Machine Building Challenge

A. Voronin

Though the Government and business community managed to join their forces and get the machine building industry consolidated, the sector’s critical systemic risks — technology backwardness and industrial base wear and tear — continue to persist.

Notably, machine building has grown to become the third-largest sector (following fuel & energy and base metals) in terms of names featured by the Top-400 list of bigger-foot Russian companies. Last year the sector accounted for 6.3% of the aggregate revenue generated by the Top-400 businesses. Interestingly, the state of play in the Russian machine building industry is reminiscent of the notorious Boston-based consulting group’s matrix: the jobs for "stars", "cats" and even "dogs" are all filled out; but the "milking cow" opening remains vacant.

Transport Machine Building

Following the Boston-type classification, Russian transport machine building could be passed as a "wild cat". Though prospective demand for its products is huge and available government backing is most meaningful, the sector desperately needs more capital investments.

Rail engine and car manufacturers were amongst the first machine builders that started to reap the benefits of the lucrative state of play in the global market for our export commodities and overall growth of the national economy. The shabby status of rolling stock that had not been rejuvenated throughout the 1990s, as a matter of fact, endangered any prospect for boosting the freight traffic volumes: by the close of last year the wear and tear of diesel locomotives had reached 84.2%, the relevant indicator for freight rail cars standing at 85.9% and for electric locomotives — at 72.5%.

Domestic exporters rushed to place orders for their own rolling stock, which triggered a tank-car and then regular freight-car production boom. Luckily, the recently established OAO RZD happened to command substantial resources to support assorted capital investment projects. While starting in the last quarter of 2003 with a modest amount of RUR41 billion in general-purpose investments, RZD now plans to have as much as RUR369.1 billion committed in rejuvenation of rolling stock in the 2008-2010 period. Most of the funding will be used by Transmashholding, the company being established as part of the non-core assets held by the A. Usmanov business empire. Notably, RZD, prime customer for the rolling stock, now comes as co-owner of that company. Understandably, this crossover of interests, when one entity poses as owner and nearly a monopoly customer, puts the holding in rather an unenviable situation: Transmash would be compelled to tolerate the prohibitively low returns on its products, which would eventually mean prohibitively low R&D expenditures. Things, however, might look brighter with either France’s Alstom or Canada’s Bombardier Transportation buying into the company and bringing in their top-line manufacturing technologies and new developments.

Car Manufacturing

Clearly, car manufacturing now poses as a "star" in the entire Russian machine building effort. Of course, the status has largely been secured through making the kind of cars that can hardly be passed as Class A products normally turned out by the industrial machinery sector. Given meaningful improvements in the living standards and attractive market conditions for setting up foreign-brand car assembly centers in Russia, new car sales have been exponentially growing (by dozens of percentage points year on year) for some years now. Last year alone saw 1.8 million new car sales being reported, the figure outperforming the previous year’s level by 23.6% and by 45% in absolute ruble amounts. Importantly, 2006 made the first year when Lada’s and Volga’s yielded to foreign-brand cars in terms of sold vehicles (including those assembled in Russia).

Understandably, the ongoing rise of foreign-brand car production comes from application of the April 2005 Government Resolution on Industrial Car Assembly Activities. Under the document’s provisions, foreign car manufacturers enjoy a number of preferences in setting up their assembly centers in Russia provided they meet some requirements for getting their industrial effort localized. Since the day the Resolution was made effective most of the world’s car manufacturing giants have already deployed a range of assembly facilities or released their plans to do so within the next two years. The majors include such globally known brands as Ford (planning to boost the available capacity in order to roll out 125 thousand vehicles annually starting from 2009), Autoframos (building 80 thousand cars per year with an option to raise that number to 120 thousand), Toyota (setting up an initial capacity to build 50 thousand cars a year with an option to boost that number to 200 thousand), GM (70 thousand), Volkswagen (115 thousand vehicles per year).

The current trend, when domestic-brand cars get incrementally phased out in terms of market share and then in absolute numbers, will be only picking up in its intensity, according to the market watchers. Given the scene, AvtoVAZ — Russia’s largest car maker — would have to either radically boost R&D spending and reengineer its product line-up or else seek more backing from the Government holding the Volga-river-based car giant through the agency of Rosoboronexport starting from 2005.

Power Engineering Machinery Industry

Russian power engineering is on the cusp of implementing a nationwide investment program, the largest one in the past 20 years. The goal is to have 25 GW of new capacities installed by 2010. Alas, there is a big question as to whether the Russian power engineering machinery industry would be able to effectively digest the funding to be committed and do the job (just to run a small comparison, within 2000-2005, on average, merely 1.2 GW of new capacities had been installed on an annual basis).

To remind, with the local orders for industrial products being nearly unavailable, Power Machines — the uncontested domestic leader in power engineering machinery building (NPP-related machinery being excluded) - managed to stay afloat by way of securing contracts for foreign customers. However, that sort of survival strategy happened to fraught with problems that particularly came to the fore as soon as domestic orders were resumed. Admittedly, Indian and Vietnamese turnkey heat-and-power-plant and hydro-power-plant projects generated very poor returns, with metal and electricity costs in the final stages nearly phasing out the profit margins. As a result, the company ended the year 2006 in the red, the losses being posted at RUR3.6 billion. Add in the 80+% wear and tear of capital assets and you will be getting rather a bleak picture. The company’s 2010 modernization program was valued at $1billion, with $400 million out of that amount having to be raised externally. But the problem is that the company’s poor performance for the reporting year just serves to keep prospective investors away. The right way out could be to attract new shareholders, particularly given that Interros, the company’s largest beneficiary, is no longer interested in making strategic investments. Holding a 30.4% stake in Power Machines now is Severstal Group that, as a matter of fact, secured a major consumer for its products. Russian Machines might make another fresh shareholder in the company provided RAO UES of Russia decides to drop its stake in Power Machines.

Nuclear power engineering likewise has a set of rather awesome tasks to perform. Russia’s principal nuclear-fuel-cell assembly provider has been annually growing its earnings through lucrative export-delivery and domestic contracts. In July 2006 the Russian Government adopted a concept for the federal program "Developing Russian Nuclear Power Engineering Machinery Sector in 2007-2001 and through 2015" under which RUR1175.4 billion would be committed to support new NPP capacity projects. To be more specific, ten nuclear power engineering units, all featuring a total of 9.8 GW of installed capacity, would be commissioned by 2015, with a similar number of projects being under way.

But the bigger problem is that the scheduled (and to emphasize, funded) power engineering investment programs (hydro-power and combined heat-and-power projects in particular) that can provide an unprecedented push for expanding the domestic power engineering machinery building effort might fail to be successfully completed on account of lacking industrial base. The matter is that over the years of economic hardships in Russia the core power-engineering-machinery industrial capacities had rapidly deteriorated, lost large numbers of skilled labor and happened to be left behind the world’s leading manufacturers (see Expert magazine, issue #9, 2007). Clearly, this state of play generates some misgivings as to viability of the aforementioned plans that have already been dubbed "second GOELRO" (Lenin’s strategy for electrification of Russia).

Defense Industrial Sector

A focused effort to create industry-based holdings out of disparate enterprises appears to be the key trend sustained within the domestic defense industry sector. Tacticheskoe Raketnoe Vooruzhenie (Tactical Missiles) came to be the first such corporation established in 2002. Then, following rather a lengthy stretch of permits and approvals being secured, Obyedinennaya Aviastroitelnaya Korporatsiya (United Aviation Building Corporation) was set up by the close of last year, with Obyedinenny Sudostroitelny Holding (United Shipbuilding Holding) and Bronetankovaya Tekhnika I Artilleriya Holding (Armor and Artillery Holding) on the industrial base of NPK Uralvagonzavod coming in the wake. However, as the integration effort proceeds, more and more challenges and even conflicts emerge. The thing is that in the post-Soviet years many of defense enterprises have had their ownership switched by going private. So, putting things in the reverse appears to be rather a challenging job or even mission impossible altogether. After all, operating as part of that or other industrial corporation would require that private equity holders inevitably contract or drop control of their capital assets. By way of example, the armor and artillery holding derived from Uralvagonzavod would have to include Motovilikhenskie Zavody — supplier of mono-block gun barrels, with the Government merely commanding a 33% stake in the latter. Obviously, the sector would be in for a new wave of reviewing the ownership rights, which would radically boost the relevant corporate governance risks and enhance their implications.

Notwithstanding the circumstance, the ongoing consolidation drive has been rather positively impacting the level of financial risks faced by the sector. Of course, the unified industrial effort would take out the need for VAT having to be put on hold when closing settlements with vendors and suppliers. A shift over to a three-year planning strategy to assure better management of growing government defense-related orders would enable the manufacturers to build up their leg of borrowings and do away with the cash-gap curse. This kind of transformation would enable government-run enterprises, now capable of generating most of its receipts through implementation of defense orders, to be more active in tapping the debt capital market. Interestingly enough, at this point in time there are only two domestic corporate bond issues outstanding and generally valued at RUR 1.1 billion: RUR1 billion for Uralsky Optiko-Mekhanichesky Zavod (Optics Engineering Plant) and RUR 100 million for NPO Aurora.

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