A New Frontier

By Peter Gumbel

Like most big western companies, the British home-electronics retailer Dixons Group has closely tracked the rise of Russia's consumer market over the past few years, agonizing over when and how to jump in. In April the company finally took the plunge, announcing a $1.9 billion deal to acquire Eldorado, Russia's leading specialist retailer of consumer electronics and domestic appliances, with more than 600 stores. But Dixons is still nervous about the Russian investment climate, and its worries haven't been helped by recent problems at high-profile Western firms, including BP. So the firm has made an arrangement in which it won't have to start paying for Eldorado for at least two years. In essence, Dixons has given itself a trial period to determine whether it really wants to be in Russia. "It's a no-risk option," says Dixons spokesman Hamish Thompson.

Few executives would describe Russia as "no risk," and the mixture of apprehension and opportunism with which Dixons is entering the market perfectly captures the feelings of Western investors about the country's business climate. The Russian economy is powering ahead, propelled by the high price of oil, Russia's key export. Growth exceeded 7% in each of the past two years and is expected to be about 5.5% this year, more than triple the euro-zone average. Many Russians are still poor and live in wretched conditions, but on the whole, household income is up, and especially in big cities like Moscow and St. Petersburg, people are ready to splurge. The spending boom is creating a merger wave in sectors as varied as banking, brewing and confectionery. Alongside the Dixons deal, the huge Belgian beer company InBev is finalizing the last pieces of a $730 million acquisition of Russian beer giant Sun Interbrew, and Coca-Cola recently agreed to buy Multon, Russia's second largest juice company, for an estimated $600 million. Excluding the energy sector, mergers and acquisitions of Russian firms soared to more than $8 billion last year from $4.8 billion in 2003, according to Thomson Financial. Yet even as Western firms rush to buy Russian, at the back of everyone's mind is the nagging question, Just how big is the risk, and is it really worth taking?

Since President Vladimir Putin came to power, the Russian economy has staged a dramatic comeback after its near collapse in 1998. But along with red tape and corruption, companies face government meddling, primarily in the form of a highly unpredictable tax-enforcement policy. The most battered victim is Yukos, the former Russian oil giant that is in its death throes after being hit with multibillion-dollar back-tax claims that its erstwhile owners say were part of a Kremlin campaign against them. A Moscow court last month sentenced Mikhail Khodorkovsky, the former Yukos chief executive and a major shareholder, to nine years in jail on charges of tax evasion and fraud.

Foreign firms too are vulnerable. Russian tax authorities recently slapped BP's joint oil venture in Russia, TNK-BP, with a $1 billion back-tax bill for 2001. The move has caused dismay at BP in London and prompted chief executive John Browne to visit Moscow last month, where he met with Putin. The Russian leader reassured Browne, "We were not mistaken when we supported your decision two years ago" and praised the company for being "a good corporate citizen." Meanwhile, the Japanese tobacco company JTI, which makes Winston and Camel brands at a $400 million state-of-the-art factory it built in St. Petersburg, is embroiled in a court battle with authorities over a tax demand from 2000 for more than $80 million that has prompted complaints from the Japanese government.

And tax isn't the only weapon. Earlier this year, the German electronics manufacturer Siemens was officially told it couldn't acquire a majority stake in a Russian company that manufactures some defense-related equipment. Siemens had offered $200 million to $300 million for a 73% stake in the firm, Power Machines, but the deal was blocked by Russia's antitrust authority, reportedly for national-security reasons. The firm's owners said this month that they are negotiating to sell a majority stake to the Russian government instead. "Success automatically makes you a target," says Mikhail Kozhokin, vice president of KROS, a major Russian consulting and promotional firm. "Once your business becomes a success, you'll have to spend 70% of your time defending rather than developing it."

Western businesses are investing with eyes wide open. "The politics do concern us," says Grant Winterton, Coca-Cola's regional manager for Russia, Ukraine and Belarus. The beverage titan knows the risks firsthand. Coca-Cola invested $800 million in the 1990s to build 11 plants in Russia and an extensive distribution system. The company's fortunes took a severe knock in 1998 when Russia was hit by a debt crisis and a massive devaluation of its currency. But since then, Coca-Cola's Russian operations have grown back to profitability, Winterton says, and it has half of Russia's $1.9 billion carbonated-soft-drink market. Thus, concludes Winterton, "the opportunity far outweighs the risk."

Where are the greatest dangers? Christopher Weafer, chief strategist at Alfa Bank in Moscow, expresses caution about the energy sector and other areas that could be construed by the Kremlin as being of strategic value. A lack of legal enforcement of ownership rights makes investments in those areas particularly vulnerable. "Putin will have to follow through on his promise to end some of the unsettling actions that are driving capital flight and blocking investment," says Weafer. According to Russia's Central Bank, capital flight quadrupled last year, to $9.4 billion. But for now, Western companies seem eager to keep on buying, and it's not hard to see why. Many are lured by the stellar performance of such companies as Eldorado, founded a decade ago by two brothers, Igor and Oleg Yakovlev. The company says its sales jumped 83% last year alone, to $2.5 billion. With numbers like that, Russia may well be a risk worth taking. --With reporting by Yuri Zarakhovich/Moscow

With reporting by Yuri Zarakhovich/Moscow