For the foreign manufacturer of consumer goods, Russia is no longer virgin territory. Since the break up of the Soviet Union in 1991, multinationals have been satisfying Russians’ hunger for products that were in scarce supply in the old centrally planned economy. Some Western brands have already become household names. Today’s true pioneers, then, are not those trying to enter the Russian market, but those intent on building market share in the face of fierce competition and realizing decent returns in what remains a perilous environment.

To succeed in Russia, companies will need to have commitment to long-term rewards, flexibility in adapting to local conditions, which might mean overturning what is accepted wisdom at home, and excellent local management skills. But these things are not enough. Companies that thrive here will quickly seize opportunities to position themselves, and then prepare for keener competition. By actually driving the restructuring process in Russia, foreign manufacturers can help secure their own future. For consumer goods companies, that means controlling critical links in the emerging industry chain—distribution in particular.

Mapping demand

Few doubt the potential rewards in a market of 150 million consumers. Greater Moscow alone has a population of over 11 million, more than the entire Czech Republic. St Petersburg, Russia’s second largest city, has 5 million inhabitants, making it as big as Slovakia, Denmark, or the state of Indiana. Already, purchasing power parity easily outstrips that of India and China (Exhibit 1), and such indicators as inflation, per capita income, and wages (Exhibit 2) suggest that "catch-up" consumption will drive growth as Russia’s economy evolves along free-market lines.

Per capita income at present is very low, and will take generations to approach current Western levels. Yet official figures undervalue the wealth that exists in a society with such a large unofficial economy—and they certainly cannot explain why so many Mercedes crowd the streets of Vladivostok. Moreover, with many costs—such as rent and certain staples, like bread and milk—remaining under price control, disposable income is relatively high. An unusually large proportion of household spending goes on food: some 35 percent, compared with around 15 percent in the West (Exhibit 3).

A growing market

Since the demise of the Soviet Union, income distribution has become more uneven and a middle class has emerged that can afford to buy foreign goods regularly. Estimates suggest that at least 30 percent of Russian households currently earn over US$200 per month (Exhibit 4). These higher income groups tend to be concentrated in major urban areas, creating islands of opportunity for manufacturers seeking new markets. In Moscow alone, there is a target high-earning market of 4 million people. Fifteen of Russia’s 23 biggest cities represent attractive staging posts for foreign manufacturers by virtue of absolute income level, disposable income, or economic base. Of these, five—Moscow, St Petersburg, Nizhni Novgorod, Samara, and Chelyabinsk—stand out as particularly attractive; they also form the core of regional concentrations, such as Moscow, Tula, and Yaroslavl’ (Exhibit 5).

The product categories available to these wealthier consumers have mushroomed, and some are already dominated by foreign brands. Chocolate bars, for example, were largely unknown in Russia before MasterFoods began importing its Snickers product in 1991. MasterFoods now has a combined 65 percent of a US$300 million market. Further proliferation will inevitably occur as lifestyles and tastes change. Pet food sales are already rocketing as pet ownership—regarded as a sign of wealth—increases; the Russian diet is starting to include more protein and fresh produce in place of basic carbohydrates as better distribution improves availability; and convenience foods are likely to grow in appeal to women still accustomed to spending long hours in buying and preparing food.

Russians are sophisticated and growing more so—they are said to be the only people in the world who can read bar codes

All this gives manufacturers the opportunity to shape consumer tastes and develop brand awareness. But this will be no pushover. Russian consumers are sophisticated and growing more so—they are said to be the only people in the world who can read bar codes—and their initial curiosity is turning to cynicism under the barrage of advertising and increasing choice. As yet, brand loyalty is limited. Awareness of certain Western products, such as Coca-Cola and Levi jeans, existed before the liberalization of the market and is extremely high. In general, though, consumers are keen to sample different products, and price is no longer the sole factor in decisions.

Assessing risks

These opportunities sometimes seem outweighed by problems. The vast terrain (three times the size of the European Union), poor infrastructure, confusing legislation, and changing political landscape will test even the best. Then there is red tape, corruption, high taxes, and organized crime to contend with, all absorbing management time and resources and cranking up the cost of doing business in Russia.

Precarious supply

Consider the problem of transportation. Greater urban affluence makes cities obvious targets for foreign manufacturers (see the map opposite). As a result, in a handful of highly developed markets, such as Moscow and St Petersburg, demand for established product categories already approaches saturation point.

Stray further afield—a strategy late entrants to Russia are being forced to consider—and you encounter a logistical nightmare. Though operating at a lower cost in the regions might seem preferable to fighting entrenched first-movers in Moscow and St Petersburg, participants will feel the burden of greater distances. If it takes a week to truck goods from the West to Moscow, it will take another week to get them from Moscow to the Urals. Perishable goods may not survive the journey—if they arrive at all, for trucks frequently disappear en route. Hiring guards is not uncommon, adding to freight costs.

Meanwhile, the unofficial grey market can supply almost anything. One well-known US canned food producer lamented that local distributors hardly bothered to contact it to arrange supplies or prices: "In reality we control very little. We’re pleased the product is popular, but we are in danger of losing control of it and our brand name." Manufacturers of costlier durable consumer goods are particularly concerned about the emergence of local "me too" products, which mimic their brands and have forced them to spend time and money defending their territory in court and via advertising. Reebok has resorted to television ads that list the tell-tale signs that distinguish its shoes from the counterfeits.

Stable demand?

The good news is that Western goods are much in demand relative to local ones, though companies should be aware that this advantage could prove short-lived. Much Soviet production collapsed along with the economy, which is why Russians often have no choice but to import. There is also a clear preference for Western goods, as products manufactured locally are thought inferior.

In similar markets, foreign companies lost market share when national pride reasserted itself after an initial infatuation with all things Western

For the time being, consumers are willing to pay a premium for imports. But at some point in the future, once Russian manufacturers are back on their feet, there could be a backlash like those seen in such countries as Poland, Slovakia, and the Czech Republic. In these markets, foreign companies lost market share when national pride reasserted itself after an initial infatuation with all things Western. In Russia, there seems to be a trend toward more protectionist legislation, with tariffs on imported consumer goods steadily rising to protect domestic companies.

MasterFoods already faces something of an ideological problem with Snickers, which has been so successful that some Russians associate it with negative as well as positive aspects of the shift to a market economy. Though consumers welcome the availability of Western goods, their presence calls attention to the widening gap between those who can and those who cannot afford such luxuries. Against this background, a long-established local brand like Romance stands a good chance of gaining market share through its appeal as "real Russian chocolate." Recognizing this national loyalty, some local manufacturers are upgrading packaging and product quality and employing increasingly sophisticated advertising techniques to compete with foreign rivals.

Multinationals need to choose between wearing a Russian badge, retaining a Western image, or blending the two

In response, multinationals are tailoring their products for greater Russian appeal. Knorr has selected soups most likely to please the Russian palate; Vidal Sassoon packages its shampoos in smaller bottles to suit the Russian pocket; Uncle Ben’s markets its tartar sauce not to accompany fish, but to pour over potatoes; Cadbury has transcribed its logo into Cyrillic; and Pripps/Hartwalls’ improvements to some of Baltica’s beers reflect the sensitivity needed to raise quality without losing the distinctive Russian taste. These kinds of marketing decisions reflect manufacturers’ awareness of a distinctive and increasingly discerning Russian consumer. Multinationals need to be able to make the choice between wearing a Russian badge, retaining a Western image, or blending the two.

Building a position

Weak legal protection has limited direct foreign investment in Russia. At the beginning of 1994, the figure stood at US$2.5 billion, compared with US$5.6 billion in Hungary and US$3.0 billion in Poland. Consumer goods investment—accounting for some 25 percent of Russia’s total—has tended to favor industries where margins are high, such as tobacco, or where technology is basic, such as detergents. Even experienced foreign players have found themselves conned, paying millions of dollars for a nonexistent stake in a joint venture or manufacturing plant.

Almost all foreign entrants have imported their products at first—an opportunistic strategy that exploits demand based on novelty and scarcity. While such an approach can create a new category, it appears to be unable to support more than a small (5 to 10 percent) share of a more established category, and is thus not a sustainable strategy. Manufacturers tend to opt for some sort of local production as the market grows, often to guarantee supplies as well as to control overall costs.

"The rationale to build a plant is not that of production cost per se, but of logistics and availability, and the uncertainty of import duties," says the general manager of Wrigley in Russia. "Not to manufacture in Russia is a risk in the long term," Pepsi-Cola concludes. "The factory helps us to support our local customers and cope with unforecasted demand."

For durable products like white goods, however, the move toward local production is proceeding more slowly, since the market for such relatively costly appliances is still quite small.

Brown- or greenfield?

To establish local production, a newcomer can opt (perhaps in a joint venture) to buy and refurbish an existing facility, a so-called "brownfield" development. Alternatively, it can elect to invest in a new "greenfield" site. Experience of the two options to date has been mixed.

The brownfield approach has the advantage of utilizing an established operation that may offer some protection in an unknown environment. It is better suited to low-technology industries. Pripps/Hartwalls’ joint venture investment in Baltica Breweries of St Petersburg is an example.

On the other hand, investment in a greenfield site means superior efficiency and productivity, but entails a greater outlay, as Coca-Cola and MasterFoods have discovered. A variation with fewer risks attached is to acquire and adapt Russian brands, a strategy pursued by manufacturers keen to capture local tastes. Grand Metropolitan, convinced that consumers will prefer traditional products if they are of good quality and packaged well, is investing US$100 million in joint ventures with Russian food and beverage manufacturers.

However manufacturers source their products, the key to success will be efficient distribution

However manufacturers choose to source their products, the key to success will be efficient distribution; whether from importer or factory gate, right through to distributor, wholesaler, and retail outlet. It is by controlling distribution that manufacturers will strengthen their market position and keep a lid on costs.

Distribution is key

The centralized distribution of the old Soviet economy, where state-produced goods were shifted from regional warehouses to tied retail outlets and monopolistic trade organizations, has evolved somewhat, but remains inefficient and uncompetitive. However, more dynamic and commercial private distributors are emerging, and already account for the lion’s share of the market.

Some one hundred large distribution companies operate in Russia, most of them in and around Moscow (Exhibit 6). The top 30 account for 70 percent of sales and are increasing their hold. Distributors are finding it easy to make money in the transition to a market economy. As a result, they are not particularly interested in investing, prefer new categories to intensely competitive ones, and are reluctant to take products that are not backed by advertising.

The bigger distributors are likely to demand credit terms that will prove expensive in an inflationary environment. Moreover, they are rapidly developing into cartels to protect their position; indeed, some manufacturers are already experiencing pricing pressures. The feeling is that these distributors could become a barrier to progress.

In response, some foreign manufacturers have decided to try and exert influence over their distributors, either by injecting competition into the system by avoiding exclusivity, or by investing in distributors to ensure better service. Kellogg, for example, has chosen to buy its distributors’ vans.

In Russia, you often need pragmatic compromises—you do what you can yourself, but have to leave some things to others

Another option—but an expensive one—is to build your own channels. Pepsi-Cola has its own distribution networks in Moscow and St Petersburg, but relies on distributors in outlying regions where demand is too thinly spread to justify the expense of a salesforce. To overcome early distribution problems in Moscow, Spendrups distributed its beer via local post trucks and sorting offices. Danone chose to preempt any difficulties by having its own truck fleet delivering to its own in-store shops in large stores. These are the kind of pragmatic compromises often needed in Russia: you do what you can yourself, but you have to leave some things to others.

A third route is to create retail pull. The retail link in the industry chain remains relatively unsophisticated. Russian retailers fall into three main types: traditional stores, kiosks, and new Western-style shops—supermarkets and specialty boutiques. As with distribution, retailing is less developed in the regions, with fewer outlets, smaller assortments, and shallower penetration.

Many shops continue to use shelf space primitively, relying on merchandising criteria rather than rate of sale or profit per square meter. For manufacturers, this means frequent store visits in return for small orders. To boost retail demand, some manufacturers have invested in salesforces to recruit retailers and control merchandising. MasterFoods, for example, has installed chilled cabinets for free in some shops.

In downstream activities like advertising and promotion, the most striking development is the surge in costs. In 1994, advertising costs increased fourfold, reflecting rising demand for limited resources (Exhibit 7). Television remains the most effective advertising medium because of the sheer size of its audience: a slot on the Ostankino channel reaches 120 million viewers. As a result, control of advertising slots currently gives any manufacturer a leading edge.

The rewards

In the past four years, foreign consumer goods companies have entered the Russian market in three distinct phases. First came opportunistic sales in Moscow and St Petersburg. Then joint ventures followed, with some regional penetration, advertising, and closer ties with distributors. Now that the market is coming to life, acquisitions and greenfield investments are growing, greater attention is being paid to Russian preferences, and manufacturers are forging more professional links with retailers. Most entrants have found that low entry costs quickly give way to substantial investments.

Successful participants are those that identify the opportunities and move quickly and decisively to realize them. Such players will enjoy the cost advantages in the years to come. Take MasterFoods, which became the first foreign confectionery manufacturer to enter the Russian market when it launched Snickers four years ago. For a while it enjoyed a virtual monopoly, and it still possesses a market share more than three times that of its two closest competitors—Cadbury Schweppes and Nestlé—put together (Exhibit 8).

With the exception of the final distribution to retailers, MasterFoods has established near-total control of the industry chain. As part of this strategy, it is building greenfield production plants at Stupino, near Moscow, and has won an import duty break on its cocoa imports thanks to the size of its investment. By introducing nearly all its confectionery, plus its ice-cream bars, MasterFoods has been able to spread the cost of distribution over a wide range of products.

Cadbury Schweppes, which entered Russia a year later than MasterFoods, had no local production, relying instead on an exclusive agreement with both a local importer and a distributor to handle its products. The company has recently announced plans to build a plant near Novgorod, in conjunction with its Russian distributor. Nestlé, which entered the market in 1993, uses several importers but has recently acquired a 49 percent stake in a local company based in Samara.

MasterFoods’ early entry and decisive campaign to secure control of the various stages of the industry chain have given it a lead that will help it withstand the competitive challenges ahead. It may lose market share as competitors establish themselves, but its Stupino plant will reduce its cost base in a category that has already seen aggressive pricing among leading brands. Being the first mover has enabled the company to build up a powerful brand awareness that hinders competitors’ attempts to recruit competent personnel—a scarce resource. Moreover, the massive recent increases in advertising costs make it all the more difficult for newcomers to bridge the gap.

At the very least, MasterFoods has provided itself with a cost cushion that will allow it to enjoy above-average margins for a few years. It may even have closed the window of opportunity for others not already operating—or only marginally involved—in Russia.

Beach-head fundamentals

The companies that prosper in Russia will be those that can engineer their costs down. When market share and price wars emerge, the outcome for others is likely to prove dismal. It is clear that the middle-class markets of Moscow and St Petersburg will not provide sufficient critical mass to recoup high fixed costs. In smaller Eastern European markets like Hungary, even companies with market shares of over 40 percent have been losing money. Some believe that because Russia is much bigger, it will develop differently. Though this may be true, for the foreseeable future Russian markets will resemble unconnected islands, where as fast as sales grow, so will margins be squeezed.

Margins will be squeezed by Western competitors looking for new markets to compensate for stagnant demand at home. They will be squeezed by enterprising distributors who seem to be well on the way to creating local oligopolies. They will be squeezed by resourceful retailers and, eventually, by local consumer goods manufacturers.

Once you secure a beach-head, you cannot afford to wait for business conditions to improve and risks to fade

Multinationals that are already well established are in the best position to begin lowering their costs. Openings remain for manufacturers that can identify neglected market segments, though experience suggests that once you secure a beach-head, you cannot afford to wait for business conditions to improve and risks to fade. If the Russian opportunity is not to be missed, pioneers must move quickly to defend and expand their position by controlling distribution, advertising heavily, and planning local capacity—which all adds up to a significant financial commitment.

If the Russian opportunity is not to be missed, pioneers must budget for significant financial commitment

There are few rules, and each pioneer will have to devise its own solutions to the problems it encounters. But one thing is sure: given the size of the necessary investments and the risks in a changing political, social, and economic environment, Russia is not for the faint-hearted.