Slow Death




Huge, inefficient and crime-infested, Russia's biggest automaker AvtoVAZ faces enormous troubles as cars stack up, workers go without pay and large tax bills threaten to bankrupt the company.


"The company is going to die a death by a thousand cuts".


Victor Frumkin


TOLYATTI, Central Russia -- Looking down from the 24th floor of the blue, glass administrative building at AvtoVAZ, Russia's largest auto maker, it's hard to miss the cars. More than 14,000 of them, new models and old, stretch out across the inventory lot in long, multicolored lines and make a sort of paisley pattern on the test track.


The cars are a big problem. AvtoVAZ has been producing a lot of them -- 742,470 last year -- but Russians aren't buying. Now, at the factory and at regional distribution centers, the company has a backlog of as many as 140,000 cars, or a full quarter's production. Salaries are as much as two months late, and management has announced a 17 percent production cut for 1998. In short, AvtoVAZ is headed for a long, hot summer.


"The market is saturated," said Tatyana Sokolova, president of the Renom dealership, located a few blocks from the factory gates in Tolyatti, 800 kilometers southeast of Moscow on the Volga River. "They have overfed it."


How quickly things change. Only in March, chairman Vladimir Kadannikov was boasting that AvtoVAZ's production had reached the highest level in years, and the factory was planning a joint venture with General Motors division Adam Opel AG to make another 50,000 cars annually. Some stock market analysts were even calling the chronic dud a good buy.


But now, AvtoVAZ's warts have come to the surface. Its production targets have proven too high for the market to bear: While auto registrations continue to rise, nobody wants the factory's clunky cars, even though their average price has fallen about 10 percent since the beginning of the year. Its huge debts, which include about $1.2 billion in back taxes, look much less surmountable than they did last year, when interest rates were much lower.


"The company is going to die a death by a thousand cuts," said Victor Frumkin, an automobile analyst at United Financial Group in Moscow. "It's just going to sit there ... until someone sees the potential value in some of its assets, strips them out and creates a different franchise or does a complete management overhaul."


AvtoVAZ announced Monday that it had started cutting back production. Beyond that, management appears to have pinned its hopes on a ruble devaluation to solve its financial problems.


"It's cynical to say, but in the case [of a devaluation], the situation at AvtoVAZ would be better," Russian media quoted Kadannikov as saying at the company's last shareholders' meeting in late May. "There would be a different effectiveness of export sales, and demand would be different. Seeing that money is losing its value, people would buy durable goods in the hopes of saving at least something."


In many ways, AvtoVAZ epitomizes the problems of corporate governance in Russian industry. Huge and inefficient, the company has been glacially slow in shedding the Soviet notion of production at all costs. Privatization hasn't helped, since no clear owner has emerged to sort out the company's problems. AvtoVAZ was the first stomping ground of shady financier Boris Berezovsky, who is reputed to maintain influence over the company through his auto dealership Logovaz and through the All-Russian Automobile Alliance, an investment company. Insider deals and criminal groups sap would-be profits, and attempts at reform have been half-baked at best.


Despite protectionist import tariffs, AvtoVAZ has lost much of its market share to foreign competitors and put out only one truly new model -- the slow-selling 2010 -- in this decade. Short on working capital, which often disappears in mysterious ways, it has become a giant in the cashless economy, bartering its cars for inputs from suppliers throughout the country and abroad.


The company has halted its production several times over the past decade, but this time, it faces a tough constraint. If sales don't pick up, the company could default on its back tax debts, triggering a mechanism under which the government would be able to auction off a controlling stake to the highest bidder.


If a big foreign auto maker like Daewoo or General Motors could be tempted to take over, the company might see some positive change. Chances are slim, however, that the foreigners would want to take on such a challenge, given the company's bad reputation and a fear of emerging markets.


"There's a lot of concern about getting in bed with Russian companies now," said James Fenkner, managing director of CentreInvest Capital Management. "The tide of perception has changed."


The other glimmer of hope is the joint-venture deal with Opel, under which the company could produce the relatively desirable Astra. Competitors such as GAZ, which recently signed an $850 million joint-venture deal with Fiat, are already off the starting line. At the May shareholders' meeting, Kadannikov said a general agreement could be signed this month "if they don't get scared."


"The paramount problem is the product, which is not competitive, even at the current price levels," said Sergei Arsenyev, an automotive analyst at Fleming UCB investment bank. "The joint venture with Opel would be the threshold after which the company could present value for investors."


BAD MANAGEMENT


If AvtoVAZ can be turned around, anything in Russia can. The company's recent history reads like a litany of the shortcomings of economic reforms, from organized crime to crony capitalism.


The factory was born in the late 1960s under Leonid Brezhnev, who invited Fiat engineers from Italy to build the biggest automobile factory the Soviet Union had yet seen. The assembly line alone stretches for two kilometers, and the factory is now by far the largest employer in Tolyatti, with 259,000 employees making an average of $333 a month.


The management has built itself a shiny new administrative building with panoramic views of the factory and the nearby Volga River, but the assembly line has stayed behind the times. The factory keeps producing a lot of cars, such as the ubiquitous Zhiguli, a.k.a. Lada, that are, in their heart and soul, 1960s Fiats. The exception is the 2110, a 10-year-old design that looks more like a Japanese car, but at $10,000 costs too much to compete with imports.


The factory's efficiency is appalling. According to United Financial Group, AvtoVAZ needs 450 man-hours to produce an early model Zhiguli, and 150 to produce a new 2110. The average among Western European auto makers is 28 man-hours per car. In Japan, it's 17.5.


With the advent of perestroika, the company started to lose control of its distribution and finances. According to police sources, racketeers infiltrated the factory floor, dividing up the company's production among themselves as the cars came off the line. When the factory's customers came to pick up their cars, they would have to pay a fee to these groups to ensure safe delivery.


In 1989, AvtoVAZ became the launching pad for Berezovsky's career in business. Kadannikov and Berezovsky, who at the time was working on automated management systems at the factory, pioneered a lucrative scheme now known as "re-export." Berezovsky set up an auto dealership called Logovaz, and Kadannikov sold him cars at artificially low export prices. Logovaz resold the cars at market prices within Russia, making a tidy profit.


Logovaz went on to become Russia's premier dealer of both domestic and imported cars, such as Mercedes and BMW, while AvtoVAZ floundered, building up huge debts and bleeding cash. Dealers frequently took deliveries of cars and paid much later, terms that in an inflationary economy meant big profits. Sometimes they didn't pay at all.


Today, AvtoVAZ managers say they have ended their connection with Logovaz, although Berezovsky's company has reportedly been accepted into the International Association of VAZ Dealers, an organization ostensibly designed to create a civilized retail market. According to United Financial Group, Logovaz still holds a 2 percent stake in AvtoVAZ.


Kadannikov and Berezovsky also collaborated to launch the All-Russian Automobile Alliance, a consortium that promised to raise some $3 billion to produce a new generation of Russian cars. In 1994, AVVA sold $50 million in shares that doubled as lottery tickets for new automobiles. Most investors have yet to see any returns, though AVVA did ultimately invest in a small assembly plant in Finland. Last month, AVVA promised its investors the opportunity to convert their shares into AvtoVAZ stock. AVVA, controlled by Berezovsky, has a 34 percent stake in AvtoVAZ.


Despite the many foibles of AvtoVAZ management, the government for many years supported the factory with protectionist tariffs as high as 100 percent on imported cars. But the protection wasn't tied to any specific changes at the factory, and AvtoVAZ managers continued to complain of a lack of capital to undertake modernization and put out new models, while competitors such as GAZ in Nizhny Novgorod were busy adapting to the market.


In late 1995, just after Kadannikov had negotiated yet another tariff hike with his friend President Boris Yeltsin, former Deputy Finance Minister Sergei Alexashenko, now a deputy chairman of the Central Bank, made a prediction: "In two to three years, the Russian-produced Zhiguli will be uncompetitive, not only in Europe, but in its own country." He was right.


BRIEF REAWAKENING


The government started to get wise in late 1996, when it slashed import tariffs, starting a process that has brought more competition to the Russian market, particularly to AvtoVAZ. Then last year, the Emergency Tax Commission cracked down on AvtoVAZ, which, according to CentreInvest, had become the country's largest tax debtor, with a whopping $2.4 billion owed to the budget and various budget funds. It also owed $562 million to state-owned Vneshekonombank, including a loan of $514 million made in 1988 to develop the 2110 model.


The government agreed in August to restructure AvtoVAZ's debt, but on one condition: The company had to issue a controlling stake of 50 percent plus one share and park it with the state until the debt was paid. If the company misses two monthly payments, which average about 200 million rubles each, the government can claim its stake and auction it off to the highest bidder.


For a while, it seemed that AvtoVAZ management had been shocked into action. The 2110 finally appeared on Moscow's streets. The company started retiring older models, cooperating more closely with General Motors and giving production units more responsibility.


Most importantly, AvtoVAZ started reforming its dealership network, trying to claim a larger share of profits for itself. Under the old system, the lion's share of cars had gone to wholesale intermediaries in Tolyatti that had close connections to the company's managers. The wholesalers received large discounts either in cash or by providing supplies as barter payment. Dealers from Moscow and the regions would then come to Tolyatti to buy cars and transport them to end customers.


"These wholesale intermediaries just pass the product on and take the margin that is created by barter pricing," said Frumkin of United Financial Group. "The barter price undercuts the factory price, and the only loser in this whole situation is AvtoVAZ."


Under the new system, AvtoVAZ turned some of its service centers into a network of regional distribution centers, bypassing the Tolyatti wholesale market and getting the cars closer to the end customer. Dealers in Tolyatti immediately felt the competition.


"When the regional centers appeared, the Tolyatti wholesale market started to die," said Sokolova of Renom. "People don't like to come to Tolyatti, because they see it as criminalized."


The fact that two lower-tier managers were killed soon after AvtoVAZ launched its new system didn't help the town's reputation. AvtoVAZ sent an open letter to Yeltsin demanding extra protection. The action brought some results: Police started patrolling the factory floor, keeping out the racketeers. Dealers, however, say that the racket continues outside the factory, and that anyone who wants to take delivery of a car with special paint or modifications must pay.


"You can get a white car or a four-speed without paying extra, because they don't sell well," said one Tolyatti-based entrepreneur, who asked not to be named. "But if I need a certain color, I talk to the people who can get me one. Here, everybody knows who they are. It's a small city."


The reform of distribution, too, has been undermined by the management's bad habits. Under various re-export schemes, cars still wind up for sale in Moscow and other Russian regions at prices cheaper than the factory's own distributors can offer. The same happens with cars that the factory sends out at low implied prices as barter payment for supplies. Tolyatti management still gives privileged discounts to some dealers.


"You can't work in a situation where one dealer gets a 20 percent discount and another gets a 28 percent discount just because somebody in top management likes him better," said a distribution manager at AvtoVAZ in Moscow. "The price of the car should be the same everywhere. As it is, one and the same car can vary in price by 10 percent."


The creation of the new distribution system did, however, allow AvtoVAZ to park a lot of unsold cars in the regions, which helped it reach the 742,470-car production level that Kadannikov bragged about in March. But just as the chairman was announcing plans to produce 748,500 cars in 1998, the market was pulling the rug out from under him. Despite a bargain-basement dealer discount of 30 percent, nobody was buying the cars: In Moscow, for example, the company sold only 4,000 cars in May, compared to 7,500 in the same month of last year. The regional centers' inventory lots were filling up fast, and AvtoVAZ was running out of cash.


According to one supplier in Tolyatti, who asked not to be named, the factory started paying him in cars instead of cash as early as January. "It's a big pain when the factory starts paying in cars," said the supplier. "I have to pay bills. I have my own suppliers."


For local dealers, the growth of barter is a boon that means access to cheap cars. "I love nontraditional schemes," said Sokolova. Under one such scheme, Sokolova pays a factory in Voskresensk to send fertilizer to Bashkirian farmers, who provide food to a local factory that makes KamAZ dump trucks needed by the city of Tolyatti, to which AvtoVAZ pays taxes in cars. When Tolyatti receives the dump trucks, it gives the cars to Sokolova, who sells them at a profit.


By the shareholders' meeting at the end of May, Kadannikov could no longer ignore the company's problems, which he had previously written off as a normal seasonal fluctuation. He said that the company, which closely guards its financial data, had logged a net loss of 12 million rubles on some 22 billion rubles in 1997 revenues; analysts expect the losses to grow this year. He blamed the country's financial crisis and retreated to what has become the management's motto: "There's no money, but we have to spend more on development."


Analysts aren't buying it. "AvtoVAZ's value is being eaten away by its management's inactivity and inability to stand up and turn things around," said Frumkin. "They have no incentive to do anything, because they're getting backhanders."


AvtoVAZ officials were tight-lipped about any plans they might have for the company's recovery. The press service refused an interview request, saying that September would be better. Visited in his office, Viktor Klintsev, an aide to AvtoVAZ president Alexei Nikolayev, refused to comment.


The Moscow-based AvtoVAZ manager said that bankruptcy proceedings could soon be launched against the auto giant. But according to Yury Tyamushkin of the control and revision department at the Federal Bankruptcy Agency, no such action has yet been filed. With the government under heavy pressure to increase its tax revenues, and with 259,000 people in Tolyatti dependent on the factory, bankrupting AvtoVAZ would be difficult.


Meanwhile, competitors are taking over AvtoVAZ's market. Imports such as used Opels and Audis and new Skoda Felicias compete favorably on price and quality with the 2110. Daewoo is assembling small cars in Rostov-on-Don. In an ultimate slap in the face, Fiat, which built AvtoVAZ, has inked an $850 million joint-venture deal with GAZ to produce 140,000 cars annually by the year 2003.


Summer is a bad time for auto sales in Russia. If AvtoVAZ can't keep up with its tax debts -- it's already a month behind -- the government will end up with a big, insolvent auto factoryon its hands. The Opel deal hasn't happened yet, and AvtoVAZ's managers face a tough sell convincing the foreigners that their cars won't fall prey to the same barter and backhanding that all the company's other products have. No matter what happens, Russia's largest auto factory will need a miracle to survive.


As Fenkner of CentreInvest put it: "You can't teach an old car salesman new tricks."