admitted that McDonald‘s was affected by the economic downturn and that its growth in the market would slow down. ―I can‘t say we have gained from the crisis by taking the share from more expensive restaurants… The recession has had an impact on our customers and we haven‘t gained from it ... We won‘t see the previous pace of growth of 15-20 percent a year any more,‖ 145 he said.

140

141

142

143

144

145

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million. Restaurant chains under it include Kentucky Fried Chicken (KFC), Pizza Hut, Taco Bell, and Long John Silver. In 2005, KFC co-branded with Rostick‘s in Russia to sell their chicken products. Chechnya was a Republic within the Russian Federation. This region had been in constant conflict with Russian Federation for a long time. The First Chechen War was fought between 1994 and1996 and resulted in the independence of Chechnya. In August 1999, the Second War started, which ended around mid-2000. It resulted in Russia gaining control over the separatist region of Chechnya. However, sporadic fighting continued even till 2005. ―McDonalds Becoming Largest Corporate Land Owner in Russia,‖ www.organicconsumers.org, March 22, 2005. Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010. Diane Francis, ―Russia Good for Business: McDonald‘s,‖ http://network.nationalpost.com, September 11, 2008. ―McDonald‘s delivers another Month of Strong Global Comparable Sales - November Up 7.7%,‖ www.mcdonalds.com, December 8, 2008. Maria Plis, ―McDonald‘s Eyes Russia Growth with 40 New Stores,‖ http://uk.reuters.com, February 26, 2009.

McDonald’s Russia: A Jewel in the McDonald’s Emerging… However, he added that Russia would remain one of its most dynamic markets despite the economic downturn and that McDonald‘s Russia would continue to be the company‘s fastest growing and most profitable market.

Exhibit VIII McDonald’s Comparable Sales in November 2008 and 2007 Major segments of the company

% Increase in Sales 2008

2007

7.7

8.2

US

4.5

4.4

Europe

7.8

10.8

APMEA

13.2

12

7.1

7.0

US

3.9

4.9

Europe

8.8

7.6

APMEA

9.3

10.4

Month ended November 30 McDonald‘s Corporation

Year-to- Date November 30 McDonald‘s Corporation

“McDonald’s Delivers Another Month of Strong Global Comparable Sales November Up 7.7%,” www.mcdonalds.com, December 8, 2008. The company planned to open another 45 outlets in Russia by the end of 2012. 146 It planned to expand into areas that were less penetrated by fast-food chains. It was also speculated that the company might launch a franchise scheme to expand beyond the Ural mountains in the eastern part of the country. Analysts expected McDonald‘s to spend US$120200 million in 2010 on opening new outlets and also to spend a significant amount on revamping existing outlets. Establishing the entire production chain for McDonald‘s

Russia in the country was another priority for the company. ―Currently, 80% of what we produce [in Russia] is made in Russia. The task is to move the remaining 20% to Russia,‖147 said Khasbulatov. In January 2010, Burger King entered Russia, opening its first outlet in Moscow. 148 Experts felt that Burger King had taken the plunge attracted by the success of McDonald‘s. Subway too planned to expand its chain in Russia from 78 in December 2009 to 1,000 outlets by 2015.149 While analysts expected the competition to intensify with the entry of Burger King and the emergence of some strong domestic players, 146

147

148 149

Jenny Wiggins, ―Growing Taste for Quality Goods Lures Big Brands,‖ www.ft.com, January 20, 2010. ―McDonalds to Invest in New Restaurants in Russia,‖ http://bbjonline.hu, February 26, 2009. ―Burger King Opens First Outlet in Russia,‖ http://abcnews.go.com, January 21, 2010. Maria Kiselyova and Maria Plis, ―McDonald‘s to Target Stay-at-home Russians,‖ www.reuters.com, December 17, 2009.

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International Business they did not expect McDonald‘s position to come under threat immediately. According to Oleg Sukhotin, executive director of the Russian Association of Fast Food Enterprises, ―It‘s difficult to compete with McDonald‘s because it received privileges from the city government — at least at some stage. But I‘m sure that, for instance, Kroshka-Kartoshka has been successfully taking over McDonald‘s customers.‖ 150 McDonald‘s seemed unpurterbed by the competition and felt that there was plenty of scope for growth in Russia. According to Khasbulatov, more than two third of the population were not in the habit of eating out. ―While 70 percent of our population is not used to eating outside the house, we will have a niche that we should be looking at carefully as there are big opportunities to make these people eat out,‖ 151 he said.

150

151

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Vladimir Kozlov, ―McDonald‘s Supersize Profits Conquer Moscow,‖ www.mnweekly.ru, January 25, 2010. Maria Kiselyova and Maria Plis, ―McDonald‘s to Target Stay-at-home Russians,‖ www.reuters.com, December 17, 2009.

McDonald’s Russia: A Jewel in the McDonald’s Emerging…

References and Suggested Readings: 1. Ann Blackman, “Moscow’s Big Mak Attack,” www.time.com, February 05, 1990. 2. Foster, P, “McDonald’s Excellent Soviet Venture?” Canadian Business, Vol. 64, Issue 5, May 1991. 3. Angela Charlton, “Natalya Gracheva is Giving McDonald’s Heartburn,” www.mcspotlight.org, June 23, 1999. 4. Alf Nucifora, “Russians Learn to Smile-for Profit,” Business News, September 27, 1999. 5. Natalia Olynec, “Big Mac Blues in Russia,” Bloomberg News, www.bellybuttonwindow.com, 1999. 6. Amy Zuber, “McDonald’s 10th Anniversary in Russia Brings Future Confidence Despite Struggles,” National Restaurant News, http://findarticles.com, February 21, 2000. 7. “US Fast Food Firm Expanding in Russia,” Interfax, CDi Russia Weekly #136, www.cdi.org, January 05, 2001. 8. “The McDonald’s Effect,” http://web-japan.org, August 20, 2001. 9. Dmitry Dobrov and Kommersant Vlast www.russiajournal.com, October 26, 2001.

“Food

Industry

1991-2000,”

10. Anatoly Vereshchagin, “McDonald’s Rules Russian Fast Food Market,” www.cdi.org, October 29, 2001. 11. Vladimir Kozlov, “Fast-Food Profits Offer Food for Thought,” www.russiajournal.com, November 29, 2001. 12. Daniel Rogers, “Can Mac Fight Back?” www.marketingmagazine.co.uk, October 17, 2002. 13. Youngme Moon and Kerry Herman, “McDonald’s Russia: Managing a Crisis,” http://harvardbusinessonline.hbsp.harvard.edu, October 21, 2002. 14. Dmitry Babich, Yulia Ignatyeva “Big Mac does not Give Up,” Foreign InvestmentCDI Russia Weekly, www.cdi.org, February 26-March 4, 2003. 15. “McDonald’s Celebrates its 15th Anniversary in Russia,” www.prnewswire.co.uk, January 31, 2005. 16. Chris Mercer, “McDonald’s Plans to Double Russian Presence,” www.foodnavigator.com, February 3, 2005. 17. Geoffrey Jones, Multinationals and Global Capitalism, (Oxford University Press, February 2005). 18. Erin E. Arvedlund, “McDonald’s Gobbles up Russian Real estate,” www.iht.com, March 18, 2005. 19. “McDonalds Becoming Largest Corporate www.organicconsumers.org, March 22, 2005. 20.

Land

Owner

in

Russia,”

“McDonalds Set for 20% Expansion in Russia,” www.sptimes.ru, June 10, 2005.

21. “McDonald’s Russia,” Brand Strategy, November 2005. 22. Tony Royle, “The Union Recognition Dispute at McDonald’s Moscow FoodProcessing,” Industrial Relationship Journal, Blackwell Publishing Ltd., 2005. 23. Helen Deresky, International Management: Managing Across Borders and Cultures, (Pearson Prentice Hall, 2006). 24. “McDonald’s Russia Named Best Employer,” www.crmcdonalds.com, January 16, 2007.

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International Business 25. “Explosion hits McDonald’s restaurant in St. Petersburg; 6 injured,” www.iht.com, February 18, 2007 26. “Russian Police See McDonald’s http://news.webindia123.com, February 19, 2007.

Blast

as

Hooliganism,”

27. “Number of McDonald’s Restaurants in Russia to Exceed 200 by End of 2007,” http://eng.investmarket.ru, March 27, 2007. 28. “The Taste of Pace: Situating Fast Food Restaurants in Russia’s Agrifood System,” http://ageconsearch.umn.edu, May 18, 2007. 29. Janet Adamy, “As Burgers Boom in Russia, McDonald’s Touts Discipline,” http://online.wsj.com, October 16, 2007. 30. ―Russia Loves the Golden Arches,‖ www.newser.com, October 16, 2007. 31.

―McDonalds Russia Fights $6.5 mln Tax Claim,‖ Reuters, www.flex-newsfood.com, December 5, 2007.

32. Vladimir Kvint ―Russia’s Surging Economy,‖ www.forbes.com, January 8, 2008. 33. ―McDonald’s to Open 40 Restaurants in Russia in 2008,‖ www.cdi.org, April 22, 2008. 34. “Top 10 Consumer Trends in Russia,” www.euromonitor.com, May 7, 2008. 35. Yuri Mumchur, “Obama in Moscow: True Reset or Just Walking in Circles?” www.russiablog.org, July 8, 2008. 36. Kerry Capell, ―A Golden Recipe for McDonald’s Europe,‖ www.spiegel.de, July 18, 2008. 37. “Russian Federation HRI Food Service Sector-2008,” www.fas.usda.gov, July 28, 2008. 38. Diane Francis ―Russia Good for Business: McDonald’s,‖ http://network.nationalpost.com, September 11, 2008. 39. ―McDonald’s Delivers another Month of Strong Global Comparable Sales November Up 7.7%,‖ www.mcdonalds.com, December 8, 2008. 40. ―The Fast Deteriorating State of Russia’s Economy,‖ www.economist.com, December 14, 2008. 41. “Crisis Will not Affect McDonald’s in Russia,‖ www.realestatelife.org, December 24, 2008. 42. ―Food & Drinks Industry Day Converting Opportunities to Business: Russian and Ukrainian,‖ www.bordbia.ie, 2008. 43. “McDonald’s Corporation, 2008 Annual Report,” www.mcdonalds.com. 44. “McDonalds to Invest in New Restaurants in Russia,” http://bbjonline.hu, February 26, 2009. 45. Benjamin Scent and Natallie Cai, “To Russia with Love,” www.thestandard.com.hk, June 29, 2009. 46. “Moscow Wants to Up Rent on its Two McDonald’s,” www.dailyherald.com, July 10, 2009. 47. “Russian Ruble 43 Percent Underestimated, According to Big Mac Index,” http://newsfromrussia.com, July 21, 2009. 48. “George Cohon, Founder of McDonald’s Canada and McDonald’s Russia, Honored in Washington, D.C.,” www.marketwire.com, October 6, 2009. 49. “McDonald’s and Burger King Kill Russian Bistro,” http://english.pravda.ru, November 9, 2009.

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McDonald’s Russia: A Jewel in the McDonald’s Emerging… 50. Maria Kiselyova and Maria Plis, “McDonald’s to Target Stay-at-home Russians,” www.reuters.com, December 17, 2009. 51. Jenny Wiggins, “Growing Taste for Quality Goods Lures Big Brands,” www.ft.com, January 20, 2010. 52. “Burger King Opens First Outlet in Russia,” http://abcnews.go.com, January 21, 2010. 53. “McDonald’s Delivers Another Year of Strong Results in 2009,” www.chainleader.com, January 25, 2010. 54. Vladimir Kozlov, “McDonald’s Supersize Profits Conquer Moscow,” www.mnweekly.ru, January 25, 2010. 55. “McDonald’s in Moscow,” http://goldenessays.com 56. “McDonalds Corporation,” www.fortune500news.com. 57.

“McDonald’s Corporation, Company History,” www.answers.com.

58. “Eating out in Moscow & St. Petersburg,” www.gateway2russia.com. 59. “McDonald’s History,” www.mcdonalds.ca. 60. www.mcdonalds.com 61. www.mcdonalds.ca 62. http://finance.yahoo.com. 63. www.yumbrands.com.

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Carrefour’s Misadventure in Russia The case examines the entry and exit strategies of French retailer Carrefour in the Russian market. The company opened its first store in Russia in June 2009, after spending over two years in studying the country's retail markets. However, within four months, in October 2009, it announced its exit from the market, citing lack of growth and acquisition opportunities. The case discusses Carrefour's entry into Russia, its failed acquisition attempts and the factors that forced it to make a quick exit from the country. It also examines the business environment in the Russian retailing industry.

Carrefour’s Misadventure in Russia “In the space of just four months, Russia has gone from a “strategic priority” to an afterthought at Carrefour, the giant French retailer.”1 - New York Times, in October 2009. “Carrefour’s pending exit underlines the fact that Russia remains a highly challenging market despite its fundamental draw. Although MGR (Mass Grocery Retail) sales are forecast to strengthen by a dynamic 66.4% to RUB 1,423bn (US$ 48.53bn) through to 2014, the country’s business environment is among the least forthcoming in emerging Europe. Despite topping our Q110 food and drink regional business environment ratings, Russia’s market risks score (encompassing regulatory environment and barriers to entry) is the region’s second lowest behind Ukraine.”2 -

Business Monitor International3, in October 2009.

Carrefour Exits Russia On October 15, 2009, just four months after opening its first store in Russia, Francebased Carrefour SA (Carrefour), the second largest retailer in the world, announced that it planned to exit the Russian market. The company announced, “Carrefour has decided to sell its activities in Russia and pull out of the market, given the absence of sufficient organic-growth prospects and acquisition opportunities in the short- and medium-term that would have allowed Carrefour to attain a position of leadership. This decision is consistent with the Group‟s strategy which aims at building leadership positions that will ensure strong and lasting profitable growth.” 4 Carrefour started the groundwork to enter the Russian market in 2007, looking out for suitable locations for opening its stores. It opened its first store in the country, a hypermarket, in June 2009. Its second store was opened soon after. It also procured a location for its third store, which was to open by the end of the year. However, in a move that took industry analysts and observers alike by surprise, Carrefour announced its exit from the country in October 2009. Analysts opined that Carrefour‟s failure to acquire Russia-based grocery chain Sedmoi Kontinent5 (Seventh Continent) and shareholders‟ pressure on the company to focus on its core business were the main reasons for the exit decision. They were of the view that the bureaucracy, complicated legislative framework, corruption, and red tape that existed in the country were factors that could have influenced Carrefour‟s decision to quit Russia. Some of them opined that Carrefour had not given enough time for its operations to stabilize in the market. Viktoria Sokolova, Senior Analyst at Troika Dialog6, said the company‟s strategy was flawed and had come too late. She 1

2 3

4

5

6

Matthew Saltmarsh, Andrew E. Kramer, “French Retailer to Close Its Russia Stores,” www.nytimes.com, October 16, 2009. “Carrefour to Quit Russia,” ehttp://store.businessmonitor.com, October 16, 2009. London-based Business Monitor International is an independent information provider in the areas of country risk and information research. “French Hypermarket Chain Carrefour Leaves Russian Market,” http://en.rian.ru, October 15, 2009. Sedmoi Kontinent or Seventh Continent is a Russia-based grocery chain. As of December 2009, it operated through nine hypermarkets and 130 supermarkets in Russia. Its revenues for the year ending 2008 were 43.8 billion Rubles. Troika Dialog is one of the largest private investment banks in CIS. Its main lines of businesses include capital markets, investment banking, asset management, personal

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Carrefour’s Misadventure in Russia said, “Carrefour simply failed with its strategy to enter Russia. There is plenty of growth opportunities out there. Its nearest competitor, Auchan, has opened its 34th hypermarket in Russia, and continued its opening program, even during the crisis times. Carrefour came to Russia a little bit too late, and was talking, perhaps, not to the best operator in the market, without the distribution reach, to acquire them, as a means of an entry point.”7 Industry analysts, who had observed the Russian market closely, said that Carrefour‟s exit could affect the entry of other international retailers like Wal-Mart and Tesco, which had plans to enter the country. According to New York Times, “It also indicates that a good deal of the shine has come off the Russian retail market, in recent years one of the fastest growing in the world because of trickle-down oil wealth that helped lead a consumer boom built on decades of pent-up demand from the bleak Soviet era.”8

Background Note Carrefour was founded in 1960 by two entrepreneurs – Marcel Fournier, a textile retailer, and Louis Defforey, a wine and food wholesaler from Annecy in Eastern France. The first two stores that they opened were highly successful. In 1963, a 2,500 square meter store was opened in Sainte-Genevieve des Bois, a Paris suburb. It occupied an area of 2,500 square meters and had enough space to park more than 400 cars. The store provided a wide range of items, including self-service grocery at discount prices, and clothing, sporting equipment, electronic goods, and auto accessories. The store was inaugurated in June 1963 and its huge size earned it the name „hypermarket‟ in the media. Carrefour offered products at the lowest prices as compared to its competitors by negotiating with wholesalers and suppliers. The concept of a hypermarket found instant acceptance among the younger people, suburban dwellers, and price conscious consumers. In 1966, a 10,000 sq. meter hypermarket was opened in Lyon and a 20,000 sq. meter hypermarket was opened in Vitrolles. In 1967, Carrefour opened an office in Paris to coordinate the activities of its various stores in the country. The company began to enter international markets after a law was passed in France in 1963 to restrict the development of large stores. Its first international venture was in Belgium, where it opened an outlet in association with Delhaize Fréres-Le-Lion9, in 1969. In 1970, Carrefour‟s shares were listed on the Paris stock exchange. By 1971, Carrefour was directly operating 16-wholly owned stores, with an equity interest in five more stores. It also operated through franchises. In its first venture outside Europe, Carrefour opened a hypermarket in Brazil in 1975.

7 8

9

investments, and finance. About 33% of the equity stake in the company is owned by the Standard Bank Group and the rest is owned by 109 employee partners. “Retail Market Fight too Tough for Carrefour,” http://rt.com, October 17, 2009. Matthew Saltmarsh, Andrew E. Kramer, French Retailer to Close Its Russia Stores, www.nytimes.com, October 16, 2009. Delhaize Fréres-Le-Lion is a part of The Delhaize Group, a food retailer headquartered in Belgium. The group was founded in 1867 and operates food supermarkets in North America, Europe, and Southeast Asia. In 2008, its revenues were € 19.02 billion and profit was € 467 million.

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International Business In 1978, Carrefour developed a hard discount store10 format under the banner Ed, in France. The stores offered a limited range of products at very low prices. By 1985, Carrefour was operating in ten countries and had introduced private label products that were priced 10-20% lower than branded products and were said to be of superior quality. In 1988, Carrefour entered the US market by opening a 330,000 sq ft hypermarket in Philadelphia. Another hypermarket was set up in 1991 11. In 1991, Carrefour acquired French hypermarket chains – Euromarche and Montiaur. In 1992, Carrefour reported sales of € 17.86 billion and a net income of € 271 million. In the early 1990s, Carrefour concentrated on establishing larger stores in France (with an area of more than 2,500 square meters) and sold off its smaller stores. By the mid-1990s, Carrefour‟s European operations were spread across Italy, Spain, Turkey, Greece, and Portugal. In 1996, Carrefour opened 30 hypermarkets across the world, of which 15 were in South America. By 1997, the number of stores in South America had increased to 60 (Refer to Exhibit I for the timeline of Carrefour‟s entry into international markets). Carrefour operated through franchises in the UAE, Saudi Arabia, Oman, Qatar, Egypt, Tunisia, Algeria, and the Dominican Republic. In 1998, it acquired Comptoirs Modernes SA, which brought 790 supermarkets into its fold. In 1999, it acquired Promodès SA12, which owned several hypermarkets, supermarkets, convenience stores, and discount stores. The acquisitions helped Carrefour become the top retailer in Europe by the late 1990s.

Exhibit I Top Global Retailers (2009*) Rank

Company

Country

Retail Sales (US$ Million)

USA

374,526

France

112,604

1

Wal-Mart Stores Inc.

2

Carrefour SA

3

Tesco Plc

UK

94,740

4

Metro AG

Germany

88,189

5

The Home Depot Inc.

USA

77,349

6

The Kroger Co.

USA

70,235

7

Schwarz Unternehmens Treuhand KG

Germany

69,346

8

Target Corp.

USA

63,367

9

Costco Wholesale Corp.

USA

63,088

10

Aldi GmbH & Co OHG

Germany

54,847

Source: Deloitte, Global Powers of Retailing, 2009. * For the fiscal year ended June 2008. 10

11

12

Hard discount stores sell products at prices that are even lower than those in traditional discount stores like Wal-Mart. They are small in area and sell a limited assortment of products. Subsequently, Carrefour suspended the US operations in 1993, as the stores were not profitable. Promodès SA was established in 1950, and played a major role in promoting supermarkets in France. During the 1960s and 1970s, the group expanded rapidly in other countries in Europe and South America. In 1999, Carrefour purchased Promodès SA to become the second largest retailer in the world.

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Carrefour’s Misadventure in Russia As of 2008, Carrefour was the second largest retailer in the world and the largest retailer in Europe (Refer to Exhibit II for the list of global powers of retailing). By the end of 2008, it was operating 15,430 stores globally. It operated through different store formats like hypermarkets, supermarkets, convenience stores, hard discount stores, and cash & carry outlets (Refer to Exhibit III for Carrefour‟s store formats). Carrefour‟s revenues were at € 108.629 billion for the year ending December 2008 (Refer to Exhibit IV for Carrefour‟s country wise sales).

Exhibit II Carrefour – International Expansion YEAR

COUNTRY

1969

Belgium

1973

Spain

1975

Brazil

1982

Argentina

1989

Taiwan

1991

Greece, Cyprus

1992

Portugal

1993

Italy, Turkey

1994

Mexico*, Malaysia

1995

China

1996

South Korea*, Thailand, Hong Kong*

1997

Singapore, Poland

1998

Chile*, Colombia, Indonesia

1999

Czech Republic*, Slovakia*

2000

Japan*, Dominican Republic

2001

Romania, Switzerland**

2002

Egypt

2004

Saudi Arabia

2005

Algeria

2006

Cyprus

2007

Jordan, Kuwait

2008

Bahrain

2009

Iran, Syria, Morocco, Bulgaria, Russia,

* By 2006, Carrefour had exited from these countries. **By 2007, Carrefour exited Switzerland. Compiled from Carrefour’s Annual Reports and other sources. 367

International Business

Exhibit III

Carrefour – Store Formats FORMAT

DESCRIPTION Offers a wide range of food and non-food products Offers about 80,000 items.

Hypermarkets

Floor area of 5,000 square meters to 20,000 meters. Services like Carrefour travel, Carrefour insurance, Carrefour bookings Banner: Carrefour, Atacado Offers a wide selection of mostly food products Offers about 10,000 items

Supermarkets

Floor area of 1,000 to 2,000 square meters Banner: GS, GB, Carrefour Express, Carrefour Market, Carrefour Bairro Offers products at low prices.

Hard Discount Stores

About 800 retail branded food products Floor Areas of 300 to 800 square meters Banner: Dia, Ed, minipreco District or village shops

Convenience Stores

Products covering all the food requirements Offers a wide range of services like home delivery and ATMs Banner: Shopi, Marche Plus, 8 a Huit, DiperDi, Proxi, Carrefour City, Carrefour Express, Carrefour 5 minut

Cash-andCarry and Food Service

Wholesale and retail self-service Food products for businesses. Banner: Promocash, Docks, Super Gross.

Source: www.carrefour.com.

Exhibit IV Carrefour – Sales Country Wise (2008) Country

No. of Stores

France

47,119

5,517

Spain

15,527

3,073

Italy

7,806

1,608

Belgium

5,269

627

Greece & Cyprus

2,944

888

989

498

Portugal 368

Sales (In € Million)

Carrefour’s Misadventure in Russia

Country

Sales (In € Million)

No. of Stores

Poland

2,424

330

Turkey

1,641

760

Romania

1,190

41

Brazil

8,218

536

Argentina

2,647

589

Columbia

1,228

59

Taiwan

1,361

59

China

3,464

456

Thailand

584

31

Malaysia

326

16

Indonesia

893

73

Singapore

94

2

4,905

267

108,629

15,430

Partners Franchisees Total Group

Source: Annual Report, Carrefour, 2008.

Carrefour’s Plans for Russia In every international market in which Carrefour operated, it essentially focused on becoming one of the top three players in terms of market share. Commenting on the criteria for entering new markets, the Chairman of the Management Board of Carrefour, José Luis Duran, said, “We‟ll look toward new markets. That means local acquisitions in countries where we currently operate, but it also includes the possibility of establishing a presence in new countries, such as Russia and India. However, any such store openings will have to satisfy three criteria: we must be able to capture a leading market position within the medium term, establish our brand quickly, and secure a return on investment. It is only under these conditions that we will expand our scope of operations.” 13 Carrefour initially showed an interest in operating in Russia during the mid-1990s and opened a representative office in Moscow. It also finalized two prime locations, one in the center of the city and the other on the outskirts. However, during the 1998 financial crisis14, it exited from the country. In June 2006, Carrefour again started contemplating an entry into the Russian retail market. A delegation from Carrefour toured across Russia looking for locations, met local officials, and interacted with other retailers. After spending considerable time studying the markets, Carrefour announced its intention of entering the Russian 13 14

“Interview with the Chairman of the Management Board,” Annual Report 2006. The Russian financial crisis of 1998 was triggered by the Asian financial crisis of 1997 and resulted in high inflation. The food prices went up by 100% and with people stocking up essential items, shortages were witnessed. By 1999, the country recovered from the crisis.

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International Business market in June 2007. The retailer planned to open only hypermarkets initially. It would then follow this up with other store formats. At that time, it intended to open its chain in 20 cities. A group of managers from France were stationed in Russia to prepare for the launch of a new store by early 2008. Analysts were of the view that Carrefour had delayed its entry into Russia (Refer to Exhibit V for a note on retail industry in Russia). According to Maria Sulima, a retail analyst with Metropol15, “They are rather late in coming. At this point, it would be more effective to purchase a chain with already developed logistics and distribution networks.”16 By the time Carrefour entered the market, Auchan SA 17 (Auchan) and Metro AG18 (Metro) had established a significant presence in the country. Auchan had a presence in eight Russian cities while in Moscow alone, it had 20 stores. Metro had 74 stores across the country. Other competitors included local players like X5 Retail Group NV19 (X5) and Mosmart CJSC20 (Mosmart). On Carrefour‟s delayed entry into the country, Thierry Garnier (Garnier), Group Executive Director, Carrefour, said, “We were waiting for the best moment to enter the market. We are in Russia for the long term.”21

Exhibit V A Note on Retailing Industry in Russia (2008-09) As of 2008, the retailing industry in Russia was valued at US$ 480 billion, witnessing a growth of 27.5% over the previous year. The growth was attributed to high oil prices and strong economic growth in the market. Food retailing accounted for 45.3% of total retail sales. As of 2009, Russia was Europe‟s fastest growing consumer economy and by 2012, it was expected to overtake the UK and Germany in terms of retail sales, making it Europe‟s second largest retail market after France. According to the Economist Intelligence Unit, the retail market in Russia was expected to grow to US$ 745 billion by 2011. Moscow and St. Petersburg were the two largest cities in Russia. About 14 of its cities had a population of over 1 million and were expected to account for 60% of the retail growth in the country by 2012. The country‟s retail industry began to grow after 2004 and the growth was mainly in areas like supermarkets, electrical stores, fashion retailers, etc (Refer to Table A for the major retailers in Russia and their turnover for 2008).

15

16 17

18

19

20 21

IFC Metropol is a Russia-based investment and financial company. Its activities include corporate finance, debt instruments, equities, research, depository services, and legal services. “Carrefour Opens First Russian Store,” www.russianamericanchamber.com, June 19, 2009. Auchan is a France-based multinational retail group. The group is controlled by the Mulliez family of France. In 2008, its revenue was € 39.284 billion and net income was € 744 million. Metro is a Germany-based retail group. It was the fifth largest retailer in the world as of 2009. In 2008, its revenue was € 67.96 billion and profit was € 403 million. X5 was the largest retail group in Russia as of 2009. It operates through three formats – hypermarkets, supermarkets, and soft discount stores. In 2008, its sales were US$ 8892 million and EBITDA was US$ 803 million. Mosmart is a Russia-based multi-format retail chain. “Carrefour Opens First Russian Store,” www.russianamericanchamber.com, June 19, 2009.

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Carrefour’s Misadventure in Russia Table A: Major Retailers in Russia and their Turnover (2008) RETAILER

TURNOVER (In US$ Billion)

X5 Retail Group

9.0

Magnit

5.0

M.Video

2.7

Kopieka

2.0

Lenta

2.0

Dixy Group

1.5

Seventh Continent

1.4

The growth in the retailing industry in Russia was fueled by high disposable incomes as most of the Russians unlike US citizens were free of mortgages and lived in their family homes. As many Russians saw their savings being wiped out during the crisis during the late 1990s, they preferred to spend money rather than save it. In 2002, people in Moscow spent 94% of their monthly earnings. By 2007, per capita income in Russia, which was at US$ 1185 in 2001, had increased to US$ 4803. However, non-Russian companies found it very difficult to do business in the country, due to the high degree of bureaucracy existing there. Every activity from obtaining permission for land, finalizing property deals, clearing goods through customs, or obtaining visas, consumed a lot of time and effort. According to Chris Skirrow, Head of PricewaterhouseCoopers‟ retail and consumer practice in Moscow, “It is the day-to-day bureaucracy that can grind people down. It sometimes seems that if a comma is in the wrong place on an invoice you can lose the tax deduction. One of the biggest problems is unpredictability and unreliability – including tax authorities and the judiciary. There is not only potential for corruption but also uncertainty, which makes the operating environment a lot more difficult.”22 In several cases, companies opted to bribe the authorities in order to obtain the necessary permissions. Some of the businesses hired a Krisha (security firm), which handled payments etc. that enabled businesses to operate smoothly. Many foreign companies opted to partner with a local company to lead highly complex negotiations or operate through a franchisee. At the same time, there were retailers like Ikea, which from the beginning, emphasized that it would work only with those local governments that would agree to its no-bribery policy. Several local governments wanted Ikea to open stores in their region to show that they were against bribery, to attract other investors. Much of the retail activity in Russia was concentrated around Moscow, where the salaries were double that in other regions. But the market was highly saturated with several retailers, both international and local, having a presence in these cities.

22

“Russia‟s Retail Revolution,” www.managementtoday.co.uk, June 01, 2008.

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International Business Another problem that investors faced in Russia was the crumbling infrastructure. Finding the right people to fit into retail roles was also a major challenge. Though the country‟s education system was highly sophisticated, it churned out more scientists than management graduates. In mid-2008, UBS predicted that Russia‟s retail sales would grow by 22% per year till 2010. But by early 2009, the global economic crisis had started showing its impact on Russia and the retail sales slowed down after several years of growth. The retail sales in August 2009 were down 9.8% as compared to retail sales in August 2008. The crisis showed that Russia lacked good quality retail assets. In 2008, the top ten players accounted for only a 10% market share. The spending patterns of the Russian consumers also underwent a change with consumers exercising caution on spending due to the economic crisis. The growing unemployment rate also had an adverse impact on the retail sector in Russia. The Russian retail sector was estimated to grow by 3% in 2010. In the third quarter ending September 2009, the Russian economy witnessed a net capital outflow of US$ 31.5 billion. By October 2009, with oil prices going up, the Russian economy showed signs of revival. In spite of all the problems, Russia with a population of 143 million remained an attractive destination for retailing. According to the analysts, the top five retailers had a share of 12% in the Russian food market, and this was expected to increase to 14% by the end of the year. Consumers still preferred to shop at outdoor markets, street stands, and unbranded shops but a gradual shift toward larger outlets was being seen. Compiled from various sources. In order to step up its presence, Carrefour wanted to have an association with a local partner, and intended to acquire local grocery chain Seventh Continent, which operated through 140 stores. In February 2009, Carrefour made a non-binding offer to Seventh Continent valuing it at US$ 1.25 billion. On Carrefour‟s interest in Seventh Continent, Marie Lhome, analyst with Aurel BGC23 in Paris, said, “It is more expensive and difficult to set up operations in Russia. Some retailers, like Ikea, have run into legal issues there. The interest in Seventh Continent comes from the company‟s stores prime locations in the center of Moscow.”24 Analysts also expressed doubts about the fit of Seventh Continent with Carrefour‟s overall strategy, as Seventh Continent was a luxury store. However, the offer was rejected by the shareholders of Seventh Continent. Carrefour persisted with its acquisition effort and in May 2009, the company signed a preliminary letter of intent to acquire a 75% equity stake in Seventh Continent. Reports suggested that both the companies were under the exclusivity period25 due to which Seventh Continent could not enter into agreements or talks with any other potential buyers. Analysts were of the view that after the acquisition, the Russian retail market would account for 1% of Carrefour‟s total sales. 23

24

25

Aurel BGC is the result of a merger between ETC Pollak, Aurel, and BGC. The services provided by Aurel BGC include fixed income and equity derivatives. It also conducts economic and financial research and provides forecasts. Javier Espinoza, “Carrefour Flirts with Seventh Continent,” www.forbes.com, April 20, 2009. During the exclusivity period, both Carrefour and Seventh Continent was banned from negotiating with any other potential buyers. This, according to analysts, showed that the deal was imminent.

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Carrefour’s Misadventure in Russia But before Carrefour could conclude the deal, the owner of Seventh Continent ran into financial problems. The company defaulted on bond payments in June 2009 and went in for debt restructuring. Ultimately, Valdimir Gruzdev who controlled a10% equity in Seventh Continent, decided not to sell the company, citing that the time was not right to sell well-performing assets.

Opening Stores In June 2009, Carrefour opened its first store in Moscow. Commenting on this occasion, Jacobo Caller, General Director of Carrefour in Russia, said, “We are very happy to start our business operations in Russia where we will follow our clientoriented principles: offering quality products at low price, great value, and high level of services to Muscovites. We believe that the opening of the first Carrefour store in Moscow is an important step for Carrefour‟s development in Russia and will have a positive impact on the economic development of the city.” 26 At that time, Carrefour announced that it believed in the long-term potential of the country and considered the Russian market to be strategically important for the development of Carrefour. According to Garnier, “As the second world and most internationalized retailer, the Carrefour Group is now developing its activities in a new country. Starting our operations in Russia is an important milestone for our company. The Carrefour Group believes that the Russian retail market has outstanding long-term potential and considers it to be one of the strategic priorities for the company‟s international development.” 27 However, analysts cautioned that it would be difficult for Carrefour to expand in the country without acquiring an established player. According to Mikhail Terentiev, analyst with Nomura International 28 in Moscow, “It is not very easy to establish a footprint in Russia. If you want to expand in Russia rapidly it would be a good idea to buy somebody else with a very developed market.”29 Carrefour‟s first store was located in Filion Shopping Mall, and occupied two floors with a sales area of 8,000 square meters, 58 checkout counters, and 450 staff. It sold 15,000 food items and 30,000 non-food items. Of the total 45,000 SKUs on offer, over 5,000 were private label products. Fillion Shopping mall occupied an area of 87,000 sq. meters and included a 10-screen multiplex cinema and a theme park. The shopping mall had facilities to park 3,000 cars. Carrefour had reportedly invested € 8.8 million on its first store and its opening was a grand event with the guests being entertained by mime artists, musicians, dancing troupes, etc. However, industry experts were not impressed with the location of Fillion Shopping Mall, pointing out that though it was located close to the city center, it was not easily accessible, not prominently visible, and was located among low-income group families.

26

27

28

29

“Carrefour Starts Business Operations in Russia and Moves Forward with its International Expansion,” Press Release, Groupe Carrefour, June 18, 2009. “Carrefour Starts Business Operations in Russia and Moves Forward with its International Expansion,” Press Release, Groupe Carrefour, June 18, 2009. Nomura international is a part of Japan-based Nomura Group, which is an industrial and financial conglomerate. The group has interests in oil and gas, construction, chemicals, foodstuff, and finance. Javier Espionoza, “Carrefour May be Stumbling with Russian Dreams,” www.forbes.com, June 18, 2009.

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International Business Carrefour instantly attracted customers who mostly shopped there for food products. One item that proved to be highly attractive was the different varieties of bread that Carrefour sold. As most of the customers were used to the French retailer Auchan, they found shopping at Carrefour convenient due to the high service standards, availability, and wide choice of products. Just after the first store was opened, newspapers reported that negotiations between Carrefour and Seventh Continent had been stopped. Thus, Carrefour was not able to acquire Seventh Continent on which it was banking for its expansion in Russia. The second store was opened on September 10, 2009, at Krasnodar in South Russia. For this store, Carrefour entered into an MoU with the local government to implement an investment project. As per the MoU, the company planned to invest up to US$ 100 million in the region, over five years. Carrefour was to be provided with support in terms of business development, finding suitable plots, infrastructure, etc. by the regional authorities. On this store, Carrefour invested € 8 million. The store had a sales area of 8,500 meters, and employed 350 people. The company invested € 7.8 million on developing the store. At that time, it announced that though Russia was under a recession, for the first time in a decade, the crisis would not change Carrefour‟s plans for the market and it would open its third store as planned. According to Jacobo Caller, Carrefour Russia‟s Director, “For Carrefour, (the) Russian retail market has outstanding longterm potential. Despite the crisis, we are not going to change our long-term vision of this country. With Brazil, India, and China, Russia is one of the priorities in the longterm expansion of Carrefour.”30 At that time, he also announced that in a few months‟ time, Carrefour would come out with its elaborate expansion strategy for Russia. By the time the second store was opened, Carrefour had already announced its plans to open a third store in Lipetsk and had also entered into a lease agreement to open its fourth store at River Mall in Moscow. According to the analysts, Carrefour chose these locations as the major locations like Moscow and St. Petersburg were stagnating and Krasnodar and Lipetsk were some of the regions that were experiencing rapid growth.

.… And pulls out In September 2009, a report in Le Monde31 mentioned that Carrefour was under pressure from top shareholders to pull out of emerging markets. Carrefour, on its part, denied the report. According to a Reuters report, “French retailer Carrefour is seriously considering exiting Latin America, one of its most lucrative markets, under pressure from top shareholders, Le Monde newspaper reported…. But the board of the world‟s second-biggest retailer has rejected the idea of abandoning all emerging markets including Asia as this would give the impression the company was being broken up, the newspaper said.”32 However, on October 15, 2009, Carrefour announced that it had decided to close down its Russian operations. The company cited inadequate growth and acquisition opportunities as the reasons for its exit. It did not reveal details of total investments in Russia and said that the losses due to the exit were not significant. Carrefour also said 30

31 32

“Carrefour Says Looking at Acquisitions in Russia,” www.ibtimes.com, September 10, 2009. Le Monde is a French newspaper. “Carrefour Mulls Exit from Latin America – Le Monde,” http://uk.reuters.com, October 07, 2009.

374

Carrefour’s Misadventure in Russia that there were no prospects of its being among the top three retailers in the country, as it had planned. Carrefour also announced that the stores in Russia would continue to remain open till the company found a buyer for them, and that it would also open the third one as planned. This was done in order to cut the costs of exit and also to reduce the penalties that it could attract for severing the contracts with suppliers and landlords. Carrefour also looked around for a franchising partner to operate the stores and to develop the brand in the country. Industry experts opined that it took retailers several years to establish themselves in new markets, especially emerging markets like Russia which had high growth potential. They were surprised that Carrefour did not stay long enough to test the market. According to them, four months was too short a time to gauge the potential of the market. They said that Carrefour‟s justification about lack of acquisition and poor sales targets appeared more like excuses. The exit also made analysts question Carrefour‟s commitment to countries with high potential, but short-term difficulties and problems. According to Jaime Vazquez, an analyst at JPMorgan Chase & Co. in London, “Turning around the hypermarkets in a deflationary environment and with a weak price image is not going to be easy. Stores in emerging markets are the only ones doing well and offering good growth prospects,” so selling them makes no sense other than making short-term financial gain. 33 Analysts also said that Carrefour had spent more than three years studying and understanding the market and this time was sufficient to understand the difficulties associated with the retailing industry in Russia and also about the potential acquisition targets. As it knew the market well, it was not right for Carrefour to expect positive results within such a short span of time, that too when Russia was in the midst of recession, they said. The analysts said Carrefour could have halted expansion and waited in the market for a few more years before taking a final decision on its operations in the country. According to industry observers, Carrefour‟s failure to acquire Seventh Continent was the main reason for its exit. They said that without Seventh Continent, Carrefour did not find enough scope to grow in the country, though the market was highly lucrative. The retail industry in Russia was concentrated mainly around Moscow and St Petersburg, and in these locations, retailers like X5 and Auchan were firmly established and the markets were also oversaturated. With the retail space in limited supply, it was not possible to establish a significant presence in these markets without acquisitions (Refer to Exhibit VI for major retailers in Moscow and St Petersburg). In spite of its high growth potential, there were several obstacles which international retail companies had to face in the Russian retailing industry. A complicated legislative framework, bureaucracy, along with corruption hampered the operations of several companies in Russia. Analysts said red tape, poor economic conditions, etc. could have influenced Carrefour‟s decision to exit the market. Carrefour was also caught up in bureaucratic hassles as its first store in Moscow could not get a license to sell alcohol, which cost it almost 15% of the stores‟ revenues. Legislation in Russia that aimed at increasing the competition in the country 34 was also cited as one of the main reasons for Carrefour‟s plan to exit. 33

34

Ladka Bauerova, “Carrefour Replaces Head of French Superstores, Exits Russia,” www.bloomberg.com, October 15, 2009. The new retail trade law in Russia was passed in December 2009. According to the law, the government can impose price ceilings on specific products (whose prices have grown by 30% in a span of 30 days) for a specific timeframe (not more than 90 days). Limitations were

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International Business

Exhibit VI Major Retailers in Moscow and St. Petersburg (October 2009) ST. PETERSBURG Retailer

Brand

Format

X5 Retail Group

Perekriostok

Supermarket

Pisterochka

Discounter

Karusel

Hypermarket

16

Okay

Hypermarket

14

Okay

Supermarket

13

Lenta

Lenta

Hypermarket

14

Dixy

Dixy

Discounter

84

Auchan

Auchan City

Hypermarket

2

Metro

Metro CC

Cash & Carry

3

Okay

No. of Outlets 21 278

MOSCOW Retailer

Brand

Format

No. of Outlets

X5 Retail Group

Perekriostok

Supermarket

Pisterochka

Discounter

Karusel

Hypermarket

10

Auchan

Auchan City

Hypermarket

9

Metro

Metro CC

Cash & Carry

11

Real

Real

Hypermarket

3

Alye Parusa

Alye Parusa

Supermarket

16

ABC of Taste

ABC of Taste

Supermarket

25

Sellgross

Sellgross

Cash & Carry

1

Spar

Spar

Supermarket

1

Seventh Continent

Nash Hypermarket

Hypermarket

4

Seventh Continent

Corner Shop

30

Seventh Continent

Supermarket

54

Seventh Continent 5 Stars

Supermarket

31

Mosmart

Mosmart

Hypermarket

4

Stokmann

Stokmann

Hypermarket

4

Billa

Super

Supermarket

3

Paterson

Paterson

Supermarket

20

76 181

Source: www.bordbia.ie.

set on bonuses suppliers could pay to the retailers to stock their products, payment timeframes within which retailer had to pay suppliers, etc. The Russian government aimed to increase the competition in the retail sector by passing the law.

376

Carrefour’s Misadventure in Russia Due to volatile economic conditions in the Russian market, acquiring a Russian retailing company also proved to be a tough task for Carrefour. Though due to the global financial crisis35, the share prices of Russian retailers were down making them an ideal target for acquisition, the lack of credit to the retailers for carrying out the acquisitions and the high debt burden of the local retailers, proved to be unattractive for Carrefour. The acquisitions were also priced high. For example, X5 with a share of 4% in the food retail market in Russia was valued at US$ 7 billion. According to Datamonitor, “Facing these challenges, Carrefour has probably made the right call in making an early withdrawal from the market. A dire macroeconomic environment and the strength of domestic discounters in the current climate make breaking into Russia organically a significant challenge. Furthermore, the difficulties in acquiring a local player and other market hindrances would have made Carrefour‟s quest to gain scale and leadership in the country a costly uphill struggle.”36 There were also reports that the company was under pressure from key shareholders like Colony Capital LLC37 and Bernard Arnault38, a French investor and Chairman of LVMH, who insisted that Carrefour concentrate on its French operations and exit from the emerging markets including China and Latin America after its global sales dropped by 2.9% in the third quarter ending September 2009 to € 24 billion. Reports in Le Monde suggested that the top investors were insisting on Carrefour exiting China and Brazil too, in order to regain their investment, after Carrefour lost 30% of its market value between March 2007 and September 2009. However, at the same time, other retailers in Russia were performing well. The X5 Retail Group reported that its profits had grown by 38% between January and September 2009, as compared to the corresponding period the previous year. The store count in 2009 was expected to increase by 25%. The net revenues of another leading retailer Magnit increased by 31% in the first nine months of 2009. As of September 2009, it had 2981 stores in operation. Many analysts opined that the withdrawal from Russia meant that Carrefour remained committed to its goal of attaining a leadership position in the markets in which it operated and exiting the countries where it did not find the opportunity to be among the top retailers in a span of few years. Earlier, in 2005, Carrefour had exited from four countries namely, Japan, Mexico, the Czech Republic, and Slovakia, where it failed to make a mark, and decided to focus on Eastern Europe and Latin America. Analysts pointed out that as far as the Russian market was concerned, it had realized soon that there were not enough opportunities for it to become the top player in the country. According to Pierre Bouchut, Chief Financial Officer, Carrefour Group, “It is precisely because we are adopting a longterm stance that we are exiting from Russia.”39 Carrefour, however, maintained that it would remain committed to its expansion plans in other emerging markets where it already had a significant presence.

35

The global financial crisis refers to the credit, banking, trade, and currency crisis that emerged in 2007-08. This was the result of the failure of several US-based investment companies, mortgage companies, and insurance companies due to the sub-prime crisis in the country. The sub-prime crisis was the result of mortgage delinquencies and foreclosures, which had an impact on banks and markets around the world. 36 “Carrefour: Abandoning Russia,” Datamonitor, October 19, 2009. 37 Colony Capital LLC is an investment firm based in the US. 38 Bernard Arnault is the founder, Chairman and CEO of LVMH Moët Hennessy Louis Vuitton SA (LVMH), which consists of over fifty luxury brands like Louis Vuitton, Mercier, TAG Heuer, Donna Karan, Dior, and Fendi. He was the 15th richest person in the world as of 2009 according to Forbes. 39 “Carrefour to Exit Russia, Hit by Challenging Markets,” www.reuters.com, October 15, 2009.

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International Business

Suggested Readings and References: 1. Carrefour to Approach from Regions, www.kommersant.com, November 09, 2006. 2. Carrefour or Perekrestok – What will Russians Prefer? www.freshplaza.com, January 11, 2007. 3. Russia’s Retail Revolution, www.managementtoday.co.uk, June 01, 2008. 4. Carrefour Starts the Investment Programme in Krasnodar Region (South Russia), www.carrefour.com, September 22, 2008. 5. Jess Halliday, Russian Regions Present New Possibilities for Food Firms, www.foodnavigator.com, October 21, 2008. 6. Carrefour to Open at Least Three Russian Stores in 2009, www.reuters.com, April 15, 2009. 7. Javier Espinoza, Carrefour Flirts with Seventh Continent, www.forbes.com, April 20, 2009. 8. Carrefour Looks East to Russia, Checkout, April 2009. 9. Javier Espinoza, Carrefour Wants a Piece of Russia, www.forbes.com, May 05, 2009. 10. Javier Espinoza, Carrefour May be Moving to Russia Soon, www.forbes.com, May 05, 2009. 11. Lionel Laurent, Carrefour's Mission to Moscow, May 29, 2009. 12. Carrefour Starts Business Operations in Russia and Moves Forward with its International Expansion, Press Release, Groupe Carrefour, June 18, 2009. 13. Javier Espionoza, Carrefour May be Stumbling with Russian Dreams, www.forbes.com, June 18, 2009. 14. Carrefour Opens First Russian Store, www.russianamericanchamber.com, June 19, 2009. 15. Carrefour Opens up in Moscow for the Longer Term, http://rt.com, June 19, 2009. 16. Maria Antonova, Carrefour Opens First Russian Store, www.straightstocks.com, June 19 2009. 17. Carrefour Says Looking at Acquisitions in Russia, www.ibtimes.com, September 10, 2009. 18. Carrefour Mulls Exit from Latin America – Le Monde, http://uk.reuters.com, October 07, 2009. 19. Carrefour Says Looking at Acquisitions in Russia, www.reuters.com, October 09, 2009. 20. French Hypermarket Chain Carrefour Leaves Russian Market, http://en.rian.ru, October 15, 2009. 21. Ladka Bauerova, Carrefour Replaces Head of French Superstores, Exits Russia, www.bloomberg.com, October 15, 2009. 22. Carrefour to Exit Russia, Hit by Challenging Markets, www.reuters.com, October 15, 2009. 23. Scheherazade Daneshkhu, Jonathan Birchill Carrefour Beats Hasty Russian Retreat, www.ft.com, October 15, 2009. 24. French Hypermarket Chain Carrefour Leaves Russian Market, http://en.rian.ru, October 15, 2009.

378

Carrefour’s Misadventure in Russia 25. Lionel Laurent, Robin Paxton, Carrefour to Exit Russia, Hit by Challenging Markets, www.reuters.com, October 15, 2009. 26. Ladka Bauerova, Carrefour Replaces Head of French Superstores, Exits Russia, www.bloomberg.com, October 15, 2009. 27. Matthew Saltmarsh, Andrew E. Kramer, French Retailer to Close Its Russia Stores, www.nytimes.com, October 16, 2009. 28. Carrefour to Quit Russia, http://store.businessmonitor.com, October 16, 2009. 29. Carrefour Reports Challenging Q3, Exits Russia, www.igd.com, October 16, 2009. 30. Carrefour Abandons Russia, www.fis.com, October 16, 2009. 31. Carrefour to Quit Russia, ehttp://store.businessmonitor.com, October 16, 2009. 32. Retail Market Fight too Tough for Carrefour, http://rt.com, October 16, 2009. 33. Carrefour to Exit Russia, Hit by Challenging Markets, www.reuters.com, October 16, 2009. 34. Jennifer Creevy, Carrefour to Pull out of Russia, www.retail-week.com, October 16, 2009. 35. Retail Market Fight too Tough for Carrefour, http://rt.com, October 17, 2009. 36. Carrefour: Abandoning Russia, Datamonitor, October 19, 2009. 37. Carrefour Turns its Back on Russia’s Promise – Fast, www.worldfinance.com, October 19, 2009. 38. Carrefour to Keep Operating in Russia Until Selloff Complete, http://en.rian.ru, October 19, 2009. 39. Maria Antonova, Carrefour to Leave Russia 4 Months after Opening, The St. Petersburg Times, October 20, 2009. 40. Jason Bush, Russia's Foreign Investment Revival? www.forbes.com, October 20, 2009. 41. Greg Hodge, Carrefour’s Retreat from Russia a Mysterious Move, www.retailweek.com, October 23, 2009. 42. Carrefour Abandons Russian Food Retail Market, www.stat-usa.gov, November 03, 2009. 43. Tim Gosling, Russian Supermarket Chains - Seats Reserved at the Top Table, http://businessneweurope.eu, November 3, 2009. 44. Deloitte Global Powers of Retailing, 2009. 45. Carrefour Annual Reports, 2005-09. 46. www.carrefour.com.

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Sakhalin-1 Project: Delivering Excellence in Project Execution This case is about the Sakhalin-1 Project considered to be the largest and the most ambitious world-class oil and gas development projects in the world. Located on the northeast shelf of Sakhalin Island in Russia, the project is developed by a consortium of Russian, Indian, Japanese, and US oil and gas companies. Operated by Exxon Neftegas Ltd (ENL), the Sakhalin 1 Project includes three offshore oil fields, the Chayvo, Odoptu, and Arkutun Dagi. The project is being developed in four phases using both onshore and offshore drilling fields. The total recoverable reserves were estimated at 307 million tons of oil and 485 billion cubic meters of natural gas. The case describes the development and execution of the project. Advanced technologies and construction methods were adopted in the execution of the project which reduced the overall cost of development and minimized environmental impact. The case highlights how the project overcame the technical and environmental difficulties to achieve its goals. It discusses how the project team successfully managed the challenges associated with the project such as limited infrastructure, complex regulatory rules, limited skilled labor, and difficult logistics. Analysts opined that with careful planning and efficient use of technologies, the project successfully completed its first phase of development. The project, one of the largest single foreign direct investments in Russia, aimed to fulfill the growing energy demand worldwide. It provided energy supplies for domestic use and for export to Northeast Asia and consolidated Russia's strategic position as an energy supplier to world markets. The case also discusses the benefits the project brought to Russia, particularly to people of the island of Sakhalin. The case concludes by discussing the future phases of the Sakhalin-1 Project.

Sakhalin-1 Project: Delivering Excellence in Project Execution “The key to maximizing resource value lies in the ability of a global organization to apply leading-edge technology and deliver excellence in project execution. Nowhere is this truer than in the challenging Russian Arctic, where ExxonMobil is proud to be associated with Sakhalin-1 – one of the most ambitious projects industry has ever undertaken.”1 -

JB McNeil, vice-president, ExxonMobil Development Company in 2008.

Introduction In December 2008, the American oil and gas company ExxonMobil Corporation‘s2 (ExxonMobil) oil and gas development project in Russia3, the Sakhalin-1 project received the Excellence in Project Integration Award from the committees and sponsoring societies of the International Petroleum Technology Conference 4 (IPTC). The award was given to the company for effectively implementing the first phase of the Sakhalin-1 Project through the application of modern production engineering techniques, geoscience knowledge, construction and facilities engineering practices, health, safety, and environmental processes, human resources policies, community development, and collective teamwork. Commenting on the achievement, Mark Albers, senior vice president of ExxonMobil, said, ―We are extremely proud of the Sakhalin-1 project achievements. The Sakhalin-1 project is one of the largest energy investments in Russia and is a testament to international cooperation to successfully execute this project in one of the most challenging Arctic environments in the world in a safe and environmentally responsible manner.‖5 The Sakhalin-1 Project is one of the largest oil and gas development projects in the world. Located on the northeast shelf of Sakhalin Island, the project comprises three offshore oil fields, the Chayvo, Odoptu, and Arkutun Dagi. The total oil and gas 1

2

3

4

5

―Sakhalin 1- A New Frontier,‖ http://www.exxonmobil.com/Corporate/Files/Corporate/SakhalinEnglish_Intro.pdf. Based in Irving, Texas, ExxonMobil Corporation is one of the world‘s largest oil & gas companies. It is involved in the exploration, production, transportation, and sale of crude oil and natural gas. The company markets fuels and lubricants under three brands — Esso, Exxon and Mobil. For the year ended 2008, the company‘s revenues were US$ 477.35 billion. Prior to 1991, Russia was the largest republic in the Soviet Union (USSR). The troubled economic conditions together with political turmoil led to the dissolution of the Soviet Union in 1991 into fifteen separate countries. As a result, Russia together with the Ukraine and Belarus formed the Commonwealth of Independent States which was later joined by other Soviet republics. The IPTC ‗Excellence in Project Integration Award‘ recognizes companies which successfully execute multi billion oil and gas industry projects. The International Petroleum Technology Conference (IPTC) is an international oil & gas conference and exhibition. IPTC addresses key challenges and issues plaguing industry specialists in the gas sector world over. The third edition of the IPTC was held from 3-5 December 2008 at the Kuala Lumpur Convention Center and was hosted by PETRONAS, the national petroleum corporation of Malaysia. About 7,568 participants from 57 countries attended the event. ―Sakhalin-1 Project Receives Award for Excellence from International Petroleum Technology Conference,‖ www.sakhalin1.com, December 3, 2008.

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Sakhalin-1 Project: Delivering Excellence in Project Execution reserves of the fields are estimated to be about 307 million tons (2.3 billion barrels) of oil and 485 billion cubic meters (17.1 trillion cubic feet) of natural gas. The project is operated by Exxon Neftegas Limited 6 (ENL), a subsidiary of ExxonMobil, on behalf of an international consortium comprising Russian, Indian, Japanese, and US oil and gas companies. The project was declared commercial in October 2001, and the development of oil and gas from the fields began in 2005. In the first phase of development of the project, oil was produced from the Chayvo field using both onshore and offshore facilities. These facilities included the construction of one of the world‘s largest land-based drilling rigs, an offshore drilling platform, an onshore oil and gas processing facility, a crude oil pipeline, and an oil export terminal. Initially, the project produced up to 50,000 barrels of oil and 60 million cubic feet of natural gas per day. The oil was exported to the Asian markets whereas the natural gas was supplied to domestic customers in the Khabarovsk Krai7 region. The subsequent phases were to involve development of oil and natural gas from the Odoptu and Arkutun-Dagi fields. In 2008, the development of the Sakhalin-1 Project was put on hold for about two months as it awaited budget approval from the Russian government for the years 2008 and 2009. After the budget was approved by the Russian Energy Ministry in April 2009, the project resumed with the development of the second phase of the project. According to experts, the multi-billion dollar Sakhalin-1 Project was one of the largest foreign investment projects in Russia. The investment was expected to reach US$ 12 billion over the life period of the project. In addition to oil and gas development, the project was expected to bring in significant economic as well as social benefits to the Russian community. Economic benefits included improved transportation and medical facilities and other infrastructure developments. Besides generating revenues to the government, the contracts awarded to Russian companies as part of the development of the project were estimated to be more than US$ 3.2 billion. More than 13,000 jobs were created for Russian nationals during the initial development of the project. Experts opined that though the project brought in significant benefits, it was replete with challenges. The project had to deal with multiple problems including a harsh subArctic climate, a remote location with minimum infrastructure, logistic problems, limited availability of skilled labor, and a complex regulatory system. Despite these challenges, it was successful in completing the initial development phase and was reportedly prepared to address the future challenges too. Experts were of the view that with global energy demand expected to increase by almost 50% by 2030, the Sakhalin-1 Project would become a vital link in the global energy supply and in meeting the worldwide energy demand. Talking about the benefits of the project, Steve Terni (Terni), president of ENL, said, ―Working together, Russians, Americans, and our international partners have overcome great challenges to accomplish what many previously doubted was even possible. Forty years from now, Sakhalin-1 is expected to still be reaping benefits for Russia, the Asia-Pacific, and an energy hungry world. Equally important, it has created opportunities for people to enjoy a better quality of life. With support from the Russian local, regional, and federal governments, the Sakhalin-1 consortium will continue to work to make this ‗people achievement‘ even greater.‖8 6

7

8

Exxon Neftegas Limited (ENL) is a subsidiary of ExxonMobil Corporation. It is the operator of the Sakhalin-1 Project and holds an interest of 30% in the project. Khabarovsk Krai is a Russian federation located in the Russian Far East along the coastline of the Sea of Okhotsk. The administrative center of the Krai is the city of Khabarovsk. ―Sakhalin 1- A New Frontier,‖ http://www.exxonmobil.com/Corporate/Files/Corporate/SakhalinEnglish_Intro.pdf.

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International Business

Background Note Sakhalin, one of largest islands in Russia, is located off the east coast of Russia in the Sea of Okhotsk. Colonized by Russia and Japan in the 18th and 19th centuries, the island came under Russian control in 1875. The Sakhalin region is popular for its vast natural and hydrocarbon resources. Oil reserves in the area are estimated to be around 14 billion barrels while the natural gas reserves are approximately 96 trillion cubic feet.9 Commercial oil reserves were discovered in the region in 1910 in the Okha field. But because of political unrest, difficult climatic conditions, and lack of adequate finance, the oil fields could not be developed. In the early 1970s, a subsidiary of Rosneft,10 Sakhalinmorneftegas Ltd.11 (Sakhalinmorneftegas) pursued the development of offshore oil resources in the Sakhalin continental shelf. During that time, the Russian oil and gas industry lacked adequate infrastructure to carry out oil explorations in the region. Moreover, the industry did not have the technical know-how and had very limited experience of offshore oil and gas development in sub-arctic regions such as Sakhalin Island. Therefore, Sakhalinmorneftegas, with support from the Russian government, decided to seek foreign assistance. Japan was considered as a potential investor as it had some major oil and gas companies which could provide the needed infrastructure. Geographically too, it was close to the Sakhalin Island. In 1975, Russia signed a cooperation agreement with the government of Japan for oil and gas exploration and development in the region. As per the agreement, Sakhalinmorneftegas had to work with Japanese consortium Sakhalin Oil and Gas Development Co., Ltd. 12 (SODECO) to carry out oil and gas development in the region. Between 1977 and 1989, Sakhalinmorneftegas and SODECO were involved in exploring the oil fields in the region. The oil exploration process involved seismic surveys13 and exploratory drilling. The extensive efforts led to the discovery of three oil fields in the region – the Odoptu field in 1977, the Chayvo field in 1979, and the Arkutun Dagi field in 1989. With the discovery of the oil fields, the Russian government planned to develop Sakhalin Island‘s offshore oil reserves and export energy to Northeast Asian markets, mainly Japan. In 1991, after the dissolution of the Soviet Union, Russia became a separate state and the country opened its doors to foreign investments. The Russian government was looking for more international investors who could explore and develop the oil fields in the island. The government then decided to auction off sections of the Sakhalin shelf for developing oil and gas. It began to offer tenders for blocks of acreage on 9

http://www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia. Rosneft is the largest oil producing company in Russia. It is involved in the exploration and production of hydrocarbons, petroleum products, and petrochemicals. For the year ended 2008, the company‘s average daily crude oil production was about 2.12 million barrels. The Russian government holds a 75.16% stake in the company. 11 In 2008, Sakhalinmorneftegaz Ltd produced 1.76 million tons (12.9 million barrels) of crude oil and 0.63 billion cm of gas. 12 Sakhalin Oil and Gas Development Co., Ltd. (SODECO) is a consortium of several major Japanese companies, including the Japanese National Oil Company. The other principal shareholders in the company are Japanese investment companies such as JAPEX, Itochu and Marubeni. 13 The seismic survey is a type of geophysical survey which measures the properties of the earth‘s sub surface by generating, recording, and analyzing sound waves (also called as seismic waves) that travel through the Earth. The surveys generate seismic images which help geologists in locating underground structures that may contain oil or gas reserves. These surveys are primarily used for oil and gas exploration. 10

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Sakhalin-1 Project: Delivering Excellence in Project Execution Sakhalin Island. The government along with the local Sakhalin Oblast administration14 divided the Sakhalin continental shelf into six blocks and named them Sakhalin 1-6 (Refer to Exhibit I for a snapshot of the Sakhalin blocks). The contracts for developing the oil reserves in each of these blocks were allocated to various consortiums comprising foreign as well as Russian multinational oil companies. Besides the six blocks, the government planned to develop three more blocks on the Sakhalin continental shelf. The new blocks which were yet to be awarded would be called Sakhalin 7–9. As of 2008, all the six Sakhalin projects were in different stages of development. Of the six blocks, Sakhalin-1 and Sakhalin-2 were the front-runners as the oil and gas produced from these regions was expected to meet a significant percentage of energy demands in the Asian continent. The Sakhalin-1 Project area comprised the Chayvo, Odoptu, and Arkutun Dagi fields. These fields were estimated to contain 2.3 billion barrels of oil (307 million tons) and 17 trillion cubic feet of gas (485 billion cubic meters). Initially the contract to develop the Sakhalin-1 oil fields was awarded to a consortium comprising US, Russian, and Japanese oil and gas companies. ENL and SODECO held a 30% interest each in the project. The other investors were Russian oil companies Sakhakinmorteneftegas (23%), and RosneftSakahalin (17%). In 2001, the ownership pattern changed as Indian oil and gas company ONGC Videsh Limited15 joined the Sakhalin-1 consortium with a stake of 20% while the subsidiaries of Russian oil company Rosneft, Sakhalinmorneftegas-Shelf, and RN-Astra had an 11.5% and 8.5% stake in the project respectively. The responsibility of the consortium was to manage the construction of the project‘s oil and gas extraction and transportation facilities. Capital investment over the life of the project was estimated to reach US$ 12 billion, making it one of the largest foreign direct investments in Russia.

Exploration and Project Documentation In late 1993, the five-member consortium signed a Memorandum of Understanding with the Russian government to formulate the Sakhalin-1 production-sharing agreement16 (PSA).The PSA, considered as the governing document for the Sakhalin1 Project, required about two years to negotiate. Finally in October 1996, the PSA was approved and executed. It established a clear set of guidelines related to the operational, financial, and administrative aspects of the project. Under the PSA, the Russian government was to retain ownership of the oil and gas resources in the state while the consortium would invest the capital required to develop the fields.

14

15

16

The Sakhalin Oblast is a federal region of Russia comprising the island of Sakhalin and Kuril Islands. The ONGC Videsh Limited (OVL) is a wholly-owned subsidiary of the national oil company of India, the Oil and Natural Gas Corporation Limited (ONGC). It is involved in the development of oil and gas acreages including acquisition of oil and gas fields, exploration, development, production, transportation, and export of oil and gas. The company‘s international oil and gas operations produced about 8.802 million metric tons of oil and gas in 2007-08. Production sharing agreements (PSAs) is a commercial contract between an investor and the state government which allows the investor to undertake large scale and long term investments in the state. The PSA defines the terms and conditions for the exploration and development of resources through a contract based arrangement that exists over the life of the project.

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Exhibit I The Sakhalin Blocks (May 2008) Sakhalin I

Sakhalin II

Sakhalin III Kirinskii,

Odoptu Primary Field/Block Names

Chayvo Arkutun-Dagi

Veninskaya, VostochnoOdoptu, Aiyashkii

Sakhalin V

Sakhalin VI

Pogranichny Block, West Schmidt, Okruzhnoye field

KaiganskoVasyukansk (KV), E. Schmidt

Pogranichny

Oil Reserve Estimate

975 million bbl*

1.0-1.2 billion bbl

4-5 billion bbl

880 million bbl.

E. Schmidt -2.98 bill. bbls). K-V 8.5 billion bbls

600 million bbl

Natural Gas Reserve Estimate

11 Tcf**

17.3 Tcf

27-38 Tcf

19 Tcf.

15.2-17.7 Tcf

n/a

Phase 1: $4.5 billion, Phase 2: $20 billion

$13.5 billion expected (ExxonMobil$80m in geological studies)

$2.6 billion expected

$3-5 billion expected

n/a

Net Total Investment

386

PiltunAstokskoye, Lunskoye

Sakhalin IV

Phase 1: $5 billion

Sakhalin-1 Project: Delivering Excellence in Project Execution

Sakhalin I

Current & Expected Production Level

Primary Project Developers

Max oil production from Chayvo field achieved in Feb. 2007 at 250 kb/d. Commercial gas production expected in 2008

Exxon Neftegaz (30%), SODECO (30%), ONGC Videsh (20%), Sakhalinmorne ftegaz (RosneftSakhalinmorne ftegaz Subsidiary, 11.5%), and RN Astra (Rosneft

Sakhalin II

Sakhalin III

Sakhalin IV

Sakhalin V

Sakhalin VI

Current: 80,000 bbl/d for 6 months Phase II: 180,000 bbl/d, year-round oil production expected by 2009, LNG production expected by 2009

n/a

n/a

n/a

n/a

Gazprom (50%+), Sakhalin Energy Investment Company: Shell (27.5%), Mitsui (25%), Mitsubishi (20%)

Rosneft is primary developer. Veninsky Block: Rosneft (49,8%), Chinese Sinopec (25.1%) and Sakhalinskaya Neftyanaya Kompaniya (25.1%)

BP (49%), Rosneft (51%)

Elvary Neftegaz: BP (49%), Rosneft (51%)

Urals Energy (via Petrosakh), Alfa Eco

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Sakhalin I

Sakhalin II

Sakhalin III

Sakhalin IV

Sakhalin V

Sakhalin VI

Oil production began in 1999; Processing terminal under construction with capacity of 66,000 bbl/d of oil, 1.8 bcf/d of gas

License possibly suspended. Lukoil in association with Gazprom would probably take part in new tenders for Kirinskii and Vostochno blocks.

There is speculation that unreleased dril ling results during 2007 were not positive. No drilling planned in 2008, although seismic activities continued.

Activities in 2008 included seismic processing, interpretation and acquisition on the existing license blocks

3 blocks in Sakhalin VI have not been awarded, but Gazprom seems to be interested.

Subsidiary, 8.5%)

Status

Mode of gas export still up for negotiation. Exxon preferred pipeline exports to China. Other shareholders, Gazprom preferred piping to LNG terminal at Sakhalin II.

* bbl stands for barrels **tcf stands for trillions of cubic feet Source: www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia

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Sakhalin-1 Project: Delivering Excellence in Project Execution The Russian government was to receive a proportion of revenues from production as the project progressed. As per the PSA, the oil derived from the Sakhalin shelf would be shipped to Asia and other markets while the natural gas would be sold exclusively in the domestic market. The PSA stipulated that all the members of the consortium would proportionally share income from the sale of oil and natural gas generated from the project. Upon the execution of the PSA in 1996, a five-year exploration period began. A commercial development plan for the Sakhalin-1 Project was also formulated during this period. The exploration period involved delineation of the three oil fields, assessment of hydrocarbon volumes in the region, and identification of the best resource location from where oil could be developed. As part of the exploration process, seven appraisal wells17 were drilled and three-dimensional seismic data was collected covering more than 1,200 square kilometers area. ENL used advanced 3D seismic technology18 to map the Sakhalin-1 fields. With continuous 3D surveys and evaluation drilling, the consortium discovered crude oil on the western flank of the Chayvo field. This was a major discovery for the project to proceed further. Finally, in September 2000, the exploration period ended with the demarcation of the Chayvo 6 well which confirmed the presence of a 150-meter oil column in the Chayvo reservoir. Talking about the discovery of oil reservoirs in the Chayvo field, Richard Powell (Powell), ExxonMobil‘s Geoscience project manager for the Caspian, Russia, and the Middle-East, said, ―We now had found what could be a 150 million-metric ton (1 billion barrel) oil development that was previously unknown. This became the ‗centerpiece to the dining room table‘ we had been searching for. But in the end, it really was about more than just new technology. It truly came down to the team‘s creativity, innovation, and determination to find and deliver that first step for Sakhalin 1.‖19 After successfully completing the exploration period, the Sakhalin-1 consortium declared the project commercial on October 29, 2001. It was approved by the Russian Federation on December 3, 2001. The declaration formally ended the exploratory phase and marked the commencement of the 20-year development period of the project. The project was subjected to over one hundred agency inspections and audits to ensure that it complied with Russian regulatory and project documentation procedures. In July 2002, the project was given the green signal by the State Ecological Expert Review20 (SEER) for use of Extended Reach Drilling 21 (ERD) technology to drill wells in the region. In October 2002, the technical expertise bureau 17

18

19 20

21

Appraisal wells are drilled to assess characteristics of a hydrocarbon source accumulated in a reservoir 3D seismic technology constructs models of underground rock formations based on threedimensional models. Earlier, 2D models were used but they were difficult to read. 3D techniques significantly reduced the number of dry holes drilled, thereby increasing the number of productive wells. ―The Quest Begins,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish4.pdf. The State Environmental Expert Review (SEER) is an independent body which assessed Sakhalin-1 Project‘s design, waste management, and water protection measures, disaster management, economic and social impact as well as the measures taken by the project to protect marine and land biological resources. Extended Reach Drilling (ERD) is an evolved form of simple directional drilling and employs both directional and horizontal drilling techniques. It is defined as a type of directional drilling in which the horizontal well departure is at least twice that of its total vertical depth-to-deviation (TVD). ERD is cost effective as it does not require installation of additional offshore facilities or pipelines. Production from ERD wells which run through long distance reserves is much greater than output from conventional wells.

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International Business of Russia approved the Justification of Investment 22 (JOI) for the Sakhalin-1 Project. Approval of the JOI was a key milestone for the Sakhalin-1 Project as it allowed the project to proceed to the Technical and Economic Substantiation of Construction (TEOC) stage required for the construction of the oil export pipeline route across Sakhalin Island to an export terminal. As part of the project documentation stage, the consortium received over 1,000 additional approvals, licenses, and permits from federal, regional, and local district authorities in the Sakhalin region. In April 2003, the Authorized State Body23 (ASB) approved the Development Program and Budget24 (DP&B) for the Sakhalin-1 Project. Total capital expenditure for the project was set at US$12.8 billion. In April 2004, the Russian government approved the TEOC stage which allowed the consortium to start full-scale construction of facilities at the project site. According to project operator ENL, once the Sakhalin-1 Project had passed the exploratory stage, project costs increased significantly. To carry out operations related to the development and construction of oil fields in the region, tenders were awarded to Russian contracting companies. In 2002, Russian businesses acquired large contracts, and the total value of the contracts awarded to Russian suppliers and contractors as part of the Sakhalin-1 Project exceeded US$ 1 billion (Refer to Exhibit II for the list of contacts awarded). According to Galina N. Pavlova, Director of the Oil and Gas Industry Department of the Sakhalin Oblast Administration, ―The successful implementation of the Sakhalin-1 Project became possible thanks to mutually-beneficial cooperation between Federal and regional Russian authorities, and the members of an international consortium including operator ExxonMobil, a global leader in the oil and gas industry. This consortium brings together the talents of major companies: ExxonMobil, SODECO of Japan, ONGC of India, and the Russian state oil company Rosneft.‖ 25

Development The Sakhalin-1 Project was executed in phases. According to analysts, a phased development approach was followed so that the procedures built in the first phase could be used in the future phases, thereby making the project cost-effective. The first phase of the Sakhalin-1 Project involved the development of oil and gas in the Chayvo oil field. The subsequent phases included oil and gas development in the Odoptu and Arkutun Dagi fields, Chayvo field gas development, and late-life gas development. It was reported that these future phase developments would push the Sakhalin-1 Project through 2050.

22

23

24

25

Justification of Investment (JOI) is a document that addresses the feasibility of a proposed project. It analyzes the returns from an Investment by demonstrating the proposed project‘s goals and capabilities. Authorized State Body (ASB) is a constituent of the Russian Industry and Energy Ministry. It is the governing authority of the Sakhalin 1 Project and oversees the implementation of the PSA on behalf of the Russian Federation. It includes representatives of the Federal Ministries of Economic Development and Trade, Taxes and Levies and Energy, and the Sakhalin Oblast Administration. The Development Program and Budget (DP&B) is a strategic plan which provides cost estimates of activities related to the oil and gas development production in the Sakhalin region. It also lists the benefits the project would bring to Russia and provides details of environmental protection measures undertaken as part of the project. ―Exxonmobil Announces Production Start-Up from Sakhalin-1 Project in Russia,‖ www.sakhalin1.com, October 2, 2005.

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Exhibit II List of Contracts Awarded for Sakhalin-1 Project Contract Project Area

Scope of Work

Contractor

DeKastri

Material Supply, Transportation and General Services at DeKastri

ACCESS - Amur Services Co., LLC.

Orlan, Chayvo, DeKastri, Yuzhno

General Maintenance and Mechanical Services for Production Facilities

ECC-VECO, LLC.

Orlan, Chayvo, DeKastri, Nogliki, Odoptu, Yuzhno

General Instrument, Control & Automation, Electrical, Telecommunication Maintenance and Construction Services

OOO Kentech Sakhalin Technical Services

Orlan, Chayvo, DeKastri, Nogliki, Odoptu, Yuzhno

General Engineering and Procurement Services for Sakhalin-1 Facilities

OOO Sakhalin Technical Services Network

Chayvo

Fleet Management, Fuel Depot and General Services at Chayvo

Pacific Rim Constructors

Orlan, Chayvo, DeKastri, Nogliki, Yuzhno

Camp Management and Catering Services at various Sakhalin-1 sites

Remote Project Services Group Global, LLC.

Orlan, Chayvo, DeKastri, Nogliki, Odoptu, Yuzhno

Misc. Personal Protective Equipment

ZAO Vostok-Service Sakhalin

Kholmsk, Korsakov

Shorebase Services (facility, manpower, equipment)

Sakhalin Shelf Services

*Data as of 2007 Source: www.sakhalin1.com/en/contracting/opportunities.asp

Phase I - Development of Chayvo Field The first phase of the Sakhalin 1 Project focused on oil and limited natural gas production from the Chayvo field. The development costs of this phase were expected to be about US$ 4 billion. The initial phase was expected to produce 50,000 barrels (6,300 metric tons) of oil per day by the end of 2005. By 2006, the production was expected to reach 250,000 barrels (33,000 metric tons) of oil per day. The development of oil from the initial phase of the Sakhalin-1 Project began on October 2, 2005. The time period of Phase I of the Project was about five years. The harsh Arctic weather and the remote location of Sakhalin Island presented significant challenges for the execution of the initial phase. Experts opined that the development of infrastructure amidst such climatic conditions was a herculean task. However ENL, which had developed some of the major oil fields in the world, was able to overcome these barriers. Despite the adverse climatic conditions, phase I of the

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International Business Sakhalin-1 Project started on schedule. The Russian Amur Services Company (ASC)26 provided a complete range of construction support services for the Sakhalin-1 Project while ECC-VECO LLC27 provided civil construction, maintenance, and other services for the project. ―ExxonMobil is pleased with the timely start-up of Phase 1 of the Sakhalin-1 project. This project employs leading-edge technology including the use of Arctic development technologies and extended reach drill wells that are among the longest in the world. Application of this technology for the Sakhalin-1 project is a significant breakthrough in our ability to develop the resources in the most costeffective, efficient, and environmentally sound way possible,‖28 said Rex W Tillerson, Chairman and CEO of ExxonMobil. The first phase of development involved the construction of offshore and onshore drilling facilities, an onshore oil and gas processing facility, a crude oil pipeline, and a marine export terminal with year-round storage and tanker loading facilities (Refer to Exhibit III for a route map of the first phase of the Sakhalin 1 Project). The first step in the Phase I of the Sakhalin-1 Project was to access the oil and gas reserves in the Chayvo field using onshore and offshore drilling procedures.

Exhibit III Route Map of Sakhalin-1 Project

Source: www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia

26

27

28

Founded in 2002, Amur Services Company (ASC) provides infrastructure and support services for construction projects including transportation, cargo hauling, logistics, waste management, etc. ECC-VECO LLC is a Russia-based construction company formed specifically to carry out construction activities at Sakhalin shelf projects. ―ExxonMobil Announces Production Start-Up from Sakhalin-1 Project in Russia,‖ www.sakhalin1.com, October 2, 2005.

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Sakhalin-1 Project: Delivering Excellence in Project Execution

Onshore Drilling The Chayvo field was developed using onshore as well as offshore drilling facilities. To drill the north western flanks of the Chayvo fields which were about 8-11 kilometers offshore, a suitable option was ERD as it not only reduced the amount of drilling but also saved on time and costs per well. For this purpose, ENL planned to construct an onshore land rig29 with numerous extended-reach wells from the shoreline to the Chayvo field. Talking about the application of ERD, Powell said, ―We were aware that 11 kilometer (seven-mile) extended-reach wells had been drilled in the United Kingdom and South America. What about at least partially developing Chayvo with extended-reach drilling (ERD) from the Sakhalin shore-line? It not only would offer the potential for lower cost and faster drilling start-up but would reduce environmental impact as well.‖30 The construction of the 22-storied land rig and its support equipment began in October 2001 in Louisiana, USA. The rig was designed and built by Parker Drilling Company31 in less than two years. The rig was disassembled and shipped to Sakhalin Island, which was about 11,000 kilometers from the construction site, aboard three cargo vessels. Despite the adverse weather conditions on the Island, the rig reached on time, was reassembled at the Chayvo field, and was ready for drilling by June 2003. According to Richard Rush, Sakhalin drilling group manager, ―The weather-related delays and logistic hurdles stemming from the absence of a dock at Chayvo worksite forced us to continue working into late fall and winter. In all, we shipped 1,500 to 1,800 loads by rail and truck, and still managed to get the rig assembled and ready to drill on schedule by June 2003.‖32 Named Yastreb (meaning hawk in Russian), the land-based drilling rig was 230 feet tall (70 meters) and was custom designed to drill extra long extended reach wells from land-based locations to offshore fields. The rig could withstand temperatures of -400 Celsius and high intensity earthquakes. Its power was 13,000 hp33 — almost double that of conventional land rigs. The Yastreb rig could drill extended reach wells downward and then horizontally under the sea to a total distance of up to 6.8 miles till the Chayvo field, making it one of the most powerful land rigs in the world. ―We called it the Yastreb, which is the Russian word for hawk. And like a hawk, the Yastreb has soared to great accomplishments with the extended-reach wells it has drilled,‖34 said Sam Vera, drilling engineering supervisor of Sakhalin-1 project. The rig became functional in November 2003. The rig drilled the first Sakhalin-1 well, the Z6, to a total measured depth of 9,375 meters (30,938 feet). To improve the drilling rate and to ensure safety, ENL used modern drilling procedures. Baker 29

A land rig is a drilling machine that drills only on land. It consists of pumps, a derrick or mast, a substructure, drill pipe, mud tanks, a rotary table, and engines to power the equipment. 30 ―The Hawk and the Sea Eagle,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf. 31 Parker Drilling Company is a US-based global energy company which provides offshore and onshore contract drilling services, project management, and rental tools to the energy industry worldwide. 32 ―World-Class by Any Measure,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish1.pdf. 33 Horsepower (hp) is a non-metric unit of power. It is equal to 746 watts. 34 ―The Hawk and the Sea Eagle,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf

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International Business Hughes INTEQ‘s35 AutoTrak Rotary Closed Loop System (RCLS)36 was used to enhance well-site efficiency and improve the quality of bore holes. With continued improvements in well design and drilling procedures, the daily drilling rates doubled. In April 2007, ENL completed drilling of the 17th ERD well, the Z-11,37 at the Chayvo field. It was drilled in 61 days, about fifteen days ahead of the schedule, with below expected costs. By 2007, about 17 ERD wells were drilled from the Yastreb rig as part of Phase I of the Sakhalin-1 Project. Experts pointed out that since the drilling of the Z6 well in 2003, the time required to drill these wells had come down by more than 50%. The presence of repair centers close to the Chayvo well installed by the Russian contract companies ensured smooth drilling without any delays. Repair and maintenance of key drilling equipment was carried out at these service centers. Otherwise, the equipment would have had to be repaired at regional centers as far as Singapore. Experts also pointed out that by using ERD, ENL had curtailed operational costs as extended reach wells did away with the need for building and installation of additional offshore structures. Moreover, ERD followed safe drilling practices and addressed environmental issues by minimizing the impact on marine environment, they said.

Offshore Drilling To develop the south western flank of the Chayvo field, a gravity-based offshore platform was used. Called Orlan38, it was one of the largest offshore drilling platforms constructed in the world. The earthquake and high wave resistant Orlan platform featured a drilling rig with more than 13,000 hp, a 10 mega-watt power plant, and living quarters for 120 workers. The Orlan platform was actually a concrete island drilling system39 (CIDS), which was withdrawn from use and kept in reserve in Alaska. ENL decided to use the CIDS for offshore drilling at Chayvo. Talking about the procurement of the Orlan platform, John Plugge (Plugge) offshore subproject manager of ExxonMobil, said, ―We were pleased to find it in quite good condition. But before we reached a decision, we invited a team of about 25 Russian specialists to come look it over the following summer. Nobody knows ice and the Arctic like the Russians. After a very thorough inspection, they concurred that it was quite suitable for Chayvo and could be used for many years to come. This was great news for the project since we originally estimated the use of CIDS would save a minimum of $100 million. And with the better understanding of costs we have today, we know that the savings is considerably more.‖ 40 The CIDS platform was shifted to the Amursky Shipbuilding yard located in Far East Russia for removing the CIDS‘ topside facilities and a large wave deflector was constructed around the platform base to make it earthquake resistant. In 2001, the 35

36

37

38

39

40

Based in Houston, Baker Hughes INTEQ is one of the eight divisions of Baker Hughes Inc., an Oil field service company. It is one of the world‘s leading oilfield drilling and evaluation service companies. Rotary Closed Loop System (RCLS) is an advanced drilling technique used to drill deep bore holes in extended-reach wells. The Z-11 was the longest ERD well in the world. It achieved a total measured depth of 37,016 feet (11,282 meters) or over seven miles. The Orlan platform was named after a white-shouldered sea eagle unique to the Sakhalin island. The CIDS is gravity-based offshore drilling platform. Built in 1983, the CIDS was designed for year round drilling in Arctic waters. ―The Hawk and the Sea Eagle,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf.

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Sakhalin-1 Project: Delivering Excellence in Project Execution CIDS platform was towed to Russia using three super-class tugs. The renovation of the platform was completed in 2004 after which it was taken to Ulsan, South Korea, where top side modules weighing nearly 12,000 metric tons and a fully automated drilling rig were installed. After installation of the support equipment, the platform was tugged to Russia and was ready for offshore drilling. Talking about the advantage of the platform, Plugge said, ―A major advantage of the gravity-based platform is that it‘s self contained. Crews can live onboard and get the platform ready for drilling while it‘s still in the shipyard. Then, when you are ready, you essentially just deballast and go offshore.‖41 The Orlan drilled its first extended reach well in December 2005. A total of 18 extended wells were drilled using the Orlan offshore drilling platform.

Onshore Processing Facility In order to separate the oil and gas produced from the drilling operations, an onshore processing facility (OPF) was installed at the Chayvo field. The OPF was designed to process up to 34,000 metric tons (250,000 barrels) of oil and 23 million cubic meters (800 million cubic feet) of gas per day from the Chayvo field.42 An off-site modular construction approach was followed to build the OPF instead of a stick build approach. Talking about the importance of the facility, the project manager of Sakhalin-1, Jim Flood (Flood), said, ―It‘s truly the heartbeat of this project. All of the pieces of the project were ancillary to some extent to the successful completion of the OPF. Any delays in the OPF construction and start-up would greatly impact the overall economics of the project. Yet with a scheduled construction cycle of only 36 months and the major limitations on the productivity due to the highly remote subArctic location, we were not confident that a conventional stick-build approach would get the job done in time.‖43 The construction of the OPF began in 2003 and the contract to design the facility was awarded to Fluor Corporation44. The modules of the OPF were fabricated at the Hyundai Heavy Industry yards in Ulsan, South Korea. The platform contained 36 modules weighing 40,000 tons. The heavy modules were unloaded at Sakhalin through two sea lifts and moved to the OPF site through the Chayvo Bay Bridge45. The offsite construction of the OPF helped the project in saving 18 months of time and more than US$300 million in cost. ―Our execution strategy for the OPF included using 36 pre-assembled and pre-commissioned modules for a majority of the plant facilities. This helped offset the productivity impacts of working in a remote Arctic environment with a short construction window,‖ 46 said Flood. Until the OPF became fully operational, the project team decided to install an interim processing facility (IPF) in order to process the crude oil obtained as a result of drilling at Yastreb and Orlan. In 2004, an IPF comprising 60 modules was built in the 41

42

43

44

45

46

―The Hawk and the Sea Eagle,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf. ―From Design to Loading Tankers in 34 Months,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf. ―From Design to Loading Tankers in 24 Months,‖ ww.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf. Fluor Corporation is a US-based engineering, construction, and maintenance services company. The Chayvo Bay bridge, completed in 2003, links the Chayvo well site with the OPF. Built by Dalmostostroi, a Khabarovsk Krai construction company, the bridge is 830 meters (2,700 feet) long. ―ExxonMobil-40 Years of Arctic,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish3.pdf.

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International Business US and Canada and then sea lifted to Sakhalin and assembled. The IPF was installed by the Expro International Group Plc, a UK-based oilfield services company. In August 2005, the IPF with the capacity to process 6,300 metric tons (50,000 barrels) of oil and 4.2 million cubic meters (150 million cubic feet) of gas per day became operational. In 2006, when the OPF became functional, the IPF was closed down. The OPF produced stabilized crude oil called Sokhol crude oil which was piped to the De Kastri oil export terminal. The dry gas obtained was re-injected into the Chayvo field for conservation.

Oil Export System The oil export system of the Sakhalin-1 Project included a pipeline which was of 24 inch diameter and about 225 kilometers long, valve stations, an oil export terminal, a single point mooring (SPM) facility, and oil tankers. From the OPF, the pipeline transported oil across the western Sakhalin Island and the Tatar Strait47 to an oil export terminal located at De Kastri in the Khabarovsk Krai region. The construction of the pipeline began in 2004. The design and location of each pipeline was approved in advance by the Russian environmental protection agencies and the construction was carried out during winters when the streams were frozen to reduce possible impacts on the marine life. Adequate measures were taken to ensure the safety of endangered species during construction of the pipeline. For instance, on discovering a nest of an Orlan sea eagle during construction, the project team rerouted the pipeline. The project operators installed eight remotely operated valve stations to shut down the pipeline in case of a leak or any emergency. To facilitate communications across the entire pipeline route, the team installed a fiber optic cable along the length of the pipeline and a microwave tower on each side of the Tatar Strait. The pipeline could transport approximately 250 thousand barrels of oil per day (12 million tons of oil a year). The construction of the oil export terminal at De Kastri began in December 2003. A Russian construction company JST Trust Koksokhimmontazh (KXM) designed, manufactured, and built two 100,000 cubic meter (650,000 barrel) storage tanks for the De Kastri oil terminal. By June 2006, the oil terminal became operational. The De Kastri oil export terminal had oil storage facilities and a single point mooring (SPM) tanker loading facility to load crude oil onto tankers for export to world markets. The SPM facility located 5.7 kilometers offshore was fully automated with a conical base built to withstand heavy loads. It weighed 3,200 tons and was 210 feet above sea level. The facility was installed by J. Ray McDermott, a US-based supplier of offshore field development products. The oil was transferred from the oil terminal through a subsea loading line to the SPM facility. The SPM, considered as the world‘s largest fixed tower, allowed emergency shutdown and released tankers during unfavorable weather conditions. It was considered as the safest, most environmentally sound, and cost-effective method of tanker loading in an Arctic environment as it eliminated the need for a jetty48 for tankers.

The Delivery In August 2006, the Sakhalin-1 Project‘s oil export system was commissioned. With the commissioning of the system, the Sokhol crude oil developed by the project was supplied to international markets. ―The startup of Sakhalin-1 exports will provide 47

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The Tatar Strait is a channel between Sakhalin Island and the Asian mainland, in the Northwest Pacific Ocean, connecting the Sea of Japan and the Sea of Okhotsk. A jetty is a structure which extends into the sea and generally protects a harbor or coastline from the effects of currents and tides.

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Sakhalin-1 Project: Delivering Excellence in Project Execution additional needed energy supplies to the expanding economies of Asia and to other global customers. This project is another example of a long-lead time, technology intensive development brought to fruition this past year to help address the world's ever-growing energy demand,‖49 said Stuart McGill, senior vice president of ExxonMobil. On August 29, 2006, SPM received the Sokhol crude oil from the De Kastri terminal for loading onto tankers. On September 30, 2006, the first tanker loading of the crude oil started. Aframax class tankers50 were supplied to the project by Russia‘s Primorsk Shipping Corporation (PRISCO)51. Each tanker carried up to 720,000 barrels (100,000 tons) of crude. According to Les Carter, sub-project manager at DeKastri terminal, ―Our pumps at the terminal are designed to move 6,100 metric tons (45,000 barrels) of oil an hour into the subsea loading line, through the SPM, and onto the tankers. With the loading operations gradually ramped up to full project capacity, tankers began departing De-Kastri on average every three to four days in early 2007.‖52 In the first quarter of 2007, the Sakhalin-1 Project achieved its production goal as it reached production rate of 34,000 metric tons (250,000 barrels) of oil per day. The oil was supplied to refineries throughout the Asia-Pacific region while the natural gas was supplied to domestic consumers in the Khabarovsk Krai region. In December 2007, the Sakhalin-1 Project achieved a production milestone of 100 million barrels of crude oil from the Chayvo field. Commenting on the achievement, Stuart McGill, Senior Vice President of ExxonMobil, said, ―ExxonMobil, through the operatorship of Exxon Neftegas Limited, is pleased that the Sakhalin-1 Consortium achieved its production goal for peak crude oil operations in a timely manner. Achieving this production milestone is a significant example of how the energy industry and exporting nations can work together to provide needed energy supplies to global markets.‖53 The domestic sales of natural gas began in 2005 and totaled 575 million cubic meters (20.3 billion cubic feet) in 2006. Experts opined that the supply of natural gas from the Sakhalin-1 Project to customers in the Khabarovsk Krai was a significant step in the Russian Far East Gasification Program54. By February 2007, the natural gas supply to the Khabarovsk Krai region had reached 35 billion cubic feet (one billion cubic meters). In 2007, the average gas supplies to Khabarovsk Krai were 115 million cubic feet (3.27 million cubic meters) per day. In January 2008, local natural gas sales were above 200 million cubic feet/day (5.85 million cubic meters) per day. 55 As of August 2008, domestic gas sales totaled 105 billion cubic feet (3 billion cubic meters). According to experts, the gas supply from the Sakhalin- 1 Project was expected to fulfill the demand in the Khabarovsk Krai region until 2025. According to governor of Khaborovsk Krai Viktor Ishaev, ―This gas has helped bring fuel stability to our region and represents a major step in support 49

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―ExxonMobil Announces Start of Sakhalin-1 Exports; Newest Milestone in Company's Effort to...,‖ www.allbusiness.com, September 7, 2006. Aframax tankers are small oil tankers which carry oil through narrow harbors and canals. Primorsk Shipping Corporation (PRISCO) is a Russian shipping company involved in the transportation of various oil and liquid cargos. ―From Design to Loading Tankers in 24 Months,‖ ww.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf. ―Sakhalin-1 Project Production Goal Achieved,‖ www.sakhalin1.com, February 14, 2007. The gasification of Russian regions was started in 2001 by state-owned oil company, Gazprom. As part of the program, Gazprom finances construction of gas pipelines and ensures gas supply for regional consumers. http://www.sakhalin1.com/en/project/marketing.asp.

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International Business of Russia‘s Far East Gasification Program. With increased supplies becoming available from Sakhalin 1, we look forward to being able to move more of our communities away from dependence on coal to greater use of natural gas.‖ 56

Project Benefits According to experts, the Sakhalin-1 Project was one of the biggest projects developed by the international oil and gas industry. It represented one of the largest single FDIs in Russia managed by a multinational consortium. According to analysts, the Sakhalin-1 Project had helped Russia in strengthening its position as an energy supplier to world markets by providing oil and gas supplies for export to domestic and commercial markets. It also served as a medium for developing friendship between Russians and other foreign nationals, they said. According to Anna Kuniasky, Vice President Corporate Affairs, ENL, ―The joint work on the project, including the many years of negotiations, is a vehicle for developing friendships between Russians and foreigners and appreciation for each other's capabilities. This experience has increased the trust between the Russians and foreigners and thus has contributed to the success of the Sakhalin-1 project. I also believe that our positive experience will open future opportunities for foreign investment.‖ 57 The Sakhalin Project was one of the first oil and gas projects in Russia to employ PSAs. The PSA approach attracted a huge amount of foreign investment as it offered suitable tax procedures and guaranteed stability of the project over its lifetime. This, in turn, allowed the development of the project in harsh environmental conditions. Experts opined that the Sakhalin-1 Project was successful in developing the oil resources present in the Sakhalin Island in an efficient and cost-effective manner. Some of the achievements of the Sakhalin-1 Project included the on-schedule commencement of the first phase of the project, drilling of record breaking ERD wells, commissioning of the OPF before schedule, timely completion of the export pipeline and terminal, start-up of the oil export operations, and attaining the targeted levels of 250,000 barrels of oil per day. Commenting on the key elements which ensured the success of the Phase I development of the Sakhalin-1 Project, Terni said, ―Today‘s world-scale projects require proven capability to develop, extend, and apply leading edge technology to all aspects of a project. Technology was fundamental to the project‘s focus on developing the Chayvo resource at maximum value. However, leading-edge technology alone was not enough. Also key to maximizing value was the ability of ExxonMobil‘s global functional organization to deliver excellence in project execution from concept selection to start-up and a strong commitment to excellence in all aspects of project development. Equally important, these capabilities were brought to bear in partnership with co-ventures, the Russian government, and local contractors as well as the Sakhalin and Khaborovsk communities to successfully execute the project on schedule despite one of the world‘s toughest environments.‖ 58 Besides developing oil and gas, the project offered economic as well as social benefits to Russia and to the Sakhalin region in particular. Benefits to Russia from the Sakhalin-1 Project included direct revenues to the Russian state, major infrastructure developments, technology transfer, the employment of Russian citizens, and the use of 56

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―To Full Production and Beyond,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish7.pdf. http://www.sakhalin1.com/en/news/project/pnw_03152002_lamp.asp. www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish3.pdf.

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Sakhalin-1 Project: Delivering Excellence in Project Execution Russian suppliers for contracts and procurement. It was reported that over the life of the project, the Russian state would receive more than RUB59 1.250 trillion (US$50 billion) as taxes, royalties, and the state‘s share of hydrocarbons from the Sakhalin-1 Project. As of August 2008, the Russian government had received approximately US$ 1.1 billion (RUB 28 billion) in royalties and the state‘s share of oil production. Since the inception of the project, the Sakhalin Oblast administration received RUB 5.3 billion (US$ 211 million) in revenues. The Sakhalin-1 Project also brought significant benefits to the people of Russia, particularly to those in the Sakhalin region. In 2005, the project employed approximately 8,000 workers, including direct employees and contractors. Nearly 500 Russians worked directly for ENL. To enhance their skills, many of them received professional training in Russia, the US, and Canada. The value of these training programs was estimated to be about US$ 12 million. For instance, a workshop at the Sakhalin-Alaska College helped 60 Sakhalin welders to improve their professional skills and obtain international certificates. According to ENL, More than 13,000 direct and indirect jobs would be created for Russian nationals as part of the initial development of the project. It was expected that the number of Russian nationals working on the project would reach 90% within 10 years. (Refer to Exhibit IV for some of the achievements of the Sakhalin-1 Project).

Exhibit IV Accomplishments of Sakhalin-1 project The project applied cutting-edge technologies engineered specially for Arctic operations to develop the Sakhalin Island energy resources with careful regard for the environment, efficiency, and costs. The three-dimensional seismology used by ExxonMobil increased exploration success and reduced exploration costs. The project undertook successful operations in seas with six feet thick ice which were carried out using state-of-the-art computer models and five years of ice data. The project invested over 17.5 billion RUB (US$700 million) in environmental projects to help protect wildlife and habitats in the areas of operation. The design of the project facilities was protective of the Western Gray Whale, the Orlan eagle, and other wildlife native to Sakhalin Island. Employees worked over 80 million hours with industry-leading safety performance. The project's Lost Time Injury Rate (or LTIR) of 0.02/200,000 work-hours was several times better than the international oil and gas construction industry average. The project followed a phased development strategy along with detailed and integrated front-end execution planning. It implemented a ―plug-and-play‖ approach which allowed it to capture efficiencies and minimize risk. The project set 17 world records for extended-reach drilling and also for drilling speed. The world‘s most powerful land-based rig was drilled in the Chayvo field as part of the Sakhalin-1 project.

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Ruble (RUB) is the currency of Russia. As on November 2009, 1 US$ was approximately equal to 28.70 RUB.

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International Business The project awarded contracts worth over US$5 billion to Russian companies or joint ventures. The project funded over US$120 million to improve infrastructure in the Sakhalin region including hospitals, clinics, roads, bridges, harbors, airports, and power and water facilities. The project donated over US$3.5 million in charitable contributions to local community organizations, including health, youth, arts, and civic projects. Compiled from various sources One of the key objectives of the consortium was to promote Russian content. It hired as many local contractors as possible for the project. ENL, along with the Sakhalin Oblast Administration and the Ministry of Economic Development and Trade of the Russian Federation, established a Joint Committee to promote local content. The main objective of the Joint Committee was to maximize the involvement of Russian subcontractors and Russian suppliers of goods and services in the project. According to Neil Duffin, president of ENL, ―For Russia, a key is to create jobs and maximize local content — that is, Russian goods and services — in the project. One of our goals is to maximize involvement of Russian companies in our operations where possible and recruit Russians to commence building the operations group in 2002. We also have employees from both of our Russian consortium partners helping to manage the project.‖60 As of 2008, the value of contracts awarded to Russian companies as part of the Sakhalin-1 Project was about 125 billion RUB (over US $5 billion), more than twothirds of the total contracts awarded to third-party vendors. The consortium also launched a project website to communicate information related to the Sakhalin-1 Project to Russian contractors and suppliers. Seminars related to the project were held in Moscow, Khabarovsk, and Yuzhno-Sakhalinsk. The strategy to promote Russian content was mutually beneficial to the Russian contractors as well as to the project operators. The project operated smoothly due to the experience of the regional contractors who understood the local operating environment better. On the other hand, ENL‘s latest construction, drilling, and production procedures helped the local contractors gain sufficient knowledge about the latest technologies and improve their productivity.

Community Development Besides creating jobs and awarding contracts to Russian suppliers, the Sakhalin-1 consortium contributed to the well-being of the community as it tried to improve the standard of life of the communities in which it operated. ENL implemented various charitable small-grant programs to support communities in the Sakhalin Oblast and Khabarovsk Krai region. These programs primarily focused on areas of education and healthcare and support for local people. ENL contributed over RUB 85 million (US$3.5 million) to support education, healthcare, and cultural projects in the Sakhalin region such as instituting ‗Teacher of the Year‘ awards, setting up hospitals for children, organizing summer camps, as well as supporting earthquake victims (Refer to Exhibit V for community development initiatives of Sakhalin-1 Project). 60

Denise Allen Zwicker, ―Multi-national Project to Represent Record Foreign Investment in Russia,‖ http://www.sakhalin1.com, 2002.

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Exhibit V Sakhalin-1 Project: Community Development Initiatives Education The Sakhalin-1 project supported educational organizations and elementary and secondary schools in order to improve teaching and learning and achieve professional development. It provided educational materials and equipment and sponsored student programs and extracurricular activities to enhance the quality of learning. The Sakhalin-1 project offered grants toward educational development to the following: Sakhalin State University, for purchase of equipment for the media laboratory of the Journalism Faculty. Junior Achievement Sakhalin Foundation, which helped students from K-12 to learn the basics of business and economics. In 2005, over 7,500 students participated in the JA events compared to 1,980 students in 2000. Sakhalin Oblast Department of Education, where ENL was the General Sponsor for the annual Teacher of the Year Competition. Logos Club, which organized intellectual competitions (trivia contests) for high-school and college-age students in Yuzhno-Sakhalinsk. During the years of ENL‘s sponsorship, more than two thousand students participated in the Logos Club competitions. Volunteer Involvement Program. ENL offered small grants to support employees‘ volunteer activities in schools and kindergartens that their children attended. The program made possible field trips to natural history sites, classroom improvements, book purchases, and many other contributions. Val Settlement (Nogliki District) Secondary School, for purchase of personal computers to improve computer training resources. Sakhalin Oblast Traffic Inspectorate and the Sakhalin Oblast Committee of sports and physical culture. ENL sponsored the Safety Wheel children's traffic safety festival, in which teams from all over Sakhalin competed to show their knowledge of the rules of the road. Yuzhno-Sakhalinsk Education Department, to sponsor academic Olympiads in which over 1,500 high school students took part each year. Special Correction Comprehensive School for Mentally Challenged Children, for purchase of athletic equipment and educational materials. Health ENL supported programs targeted at health issues and made contributions to health-related organizations which addressed public health issues and local community needs. Examples of organizations and programs that received contributions included: Paramedics-Midwife Stations in remote areas (Val, Nekrasovka): purchase of medical equipment. Nogliki Secondary School for purchase of medical equipment. Support of the International Conference ―Publicly Accessible Defibrillation and Preventive Measures for Sudden Cardio Death‖. 401

International Business Civic and Community Service ENL supported civic and community service organizations which fulfilled social needs and enhanced social and economic conditions. It also supported cultural organizations, which provided access to art. Examples of organizations and programs that received contributions included: Sakhalin Culture Fund rewards which gifted youth and professionals for their contribution in culture and arts. Publication of the Sakhalin Oblast Commemorative Book dedicated to the history of Sakhalin from 1930 to 1950. Centennial Celebrations of the Yuzhno-Sakhalinsk City Park. Okha Central Library for purchase of office equipment, software, and books. Okha Children‘s Library for purchase of personal computers and office equipment. Sakhalin Regional Library for purchase of equipment Yuzhno-Sakhalinsk Chamber Orchestra for purchase of musical instruments and sponsorship of concerts. Indigenous Minority People of the North (IMPN) was an important recipient of ENL contributions. ENL financed the following organizations and programs in association with IMPN: Summer camp for IMPN children from Ulchi District; Support of the Giva IMPN Folk Ensemble (Bulava Settlement) Tourist equipment for IMPN children of the De-Kastri Settlement Equipment for restoration of documents in the Bogorodskoye Public Museum Sponsorship of the Ulchi District Nivkh delegation participation in the 1st Nivkh Congress Support of the Bulava social center Contribution of furniture, athletic, and other equipment for Sofijsk and Tyr Boarding Schools Equipment for the sewing lab of Khabarovsk Technical College Bulava Branch Source: www.sakhalin1.com The Sakhalin-1 Project invested over RUB 3 billion (US$120 million) in infrastructure improvements in the Sakhalin region such as upgrading hospitals, roads, bridges, ports, and airports. The project also contributed to the development of the local communities. For instance, the project donated US$ 300,000 for the purchase of new surgical and diagnostic equipment at the Central District Hospital in Khabarovsk Krai. In 2007, ENL made significant investments in the modernization of the YuzhnoSakhalinsk Women‘s Clinic. 402

Sakhalin-1 Project: Delivering Excellence in Project Execution Another noteworthy initiative launched by the Sakhalin-1 Project was a regional small business development program launched in 2004 in the northern Sakhalin districts of Nogliki and Okha in association with USAID.61 The program launched with an investment of US$ 500,000, created about 180 small businesses and more than 500 local jobs in the region. It provided financial support to small business units which were unable to obtain commercial bank loans. The project also contributed about US$ 100 million to the Sakhalin Development Fund over a five-year period (2003-2008) and offered production bonuses of about US$ 60 million.

Safety and Environment Besides offering multiple benefits to Russia, the project paid attention to operational, environmental, and safety performance. The Sakhalin-1 project ensured the safety of people, the environment, and the local community through effective application of the safety system and tools. With support from the consortium and the Russian government, the project applied best safety and environmental practices in a phased development approach. The lost-time incident62 (LTI) rate reported by the project was significantly better than the average for the worldwide oil and gas construction industry. From the first quarter of 2005 to January 2006, the project operated for 26 million work hours without an LTI. By the end of 2006, the project‘s LTI rate was nine times better than the worldwide oil and gas construction industry average. The total recordable injury index of the Sakhalin-1 Project was 0.21, three times better than the index of 0.59 for all projects operated globally by ExxonMobil. ―When you take into account a multinational workforce operating in a harsh sub-Arctic environment and amassing more than 75 million work hours since the start-up of drilling and construction activity in 2003, this was an incredible accomplishment. Making these safety records even more impressive was the fact that the workers achieved them while keeping the project moving ahead on schedule,‖63said Tim Murphy, lead safety advisor of Sakhalin 1 Project. One of the primary reasons for the safety success of the project was an ExxonMobil business plan called the Operations Integrity Management Systems (OIMS). The Sakhalin-1 Project fully adopted and implemented the OIMS. Jim Reisz, the OIMS safety manager, described the OIMS as ―defining everything we do and how we do it. It takes the randomness out of your approach to business, safety, and the environment and makes it predictable. Just as you develop a business plan, you also develop a safety plan and an environmental plan. And, most importantly, every employee is accountable.‖64 According to experts, besides achieving excellence in safety, the Sakhalin-1 Project also ensured environmental protection. For instance, the oil export pipeline was designed to run east-west rather than north-south to reduce the number of stream crossings and lessen environmental impact. While carrying out drilling and construction activities, care was taken to protect fish and endangered wildlife. To protect endangered marine species, the construction of jetties along the shoreline north of Chayvo was eliminated from the development plan as that construction might 61

The United States Agency for International Development (USAID) is the US federal government organization providing economic and humanitarian assistance to countries worldwide. 62 Lost-time incident (LTI) is any work related injury which prevents personnel from doing any kind of work after the accident. 63 ―Champions for the Safety and Environment,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf. 64 ―Champions for the Safety and Environment,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.

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International Business disturb the marine life. The Orlan platform was successfully towed from the ice conditions of the Bering Sea to the Sakhalin Island. ―In Russian, Orlan symbolizes strength, boldness, and speed, and Orlan‘s 3000-mile journey from Alaska to the Russian port of SovGavan without incidents underlines our commitment to safety and the environment in all aspects of our business,‖65 said Tom Hall, manager of Sakhalin1 Project. Western gray whales, which were considered as an endangered species by the World Conservation Union,66 inhabited the shallow waters off Sakhalin‘s northeast coast. Since 1997, the Sakhalin-1 consortium spent about US$15 million on studies related to these whales and adopted measures to protect them. During the 2001 seismic survey in the Odoptu field, the project implemented the most extensive whale protection program ever undertaken by the oil and gas industry. ―We developed a monitoring program in which we had trained observers, usually marine biologists, stationed on the seismic vessel and support boats. When a gray whale was sighted within a protection zone of four to five kilometers between the vessel and the mammal, operations were shut down until it had cleared the area,‖ 67 said Dan Egging, Sakhalin-1 Houston regulatory manager. To protect endangered birds such as Steller‘s Sea Eagle (Orlans), the Sakhalin-1 team carried out field studies in association with environmental experts. For example, with help from Vladimir Masterov, a leading ornithologist from Moscow State University, the project conducted a number of baseline studies to identify sea eagle habitat along the coasts of Sakhalin including the mapping of nests and hunting areas. They constructed artificial nests and perches to attract the birds to new coastal sites away from project facilities. The project also gave precedence to protecting native islands and the livelihoods of reindeer herders, who inhabited the northern Sakhalin Island and the Khabarovsk Krai. As of June 2008, the project had spent over US$ 700 million in environmental projects to help protect wildlife and safeguard environment in the areas of operation. Out of this, over US$ 40 million were spent on various archaeological, ornithological, bathymetric, meteorological, seismic, topsoils, fisheries, stream crossing, waste management, bioremediation, oil spill response, and other studies, and another US$ 17 million on initiatives aimed at preserving the western gray whale population.

Challenges Experts considered the Sakhalin-I Project to be a multifaceted engineering project as it posed some of the most difficult challenges that the oil and gas industry had faced anywhere in the world. The project faced both environmental as well as manmade problems. These challenges included operating in a harsh physical environment, a remote location with limited infrastructure, environmental limitations, government regulations, and lack of skilled labor. Analysts opined that the project team had to understand the physical, cultural, and political environment of the area to make the project successful.

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Denise Allen Zwicker, ―Multi-National Project to Represent Record Foreign Investment in Russia,‖ http://www.sakhalin1.com, 2002. The name ―World Conservation Union‖ was used in conjunction with the International Union for Conservation of Nature (IUCN), an international organization dedicated to the conservation of natural resources. Champions for the Safety and Environment,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.

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Sakhalin-1 Project: Delivering Excellence in Project Execution Sakhalin Island, situated between Russia and Japan in the North Pacific, is a mountainous region with a harsh Arctic environment. The region is covered by a pack of ice three to five feet thick about six to seven months in a year. As a result, the project could operate only during the months of summer. The region is seismically active and earthquakes occur frequently. Moreover, the geology of the region is complex, leading to exploration problems. The remote location of the site made travel difficult. An extensive network of helicopters, trains, and vehicles was required to reach the work site. Besides climate-related problems, another important challenge confronting the project was environmental protection. The region was characterized by abundant flora and fauna. Developing oil and gas in an ecologically sensitive area would lead to protests from environmentalists. Environmentalists pointed out that that increasing seismic surveys, constant drilling, and oil spills from rigs and tankers and movement of vessels and helicopters at the production site affected the marine environment present in the Sea of Okhotsk. To protect the marine life, the Russian Ministry of Natural Resources restricted seismic testing and drilling in some areas of the island. Due to environment restrictions, drilling of some of the wells was carried out from onshore instead of offshore. This resulted in a delay in the project and increased costs. Due to the delay, the payback period of the project could get extended, analysts said. In October 2008, a group of NGOs filed a lawsuit, appealing against the verdict of the State environmental appraisal for the Sakahlin-1 Project. According to them, the project‘s appraisal required a thorough investigation as some significant changes had been recorded in the distribution and number of Western Pacific grey whales in the Piltun spit. They attributed the changes in the number of grey whales to the activities related to the Sakhalin-1 Project in the region. According to them, the pipeline between the Odoptu drilling platform on the Piltun spit and the Sakhalin Island was dangerous for the whales. They demanded that the pipeline construction across Piltun bay be stopped. According to Alexey Knizhnikov, head of the The World Wildlife Fund (WWF) - Russia68 Program on environmental policies of the oil and gas sector, ―Sakhalin 1‖ project must immediately halt its pipeline construction across Piltun Bay, before the formal Court consideration. It is also important to identify the exact reasons for the changes in the whales‘ distribution observed in the summer 2008.‖ 69 A court ruling was awaited in the lawsuit. In addition to physical and environmental challenges, the Sakhalin-1 Project also faced workforce related problems. There was no skilled labor in the region. ENL had to invest significantly in training the workers but they were not very adept with the latest construction and drilling procedures. To minimize training expenses, the project operators imported manpower from other regions. The Sakhalin regional administration alleged that most of the workers participating in the project were foreigners. According to them, the project should maximize Russian content by hiring contractors and workers from the region as stipulated in the PSA. Analysts were of the view that though the project faced some harsh challenges, ENL through the application of leading-edge technologies such as 3D seismic and ERD, visualization analysis, simulations, and field studies had managed to successfully complete the first phase of the Sakhalin-1 Project. Commenting on the challenges of the project, Terni said, ―People ask me if ExxonMobil with its 100-plus years of global exploration and development has ever been involved in a project that offered so 68

The World Wildlife Fund (WWF) – Russia Program works for the conservation of wild life in Russia. 69 ―Environmentalists Appeal to Halt «Sakhalin 1» Project Before any Formal Court Ruling,‖ www.wwf.ru, January 12, 2009.

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International Business many challenges. I tell them that the company has had experience with all of these challenges-operating in sub-Arctic environments with short work seasons, researching and applying ice-breaking technology so we get could get the oil to the market, working in remote areas thousands of miles from manufacturing and supply centers which required extensive logistics planning, developing drilling plans for extreme horizontal drilling, working under complex regulatory regimes, and many others. However, while we might have faced two or three of these challenges on a project before, just about every single one of them came together on this project.‖70

Outlook After completing its first phase, the project moved on to the next phase which was to develop oil and gas from the Odoptu field. According to the project consortium, experience gained during the first phase including ERD, logistics, winter work productivity, contracting strategies and Russian contractor expertise, regulatory processes and design criteria would be used to carry out the subsequent phase of the project. Future phases of the Sakhalin-1 Project would include developing the Arkutun-Dagi fields, expanding the Chayvo OPF, and further developing the Chayvo gas field (Refer to Exhibit VI for a brief on the future phases of Sakhalin 1 Project). Experts felt that the three fields in the Sakhalin oil field area could provide a longterm supply of gas for export and domestic use in Russia. It was estimated that the Chayvo field alone had enough gas to produce 1 billion cubic feet per day (10 billion cubic meters per year) for more than 25 years. Similarly, the Odoptu and ArkutunDagi oil fields could sustain oil development for more than 40 years at a production rate of 1 billion cubic feet per day (10 billion cubic meters per year). In February 2009, ENL suspended work on the Odoptu and Arkutun Dagi fields at Sakhalin as the Russian government did not approve its development plans and budgets for 2008 and 2009. However, production from the Chayvo field was not halted. Due to suspension of work, a 23% fall in oil production was noticed. As in February 2009, output decreased to about 193,000 barrels of crude oil per day from a peak of 250,000 barrels per day in February 2007. It was speculated that production might further drop by 11% in 200971. According to some analysts, the reason for the suspension of work at the two fields was a dispute between ENL and the Russian government over the sale of natural gas developed from the region. The Russian government wanted the operators of Sakhalin-1 to sell the natural gas to Gazprom72 to cover domestic needs, while Exxon planned to export the gas to China. ENL wanted to build a natural gas pipe line to China and supply 8 billion cubic meters of gas annually to China. But the Russian government did not approve the pipeline to transport the gas as it wanted ENL to sell the project‘s gas to Gazprom at a lower price. Some observers felt that the Russian government was creating obstacles for the project as it felt that it was losing control over the domestic oil and gas companies and wanted to confine the Sakhalin-1 consortium just to developing the Chayvo field and to develop the remaining two fields on its own. 70

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―World-Class by Any Measure,‖ www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish1.pdf. ―OVL's Sakhalin-1 project faces roadblocks,‖ www.financialexpress.com, February 25, 2009. Gazprom is a global energy company involved in the exploration, production, transportation, storage, processing, and marketing of gas and other hydrocarbons as well as electric power and heat energy production and distribution. The Russian Ministry of Oil and Gas holds a 50 per cent controlling stake in Gazprom.

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Exhibit VI Future Phases of the Sakhalin-1 Project Odoptu Development The second phase of the Sakhalin-1 project included the development of the Odoptu field. The field is located off the northeast coast of Sakhalin Island about 35 miles (55 km) north of the Chayvo operations. The first stage of development in the Odoptu field would include modification of the existing Chayvo facilities. Development plans included the construction of roads to the Odoptu site and the establishment of on-site housing and work facilities. The Yastreb drilling rig, which was used for onshore drilling at the Chayvo field, was relocated to the Odoptu site where it would be used to drill onshore extended reach wells. A 49 mile (79 km) 16-inch flowline would be laid to transport the oil and gas to the existing Chayvo Onshore Processing Facility, from where the pipeline to the De-Kastri Terminal would further transport the oil to international markets. As of April 2009, the Odoptu field development was going through regulatory and government reviews and the Yastreb rig was relocated to the Odoptu site. The project was to undertake additional construction activities after obtaining the required regulatory approvals. Arkutun-Dagi Development The third phase of development of the Sakhalin-1 project involved the development of oil and gas from the Arkutun-Dagi field. The field is located approximately 25 kilometers off the northeast coast of Sakhalin Island, east of the Chayvo field. As part of the Arkutun-Dagi development, a new offshore drilling and production platform with a gravity base substructure and topsides facilities was to be constructed. A new flowline would transport the oil and gas from the ArgatunDagi field to the existing Chayvo Onshore Processing Facility, where existing pipelines would transport the oil and gas for export. Over 30 Russian design institutes and contractors were involved in the development of the Arkutun-Dagi field. As of 2009, the development of the Arkutun-Dagi field was passing through regulatory and government reviews. Chayvo Field Phase 2 Commercial Gas Development The Sakhalin-1 project was supplying natural gas to domestic customers in the Russian Far East as part of the first phase of the Chayvo field development. The phase succeeding the Arkutun-Dagi field development would be Chayvo Phase 2 gas development. This phase would expand natural gas production by developing and producing non-associated gas. The development of this phase required a multibillion dollar investment and significant expansion of existing onshore and offshore facilities at the Chayvo field site including additional drilling, processing, power, and other infrastructure developments. The gas produced from this phase was to be supplied to both domestic and export markets. In order to deliver the gas to export markets such as China and Japan in a cost-effective way, the project consortium planned to construct a gas pipeline. In October 2006, a Heads of Agreement was signed with China National Petroleum Company (CNPC) for supply of gas through pipelines from Sakhali to China. Source: www.sakhalin1.com Though the issue related to the supply of natural gas remained unresolved, the government went ahead and approved the Sakhalin-1 budget after a long delay. According to analysts, the government approved the budget as the project functioned under a PSA and any spending delay would reduce the government‘s income from the project. It was reported that the budget approved for the project for the year 2009 was US$ 1.978 billion. Additional spending for 2008 was approved at US$ 404 million, compared to US$ 627 million in 2007. With the budget approval, the project resumed its work on the Odoptu field. 407

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References & Suggested Readings 1.

“Exxon Deal Pending on Sakhalin-1 Gas? (XOM),” http://247wallst.com, May 7, 2009.

2.

―OVL’s Sakhalin-1 Project Faces Roadblocks,” www.financialexpress.com, February 25, 2009.

3.

“Environmentalists Appeal to Halt «Sakhalin 1» Project Before any Formal Court Ruling,” www.wwf.ru, January 12, 2009.

4.

“Sakhalin-1 Project Receives Award for Excellence from International Petroleum Technology Conference,” www.sakhalin1.com, December 3, 2008.

5.

“Sakhalin-1– Beyond the Controversy,” www.offshore-technology.com, July 27, 2007.

6.

“Sakhalin-1 Project Production Goal Achieved,” www.sakhalin1.com, February 14, 2007.

7.

“ExxonMobil Announces Start of Sakhalin-1 Exports; Newest Milestone in Company's Effort to...,” www.allbusiness.com, September 7, 2006.

8.

“ExxonMobil Announces Production Start-Up from Sakhalin-1 Project in Russia,” www.sakhalin1.com, October 2, 2005.

9.

“Sakhalin-1 Launches Oil Pipeline Construction,” www.indianexpress.com, November 10, 2004.

10.

Denise Allen Zwicker, “Multi-national Project to Represent Record Foreign Investment in Russia,” http://www.sakhalin1.com, 2002.

11.

“Sakhalin 1- A New Frontier,” http://www.exxonmobil.com/Corporate/Files/Corporate/SakhalinEnglish_Intro.pdf.

12.

“World-Class by Any Measure,” ww.exxonmobil.com/Corporate/Files/.../SakhalinEnglish1.pdf.

13.

“ExxonMobil-40 Years of Arctic,” www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish3.pdf.

14.

“The Quest Begins,” www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish4.pdf.

15.

“The Hawk and the Sea Eagle,” www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf.

16.

“From Design to Loading Tankers in 34 Months,” www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf

17.

“To Full Production and Beyond,” www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish7.pdf.

18.

“Champions for the Safety and Environment,” www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.

19.

www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia.

20.

www.sakhalin1.com/en/news/project/pnw_03152002_lamp.asp.

21.

www.sakhalin1.com

408

Volkswagen’s Marketing Strategy in India The case examines the marketing strategies of Volkswagen Group India, the Indian subsidiary of German automobile manufacturer, Volkswagen AG (Volkswagen). Volkswagen entered the Indian passenger car market in 2001 by launching its car brand – Skoda. In 2007, two of its other brands Audi and Volkswagen, were also launched in India. Volkswagen Group India emphasized on all aspects of marketing mix including product, price, place and promotion. The company offered three brands including Audi, Skoda and Volkswagen that together comprised of 15 different models as of late 2009. Volkswagen Group India mainly catered to the luxury segment of the Indian car market. The company had established presence in India through separate distribution channels for each of its brands. In its initial years, Volkswagen Group India primarily used the print media to promote its products. However, considering the growth potential of India's automobile market, the company started using electronic, digital and out of home media along with print media. In November 2009, the company launched an integrated marketing campaign to strengthen its brand image. The case describes the marketing campaign and ends with a discussion on the growth prospects of the company in future.

Volkswagen’s Marketing Strategy in India “We are fairly new in the Indian market. The brand awareness of Volkswagen is low. We have to raise awareness, create and improve the brand.” 1 -

Lutz Kothe, Chief General Manager, Marketing and Public Relations, Volkswagen India, in November 2009.

“Volkswagen is committed to the Indian market, the proof of which is the constant investment and growth that we provide through the various projects initiated. India is one of our key markets and we know that the future harbors a huge potential.”2 -

Jochem Heizmann, Member of the Management Board, Volkswagen AG, in August 2009.

Introduction On December 21, 2009, Volkswagen India Private Limited (Volkswagen India), the group company of Volkswagen Group India, announced that it aimed to sell 300 units of Beetle, its iconic car, in India in the year 2010. The Beetle was launched in India on December 04, 2009. Raj Sawant, Business Head of Automark Motors, a Volkswagen dealer in Ahmedabad, Gujarat, India, said, ―There are already over 170 advance bookings across India, and we have started delivering the cars as well. Going by the initial euphoria, we expect to sell around 300 Beetles in 2010.‖3 Volkswagen Group India, the Indian subsidiary of leading automobile manufacturer, Volkswagen AG (Volkswagen), based in Wolfsburg, Germany, had entered the Indian passenger car market in 2001 by launching its car brand – Škoda. In 2007, two of its other brands Audi and Volkswagen, were also launched in India. Over the years, Volkswagen Group India not only launched several products, but also ensured that its brands were well known among the Indian consumers. Although, the company had had a presence in the Indian car market since 2001 and the Škoda and Audi branded cars were well known among consumers, the Volkswagen brand was not well recognized in the country. Therefore, in November 2009, the company launched an integrated marketing campaign to build its brand image. It also launched a marketing campaign for its iconic model, the Beetle. Volkswagen India expected that with its brand building exercise, it would be able to increase its sales and capture a significant market share in the Indian car market. According to Neeraj Garg (Garg), Director (Passenger Cars), Volkswagen India, ―It is true the Volkswagen brand is not well known in the country. This will be corrected with appropriate branding strategy.‖4

1

2 3

4

―Volkswagen Launches First Brand Campaign in India,‖ www.afaqs.com, November 10, 2009. ―Volkswagen Group India Holds A Positive Outlook,‖ http://machinist.in, August 29, 2009. ―Volkswagen Aims to Sell over 300 Beetles in 2010,‖ www.business-standard.com, December 21, 2009. ―Volkswagen India Plans to Double Distribution Network,‖ http://economictimes.indiatimes.com, September 25, 2009.

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International Business Volkswagen Group India had built a widespread distribution network for its three brands across India. The company offered different car models ranging from luxury sedans to compact cars. According to Jochem Heizmann, Member of the Management Board, Volkswagen, ―India is a huge market that we believe offers us potential. In India, the passenger vehicle segment has seen a growth despite the current market situation and Volkswagen plans to tap this. With the varied models across our brands as well as the establishments that have been set up we hope to be able to cater to our customers as well as dealers in the best possible manner.‖5

About Volkswagen The history of Volkswagen (which means ‗people‘s car‘ in German) can be traced back to the 1930s when Ferdinand Porsche, a reputed automobile engineer and designer, started designing an affordable car for the common man. In 1936, the first prototype of the car, called the KdF-Wagen, was designed in Stuttgart, Germany. This prototype was similar to what later came to be known as the Beetle. On May 28, 1937, the ―Gesellschaft zur Vorbereitung des Deutschen Volkswagens mbH‖ company was founded, and on September 16, 1938, it was renamed as ―Volkswagenwerk GmbH.‖ In 1938, the construction work resumed on a production plant at Wolfsburg, Germany. During World War II, Volkswagen‘s core focus shifted to the production of military vehicles. After the War, as the area fell under the occupation zone of the United Kingdom (UK), in mid-June 1945, the company was revived by Major Ivan Hirst, a British army officer. Under his management, the company again started producing the Beetle. By 1946, the production plant at Wolfsburg was producing 1,000 cars per month. In 1948, Heinrich Nordhoff (Nordhoff), a former senior manager at Adam Opel GmbH (Opel), was appointed to manage the company. Under Nordhoff, Volkswagen started producing a number of Type 2 commercial vehicles like vans and pickups. The Volkswagen Bus called the ‗VW Bully‘ soon became very popular among consumers. In 1956, a separate manufacturing base was established in Hanover. In 1973, the production of new generation of Volkswagen vehicles began with the Passat. In January 1974, production of the Golf was started at the Wolfsburg plant. In 1974, Volkswagen launched another car the Scirocco. In 1976, the Golf GTI rolled off the production line. The car, with its110 bhp engine, became an instant hit among consumers. In June 1983, the company started production of the second-generation Golf. The company used a highly automated assembly process for the production of the car, and for the first time in vehicle manufacturing, robots were used. In July 1999, Volkswagen started the production of Lupo 3L TDI, which had a fuel consumption of just three liters per 100 kilometers. In August 2002, the company started mass production of the Touareg, a luxury-class Sports Utility Vehicle (SUV). In 2003, production of the fifth-generation Golf was started. On December 09, 2009, Volkswagen and Suzuki Motor Corporation (Suzuki) 6 announced that they had entered into a long-term strategic partnership in which Volkswagen purchased 19.9 percent of Suzuki‘s issued shares. 5 6

―Volkswagen Group India Holds A Positive Outlook,‖ http://machinist.in, August 29, 2009. Suzuki Motor Corporation is a Japanese multinational corporation headquartered in Hamamatsu, Japan. It specializes in manufacturing compact automobiles, a full range of motorcycles, all-terrain vehicles (ATVs), outboard marine engines, wheelchairs, and a variety of other small internal combustion engines. It was founded in 1909. As of 2008, it generated revenues of US$ 33.46 billion and net income of US$ 305.43 million (Source: http://en.wikipedia.org).

412

Volkswagen’s Marketing Strategy in India As of 2009, Volkswagen was the largest car manufacturer in Europe. In the third quarter of 2009, the company generated revenues of € 25, 956 million and reported a profit after tax of €161 million (Refer to Exhibit I for Volkswagen’s Financial Highlights). The company had eight brands — Volkswagen, Audi, Bentley, Bugatti, Lamborghini, SEAT, Škoda, and Volkswagen Commercial Vehicles (Refer to Table I for Volkswagen’s Third Quarter Results in 2009 and 2008).

Exhibit I Volkswagen’s Financial Highlights (2006-08) (In € millions) 2008

2007

2006

113,808

108,897

104,875

Operating Profit

6,333

6,151

2,009

Profit before Tax

6,608

6,543

1,793

Profit after Tax

4,688

4,122

1,955

Net Cash Flow

-2,679

7,109

5,631

8,039

13,478

7,133

Sales Revenue

Net Liquidity on December 31 Source: www.volkswagenag.com.

Table I: Volkswagen’s Third Quarter Results (In € millions) Q3 2009

Q3 2008

25956

28932

-10.3

Operating profit

278

1485

-81.3

Profit before tax

262

1481

-82.3

Profit after tax

161

1161

-86.1

Net Cash flow

791

-2408

-

13391

11767

+13.8

Sales Revenue

Net Liquidity on September 30

% Change

Source: www.volkswagenag.com.

Marketing Strategy in India Volkswagen entered the Indian market in 2001 by setting up its Indian subsidiary Volkswagen Group India. As of 2009, Volkswagen Group India had two group companies – Volkswagen India Private Limited (Volkswagen India) and Volkswagen Group Sales India Private Limited (VGSIPL). Volkswagen India focused on the manufacturing and sales of Volkswagen branded cars in India. Skoda Auto India Private Limited (Skoda Auto India)7 and Audi India8 both were divisions of VGSIPL. 7 8

Skoda Auto India Private Limited is a subsidiary of Skoda Auto part of Volkswagen Group, Audi India is a subsidiary of Audi AG, part of Volkswagen Group.

413

International Business The marketing strategy including product launch, product positioning, promotional campaigns, and establishing widespread dealer networks of each brand of Volkswagen Group India which was handled by the group companies and their divisions separately. Commenting on the rationale for following such a marketing strategy, Rupert Stadler, Chairman of the Board of Management of Audi AG, said, ―If you compare Volkswagen to other big automobile groups in the world, you can see how it has given independence to individual brands. Each of us has to do our job and not ask mama‘s help all the time! This is what finally drives brands in the business.‖9

Products Skoda Auto India entered the Indian car market in 2001 by setting up a plant at Shendra, on the outskirts of Aurangabad, Maharashtra. In March 2007, when Audi India was set up as a division of VGSIPL, it also started using the same plant. In March 2009, Volkswagen India and Skoda Auto India started a joint manufacturing plant at Chakan, near Pune, in Maharashtra. While Skoda Auto India invested € 90 million, Volkswagen India invested approximately € 580 million to build the plant. In mid-2009, Audi India assembled only two of its models – the A4 and the A6 in India; the rest were imported as Completely Built Units (CBU). According to Martin Birkner, the Head of Audi India (Marketing), it would soon assemble more models in India so as to get a competitive advantage. As of late 2009, Volkswagen Group India was marketing three different brands including Audi, Škoda, and Volkswagen that comprised 15 different models (Refer to Table II for the cars offered by Volkswagen Group India).

Table II: Car Models Offered By the Volkswagen Group India (December 2009) Brand

Car Models

Audi

Audi A4, Audi A6, Audi A8, Audi Q5, Audi Q7, Audi TT, Audi R8.

Škoda

New Superb, New Laura, Octavia, Fabia.

Volkswagen

Passat, Jetta, Beetle, Touareg.

Source: www.volkswagenindia.co.in. Volkswagen Group India received several awards in 2009. CNBC-Overdrive Award recognized the company as the most successful car manufacturer in 2009. Škoda Fabia received the Car of the Year as well as the Compact Car of the Year awards. The Volkswagen Jetta received the Premium Car of the Year award and the Audi A4 3.2 the Performance Car of the Year award.

Price Volkswagen Group India mainly catered to the luxury segment of the Indian car market. Skoda Auto India had four models among which three the New Superb, the New Laura, and the Octavia, were luxury cars and the Fabia was a mid-segment car. The Fabia had both petrol and diesel variants. Škoda branded cars had 20 variants in total and were available in the price range of Rs. 490,043 and Rs. 2,576,383.

9

―Audi Bullish on India; Sees ‗Metropolitan‘ Strategy as the Way Forward,‖ www.blonnet.com, April 20, 2009.

414

Volkswagen’s Marketing Strategy in India Audi India had seven models with prices ranging from Rs. 2,900,000 to Rs 12,300,000. Volkswagen India had four models which were available in the price range of Rs. 1,240,379 to Rs. 5,185,000 (Refer to Table III for Volkswagen Group India’s Car Prices).

Table III: Volkswagen Group India’s Car Prices (Ex-Showroom Delhi Price as of December 2009) Brand

Price Range

Audi A4

Rs. 29,00,000 to Rs. 36,00,000

Audi A6

Rs. 39,80,000 to Rs. 49,75,000

Audi A8

Rs. 61,21,717 to Rs. 1,23,00,000

Audi Q5

Rs. 38, 29, 000

Audi Q7

Rs. 52,00,000 to Rs. 73,01,771

Audi TT

Rs. 46,19,693 to Rs. 47,51,424

Audi R8

Rs. 1,17,00,000

Škoda New Superb

Rs. 19,39,705 to Rs. 25,76,383

Škoda Laura

Rs. 13,05,207 to Rs. 17,68,528

Škoda Octavia

Rs. 10,19,845 to Rs. 12,10,023

Škoda Fabia Volkswagen Passat Volkswagen Jetta Volkswagen Beetle Volkswagen Touareg

Rs. 4,90,043 to Rs. 7,63,274 Rs. 21,61,458 to Rs. 25,77,860 Rs. 12,40,379 to Rs. 16,38,251 Rs. 20,45,000 Rs. 51, 85,000

Compiled from various sources.

Promotion Skoda Auto India and Audi India In 2001, Skoda Auto India launched its first product, the Octavia, in India. The company primarily used the print media whenever it launched a new product. To promote the brand image of the company, it also used print ad campaigns (Refer to Exhibit II for Skoda Auto India’s Print Ads). In June 2004, the company launched a print ad campaign which read ‗We fill our airbags with life‘. In the print ad campaign, the company emphasized the fact that Škoda cars had six airbags to ensure proper safety. In 2005, Skoda Auto India launched several television commercials (TVCs) to promote its models. The company launched a TVC with the tagline, ―You need to be well-built to carry your loved ones...‘ In 2008, when the company launched the Fabia, it launched a TVC with the tagline ―Because You‘re Special.‖ (Refer to Figure I for an Image of Škoda Fabia’s TVC). Commenting on the advertisement strategy, Shashank Vaid, Manager (Marketing), Skoda Auto India, said, ―We use television commercials as part of the corporate branding strategy, while the print advertisements communicate the benefits.‖10 10

Nirmal D. Menon, ―The Skoda Score,‖ www.blonnet.com, January 13, 2005.

415

International Business

Exhibit II Skoda Auto India’s Print Ads

Source: www.skoda-auto.co.in.

Figure I: An Image of Škoda Fabia’s TVC

Source: http://www.bigadda.com. 416

Volkswagen’s Marketing Strategy in India As of 2009, Law & Kenneth11 handled the creative duties for Skoda Auto India‘s four brands – the Fabia, the Octavia, the Laura, and the Superb. Since its launch in India, Audi India‘s focus had been on establishing itself as a luxury car brand in India. According to Birkner, ―As a group, we have presence in almost every segment. We are in no hurry to launch Audi‘s compact cars. Our focus is currently on establishing our luxury brand image.‖12

Volkswagen India In September 2007, when Volkswagen India launched its first model, the Passat, in India, it appointed DDB Mudra Group (DDB Mudra) as its creative agency. In the first week of September 2007, the company launched an advertising campaign which aggressively used the print media. Commenting on the rationale for launching the campaign, Bobby Pawar (Pawar), Chief Creative Officer, DDB Mudra Group (DDB Mudra)13, said, ―Volkswagen has just launched the Passat and it has other big plans for India. They are planning to launch cars here in India to suit every pocket. The brief for us was to establish the spirit and philosophy of Volkswagen makes people believe that there‘s a certain way of life at Volkswagen.‖ 14 In July 2008, the company launched its second model, the Jetta, in India. Initially, Volkswagen India did not market its products aggressively. However, considering the growth potential of India‘s automobile market which was expected to sell two million vehicles in 2014 and three million vehicles by 2018 as compared to 1.1 million vehicles in 2009, the company started laying special emphasis on marketing its products. Volkswagen India‘s internal research conducted in 2008 showed that the company‘s brand was not well known among Indian consumers. According to the Society of Indian Automobile Manufacturers (SIAM) 15, Volkswagen India had sold only 1,172 cars between April and October 2009, as compared to other European automobile manufacturers like BMW India Private Limited 16 which sold 2089 cars and MercedesBenz India17 that sold 1869 cars during the same period.18 Therefore, the company felt 11

12

13

14 15

16

17

Law & Kenneth, the Indian subsidiary of UK based Kenneth Worldwide Group Company, was aleading ad agency in India. As of 2009, it handled creative duties of many leading brands including Johnson & Johnson Baby Products, ITC Personal Care, Cox & Kings Travel Agency, Haier Electronics, GoAir, Bajaj Scooters, ICICI Prudential Life Insurance, Oberoi and Trident group of Hotels etc. ―Audi Weighing Options for Luxury Small Car Launch in India,‖ www.thehindubusinessline.com, August 31, 2008. DDB Mudra Group is an alliance between the India-based Mudra Group and DDB Worldwide Communications Group Inc (DDB), a part of Omnicom Group Inc. It is a leading advertising company in India. Some of its clients are Johnson and Johnson, Hindustan Unilever Limited, Henkel, Volkswagen, Reliance ADAG, AIG Corporate and Tourism Australia. ―Volkswagen Drives in with Mudra DDB,‖ www.afaqs.com, September 11, 2007. The Society of Indian Automobile Manufacturers (SIAM) is the apex industry body representing 44 leading vehicle and vehicular engine manufacturers in India. SIAM works closely with all the concerned stake holders and actively participates in the formulation of rules, regulations, and policies related to the automobile industry (Source: www.siamindia.com). BMW India Private Limited, the Indian subsidiary of the BMW Group, is headquartered in Gurgaon, National Capital Region, India. The company offers a wide range of luxury cars including its BMW 3 Series, BMW 5 Series, BMW 6 Series, and BMW 7 Series. (Source: www.bmw.in). Mercedes-Benz India, the Indian subsidiary of Mercedes-Benz, a division of Daimler AG, was established in 1995. It offers a wide range of luxury cars including the S-Class, the E-

417

International Business it was necessary to build brand awareness in India. According to Joerg Mueller, Chief Representative of Volkswagen Group India and President and Managing Director, Volkswagen India, ―In India, it is very important because people (have been) associated with the brand since the time of the Beetle. Then we were not in the market for many years, and now we are here again. It means that people in India and potential customers don‘t know exactly what Volkswagen stands for. Therefore, it is important now to build up the brand, to make it famous again, and to show what Volkswagen stands for in terms of our values.‖19 In November 2009, Volkswagen India for the first time launched an integrated 360 degree communication campaign using the print, electronic, digital, and out of home media. Till then, the company had been using mainly the print media to promote its brands the Passat and the Jetta. Commenting on the campaign, Lutz Kothe (Kothe), Chief General Manager, Marketing and Public Relations, Volkswagen India, said, ―Based on a clear brand strategy, Volkswagen is known for its cutting-edge advertising across the world. Our powerful and creative campaigns continue to have a special place in the consumer‘s mind through decades. With our first brand campaign in India, we have strived to achieve the same for our consumers here and are confident that they will take to it. Our aim has been to break away from the communication clutter by being innovative and refreshing with the way we narrate our brand story to the customer.‖20 MediaCom India Private Limited (MediaCom)21 was the media agency of Volkswagen India for the campaign. The company planned to spend Rs. 400 million on the marketing campaign to build its brand image in India. The campaign included ‗18,000 TV spots, 150 print advertisements in daily newspapers, about 300 OOH installations, and a digital campaign‘ that would last till February 2010. The integrated marketing campaign started on November 11, 2009, when the Times of India (TOI)22 created a ‗roadblock‘23 for Volkswagen India across its 16 editions and nine pages.24 As part of the roadblock, Volkswagen‘s brands including the Jetta, the Passat, and the Touareg were advertised on all the editions of TOI (Refer to Exhibit III for Volkswagen India’s Print Roadblock). According to Divya Gururaj, MD, MediaCom, ―Currently, there‘s very little awareness for brand VW and the company has been selling select premium car brands in India so far. But now they are getting aggressive and print allows them to disseminate a lot of information about the brand.

18 19

20

21

22

23

24

Class, the C-Class, the M-Class, the CLS-Class, the SLK-Class, the CL-Class, and the Maybach (Source: www.mercedes-benz.co.in). ―India, China Key for Honda, Says CEO Ito,‖ www.livemint.com, November 12, 2009. Ammar Master, ‗We are of the Opinion We Are Right On Time for The India Party,‘‖ www.livemint.com, January 17, 2008. ―Volkswagen Connects with Indian Hearts in New TVC,‖ www.exchange4media.com, November 10, 2009. MediaCom India Private Limited, in which Madison Communications Private Limited had a 51 percent stake, is one of the leading media agencies in India. The Times of India (TOI) is a popular English-language broadsheet daily newspaper in India. It is owned and managed by Bennett, Coleman & Co. Ltd. In 2008, the newspaper reported that (with a circulation of over 3.14 million) it had been certified by the Audit Bureau of Circulations as the world‘s largest selling English-language daily newspaper. (Source: http://en.wikipedia.org). A Roadblock is defined as exclusivity in any number of advertisement slots for a single client over a given period of time (Source: http://ads.economist.com) Byravee Iyer, ―Hit the Road,‖ www.business-standard.com, November 24, 2009.

418

Volkswagen’s Marketing Strategy in India

Exhibit III Volkswagen India’s Print Roadblock

Source: “Volkswagen India Road Block: Blitzkreig!” www.lbhat.com, November 11, 2009. 419

International Business Print gives a far bigger spread to disseminate information and talk about the technical specifications.‖25 On November 11, 2009, Volkswagen India also aired its first TVC to promote the brand instead of a specific car. The TVC was developed by DDB Mudra. The TVC focused on the Volkswagen brand as a whole and showcased different Volkswagen car models. The TVC showed a young boy in a Volkswagen showroom deciding on the cars that he wanted to ‗book in advance‘ at various stages of his life. The boy went on to select the Beetle for his 18th birthday, the Jetta for when he became the ‗Vicepresident‘ of a company, and the Passat for when he became the ‗Chief Executive Officer‘. The TVC ended with Volkswagen‘s baseline ‗Das Auto‘ which, in German, means ‗The Car‘, and the tagline, ‗German engineering. Made for India‘ (Refer Figure II for an Image of Volkswagen India’s TVC to Promote the Brand). Commenting on the rationale for the TVC, Pawar said, ―It is about giving people different cars at different stages of their lives. There is a Volkswagen for every stage.‖26 He added, ―Volkswagen has been known globally for its iconic brand campaigns. The challenge for us was to transfer that greatness in India as well. The car is not only the soul of German engineering, but also about the democratization of innovation.‖27 Volkswagen India appointed Portland Outdoor Limited (Portland) 28 for the OOH campaign. The outdoor campaign was launched in 23 cities across India. Portland announced that the OOH campaign would be implemented in three phases, each over a period of one month. Commenting on the campaign, Madhuri Sapru, Managing Partner – South Asia, Kinetic & Dialect, said, ―The brief for the campaign was to increase the awareness for brand Volkswagen, and to reinforce the perception of Volkswagen as an innovative company.‖ 29 (Refer to Exhibit IV for Volkswagen India’s OOH Campaign).

Figure II: An Image of Volkswagen India’s TVC to Promote the Brand

Source: “Volkswagen Launches First Brand Campaign in India,” www.afaqs.com, November 10, 2009. 25

26

27

28

29

―When It Comes to India, Volkswagen Isn‘t Thinking Small,‖ http://economictimes.indiatimes.com, November 25, 2009. ―Volkswagen Launches First Brand Campaign in India,‖ www.afaqs.com, November 10, 2009. Arcopol Chaudhuri, ―Volkswagen Set to Roll out Brand Campaign for India,‖ www.campaignindia.in, November 10, 2009. Portland Outdoor Limited was promoted by the WPP Group, a leading communications services group in the world (Source: www.wpp.com). Anushree Bhattacharyya, ―Portland Drives German Auto Brand Volkswagen to 23 Cities in India,‖ www.network.media.com, December 01, 2009.

420

Volkswagen’s Marketing Strategy in India

Exhibit IV Volkswagen India’s OOH Campaign

Source: Anushree Bhattacharyya, “Portland Drives German Auto Brand Volkswagen to 23 Cities in India,” www.network.media.com, December 01, 2009. On December 04, 2009, Volkswagen India launched the Beetle. The company planned to import the car, priced at Rs. 2.045 million, for sale in India. It launched a marketing campaign to support the launch of the Beetle. Before the launch of the car, the company started a teaser outdoor campaign including hoardings with the tagline, ‗Curves are back.‘ Commenting about the campaign, Kothe said, ―Recreate a legend — that was the brief that we gave to the agency. It addresses a non-existent segment because no other car in the world can compare with the Beetle. We are very confident that the Beetle will make its way in India.‖30 On December 05, 2009, the first TVC to promote the Beetle was launched by DDB Mudra. In the TVC, a couple was shown riding a Beetle. The TVC continued as the couple reached their destination and the man asked how much he had to pay the valet. Instead of taking money from the man, the valet paid him Rs. 200, put on a pair of sunglasses, and took away the car in style to park it. The TVC ended with the tagline ‗German Engineering. Recreating Legends.‘ Commenting on the rationale for launching the campaign, Pawar said, ―The launch campaign was in keeping with the continuation of the Beetle‘s brand values. It remains among the world‘s most beloved cars; the old Beetle was the original love bug. The newly designed Beetle is the love bug with aphrodisiac added. The idea was to showcase the reaction to a Beetle as one where the brain is disconnected; those who buy the Beetle are buying into an emotional promise, that of a fantastic design innovation. So the reaction when one 30

Bindu Nair Maitra, ―DDB Mudra Creates Launch Pad for Volkswagen‘s Beetle,‖ www.campaignindia.in, December 07, 2009.

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International Business sees the car is one where your heart talks to you. The commercial talks about the pleasure of riding the new Beetle. At a time when most car designs tend to be all about hard edges, the new Beetle celebrates curves and voluptuousness.‖31 Volkswagen India also launched a print and an outdoor campaign to promote the Beetle. The campaign had the tagline ―It‘s official. Curves are back.‖ As part of its OOH campaign, Volkswagen India took up the entire OOH space at the busy Bandra Junction in Mumbai. According to Rajiv Sabnis, President, DDB Mudra, ―Volkswagen has an innovating spirit when it comes to marketing, just like the cars they make. They also believe in dominating the media, not just the roads. After the hugely innovative and impactful TOI roadblock, we conceived the launch of the new Beetle with an innovative outdoor campaign. The six-part Beetle outdoor came together part-by-part in the first week of December, heightening people‘s anticipation and excitement about an imminent launch.‖32

Distribution As of 2009, Škoda, Audi, and Volkswagen each had a presence in India through their separate distribution channels. Škoda Auto had a strong presence in the Indian luxury car market through its 62 dealerships covering over 50 cities across India. As of 2009, Audi India had 14 dealerships across India including cities like Delhi, Gurgaon, Chandigarh, Ludhiana, Mumbai, Mumbai West, Pune, Ahmedabad, Bangalore, Hyderabad, Chennai, Jaipur, Kolkata, and Kochi. The company aimed to have 15 dealers by 2010 and 18 dealers by 2011.33 Volkswagen India said it would increase its dealerships from 25 to 40 by the end of 2009. The expansion would involve opening of new outlets in Indore, Jalandhar, Bhopal, Vijayawada, and Kozhikode. The company already had outlets in several major places in India including Delhi, Chennai, Bangalore, Hyderabad, Ahmedabad, and Kolkata.

The Road Ahead In November 2009, Audi India announced that it had achieved 59 percent year to date sales growth. In the period between January and November 2009, it sold 1,550 cars as compared to 974 cars in the same period in 2008. The company aimed to achieve a 50 percent sales growth in 2010.34 It announced that it aimed to capture a 30 percent share in the Indian luxury car market by 2011 from 20 percent in June 2009. 35Skoda Auto India was set to launch its sports utility vehicle (SUV), the Yeti, in January 2010. On December 04, 2009, Volkswagen India also showcased its next launch in India, the Touareg, an SUV. The vehicle was priced at Rs. 5.185 million. According to Garg, ―The launch of the Touareg is our marketing debut in the SUV segment. India has a great demand for SUV. The Touareg has been successful across countries and the entry will further enhance our presence in the market.‖36

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Bindu Nair Maitra, ―DDB Mudra Creates Launch Pad for Volkswagen‘s Beetle,‖ www.campaignindia.in, December 7, 2009. ―Volkswagen & DDB Mudra Execute a Unique OOH Roadblock in Mumbai,‖ www.exchange4media.com, December 17, 2009. ―India to Be Fifth-Largest Auto Mkt by 2015: Audi India MD,‖ http://economictimes.indiatimes.com, October 5, 2009. ―Audi India to Assemble More Models Locally, Targets 50 percent Growth In Sales,‖ www.driveinside.com, October 28, 2009. ―Audi to Expand More Dealerships in India,‖ http://burnyourfuel.com, June 15, 2009. ―The Volkswagen Beetle Finally Comes to India,‖ www.moneycontrol.com, December 14, 2009.

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Volkswagen’s Marketing Strategy in India Volkswagen India planned to launch its small car, the Polo, in the first half of 2010. The company wanted to build its brand image before launching its new car in India. According to Kothe, ―By the time Polo is launched, we would want to be ready and make sure there is enough brand awareness. While our target group is essentially premium and upper premium, we want to be warm and appealing and a part of the masses.‖37 On December 12, 2009, the production of Volkswagen‘s Polo started at its Chakan plant near Pune, Maharashtra. According to analysts, Volkswagen India‘s market share in India would largely depend on the success of the Polo. According to Umesh Karne, a Mumbai-based analyst at BRICS Securities Limited38, ―The Polo is a key model for Volkswagen as they have created a big capacity in India. India will continue to be a small-car market for at least the next five or six years and every company needs a compact car to get market share.‖39 However, some analysts were of the opinion that Volkswagen Group India would have two compact cars once the Polo was launched in 2010, as it already had the Škoda Fabia. They were of the view that, the two cars would compete with each other. To further improve its presence in the Indian car market, Volkswagen India also planned to roll out a low-priced car named UP! in India by the fiscal 2010-11. The car was expected to be priced at about Rs 0.3 million. The company also planned to launch a sub-B segment car with a price tag of between Rs. 0.35 million and Rs. 0.45 million in India. According to Jochem Heizmann, Member of the Board of Management of Volkswagen, ―It is clear we need a car below the Polo and are looking at different options and working on it. That maybe the Up, or another car. However, no decision has been made yet.‖40 With the new launches from all its three brands, Volkswagen Group India aimed to capture an eight percent market share of India‘s car market by 2013 to 2014. According to Mueller, ―We are looking to have 8 per cent market share of the Indian car market in the next 4-5 years by the Volkswagen Group which includes Volkswagen, Audi, and Škoda. The market has recovered and we are firmly on a growth track. Our plan is to increase our sales every month.‖41

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―Volkswagen Launches First Brand Campaign in India,‖ www.afaqs.com, November 10, 2009. BRICS Securities Limited is an India based financial services company. It was founded in 2004. Vipin Nair, ―Volkswagen Aims to Capture 10% of India‘s Car Market (Update 1),‖ www.businessweek.com, December 13, 2009. ―VW India Could Enter Sub-B Segment with Up Rollout,‖ www.wheelsunplugged.com, December 14, 2009. ―Volkswagen Connects with Indian Hearts in New TVC,‖ www.exchange4media.com, November 10, 2009.

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International Business

References and Suggested Readings: 1.

―Volkswagen Aims to Sell over 300 Beetles in 2010,‖ www.business-standard.com, December 21, 2009.

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―Volkswagen & DDB Mudra Execute a Unique OOH Roadblock in Mumbai,‖ www.exchange4media.com, December 17, 2009.

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―VW India Could Enter Sub-B Segment www.wheelsunplugged.com, December 14, 2009.

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―The Volkswagen Beetle Finally Comes to India,‖ www.moneycontrol.com, December 14, 2009.

5.

Vipin Nair, ―Volkswagen Aims to Capture 10% of India’s Car Market (Update 1),‖ www.businessweek.com, December 13, 2009.

6.

Bindu Nair Maitra, ―DDB Mudra Creates Launch Pad for Volkswagen's Beetle,‖ www.campaignindia.in, December 07, 2009.

7.

Anushree Bhattacharyya, ―Portland Drives German Auto Brand Volkswagen to 23 Cities in India,‖ www.network.media.com, December 01, 2009.

8.

―When It Comes to India, Volkswagen Isn’t Thinking Small,‖ http://economictimes.indiatimes.com, November 25, 2009.

9.

Byravee Iyer, ―Hit the Road,‖ www.business-standard.com, November 24, 2009.

with

Up

Rollout,‖

10. ―India, China Key for Honda, Says CEO Ito,‖ www.livemint.com, November 12, 2009. 11. ―Times of India Creates Roadblock www.indiantelevision.com, November 11, 2009.

for

Volkswagen

Brands,‖

12. ―Volkswagen India Road Block: Blitzkreig!‖ www.lbhat.com, November 11, 2009. 13. ―India Eco Summit: VW Group eyes 8% shares in India,‖ www.businessstandard.com, November 10, 2009. 14. ―Volkswagen Connects with Indian Hearts in New TVC,‖ www.exchange4media.com, November 10, 2009. 15. ―Volkswagen Launches First Brand Campaign in India,‖ www.afaqs.com, November 10, 2009. 16. Arcopol Chaudhuri, ―Volkswagen Set to Roll out Brand Campaign for India,‖ www.campaignindia.in, November 10, 2009. 17. ―VW India Eyeing to Clock 3,000 Units Sale during CY 2009,‖ www.wheelsunplugged.com, October 31, 2009. 18. ―Audi India to Assemble More Models Locally, Targets 50 percent Growth In Sales,‖ www.driveinside.com, October 28, 2009. 19. ―India to Be Fifth-Largest Auto Mkt by 2015: Audi India MD,‖ http://economictimes.indiatimes.com, October 05, 2009. 20. ―Volkswagen India Plans to Double Distribution Network,‖ http://economictimes.indiatimes.com, September 25, 2009. 21. ―Volkswagen Group India Holds A Positive Outlook,‖ http://machinist.in, August 29, 2009. 22. ―IFC to Invest 135 Million Euros in Volkswagen’s Pune Plant,‖ www.businessstandard.com, August 06, 2009. 23. ―Audi to Expand More Dealerships in India,‖ http://burnyourfuel.com, June 15, 2009.

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Volkswagen’s Marketing Strategy in India 24. ―Volkswagen Group Preparing the Ground for Sustainable Growth in India,‖ http://machinist.in, June 09, 2009. 25. ―Volkswagen Mulls Beetle Launch in India This Year,‖ www.dnaindia.com, June 09, 2009. 26. ―VW India Appoints Maik Stephan as Managing Director, Lutz Kothe as CGM Marketing and PR,‖ www.wheelsunplugged.com, June 08, 2009. 27. ―Audi Bullish on India; Sees ‘Metropolitan’ Strategy as the Way Forward,‖ www.blonnet.com, April 20, 2009. 28. ―Volkswagen Group Most Successful Car Manufacturer at the CNBC-Overdrive Awards,‖ www.indiaprwire.com, January 13, 2009. 29. ―Audi Weighing Options for Luxury Small Car Launch in India,‖ www.thehindubusinessline.com, August 31, 2008. 30. Ammar Master, ―We Are Of The Opinion We Are Right On Time For The India Party,‖ www.livemint.com, January 17, 2008. 31. ―Volkswagen Drives in with Mudra DDB,‖ www.afaqs.com, September 11, 2007. 32. Nirmal D. Menon, ―The Skoda Score,‖ www.blonnet.com, January 13, 2005. 33. www.bmw.in. 34. www.ifc.org. 35. www.mercedes-benz.co.in. 36. www.siamindia.com. 37. www.wpp.com. 38. http://en.wikipedia.org. 39. http://ads.economist.com. 40. http://www.bigadda.com.

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Mylan’s Acquisition of Matrix In January 2007, Mylan Inc. (Mylan), one of the largest US generic drug makers, acquired a 71.5 percent stake in Matrix Laboratories Ltd. (Matrix), India, a leading Active Pharmaceutical Ingredients (API) supplier globally, for a cash and stock deal of US$736 million. The Mylan-Matrix deal was the largest acquisition in the Indian pharmaceutical industry and was viewed by analysts as a step toward backward integration for Mylan. The deal not only gave Mylan access to a low cost manufacturing platform, but also immediate presence in the emerging markets of Asia and Africa as well as the lucrative generic drugs markets in Europe. Matrix, on the other hand, gained the much-needed scale that generic companies required to survive in a very competitive market place. It was very important for Indian pharmaceutical companies considering that these companies did not have research molecules of their own. Analysts felt that with the global generic drugs industry undergoing a consolidation phase, large pharmaceutical companies were eyeing Indian pharmaceutical companies as potential targets of M&A deals. This was because, with considerable pricing pressures in the US, these companies were on the lookout for low-cost suppliers. In addition to the low-cost manufacturing platform, the attractiveness of the Indian companies stemmed from the fact that they had large and varied product portfolios and world-class manufacturing facilities. Indian pharmaceutical companies also had a number of Drug Master Files (DMFs) and Abbreviated New Drug Application (ANDA) filings in the US, the world's largest market for pharmaceuticals. Moreover, some of these companies had developed a significant presence in the European and African markets through the inorganic route.

Mylan’s Acquisition of Matrix “This is an extremely complementary transaction that accomplishes a number of Mylan’s key objectives. Mylan is executing on its commitment to establish a global platform and expand its dosage forms and therapeutic categories. Additionally, this acquisition deepens Mylan’s vertical integration and enhances its supply chain capabilities. The transaction will allow Mylan and Matrix to strengthen and expand their core businesses and competencies, while creating significant opportunities for global expansion and growth.”1 - Robert J Coury, Vice Chairman and CEO, Mylan Inc. in 2006. “A player has to decide how he can stay in the field for as long as possible. Matrix, as a significant API supplier, needed a bigger playing field. Partnering with Mylan gives us that.”2,3 - Nimagadda Prasad, Executive Chairman, Matrix Laboratories Ltd. in 2006. “Clearly, we’re seeing a trend in the industry toward acquisitions and consolidation... This is a continuing trend to move more sourcing and manufacturing overseas and to own it as opposed to just contracting it.”4 - Martha Freitag, an industry analyst at Argus Research Corp. 5, in 2006.

Benefits beyond Global Expansion Mylan Inc. (Mylan), one of the largest US generic drug 6 makers, acquired a 71.5 percent stake in Matrix Laboratories Ltd. (Matrix), India, a leading API supplier, globally in January 2007 for a cash and stock deal of US$736 million. The MylanMatrix deal was the largest acquisition in the Indian pharmaceutical industry and was viewed by analysts as a step toward backward integration for Mylan. 7 On completion of the deal, Robert J Coury (Coury), Vice Chairman and CEO of Mylan, said, “Today‟s announcement marks the successful closing of the transformational Matrix transaction, and it also marks the beginning of a new era at Mylan where our organization is continuing to expand beyond our well-established position as a leading domestic generic pharmaceutical company toward our objective of establishing Mylan as a world leader in generics and specialty pharmaceuticals.”8

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“Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,” www.matrixlabsindia.com, August 28, 2006. API (acronym for Active Pharmaceutical Ingredients), also known as bulk drugs, are active chemicals used in the manufacturing of drugs. Gina S Krishnan, “Matrix Unloaded,” www.businessworldindia.com, September 11, 2006. “Mylan Laboratories Mylan to Have Majority of India‟s Matrix,” www.advfn.com, August 29, 2006. Argus Research Corp. is an independent research firm. Generic drugs (or Generics) are either copies or the basic form of a proprietary drug (or “brand-named”) drugs produced by large multinationals. For example, Lipitor is the brand names for the drug Atorvastatin that was patented by Pfizer Inc. Any other drug with the same composition manufactured and marketed by other companies is called generics. Surojit Chatterjee, “Mylan Buys Majority Stake in India‟s Matrix Lab for $ 736 Million,” www.in.ibtimes.com, August 30, 2006. “Mylan Laboratories Inc. Completes Matrix Laboratories Limited Transaction,” www.devicespace.com, January 9, 2007.

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Mylan’s Acquisition of Matrix According to analysts, the deal was a winning proposition for both the parties to the transaction. Where Mylan was concerned, Matrix‟s takeover helped it to enter the global generic markets beyond the US market. In particular, this acquisition helped Mylan to enter the emerging pharmaceutical markets of India, China, and South Africa, given Matrix‟s presence in these regions. Second, the deal would also aid Mylan enter the high-margin European markets through Matrix‟s subsidiary Docpharma NV9 (Docpharma), which was already operating in the European markets. In addition to this, Matrix would also act as a low-cost product sourcing platform for Mylan given Matrix‟s strong pipeline of APIs. Jim Miller, president of PharmSource Information Services, Inc. 10, noted, “What is most striking about the deal is that although Mylan is the buyer, Matrix is clearly the more sophisticated global player. Matrix has built a sophisticated supply chain that sources early-stage intermediates in China, converts them to APIs in FDA-approved plants in India, formulates the APIs into finished dosage forms, and sells them in Asian and European markets. Mylan, by contrast, manufactures only drug products and operates largely in the United States. Matrix‟s global capabilities are likely to have much greater value to Mylan in the generics and branded generics markets than they are in contract manufacturing.” 11,12 The tie-up with Mylan would benefit Matrix in terms of providing it with a bigger playing field. Moreover, it would be able to leverage on Mylan‟s existing manufacturing and sales network in the US to penetrate deeper into the US market and benefit from economies of scale. Besides, given Mylan‟s financial resources, Matrix‟s subsidiary Docpharma could consolidate its position in the European market and in the medium term use Mylan‟s knowledge to enter the US generics market. Commenting on the deal, Nimagadda Prasad (Prasad), the Executive Chairman of Matrix, said, “Mylan, a proven industry leader, is an ideal partner for Matrix. Our strategic vision remains unchanged and we believe this transaction creates greater growth opportunities for Matrix and its employees and also will allow us to accelerate our existing expansion plans in India and abroad.”13 Analysts felt that with the global generic drugs industry undergoing a consolidation phase, large pharmaceutical companies such as Teva Pharmaceutical Industries Ltd. 14 (Teva), Sandoz15, Barr Pharmaceuticals, Inc. 16 (Barr), the Actavis Group17 (Actavis),

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Docpharma NV was a Belgium-based generic drugs company that was acquired by Matrix in 2005. PharmSource Information Services, Inc. is a provider of information services to the pharmaceutical and biopharmaceutical companies on contract drug development and manufacture. US Food and Drug Administration (FDA) is an agency of the US Department of Health and Human Services and is responsible for the safety regulation of most types of foods, dietary supplements, drugs, vaccines, biological medical products, blood products, medical devices, radiation-emitting devices, veterinary products, and cosmetics. Jim Miller, “Will Delivery Technologies Deliver Profits to CMOs?” www.pharmtech.com, October 2, 2006. “Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,” www.prnewswire.co.uk, August 28, 2006. Teva Pharmaceutical Industries Ltd., headquartered in Petah Tikva, Israel, is the leading generic drugs company. In 2006, it had total sales of US$8.4 billion. Sandoz, headquartered at Holzkirchen, Germany, is the generics subsidiary of Swiss multinational pharmaceutical company Novartis AG. In 2006, it had total sales of US$5.9 billion. Barr Pharmaceuticals, Inc., headquartered in Montvale, New Jersey, USA, is a leading generic drugs company. In December 2006, it acquired a leading Croatian generic drugs major Pliva d.d. to become the world‟s third largest generic drugs company with combined

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International Business Watson Pharmaceuticals, Inc.18 (Watson), etc., were eyeing Indian pharmaceutical companies as potential targets of M&A deals. This was because, with considerable pricing pressures in the US, these companies were on the lookout for low-cost suppliers. In addition to the low-cost manufacturing platform, the attractiveness of the Indian companies stemmed from the fact that they had large and varied product portfolios and FDA-approved manufacturing facilities. Indian pharmaceutical companies also had a number of DMFs19 and ANDA20 filings in the US, the world‟s largest market for pharmaceuticals. Moreover, some of these companies had developed a significant presence in the European and African markets through the inorganic route. In this context, analysts felt the acquisition of Matrix would benefit Mylan. Datamonitor Plc‟s21 pharmaceutical markets analyst, Joshua Owide, noted, “As the generics industry becomes increasingly competitive, Mylan has found a deal that will help it to not only target emerging markets but also establish it as a prominent force in the global market. On the whole, the deal represents an excellent opportunity for Mylan to strengthen its core business activities. As a generic-focused pharmaceutical company, manufacturing level competencies, particularly that pertaining to drug composition, are fundamental to its operation. Subsequently, it is likely that the synergies created by this deal will optimize Mylan‟s market share and margins.”22 However, not everyone was optimistic about the deal. Some analysts considered the deal to be too expensive for Mylan given the fact that it valued Matrix at 22x earnings multiple v/s 18x, the average multiple for the Indian pharmaceutical industry. Others kept their fingers crossed considering that this was Mylan‟s first foray outside the US, and as such, the company might face a problem in transforming itself into a global organization. Mylan defended the deal saying Matrix‟s acquisition was strategic and was a calculated risk essential to provide Mylan a global reach.

Background Note Mylan Mylan was the second-largest US generic drug maker as of 2006.23 The company was headquartered in West Virginia, USA, and was involved in developing, licensing, manufacturing, marketing, and distributing many generic and proprietary drugs. The company primarily focused on solid oral dosage generic drugs. These generic drugs

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sales of approximately US$ 2.4 billion. (Source: Victoria Harrison, “Barr Acquires 92% Share in Pliva,” www.pharmaceutical-business-review.com, December 23, 2006.) Actavis Group, Reykjavík, Iceland, is a leading generic drugs company. Watson Pharmaceuticals, Inc., headquartered in Corona, California, USA, is a leading generic drugs company. DMFs (acronym for Drug Master File) contain information on the processes and facilities used in drug manufacture and storage and are submitted to the US Food and Drug Administration (FDA) for examination. An ANDA (acronym for Abbreviated New Drug Application) contains data which when submitted to FDA‟s Center for Drug Evaluation and Research, Office of Generic Drugs, provides for the review and ultimate approval of a generic drug product. (Source: www.fda.gov) Datamonitor Plc, headquartered in London, UK, is a leading provider of information services to key industries. Joshua Owide, “Mylan Laboratories: Entering the Matrix,” www.pharmaceutical-businessreview.com, August 30, 2006. Mrinalini Datta, “Mylan Labs to Acquire India Rival,” www.iht.com, August 28, 2006

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Mylan’s Acquisition of Matrix were more affordable than the branded prescription drugs that were marketed by research-based pharmaceutical companies. Mylan Pharmaceuticals Inc., Mylan Technologies Inc., Bertek Pharmaceuticals Inc., and UDL Laboratories Inc. were its four principal subsidiaries. Mylan‟s history dates back to 1961 when Milan Pharmaceuticals (Milan) was founded by Milan “Mike” Puskar (Puskar) and his friend Don Panoz in White Sulphur Springs, West Virginia, as a pharmaceutical distribution company. In 1970, Milan became incorporated as Mylan Inc. and the company was listed in 1973. In 1980, under Puskar‟s leadership, the company achieved a milestone by introducing its own brand of Mylan drugs. This laid the platform for its future growth. The year 1984 marked the approval of Mylan‟s first proprietary drug, Maxzide, an anti-hypertensive drug. With this, Mylan became the first generic drug maker to get a patent for its own product.24 In the next ten years i.e. by 1995, Mylan had the most dispersed line of pharmaceuticals in the US, be it generic or branded. Mylan also made some notable acquisitions during 1993 to 1999 (Refer to Exhibit I for Mylan: A Timeline) to consolidate its market size and to emerge as a stronger pharmaceutical player. These included Bertex Inc, which was recognized for its transdermal drug delivery, Penederm Inc renowned for dermatology products, and B. Hickman Inc. that was acknowledged for its skilled workforce. The acquisition of these three companies laid the foundation of Bertex Pharmaceuticals Inc. By 2002, the Mylan‟s revenues had crossed the US$1 billion mark and in 2004 the company was included in S&P 500 25.26

Exhibit I Mylan: A Timeline Event

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Remark/ Rationale

1961

Milan Pharmaceutical is incorporated

Principal business is of distribution of drugs.

1965

Starts manufacturing vitamins

First product to be manufactured under Milan banner.

1973

Mylan becomes a public limited company

Milan Pharma is incorporated as Mylan Inc. and the company gets listed.

1984

It starts marketing its first proprietary drug Maxzide, an antihypertensive drug

Becomes the first generic drug maker to get a patent for its product.

1987

Opens a new manufacturing unit at Caguas, Puerto Rico

To enhance its manufacturing capacity in order to move toward a bigger platform.

1989

Acquires a 50 percent stake in Somerset Pharmaceuticals Inc, a US-based a proprietary research and development pharmaceutical company.

To acquire the rights to market a new medication for the treatment of Parkinson‟s disease called Eldepryl.

“Mylan History,” www.mylan.com. The S&P 500 is an index containing the stocks of 500 Large-Cap corporations. It is maintained by a leading publisher of financial research and analysis on stocks and bonds, Standard & Poor‟s. “Mylan History,” www.mylanpharms.com.

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International Business Event

Remark/ Rationale

1991

Acquires another US-based pharmaceutical company, Dow B. Hickam Pharmaceuticals

To acquire its skilled workforce and marketing and manufacturing facilities of wound and burn care pharmaceutical products.

1993

Acquires Bertek Inc. US-based manufacturer and innovator of transdermal (patch) drug delivery systems

Addition of Bertek gives Mylan five worldwide and seven domestic patents for transdermal drug delivery technology.

1996

Acquires UDL Laboratories Inc, a US-based supplier of unit dose multi source pharmaceuticals

To gain its supplying capabilities of unit dose to the institutional and long-term care market place.

1996

Establishes Bertex Pharmaceuticals as its main branded pharmaceuticals subsidiary

To increase participation in the branded drug segment, which offered higher profits than the generic sector

1998

Acquires Penederm Inc., a USbased pharmaceutical company recognized in the dermatology segment, and merges it with Bertek.

To acquire Topicare27.

its

technology

Adapted from “Company History”, www.mylan.com and www.fundinguniverse.com. In mid-2004, Mylan made a bid to acquire King Pharmaceuticals 28 in a deal valued at US$4 billion to enhance its business in the brand drug segment.29 However, the deal was aborted in February 2005, as the two companies could not arrive at an agreement. Since then, the company was trying to bolster its business in generics. With the global generic drugs industry already in a consolidation phase, Mylan was on the lookout for an M&A deal that would help it remain competitive (Refer to Exhibit II for a note on the global generic drugs industry). As of 2007, Mylan Pharmaceuticals Inc. and UDL Laboratories Inc. looked after the generic drugs operations of Mylan while Bertek Pharmaceuticals Inc. and Mylan Technologies Inc. looked after the branded segment. The company‟s pharmaceutical basket had 150 products including antibiotics, antidepressants, anti-inflammatory drugs, beta-blockers, and laxatives that catered to various therapeutic segments. The company also enjoyed a global presence and had a strong marketing and distribution network stretching from North America to Europe, the Middle East and Africa (EMEA), as well as the Asia Pacific region (APAC). For the fiscal year ended 2007, Mylan‟s total revenue has increased by 28 percent year-on-year from US$1257 million in 2006 to US$1611 million (Refer to Exhibit III for selected financials of Mylan).

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Topicare is a proprietary delivery technology of Penederm Inc in which it markets patented topically administered prescription product. King Pharmaceuticals, headquartered in Bristol, Tennessee, USA, is a pharmaceutical company that was founded in 1994. In 2006, its revenues were US$2 billion. “Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European Markets,” www.levinassociates.com, 2006.

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Mylan’s Acquisition of Matrix

Exhibit II A Note on the Global Generic Drug Industry In 2006, the global market for generic drugs was estimated to be US$77 billion. 30 The top four players in this industry were Teva, Sandoz, Barr, and Merck KgaA‟s 31 generic unit.32 Other notable players in this industry included Mylan, Watson, and Actavis. In addition to competing among themselves, the generic drugs companies also competed with pharmaceutical companies that sold branded drugs on the price platform. So, they also competed in the total pharmaceutical market that was estimated to be US$607 billion in 2006 (according to IMS Health 33). Generic drugs are generally sold under their chemical name. For instance, generic versions of Viagra may sell under the chemical name Sildenafil citrate. But in some markets, generic drugs may be sold under a brand name. For instance, Viagra is sold in India by various companies under names such as Manforce, Penegra, Caverta, Androz, etc. Such products are called branded generics. Factors such as a number of patent expirations of blockbuster drugs of researchbased pharmaceutical companies between 2000 and 2006 had given a huge impetus to the generics drugs industry. In addition, changes in legislation and regulation in various countries that favored the use of generic drugs and pressure from various government and other third party payers to adopt low-priced generic drugs to minimize healthcare costs had led to an increase in the usage of generic drugs. For instance, in the world‟s largest pharmaceutical market, USA, generic drugs accounted for around 50 percent of the pharmaceutical market by volume. This made the US an attractive market for companies that manufactured and marketed generic drugs and some of the largest generic drug manufacturers had a strong presence in this market. In Europe too, the generic drugs were getting increased acceptance. While countries like Germany, Sweden, Denmark, the UK, and the Netherlands were the larger markets for generic drugs, the smaller generic markets of Spain, Italy, and Portugal were forecast to increase rapidly mainly as a result of government cost-containment pressures. Increased acceptance of generic drugs had catapulted the leading generic drugs companies such as Teva and Sandoz to the league of major pharmaceutical companies. These companies were also becoming increasingly ambitious and were often engaging the research-based pharmaceutical companies in litigations by challenging their patents in order to bring their generic drugs into the market even before the patent of the branded drug had expired. Analysts felt that the generic drugs market was poised for high growth rates in the future. According to Visiongain34, the market for generic drugs would increase to 30

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“Consolidation in the Generic Pharmaceutical Industry: An Evolving Landscape,” Urch Publishing, October 2007. Merck KGaA, headquartered in Darmstadt, Germany, is one of the oldest chemical and pharmaceutical companies. Its history dates back to the 17 th century. In 2006, Merck KGaA‟s generic unit had total sales of US$1.8 billion. Tova Cohen and Steven Scheer, “Teva Pharma Seen Best Placed to Win Merck Generics,” www.reuters.com, May 8, 2007. IMS Health is the world‟s leading provider of business intelligence and strategic consulting services to the pharmaceutical and healthcare industries. Visiongain, headquartered in London, UK, is a company that provides analysis of the worldwide telecom and pharmaceutical industries.

433

International Business US$83.9 billion by 2010.35 IMS Health predicted that the generic drug market would grow by 22 percent annually until 2010 in the five largest generic markets. 36 However, the generic drugs companies also faced a number of challenges. Factors such as pricing pressure and several legislative and regulatory hurdles put a lot of pressure on the generic drugs companies. The patent regulations in the US gave enough scope for research-based pharmaceutical companies to create barriers for entry through litigations. Research-based pharmaceutical companies sought to extend the patent life of their blockbuster drugs and discourage the entry of generic drugs manufacturers. In such a scenario, generic drugs companies had to survive in a very competitive market. These challenges had led to this industry entering a consolidation phase. Many leading generic drugs companies entered into M&A deals. Between 2005 and 2007, there were as many as 18 M&A deals in this industry. 37 The number of dominant players had gone down to around six from 14 two years earlier. Some notable deals were Teva‟s acquisition of Ivax Corporation 38 in 2005, Sandoz‟s acquisition of Hexel AG39 and Eon Labs, Inc.40 in 2005, and Barr‟s acquisition of Pliva. These deals had put pressure on other generic drugs companies to consolidate or risk compromising their competitiveness. Compiled from various sources.

Exhibit III Selected Financial Data of Mylan Inc. (in US$ million)

2007

2006

2005

2004

2003

1,611.82

1,257.16

1253.37

1374.62

1269.19

Cost of Sales (B)

768.15

629.55

629.83

612.15

597.76

Gross Profit (A-B)

843.67

627.62

623.54

762.47

671.44

Research and Development

103.70

102.43

87.88

100.81

86.75

Acquired in process research and development (from Matrix)

147.00

_

_

_

_

Selling, general and administrative

215.54

225.38

259.48

201.61

173.07

Total Revenues (A)

Operating Expenses:

35 36 37

38

39

40

“The World‟s Top Ten Generic Companies,” www.leaddiscovery.co.uk, November 2005. Brian Lawler, “The Coming Generic Drug Boom,” www.fool.com, October 16, 2006. “Mylan Outbids Teva and Private Equity Investors to Acquire Merck KGaA‟s Generics Unit,” www.globalinsights.com, 2007. Ivax Corporation was a US-based generics drugs major and one of the world‟s top ten generics drugs company. Hexel AG (Hexel) was a Germany-based generics drugs major and one of the leading generics drugs companies. Eon Labs, Inc., an affiliate of Hexel, was a US-based generic drugs company.

434

Mylan’s Acquisition of Matrix Litigation settlements, net

50.12

12.42

25.99

34.76

2.37

427.55

287.39

302.17

494.80

413.99

Interest Expense

52.28

31.29

_

_

_

Other income, net

50.23

18.50

10.08

17.81

12.53

Earnings before income taxes and minority interest

425.51

274.61

312.25

512.61

426.51

Provision for income taxes

208.02

90.06

108.66

177.99

154.16

0.21

_

_

_

_

217.28

184.54

203.59

334.61

272.35

Earning from operations

Minority Interest Net Earnings

 Mylan’s fiscal year ends March 31. Source: Mylan Inc., “Annual Report-2007”, www.mylan.com

Matrix Matrix, a listed Indian pharmaceutical company, was an API manufacturer established in February 2001. It was the world‟s second-largest manufacturer of APIs in terms of DMF filing.41 Its core business was to manufacture APIs and solid oral dosage forms. Matrix operated in regulated markets such as the US and the European Union and had a wide range of products catering to the anti-AIDS, cardiovascular, central nervous system, anti-asthmatic, anti-bacterial, anti-fungal, gastrointestinal, pain management, and lifestyle related therapeutic segments. Tracing back the history of Matrix, its foundation lay in the dreams envisioned by its promoters viz Prasad, C Satyanarayana, and M Ravinder. 42 The trio took over an ailing Hyderabad-based pharmaceutical company, Herren Drugs & Pharmaceuticals43 (Herren), in June 2000. Matrix was formed as a result of the renaming of Herren in February 2001. During that time it fended off an acquisition bid by H. Lundbeck A/S44 (Lundbeck). Lundbeck wanted to buy Matrix to own a new process that Matrix haddeveloped to manufacture Citalopram, a drug originally developed by the Danish company. Analysts felt that the company‟s refusal to sell out had earned it a lot of free publicity.45 In 2002, Matrix filed the process patent for Citalopram under the Patent Co-operation Treaty. Even before the US patent on Citalopram expired in January 2004, Matrix was prepared to supply the drug. Initially the company was heavily dependent on the sales 41 42

43 44 45

“Form 8-K for MYLAN INC,” www.yahoo.com, November 7, 2007. N Prasad was then the CEO and Managing Director of Vorin Laboratories Ltd. (Vorin), a Hyderabad-based subsidiary of one of the leading Indian pharmaceutical companies, Ranbaxy Laboratories Ltd. C Satyanarayana was the R&D chief at Vorin. M Ravinder was a successful pharmaceutical trader, distributor, and an investor entrepreneur. Herren Drugs and Pharmaceuticals was a Rs.450 million company then. H. Lundbeck A/S (Lundbeck) is a Danish international pharmaceutical company. Gina S Krishnan, “The Matrix Evolution,” www.businessworldindia.com, Debember 29, 2003.

435

International Business of Citalopram, which accounted for 50 percent of its revenues in the fiscal year 2002.46 Over the years, Matrix strategically diversified its product portfolio. By 2006, the company‟s API product range had increased to 169 and was spread across 17 therapeutic segments. Its API product portfolio also contained 10 anti-retrovirals47 (ARV). Along with this, Matrix had also started selling generic drugs under DMF filing and Para IV filing48 in the US. It had a number of such Para IV filings in the pipeline. To expand its capacity and to penetrate the regulated markets in the US and Europe in a big way, the company adopted the inorganic growth route. In line with this strategy, Matrix acquired a 54.89 percent stake in May 2002 in Medicorp Technology (Medicorp), an API manufacturer which had FDA approval. By the end of the year, the company further consolidated its size through merger & acquisition deals with Vorin Laboratories Ltd (Vorin), an API manufacturer. By May 2003, the process of consolidation of Medicorp and Vorin with Matrix was completed. The merged entity Matrix Labs was headed by Prasad as the managing director and chairman (Refer to Exhibit IV for the values added by the three companies to the Matrix Labs).

Exhibit IV Value Added by the Respective Companies to the Merged Entity (Matrix) Parameters

Matrix

Medicorp

Vorin

Products

Six: CNS agents & antibacterial

Ten: Gastro-intestinal, proton pump inhibitors, anti-inflammatory & cardio-vascular

Fifteen: Antibacterial, antiasthma & antivirals

Markets and customers

Europe

North America and Japan

India, Middle East, Africa and South Africa

Facilities

TGA and European norms

USFDA, TGA and MICA

ISO 9000

Regulatory compliance

----

DMFs filed in developed markets

----

Source: “Annual Report: 2002-03”, www.matrixlabsindia.com Continuing with its policy of sustained growth through the M&A route, Matrix under the leadership of Prasad struck some major deals during 2004 and 2005 (Refer to Exhibit V for Matrix: A Timeline). These deals helped Matrix to expand its market from a single country to five countries by the end of fiscal year 2006. In addition to being an international API company, it started competing as a manufacturer of finished dosage forms (FDF) in Europe and China and also ventured into medical devices. This also helped the company to diversify its risks considerably.

46 47 48

Matrix Laboratories Ltd., “2001-02 Annual Reports”, www.matrixlabsindia.com Anti-retroviral drugs (ARV) are used in the treatment of HIV infection. Para IV filing provided the company with exclusive rights of 182 days to market the generic version of a drug in US market, once the patent for the proprietary drug expired.

436

Mylan’s Acquisition of Matrix

Exhibit V

Matrix: A Timeline Event

Impact/ Benefit

February 2001

Herren renamed as Matrix.

February 2002

Process Patent for Citalopram is filed by Matrix on February 27.

To gain the preferred supplier status in global generic market.

May 2002

Acquires 54.89 percent stake in Medicorp

To gain a large customer base, presence in regulated market and also access to sophisticated technologies.

May 2003

Amalgamation of Medicorp and Vorin into Matrix Laboratories Ltd.

Reduced time cycle of its market and product development helped in increasing its profit and sustainability in the competitive business environment.

November 2003

Decides to launch two joint venture companies, Medikon Galenicals in India and CEM Pharma Life Science in Ireland with two German companies having a total capital outlay of €3.90 million.

Backward integration for the supply of IPPs (generic APIs business) and R&D support.

March 2004

FDA approves the manufacturing facility of Matrix at Jeedimetla, Hyderabad.

Gains clearance for supplying APIs to the US market.

March 2004

Vera Laboratories Ltd, Fine Drugs and Chemicals Ltd, Medikon Laboratories Ltd. and Caliber Engineering Private Ltd. merge with Matrix Laboratories Ltd.

To enhance transparency and corporate governance practices and to move toward a more derisk business model.

January 2005

Acquires Finished Dosage Facility situated near Nashik .

In order to integrate forward into formulations manufacturing.

February 2005

Acquires a 60 percent stake in Mchem, China

Backward integration for the manufacture of intermediates and to help consolidate its position as a major supplier of APIs

April 2005

Floats two 50:50 joint venture with South Africa based Aspen Pharmacare Holdings Ltd. having largest FDA approved API manufacturing facility.

To manufacture and market anti-HIV drugs in South Africa.

437

International Business Event

Impact/ Benefit

June 2005

Acquires controlling stake in Docpharma, a Belgium-based generic drug distributor.

To gain generics marketing expertise in the underpenetrated markets of Europe such as Belgium and other markets of Southern Europe.

September 2005

Matrix acquires a 43 percent stake in Explora Laboratories SA, a Switzerland-based pharmaceutical company engaged in R&D for high potency API manufacture

To gain access to technology platforms and product portfolios such as corticosteroid and anti-cancer therapeutic segment. Opportunity to leverage on technology platform to project itself as a partner to research based pharmaceutical companies in the area of contract research and contract manufacturing.

Matrix acquires up to 55 percent controlling interest in Concord Biotech Ltd., a USFDA approved biotechnology company in India.

Gains fermentation & Biocatalytic technology capabilities for manufacture of APIs.

December 2005

Compiled from various sources In addition to its core business of API manufacturing, the company had also identified contract research and manufacturing as a potential growth opportunity. In this regard, it decided to supply APIs and to make product dossiers49 of products going off patent in the mature markets of the West. These comprehensive product dossiers, which Martix then licensed to different companies for different markets, helped it to obtain the contract for supplying the API in addition to the license fee. For this, Matrix launched two joint venture companies in November 2003 – Medikon Galenicals in India and CEM Pharma Life Science in Ireland – with two German companies.50 It also signed a deal with Niche Generics Ltd.51 (UK) for the dossier for Perindopril, a US$400-million per annum product. Analysts felt that Matrix‟s global presence had resulted in it having a more de-risked business model and also enabled it to achieve a more predictable growth in the long run. As of 2007, the company operated in five key business segments (Refer to Exhibit VI for the five segments and their contribution). It had 10 API intermediate manufacturing facilities, six of which were FDA approved. These facilities are located in India (6), China (3), and South Africa (1). Its manufacturing facility of FDFs had the capacity to produce 2 billion tablets and 300 million capsules on a two-shift basis per annum. It had a total workforce of 2000 which included more than 300 R&D 49

50

51

These are regulatory submission documents and may include data from clinical trials, data from other studies on the drug such as bioequivalence studies, etc. The German investment partners of the two joint venture companies were H Fischer & Co International GmbH and CES Beteiligungs GmbH respectively. Both the companies were part of the lucrative German pharmaceutical industry with a focus on generics. Niche Generics ltd. is a Europe based generic drug supplier which tries to roll out the generic drug as soon as the patent expires.

438

Mylan’s Acquisition of Matrix scientists. The company had five key business segments viz. Generic APIs, ARVs, FDF, hospital business, and contract manufacturing services (Refer to Exhibit VI to see their Contribution to Matrix‟s Sales). For the fiscal year ended 2007, Martix‟s total sales had increased by 42 percent year-on-year from Rs.11.59 billion in 2006 to Rs.16.48 billion (Refer to Exhibit VII for the key financials of Matrix). Exhibit VI

Contribution of Matrix’s Business Segments 2006-07 Rs.(Mn)

% to total sales

2005-06 Rs.(Mn)

% to total sales

Year-onyear Growth %

Generic APIs

5,505

33

3,859

33

43

Anti-retro Virals (ARVs)

3,390

21

2,797

24

21

Finished Dosage Forms

4,295

26

2,484

22

73

Hospital business

2,209

13

1,654

14

34

Contract Manufacturing Services

1,081

7

792

7

36

Total Sales

16480

100

11586

100

42

Particulars

Source: Matrix Laboratories Ltd., “Annual Report: 2006-2007”, www.matrixlabsindia.com.

Exhibit VII Matrix Laboratories Ltd. Financial for Fiscal 2006- 07 Particulars ( Rs. Millions)

2007

2006

Total sales

16,480.27

11586

Total assets

27,989.42

30788.66

Total liabilities

17,399.26

30788.66

Profit before tax

1,021.42

2381.72

756.53

2005.63

Profit after tax before share of Associate Matrix’s fiscal year ends March 31.

Source: Matrix Laboratories ltd., “Annual Report-2007”, www.matrixlabsindia.com With the generic drugs industry in a consolidation phase, leading companies were targeting Indian generic drugs companies for M&A deals. Matrix was one of the prime candidates for such a deal. Analysts felt that entering into such deals would be beneficial for the Indian generic drugs companies as well, as these companies lacked the scale that was vital for survival in the highly competitive generics drugs market. With India bringing its patent law in line with the patent laws in mature markets such as the UK and the US in 2005, a majority of the 3,000-odd Indian pharmaceutical companies were in a precarious position52 (Refer to Exhibit VIII for a note on the Indian pharmaceutical industry).

52

Gina Krishnan, “The Sell-Out Begins,” www.businessworldindia.com, September 11, 2006.

439

International Business

Exhibit VIII A Note on the Indian Pharmaceutical Industry In 2006, the total market for pharmaceuticals in India was estimated to be US$7.3 billion. The market is dominated by companies manufacturing and marketing branded generic drugs. As of 2006, Indian pharmaceutical companies also produced more than 22 percent of the world‟s generic drugs. The significant presence of Indian pharmaceutical companies in the generic drugs market had been attributed, in part, to the loose patent regime prevalent in India before 2005. Between 1970 and January 1, 2005, India recognized only process patents. This patent environment was not suitable for research-based pharmaceutical companies as their products could be reverse engineered by Indian pharmaceutical companies and sold in India. Due to this, many Indian companies specialized in reverseengineering, which enabled them to develop generic drugs at a very low cost. The competition among the various Indian companies also brought the price down further. This prompted many research-based pharmaceutical companies to either market their drugs at a moderate premium price or simply ignore the Indian market. After becoming a member of the World Trade Organization (WTO), India had to comply with TRIPS53 (trade-related aspects of intellectual property rights). TRIPS ensures that profits from any new product go exclusively to the innovator (patent holder) for the full duration of the patent. TRIPS came into force on January 1 1995, but some developing and transitional economies were given time to comply with the agreement. India was given time till January 1, 2005, to enforce a new patent law that recognized product patents. However, certain flexibilities have been introduced in TRIPS so that a patient‟s access to life saving drugs is not denied. A „waiver‟ was issued in the WTO Doha ministerial conference in 2001, stating that intellectual property should not take precedence over public health. Moreover, countries like India that had newly introduced TRIPS legislations were allowed to copy any drug that was patented before 1995, i.e. before the introduction of TRIPS. Those companies that seek to copy drugs patented after 1995 can do so under a system called compulsory licensing, if the company that owned the patent was found to have misused its rights. On December 27, 2004, the Indian government issued a temporary executive order to meet the January 1, 2005 deadline. The Indian Parliament passed the new patent law recognizing product patents, in March 2005. However, the law did not impact those products invented before 1995 and generic companies still had the right to continue manufacturing and selling those drugs. With the change in patent law favoring research-based pharmaceutical companies, analysts expected problems for Indian pharmaceutical companies, as most of them did not have the R&D capability to discover new drugs. In such a scenario, the research-based pharmaceutical companies were expected to be more open to introducing new products in the Indian market, while most Indian companies would be dependent on marketing licenses to market these new drugs in India. Indian pharmaceutical companies were also focusing on contract 53

The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) is an international treaty administered by the World Trade Organization (WTO) which sets down minimum standards for most forms of intellectual property (IP) regulation within all member countries of the World Trade Organization.

440

Mylan’s Acquisition of Matrix research/manufacturing. However, to attract such global contracts, these companies have to achieve a critical mass or economies of scale to be viewed as a suitable partner. Therefore, in order to diversify risks, leading pharmaceutical companies in India were looking for growing through M&A in foreign markets. The fact that the patents for a large number of drugs in the US and Europe were due to expire in the next few years, also added to the attractiveness of these markets to Indian pharmaceutical companies. Since Indian pharmaceutical companies specialize in manufacturing low cost and good quality generic drugs, they were in a position to make the most of this opportunity. However, analysts believe that in order to be more competitive the companies had to develop scale. Scale was very important for companies considering that these companies did not have research molecules of their own and relied on reverse engineering of drugs developed by research-based pharmaceutical companies. Compiled from various sources.

The Deal In mid-2006, there were speculations that Mylan was in the process of acquiring a majority stake in Matrix. Though the management at Matrix denied the reports, there was a 10 percent rise in the company‟s share prices in anticipation of the deal. 54 These reports followed reports earlier in the year that the world‟s largest generic drugs company Teva was interested in acquiring Matrix. On August 27, 2006, Mylan announced its intention of acquiring Matrix in a cash and stock deal worth US$736 million. With this, Mylan intended to establish a global presence in emerging pharmaceutical markets such as India, which was the fourth biggest drug market in terms of volume. 55 Coury commented, “Mylan Matrix transaction marks the beginning of a new era at Mylan where our organization is continuing to expand beyond our well-established position as a leading domestic generic pharmaceutical company toward our objective of establishing Mylan as a world leader in generics and specialty pharmaceuticals.” 56 As per the terms of the transaction approved by the Mylan Board of Directors, Mylan acquired up to 71.5 percent of Matrix‟s outstanding paid-up share capital. Merrill Lynch & Co., Inc. 57 and DSP Merrill Lynch Ltd.58 were the advisors to Mylan for completing this deal. Matrix was advised by ABN AMRO Holding NV 59 and UBS AG60.

54 55 56 57

58

59

60

Mobis Philipose, “Matrix Unloaded?” www.dnaindia.com, June 22, 2006. “Pharmaceuticals”, www.ibef.org, November 15, 2007 “Mylan Lab Acquires Stake in Matrix,” www.ciol.com, January 9, 2007. Merrill Lynch & Co. Inc. (ML), headquartered in New York, USA, is a leading wealth management financial services, and advisory company. DSP Merrill Lynch Ltd. (DSPML), headquartered in Mumbai, India, is a leading financial service provider in India. ML holds a 90 percent stake in DSPML. ABN AMRO Holding NV, Amsterdam, the Netharlands, is a leading European bank with a global presence. UBS AG, headquartered in Basel & Zürich, Switzerland, is a leading financial services company.

441

International Business There were two phases to the Mylan Matrix deal. In the first phase, Mylan purchased 51.5 percent of the paid up share capital of Matrix in accordance with the agreement made with certain selling shareholders. In order to do so, Mylan‟s wholly-owned subsidiary, MP Laboratories Ltd. (Mauritius) entered into a Share Purchase Agreement (SPA) with key shareholders of Matrix viz. Prasad, N Prasad HUF61, G2 Corporate Services Limited, Maxwell (Mauritius) Pte. Limited 62, entities controlled by Newbridge Capital63, and Spandana Foundation64. In the second phase of the deal on November 22, 2006, Mylan made a public announcement of an open offer to acquire 20 percent of Matrix‟s share capital held by the general public. This was done in accordance with SEBI65 regulations. On completion of the open offer on December 21, 2006, and closing of the SPA, Mylan acquired 71.5 percent of Matrix‟s total paid-up share capital. Both these transactions were performed at Rs.306 per share (US$6.84 per share), putting the deal at US$ 736 million, an approximate 15 percent premium to the last 30-days‟ average stock price of Matrix. Though the price to revenue multiple in relation to the market value of Matrix stock in December 2006 was 2.8x and the price-to-EBIT multiple was 12.3x, the purchase price (Rs. 306) implied that Mylan valued Matrix at above US$1 billion, with a price to revenue multiple of 3.9x and a price-to-EBIT multiple of 17.2x.66 On January 8, 2007, Mylan finally closed the purchase of 71.5 percent of Matrix‟s outstanding share capital. Though Mylan acquired the controlling stake in Matrix after completion of the transaction, the rest of its share still continued to trade on the Indian Stock Exchanges (Refer to Exhibit IX for the shareholding pattern of Matrix). Mylan said that Matrix would continue to operate as an independent entity after the deal. One of the strategic pre-conditions attached to this deal was induction of Prasad on Mylan‟s Board of Directors as head of Global Strategies. Prasad was highly regarded in the industry as a wealth creator who had bought Matrix for Rs.30 million in 2000 and sold it for an enterprise valuation of Rs.62.1 billion in 2006. 67 This precondition was intended to make Mylan‟s entry into the global API landscape a successful venture backed by Prasad‟s long experience in the global API industry. It was also intended to keep Prasad away from launching a new pharmaceutical company as he was reportedly keen on pursuing his entrepreneurial dreams. Prasad invested US$25 million of the proceeds from the sale of his share in Matrix in Mylan. 68 “The idea behind retaining an equity stake of five per cent in Matrix and investing $25 million in Mylan and joining their management team heading the global business strategies is to ensure confidence levels of the Matrix shareholders, employees, and also to the new partner – Mylan,”69 said Prasad. 61

62

63

64 65

66

67 68 69

HUF (acronym for Hindu Undivided Family) is a legal taxable entity in the eye of law and Income Tax Act of India. Maxwell (Mauritius) is an arm of Singapore-based investment company, Temasek Holdings. It held a 13.8 percent stake in Matrix. Newbridge Capital is a joint venture between Texas Pacific Group and Blum Capital Partners. Along with its entities, it held a 26 percent stake in Matrix. Spandana Foundation is a charitable trust promoted by Prasad. SEBI (acronym for Securities and Exchange Board of India) is the regulatory authority of Indian securities markets. “Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European Markets,” www.levinassociates.com, 2006. Gina S Krishnan, “Matrix Unloaded,” www.businessworldindia.com, September 11, 2006. “Mylan Lab Acquires Stake in Matrix,” www.ciol.com, January 9, 2007. CR Sukumar, “Matrix Promoter May Turn Angel Investor,” www.thehindubusinessline.com, September 2, 2006.

442

Mylan’s Acquisition of Matrix

Exhibit IX Shareholding Pattern of Matrix

12%

1% 5%

1% 10%

71%

Indian Promoters

Foreign Promoters

Institutional Investors

NRIs

Indian Public

Foreign Nationals

* As on March 31, 2007. Source: Matrix Laboratories Ltd., “Annual Report: 2006-07”, www.matrixlabsindia.com.

Rationale behind the Acquisition Benefits for Mylan Mylan acquired the majority stake in Matrix primarily to establish a global distribution network for its generic drug portfolio. This acquisition acted as an entry window for Mylan to tap the huge potential of emerging pharmaceutical markets such as India, China, and Africa, where Matrix already had a significant presence through its various strategic alliances. Analysts felt that its presence in emerging markets would be profitable for Mylan in the long term. 70 Matrix, in addition to having full-fledged facilities in India, had tie-ups with Aspen Pharmacare Holdings Ltd., South Africa, and Mchem Group, China. The deal provided Mylan with the opportunity to expand its market for generic drugs to these emerging markets, where the generic drug turnover was greater than that of branded drugs. With the mature markets of the West showing signs of saturation, these emerging markets provided pharmaceutical companies with the next opportunity for growth. For instance, in 2006, the Indian pharmaceutical market grew at the rate of 17.5 percent to US$7.3 billion while the pharmaceutical market in China grew by 12.3 percent to US$13.4 billion.71 This was much higher than the 5-6 percent growth experienced by the pharmaceutical industry as a whole in the mid-2000s. 70

71

“Mylan Signs US$736-million takeover Deal for India‟s Matrix Laboratories,” www.globalinsights.com, 2006. “Robust Growth in Specialist-Driven Products, Including Oncology Treatments, Reflect Changing Market Dynamics,” www.imshealth.com, March 20, 2007.

443

International Business Further, the acquisition was also expected to help Mylan enter the high-margin European market through the Matrix subsidiary, Docpharma. Docpharma was a leading distributor of branded generics in Belgium, the Netherlands, and Luxembourg, and was in the process of expanding its operations into France and Italy. By utilizing Docpharma‟s sales network, Mylan expected to market its products in the European markets. The inclusion of Matrix‟s world class 10 APIs and intermediate plants would enhance Mylan‟s back-end supply chain capabilities and provide a low-cost raw material sourcing platform. This was expected to eventually improve Mylan‟s cost structure and enable it to compete more aggressively in price competitive markets such as the US. As a result of the acquisition, Mylan would have an expanded and more flexible manufacturing base. Some analysts felt that Matrix could well end up as one of Mylan‟s manufacturing centers.72 However, Mylan‟s spokesman Patrick Fitzgerald said that the company was not interested in off-shoring its manufacturing to Matrix‟s facilities. “What we will be doing is source our APIs from Matrix and also expand our high-barrier-to-entry product capabilities – Matrix is the world‟s largest supplier of generic anti-retroviral APIs and will allow us to be a leader in HIV medications,” 73 he said. According to Mylan, Matrix‟s product portfolio in the solid dosage forms did not clash with that of Mylan but rather complemented it. Matrix being the world‟s largest supplier of generic ARV APIs, Mylan would now be able to enter into the highbarrier-to-entry product segments, particularly in the area of ARV. Matrix‟s finished dosage form pipeline would enable Mylan to pursue a broader portfolio of products in a more cost-effective manner. Matrix had strong reverse engineering and scientific capabilities and access to highly talented and skilled manpower, which would help Mylan increase its number of ANDA submissions. Coury said, “Matrix brings to Mylan a highly experienced management team, whose robust international experience and strong track record managing integration will complement our U.S. team.”74

Benefits for Matrix The Mylan Matrix merger was expected to benefit Matrix as well. Experts felt that the merger would help in accelerating Matrix‟s expansion plans in India and abroad. As a part of Mylan, Matrix would benefit from Mylan‟s predominant presence in the US and their combined expanded production capabilities and manufacturing capacity, which would result in economies of scale. The additional financial resources from Mylan would help Matrix in enhancing its manufacturing capabilities and product development activities and also to expand Docpharma‟s portfolio and European presence, thereby helping Matrix strengthen its position in the European market. Commenting on the deal, Prasad said “This transaction offers significant benefits for our customers. Together, our companies will be able to compete more effectively, while delivering cost savings to our customers. The additional financial resources Mylan brings us also will allow us to further enhance Matrix‟s capabilities in 72 73

74

Atul Sathe, “How Mylan Can Turn around Matrix,” www.rediff.com, September 18, 2006. “Mylan in India‟s Biggest Pharmaceutical Takeover as it Enters the Matrix,” www.inpharmatechnologist.com, August 30, 2006. “Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories”, www.matrixlabsindia.com, August 28, 2006

444

Mylan’s Acquisition of Matrix manufacturing and product development and expand Docpharma‟s portfolio and presence across Europe. We look forward to drawing on Mylan‟s strengths to advance our anti-viral initiatives, as we believe bringing these products to patients at lower costs is critical.”75 Viswanathan Vasudevan, a fund manager at Aquarius Investment Advisors 76, said, “There will definitely be a broadening of the market of Matrix and it will give more depth, reach, and coverage for the company,” 77 For instance, the Mylan-Matrix combine, with its global presence, would further augment Matrix‟s ARV sales. Matrix‟s ARV business comprised 25 percent of its total revenues in 2005 and it continued to be its focus area. It was one of the few players globally that offered complete integration for ARV drugs right from the intermediate stage to the finished dosage stage. The combined entity was well placed to partner with international HIV programs to bring low-cost anti-AIDs drugs to HIV patients across the globe. Analysts felt that the merger with Mylan would provide Matrix with the much-needed scale that generic companies required to survive in a very competitive market place. It was very important for Indian pharmaceutical companies considering that these companies did not have research molecules of their own. Some analysts said that since 2004, Matrix had been facing considerable pricing pressures in the US and European markets.78 Both the companies said that they did not expect any problems in cultural integration post-merger. Prasad said that the culture of Matrix would remain intact as the culture at Mylan was a “mirror image of Matrix,”79 Coury too felt that Matrix was a good culture fit for Mylan. We are very excited about the transaction and expect, based on our time together thus far, a smooth and effective integration. We have found that Matrix and Docpharma have cultures and values that are extremely consistent to our own at Mylan,”80 he said.

The Other View Though overall, the deal was expected to be a win-win proposition for both the parties, analysts were cautious about the long-term sustainability of Matrix‟s existing supply chain arrangements with other US generic players who would now become its direct competitors. Further, as Matrix had already been the second largest API supplier to Mylan since 2003, transfer pricing of drugs between Mylan and Matrix was also expected to be an issue of concern which would affect the potential top-line synergies expected from this deal in the near term. Moreover, as per Mylan‟s press release in December 2006, accretion to earnings would be mild in the short term. Significant top-line synergies resulting from the combined operations would only flow in the long term (by 2009-10) when Mylan and Matrix‟s subsidiary Docpharma, were able to list their respective drugs in the Europe and the US market respectively. 75

76

77 78 79

80

“Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories”, www.matrixlabsindia.com, August 28, 2006 Aquarius Investment Advisors is a Singapore-based company which provides financial advisory services. Mrinalina Datta, “Mylan Labs to Acquire India Rival,” www.iht.com, August 28, 2006. Atul Sathe, “How Mylan Can Turn around Matrix,” www.rediff.com, September 18, 2006. J.Padmapriya, “Matrix Founder Prasad Set to Get into the Groove at Mylan,” www.economictimes.indiatimes.com, September 9, 2006. “Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,” www.matrixlabsindia.com, August 28, 2006.

445

International Business Many analysts also felt that Mylan had over-paid for the acquisition of Matrix. According to them, by valuing Matrix at US$ 1 billion plus, Mylan had paid 22x Matrix‟s expected earnings. This was high, considering the Indian drug sector‟s average multiple of 18x. However, Mylan defended the deal, explaining that the acquisition was a calculated risk essential to enable it to expand its presence beyond US generic markets on a global scale and to keep up with its peers. Some analysts too justified the price paid by Mylan as they viewed India as an attractive market for pharmaceutical products -- a market that the pharmaceutical companies just couldn‟t afford to ignore keeping the future in mind. 81 Some analysts felt that it wouldn‟t be easy for a company like Mylan, which had only operated in the US, to suddenly transform itself into a global generic drugs company.82

Post Deal Developments After the deal was completed, Coury and Prasad were appointed as the Non-executive Chairman and Non-executive Vice Chairman of the board of Matrix respectively. Mylan also established its Asian headquarters in Singapore for Prasad and his team. 83 It was decided that Rajiv Malik (Malik) would continue to head Matrix, while Stijn Van Rompay, the co-founder of Docpharma, would continue to manage Docpharma. In the restructuring that followed at Mylan, Malik was appointed the Head of Global Technical Operations at Mylan. In the new position, he was expected to look after the global R&D, manufacturing, supply chain management, and regulatory affairs. 84 S Srinivasan, Senior Vice President of Matrix, was promoted as COO of Matrix. Mylan‟s Senior Vice President of Strategic Corporate Development and Chief Integration Officer was promoted to head Mylan‟s North American operations. Mylan‟s Vice President of Facilities was promoted as head of Global Manufacturing. The company also announced that its Chief Scientific Officer John O‟Donnell would retire on April 1, 2007. “During the past several months leading up to the successful closing of this transformational transaction we‟ve had the opportunity to carefully evaluate all aspects of our organizations and we are realigning to allow us to realize the full benefit, efficiencies, and growth potential of our new global platform. I am very pleased at how quickly and efficiently we have brought these organizations together and this reorganization will further enhance and accelerate the benefits to Mylan and Matrix,”85 explained Coury. Mylan also increased its fiscal 2007 adjusted earnings per share guidance to US$1.50US$1.55 from the earlier projection of US$1.35-US$1.55 per share.86 The company had cited the successful acquisition of the Matrix as a reason for this increase.

81

82

83 84

85

86

“Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European Markets,” www.levinassociates.com, 2006. “Mylan in India‟s Biggest Pharmaceutical Takeover as it Enters the Matrix,” www.inpharmatechnologist.com, August 30, 2006. “Mylan Lab Acquires Stake in Matrix,” www.ciol.com, January 9, 2007. “UPDATE 1-Mylan Reorganizes Management after Matrix Deal,” www.today.reuters.com, January 31, 2007. “Mylan Laboratories Announces Strategic Global Reorganization to Maximize Growth Opportunities and Leverage Efficiencies Provided by New Global Platform,” www.drugnewswire.com, February 1, 2007. “Mylan Laboratories Ups 2007 Outlook,” www.businessweek.com, February 1, 2007.

446

Mylan’s Acquisition of Matrix Shortly after the acquisition of Matrix, Mylan further consolidated its position in the global arena by acquiring Merck KgaA‟s generic unit for US$6.8 billion in October 2007. This acquisition catapulted Mylan to the position of the world‟s third largest generic company behind Teva and Sandoz87, employing around 12,000 people globally in more than 90 countries. As of end 2007, Mylan‟s broad product offering included more than 570 products and the world‟s second largest portfolio of APIs and 126 US DMFs. The mood at Matrix was also upbeat. “Becoming a Mylan subsidiary has opened up new opportunities for Matrix and the recent announcement of the acquisition of Merck KgaA‟s generic business by Mylan provides additional opportunities for Matrix. These developments would provide a global scale for achieving very efficient utilization of R&D, manufacturing, and other resources of the company. We are proud that Matrix will become part of one of the world‟s leading global generics companies,”88 said Malik.

Outlook The acquisition of Matrix helped Mylan to expand beyond the US market and establish a global presence with 5100 employees in 10 countries. This deal was a landmark one, suggesting that Indian generic drug makers with FDA approved plants, a strong product pipeline, and a low-cost and robust manufacturing base were attractive takeover targets for global generic makers. Some analysts also expected Mylan‟s acquisition of Matrix to trigger more such M&A deals in the Indian pharmaceutical industry. In this regard, Sanjiv Kaul, MD, ChrysCapital Management Company89, said, “The ticket size of this deal has been noticed by everyone. It will open the eyes of both the overseas companies and Indian companies who will realize that tremendous shareholder value can be unlocked through the divestment route… Just as the Mylan-Matrix deal is based on strong strategic fit, foreign companies such as Barr, Watson, and Teva will find companies in India which have excellent fits with them.”90 In a nutshell, the Matrix deal, which was completed in January 2007, provided Mylan with an in-house API supplier, a strong entry platform into the lucrative European generic markets and the fast growing emerging markets such as Indian and China, and, above all a robust manufacturing base using a low-cost work force. According to analysts, through the acquisition of Matrix and Merck KgaA‟s generic unit, Mylan had not only expanded its global reach, but was also in a position to reap benefits of economies of scale and a more diversified and balanced product portfolio. According to Goldman Sachs Group91 equity analyst, Randall Stanicky, Mylan would post revenue and profits of US$5.2 billion and US$362.3 million respectively, 87

88

89

90

91

Sandoz, headquartered at Holzkirchen, Germany, is the generics subsidiary of Swiss multinational pharmaceutical company Novartis AG. “Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories”, Press Release, www.matrixlabsindia.com, May 23, 2007. ChrysCapital Management Company is an investment firm headquartered in Mauritius with its prime focus on Indian market. Javed Sayed, “Matrix Deal to Trigger M&As in Pharma Sec,” www.economictimes.indiatimes.com, August 30, 2006. Goldman Sachs Group is headquartered in New York and it is a global investment banking, securities, and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base.

447

International Business compared to its revenue of US$1.3 billion and profit of US$188.7 million in 2006. 92 This would also substantially de-risk the entire business from downturns in any particular market or segment, according to analysts. The management of Mylan was understandably pleased with their newly acquired global standing and was gearing up to further build on that. “The new Mylan now has all of the critical attributes we need to ensure future success and deliver powerful growth. We have enhanced scale and stability, a truly global reach, vertical and horizontal integration, and breadth and depth in our management team,”93 said Coury.

92

93

Rick Stouffer, “Generics Deal a Shot in Arm for Mylan,” www.pittsburglive.com, December 9, 2007. “Mylan Laboratories Inc Completes Acquisition of Generic Business of Merck KGaA,” www.biospace.com, October 2, 2007.

448

Mylan’s Acquisition of Matrix

References & Suggested Readings: 1.

Gina S Krishnan, “The Matrix Evolution,” www.businessworldindia.com, Debember 29, 2003.

2.

“The World’s Top Ten Generic Companies,” www.leaddiscovery.co.uk, November 2005.

3.

Mobis Philipose, “Matrix Unloaded?” www.dnaindia.com, June 22, 2006.

4.

Mrinalini Datta, “Mylan Labs to Acquire India Rival,” www.iht.com, August 28, 2006.

5.

“Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,” www.prnewswire.co.uk, August 28, 2006.

6.

“Mylan Targets Indian Drugs Firm,” www.news.bbc.co.uk, August 28, 2006.

7.

“Mylan Laboratories Mylan to Have Majority of India’s Matrix,” www.advfn.com, August 29, 2006.

8.

“US-Based Mylan Buys Majority Stake in Matrix,” www.indiatimes.com, August 29, 2006.

9.

Brian Gorman, “Mylan’s Biogeneric Play,” www.fool.com, August 30, 2006.

10.

Joshua Owide, “Mylan Laboratories: Entering the Matrix,” www.pharmaceuticalbusiness-review.com, August 30, 2006.

11.

Javed Sayed, “Matrix Deal to Trigger M&As in Pharma Sec,” www.economictimes.indiatimes.com, August 30, 2006.

12.

“Mylan in India’s Biggest Pharmaceutical Takeover as it Enters the Matrix,” www.in-pharmatechnologist.com, August 30, 2006.

13.

Surojit Chatterjee, “Mylan Buys Majority Stake in India’s Matrix Lab for $ 736 Million,” www.in.ibtimes.com, August 30, 2006.

14.

CR Sukumar, “Matrix Promoter May www.thehindubusinessline. com, September 2, 2006.

15.

J.Padmapriya, “Matrix Founder Prasad Set to Get into the Groove at Mylan,” www.economictimes.indiatimes.com, September 9, 2006.

16.

Gina S Krishnan, “Matrix Unloaded,” www.businessworldindia.com, September 11, 2006.

17.

Gina Krishnan, “The Sell-Out Begins,” www.businessworldindia.com, September 11, 2006.

18.

Atul Sathe, “How Mylan Can Turn around Matrix,” www.rediff.com, September 18, 2006.

19.

Jim Miller, “Will Delivery Technologies www.pharmtech.com, October 2, 2006.

20.

Brian Lawler, “The Coming Generic Drug Boom,” www.fool.com, October 16, 2006.

21.

Nath Balakrishnan, December 3, 2006.

22.

“Mylan Buys Part of Drug Maker,” www.pittsburgh.bizjournals.com, December 21, 2006.

23.

“Mylan Signs US$736-million Takeover Deal for India’s Matrix Laboratories,” www.globalinsights.com, 2006.

24.

“Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European Markets,” www.levinassociates.com, 2006.

25.

“Mylan Laboratories Completes www.cnnmoney. com, January 8, 2007.

“Matrix-Mylan:

Accept,”

Matrix

Turn

Deliver

Angel

Profits

Investor,”

to

CMOs?”

www.thehindubusinessline.com,

Laboratories

Transaction,”

449

International Business 26.

Lee Brodie, “Mylan, World Leader in Generic Drugs,” www.cnbc.com, January 9, 2007.

27.

“Mylan Lab Acquires Stake in Matrix,” www.ciol.com, January 9, 2007.

28.

“Mylan Laboratories Inc. Completes Matrix Laboratories Limited Transaction,” www.devicespace.com, January 9, 2007.

29.

“UPDATE 1-Mylan Reorganizes Management www.today.reuters.com, January 31, 2007.

30.

“Mylan Laboratories Announces Strategic Global Reorganization to Maximize Growth Opportunities and Leverage Efficiencies Provided by New Global Platform,” www.drugnewswire.com, February 1, 2007.

31.

“Mylan Laboratories Ups 2007 Outlook,” www.businessweek.com, February 1, 2007.

32.

“Robust Growth in Specialist-Driven Products, Including Oncology Treatments, Reflect Changing Market Dynamics,” www.imshealth.com, March 20, 2007.

33.

Tova Cohen and Steven Scheer, “Teva Pharma Seen Best Placed to Win Merck Generics,” www.reuters.com, May 8, 2007.

34.

CR Kumar and Bhuma Shrivatava, “Mylan’s India Unit Key to Merck Buy,” www.livemint.com, May 14, 2007.

35.

“Mylan Reportedly Wants Stake in Matrix,” www.pittsburghlive.com, August 26, 2007.

36.

“Mylan Laboratories Inc Completes Acquisition of Generic Business of Merck KGaA,” www.biospace.com, October 2, 2007.

37.

“Consolidation in the Generic Pharmaceutical Industry: An Evolving Landscape,” Urch Publishing, October 2007.

38.

“Pharmaceuticals,” www.ibef.org, November 15, 2007.

39.

Rick Stouffer, “Generics Deal a Shot in Arm for Mylan,” www.pittsburglive.com, December 9, 2007.

40.

“Mylan Laboratories Completes Acquisition of 51.5% in Matrix Laboratories,” www.equitybulls.com, January, 2007.

41.

“Mylan Outbids Teva and Private Equity Investors to Acquire Merck KGaA’s Generics Unit,” www.globalinsights.com, 2007.

42.

www.fundinguniverse.com

43.

www.myiris.com

44.

www.globalinsight.com

45.

www.googlefinance.com

46.

www.matrixlabsindia.com

47.

www.mylanpharms.com

48.

www.wikipedia.com

450

after

Matrix

Deal,”

Troubled Times for the Chinese Toy Industry The history of modern Chinese toy industry dates back to the early 1900s. By the early 1980s, the Chinese toy industry was developed enough to compete in the international market. By 2006, benefiting from economies of scale and cheap labor, the Chinese toy industry had come to dominate the global market for toys, accounting for around 75% of the world's output. However, in 2006-07, the Chinese toy industry faced a series of product recalls, adversely affecting its global image. The case discusses the development of Chinese toy industry over the years. It discusses the problems facing the toy industry in China, with specific emphasis on the issue of recalls in 2007 and the reason behind the recalls. The case examines some of the other challenges that the Chinese toy industry faces such as increasing labor costs, technological inferiority of Chinese toys and the growing demand for high tech toys, and the Chinese toy manufacturers' lack of brand power. The case ends with a discussion on the actions taken in response to the series of recalls and the possible impact of these recalls on the Chinese toy industry.

Troubled Times for the Chinese Toy Industry “If this flood of dangerous products continues and retailers are forced to pull toy after toy from their shelves, China will become the Grinch that steals Christmas this year.”1 - Richard J. Durbin, Democrat Senator from Illinois, commenting on the recalls of Made in China toys, in August 2007 “This is the last warning. If there is an unsatisfactory report in October [2007] we will [impose] the next layer of measures. Among them is a ban on products.” 2 - Meglena Kuneva, the EU commissioner responsible for consumer protection, in response to recalls of Chinese toys “It’s quite urgent that we re-construct the Chinese toy industry. Otherwise, we will not only lose the domestic market, but also the global market in the long term.” 3 - Shi Xiaoguang, president of the China Toy Association4, in 2002.

Introduction On October 4, 2007, the Consumer Product Safety Commission (CPSC) 5 in the US recalled more than half a million toys made in China as they contained dangerous levels of lead. The CPSC announced that the recalled toys included ‗Pirates of the Caribbean‘, ‗Baby Einstein‘, and ‗Totally Me! Funky Room Decor Set‘ decorating kits, imported and sold by Toys ―R‖ Us Inc. 6, and a variety of wooden toys imported and sold by KB Toys Inc. 7 ―A lot of what is being recalled is because it violates the law, not that there is an imminent health risk,‖ said CPSC spokeswoman Julie Vallese (Refer Exhibit I for more information on toy recalls in October 2007). The October 2007 recall was the latest in a series of Chinese toy recalls by toy companies and retailers in developed countries. Among the reasons given for the recalls were excessive levels of lead paint, loose magnets that could be swallowed by children, or other potentially serious problems.

1

2

3 4

5

6

7

Louise Story, ―Toy Makers Brace for a Chill in Sales,‖ www.nytimes.com, August 16, 2007. Elitsa Vucheva, ―EU could Ban Unsafe Chinese Products,‖ www.businessweek.com, September 14, 2007. ―Toying with the Future,‖ http://app1.chinadaily.com.cn, 2002. The China Toy Association is an industry association, with Chinese toy companies as its members. It has four committees for each toy category – wooden toys, plush toys, plastic and mechanical toys, and prams. The United States Consumer Product Safety Commission (CPSC) is an independent agency of the United States federal government. CPSC was created in 1972 through the Consumer Product Safety Act that was framed to protect the public from unreasonable risks of serious injury or death from more than 15,000 types of consumer products that come under the agency‘s jurisdiction. (Source: www.cpsc.org) Toys R Us Inc., headquartered in New Jersey, USA, is one of the largest retailers of toys and baby products in the world. A public limited company between 1978 and 2005, Toys R Us was acquired by an investment group. As of 2007, it had around 1,500 stores, with 830 stores in the US. Founded in 1922 by Kaufman brothers, KB Toys Inc. is a large mall-based retailer of toys. As of 2007, this privately-owned Massachusetts company operated around 600 stores in the US.

476

Troubled Times for the Chinese Toy Industry

Exhibit I Products Recalled in the US in October 2007 i.

About 35,000 Baby Einstein Discover & Play Color Blocks, distributed by Kids II Inc. The blocks were sold around the country between June and September.

ii. About 79,000 ―Pirates of the Caribbean‖ medallion squeeze lights, imported by the Eveready Battery Co., a brand of Energizer Holdings, Inc. The flashlights were sold nationwide and online between September 2006 and October 2007. iii. About 15,000 Totally Me! Funky Room Decor Sets, manufactured by Hong Kong-based CKI Toys and imported by Toys ―R‖ Us Inc. The kits were sold at Toys ―R‖ Us stores around the country and on the company‘s website between May and September 2007. iv. About 10,000 wooden Pull-Along Alphabet & Math Blocks wagons, Pull-Along Learning Blocks wagons, 10-in-1 Activity Learning Carts and Flip-Flop alphabet blocks, imported by KB Toys Inc. The toys were sold at KB Toys stores around the country between August 2005 and September 2007. v.

About 63,000 green plastic cups shaped like Frankenstein‘s head, imported by Dollar General Merchandising Inc. The cups were sold at Dollar general stores around the country in September.

vi. About 192,000 key chains imported by Dollar General Merchandising Inc. The key chains featured a metal charm engraved with ―wisdom,‖ ―truth,‖ ―believe,‖ ―love,‖ ―hope‖ or ―dream.‖ They were sold at Dollar general stores around the country between June 2005 and August 2007. vii. About 150,000 bookmarks and journals, imported by Antioch Publishing. The products featured a variety of decorations including Winnie the Pooh. The bookmarks and journals were sold at book, card, and gift stores around the country between March 2005 and October 2007. Some of the bookmarks were sold with bracelets.

Source: “Another Huge Recall of Chinese made Toys,” www.cbsnews.com, October 4, 2007. The recalls had a limited impact on toy sales in the US and the EU but they severely dented the Chinese toy industry‘s image in international markets. The possible long-term impact on its reputation, however, was only one of the many issues confronting the toy industry in China. With costs of raw materials and labor increasing, the toy companies were seeing an erosion in margins. Also, the growing popularity of high-tech electronic toys was a challenge to Chinese toy companies as they were not very strong in this field. Furthermore, even in the traditional toy markets, Vietnam and Thailand were beginning to pose a threat.

Background Note Toys have had a prime place in Chinese society since ancient times. Folk toys made of wood, clay, and paper have always been very popular with Chinese children. Masks and clay figurines in the shape of animals have been found in the ruins of ancient Chinese habitations. The history of modern Chinese toys, however, dates back to the early 1900s. Around 1910, the first factories that made toys from tin were set up. Toy making in China started gaining momentum after the May Fourth movement 8 in 1919. Several toy factories came up in the region around Shanghai. These factories made clockwork, tin-plate warships, tram toys, simple tin containers, plates, and other objects. With the demand for tin increasing (for making cans for paints, cosmetics, 8

The May Fourth Movement in China began on May 4, 1919. The movement promoted Marxism in China and resulted in the birth of the Communist Party of China.

477

International Business biscuits, and sweets), tin sheet manufacturing units started to be established around Shanghai in the 1920s and the 1930s. This gave a boost to the local toy industry. However, in this period, Germany dominated the world‘s toy markets with its high quality tin toys. Though the Chinese tin toys were no match for the German ones as far as quality was concerned, they scored on the price front. By 1935, Chinese companies which had earlier been producing tin cans, started making tin-plate toys including toy planes, wind-up tin monkeys, and other toys. During the Second World War, war related toys like fighter planes, tanks, and soldiers constituted a major percentage of toy production in China. The war adversely affected the German toy industry, with most toy factories there being used for making ammunition. In the 1950s, Japanese tin toys started gaining popularity for their novel designs and good quality. In this period, Japanese toy companies also began producing plastic toys, which were very inexpensive. In China, toys began to be made with Chinese designs, as opposed to the western designs being used earlier. According to Marvin Chan,9 a Hong Kong-born graphic designer,10 ―Before the 1950s, the toy designs are very influenced by Europeans, but after, the toys have a more Oriental feel to their patterns and design.‖ In the mid-1960s, most Japanese toy companies stopped making tin toys and shifted to making toys out of plastic and superalloys11. China then became the manufacturing center for tin toys. Though the tin toys from China were of poor quality initially, the quality improved over time. During the Cultural Revolution, 12 toys were used as a propaganda tool in China. Dolls dressed up in Mao-suits, cars with political slogans, and building block cubes with propaganda scenes on them were some of the popular toys during this period. 13

The Growth Chinese toy companies, like other companies in the manufacturing sector, benefited from the reforms initiated in China in 1979. With the opening up of the Chinese economy, toy makers from Hong Kong, which by then had become a major global center for good quality toys, started setting up production facilities in mainland China in order to take advantage of the lower operational costs. However, most of the valueadded work such as product design, production planning, quality control, management, and marketing continued to be done from Hong Kong. Over the years, Chinese entrepreneurs and multinational companies too started setting up toy factories in China. As several cities of the Guangdong province were allowed to adopt a more open industrial policy than the cities in the rest of China, most of the toy factories came up in the Pearl River Delta region of Guangdong Province. The 9

10

11

12

13

Marvin Chan opened the Museum of Shanghai Toys in Singapore. The museum was dedicated to high quality Shanghai toys made in the period between 1910s and 1970s. Sonia Kolesnikov-Jessop, ―A Trip into China‘s Past, through its Toys,‖ www.iht.com, March 27, 2007. Superalloys are metallic alloys that exhibit excellent mechanical strength even at high temperature, and are resistant to oxidation, corrosion, and deformation. Most superalloys are based on iron, nickel, or cobalt. The Great Proletarian Cultural Revolution in China was a struggle for power within the Communist Party of China. The Cultural Revolution started in October 1966 and ended in October 1976. Sonia Kolesnikov-Jessop, ―A Trip into China‘s Past, through its Toys,‖ www.iht.com, March 27, 2007.

478

Troubled Times for the Chinese Toy Industry special economic zones, especially in Shenzhen, attracted several international toy makers. Several of these factories were very large. Scale economies, together with cheap labor, helped the Chinese toy-making firms to compete with toy producers from other countries, who were mostly small or medium-sized. Besides cheap labor, China was able to attract international toy companies also because of an efficient network of supporting industries such as component industries and services such as logistics, communication, etc. This helped international toy makers to strengthen their competitiveness in terms of productivity, reliability, and delivery. In 1987, the country‘s first toy design institute was set up at Tianjin Science and Technology University. Around this period, toy makers in China started incorporating modern technology like battery-operated controls, magnetic controls, and sound and light controls in their products. China‘s accession into the World Trade Organization (WTO)14 strengthened the domestic toy industry, with a sharp rise in exports. China organized its first international toy exposition in October 2002. Held between October 8 and 11 in Guangzhou, the capital of Guangdong province, the expo was hosted by China Toy Association (CTA) in cooperation with its counterparts in Hong Kong and Taiwan and Spielwarenmesse, a Germany-based toy exhibition company that hosts the International Toy Fair. 15 Toy producers and dealers form Germany, Britain, Russia, Spain, Mexico, the Republic of Korea, and other countries attended the expo. As of 2006, there were about 7,000 toy factories in and around the cities of Shenzhen, Dongguan, and Guangzhou (Refer Exhibit II for information on some toy manufacturing centers in China). In 2006, China exported 22 billion units of toys worth more than $7.5 billion (Refer Exhibit III for statistics on Chinese toy exports and imports). According to the China Chamber of Commerce for Import and Export of Light Industrial Products and Arts-Crafts (CCCLA),16 as of end 2006, Chinese toys constituted 75% of world toy output. 17

The Problems Though the Chinese toy industry had several strengths, it was also up against several problems that had the potential to significantly impact future growth. To start with, Chinese toy companies were faced with the dual pressures of rising costs and declining prices. On the one hand, buyers demanded lower prices. ―There is so much pressure on prices from foreign companies,‖ said Chen Huangman, Secretary General 14

15

16

17

The World Trade Organization (WTO) is an international organization that deals with rules for international trade through negotiations among its member governments. It also helps settle disputes between members based on an agreed legal foundation. The International Toy Fair, organized annually on a one million sq. m. exhibition space at Nuremberg, Germany, is the world‘s leading fair for toys, and hobby and leisure-time articles. The fair reportedly attracts around 2,750 exhibitors from 60 countries and 80,000 trade visitors from 120 countries. The China Chamber of Commerce for Import and Export of Light Industrial Products and Arts-Crafts (CCCLA) was founded in 1988. It coordinates the trade in light industrial products and arts-crafts, and provides service for its member enterprises. (Source: www.cccla.org.cn) Guangdong is a province on the south coast of China.

479

International Business of the Guangdong Toy Association. ―Wal-Mart18 in particular, puts a lot of pressure on prices, and as they order so much from China, it has a large influence,‖ said Li Zhuoming (Zhuoming), Vice Chairman of the Guangdong Toy Association. 19 And on the other hand, raw material and labor costs were increasing. Toy factory executives across the country admitted that they were forced to raise wages, sometimes by double digit rates, in order to attract and retain young workers.

Exhibit II Major Toy Manufacturing Centers in China Yunhe, Zhejiang Yunhe, a picturesque county in Lishui, a prefecture-level city is a major center for wooden toys. Around 500 toy factories that manufacture wooden toys have sprung up in the 2000s. The annual output of the region crosses Yuan 1.5 billion. Yunhe is considered the largest center for wooden toys in China. The city was given the title ‗Wooden Toy City‘ by the China Light Industry Association. Pinghu, Zhejiang Pinghu, a major city on the Pearl River delta region and one of China‘s largest garment export hubs, is also a major center for prams. It accounts for around 25% of the prams manufactured in China. According to 2006 estimates, exports of prams from Pinghu were valued at $ 4 million. Chenghai, Guangdong Chenghai district in the city of Shantou is a major toy manufacturing center with more than 2,500 enterprises engaged in the toy business and over 100,000 employed in the industry. The annual output of toys and gift articles is worth around Yuan 8.8 billion Yangzhou & Yizheng, Jiangsu Yangzhou, a prefecture-level city in China, and especially Yizheng city, are famous for their plush toys (or stuffed toys). There are around 100 large-scale factories in this region, with an annual output of around Yuan 3 billion.

Compiled from various sources In addition to rising costs, and demands from foreign clients to keep prices low, there was increasing pressure on China‘s toy companies from clients in the US and the EU to meet their high labor standards. Chinese toy factories had long been branded as sweatshops20 and toy factory owners had been accused of denying workers their legal rights. Violations allegedly included forced overtime, wage payment below the minimum standard, failure to provide social insurance, restriction of workers‘ personal freedoms, etc. However, Chinese toy manufacturers shifted the blame onto Western retailers and toy companies, saying they were squeezing their margins, leaving them with little money to improve working conditions. Liu Kaiming, Executive Director of the Institute of Contemporary Observation (ICO), 21 said, ―There are more serious problems in the [Chinese] toy industry than any other sector as the prices are too low.‖22 Bama Athreya, Director, International Labor Rights Forum, also 18

19

20

21

22

Wal-Mart Stores, Inc. was founded in 1962. It is the world‘s largest retailer and one of the world‘s largest corporations by revenues. Calum MacLeod, ―China‘s Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006. A sweatshop is a shop or factory in which employees work long hours at low wages under poor conditions. The Institute of Contemporary Observation (ICO), founded on March 18, 2001, is a civil society organization dedicated to labor development and corporate social responsibility. (Source: www.icochina.org) Calum MacLeod, ―China‘s Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006.

480

Troubled Times for the Chinese Toy Industry shared the same view. In her testimony23 to the Congress, she said, ―Wal-Mart bears a lion share of responsibility for pushing the [Chinese] toy industry to a place where worker health and safety are basically nonexistent.‖24

Exhibit III Chinese Toy Import and Export Statistics Category

2005 Exports ($)

2006 Imports ($)

Exports ($)

Imports ($)

16‖, 18‖ or 20‖ Cross-country bicycles

275,358,952

8,021

260,999,221

17,122

Bicycles not larger than 16‖, not elsewhere specified or included

174,573,263

44,643

214,011,194

64,672

Baby carriages and parts

565,990,037

9,146,881

663,350,087

9,806,131

19,037,697

541,223

21,731,462

172,980

for

5,791,566

1,292,657

6,958,622

1,277,389

Wheeled toys designed to be ridden by children, dolls‘ carriages

270,006,643

635,640

355,774,372

943,052

Dolls, whether or not dressed

318,705,789

11,449,860

389,714,240

13,382,616

Dolls‘ garments and accessories, footwear, and headgear

66,734,251

9,980,431

72,254,540

3,436,787

Other dolls‘ parts and accessories

35,376,056

9,778,648

37,706,999

13,195,698

Electric trains, including tracks, signals, and other accessories

40,557,441

1,816,729

39,582,741

1,066,407

Reduced-size model assembly kits, working models

38,805,107

3,869,446

45,886,660

3,871,976

Other construction sets and constructional toys

5,342,864

180,716

12,243,909

255,553

Musical boxes Mechanisms musical boxes

23

24

Bama Athreya was testifying to a Senate panel which was considering passing a law that would make it illegal to import or sell goods in the US that were made abroad in sweatshops or by prisoners. Byron Wolf, ―Sweatshop Toys? China‘s Goods Finds US Homes,‖ www.abcnews.com, October 25, 2007.

481

International Business Stuffed toys representing animals or nonhuman creatures

1,570,834,234

6,344,984

1,605,111,623

6,407,679

Other toys representing animals or nonhuman creatures

124,539,699

1,692,589

136,856,016

2,263,466

68,014,801

805,718

75,767,193

704,982

Puzzles

355,525,300

8,133,680

397,326,556

10,541,972

Other toys, put up in sets or outfits

226,013,097

3,111,896

307,838,064

4,501,503

Other toys and models, incorporating a motor

716,962,733

5,406,644

724,520,854

11,116,661

Other toys

2,724,867,112

51,348,669

2,855,080,436

51,001,271

Video games used with a television receiver

3,888,966,084

46,635,371

5,077,008,358

189,892,142

Other video games

2,472,537,295

136,149,393

3,146,348,401

100,254,202

Articles Christmas

for

1,073,407,609

1,431,126

1,151,238,737

2,592,939

Other festival and entertainment articles, including conjuring tricks

146,917,463

1,814,837

163,916,886

2,729,764

Toy musical instruments and apparatus

Source: www.toy-cta.org. To put things in perspective, the prices of many exported Chinese toys were a fraction of the prices of similar toys manufactured in developed countries. For example, the cost of manufacturing a pair of roller-skates in China was 16.8 euros ($21.15) on an average, compared to 62.3 euros in Japan.25 Also, toy manufacturers claimed that repeated inspections and evaluations of their factories in China caused lower productivity. Cited often was the case of a toy factory that was inspected over 50 times in one year. In 2005, international toy producers such as Mattel 26, Hasbro27, and Leapfrog Enterprises Inc. (Leapfrog),28 submitting to international pressure, announced that they would cancel the orders placed with Chinese toy manufacturers unless these 25 26

27

28

April Mei, ―Playtime is over for China‘s Toy Industry,” www.atimes.com, June 21, 2006 Mattel Inc., founded in 1945, is an American toy company. As of 2007, it is the world‘s largest toy company based on revenues. Hasbro was founded by two brothers – Henry and Helal Hassenfeld – in 1923 in Providence, Rhode Island as a company that sold textile remnants. It started selling toys in the 1940s. As of 2007, it was the second largest toy maker in the world, after Mattel Inc. LeapFrog Enterprises Inc., founded in 1995, is a toy company based in Emeryville, California.

482

Troubled Times for the Chinese Toy Industry manufacturers secured the International Council of Toy Industries (ICTI)29 Code of Business Practices certification by January 1, 2006 (Refer Exhibit IV to know more about the ICTI code). Alan Hassenfeld, President, CARE Foundation30 at the ICTI, said ―What we need to do is to set up unified factory inspection standards before NGOs make allegations against us.‖31

Exhibit IV A Note on the ICTI Code ICTI released the ICTI Code of Business Practices (ICBP) in 2002. The ICBP is also called the CARE Process, where CARE stands for caring, awareness, responsibility, and ethics. The ICBP bars the use of underage, forced, or prison labor and the denial of a job on the grounds of gender, ethnic origin, religion, affiliation, or association. Also, factories have to comply with laws protecting the environment. In all, the code covers eight aspects: child labor, prison/forced labor, working hours, wages and compensation, discrimination, working conditions, industrial safety, and EHS (environment, health, and security). ICTI delegates the monitoring work to six independent monitoring agencies which adopt monitoring approaches such as checking local laws, conducting on-site visit/inspection, interviewing workers, etc. Monitoring involves the inspection of original documents. Interviews of workers are conducted in a separate room with no factory representative present, and special efforts are made to protect confidentiality. The ICTI certification procedure involves an ―audit checklist‖ (in the Appendix II of the Code). A high-ranking official of a factory is required to state whether the factory has complied with items in the checklist by ticking in the ―Yes/No‖ box provided against each item and write how it was implemented in the ―Comment‖ box. If the factory has failed to comply with any of the items in the checklist, it must take measures and then apply to be re-examined, until the certifying agency approves. After that, it also needs to be inspected by the ICTI Certification Technical Consulting Committee and confirmed by the ICTI (Asia) Co. Ltd. before the factory can receive certification. Furthermore, factories need to undergo evaluation on a yearly basis. Certification will be revoked if factories fail any evaluation. Toy factories‘ subsidiary factories and subcontracting factories must also undergo evaluation. Though only a voluntary code, an increasingly large number of brand name companies require that their suppliers (of both components and finished goods) receive the ICTI certification. As per ICTI data, until February 2005, over 150 brand-name companies including Mattel, Hasbro, Leapfrog, Lego, and Toys ―R‖ Us, have signed and acknowledged the ICTI certification. These companies accounted for more than 50% of the global sales of toys. Source: Liu Songjie, “Mainland Toy Companies Facing the ICTI Dilemma,” www.chinalaborwatch.org, February 15, 2006.

29 30

31

ICTI promotes ethical and safe practices in toy factories and looks after the interests of toy manufacturers in 21 member countries. The CARE (Caring, Awareness, Responsible, and Ethical) Process is the ICTI program to promote ethical manufacturing in the form of fair labor treatment, as well as employee health and safety, in the toy industry supply chain, worldwide. (Source: www.icti-care.org) Liu Songjie, ―Mainland Toy Companies Facing the ICTI Dilemma,‖ www.chinalaborwatch.org, February 15, 2006.

483

International Business At the beginning of 2006, the Chinese government in an attempt to improve the quality of Chinese toys, imposed the China Compulsory Certification (CCC) 32 scheme on toy makers. Under the scheme, effective from June 1, 2007, only toys that met CCC standards would be allowed to be exported to foreign markets or sold in the domestic market. In April 2006, the Chinese toy industry suffered a blow when a EU report stated that 25% of the ‗problematic imported products‘ recognized by the Union‘s Rapid Alert System for Non-Food Products (RAPEX)33 were toy products, and 85% of these were toys imported from China. 34 The same month, China‘s General Administration of Quality Supervision, Inspection, and Quarantine and the EU‘s Health and Consumer Protection agency signed a draft guide for strengthening the Sino-EU Cooperative Action for Toy Safety. In the months preceding June 1, 2006, Children‘s Day in China, the Guangdong quality inspection authority checked toys produced in the province. The authority found that more than 45 percent of them did not meet state quality and safety standards. Despite lingering quality issues, even as late 2006, foreign buyers continued to express confidence in the Chinese toy industry. Michael Araten (Araten), President of K‘Nex Industries Inc.,35 said, ―There‘s a comfort level about China now — they have the investment and infrastructure, and meet U.S. and European safety standards.‖36 Tom Debrowski (Debrowski), Executive Vice President of Mattel, also held the same view. He said, ―There are other places in the world where you can get lower labor costs, but China has a very well-developed infrastructure, well educated engineers, excellent transport, and a business-friendly government.‖37

A Spate of Recalls In mid-December 2006, in what was to be the first in a series of major recalls, the CPSC in the US issued warnings against Chinese products like BRIO bell rattles, Lobby Christmas lights, Holiday Time stuffed Christmas beagles, and three other types of toys. The commission said that as the parts of these products could be easily separated, there was a ‗choking‘ risk for children. This apart, high lead 38 content, battery leakage, and inflammable parts were given as other reasons for the warnings. Several retail outlets in the US too issued warnings, and recalled the China-made toys. Around this period, the EU too issued safety warnings on a list of 15 made-in-China 32

33

34 35

36

37

38

The CCC is the compulsory Safety and Quality mark for many products sold in the Chinese market. The CCC Mark became effective on May 1, 2002. It is the result of the recent integration of China‘s two compulsory inspection systems (one to check contents of products for import and export, and the other for quality control) into a single procedure. (Source: www.ccc-mark.com) RAPEX is the EU‘s rapid alert system for all dangerous consumer products, with the exception of food, pharmaceutical, and medical devices. (Source: http://ec.europa.eu) April Mei, ―Playtime is Over for China‘s Toy Industry,” www.atimes.com, June 21, 2006. K‘Nex Industries Inc. was founded in 1992. It is a privately held company, with its headquarters and manufacturing facility located in Hatfield, Pennsylvania, USA. (Source: www.knex.com) Calum MacLeod, ―China‘s Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006. Calum MacLeod, ―China‘s Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006. Lead is a toxic metal that can cause adverse health effects if ingested.

484

Troubled Times for the Chinese Toy Industry toys including indoor Christmas lights, decorative string lights, fruit-shaped erasers, toy telescopes, toy air guns, and toy rifles. 39 In 2007, the Chinese toy industry faced a series of product recalls and import bans with importing countries raising numerous consumer safety issues. In fact, the year recorded a sharp rise in the number of recalls, with some analysts referring to 2007 as the ‗year of recalls‘40. In February 2007, the CPSC and Hasbro recalled about 985,000 China-made EasyBake Ovens41. The stated reason for the recall was that the door of the toy oven could trap children‘s fingers and cause burns. The CPSC said it had received 29 reports of children getting their hands or fingers caught in the oven door, including five reports of burns.42 In June 2007, the CPSC and RC2 Corporation43 announced a recall of 1.5 million Thomas & Friends wooden railway toys manufactured in China. The products were recalled because the surface paint on these products was found to contain lead. Under US regulations, children‘s products containing more than .06% of lead 44 were subject to recalls.45 In July 2007, the CPSC and Hasbro again recalled China-made Easy-Bake Ovens (about 1 million) citing the same reason as they had in February 2007.46 The CPSC said that it had received 249 fresh reports of children getting their hands or fingers caught in the oven‘s opening and getting burnt. Out of the 77 reported cases of burns, 16 cases were reported as second and third-degree burns. It said it had also received one report of a five-year-old girl suffering a serious burn that required amputating her fingers. In August 2007, Mattel recalled China-manufactured toys twice as the paint used on them contained more than the permissible levels of lead. The first recall of almost one million toys was on August 1, 2007, and the second on August 14, 2007. Nancy A. Nord, Acting Chairwoman, CPSC, said, ―These recalled toys have accessible lead in the paint, and parents should not hesitate in taking them away from children.‖47 Mattel also recalled magnetic toys manufactured in China as they had small but powerful magnets that could come loose and be swallowed by children. On September 4, 2007, Mattel again recalled 844,000 toys that contained excessive levels of lead paint. The successive recalls seemed to have seriously eroded the confidence of US companies in China-based manufacturers. Soon after the August recalls, Jim Walter, Senior Vice President for worldwide quality assurance, Mattel, reportedly visited Mattel‘s contract 39 40

41

42 43 44

45

46

47

―Rough Play for Guangdong‘s Toy Exports,‖ www.tdctrade.com, March 27, 2007. The recalls of 2007 on consumer goods manufactured in China also included pet food, toothpaste, lipstick, and certain types of seafood. Easy-Bake Ovens were launched by Kenner Products (later purchased by Hasbro) in 1963, allowing little girls to bake treats by themselves. ―Nearly 1 Million Hasbro Toy Ovens Recalled,‖ www.money.cnn.com, February 6, 2007. RC2 Corporation is a US-based designer, producer and marketer of toys and infant products. The US Consumer Product Safety Commission had banned paint containing more than 0.06% (600 ppm) lead for residential use in the United States in 1978. The US Government defines ―lead-based paint‖ as any ―paint, surface coating that contains lead equal to or exceeding one milligram per square centimeter or 0.5% by weight.‖ ―RC2 Corp. Recalls Various Thomas & Friends Wooden Railway Toys Due to Lead Poisoning Hazard,‖ www.cpsc.gov, June 13, 2007. ―New Easy-Bake Oven Recall Following Partial Finger Amputation; Consumers Urged to Return Toy Ovens,‖ www.cpsc.gov, July 19, 2007. ―Lead Paint Prompts Mattel to Recall 967,000 Toys,‖ www.nytimes.com, August 2, 2007.

485

International Business manufacturers in China to reemphasize the company‘s standards. He later described in an interview what he had conveyed to Mattel‘s contract manufacturers – ―The message was very clear. If you cannot do these things [meeting the quality standards], please let us know. No problem, but you won‘t be doing business with us.‖48 Although recalls of made in China toys were not a new development (Refer Exhibit V for recalls of China-made toys between 1988 and 2007 and the reasons), the fact that the year witnessed the recall of other made in China items such as pet food, toothpaste, etc. attracted more attention from the world press, thus denting the international image of Chinese manufacturing in general and toys in particular. Chinese officials, however, maintained that the majority of its toy exports were safe and of high quality. Some international toy industry officials came out in support of the Chinese toy industry, arguing that made in China toys were largely safe and that the issue was being blown up out of all proportion. ―There is something like 30,000 different toy products on sale at any one time. How many items have been recalled lately? Anyone can have something go awry. It‘s difficult to stay on top of everything,‖ said Ian J. Anderson, the Asia Pacific director at SGS, a consumer testing company that worked with Mattel and other toy makers in China. 49

Exhibit V

Toy Recalls between 1988 and 2007

48

49

Year

Total Number of recalls

Recalls of toys made in China

Percent of recalled toys that were made in China

1988

29

1

3

1989

52

4

8

1990

31

14

45

1991

31

8

26

1992

25

13

52

1993

20

8

40

1994

29

16

55

1995

35

19

54

1996

26

13

50

1997

22

9

41

1998

29

12

41

1999

20

4

20

2000

31

15

48

2001

23

12

52

2002

25

11

44

David Barboza and Louise Story, ―Mattel Issues New Recall of Toys Made in China,‖ www.nytimes.com, August 14, 2007. David Barboza and Louise Story, ―Mattel Issues New Recall of Toys Made in China,‖ www.nytimes.com, August 14, 2007.

486

Troubled Times for the Chinese Toy Industry 2003

15

10

67

2004

15

13

87

2005

19

16

84

2006

33

26

79

2007

40

38

95

Toy Recalls by Type of Flaws between 1988 and 2007 Year

Total number of recalls

Recalls due to Design Flaws

Recalls due to Mfg. Flaws

1988

29

25

2

1989

52

42

2

1990

31

25

3

1991

31

29

1

1992

25

16

0

1993

20

15

1

1994

29

21

4

1995

35

32

0

1996

26

15

5

1997

22

17

1

1998

29

23

1

1999

20

15

2

2000

31

25

2

2001

23

15

4

2002

25

20

3

2003

15

14

0

2004

15

8

4

2005

19

14

3

2006

33

23

6

2007

40

26

10

Source: Hari Bapuji and Paul W. Beamish, “Toy Recalls - Is China Really the Problem?” www.asiapacific.ca, September, 2007. In what could be seen as a positive development for the Chinese toy industry, on September 21, 2007, the Mattel management apologized to Chinese officials, toy manufacturers and the country as a whole for the loss of image and said that the company would take the blame. Debrowski said that the majority of these toys had been recalled because of loose magnets (around 17.4 million units), which were the result of design flaws. He apologized personally to Li Changjiang, Director of the State Administration of Quality Supervision, Inspection and Quarantine, China. 487

International Business Debrowski said, ―Mattel takes full responsibility for those recalls [of magnetic toys] and I would like to apologize personally to you, the Chinese people, and all of the customers who received toys that have been manufactured.‖50 Mattel‘s press release stated, ―Mattel does not require Chinese manufacturers to be responsible for the magnets-related recalls due to design problems. The magnet-related recalls do not involve lead paint or manufacturing failures by Mattel or its vendors, including vendors in China.‖51 However, regarding the lead related recalls, Mattel stated they were the result of a minority of manufacturers [in China] not following the company‘s guidelines; though even in the case of lead-related recalls, the company said that they were ―overly inclusive.‖52 Mattel‘s follow-up inspections also seem to have confirmed that some of the recalled toys complied with US standards. However, after repeated recalls of China-made toys, more consumers in the US were reportedly looking for alternatives to Chinese toys. Sales of US-made toys apparently increased and US-based manufacturers found it difficult to meet the sudden increase in demand. Some of them were forced to hire more people and lease more warehouses to stock their produce. ―Every time there‘d be a new recall this summer, we‘d get a huge new order,‖ said Deborah Evanoff, owner of Arrowcopter Inc., a private toy manufacturing company based in the US. 53 Earlier US producers had been unable to compete against low-cost Chinese toys, but now they were able to successfully lure customers using ‗made in USA‘ labels. Some of these manufacturers brought photos of their manufacturing facilities to toy fairs, and placed advertisements in industry publications to drive home the point that their quality standards were much higher than those of Chinese manufacturers. According to some analysts, the increase in the demand for US-made toys was unlikely to last. They were of the view that claims by US-based toy manufacturers of superior quality were not entirely true as the quality of US-made toys varied from factory to factory and some Chinese toys were of higher quality and yet cheaper. In 2007, the EU, the second largest export market for the Chinese toy industry, introduced new environmental safety rules including those that banned the sale of toys containing over 1% of phthalate54 and five other chemicals. As phthalates were widely used in the manufacture of plastic toys in China, the new rules were expected to significantly impact the Chinese toy industry.

Other Issues Meanwhile, the Chinese toy industry was facing problems on the home front as well. With labor costs in China increasing rapidly, the industry was beginning to lose competitiveness in the export market. A survey by the Guangdong Toy Association indicated that Vietnam and Eastern Europe with their low prices posed a threat to Chinese toy exports. Bryan Ellis, Chairman of the Toy Industries of Europe, also held the same view. He said, ―Production is going to develop elsewhere, in Thailand, Indonesia, India, and Eastern 50

51 52

53

54

―Mattel Apologizes to China, Pledging to Take Responsibility for Defective Toys,‖ http://news.xinhuanet.com, September 21, 2007. ―Media Statement – September 21, 2007,‖ www.shareholder.com. ―Mattel Apologizes to China, Pledging to Take Responsibility for Defective Toys,‖ http://news.xinhuanet.com, September 21, 2007. Rachel Konrad, ―Chinese Toy Recalls Benefit U.S. Firms,‖ www.courierpostonline.com, October 15, 2007. Phthalates or phthalate esters are a group of chemical compounds that are mainly used as additives to plastics to increase their flexibility. Some researchers believe that phthalates pose no health risks while others believe that significant exposure to some kinds of phthalates cause allergies, asthma, cancer, etc.

488

Troubled Times for the Chinese Toy Industry Europe.‖55 The appreciation of the yuan56 against the dollar, though gradual, was further reducing the already thin margins of Chinese toy manufacturers. In an attempt to cut costs, some toy companies shifted operations to lower-cost areas within China. ―The [stringent labor] standards and rising labor costs are forcing an ‗exodus of downstream manufacturing‘ out of Shenzhen57 to second border locations and even the hinterland of China‖ said Apo Leung, Director of the Asia Monitor Resource Center (AMRC)58 in Hong Kong.59 The Chinese Ministry of Commerce further predicted that the toy industry would restructure, with larger and more organized companies eventually acquiring smaller and sub-standard factories. A major challenge for the Chinese toy industry, despite its dominance in the global market, was that it lacked brand power. The Chinese companies acted merely as original equipment manufacturers (OEMs) who manufactured products for foreign companies. These products were then sold under foreign brands. In addition, Chinese toy factories were weak in market knowledge and product promotion. Apart from marketing, design was another weak area. There was moreover a severe shortage of international quality designers. ―China needs lots of talented toy designers to turn itself from a big toy maker into a powerful one,‖ 60 said Liang Mei, secretary-general of the China Toy Association. Though China had established some design institutes, the demand for designers often outstripped supply. ―I really don‘t know how to distribute this small number of graduates for such a big demand,‖ said Jin Guifang, director of the design institute at Tianjin Science and Technology University. Another challenge was technology. Though many China-made traditional toy products such as stuffed toys and dolls had taken a substantial share of markets in the EU as well as in the US, Chinese toymakers were unable take advantage of the growing demand for high-tech toys including electronic games and educational toys (Refer Exhibit VI for trends in the toy industry). This was because the business model of a large majority of China-based toy companies was one of cheap labor and a low level of technology. ―Most toy factories are small or middle-sized, with limited staff and budgets for toy innovation. Besides, developing new products requires a large investment and long-term payback,‖ said Mei Meng, general manager of the Nantong Eurofield Art‘s Toy Company. Among toys China exported to the EU in 2006, more than 80% were traditional toys; high-tech toys were less than 5%. By competing on price, the Chinese toy industry also faced the danger of losing orders to other emerging manufacturing hubs. However, the authorities were aware of the downside to following a ‗processing model‘. Shi Xiaoguang, president of the China Toy Association, said, ―The toy processing model is highly risky for the Chinese toy industry. About 60 to 70 per cent of exported toys are produced in Guangdong Province (in South China). If they lose overseas orders, they could lose their whole market.‖61 55

56 57 58

59

60

61

―China‘s Lockhold on Global Toy Industry Set to Ease,‖ www.taipeitimes.com, February 12, 2006. As on October 26, 2007, US$ 1 was equal to 7.4976 yuan. Shenzhen is a city in the Guangdong province in southern China. The Asia Monitor Resource Center (AMRC) was founded in 1976. It is an independent nongovernment organization which focuses on Asian labor concerns. (Source: www.amrc.org.hk) Calum MacLeod, ―China‘s Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006. ―Barbie Doll Poses a Challenge to Mammoth Chinese Toy Industry,‖ http://english.peopledaily.com.cn, January 06, 2003. ―Toying with the Future,‖ http://app1.chinadaily.com.cn, 2002.

489

International Business

Exhibit VI Trends in the Toy Industry as of 2007 Continued popularity of smart toys: Toys with electronics and new technology integrated into them continue to see increased demand. Some companies have recreated their very successful toys with new electronic features. For example, wooden trains by BRIO are now equipped with modern infrared remote control and electronic sounds. Some newly introduced dolls and toy robots communicate interactively with other toys in the same product line, such as Hasbro‘s Furreal Friends. Sustained interest in licensing: Licensed products continue to be successful in the market. In the case of video games, companies are now constantly inventing new characters even as sales of games featuring licensed characters remain satisfactory. Strong and clear focus on educational, creative, and developmental toys: With more parents looking at toys as aids to develop their child‘s listening, creative, and inter-personal skills, the market for educational toys is growing in size. Hasbro has launched a product called T.J. Bearytales, an animated bear that encourages children to read with it. Another company Toy Quest has video books, which encourage families to learn together through reading and sharing stories. Trend of shorter product life cycles and a wider variety of novelty designs: The product life cycle of toys has shortened over the past decade. In order to achieve higher sales for products in their maturity phase, companies are using fancy designs and gimmicks. Even for classic toys such as LEGO construction sets and Barbie dolls, new features are regularly being added or improved to spur new sales. Wide interest in multi-media and web-compatible toys: The rising popularity of the Internet is making companies assimilate real and virtual toys together. New toys that are capable of linking with the Internet are being introduced. For example, Bandai, a large Japan-based toy maker, has introduced toy robots that allow buyers to play games with animated versions of their robots over the Internet. Youth electronics: Youth electronic toys are kid-size versions of adult products. As most parents are not very keen on buying their younger children expensive electronic products, the popularity of youth electronic toys is growing. Kid-sized and affordably priced MP3 players and digital cameras are some examples of youth electronics. Sports-like toys: As concerns about health and child obesity rise, sales of sportslike toys such as aquatic toys and equipment, are growing. Growing demand for collectibles: Collectors‘ articles have a loyal clientele even among adults, particularly in the US, Germany, and Japan. The most popular collectibles are soft toys and dolls, model railways, and parlor games. In response to the growing demand, more and more companies are introducing two lines for the same product, one for kids and the other for collectors. For example, besides its children‘s line, Mattel sells collector‘s lines of Barbie dolls, Matchbox die-cast cars, and the Hot Wheels racing system. Adapted from “Profiles of Major Hong Kong Manufacturing Industries,” www.tdctrade.com. 490

Troubled Times for the Chinese Toy Industry

Outlook In an attempt to improve the quality of toys, the Chinese government sponsored a twoday training session on October 11 and 12, 2007, on quality control for more than 1,000 people from the Chinese toy industry. At these sessions, Chinese government officials and executives from multinational companies lectured on European and US quality and safety standards, China‘s toy licensing system, toy certificate systems, export test regulations, etc. Participants were also taught how to deal with high lead levels or design flaws in their products. Officials from the Ministry of Commerce advised toy companies to specify their obligations with respect to quality in the contracts so that they could protect themselves from potential losses. 62 According to Liang Mei, Secretary General of the China Toy Association63, the recalls presented ―both a challenge and an opportunity for the Chinese toy industry.‖ 64 In late October 2007, the provincial government of Guangdong announced that it had suspended or revoked the export licenses of 764 toy factories ―because of various quality problems‖. Another 690 toy factories were ordered to renovate their plants and improve product quality. According to sources, the provincial government had, by late October 2007, finished inspecting 85 percent of Guangdong‘s toy factories and expected to complete the process soon. Though the majority view within China was that the toy recalls, especially those of toys containing high levels of lead, were due to lapses on the part of Chinese toy makers, there were some who believed that the recalls were part of a conspiracy to sully the image of China‘s toy industry. China‘s product safety chief, Li Changjiang, was of the view that some importing countries had orchestrated the recalls so as to protect their domestic toy industries and slow down China‘s toy exports. On customer response to Chinese toys post-recalls, Ron Boire, president of Toys ―R‖ Us Inc.‘s North American division, said, ―Consumers are still confused.‖ However, he added that he did not see ―a sea change.‖65 Chris Byrne, a New York-based toy consultant,66 talking about toy sales in the Christmas season, said, ―It‘s a blip. In the fourth quarter, a lot of purchases are made based on supplications to the North Pole and the phrase ‗country of origin‘ isn‘t in the vocabulary of children writing to Santa.‖ In late 2007, a weak dollar and US economy that appeared to be slipping into recession seemed to have impacted exports from China, especially of toys and tiles. ―The dollar has depreciated so much that American goods are more competitive. On the other hand, the import decline tells you about what retailers are thinking about the holiday shopping season. They‘ve cut back orders,‖ said Sung Won Sohn, chief executive of Hanmi Bank in Los Angeles. 67 In an attempt to encourage toy sales, WalMart, US‘s largest retailer of toys, slashed prices by 10 percent to 50 percent in October, several weeks ahead of the usual shopping season. However, analysts feared that sales in the all-important Christmas season would be disappointing. 62

63

64

65

66

67

―China Gives Toy Industry Crash Course in Quality,‖ www.chinapost.com, tw, October 15, 2007. The China Toy Association, founded in 1986, is an industry organization with more than 1,000 members. It acts as an interface between the toy industry and the Chinese government. (Source: http://www.shanghai-toy-expo.com) Tim Johnson, ―Chinese Toy Factories Retool after Recalls,‖ www.mcclatchydc.com, October 23, 2007. Anne D‘innocenzio, ―Despite Recalls, Chinese Toys Still Sell,‖ www.theledger.com, October 2, 2007. Rachel Konrad, ―Chinese Toy Recalls Benefit U.S. Firms,‖ www.courierpostonline.com, October 15, 2007. ―Cargo Decline Portends Consumer Weakness,‖ http://globaleconomicanalysis.blogspot.com, October 10, 2007.

491

International Business Meanwhile, the price of crude oil crossed an all-time high of $93 a barrel. This was expected to increase the cost of plastics, of which the majority of toys were made, creating further problems for Chinese toy makers. Despite the problems, some toy industry experts were of the view that the 2007 recalls would not affect future demand for Chinese toys. ―Next year at this time – when an awesome new battery-operated toy comes out and it‘s made in China will people say no way? It just depends on the mood of the consumer,‖ said Mary Jo Meister, sales manager for Lauri Toys Inc., a US-based toy manufacturing company. While it was anyone‘s guess whether Chinese toy exports would contract or not, China-based toy makers were increasingly hopeful of the booming domestic market. In 2006, Toys ―R‖ Us opened its first store in China signaling the huge potential of the domestic toy market in China. Frank Clarke of Strategy XXI Ltd., 68 the communications agency of Toy Industry Association Inc. (TIA)69 in New York, said. ―All our members are looking at China as a retail opportunity, not just an export base. In the U.S., there are 50 million children in the 0-8 age group. China has 300 million in that age group.‖ 70 According to some estimates, China‘s toy market would grow 40 percent annually in the next few years to be worth $12.5 billion by 2010.

68

69

70

Strategy XXI Ltd. is a member of the Kreab Group, a communications consultancy. Strategy XXI solves public relations and public affairs problems for corporations, governments, trade associations, and non-governmental organizations. (Source: www.strategy-xxi.com) Toy Industry Association Inc. (TIA) is a non-profit trade association for producers and importers of toys and youth entertainment products sold in North America. (Source: www.toyassociation.org) Calum MacLeod, ―China‘s Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006.

492

Troubled Times for the Chinese Toy Industry

References and Suggested Readings: 1.

Tim Johnson, ―Chinese Toy Factories Retool after Recalls,‖ www.mcclatchydc.com, October 23, 2007.

2.

Rachel Konrad, ―Chinese Toy Recalls www.courierpostonline.com, October 15, 2007.

3.

―China Gives Toy Industry Crash Course in Quality,‖ www.chinapost.com.tw, October 15, 2007.

4.

Anne D‘innocenzio, ―Despite Recalls, Chinese Toys Still Sell,‖ www.theledger.com, October 2, 2007.

5.

―Media Statement-September 21, 2007,‖ www.shareholder.com.

6.

―Mattel Apologizes to China, Pledging to Take Responsibility for Defective Toys,‖ http://news.xinhuanet.com, September 21, 2007.

7.

Kelly Marshall and Rob Kelley, ―Mattel Announces Third Toy Recall,‖ www.money. cnn.com, September 5, 2007.

8.

Hari Bapuji and Paul W. Beamish, ―Toy Recalls www.asiapacific.ca, September, 2007.

9.

―Consumers: Mattel Expands Recall of Chinese Toys,‖ http://europa.eu. August 16, 2007.

10.

Anne D‘Innocenzio, ―Toy Industry Challenged by Disposal Plan,‖ www.boston.com, August 15, 2007.

11.

David Barboza and Louise Story, ―Mattel Issues New Recall of Toys Made in China,‖ www.nytimes.com, August 14, 2007.

12.

―Mattel Issues New Massive China Toy Recall,‖ www.msnbc.msn.com, August 14, 2007

13.

―Lead Paint Prompts Mattel to Recall 967,000 Toys,‖ www.nytimes.com, August2, 2007.

14.

―New Easy-Bake Oven Recall Following Partial Finger Amputation; Consumers Urged to Return Toy Ovens,‖ www.cpsc.gov, July 19, 2007.

15.

―RC2 Corp. Recalls Various Thomas & Friends Wooden Railway Toys due to Lead Poisoning Hazard,‖ www.cpsc.gov, June 13, 2007.

16.

―Rough Play for Guangdong‘s Toy Exports,‖ www.tdctrade.com, March 27, 2007.

17.

Sonia Kolesnikov-Jessop, ―A Trip into China‘s Past, through its Toys,‖ www.iht.com, March 27, 2007.

18.

―Nearly 1 Million Hasbro Toy Ovens Recalled,‘ www.money.cnn.com, February 6, 2007.

19.

Calum MacLeod, ―China's Toy Industry Feels Growing Pains,‖ www.usatoday.com, December 21, 2006.

20.

April Mei, ―Playtime is over for China‘s Toy Industry,‖ www.atimes.com, June 21, 2006.

21.

―Toy Industry Gets Improved Regulation,‖ http://english.peopledaily.com.cn, April 1, 2006.

22.

Liu Songjie, ―Mainland Toy Companies www.chinalaborwatch. org, February 15, 2006.

23.

―China‘s Lockhold on Global Toy Industry Set to ease,‖ www.taipeitimes.com, February 12, 2006.

Benefit

U.S.

Firms,‖

Is China Really the Problem?‖

Facing

the

ICTI

Dilemma,‖

493

International Business 24.

―Tin Toys‘ Tradition Lives On,‖ www.tinmantintoys.com.

25.

―Conquering China‘s Consumer Market – Example: Toy Industry,‖ www.fiduciachina.com.

26.

Keith Bradsher, ―Wages Up in China as Young Workers Grow Scarce,‖ www.nytimes.com, August 29, 2007.

27.

www.toyassociation.org.

28.

www.strategy-xxi.com.

29.

www.chinalaborwatch.org.

30.

www.amrc.org.hk.

31.

www.cpsc.org.

32.

www.icti-care.org.

33.

http://ec.europa.eu.

34.

www.ccc-mark.com.

494

The European Union and Immigration from New Member Countries The case focuses on the issue of immigration from the new member states who joined the EU in 2004 into the older member states of the European Union. It traces the process of European integration from the period after the Second World War, and the formation of the European Union and its subsequent expansions. The case further discusses the different approaches adopted by the older member states of the EU to deal with the expected flood of job seekers from the newly independent states from Central and Eastern Europe, which joined the EU after the disintegration of the Soviet Union. While Ireland, the United Kingdom and Sweden were fairly open to immigrants from these countries, the other EU members imposed many restrictions on the movement of workers from the new member states. The case then compares the impact of immigration on the three EU member states that chose to allow immigrants in, with the countries which followed a more restrictive approach. It ends by examining the issue of the expected eventual decrease in the EU's population in the coming years/decades and the need for these countries to supplement their indigenous labor markets with immigrants.

The European Union and Immigration from New Member Countries “The [European] Union has today set itself a new strategic goal for the next decade: to become the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion.”1 Presidency Conclusions, Lisbon European Council, in March 2000 “The „old‟ EU owes them [the new members] a welcome. In practical terms, this means that West European politicians should stop exploiting populist resentment of low-wage competition. They should explain to their voters that economic reforms would be necessary even in the absence of enlargement and that, on the whole, the addition of ten new members has been good for the EU economy.” 2 Katinka Barysch, Chief Economist, Centre for European Reform, 3 in 2005.

Introduction On March 09, 2006, the Spanish Prime Minister, Jose Luis Rodriguez Zapatero (Zapatero), and his Polish counterpart, Kazimierz Marcinkiewicz, announced at a joint press conference that from May 01, 2006, Spain would open up its labor market to workers from Poland and the other seven countries from Central and East Europe (CEE) which had joined the European Union (EU) on May 01, 2004 4. The announcement was not unexpected as it had been widely anticipated that Spain would favor opening up its labor market to the new members 5 of the EU. On February 28, 2006, Portugal had also indicated that it would open up its labor market to the new members from the CEE. Before that, on February 13, 2006, Finland‘s Labor Ministry had proposed that restrictions on labor movement from the new EU member countries be lifted. At the time of the 2004 enlargement, the EU had allowed its existing members (the old member states) to impose restrictions on the free movement of labor from the new member states for a transition period extendable up to 2011. Twelve out of the fifteen countries opted for labor restrictions, fearing that there would be a large-scale influx of immigrants from the new member countries chasing jobs and driving down wage rates. Only the UK, Ireland, and Sweden decided to allow the new member countries access to their labor markets (Refer to Exhibit I for a map of the European Union in 2005).

1 2 3

4

5

www.union-network.org/uniibits.nsf www.cer.org.uk/pdf/essay_eastvswest_jan06.pdf The Centre for European Reform is a London-based think tank devoted to improving the quality of the debate on the future of the European Union The EU was enlarged in May 2004 with ten new members. They were Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. While the nationals of Cyprus and Malta were given the freedom to access the labor markets within the EU, others were severely restricted. Here ‗new‘ members would mean the eight new members from the CEE; i.e., all the new members of 2004, except for Cyprus and Malta. The ‗old‘ members would mean the 15 EU member states before the 2004 enlargement.

522

The European Union and Immigration from New Member Countries

Exhibit I Map of European Union in 2005

Source: www.ezilon.com/ eu_map_europe.jpg. A year later, these three economies reported that they had not experienced any upheavals or disruptions in their labor markets. Instead, they claimed, the immigrants had helped fuel their economic growth by filling in the gaps in their labor markets – be it in construction, health & hospitality, or in other areas, while making few claims on the welfare system or public services.

Background Human migration, or the movement of people from one place to another, is a phenomenon that is as old as mankind itself. Indeed, it is believed that humans first appeared in Africa, and subsequently spread out toward the Middle East, Europe, Asia, Australia, and finally to the Americas. Even after the advent and growth of 523

International Business human settlements, people have continued to migrate from one place to another, shaping the growth of civilizations and the progress of human history. For example, the migration of the Huns, the Goths, and other tribes during and after the fall of the Roman Empire changed the demographic and cultural landscape of Europe. In the 17th century, the movement of English religious groups to the New World, seeking a place where they could practice their religion freely, laid the foundation of the present day United States. In modern times, after the advent of the nation states and the consolidation of nationalities, the migration of people from one nation to another came to be regulated by the national governments. The inflow of migration into a country became ‗immigration‘ while the outflow came to be known as ‗emigration.‘ Emigration had a profound influence on Europe in the 19th century and the early 20th century, when hundreds of thousands of poor families left Western Europe for the United States, Canada, Brazil, Argentina, and Australia. 6 Why do people move from one place to another? The reasons could be to escape war, famines, droughts, disease, political and religious persecution, and poverty. Or they may migrate for more positive reasons to seek adventure, better employment and business opportunities, higher incomes, or better healthcare facilities, or to reunite with their family members. In the late 20th century, while the development of transport and communications turned the world into a global village, increasing restrictions by national governments on immigration made it very difficult for people to move from one country to another. The arrival of new immigrants into a country was often seen by its citizens as diluting their country‘s national, ethnic, or religious character. Immigrants were also often viewed as job-chasers who drove down wages and salaries. However, there were also others who welcomed the immigrants, seeing them as hard-working people contributing to the development of the host country‘s cultural and economic life. Immigrants have thus been welcomed and despised at the same time by different sections of their host country.

The European Community (EC) After the end of the Second World War, Europe was divided into two opposing blocs – the US-led free-market oriented Western Europe and the Soviet Union-led socialist Central and East Europe. The West European countries, devastated by the war, realized that economic protectionism and chauvinistic nationalism were factors that could lead to war among various nations. Jean Monnet, considered by many as the architect of the European Union, felt that if Europe was to avoid the scourge of destructive wars, the European states must come together. He declared, ―There will be no peace in Europe, if the states are reconstituted on the basis of national sovereignty...The European states must constitute themselves into a federation.‖ 7 Accordingly, the European Coal and Steel Community (ECSC) was founded in 1951 by Belgium, the Netherlands, Luxembourg, France, Italy, and West Germany, in order to pool their all-important steel and coal resources. The process of integration was further strengthened with the signing of the Treaty of Rome in 1957 establishing the European Economic Community (EEC), which came into effect on January 1, 1958. 6 7

―Emigration,‖ http://en.wikipedia.org/wiki/Emigration Jeremy N. Smith, ―The Father of Europe,‖ http://www.worldtrademag.com/CDA/Articles/Column/ 0489bc5ec5499010VgnVCM100000f932a8c0__

524

The European Union and Immigration from New Member Countries The EEC was established with the aim of creating a Customs Union (CU) among the six member states based on the four fundamental freedoms: the freedoms of movement for goods, services, capital, and people. The CU was finally established in 1968. The EEC was later renamed the European Community (EC).

Enlargement of the EC and the Creation of the European Union The success of the EC in stimulating trade, growth, and development among the member states prompted Britain, Denmark, and Ireland to apply for the EC membership in 1961.8 A series of negotiations followed in which the EC members and the prospective members evaluated a number of proposals and counter-proposals. Finally, Britain joined the EC along with Denmark and Ireland in 1973. This was the first enlargement of the EC. In 1981, six years after its application for membership, Greece acceded to the EC. When Spain and Portugal applied for EC membership in 1977, the existing EC members were forced to face the problem of immigration associated with the enlargement of the EC. Although Portugal and Spain eventually gained membership in 1986, the people of these two countries were restricted for a period of 10 years from moving freely within the EU in search of work. One of the reasons for these restrictions was the fear that there would be a large influx of Portuguese and Spaniards looking for work into the more prosperous countries of the EC if the borders of these countries were opened up fully. 9 In 1993, the Maastricht treaty, signed a year earlier, modified the Treaty of Rome and established the European Union (EU). The EC became an integral part of the new EU. The EU was enlarged in 1995 to include Austria, Finland, and Sweden.

The Collapse of the Socialist BLOC and the Copenhagen Criteria Meanwhile, the collapse of the socialist bloc in Central and Eastern Europe in 198990 released many countries from the control of the Soviet Union. During this period, Poland, Hungary, Bulgaria, Romania, and Czechoslovakia became free of Soviet control. In 1991, the disintegration of the Soviet Union led to the emergence of several new states on the international stage -- the Russian Federation, Lithuania, Latvia, Estonia, Ukraine, Belarus, Moldova, Georgia, Armenia, Azerbaijan, Kazakhstan, Kyrgyzstan, Uzbekistan, Tajikistan, and Turkmenistan. Having been severely constrained for decades by centralized planning, many of these newly independent states looked eagerly toward the EC for the development of their economies. It also provided an opportunity for the EC to further the process of European integration. Therefore, as initial steps to future integration, the EC concluded Europe Agreements with Hungary and Poland in December 1991, Romania, Bulgaria, the Czech Republic, and Slovakia in February 1995, Estonia, Latvia and Lithuania in February 1998, and Slovenia in February 1999. The aim of these agreements was to liberalize trade between these countries and the EU.10

8

9

10

Norway also applied for the EC membership. But in a referendum held in 1972, its people rejected the government‘s decision to join the EC. More than two decades later in a referendum held in 1994, the Norwegian electorate again voted against joining the EC. Antonio Vitorino, ―The Challenges of Global Migration: An EU View,‖ http://www.carnegiecouncil.org/ viewMedia.php/prmID/4985 ―The Enlargement of the European Union,‖ http://www.auswaertigesamt.de/www/en/eu_politik/ vertiefung/erweiterung_html

525

International Business In June 1993, the EU formulated the Copenhagen Criteria that defined the eligibility for EU membership. These criteria required that the candidate countries have stable institutions to guarantee democracy, the rule of law, human rights, and the protection of minorities (the political criterion); a functioning market economy and the capacity to cope with competitive pressures and market forces within the EU (the economic criterion), and the ability to take on all the obligations of membership, i.e. the ability to conform to the entire body of EU law (the so-called ‗acquis communautaire‘), and adhere to the aims of political, economic, and monetary union (the acquis criterion).11

The Accession of New Members Following the formulation of the Copenhagen Criteria, many of the CEE countries applied for EU membership. Hungary applied in March 1994, Poland in April 1994, Romania and Slovakia in June 1995, Latvia in October 1995, Estonia in November 1995, Lithuania and Bulgaria in December 1995, the Czech Republic in January 1996, and Slovenia in June 1996. Turkey had already announced its desire to become a member in April 1987. Cyprus and Malta had done likewise in July 1990 12. The applicants had to go through painful transitions of their polities, economies, and societies so as to conform to the eligibility criteria. It was not easy for these countries, which for decades had been planned socialist economies with strict policing and almost no concern for human rights, to undergo the democratization process and move toward becoming market-oriented economies. The prospective candidates were to incorporate all the existing laws of the EU into their domestic legal framework and work for their active application. The EU continuously monitored the progress of the candidate countries with respect to the Copenhagen Criteria to determine their eligibility. In 1997, the EU decided to open accession negotiations with Cyprus, Hungary, Poland, Estonia, the Czech Republic, and Slovenia. Romania, Slovakia, Latvia, Lithuania, Bulgaria, and Malta were added to the list in 1999. In December 2002, leaving Bulgaria and Romania aside for further negotiations, the EU concluded access negotiations with the remaining ten candidates. The Treaty of Accession with these ten countries was signed in Athens on April 16, 2003, and the treaty came into effect on May 01, 2004. Bulgaria and Romania were slated to accede to the EU in 2007. Thus, ten new countries became members of the EU on May 01, 2004. These countries, when compared to the old members, were very small in terms of GDP, but quite large in terms of population and labor force. While the new member states‘ combined GDP was 5% of the GDP of the old EU, their labor force amounted to 25% of that of the latter. Moreover, there were huge differences in wage rates between the old and new members. The new members were erstwhile socialist countries which gave their citizens full employment at the expense of economic health and competitiveness. Dismantling of these economic systems in the early 1990s led to huge lay-offs and high levels of unemployment in these countries. With accession, the new member countries gained the right to participate on an equal basis in the institutions and committees of the EU. The market for their goods and services expanded and the free movement of goods, introduced as per the Europe Agreements of the early 1990s, was to be complete. Membership of the EU also provided full freedom of movement for persons from one country to another within the EU. Citizens of both the old and new members could travel freely anywhere in the

11

12

―The Enlargement of the European Union,‖ amt.de/www/en/eu_politik/ vertiefung/erweiterung_html The Enlargement of the European Union,‖ amt.de/www/en/eu_politik/ vertiefung/erweiterung_html

526

http://www.auswaertigeshttp://www.auswaertiges-

The European Union and Immigration from New Member Countries enlarged EU.13 However, for a transition period of seven years, the old members were allowed to impose restrictions on the movement of labor from the new members, if they so wished. This provision was made out of fear that people from some of the new member states would swamp the labor markets of the old members. However, the citizens of Cyprus and Malta did not face this restriction. Only three of the old members opted not to apply these restrictions on the free movement of workers. The UK, Ireland, and Sweden opened their labor markets to people from the new member states. However, there were fears even in these countries, especially in the UK, that the workers from the new member states would chase local jobs and strain the economy by seeking welfare benefits.

The Demographic and Economic Profile of the EU To understand the issue of migration in the EU, it is essential to understand certain important characteristics of the demography and economy of the EU member states. These issues were interlinked, and, individually and in combination, had a significant impact on the growth rates in these countries. The old EU economies, especially, had been struggling with low growth rates for many years. Between 2000 and 2004, the growth rates of GDP of the old EU countries had ranged between 1.0% and 3.8% (Refer to Exhibit II for growth rates in the EU between 2000 and 2004). Exhibit II

Real GDP Growth Rates in the Old and New Member States in % 2000

2001

2002

2003

2004

Old EU – 15

3.8

1.8

1.1

1.0

2.2

New EU – 10

4.1

2.4

2.4

3.8

5.1

Source: Katinka Barysch, “East versus West?The European economic and social model after enlargement,” www.cer.org.uk/pdf/essay_social_model_barysch_oct05.pdf. The old EU economies had also been facing very low employment rates 14 – 64% as against the EU norm of 70%. Paradoxically, in spite of high wage rates, there were also many gaps in the labor market that were unfilled because of the unwillingness of the domestic labor force to take up certain jobs (Refer to Exhibit for III hourly labor costs in the EU). At the same time, they also had high unemployment rates – 8.5% (Refer to Exhibit IV for unemployment rates in select old EU member countries). This paradox of high unemployment and huge gaps in the labor market was explained by the welfare nature of these economies, and their high and rigid wage rates. Many of the EU countries were welfare states, where the governments provided generous unemployment benefits and allowances to workers, to help them get through periods of unemployment, and find jobs better suited to their abilities and aptitudes. These allowances, in some instances, had the effect of people deliberately choosing to remain unemployed. The allowances also made people reluctant to move in search of 13

14

There were also other transition measures such as the precedence of national rules over the free movement of capital with regard to the purchase of agricultural and forest land in all the new member states (again Cyprus and Malta along with Slovenia were excluded) Employment rate refers to the percentage of the labor force that is employed, while unemployment rate is defined as the percentage of the total labor force that is unemployed but actively seeking employment and willing to work.

527

International Business employment. As a result, in many of these these countries, high unemployment rates coexisted with a large number of unfulfilled job vacancies. These unfulfilled job vacancies were partly responsible for the slow growth rates of these economies (Refer to Exhibit V for economic indicators of the EU).

Exhibit III Hourly Labor Costs in Industry and Services in 2000 & Labor Productivity in the EU in 2002 Hourly Labor Cost in Euros

Labor Productivity in 1000 Euros

Sweden

28.56

64.4

Denmark

27.10

Germany

Hourly Labor Cost

Labor Productivity

Cyprus

10.74

NA

68.0

Slovenia

8.98

25.4

26.34

56.9

Portugal

8.13

NA

Luxembourg

24.61

90.5

Poland

4.48

16.9

France

24.42

65.6

Czech Rep.

3.90

17.3

UK

23.85

58.1

Hungary

3.83

17.0

Austria

23.60

63.1

Slovakia

3.06

13.3

Netherlands

22.99

55.6

Estonia

3.03

12.0

Finland

22.13

64.3

Lithuania

2.71

12.9

Italy

18.99

56.5

Latvia

2.42

10.7

Ireland

17.31

81.6

Old average

22.10

57.6

Spain

14.22

45.9

New average

4.20

16.7

Greece

11.62

39.3

Combined

19.09

51.9

Country

Country

NA – Not Available. Countries in bold are new EU members. No data were available for Belgium and Malta. * French labor productivity data is of 2001. Source: Eurostat; printed in The Wall Street Journal 16–18 April 2004.

Exhibit IV Unemployment Rates in Select Old EU Members

528

Country

2003

2004

2005

Austria

4.3

4.9

5.2

Finland

9.0

8.9

8.3

France

9.5

9.6

9.5

The European Union and Immigration from New Member Countries

Germany

9.1

9.5

9.5

Ireland

4.7

4.5

4.3

Italy

8.4

8.0

7.7

Spain

11.1

10.6

9.2

Sweden

5.6

6.4

United Kingdom

4.9

4.7

NA 4.7

NA = Not Available. Source: OECD

Exhibit V Economic Indicators of the EU and its Member States GDP % of EU (2004)

GDP per capita in PPP $ (USD) (2005)

Public Debt % of GDP

12,690.6

100.0%

26,900

63.8

-2.6

2.0

Germany

2,714.4

21.4%

28,988

66.0

-3.7

1.8

United Kingdom

2,140.9

16.9%

28,938

41.6

-3.2

2.0

France

2,002.6

15.8%

27,738

65.6

-3.7

1.8

Italy

1,672.3

13.2%

27,984

105.8

-3.0

2.2

Spain

991.4

7.8%

23,627

48.9

-0.3

3.2

Netherlands

577.3

4.5%

29,332

-2.5

1.5

Belgium

349.8

2.8%

29,707

95.6

-0.1

2.7

Sweden

346.4

2.7%

28,205

51.2

-1.4

0.8

Austria

290.1

2.3%

31,254

65.2

-1.3

2.0

Denmark

243.0

1.9%

33,089

42.7

-2.8

1.7

Poland

241.8

1.9%

12,452

43.6

-4.8

1.4

Greece

203.4

1.6%

22,000

110.5

-6.1

3.2

Finland

186.6

1.5%

29,305

43.6

-2.1

1.0

Ireland

183.6

1.4%

37,663

29.9

-1.3

1.9

Portugal

168.3

1.3%

18,503

61.9

-2.9

0.6

Czech Republic

107.0

0.8%

18,370

37.4

-3.0

1.3

99.7

0.8%

15,546

57.6

-4.5

3.7

Country

European Union

Hungary

GDP in billions of $ (USD) (real exchange rates) (2004)

55.7

Deficit % of GDP

Inflation % Annual

529

International Business Slovakia

41.1

0.3%

15,066

43.6

-3.3

2.5

Slovenia

32.2

0.3%

20,306

29.4

-1.9

1.7

Luxembourg

31.1

0.2%

61,220

7.5

-1.1

3.2

Lithuania

22.3

0.2%

12,610

19.7

-2.5

2.0

Cyprus

15.4

0.1%

22,330

62.3

-3.5

1.5

Latvia

13.6

0.1%

11,850

14.4

-0.8

6.6

Estonia

10.8

0.1%

13,190

4.9

-1.8

4.6

5.4

0.04%

18,720

75.0

-5.2

2.1

Malta Source: wikipedia.com.

The EU also faced the problem of an ageing population. As the proportion of retired people in the population increased, the burden on the working age population in terms of financing their pension and healthcare costs increased. In 2005, the EU economic and monetary affairs Commissioner Mr Joaquin Almunia (Almunia) said that under the existing (current) policies, ageing would increase public spending on pensions, healthcare, and long-term care by 4% to 8% of GDP in most of the EU's 25 states by 2050.15 In 2004, almost 35% of the EU population was above the age of 50 16. At the same time, the number of people aged between 0 and 24 was decreasing, creating possibilities of a demographic crisis in the future. Logically therefore, the economic problems caused by the unfilled job vacancies and the shrinking population in the working age group, should have led these countries to welcome immigrants from the CEE (Refer to Exhibit VI for area and populations statistics of the EU).

Exhibit VI

Area and Population Statistics of the EU and its Member States Member State

Population in millions

Population % of EU

Area km2

Area % of EU

Pop. density People/km2

454.9

100%

3,976,952

100%

115

Austria

8.2

1.8%

83,858

2.1%

98

Belgium

10.3

2.3%

30,510

0.8%

340

Cyprus

0.8

0.2%

9,250

0.2%

84

10.2

2.2%

78,866

2.0%

130

Denmark

5.4

1.2%

43,094

1.1%

126

Estonia

1.4

0.3%

45,226

1.1%

29

Finland

5.2

1.1%

337,030

8.5%

15

France

60.2

13.2%

547,030

13.8%

111

European Union

Czech Republic

15

16

―EU needs immigration to support ageing population,‖ http://www.workpermit.com/news/2005_10_25/ europe/eu_needs_immigration ―Europe in figures: Eurostat yearbook 2005,‖ European Commission, Luxembourg.

530

The European Union and Immigration from New Member Countries

Germany

82.4

18.1%

357,021

9.0%

231

Greece

10.7

2.4%

131,940

3.3%

81

Hungary

10

2.2%

93,030

2.3%

108

Ireland

3.9

0.9%

70,280

1.8%

57

Italy

58

12.8%

301,320

7.6%

193

Latvia

2.3

0.5%

64,589

1.6%

35

Lithuania

3.5

0.8%

65,200

1.6%

55

Luxembourg

0.5

0.1%

2,586

0.1%

181

Malta

0.4

0.1%

316

0.0%

1,261

Netherlands

16.2

3.6%

41,526

1.0%

395

Poland

38.6

8.5%

312,685

7.9%

124

Portugal

10.1

2.2%

92,931

2.3%

114

Spain

40.2

8.8%

504,782

12.7%

80

Slovakia

5.4

1.9%

48,845

1.2%

111

Slovenia

1.9

0.4%

20,253

0.5%

99

Sweden

8.9

2.0%

449,964

11.3%

20

60.1

13.2%

244,820

6.2%

243

United Kingdom

Source: www.wikipedia.com. In comparison, the new members of the EU, especially the eight members from the CEE, had similar but bigger problems. In some of these countries, unemployment was as high as 19% in 2004 (Refer to Exhibit VII for unemployment rates in select new EU member states). High unemployment coupled with a relatively strong educational environment created a fertile ground for migration to countries with better employment opportunities. Added to this was the disparity in wage rates between the CEE countries and the older EU members. With huge differences in wage rates between the old and the new members, potential migrants could earn much higher incomes in the old EU countries. All these factors created an environment favorable to emigration in the new EU countries.

Exhibit VII Unemployment Rates in Select New EU Member States Country

2003

2004

2005

Czech Republic

7.8

8.3

7.9

Hungary

5.9

6.1

7.2

Poland

19.6

19.0

17.8

Slovak Republic

17.6

18.2

16.4

Source: OECD. 531

International Business The enlargement thus had the potential to stimulate growth in the economies of the old EU countries, by solving some of their labor problems. However, this was not to be. Theoretically, in a free market, market forces determine the supply of and demand for labor. These forces also determine the wage rates. However, as mentioned earlier, the wage rates in the old EU countries were quite rigid. In countries like the UK, the government fixed the minimum hourly wage rates. In Germany, the wage rates in many sectors were negotiated by trade unions and federations of employers. As the wage rates were comparatively rigid, there were apprehensions that the incoming migrants could have the effect of driving the locals from their jobs and into unemployment, leading to higher government expenditure on unemployment benefits. It was also feared that the immigrants themselves might eventually claim unemployment benefits, further draining government resources. Some conservative politicians seized on the issue with claims that the enlargement of the EU and the resultant migration from the East to the West would disrupt the labor markets in the EU-15 and cause a huge drain on the government exchequers through claims on welfare benefits. Eventually, they were successful in forcing the EU to provide for an option to limit immigration from the new members. Many of the old members opted to impose restrictions on immigration from the new member countries. These measures ranged from requiring immigrants to obtain work permits, to restricting them from claiming welfare benefits. (Refer to Table I for more details on the types of immigration regimes in the old EU member countries, relevant to immigrants from the new member countries).

Table I: Immigration Regimes in the Old EU Member Countries after the Enlargement A restrictive immigration regime in which workers from the new member states are treated in the same way as nonEEA* citizens and are required to apply for a work permit, which is to be issued only in cases where neither nationals nor other EU-15 nationals can fill the position.

Belgium, Finland, Germany, Greece, France, Luxembourg, Spain

Restrictive immigration regime but with a quota for workers from the new member states

Austria, Italy, the Netherlands, Portugal

General access to the labor market, however with limited welfare benefits. Unemployment might also constitute grounds for the withdrawal of the residence permit.

Ireland, the UK

Community rules on the free movement of workers are fully applied.

Sweden

*EEA stood for European Economic Area and comprised Iceland, Liechtenstein, Norway, and the EU along with its 25 member states. Source: Julianna Traser, “Who‟s afraid of EU enlargement?‟ www.ecas.org/file_uploads/1009.pdf.

Immigration in Post Enlargement EU While other countries imposed various kinds of quotas and restrictions, the UK, Ireland, and Sweden allowed workers from the new member countries access to their labor markets. The UK implemented a Worker Registration Scheme, and required all immigrants from the new member countries to obtain a work permit. Since the accession, till December 31, 2005, nearly 345,000 applicants from the new member countries registered with the Worker Registration Scheme to work in the UK. Of these, around 329,000 applicants were issued worker registration certificates and cards. The Polish were the largest group of all (204,895) followed by the Lithuanians 532

The European Union and Immigration from New Member Countries (44,715). More than 80% of the immigrant workers were aged between 18 and 34 (Refer to Exhibit VIII for details on immigrants to the UK between May 2004 and December 2005).

Exhibit VIII

Total

Other

Slovenia

Slovakia

Poland

Lithuania

Latvia

Hungary

Estonia

Period

Czech Rep

Nationality of Applicants by Quarter Applied in the UK May 2004 – December 2005

Q2 2004

2,520

660 1,090 2,930 7,720 23,465

3,730

50

30 42,200

Q3 2004

3,510

770 1,315 3,660 7,595 28,070

5,240

65

40 50,260

Q4 2004

3,020

615 1,430 2,770 5,360 23,920

4,875

55

30 42,075

Q1 2005

2,840

730 1,460 3,150 5,915 23,805

4,950

55

35 42,940

Q2 2005

2,825

740 1,650 4,340 7,685 33,700

6,025

30

30 57,030

Q3 2005

2,980

630 1,720 3,455 5,985 39,375

6,545

35

50 60,775

Q4 2005

2,310

535 1,670 2,720 4,460 32,560

4,995

55

45 49,355

20,005 4,680 10,345 23,030 44,715 204,89 36,355 5

340

265 344,63 5

Total As % of Total

6%

1%

3%

7%

Source: Accession Monitoring www.ind.homeoffice.gov.uk.

13%

Report

59%

May

11%