The Peril and Promise of Investing in Russia

Why would anyone invest in Russia? The economy is expected to shrink 8.5% this year, and will be slow to recover its momentum. Inflation is in the double digits. Even President Dmitry Medvedev calls corruption in his country "endemic." And sophisticated investors know all the horror stories of operating there: BP (BP) locked in headline-grabbing clashes with its joint venture partners. Royal Dutch Shell entangled in endless charges of violating environmental laws. William Browder, a pioneer investor in Russia, mysteriously denied re-entry into the country while his Russian fund is stripped of its assets. Swedish retailer Ikea suddenly blocked by authorities in Samara from opening a huge store it had just built, ostensibly for violating the local building code.

And yet many multinationals—big, battle-scarred companies, veterans of coups in Brazil and hyperinflation in Turkey—refuse to pull out of Russia. Instead they're digging in for the long haul. John Deere (DE), Unilever (UN), and HSBC (HBC) all have begun major Russian expansions in the past few months. Wal-Mart Stores (WMT) has an advance team on the ground as it mulls opening a Moscow location, following French hypermarkets Carrefour and Auchan. On Sept. 1, Topeka (Kan.)-based Collective Brands (PSS) announced it would open 90 Payless ShoeSource outlets across the country over the next five years. "Among emerging markets, Russia has moved to the top of our list," says Chief Executive Matthew E. Rubel. Even companies that have been beaten up in Russia, like BP and Ikea, say they'll keep investing.

For major global corporations, Russia is simply too big and too rich to ignore. Abundant reserves of oil, metals, and timber still lure multinationals eager to export those commodities, even though such investments are often fraught with difficulties. But Russia is not just a play for resource companies. Eighteen years after the fall of the Soviet Union, 140 million voracious consumers beckon. Demand for everything from kitchen cabinets to pharmaceuticals is still strong—and Russians have the petrodollars to pay for them. Disposable household income in Russia is 30% higher than Brazil's, almost four times China's, and 10 times that of India (chart).

The Kremlin's $280 billion stimulus plan, fueled by oil and gas money salted away in better times, is spurring demand. That's a boon for companies such as Unilever, which reported "strong double digit growth" in Russia during the first half of the year. The Anglo-Dutch company has eight factories in Russia and recently broke ground for a new $140 million ice cream plant and distribution center in Tula, 120 miles south of Moscow.

Russia's Soviet tradition of education—superb in math and the hard sciences, excellent in languages—still produces plenty of brainy workers. About 20% of working-age Russians have university degrees, not far below the European Union average of 24%. While Russian salaries had been rising sharply before the crisis, they've now flattened out, and multinationals can still find workers for a fraction of the cost in the West.

Consider IT giant Intel (INTC), which moved into Russia in 1999 and since then has invested $800 million. It now employs more than 1,000 engineers at four research centers, including its largest software research and development group outside the U.S. Because of Russia's top-notch math skills, Intel assigns local engineers more complex work than it gives specialists in other outsourcing venues such as India, says Dmitry Konash, the company's Moscow-based regional director. The cost of all this mind-bending work? As little as $1,000 a month for a new engineering grad.

LOCATION, LOCATIONIntel also benefits from the hunger newly middle-class Russians display for all sorts of high-tech gear—they want their laptops and PDAs just like the rest of us. Here, Intel has room to run: Only 20% of Russians own a computer, about one-fourth the rate in the U.S. and Western Europe. "Big multinational IT companies accepted a long time ago that they need to be here," Konash says in an interview at his office in a gleaming suburban Moscow office park. Intel's neighbors at the park include Microsoft (MSFT) and Cisco Systems (CSCO). Hewlett-Packard (HP) and Sun Microsystems (JAVA) also have major Russian operations.

The companies that succeed in this alluring but hostile environment follow strict rules of engagement. One key lesson: As in real estate, location is all-important. While corruption and red tape hobble business in much of Russia, some city and regional authorities are beginning to tackle the problems. Even high-ranking officials acknowledge the difficulties. Sitting in an austere, high-ceilinged Kremlin office once occupied by Communist leader Leonid Brezhnev, presidential economic adviser Arkady Dvorkovich offers frank advice. "Investors should choose carefully" among the country's regions, he says, warning that the situation in some areas probably won't improve until old-style governors and mayors have left office. "The best way to make the preliminary judgment," Dvorkovich says, "is to see where other investors have been coming."

A prime example, cited by Dvorkovich and many businesspeople, is the Leningrad region—an area about the size of Maine that surrounds St. Petersburg. The region has attracted $300 million to $500 million annually in foreign investment in recent years, including a Ford Motor (F) assembly plant and a Kraft Foods (KFT) instant-coffee factory. Local authorities have offered tax breaks and streamlined bureaucratic procedures to pull in such investments. Other up-and-coming areas include Krasnodar, home of the Black Sea resort of Sochi (site of the 2014 Winter Olympics), and the Kaluga region southwest of Moscow, which has attracted manufacturers such as Volkswagen (VLKAY), Nestlé, and Samsung. In contrast, the area around Vladivostok, in Russia's Far East—despite its strategically attractive proximity to China, Japan, and the western U.S.—has drawn little foreign investment. A reputation for corruption clings to the city, cemented in part by the arrests of two former mayors of Vladivostok on charges of abusing the office for personal gain.

Investors have also learned, to their regret, the cost of teaming up with Russian companies. Costly conflicts seem inevitable. "I haven't heard of any joint venture working well. You need 100% control," says Jostein Davidsen, head of Russian operations for Nycomed, a Swiss pharmaceutical manufacturer that recently announced plans to build an $84 million plant in western Russia. The catch is that in some industries the Kremlin deems "strategic," including oil, gas, telecoms, and aerospace, investors don't have a choice. The Kremlin allows participation only through joint ventures or minority stakes in these Russian companies. Such deals can be troubled: BP was ensnared in lawsuits and hounded by Russian tax and environmental authorities after a falling-out with local partners in its TNK-BP joint venture.

Buying Russian companies outright can be risky, too. One U.S. CEO recalls hastily backing away from a possible Russian acquisition after meeting the company's owner. The Russian company's books were awash in red ink. But the owner, arriving late for a scheduled lunch with the chief executive in London, apologized by explaining that he had been buying a Renoir painting. The affable Russian then chatted during the meal about his ultra-luxurious New York apartment. "It was clear that this company was being run for the enrichment of one person," says the American executive, who spoke on condition of anonymity. His company later decided to enter Russia without purchasing a local enterprise.

CULTURE OF CORRUPTIONStill another danger sign: the tangled structures of Russian firms. These are a legacy of 1990s-era laws that perversely encouraged Russian companies to establish legal headquarters in offshore havens such as Cyprus. Andrey Posdnyakov, a physicist in the Siberian city of Tomsk, co-founded Elecard Devices, a company that sells audio and video digital-compression technology. He says he registered the business offshore to avoid a tax that Russian authorities levy on local companies' sales to foreign customers. Theoretically, Elecard can obtain a refund of these taxes from the government. "But the procedure is so complicated, you never actually get a refund," says Posdnyakov. Now he has discovered that the offshore registration is a turnoff to potential investors, from whom he hopes to raise $8 million to expand his business over the next two years. Intel Capital, the venture capital arm of the IT giant, has invested in only six Russian companies. It has rejected Elecard and scores of others in Russia because of their complex structures. "We can't invest in companies that have even a slight shadow," says Intel's Konash.

Yet acquisitions can succeed, especially ones involving established Russian brands. In 1998, Unilever purchased a run-down Soviet-era margarine factory in Moscow, gutting the interior and installing new equipment imported from Western Europe. Since then it has snapped up other companies, including Russia's biggest ice cream maker, Inmarko, and the producer of the country's best-known ketchup brand, Baltimor. Nestlé and Danone have cut similar deals.

Corruption is still a problem, though, even when smart companies do their best to avoid it, and even in regions with a business-friendly reputation. An executive of one U.S. company operating in the St. Petersburg area says privately that payoffs are needed for routine tasks such as getting imported supplies cleared through customs. "We use customs brokers, and they build bribes into the invoice," this executive says.

Although many companies say they don't engage in such shady deals, refusing to bribe often complicates their work. Nycomed's Davidsen says setting up the pharmaceutical group's Russian factory will take two or three years longer than it would have in Western Europe, largely because the company has insisted on "100% compliance" with the law at every step of the process, from acquiring land to lining up suppliers to getting approvals from drug regulators.

Russia enacted new anticorruption legislation last year at President Medvedev's urging, but it probably won't make much difference. The law criminalizes only completed acts of bribery, not the act of demanding or offering bribes. Nor does it address widespread corruption in the judicial system.

But the lack of progress doesn't discourage veterans like Stuart Lawson, who worked for Citibank (C) in 11 countries and who now runs HSBC's Russian operations. He's still excited about the market. Russia, he says, offers "some of the most exciting opportunities and some of the finest human capital that I've ever run across."

Miriam Elder in Moscow

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkTaking the R out of BRICA new report from consultancy Euromonitor International calls into question whether Russia deserves to be included in the BRIC club. Russia's growth prospects dim next to those of Brazil, India, and China, because of its over-dependence on oil and gas, and a declining and aging population, argue the report's authors.To view the report, go to:

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