Expansion into Russia
Chapter 2
Expansion into Russia
OVERVIEW OF RUSSIAN ECONOMY
POLITICAL ENVIRONMENT
CHALLENGES TO BUSINESSES IN RUSSIA
PREFERRED MODE OF EXPANSION INTO RUSSIA — JOINT VENTURE
OTHER POSSIBLE MODES OF EXPANSION
S. W. O. T. ANALYSIS
RECOMMENDATIONS FOR EXPANSION INTO RUSSIA
Having discussed Apex-Pal's company background, we shall now take an in-depth look into their recent proposed expansion into Russia. We will provide an overview of the Russian market, as well as the modes of entry available to Apex-Pal. We will also consider the current strengths and weaknesses of Apex-Pal's plans and provide recommendations.
OVERVIEW OF RUSSIAN ECONOMY
Economically, Russia has come a long way since the 1998 financial crisis. According to the Wikipedia website, from 1999 to 2007, Russia experienced nine years of strong economic growth, with GDP growth hitting 7% annually. Much of Russia's remarkable recovery was linked to the rapid increase in oil prices during 1999 and 2000, allowing the country to
chalk up huge trade surpluses which provided much needed capital to bail it out of its financial troubles. Fixed capital investments paid huge dividends, achieving real returns of over 10% annually, while real personal incomes of Russians grew by 12% annually.
Russia's strong economic resurgence helped to reduce poverty and allowed the middle class to expand. Foreign reserves rose from a paltry US$12 billion in 1999 to a staggering US$470 billion in 2007, adding stability to the country's economy. In addition, foreign direct investment rose from US$14.6 billion in 2005 to approximately US$45 billion in 2007. However, by the end of 2007, inflation — brought about by high capital inflow and rising food prices — reached 12% and was beginning to worry politicians.
In addition to inflation, Russia was also concerned about its over-dependence on oil, natural gas and metals which together accounted for more than 80% of all its exports and 30% of government revenues. Investors fear that a sudden fall in energy prices would adversely impact Russia significantly. Between 2005 and 2006, the rubble appreciated by over 20%, increasing the cost burden of foreign investors in Russia.
POLITICAL ENVIRONMENT
Russia is currently ruled by the United Russia Party, which backs the current Russian president, Dimitri Medvedev. In the 2003 Russian parliamentary elections, United Russia Party polled 38.0% of all votes, winning 222 of the 450 seats in the State Duma, the lower house of the Federal Assembly of Russia. The elections reduced all the other participating political parties to minority status.
In subsequent years, United Russia Party continued to tighten its grip over Russian politics. In the parliamentary elections held on 14 March, 2004, Russia's ex-president, Vladimir Putin was returned for a second four-year term as president, with an overwhelming 71% majority of votes cast. The elections gave Putin a strong mandate to rule, although there were rising concerns of excessive recentralisation of power under the president since, and public opinion abroad was that democratic institutions remained weak in Russia.
By January 2005, United Russia Party controlled 305 of the 450 seats in the State Duma, giving it constitutional majority. It also controls 88 out of the 178 seats in Russia's upper house of Parliament, the Federation Council of Russia. In the recent Duma election held in December 2007, the United Russia Party won 64% of the votes cast, thus ensuring its continued hold on power in Russian politics.
In the most recent Presidential Election on 2 March 2008, Dmitri Medvedev won by a landslide of 70% of the votes. Medvedev took over from Putin and started his four-year term as President of Russia on 8 May 2008. Although Putin stepped down as the President, he took over as chair of the United Russia Party, and as the Prime Minister, replacing Viktor Zubkov.
CHALLENGES TO BUSINESSES IN RUSSIA
An issue that raised much attention abroad was the way the Russian Government handled the Yukos Oil Company and its former CEO, Russian billionaire Mikhail Khodorkovsky. While Yukos was generally believed to have indulged in
dubious accounting practices such as the use of tax havens to evade taxes, there were growing concerns that Yukos was a victim of selective enforcement of the Russian Law because Khodorkovsky had publicly opposed the then Russian President Vladimir Putin.1 This incident underscores the sensitive nature of doing business in Russia that foreign investors should take note of: it is best to stick to just doing business and avoid dabbling in Russian politics.
Businesses may be optimistic about Russia's economic future, given Russia's nine years of strong economic growth and a rising middle class, not to mention the availability of natural resources, making her a growth market with as much investment potential as China and India. However, corruption and excessive red tape are among the top deterrents to foreign direct investments. Procedures for obtaining permits and licences are confusing, often providing officials with the opportunity to demand favours in return for expediting matters. There are also growing concerns that the government prefers Russian involvement in key projects as opposed to wholly foreign-owned and foreign-run companies and multinational corporations. Hence, businesses often seek high-level officials to back their biddings, protect their investments and gain competitive advantage. In an article published in the Financial Times, Carlo Gall, a Russian analyst at Control Risk, aptly sums it up, “Corruption is probably the most immediate threat and difficulty that any business faces in Russia — and the trend is increasing.”2
1 Stephen Payne, “From Russia, With Regret,” Oil & Gas Investor, July 1, 2007, 49–51.
PREFERRED MODE OF EXPANSION INTO RUSSIA — JOINT VENTURE
Apex-Pal International's interest in expanding into Russia began in 2003, when founder and chief executive Douglas Foo first set foot in Moscow. Since then Foo has been back to Russia every year to lay the groundwork for Apex-Pal's imminent entry into the Russian market. During each trip, he spends time learning more about Russians and Russian culture, and in particular, the restaurant scene in Russia. Despite the fact that Russia's GDP per capita (PPP) was only US$14,600 in 2007, Foo remains confident that there are Russians in Moscow, a city with the world's third largest number of billionaires, who “won't blink an eye when blowing US$100 on a meal”. In fact, such occurrences, according to Foo, are “normal for them.”3
Not surprisingly, Foo has been approached by several Singaporean entrepreneurs with businesses in Russia. In fact, he has linked up with a few Russian companies to discuss the possibility of a joint venture. To overcome the difficulties of investing in Russia, Foo recognised the importance of “teaming up with the right partner who is familiar with the terrain… (and)… you need a Russian partner to hand-hold you in a fluid business environment where rules, licenses and policies are still evolving”.
Foo is clearly aware of the political complexities and challenges he faces. Given, the difficulties related to the Russian market, expanding into Russia's F&B industry via a joint venture is still the most feasible method.
3 “Sakae Sushi to Open in Moscow,” Business Times Singapore, March 9, 2006, Supplement 29.
A joint venture provides many advantages to Apex-Pal, the most immediate being Sakae Sushi's quick entry into the Russian market. This is due to many factors. Firstly, if the chosen partner has the right political connections, Apex-Pal would be able to secure the appropriate permits and licences quickly and avoid incurring excessive expenses in the process. The local partner would also be able to deal with government officials and effectively manage the relationships with the appropriate authorities to ensure success in the venture.
Secondly, Apex-Pal can tap into its partner's local knowledge and business expertise in deciding on critical aspects of running the business. This will save Apex-Pal valuable resources in time-consuming background checks, market research and preliminary assessment.
Thirdly, a partnership would give Apex-Pal wider access to good Russian managers who are vital to the day-to-day operation of the company.
Fourthly, Apex-Pal will be able to retain a good degree of control over the business compared to if they were to license its trademark to a Russian company.
Lastly, there would be a synergy of ideas and experiences, allowing both parties to improve the company together. The cost of setting up the business as well as the risks involved will also be shared by both partners.
The immediate risks would be the issue of trust and whether the Russian partners will place the interest of the joint venture ahead of their own personal interests. Also, by relying on the Russian partners to maintain strong relationships with the Russian authorities, Apex-Pal would effectively have given their partners a strong hold over them. This increases the bargaining power their partners will have, which may in turn compromise Apex-Pal's position. For example, after the transfer of technical expertise and
business know-how, there is little to prevent the partners from breaking their agreements and start a new sushi chain to compete with Sakae Sushi, unless there is legal recourse to address such damages.
OTHER POSSIBLE MODES OF EXPANSION
Greenfield Investment
This form of entry, also referred to as foreign direct investment, involves the establishment of a new wholly-owned subsidiary. In layman's terms, it means Apex-Pal setting up Sakae Sushi outlets by itself. This gives Apex-Pal absolute control over its Russian operations and avoids the risk of working with dishonest partners. In addition, Apex-Pal can protect its business model and safeguard proprietory technologies.
However, there are many disadvantages associated with Greenfield investment, especially in Russia. Firstly, set-up costs will be high and Apex-Pal may experience difficulties obtaining the permits needed to start Sakae Sushi. Essentially, all the benefits associated with having a strong partner when investing via joint venture, would be lost. Secondly, without the expertise of a local partner, entry into Russia will have to be very well planned and thought through, making expansion into Russia in the short-term unadvisable.
Franchising and Licensing
This form of entry involves licensing the Sakae Sushi trademark to a Russian company. Apex-Pal will be entitled to a
portion of either the gross sales or gross profits made by the company. Often, to obtain the licences, the franchisee would be required to pay the franchisor a fixed sum, as well as to show that they have the capital to grow the business.
This form of entry would achieve most of the advantages offered by entry via joint venture, and would enable Sakae Sushi to earn immediate revenue through licensing fees. Furthermore, since there is no capital outlay, there would be less potential losses, although it would also mean that Apex-Pal would earn less than the joint venture method, should Sakae Sushi become a commercial success.
The main disadvantage of franchising is that Apex-Pal would lose almost all control of the Sakae Sushi trademark in Russia. In addition, the success of franchises often requires a strong legal framework that will ensure that commercial contracts are not breached and the franchisee lives up to his commitments. Given the complex Russian political and legal environment, Apex-Pal may have difficulties enforcing their legal rights if there are disputes. Should the franchisee prove incompetent, this may have adverse effects on Sakae Sushi, damaging its brand equity.
Despite the disadvantages, it is likely that at some point Sakae Sushi would consider franchising as a way of further expanding into Russia. However, without strong global brand equity, it may be difficult for Apex-Pal to find businesses in Russia who are willing to pay the franchising fees. And even if there are potential franchisees who are willing to pay the right fees, not many may have adequate resources to meet the requirements set by Apex-Pal. As the franchisor, Apex-Pal would probably need to beef up its brand equity before thinking about franchising in Russia and franchising fees would probably have to be set at appropriate levels.
S. W. O. T. ANALYSIS
Strengths
Since its humble beginnings as a solitary outlet in Raffles Place 10 years ago, Sakae Sushi has grown from strength to strength to become the leading kaiten-zushi (conveyor-belt sushi) chain in Singapore. With 34 outlets in Singapore alone, Sakae Sushi has a market presence that towers over its closest competitors. Internationally, Sakae Sushi has done well, with 20 outlets in six different countries. In 2007, Apex-Pal, the holding company for Sakae Sushi, saw revenues increase 25.8% to S$83.84 million and gross profit increase 18.93% to S$60.02 million. It is difficult to dispute that Sakae Sushi has one of the most successful and sustainable business models. Compared to traditional brick-and-mortar companies, Sakae Sushi requires a lower set-up cost, allowing it to build rapidly on its success, thus making it relatively scalable.
As is often cited, “Rice is a staple (product). Fish is also a staple. But together (with reference to sushi), you have a luxury product.” The ability to charge high premiums coupled with keeping overheads low makes kaiten-zushi outlets potentially very lucrative. When queried on whether the cost of doing business in Russia would be too high, Foo coolly responded, “High cost… is not a concern because, we can always charge a high price to cover the cost… there is simply not enough supply to meet demand.”4
Expansion into Russia via a joint venture could be highly favourable to Apex-Pal. Firstly, Sakae Sushi can tap into the vast experiences of their partners while infusing their own
ideas. This will allow them to build on each other's core competencies in creating new synergies. Secondly, Apex-Pal is able to share both cost and risk with their partners. In addition, by making their partners stakeholders, mutual benefits ensure greater cooperation between the companies. Lastly, Apex-Pal can rely on the influence of their partners to better navigate the political and legislative complexities involved in starting the business.
Weaknesses
When entering a highly unfamiliar business environment, the challenge does not only lie in ensuring that the business will survive, but the very way a business is started is also a major concern. Finding the perfect partner is a risky bet to start off with. Sakae Sushi once experienced misfortune in the form of a failed franchise partnership in Indonesia. As both parties shared different focuses, the Sakae Sushi outlets did not thrive in the fast-growing sushi-eating market in Indonesia. If a similar outcome occurs in a Russian partnership, Sakae Sushi's future growth in Russia will be severely impeded.
Furthermore, by entering Russia via a joint-venture, Apex-Pal will only retain limited control over the Sakae Sushi outlets in Russia. This raises questions on how quality control may be maintained, and whether Sakae Sushi's brand equity will be tarnished if the outlets were poorly managed. Contracts may provide Sakae Sushi with a degree of protection through legal obligations. However, should relationships sour, enforcing the obligations can be tricky, especially if the legal system favours the more influential local partner. Hence, relying on local partners who have strong connections with local authorities is often a double-edged sword.
Opportunities
An article in The Business Times, Singapore, estimated that Russians spend an average of 47% of total private consumption each year on F&B. This works out to be more than US$130 per year.5 These figures represent the huge potential of the Russian food market, and Sakae Sushi should be able to reap substantial returns if, in the long run, it can establish itself as the market leader amongst kaiten-zushi chains.
Foo also hopes to use Russia as a stepping stone to break into emerging markets in Eastern Europe, in particular those newly independent countries which were former states within the Soviet Union (USSR).
Threats
The threats to Apex-Pal's intended expansion to Russia could come from circumstances that are beyond its control. For example, the strong economic growth which has made Russia an attractive place for foreign investment may not last. Russia's dependence on oil exports may cause the economy to unravel should the price of oil falls, although this is unlikely, given the current demand and supply situation. The high rate of inflation experienced toward the end of 2007 is also another cause for concern. Apex-Pal will also require official endorsement from the relevant authorities, which, at the moment, is still not secured yet.
Trust between joint-venture partners is especially vital for a successful relationship. Firstly, because of the transfer of technologies and expertise, there is little to stop partners from ending the partnership and starting their own competing outlets. In the event of a dispute with its partners, whether Apex-Pal will be able to protect its interest is debatable. Apex-Pal may face even greater complications if it is dealing with a Russian counterpart with strong political connections.
There are few barriers to entry in the kaiten-zushi business. If Sakae Sushi proves to be a hit in Russia, there is very little to prevent similar chains from springing up, resulting in downward pressure on the price premiums that Sakae Sushi may charge. As a matter of fact, in 2007, Yo! Sushi (a chain originating from London) has already opened an outlet in Moscow.
Sakae Sushi may have a tried and tested model that has proven successful so far, although one has to admit there are vast differences between South-East Asia, where the model has proven most successful, and Russia. Due to the differences in culture and business climate, Sakae's business model will have to undergo significant modifications to adapt to the Russian business environment. Whether Sakae Sushi will be able to retain the core competencies that have allowed it to excel against its competitors all these years remains to be seen.
RECOMMENDATIONS FOR EXPANSION INTO RUSSIA
As Sakae Sushi aims to be a global brand, or as Foo puts it, “The McDonald's of Sushi”, expansion into Russia will bring Apex-Pal one step closer to his vision. The economic
indicators are positive, suggesting that this is perhaps a good time to enter the Russian market.
The three modes of entry (Joint Venture, Greenfield and Franchising) into Russia have their respective strengths and weaknesses. The uniqueness of Russia's political and legal environments means that any foreign business will benefit greatly if it has a well-connected local partner. This makes Greenfield investment less attractive to foreign investors, especially to non-multinationals which do not have sufficient financial and international clout to influence local politicians and officials. Hence, Sakae Sushi should only consider this option at a later date when it has made sufficient inroads into the Russian business and political communities.
Franchising is another route for Apex-Pal to expand quickly into Russia, albeit with limited downside risk. It is an attractive prospect, and Apex-Pal should be on constant lookout for suitable franchisees. If the opportunity arises and Russian businesses do come forward with the intention to license the rights to operate Sakae Sushi in Russia, Apex-Pal should proceed — albeit with caution — after carefully evaluating that they are indeed suitable candidates. Apex-Pal should seek appropriate legal counsel to protect its interests and ensure that the franchisees remain committed to their business franchises.
Joint venture remains the most viable alternative, especially since Apex-Pal has already been in contact with suitable Russian partners. Even if Apex-Pal should enter into a joint venture, it should still constantly seek to establish the right connections and influence over the local government and administration. In this way, in the event of a dispute with its partners, Apex-Pal will not be disadvantaged from not having some local clout and be held ransom by their partners. Since trust amongst partners is vital to maintaining a successful
symbiotic relationship, Apex-Pal must ensure that its partners are adequately rewarded financially. By establishing distinctive mutual benefits of the partnership, Apex-Pal's partners will be more committed to the partnership and more willing to put in the effort needed to make Sakae Sushi a success.