Pull up to the bumper

By bne IntelliNews April 2, 2008

Ben Aris in Berlin -

Nothing epitomises capitalism more than the car, and nothing underscores the rapid catch up the former Socialist bloc is undergoing than roads from Bratislava to Almaty clogged with new cars.

Car sales in the region have mushroomed since the advent of consumer credit in about 2001 and foreign manufacturers' rush to set up factories or buy existing ones is in full swing. But according to a report from PricewaterhouseCoopers titled Eastern Influx, these companies shouldn't move too fast or they may come a cropper.

Despite the dangers, it's easy to see why these companies are drawn to the region. In 2006, some 740,782 new cars were registered in the eight member states that joined the EU in 2004 - 2.2% more than in the previous year, thanks largely to a strong performance in Slovakia and soaring demand in the Baltic states.

The combined population of the accession states is about 80m, but demand for new cars ranges from 10-15 per 1,000 people, compared with an average of about 30-40 per 1,000 people in the EU15. This suggests that the market could ultimately increase by as many as 2m vehicles. The Russian market is growing even faster, where last year the sales of foreign-made cars outstripped those of the domestically manufactured Volga and Lada saloons, despite Russian cars costing several thousand dollars less than foreign models. All in all, new European markets accounted for almost all of the world's 6% increase in demand between 2000 and 2005, while traditional markets in industrialised countries were flat, says PwC.

Foreign plants in the region

The Japanese carmaker Suzuki led the way in Central Europe when it built a plant in Hungary in 1990; it now produces about 140,000 vehicles a year and is one of the country's largest employers.

In Russia, the foreign-branded but domestically-made passenger car arrived in Russia in 2002, when the General Motors (GM)-AvtoVaz joint venture began to produce the Chevrolet-Niva SUV and Ford's Vsevolzhsk car plant started to assemble the Ford Focus. These two deals marked the start of an explosion in Russian consumer spending that has changed the economy out of all recognition. Since 2002, foreign-branded production has rocketed 24-fold and by the end of 2007, there were nine plants in Russia assembling foreign-brand passenger cars.

PwC estimates that between 1991 and 2006, foreign carmakers invested $20bn in new facilities throughout the region, boosting its share of global automotive manufacturing from less than 5% to about 6.8%. And these companies will invest another $6bn in new facilities in CEE over the next five years, according to PwC estimates. The Czech Republic, Hungary, Poland, Romania, Slovakia and Slovenia will attract the bulk of this investment.

The pull of the region

The main reason carmakers are moving east is to take advantage of the low cost of a relatively high-skilled labour force. According to the Federation of European Employers, average wages in the region are currently between 16% and 34% of those in Germany. Even Spain, once regarded as a cost-effective manufacturing country, has lost its advantage; Bernd Pischetsrieder, former chairman of Volkswagen, reports that wages at the company's Spanish subsidiary, SEAT, are now twice those of Skoda. "Given a real annual wage increase of 4% in Slovakia and 1% in Germany, for example, it would still be more than 70 years before wages in the former matched those in the latter," says PwC.

The second reason is a bizarre "trading places" scenario as the industrialised countries struggle under restrictive worker-friendly labour codes drawn up in bygone times of prosperity, while the countries of the former worker's paradise now have some of the most employee-friendly labour legislation on Europe's books. And nowhere are these problems as bad as in Germany, Europe's largest car market. "The labour laws are also far more benign and the unions far more fragmented [in CEE] than many people realise. In all but three states, it is as easy to hire and fire staff as it is in Germany and it's always cheaper," says Stephen D'Arcy, Global Automotive Leader at PwC.

Working hours are also fairly flexible outside the Baltic states. The working week is typically 40 hours and overtime is limited to 416 hours a year, except in Hungary where the limit is 200 hours.

Low taxes are another big pull factor. The Western European countries were expecting to gain access to a new consumer market with a population of over 80m after the Central European countries joined the EU in 2003. What they got was an aggressive competitor that boasted low wages, employer-friendly labour codes and undercut them by slashing corporate taxes. The Germans complained loudly about the "fiscal dumping."

However, the picture is not as simple as it first appears, and many of the countries that look like they sport extremely low taxes have a lot of hidden extras. The tax rates in the accession countries have been widely misunderstood. "Slovenia has the second highest statutory corporate income tax rate in the region, but the total tax take is lower than in any other country except Poland. Conversely, Hungary has a statutory corporate income tax rate of just 16%, but social security and health insurance costs raise the total tax take to 59.3%," says PwC.

Lack of labour

What was a no-brainer for companies 10 years ago, to make a clean exit from their home market, is not so obvious now. The rapid growth that car companies have helped fuel is undoing many of the advantages that brought them there in the first place.

Slovakia is already falling victim of its own success. Wages may be low - average wages in the region are currently between 16% and 34% of those in Germany - but this doesn't help if there is no one to employ. The huge new factories have soaked up skilled labour to the point where finding qualified employees is fast becoming the main problem manufactures are facing. "Chasing location on the basis of just labour costs is not a good strategy," says Matt Pootle, PwC's CEE regional director. "The primary driver should be the availability of labour. And this doesn't go on a country-by-country basis. There are hot spots of labour scarcity - in Bratislava, Prague and Budapest the unemployment rate is effectively zero as everyone who wants a job can have one."

Pootle points out that there are huge differences in labour costs within each country. For example, the cost of labour in eastern Slovakia is half that in the west. "The headline numbers of inflation, labour costs and growth are very misleading," says Pootle. "10 years ago this wasn't the case. But now you need to look in depth at the location you want to choose, at the region within the country and not just the country itself."

The upshot of this problem is that the "cheap labour" deal that made Central European countries so attractive for manufacturers in the past is being fast undermined. In order to maintain the high levels of profitability that manufacturers have got used to, these firms are already being forced to think about improving efficiency and profitability, which takes up increasing amounts of their time, says Pottle.

Improving efficiency and profitability: those were the headaches that managers of western car companies were hoping to leave behind.

Build or buy?

Still, if a company does its homework, it's still worth moving, but the pitfalls associated with getting it wrong are many and deep. One of the trickiest decisions a company has to make is: do you build or buy?

When Fiat entered Poland, it purchased Polish manufacturer FSM and modernised the old manufacturing site. On the other hand, Opel's Gliwice plant was a greenfield investment. The choice is fast becoming academic, as there are few big Communist-era factories left on the market, but there are still choices, especially in the second-tier firms that support big car plants and supply components. "In Central and Eastern Europe it is often difficult, for example, to obtain accurate information about a target firm's performance, so the purchaser may end up paying too much. Alternatively, when the business is dependent on a key individual, there may be conflicts of opinion about its value or how it is to be managed after the deal has been completed," says D'Arcy.

Research conducted by PricewaterhouseCoopers shows that there were 2,527 publicly disclosed deals with an aggregate value of $163bn in CEE in 2006 - 70% more than the $91bn that changed hands the previous year. The manufacturing sector accounted for by far the largest share of the deal-making, with 499 acquisitions collectively worth $32.6bn.

On balance it appears that building a greenfield factory is better in the long term to buying one. Numerous studies suggest that at least two-thirds of all M&A never deliver the financial gains on which they were predicated, says PwC. Moreover, most new factories are also 20-25% more efficient than older plants or brownfield sites because they incorporate current best practice in terms of their physical layout and operating procedures.

Roadless Russia

The further east you go, the worse the problems get. Russia's car market is clearly going to be huge and is already big, but the lack of a functioning road network makes for a logistics nightmare.

Russia's car market expanded at an unprecedented 57% in 2007 year-on-year and is now worth $53.5bn, according to Moscow-based investment bank Renaissance Capital, making Russia the second biggest car market in Europe after Germany. By 2010, the Russia car market will increase to 4.55m cars worth $115.7bn and the car loans market will expand to $56.5bn from $16bn today, according to research by Alfa Bank, overtaking Germany in the process.

The most recent addition to the Russian automotive firmament was South Korean company Hyundai's decision to build a state of the art $400m car plant in St Petersburg. Construction is due to start this summer. Japan's Nissan is also building a plant in the city, while Toyota is talking about a $150m second plant in the same location. Ford is investing $100m to expand capacity at its St Petersburg plant by almost 75% over the next two years.

One of the main reasons why so many producers have chosen to set up in St Petersburg is its international port and relatively proximity to Western Europe via the Baltic states. It makes the city one of the few viable locations in the country, but even then the logistics are bad. "All the foreign producers have announced investment plans, but the amount of actual production is still tiny," says Pootle. "The lack of transport infrastructure is a real hurdle for investment into Russia. The railway is a different gauge to Western Europe. There are no decent roads. So although you can drive new cars away from the factory, the problems surrounding getting trucks with parts to the factory in a timely way are enormous."

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