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The Cherkizovsky Group

By manouche14 Jul 19, 2013 7498 Words
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REV: MAY 31, 2006

The Cherkizovsky Group (A) (Abridged)
“If I don’t create things, I die. I have to create,” declared Igor Babaev, owner of Russia’s largest food processing enterprise. “And when I die, I want to leave behind a well-functioning company.” In December 1997, however, all that he had labored to create over the previous six years was in jeopardy. Following the demise of the Soviet Union in 1991, Babaev adjusted quickly to Russia’s economic liberalization. He had taken control of a dilapidated Soviet production unit, the Cherkizovsky Meat Processing Plant located on the outskirts of Moscow, and through five and half years of diligence and hard work had expanded it into the Cherkizovsky Agro-Industrial Group, a diversified food conglomerate with 6,000 employees. To help direct the sprawling company, Babaev had formed a three-person management committee which, in addition to Babaev, included Musheg Mamikonyan, the president whose expertise as an engineer was instrumental in reorganizing the production process, and Mike Harman, a young American expatriate who served as the financial director. In the summer of 1997, just as the management team was trying to consolidate the company’s operations into a manageable structure, disaster struck. Allegations appeared in the Russian media that Cherkizovsky, along with other Russian meat processors, was selling hot dogs it had made from tainted meat. Though blatantly false, the stories put the company on the defensive with Russia’s finicky consumers. At the same time, hot dogs of mysterious origin began inundating the market at prices far lower than Cherkizovsky’s. Neither Babaev nor any of his similarly affected competitors knew what to do. They stood by watching as sales plummeted through the rest of the year.

The Cherkizovsky Group
A native of southern Russia with a Ph.D. from Krasnodar Polytechnic Institute, the 47-year old Babaev had spent his entire career in the Soviet meat industry, where he was quickly perceived as a rising star. He was named general director of one of the largest meat plants in the Soviet Union while in his late twenties, and later was put in charge of meat distribution for southern Russia. For his innovative handling of the production process, he was appointed to the Soviet Academy of Sciences, a high academic honor.

________________________________________________________________________________________________________________ Professor Lynn Sharp Paine and Research Associate Harold F. Hogan, Jr. prepared the original version of this case, “The Cherkizovsky Group (A),” HBS No. 399-119. This version was prepared by Professor Lynn Sharp Paine and Research Associate Charles A. Nichols III. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2005 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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Babaev’s abilities were fully recognized in 1988 when he was appointed chief engineer of the Cherkizovsky Meat Processing Plant in Moscow. Obtaining any position in Moscow was considered a plum assignment during the Soviet era, for it afforded proximity to the all-important planning bureaus and Party authorities in control of the country. Babaev became president of the plant in 1991, then led it through the privatization process in the newly capitalist Russia. Despite his achievements, the gross waste and inefficiency of the Soviet central planning system had long appalled him. After two frustrating decades, he thought he had a keen sense of what was needed to refashion a Soviet company into a modern, viable enterprise. With the original Cherkizovsky plant as a base, Babaev assembled a collection of formerly stateowned meat processing factories, retail food stores, and state farms into an agribusiness conglomerate. (See Exhibit 1.) By 1997, the Cherkizovsky Group had captured the largest share of the Moscow market for processed meats, and was the largest food processor in Russia. The original Cherkizovsky plant alone was said to be the largest single meat processing facility in Europe. (See Exhibits 2 and 3.) Although it sold a wide range of food products, its core business was meat processing, which accounted for 85% of revenues and 75% of profits. Since 1991, Babaev had spent more than $200 million to expand and modernize production, far more than any competitors had invested. He also developed a management team that, according to a Western financial analyst, was “widely acknowledged to be the most capable and dynamic in the Russian meat processing industry.”1 The Group’s sales were concentrated in Russia’s three most populous cities—Moscow, St. Petersburg, and Nizhny-Novgorod. In total, European Russia accounted for 85%–90% of sales, with the Urals and Eastern (i.e., Asian) Russia providing the remaining 10%–15%. (See Exhibit 4.) Though revenues for 1997 were down from their 1996 high of $450 million, they had grown steadily under Babaev’s leadership. Babaev attributed the company’s success to its reputation for reliable quality, which he saw as the result principally of investing in world-class food processing technology. “We’ve been present in the market for a long time, and people have grown to trust anything under our logo,” he said. (See Exhibit 5 for revenue.) It was only a matter of time, Babaev felt, before he would achieve his personal goal of being the CEO of a billion dollar company that was listed on a major Western stock exchange. In the immediate term, he was looking for an infusion of capital from several Western investment funds.

The Russian Context
Ancien regime Prior to the Revolution of 1917, Russia was defined by its medieval character. An autocratic czar reigned over a feudal social structure that included a vast population (90%) of rural peasants scattered on seigniorial estates. People found security in the established social order, the habitual obedience to authority, and the routine of life on the rural mir, or commune. The state bureaucracy, including the military, afforded the sole means of social mobility. In the closing years of the nineteenth century, heavy industry was introduced, and after the failed revolution of 1905, attempts were made to establish parliamentary government, private property, and the rule of law. On the eve of the Revolution, a nascent middle class of businessmen had arisen in a few major cities, but they had little effect on larger events of the time. Communism The cataclysmic events of World War I led to the abdication of the czar in 1917. The Communist Party, which replaced the Romanov autocracy, refashioned the Russian Empire into the Union of Soviet Socialist Republics (USSR, or Soviet Union) and inaugurated a new era in 2

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centralized, bureaucratic administration. The liberalization launched after 1905 ceased. The new, allpowerful State Planning Committee (Gosplan) introduced the concept of five-year plans—launching the first one in 1928—which set production goals for future years. Whole industries were concentrated into a few massive plants employing as many as 100,000 workers, and the agricultural sector was forcibly collectivized into mammoth state-run farms. Most of the government’s effort went into creating and maintaining heavy industries, like iron, steel, and machinery. The results were gross imbalances in the economy: overproduction in one area, such as steel pipe, and underproduction in another, such as consumer goods. Moreover, the Soviet system was focused so exclusively on production that little care was given to other aspects of enterprise. The size of the bureaucracy grew phenomenally, transforming Russia into “one single vast organization, directed by cadres of the party-state apparatus” centered in Moscow.2 Statistics, always unreliable in Russia, became notoriously distorted. Achieving—or better, exceeding—production targets in a Five Year Plan redounded to a bureaucrat’s career, so fiddling with the books and padding figures, in an economy that was built on quantification, became common practice at all levels. The radical restructuring of society was consolidated under the long dictatorship of Joseph Stalin (1922–1953), who relied on a massive program of state-induced terror to accomplish the task. Millions of Russians perished as the result of famines, firing squads, and labor camps.

Reform By the 1970s, military-related technology was the lone sector of the economy that had achieved world-class standards. Otherwise, popular discontent over the scarcity of everyday necessities made it clear that the Soviet system had failed to provide an adequate standard of living for the vast majority of the population. The bureaucratic elite, who traveled outside Russia and had access to Western goods, lived very well, but ordinary Russians were more familiar with long queues for basic commodities. Cynicism and contempt toward all authority expressed itself in disintegrating social behavior as workplace drunkenness and theft became serious problems. Mikhail Gorbachev, who took command of the Soviet Union in 1985, attempted to salvage the communist system through a program of perestroika (restructuring), which opened the economy to limited market reforms, and glasnost (openness), which allowed the population greater freedom and exposure to the West. But the economic, political, and social decay was too far advanced for repair, and the Soviet Union finally collapsed altogether in 1991. A democratic system of government, with a nationally elected president and legislature (Duma), was created, and the 15 republics of the Soviet Union, of which Russia was one, became independent countries. Russia, or the Russian Federation as it became formally known, alone consisted of 89 separate regional governing units generally divided by ethnicity and traditional territorial borders. Two were cities: Moscow, with a population of almost 9 million, and St. Petersburg, with about 5 million inhabitants.

Privatization Boris Yeltsin became Russia’s first democratically elected president in 1991 (and was re-elected in 1996), and large segments of the economy were marked for privatization. With political momentum in their favor, reformers decided to make an abrupt break with the past and privatize immediately. Critics contended that the rapid sell-off of state-owned enterprises, before any restructuring was done to enhance their worth, prevented the government from realizing their maximum value. But supporters argued, “If the bureaucrats and their industrial allies had been ordered to restructure enterprises to prepare them for privatization, at best they would have done nothing.”3 Companies were assigned the debt they had accumulated during the Soviet period (an arbitrary figure), and groups of them were taken private in phases that began in 1992 and continued over the next several years. The vast majority of companies, outside of the cities and regions that were 3

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allowed to develop their own schemes, chose a plan that permitted employees to acquire 51% of the equity in their firm at a price determined by a government agency, while the remaining 49% was auctioned to the public. A percentage of each company’s shares could be purchased only with vouchers that the government distributed to the Russian people in 1992. Nearly 150 million Russians received vouchers worth 10,000 rubles apiece (about $30 at the time)—their share of the country’s property, plants, and equipment, which the public had theoretically owned under communism. By 1998, according to the World Bank, more than 130,000 enterprises had been privatized.4 The crown jewels of the Russian economy, such as oil and gas companies, still awaited privatization. Land ownership varied by region and was under the jurisdiction of local governing committees.

Post-reform environment Giving company insiders preference in the privatization process assured swift compliance, but it also gave rise to much abuse and corruption. According to Transparency International, an international anti-corruption group, Russia was perceived to be among the world’s most corrupt countries in the 1990s. Russia’s Ministry of Internal Affairs, the government department charged with combating organized crime, claimed that “40% of private businesses, 60% of state-owned enterprises, and 50% to 85% of banks [were] controlled by organized crime.”5 Nevertheless, the typical official attitude was ambivalent at best. A reform-minded economist and former mayor of Moscow argued that “although bribery is not good, at least it moves deals along and loosens the old state stranglehold on the economy.”6 The high level of corruption robbed the government of tax receipts and other funds it sorely needed. Former U.S. National Security Advisor Zbigniew Brzezinski estimated in 1997 that 65% of the $120 billion in Western aid sent to Russia had been embezzled to offshore bank accounts.7 By the mid-1990s, an oligarchy of eight powerful financiers, most former high-ranking communist officials, controlled huge financial-industrial empires built on ownership of banks, a vital commodity in a country with so little cash that many transactions were carried out through barter. Though constantly at war with one another, the financial industrial groups would work in tandem for their mutual benefit, and they were frequently accused of collaborating with top politicians to dictate government policies. The pervasive graft and corruption was having an especially ominous impact on the country’s business climate, for murdering opponents became an increasingly popular way to resolve business disputes. In 1995, there were approximately 560 recorded cases of professional killings, of which the police had solved only 60.8

The Transition to Private Control
The original Cherkizovsky plant had been typical of Soviet food processors. In contrast to the system of huge mega-complexes that characterized most Soviet industries, food production was generally a localized affair, in part because the undeveloped road system in Russia made timely distribution impossible. Everything was orchestrated from Moscow. Managers of local plants received production targets along with an allocation of ingredients, and their role was solely to ensure that production goals were achieved. Sausages and hot dogs were traditionally the staple meats of the Russian diet, eaten at all three daily meals if affordable and available. Under the Soviet system of generic products, sausages and franks were manufactured and sold by state-mandated recipes. The sole distinguishing feature was the identity of the processing plant stamped on the product. The Cherkizovsky plant began production in 1974, with boiled sausages and hot dogs comprising 83% of total production. At the end of the Soviet era, it was the smallest of six meat processing plants serving Moscow, and had the reputation for turning out the lowest quality products among the six.

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Babaev Takes Control
In anticipation of economic reforms in post-Soviet Russia, Babaev formed a limited liability company in December 1991 with all 600 employees of the plant. The terms of the privatization arrangement with the Moscow State Property Fund permitted Cherkizovsky to reinvest the plant’s profits in the business, with the increasing value of the enterprise accruing to its shareholders. At the same time, various agencies of the Moscow city government made a passive investment of some $15 million in Cherkizovsky Ltd. Over a two-year period Babaev himself made additional capital investments in the company and bought up shares of other employees who were eager to sell. With the help of a $5 million personal bank loan, he increased his stake in Cherkizovsky Ltd. to more than 60%. During this period, Babaev launched a massive modernization and expansion of the plant, increasing the workforce to around 3,000. Babaev continued to buy up employees’ shares, and in 1995 Moscow sold him 6% of its 18% interest in the company. By 1997, Babaev owned 82% of Cherkizovsky, the Moscow government owned 12%, and employees held the remaining 6%. Babaev’s modernization program owed much to Musheg Mamikonyan, whom he had lured to Cherkizovsky in 1992 to serve as production manager and head of the company’s laboratory. Mamikonyan, a well-known meat processing technician and researcher with a Ph.D. in food production from the Moscow Meat Institute, was 30 years old at the time and working for the largest meat factory in Moscow. He was Armenian, born in Turkish territory and raised in Soviet Armenia, but most of his schoolmates and friends were Russian children from a nearby military base. His upbringing was unusual for an Armenian in that it gave him fluency in the Russian language and a strong Russian national identity. Although his mother, who managed a large meat processing plant, urged him not to get too excited about the reforms—predicting they wouldn’t last—Mamikonyan was attracted to the new ideas and to Babaev. Like Babaev, he was very critical of Soviet central planning. “There were no real cost calculations. All the figures were fictional and all the data was fictional as well,” he said. “We knew, for example, that a lot of crops [used for animal feed] were bought in the West for hard currency, but [central planners] would use a fictional price instead of the real price, which would mean that the meat price was fictional as well.” The whole system was built on deception, waste, and inefficiency, which he felt discouraged any sort of technological innovation and had left the country “completely unprepared for the free economy.” Moreover, patronage and connections within the Soviet bureaucracy dictated “what plant would have certain advantages over another,” and workers were difficult to manage because of the constant intrusiveness of local Communist Party officials. Mamikonyan assumed his new responsibilities at Cherkizovsky with clear criteria for success: “what market share we have, how competitive our products are with comparative Russian or Western products, how well our products correspond with consumers’ desires and needs, and how profitable our activity is.” He approved Babaev’s insistence on conducting business honestly and lawfully, such as paying taxes in full, despite its drawbacks. “If not for [Babaev’s honesty],” he said, “our revenues and profitability would be much higher, and we would have more ability to plan.”

Upgrading Operations
Upon joining Cherkizovsky, Mamikonyan developed a comprehensive program to redesign the production process, modernize the plant with equipment purchased from Western manufacturers, increase capacity, and vastly improve product quality. When the expansion was completed in late 1993, the factory had doubled in size and total capacity had increased almost six-fold to 300 tons per 5

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day. The variety of meats offered to consumers was vastly expanded, and vacuum packaging was introduced, which greatly prolonged product shelf life. After upgrading the Cherkizovsky plant, Babaev looked elsewhere to increase capacity. In 1996, the Moscow city government awarded him control of the heavily indebted and poorly managed Biryulyovsky Meat Processing Plant (BMPK), a Cherkizovsky rival and one of Russia’s largest and most modern meat plants. In the same year, Cherkizovsky’s board of directors approved the purchase of a controlling block of shares of the nearly bankrupt Novgorod Meat Processing Plant (NMD), which included a slaughterhouse and production lines for processed meats. With easy access to rail and highway networks serving northwestern Russia and St. Petersburg, NMD’s location was highly strategic. At both plants, Babaev quickly implemented a detailed recovery plan—reorganizing and expanding production lines, replacing old equipment with new imported models, and installing new management.

Distribution From the start, Babaev had viewed distribution as a critical factor for successful growth. Under Soviet planning, distribution had never been integrated with production, and it remained a challenge. At first, Babaev tried outsourcing, but he encountered serious problems of quality control due, for example, to improper refrigeration. So he decided the company would have to build its own warehouses and distribution network. By 1997, the network included: • • • • • • the Group’s own 35 stores, mostly in Moscow, but also St. Petersburg and the Ural Mountains region; company-controlled counter space rented from retail food markets—45 in Moscow, 5 in St. Petersburg, 5 in Nizhny-Novgorod, and 5 in the Urals; 60 company trucks outfitted as mini-stores and parked at Moscow subway stations; 5–6 route trucks that solicited Moscow’s hundreds of small bodega-like grocery shops; delivery to independent retailers ordering at least 100 kilograms of meat per month; delivery to the warehouses of independent distributors, principally in the Urals and eastern regions, but also in Moscow.

Sourcing Russian agriculture, never very successful under communism, was a shambles following the collapse of the Soviet Union.9 As part of his rebuilding effort, Babaev had always intended to use Russian meat for his operations. He purchased the former Rostovsky State Farm in the Moscow countryside for construction of a slaughtering facility, organizing the project as a separate subsidiary, Cherkizivo-Kashira Ltd. By the time the slaughterhouse was ready for production, however, the supply of local cattle had evaporated. Faced with grain prices so high they could not afford to feed their herds, farmers had prematurely slaughtered them. Thus, Cherkizovsky was forced to purchase with hard currency most of its meat (as high as 80%) from abroad—Australia, Argentina, Canada, and various European countries. To alleviate the reliance on foreign sources, Babaev made further investments in the Kashira project, and in 1995 took controlling interest in another former state farm that had degenerated to the point of bankruptcy, the Kuznetsovsky Combine Closed-End Joint Stock Company. Babaev railed against the Russian government for “not even investing a single ruble in agriculture,” something Western governments did regularly. Nevertheless, he laid much of the blame for the dismal state of Russian agriculture on Western humanitarian aid that had flooded into the country. Food

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giveaways, Babaev felt, made conditions difficult and discouraged Russians from developing their own local food supplies.

New businesses As he undertook these improvements, Babaev found many opportunities for new lines of business. He got into the bottled water business after discovering an underground spring with medicinal quality water during construction of the Kashira project. In early 1997, Cherkizovsky entered the poultry business with the purchase of the Petelino egg production facility in the Moscow region, followed by the purchase of seven more poultry farms. Through acquisition of the Biryulyovsky plant and its affiliated company, BiKom Trade House Joint-Stock Company, Cherkizovsky entered the retail grocery business. Cherkizovsky was highly self-sufficient. It maintained an auxiliary materials unit at the main plant to manufacture all packaging and labels, including the company’s new multicolored logo prominently displayed on meat casings. Wire clips and string hangers used in manufacturing were also made in-house, as were the casings, both natural and synthetic, that formed the outer wrapper of a sausage loaf.

Managing the Workforce
Babaev saw himself as “Master” for the Russian staff. Many Russians attributed the problems of their country, their cities, their companies, and their families to a lack of strong management and control. In a traditional Russian enterprise, “no one could do anything without a direct order from the general manager,” said Babaev. As owner-operator, Babaev believed that he was responsible for providing the structure and discipline that would allow people to succeed. To Babaev, the ideal company was one where “an employee wakes up and goes to work because he wants to, not because he has to.” Like the traditional Russian manager, he issued directives and personally signed “every single order—no matter how small—tons of documents everyday.” Typically Babaev developed strong relationships with a few key individuals whom he trusted to carry out his goals, and held them personally responsible for any failures. Babaev focused relentlessly on “quality, quality, quality,” and from the outset, he was adamant about changing the mentality of the workforce. To attract some of the industry’s most talented staff, he recruited heavily from the Moscow Meat Institute. The biggest worker-related problems, drinking and stealing, he addressed by enforcing two ironclad rules. Employees who showed up for work drunk or were caught drinking on the job, were fired immediately. Similarly, those caught taking home or eating at work any product from the plant, even a hot dog, were dismissed on the spot. Cherkizovsky paid its workers well and offered benefits beyond those mandated by law. While the average monthly wage for workers in Moscow was $500–$600, Cherkizovsky workers were paid about $750 and foremen/supervisors, $1,000 monthly. Employers paid a 42% tax on wages (employees contributed nothing) to cover an array of welfare programs administered by the government—pensions, medical care, subsidized housing, and utilities. Besides 12 national holidays, everyone received 30 days’ annual vacation. The standard workweek was 46 hours, Monday through Saturday, although production companies had the option of declaring in their charters whether they were a five-day or a six-day facility. Beyond the basics, Cherkizovsky provided a medical and dental clinic which was available for employees and their dependents for a nominal fee, as well as a health club with indoor tennis courts. Cultural events, with nationally recognized performers, were staged for employees, and subsidized meals were available for a nominal fee in the company cafeteria. As compensation for not stealing,

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everyone received a $15 monthly credit for purchase of Cherkizovsky products at wholesale, a benefit that workers particularly liked. By 1997, the workforce at all the Group’s facilities totaled about 6,000, split evenly between men and women, with roughly 40% management/staff and 60% workers. The number of employees at the original Cherkizovsky plant remained at the 1993 level of about 3,000, despite continuous gains in productivity. The plant carried a high level of personnel compared with its Western counterparts.

A New Phase
In early 1997, Babaev recruited U.S. expatriate Mike Harman to Cherkizovsky as financial director. Babaev wanted to attract foreign investors, a move that required independent audits of the company, but like most Russians trained in the Soviet system, he knew nothing of accounting and finance. Harman, he thought, would fill this gap. Harman had earned both an MA in Russian Studies and an MBA from Wharton in 1993, then worked for three years as a privatization consultant helping Russian governments secure international financing and advising companies on financial and legal restructuring. Bringing Harman on board was nonetheless very difficult for both parties. Employees saw “themselves as the experts, and couldn’t understand what they could learn from a foreigner,” recalled Babaev. Many resented Harman’s high salary. There also was the issue of culture. “We had no systematic approach to work,” Babaev said, so “there was a difference in the level of professionalism” from what a Westerner would expect. “Very quickly,” Babaev recounted, “Mike taught us things like the importance of punctuality, and especially the function of money and the absolute need to control spending.” After a while, Harman’s adjustment seemed complete. “Russians are used to yelling,” noted Babaev, “We take everything to the extreme.” “Michael came as a quiet, patient Westerner,“ he continued, but “after six months he started to yell just like me. I told him, ‘Michael, I think you can apply for Russian citizenship now.’” For his part, Harman was attracted to Babaev’s “strong entrepreneurial instincts.” “Babaev has a vision of where he wants to take things,” Harman said, and had even developed a concept he called “passporting a region.” The basic idea was to identify and understand the unique characteristics of a new regional market beforehand so the expansion would be approached properly and successfully. Harman emphasized Babaev’s management style—atypical for Russia. Unlike other Russian employers, Babaev made no exceptions for the 20 or so relatives working in the company. He “didn’t hesitate to fire them if necessary” said Harman, adding that on occasion he had done so. Before his arrival, Harman said, the Group’s only strategic plan was what “Babaev carried around in his head.” Essentially, this meant taking advantage of opportunities in the rapidly evolving market. When competitors went out of business, as many did, Cherkizovsky moved in immediately to gain market share. With Harman on board and Mamikonyan promoted to president, Babaev set up the three-person management committee to work on an array of strategic initiatives. As finance director, Harman had responsibility for “setting the earnings mark and the investment schedule,” and together the committee set priorities, made resource allocation decisions, and worked on the myriad issues facing Cherkizovsky.

Critical Issues
The biggest problem facing the company, according to Harman, was consolidating the different acquisitions into a unified enterprise under a cohesive management structure. (See Exhibit 6.) Too 8

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much of the Soviet system remained, especially in management attitudes. Managers of the production and distribution entities identified not with the Cherkizovsky Group, but with their own units. Each, said Harman, wanted “to be his own czar.” Harman also saw the need to eliminate inefficiencies such as the duplication of functions across the plants, as well as competition for retail shelf-space and between products. “On the professional level,” said Harman, “the company had grown bigger than people’s capabilities.” Marketing, a non-existent function under central planning, had received scant attention. “Pricing still followed the basic communist method—add 10% to the cost of goods sold,” said Harman. “Never mind that cost-of-goods-sold was meaningless under the old system.” On the retail side, Harman continued, “we let our clients dictate our prices instead of the final consumer dictating our prices. The stores and distributors tell us, ‘oh, we can’t take that product, it’s too high.’” Harman believed that most Cherkizovsky products should command top price because of their superior quality, “just as Oscar Mayer will command a premium price over a local cut-rate brand in the U.S.” Harman was also troubled by the lack of information and measurement tools, apart from “tons sold.” “There was no concern about returns or profitability,” Harman said. “Nothing was broken down in any way.” Attention to cost and profitability eluded even Babaev. “He was like an old communist in one sense,” Harman said, “he still believed he didn’t have to worry about return on investment. If you had the money, then invest it and it will return. That was it.”

Key Initiatives
With Harman’s arrival, the management committee had begun to take steps to address some of these issues. The Group had adopted a holding company structure with centralized professional support for functions such as sales and marketing at the operating units. Western-trained sales and marketing professionals would be recruited for top spots at the holding company. These professionals, in turn, would organize and train the Russian staff. To improve alignment between unit-level and corporate-level thinking, the committee planned to tie plant officials’ pay to the success of the larger corporation rather than to just their unit’s production. Estimating Russia’s total market for processed meat at about $4 billion, the committee anticipated continuous expansion into new and untapped regions. Particularly appealing was European Russia, the vast area west of the Ural mountains, where most of Russia’s population was concentrated. The Group sought to acquire factories with attractive long-term potential—especially those whose products were popular with consumers. After settling into a new market and becoming acquainted with local customs, the Group would scale back the local facility to provide only the popular shortshelf life product for the local market. All other products, sealed in synthetic casings and vacuum packaging, would be manufactured and shipped from the Cherkizovsky plants in Moscow. Success in rationalizing production and centralizing it at a few plants rested on shattering consumers’—and managers’—belief that a product’s quality depended on the plant where it was made. It was essential to convince consumers that a certain type of sausage made at the Biryulyovsky or Novgorod plants could be made just as well at the Cherkizovsky plant, and that a product made at a distant site could be just as fresh and good tasting as one made locally. Russians were not used to packaging, and many still preferred to buy franks in links out of a barrel. Integral to the plan was the committee’s push toward branding—“a big, big objective for the company,” said Harman. Through different product lines, the Cherkizovsky-label products reached the high-end, middle-income, and low-income segments of the market. As the industry matured and meat evolved from a simple commodity item to a branded product, Cherkizovsky wanted to be out 9

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in front in all segments. Babaev saw one or two national brands dominating the market in the future, and a lot of local brands “that may or may not be owned by larger companies and used for local production.” “The word ‘brand’ was new in Russia,” Harman explained, noting that the concept was not well understood. Although Russians reacted to branded products in non-food sectors, such as fashion, the food sector was different. To consumers, the name “Cherkizovsky” was just the symbol of a production unit. The company’s challenge was to make it a symbol of far more. Harman was confident that Cherkizovsky could meet Russian consumers’ high expectations for clean, safe, and ecologically pure food. (See Exhibit 7 for results of a consumer survey.) He noted that “American meat didn’t meet Russian quality standards due to the use of hormones,” and therefore wasn’t a major source of imported meat. With the focus on branding, the company was exploring a full mass media advertising campaign that included print, radio, and especially television. Cherkizovsky had previously promoted itself only to wholesalers and distributors primarily at food-trade expos, and advertising was new to Russia. Western marketing experts cautioned would-be advertisers about condescending ads. Russian consumers, they advised, “were used to their country being a center of world attention and decision-making . . . a scientific and intellectual leader.”10 Following this logic, one U.S. company had found great success with an ad campaign that featured “extraordinarily drab-looking female scientists” discussing the hygienic advantages of certain brands of soap and disposable diapers. 11 Promoting meat products, however, was largely untested. Only CampoMos, a joint venture with a Spanish company and one of Cherkizovsky’s Moscow competitors, had run a few brief television commercials in 1997. They seemed to have had little, if any, effect on sales.

Cautious Optimism
As the management committee looked to the future, the members expressed cautious optimism. Harman stressed the difficulty of changing habits and outlooks formed under decades of Soviet rule. When a poll conducted by the All-Russian Center for Public Opinion Studies posed the question, “Do you prefer democracy or order?” 79% of the Russians surveyed chose order and only 8% opted for democracy.12 Harman noted that even Babaev often said he missed the certainty of the old way, “the fact of not having to worry, of having only to achieve the production goals set from above.” Mamikonyan, too, emphasized that it would take time for Russia to adapt and for Russian companies to reach “the same level as Western competitors,” which had easier access to financing and at much lower costs; more skilled employees; and long experience with the market system. Furthermore, he said: “Western business systems were supported legally and legislatively, and small companies as well as huge corporations complied with the rules. Those things that are taken for granted in the West are not taken into consideration here. And that is a very serious problem.” Of special concern to Harman was reforming what he saw as the country’s bizarre tax and accounting system. Many legitimate expenses, for example, were not deductible, and depreciation periods were extraordinarily long—buildings were depreciated for periods in excess of 100 years.13 Nevertheless, in 1997, for the first time, Harman, Babaev, and Mamikonyan produced Westernaudited financial statements—a novelty for a Russian company. In Mamikonyan’s view, the barrier to progress was bureaucrats who oversaw the government’s still-prominent role in the economy. “We have ministries working as separate units,” he said, “and there is no real coordination between the work of any two of them.” Even under the reforms, getting the government’s help was still a matter of “who you knew and what people you were close to” rather than “how your company was doing.” Whereas association with the Communist Party had 10

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once been the key to status and economic well-being, the key was now association with powerful capitalists. Mamikonyan regretted the absence of the “hero-bureaucrat,” someone neither communist nor democrat, but a true professional who stood above the fray and made fair, informed decisions. Crime and corruption was another ever-present concern. Although Babaev had tried to maintain a clean reputation and steer clear of corrupt elements in the society, the Group’s success had not gone unnoticed by crime syndicates. In early 1995, gangsters had threatened Babaev for protection money. Babaev did not surrender to the threats. Instead, he hired members of the local militia as plant security, causing many people, including organized crime figures, to assume that Babaev had close relations with the mayor of Moscow. The perception was untrue, said Babaev, but he acknowledged that it benefited the company by making most criminals wary. Attracting foreign investors to Cherkizovsky promised to be challenging. The uncertain business and political climate made foreign investors reluctant to commit funds to Russia. In 1995, foreigners invested only $2 billion in Russia compared with $38 billion in China.14 A major study blamed “the criminal environment and the failure of the legal system” for the dearth of interest on the part of investors.

Rumors Surface
Cherkizovsky officials were bewildered in June 1997 when reports in the Russian media accused the company and other meat processors of using potentially “deadly” British beef (supposedly deadly because of the “mad cow disease” that had been conjectured to cause human deaths among beef eaters in England). The company, in fact, had been relying primarily on Australian beef for quite some time. Nevertheless, despite the company’s denials, the rumors gained credibility. At the same time the rumors appeared in the media, low-cost imported hot dogs suddenly began pouring onto the market. Many Russian manufacturers watched helplessly, but Mamikonyan spent long hours every week searching for information. Late in the year, a curious piece of government trade data caught his attention. He noted explosive growth in the amount of meat imported under an obscure tariff code reserved for “salted brine meats destined for Siberia.” The code, number 0210, carried a tariff of 15% on the declared value of the imported goods, with no minimum declared value requirement. He noticed similar changes in imports under code 0206, which also carried a 15% tariff, with no minimum declared value. (See Table A.)

11

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The Cherkizovsky Group (A) (Abridged)

Table A

Imports Under Selected Tariff Codes
1994 1995 1996 1997

Code Number 0210 (salted brine meats for Siberia) Volume (‘000 tonnes) Average declared value ($/kg) (15% tariff, no minimum value) 0206 (fresh or frozen byproducts) Volume (‘000 tonnes) Average declared value ($/kg) (15% tariff, no minimum value) 1601 (code used by Cherkizovsky) Volume (‘000 tonnes) Average declared value ($/kg) (20% tariff, $.43/kg minimum value) Source: Government document.

8.9 2.15

8.5 1.40

44.3 .71

231.6 .43

42.6 1.23

87.6 .85

93.4 .63

306.1 .39

86.0 2.04

108.8 1.66

124.7 1.35

156.8 1.15

The tariff codes that processors like Cherkizovsky normally used carried a 20% tariff rate, with a minimum declared value requirement of $.43 per kilogram. The actual declared value, however, was substantially more. In 1997, the average declared value imported under code number 1601, one of the commonly used codes, was $1.15 per kilogram. Relying on his contacts in the tight-knit Armenian community, Mamikonyan probed deeper and finally got to the bottom of the story in December, when an Armenian importer told him everything. European meat brokers were working in conjunction with second-tier Russian producers, Russian importers, and customs officials to dump cheap hot dogs, mostly from the United States, on the Russian market. The imports consisted principally of low-quality sausages, hot dogs, and delicatessen products, the hardest-hit segment of Cherkizovsky’s market. Mamikonyan told his Armenian acquaintance that the import channel should be closed off because it was killing Cherkizovsky’s business. The importer responded: Listen, what can we do? Let’s not close it off, because it’s our bread and butter. Why don’t you just buy the product from us—tell us the price and the margin you’re looking for, and we’ll support it? All you have to do is slice up the meat, package it, put your label on it, and pretend you did it yourself. Mamikonyan listened intently, and then replied: “Well, that’s something we should really think about.” In mid-December, Mamikonyan met with Babaev and Harman and explained all that he had learned, including the fact that an arm of one of their leading competitors was participating in the dumping. By then, sales of Cherkizovsky’s low-end hog dogs and sausages had fallen to nearly half of their normal volume. Mamikonyan calculated that profit margins on the imported meat were in some cases as high as 400% while normal margins on processed meat were between 10% and 30%. The three considered the situation. Although many competitors also had suffered tremendously from the dumping scheme, they had done nothing about it. Cherkizovsky could ignore the matter and concentrate instead on more profitable high-end products. Or, accepting the proposal, Cherkizovsky could share in the benefits of low-cost meat and recover its lost market share. Another alternative was to try to pressure government authorities to enforce tariff regulations and put a stop to the dumping—a course of action they all knew could be personally very risky. 12

The Cherkizovsky Group (A) (Abridged)

306-021

Exhibit 1

Group Ownership Structure, December 1997

Cherkizovsky Group Ownership Interests % Ownership

Cherkizovsky Cherkizovsky Argo -industrial Group Argo -industrial Group HQ location HQ location Production Units Moscow Moscow

NMD NMD Location Location Ownership Ownership Novgorod Novgorod 76.4% 76.4%

BMPK BMPK Location Location Ownership Ownership Moscow Moscow 33.8% 33.8% (+23.32% (+23.32% pending) pending)

ChMPZ ChMPZ Location Location Ownership Ownership Moscow Moscow 80.4% 80.4%

Kashira Kashira Location Location Ownership Ownership Moscow Moscow Region Region 98.5% 98.5%

Distribution Units TD BiKom TD Bikom Location Location Ownership Ownership Moscow Moscow 100% 100% Nevsky Nevsky Location St. Petersburg Location St. Petersburg Ownership 100% Ownership 100% Cherkizovo -Ural Cherkizovo -Ural Location Cherlyabinsk Location Cherlyabinsk Ownership 100% Ownership 100%

Source:

Company documents.

Exhibit 2

Moscow Market Share, 1997 (estimated)
22 16 14 11 11 7 6 13 100%

Cherkizovsky Tsaritsino Mikoms CampoMos (Spanish joint venture) Ostankinsky Tagansky (TAMP) BiKom (Biryulyovsky) Other

Source:

Company documents.

13

306-021

The Cherkizovsky Group (A) (Abridged)

Exhibit 3

Largest Food Processors in Russia

Food Industry Meat Processing Companies Cherkizovsky Group MIKOMS Tsaritsino Meat Processing Plant Ostankinsky Meat Processing Plant Ostankinsky Meat Processing Plant Kampopos Ekatirenburgsky Meat Processing Plant Novosibirsky Meat Processing Kombinat Irkutsky Meat Processing Kombinat Other Food Processors Lianozovsky Dairy Red October Confectionery Babaevsky Confectionery Baltica Brewery Kirovsky Bakery Rossija Confectionery Maslozhirkombinat Rot Front Confectionery

Region

Sales 1996 1995 (in $US millions)

Market Share Russia Moscow

Moscow Moscow Moscow Moscow St. Petersburg Moscow Urals Siberia Siberia

$447 252 206 167 160 125 114 92 80

$316 196 158 152 124 76 80 110 60

8.7% 4.9 4.0 2.0 3.0 2.4 2.0 1.5 1.0

30.0% 19.2 17.3 14.00 10.5 NA NA NA

Moscow Moscow Moscow St. Petersburg Moscow Moscow Moscow Moscow

167 152 130 113 112 108 103 94

72 131 113 42 81 85 113 91

NA NA NA NA NA NA NA NA

NA NA NA NA NA NA NA NA

Source:

Company documents.

14

306-021

-15-

Exhibit 4

Market Share of Cherkizovsky Holding

as of June 1998

Kamachatka Oblast

Kaliningrad Oblast

Novgorod oblast Karelia St.Petersburg and oblast Murmansk Oblast

Magadan Oblast

Yakutia

Krasnoyarsk Kray

Sakhalin Oblast

Amurskaya Oblast Buryatia 21 14 Tyva Irkutskaya Oblast Chitin skaya Oblast

Khabarovsk Oblast

Pskov Oblast Baltic Arkhangelsk States Oblast 20 Smolensk Tver obl. Oblast Komi Braynsk 1 25 Oblast 4 2 3 Kursk 24 Perm Kirov Tyumen 5 Oblast 6 26 Oblast Oblast Oblast 10 8 12 Belgorod 11 79 19 Oblast 23 18 Ekaterinburg Voronezh Oblast 22 Krasnodar Rostov Volgo 16 Tomsk Kray obl. grad oblast 17 13 Saratov Karchay15 Kurganskaya Novosibirsk Oblast Cherkesia Oblast Oblast Astrakhan Orenburg North Omsk Oblast Oblast Ossetia Altai Oblast Kalmykia Kray Dagestan Altayskaya Republic

Primorsky Kray

Based on a 5-grade system 0 - not present in the market 5 - dominant market share (more than 25%) 2 3 4 (2.5%-6.5%) (6.5%-15%) (15%-25%) Distribution Unit of the Holding 5 (>25%)

0

1 (

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