Russia has the biggest population
in Europe (149 million people), nearly double the size of Germany. But Russia
ranked only sixth in new car sales in Europe in 1999, selling below 25% the volume
of Germany. Moreover, demand in Russia largely is for domestic vehicles like Lada
and GAZ, brands uncompetitive on most of the continent.

In car production last year,
Russia ranked sixth in Europe and twelfth in the world. So the market potential
in Russia is vast, and the basis of an industry exists to meet it. But means of production
must improve significantly, and means of consumers must improve significantly
to buy the output, especially the hundreds of thousands of new vehicles that
foreign manufacturers are keen to build there every year.

This report explains and
evaluates strategies of international automakers to pursue opportunities amid
high risks in Europe’s final frontier. Big projects involve Fiat
SpA, Ford Motor Co, General Motors Corp’s Adam Opel AG, Renault SA and Volkswagen
AG’s Skoda auto as.

Most small projects seem
ephemeral, including BMW, Chevrolet, Daewoo, Hyundai, Kia and Land-Rover. This
report ignores minor ventures, since the large ones are still tiny.

FIAT

Fiat, the foreign producer
most experienced in car production in Russia, provided the turnkey plant that
launched Lada in 1970. The Italians also built cars there before the 1917 Revolution.In late 1997, the company
outlined plans for the biggest foreign investment in the auto industry in Russia:
an $850 million venture in Nizhny Novgorod to make 150,000 cars a year – including
Marea sedan, Palio Weekend estate and Siena three-box.The project, ZAO Nizhegorod
Motors, is owned 40% by Fiat, 40% by Russian automaker OAO Gorkovsky Avtomobilny
Zavod (GAZ) and 20% by European Bank for Reconstruction and Development (EBRD).

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After economic crisis hit Russia
in August 1998, plans for annual production stayed the same. But the investment
target fell 40% to roughly $500 million, and the product profile changed with
Palio hatchback replacing Siena. Fiat dropped Siena, finding the hatchback better
and cheaper for Russians. The Italians then decided to source kits for Palio and
Palio Weekend from Tofas Oto Ticaret AS, Fiat’s main venture in Turkey. Originally,
Fiat’s operations in Poland were to supply kits of Palio Weekend and Siena. But
the source was switched because Poland makes no Palio, while Turkey makes Palio
plus Palio Weekend.

In March 2000, Marea was
dropped in favor of a new version of Siena with a stretched wheelbase, named
Maxi-Siena. Investment plans downgraded further to Euro400 million, and annual
production capacity was halved to 75,000 units. Production, originally to start
in autumn 1999, may not begin before early 2002. Output was to evolve from basic
assembly to complete manufacture, but it is now envisioned to start completely
with stamping, welding, painting and assembling.

FORD

Ford has struggled to find
the right place and time to launch a successful venture in car production in
Eastern Europe. Assembly plants in Belarus (opened in 1997) and Poland (opened
in 1995) underperformed expectations, and both are closing this year. But the
company hopes its third attempt will charm the markets – this time in Russia.

In June 1999, Ford announced
plans for a $150-million factory to build its compact Focus in all body styles
in Vsevolozhsk (30 kilometers outside St Petersburg) at an idle facility being
renovated on premises of Russki Diesel, a defense-industry concern.

Operations are slated to
start in October 2001, assembling kits from plants in Saarlouis (Germany) and
Valencia (Spain). Output of 25,000 cars is targeted for 2002. Later, annual
capacity is expected to reach 100,000 units with further investment (undisclosed)
for stamping, welding and painting.

Ford is looking at building
Volvos there, but this is unlikely in the short-term. The Swedish automaker
sold 756 cars in Russia in 1999, hardly a basis for even assembly.

GENERAL MOTORS

GM has talked about building
cars in Russia with AvtoVAZ for nearly 10 years. In
the early 1990s, GM jostled with Fiat over taking a stake in the Lada manufacturer.
In the mid-1990s,
the Americans and Russians envisioned a $1.0 billion venture to make 300,000
units a year of Opel Corsa plus engines and transmissions. Output of Chevrolet
S-10 pickup was even contemplated. Now
GM aims to assemble Opel Astra with initial capacity of 35,000 units a year.
Investment of $200 million by 2005 could boost annual capacity to 150,000 units.

A second step in cooperation would produce 90,000 units a year of Lada Niva
2123, an all-wheel-drive off-road vehicle, debuted as a concept at the Moscow
motor show in 1998.

Here is a photo of the 2123,
the best-looking vehicle ever unveiled by AvtoVAZ.

A prototype appeared at the
Moscow exhibition in 1999, and AvtoVAZ wants to assemble a trial set of 500 units
in 2000.

The final stage of an AvtoVAZ-GM
engagement would produce 220,000 units of Lada Calina 1119, a small car premiered
as a prototype at the Moscow show last year.

Here are pictures of Lada
Calina 1119. It looks like Corsa, and AvtoVAZ developers acknowledge they aped
Opel’s design.

(A note on nomenclature for
Russian cars. Generally, the lower the codename, the smaller the model. Oka, the
shortest, is dubbed 1111. GAZ’s Volgas, the longest, are 3102, 3110, 3111, etc.)

The feasibility of the second
and third stages are under review, and the cost is a big issue. AvtoVAZ said
it needs $350 million for the 2123 and $2.0 billion for the 1119. All stages
would rely heavily on AvtoVAZ’s capacity to design, engineer and produce vehicles
to save money. But plans have changed before, and they could change again. Some
sources hint GM is reconsidering Corsa assembly, as Astra may prove too expensive
for the market. AvtoVAZ engineers also have reservations about Astra’s suitability
for Russian roads.

RENAULT

In May 1999, Renault became
the first car mark from Western Europe made in post-Soviet Russia. Before, foreign
brands built there had been only American and Korean.

Renault’s project, a 50/50
venture with the Moscow municipality, is named OAO Avtoframos (‘Avto’ for auto;
‘fra’ for France; ‘mos’ for ‘Moscow’). It is based at Moskvich, a carmaker controlled
by the Russian capital. Moskvich is not actively involved in Avtoframos, but
its site might have seemed logical for Renault: in the 1960s, the French company
supplied equipment and technology to the Russian manufacturer, then known as
Automobile Factory of the Lenin Komsomol or AZLK (Avtomobilny Zavod Leninskovo
Komsomola).

Initially, Avtoframos forecast
production volumes of: 2,000 in 1998; 10,000 in 1999; 65,000 in 2001 or 2002;
and 120,000 in 2005. But these plans, like others, have been slowed by Russia’s
economic crisis. Output started a year late, and only 535 units rolled out in
1999. Avtoframos still aims to make 100,000 cars in 2005, only slightly off
original plans. But investment plans for 2005, once $420 million, are now 30%
lower: $300 million.

Avtoframos began making
only Mégane Classic sedans. However, poor sales prompted the introduction
of a second vehicle in November 1999 – the cheaper R19.
(Both models are assembled from kits from Renault’s plant Turkey, similar to
Fiat’s approach to Russia.)

Avtoframos later could produce
engines, and it may build a version of the Euro5,000 vehicle that Renault plans
to launch in 2003 at SC Automobile Dacia SA of Romania, which the French company
acquired in October 1999. The option of making Dacias will become increasingly
attractive, if prices for Mégane Classic and R19 remain too high for
most Russians.

SKODA

In mid-1999, the Czech company
agreed to build Felicia hatchbacks and station wagons in Russia with OAO Izhmash
in a venture named Skoda Auto Udmurtia (SAU) – owned 75% by Skoda, 25% by Izhmash.
It will be based in Izhmash’s broad complex in Izhevsk in the Udmurt Republic,
the easternmost site of car production in Europe, over 1,350 kilometers outside
Moscow.

Skoda cautiously hopes to
launch output in third-quarter 2000. Plans eventually call for investment of
$250 million to make 100,000 vehicles a year – including stamping, welding,
painting and assembling. SAU was scheduled to switch production to Felicia-replacement
Fabia in 2002, but delays in the start of operations could lead the venture
to begin with the new vehicle.

The project may look ill-conceived.
Izhmash has performed the poorest among carmakers in post-Soviet Russia: its
output plunged from 133,200 units in 1990 to 4,756 units in 1999. Logistics
on the edge of Europe could prove costly and tricky. But other signs are auspicious.
Izhmash has notable engineering credentials: the main producer of the famous
assault rifle AK-47 Kalashnikov; the largest motorcycle maker in the ex-USSR
(its first bike was built in 1928).

Car production began only
in 1966 with Moskvich-based sedans, but Izhmash has innovated vehicles. In 1973,
it created the first Soviet hatchback. It also rolled out many early car-derived
commercial vehicles in the USSR, including pickups and vans, based on Moskviches.
And there is an upside of the distance from Moscow: Izhevsk is ideally suited
as a distributor for Skoda in Asian and European Russia. Since Izhmash now builds
few cars, its commitment to Skoda should be immune to any concerns that its
output of foreign models could harm the viability of its products.

So SAU has potential for
success. Crucially, it has a car with a feasible price: Felicia could start
around $7,000, though Fabia could run close to $9,000. Skoda already has over
40 sales sites in Russia, the biggest retail network among foreign brands. Plus
the main marketing slogan is focused and strong: “Slavic cars with German
technology” – referring to Skoda-owner VW.

As an aside to explain
the difficulties at Izhmash: much of the company’s potential was untapped during
Communism because its major role in arms production kept the company under the
Ministry for Defense. Izhmash was the only producer of motor vehicles in the
ex-USSR not under the Ministry for the Automobile Industry, so it lost out on
subsidies for new models.

INVESTMENT SUMMARY

By 2005, aggregate annual
capacity is projected to reach 1.0 million units with investment to approach
$4.0 billion.

Each project embraces creative
ideas: Fiat and Renault will exploit their sophisticated operations in Turkey
as low-cost sources for kits and parts. GM plans to maximize use of resources
and talent at AvtoVAZ to make cars affordable and attractive to Russians. Skoda
hopes to draw on the remarkable technical traditions at Izhmash.

Also foreign automakers
are identifying parts that can be co-sourced for their models in Russia – to
boost volumes of components orders high enough to entice investment there by
international suppliers that have been averse to locating in a high-risk market
with low returns in the short-term. This pooling is start with 10-15 items like
batteries, cables, glass, mud flaps, tires, wheels. A positive undercurrent:
Russian automakers are shaking their dependence on barter; foreign suppliers
now can seek opportunities with Russians, expecting to be paid in cash, not
in kind.

EVALUATIONS

Much in these investment
strategies looks good, and optimism is returning to Russia. Economic and political
turmoil has hurt before, but elections recently passed with some promise, and
car production rebounded 14% to 955,406 in 1999 from 839,608 in 1998. This total
was only 27,000 below the post-Soviet high of 985,809 in 1997.

Nevertheless, foreign investment
and production targets in Russia look improbably high. Plans may be padded to
lure global suppliers there, but many signs suggest the objectives are fundamentally
misguided.

Forecasts for the car market
still vary widely. Predictions for 2005 span from 1.15 million units to 1.56
million units, indicating the great uncertainty governing outlooks.

Also foreign makers may
have chosen to build models that are too big and pricey. Most ventures aim to
offer C-segment or mid-sized cars from $10,000 to $17,000.

The prices may seem low
to Westerners, but few Russians can buy cars at these levels.

Indeed, while car demand
may be growing, it also is thinning. Before August 1998, models under $10,000
comprised roughly 80% of sales. But, last year, over 90% of sales were for vehicles
below $7,000.

Consider samples prices
of local models:

Local manufacturers are
alone with products in line with purchasing power. This is a key reason sales
of domestic output jumped last year, while import volumes of new cars dipped
from roughly 60,000 units in 1998 to roughly 40,000 units in 1999.

Skoda is the only foreign
venture that might offer a model under $7,000 with Felicia, and R19 from Avtoframos
is the only foreign vehicle to come close to that at $7,500.

To recast the numbers: before
the bubble of bullishness about Russia burst in August 1998, prices commonly
paid for cars still were far under levels that foreign makers hoped to charge.
The gap only has widened between prices of local models and foreign price targets.

The market could toughen
for foreign marks later this year, following GAZ’s introduction of the 3111,
a rear-wheel-drive sedan poised to become the best car ever mass-made in Russia.

A handful were built in December
1999, and GAZ is producing sample sets every month, until the launch of serial
output on a new production line in third-quarter 2000.

The 3111, also the longest
mass-made passenger vehicle in Russia at roughly 4800 millimeters, may not rival
quality standards of similar-sized vehicles from Western Europe, but it is a big
advance for Russia. It will feature many foreign parts, including Hella lights
and Lear seats. Options may include foreign-brand air-conditioning, anti-lock
brakes, central locking, driver-side airbags and power steering. The engine range
is to include a 4-cylinder diesel from Steyr-Daimler-Puch Fahrzeugtechnik AG &
Co KG, built on license by GAZ.

If base prices start around
$7,000, the 3111 will impact sales of models foreign and local, though output
is not expected to top 10,000 units a year in the short-term. The goal for this
year is a tentative 2,000. Foreign manufacturers may not want to admit this,
but the 3111 could reinforce the price wall of $7,000, and every dollar may
come to count more than it already does. Indeed, Avtoframos only can hope to
sell a mere 2,000 units of R19 at $7,500 in 2000.

Foreign Models Must Be
Smaller

The market’s price structure
may force foreign players to switch to smaller vehicles. To put this into perspective:
among all foreign models made in Eastern Europe throughout the 1990s, the best-selling
vehicle is in the A-segment: Fiat Cinquecento.

Of course, minis may be
too small for Russia, but the B-segment may be the answer. This view might seem
mistaken, once comparing the dimensions of foreign models with the dimensions
of local models. Astra is roughly 50 millimeters longer than Lada Samara hatchback,
while Corsa is about 250 millimeters shorter than this Russian car. But Cinquecento
always sold well in Poland, a market with the bigger outdated Polonez available
at similar prices. Among other things, Polish customers may have believed quality
advantages of Cinquecento outweighed size advantages of Polonez. Plus Cinquecento
was new; Polonez was not.

A similar case could be
made for Corsa against Samara – even if GM could not squeeze prices for Corsa
below $6,000; even if the Russian vehicle would continue to cost $3,500 to $5,000.
Or, if GM can Russify the Astra, maybe it can Opelfy the Calina.

Ford should think similarly.
It argues it will start production in Russia with a new model: the C-segment
Focus. But this will be a familiar vehicle, when output begins in mid-2001.
Yet the next generation of the B-segment Fiesta debuts in third-quarter 2001,
and insiders recently said Ford is considering making Fiesta instead of Focus
in Vsevolozhsk.

Fiat is in better shape
with Palio, but this model still could hit $8,000. (The D-segment Marea was
dropped from consideration for production in Russia, since it was expected to
overrun $10,000.)

One final thought on the
market’s price sensitivity:

Consider the Chevrolet Blazer
that GM assembled in Elabuga, Tartarstan. Only 1,464 were made in 1998, and
output stopped before 1999, since roughly 1,000 units were stuck in stock. Prices
were slashed last year to fire-sale levels of $15,000, but sales still stagnated,
and hundreds of vehicles remain unsold.

If GM struggles at that
price to sell a tiny volume of roomy rugged Blazers (great for Russia’s rough
roads), Ford should not even pray to make 100,000 compact Focus at nearly the
same price.

Exports of Foreign Models
from Russia Unviable

Another drag on foreign
ventures is Russia’s position in the geography of trade. It is one-dimensional
– in contrast to three-dimensional markets in Eastern Europe. Countries like
Poland have attracted billion-dollar foreign investments in car production,
partly because these places enjoy three vistas of commercial opportunity:

1 an established
local market with healthy sales;
2 liberal/unimpeded access to advanced markets in Western Europe;
3 easy links to fast-growing markets nearby in Eastern Europe.

Embellishing this point,
Skoda aims to sell its output evenly: a third in Czech Republic; a third in
Western Europe; a third in Eastern Europe and emerging markets elsewhere. This
balanced distribution of sales has buoyed Skoda’s overall performance, against
recent declines in Czech demand. (Daewoo and Opel are cultivating similar strategies
in Poland.)

Big projects must have multiple
options for channeling output to hedge risks. If producers fail to think along
these lines, problems will emerge. Example: When Suzuki Motor Corp started building
cars in Hungary, it focused on local sales. Unsurprisingly, the company coped
poorly with an economic downturn there in 1995, as it had inadequately developed
export prospects. Now the majority of Suzuki’s output in Hungary is shipped
abroad.

In contrast, foreign vehicles
made in Russia largely must be sold in Russia, a one-dimensional market, despite
its vastness. No attractive escape hatches exist to unload unsold vehicles there.
Neighboring markets of the former Soviet Union are weak (even compared to Russia)
with modest exceptions of Kazakhstan, Ukraine and Uzbekistan.

Moreover, Russia has no
privileged trade with mature markets like Western Europe, and it would be costly
and difficult to ship units from Russia to France or Germany. Plus foreign-brand
cars from Russia may be regarded poorly in advanced economies.

Since Russia presents scant
prospects to cope with risks of high manufacturing volumes, investors have been
slow to launch operations there. They want to be especially confident about
the market, as the 1990s have shown that confidence in Russia can be misplaced
easily.

Foreign Players Spurn
Russian Products

Another difference between
Russia and the rest of Eastern Europe: In countries like Poland, foreign investors
bought local manufacturers. In Russia, no outside producer has said it intends
to take equity in a domestic partner.

International players also
seem averse to upgrading existing Russian products. One “consequence”
for foreign automakers: They will not immediately enjoy big production volumes
that could tempt suppliers to follow them to: (1) first improve domestic products;
and (2) later support foreign vehicles.

Automakers like VW could
quickly pull parts makers to countries like Czech Republic. These suppliers
chose to support plants making high volumes of old models – because they knew
they would be in line for business later for modernized products. Renault is
now telling a similar story to suppliers about supporting Dacia SA.

By not buying local producers
in Russia, foreign players effectively prolong the existence of a huge market
of cheap poor-quality vehicles. These models often linger because their producers
lack the resources to roll out anything better. Russian automakers try to introduce
updated vehicles, but the lag between concept model and production model can
be many years. The Lada 2110 started appearing in markets in Eastern Europe
only recently – roughly 10 years after the model was first announced. GAZ is
an exception here with relative punctuality.

This is not a recommendation
for Fiat to buy GAZ, for example. But, without foreign purchases of local producers
in Russia, the country fails to get a needed push in market modernization that
international manufacturers accelerated in Czech Republic and Poland.

Global Mergers May Kill
Foreign Ventures in Russia

The fever of consolidation
in the industry worldwide aggravates uncertainty in Russia. Consider the Fiat-GM
partnership. The companies now discuss cooperation in Latin America and powertrain.
But they may talk later of consolidating projects in Russia if they would decide
that separate ventures there of Fiat and GM could cannibalize each other – especially
if an overload of foreign competitors persists.

Fiat and GM each have an
evolving presence in core emerging economies – Russia plus Argentina, Brazil,
India, Poland, South Africa and Turkey. They may decide not to be in all countries
with parallel production.

Moreover, if GM would buy
Daewoo, it would have three partners for small cars: Daewoo, Fiat and Suzuki.
In the ex-USSR, Daewoo owns a plant in Ukraine plus it contracts out assembly
of cars in Russia. So GM likely would need to rationalize its interests in the
former Soviet Union, and the abandonment of any one project may be difficult
to rule out – even though Fiat and GM have been the most dedicated in negotiating
ventures in Russia in the 1990s.

Russia overcrowded even
before serial output starts

The sheer number of foreign
investors in Russia could lead to problems, especially if their products continue
to appear over-priced.

If only one foreign manufacturer
would invest in Russia, perhaps its venture already would be running with modest
output. But five major projects plus perhaps 10 minor operations make a crowd,
even in a huge market like Russia. If each player sticks to its current plan,
if the market fails to expand dramatically, foreign plants may fall into a price
war to shift stock, similar to situations that have wracked India and Turkey.

The fallout could hurt investment
prospects – and opportunities to make small cars, especially if price gaps between
small cars and mid-sized cars erode. Yet, the first investor with an affordable
appealing product still could gain an edge on competitors.

Concepts Versus Reality

To conclude, an analogy
may capture the fate awaiting foreign ventures in Russia: these projects must
undergo the type of transformations subsequently imposed on viable concept cars
unveiled at auto shows. Like concept cars, these investments typically look
best on first presentation – confident, full of possibilities, untouched.

But, if any experimental
vehicle is to evolve into a mass-produced model, it must incur compromises and
sacrifices. It has to become less daring, more conservative. This can take years.
Still, it can die before maturity. Few actually enter production.

The same will hold true
for foreign plans to build cars in Russia. Initial objectives look impressive.
They are bold. But many will be abandoned. Survivors will require major revisions
in the early stages of existence. Some operations will change, even once production
starts.

Already, some ventures have
scaled down investment plans. Some have slashed output targets. Some have softened
product profiles… Some have revised all three.

To sharpen the picture of
the difficulties to build cars in Russia, consider a contrast:

Hungary never built cars
under Communism, and its market of 10 million people is relatively small. But,
in the 10 years that Eastern Europe has been opening to foreign investment,
Hungary has assembled cars from Audi, Opel and Suzuki: output topped 120,000
units last year.

Russia was the biggest car
producer in Eastern Europe during the Cold War, and its market of 149 million
people is the biggest in Europe East or West. But, in the 1990s, no project
has been launched there that has built even 20,000 foreign models a year.

So lots of concepts of foreign
ventures have debuted in Russia, but none has entered production in significant
volume. Let us hope this changes.

Ryan James Tutak has covered
the auto business in Eastern Europe since 1992. His work has been reported and
used by companies, institutions and media in 30 countries – including Arthur Andersen,
Automotive Business International, CNN, Financial Times, Japan Automotive News,
KPMG, Morgan Stanley, Nikkei, Reuters, Ward’s, WirtschaftsBlatt and World Bank.

This report was adapted
from a presentation at a seminar that Ryan also chaired on the automotive industry
in the ex-USSR in April. The event was organized by WBR Ltd in London.

Ryan can be contacted by:
E-Mail: rjt@pronet.hu
Telefon: +36-1 / 266-2693
Telefax: +36-1 / 317-7257

To learn about WBR auto
conferences, contact Stephen Butler:
E-Mail: sbutler@wbr.co.uk
Telefon: +44-207 / 759-9007
Telefax: +44-207 / 759-9001

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