Jumping into Russia's Red-Hot Auto Market

Magna's deal with a Russian tycoon will make it a big player in components thereas other global carmakers join the race

It has been an eventful few weeks for Magna International (MGA), one of the world's largest producers of automotive components. When the Canadian company announced on May 10 that it was forming a partnership with leading Russian tycoon Oleg Deripaska, who is investing $1.54 billion into the company, it only served to fuel speculation that Magna would triumph in its bid to snag U.S. carmaker Chrysler (DCX).

The thinking: Deripaska's financial support would free up capital that Magna could plow into Chrysler. But such speculation was quickly killed when, just four days later, Chrysler instead was sold to a rival bidder, U.S. private equity company Cerberus Capital Management (see, 5/14/07, "Daimler Gives Chrysler to Cerberus").

But Magna's loss may be a blessing in disguise. Instead of struggling to turn around an ailing North American carmaker, it can refocus its energies on more promising emerging markets such as Russia.

Indeed, despite all the speculation surrounding the Chrysler bid, both Magna and its Russian partner, Deripaska-controlled investment vehicle Russian Machines, have insisted that their tie-up was in no way related to the Chrysler situation. The real logic of the deal is that it gives Magna a headstart in tapping the exploding Russian automotive market.

Fast Growth Can't Be Ignored

"Our partnership will accelerate Magna's growth in Russia and surrounding countries, markets that we see as holding significant opportunities for us," Magna Chairman Frank Stronach said at the signing of the deal. He predicted the company will set up 300 plants in Russia over the next 10 years, and told the Canadian media that over the next decade Magna expects to double or triple its revenues, which were $24 billion in 2006, largely thanks to its expansion into Russia and Eastern Europe.

Analysts agree that there are rich pickings at hand. "What we saw in 2006 was huge growth in the number of cars being sold [in Russia]. It has opened the eyes of many automotive companies. They realized that this market is too fast-growing to be ignored," says Gairat Salimov, automotive analyst at Troika Dialog investment bank in Moscow.

Auto sales in Russia rose 23% last year, to 1.78 million units, and are expected to reach 3.4 million by 2010, according to industry group IAA Autostat. Adding to the attraction is the growing market share of foreign-brand cars produced in Russia. Nine international carmakers have either established local production in Russia or signed investment agreements.

Weak Supply Base

Foreign carmakers with existing plants in the country include Ford (F), General Motors (GM), and Renault, while Volkswagen, Toyota (TM), and Nissan (NSANY) are among the newcomers now building plants. Last year local production of foreign models increased 75%, to 277,000, and the figure is forecast to reach 1 million units by 2010.

Yet while Russia's car market is showing impressive development, its path has been uneven.

"One of the biggest problems in the Russian automotive market is that the supply base is rather weak," says Konstantin Panin, spokesman for Basic Element, Deripaska's umbrella group that owns Russian Machines and two dozen other subsidiaries.

Although car sales are booming and foreign investment is pouring into production, Russia's automotive components industry lags far behind. Russian-made components are notorious for their poor quality.

According to Ernst & Young, one Russian part in a thousand is defective, compared with an international industry standard of 70 parts per million. Although Russia has 200 components producers, only 5% of them supply international manufacturers, and just 1% have any exports.

Upgrading to Fend Off Competition

That creates a huge opportunity for big international players such as Magna. While international components manufacturers already are active in Central and Eastern European countries such as Poland and Hungary, very few have so far ventured into Russia, where high transport costs limit export opportunities. Until the recent surge in sales, Russia's own car market was considered too small to attract significant interest from international suppliers.

That's now expected to change. Modern, high-quality components are in demand not just from Western carmakers setting up in the country but also from Russian producers, which are keen to fight off the tide of foreign competition by upgrading their models with Western parts.

"The value of the automotive components market will be significant: tens of billions of dollars [per year]," says Troika Dialog's Salimov. "It opens up enormous opportunities for [international] components producers." He predicts that within the next four years, Magna's Russian sales alone will reach "a few billion dollars" annually.

Aluminum Magnate

Nor is it a surprise that, in order to crack that market, Magna has teamed up with Deripaska's Russian Machines, which owns several Russian automotive plants, including the home operation of GAZ, the leading producer of commercial vehicles and No. 2 Russian carmaker after Avtovaz.

Although smaller than Avtovaz, GAZ Group has been developing much more dynamically, doubling revenues, to $4.4 billion, over the past five years thanks to new management and production methods. Last July the company signaled its international ambitions by acquiring LDV, a British van maker that will supply GAZ with new, internationally competitive models.

Deripaska, who built his fortune in the aluminum industry in the 1990s, also has proved he can negotiate Russia's tricky business and political terrain. Although previously closely linked to the coterie around former President Boris Yeltsin, Deripaska has prospered under Yeltsin successor Vladimir Putin. According to an annual ranking by Forbes, Deripaska's fortune of $13.3 billion makes him Russia's second-richest man, after Chelsea (London) football team owner Roman Abramovich.

"A Perfect Marriage"

Deripaska's business interests include metals, insurance, and construction as well as automotive companies. Like other big Russian businesses, Basic Element is expanding internationally, acquiring Austrian construction group Strabag for $1.6 billion in April. "Deripaska is trying to create large groups that will be globally recognized in different sectors of his interest," says Elena Sakhnova, an industrial analyst at Deutsche Bank (DB) in Moscow.

The partnership with Magna reflects a continuation of the same strategy. "Obviously it's impossible to create a competitive automotive industry without modern technologies and without integrating into the global marketplace, so we've been looking for an overall strategic partner," says Alexander Filatov, director of strategy at Russian Machines. "Magna felt that to accelerate [into emerging markets] they needed a strategic partner that would have, let's say, an emerging-markets mentality. So we found that it's a perfect fit, a perfect marriage." And maybe a lot more promising than getting saddled with the woes of Chrysler.

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