Articles

Reynolds Converts Threat Into Opportunity

by Kevin McDonald

This article was published in the Wall Street Journal Europe on May 19, 1994. The article was adapted from an article in the May-June 1994 issue of the Harvard Business Review.

Most Western businesspeople assume that Russian companies won't compete in the West for another 15 to 20 years. Russia and its newly independent neighbors will need at least that long to build a market economy, generate entrepreneurial spirit, and train a generation of young managers. But there's at least one important exception to that forecast: in the raw materials sector, Russian companies are already competitive.

Indeed, as a result of huge structural changes - the radical downsizing of the Soviet defense industry and the collapse of the ruble - vast quantities of nickel, zinc, aluminum, magnesium, potash, diamonds, and other critical materials are now being sold in the West at fire-sale prices. The challenge has left Western raw materials suppliers with no choice but to lower production, lay off workers, and cut back investment.

In response to what they perceive as "dumping," Western governments are preparing for June negotiations with the Russians over the export of aluminum in particular. Next month's meetings will determine whether Russian smelters are living up to their recent promise to cut raw materials exports and give Western producers more breathing room.

How the large raw materials companies - and Western governments - respond to this competition will deeply affect C.I.S. (and Western economies). So far, most of these companies have reacted defensively, curtailing production and lobbying Western governments for protection. In the case of aluminum, for example, Norway, Australia, Canada, the U.S., Latin American countries such as Brazil and Venezuela, and the EU as a group have spoken out in favor of quotas and tariffs.

But slapping tariffs on Russia's exports is hardly a way to encourage business development there, nor will it spur Western companies to compete better. Moreover, there are alternatives. Here's how one Western company, Reynolds Metals Corp. (RMC), found a means of stemming the competitive flood of raw materials with a form of intervention that should aid the Russian economy, give RMC a foothold in the Russian market, and perform an invaluable service for some of RMC's oldest customers - all with some one else's money.

Like every Western aluminum producer, RMC saw the dim prospects for global aluminum even before the Russians unleashed their exports. For a decade or more, the market for aluminum ingots - about $15 billion - had been growing at an annual rate of 3%-4%. When market growth slowed to a crawl in 1989, due to the global recession, London cash prices plummeted. Aluminum sold for $0.74 per pound in 1990, down from $0.89 per pound in 1989 and $1.17 per pound in 1988.

Then the Russian market collapsed. In 1992, demand fell 40%, due mainly to military cutbacks. The Russians lacked the technology to make alternative civilian goods - like soda cans - so they began targeting Western markets. Shipments from Russia to the U.S. increased by a factor of 370, to 300,000 tons in 1993 (worth half a billion dollars) from 806 tons in 1991. The Russian share of Western markets rose from just over 1% in 1989 to more than 11% in 1993.

Western smelters - including RMC - responded by accumulating inventory and cutting capacity. Swelling inventories depressed prices despite cutbacks in production and capacity. Virtually all Western aluminum producers sustained losses. Though the Russians agreed to cut 500,000 tons of production if the West would also reduce output, it is not clear that Russian companies have complied with this and the basic problem of excess world capacity has remained unsolved.

Enter Randolph Reynolds, RMC's Vice Chairman and head of international operations. Mr. Reynolds had long been toying with the idea of entering the Russian market, but no one at RMC knew how or where to start a business in Russia.

Then one of RMC's equipment suppliers, the Fata European Group of Turin, Italy, approached Mr. Reynolds about forming a joint venture. Fata had been building plants in the Soviet Union for 28 years. Now its managers wanted to build a Russian plant to make foil. They even had a potential Russian partner, Sayansk Smelter in Sayanogorsk, to supervise at the local level. But Fata needed a third party to provide the necessary technological and management skills.

Having initially turned the offer down, Mr. Reynolds began having second thoughts when several customers in the food industry told him independently that they wanted to produce and sell food products in Russia but that they were afraid of the ruble's volatility, which could keep them from importing the packaging they would need to make their venture work.

Then Mr. Reynolds hit upon the solution. By setting up shop inside the former Soviet Union, he realized, the company could provide locally the foil and other aluminum products its customers needed in Russia, Ukraine, and the other former Soviet republics. And by entering Russia and becoming a ruble-based supplier, he could provide a new service to his existing Western customers by shielding them from Russian inflation and exchange rate shocks. Even if the venture broke even or lost a little money, it would enable RMC to strengthen its ties to Western customers while expanding its horizons and entering the Russian market, selling foil to Russian consumers as well. He called Fata's managers and told them he had changed his mind.

The joint venture, named Sayanol, took form accordingly. Fata supplied the equipment for the mill and the know-how that RMC lacked. Sayansk Smelter agreed to provide a new building and took on responsibility for protecting the venture against the vicissitudes of Russian politics. The $200 million in capital needed to get the venture off the ground came from a consortium led by an agency of the Italian government.

RMC thus limited its risk by using someone else's funds and linking up with solid, experienced partners. But its truly innovative step was to focus the venture on the domestic Russian market. In other countries, like Brazil, foreign aluminum producers have set up smelting operations primarily for export. Here, in contrast, was an aluminum joint venture whose first move was to build an expensive plant to utilize indigenous production for local consumption.

Mr. Reynolds hasn't stopped with Sayanol. He has since started up three other ventures in the former Soviet block, to produce beverage cans, construction materials, and wheel rims. Eventually, each of these ventures will serve one or more of RMC's Western customers that need these products to manufacture their goods for the Russian market. Moreover, because each venture has the capacity to consume a lot of aluminum, the potential volume of all four - 160,000 tons a year or more - represents one-third of the production cuts that Russia agreed to make in response to pressure from the West.

If, say, two other companies did what RMC is doing, the three together would take 500,000 tons of Russian aluminum off the export market without imposing any cutbacks whatsoever. That could end the threat to Western aluminum producers and eliminate the international trade crisis in this sector. The lead time to build the necessary pants is admittedly long, but the payback from so strong a presence in former Soviet markets may be longer by far.

Principals

Kevin McDonald
25 years of experience in investment banking, consulting, private equity, and international business
Michael Lehner
In the high technology field for 30 years, as an operating manager, consultant, venture capitalist, and investment banker
Copyright © 2010 McDonald-Lehner. All Rights Reserved.