Brand new order

Conserving value in a changing environmentHow consumer products companies are adapting to the tougher reality of the maturing Russian market

July 2013

Economic snapshot1

2 Conserving value in a changing environment

Russia is one of the very few countries in the world that is not, and does not have to be, obsessed with austerity. The budget defi cit last year was a comical -0.02% and is running currently at -0.2%. As in China, the Russian Government chooses not to allow a collapse in consumer spending and will increase social spending as it sees fi t, but perhaps not on the scale of early 2012.

Russian GDP is trending downward, similar to all markets in the world, and will probably fi nish 2013 at about 2.3% to 2.6%. This remains good compared with other markets except China (which is also slowing). Next year, we expect moderate improvement to about 3.2%, presuming stable global outlook.

Infl ation dipped under 7% in June. As expected, infl ation is on the way down, and slower administrative prices from the Government, a better grain harvest and softer demand will see infl ation at 5.9% in December this year and at about 5.7% by the end of 2014.

Retail sales are running at 3.5% growth, and we expect an average of about 3.8% this year and over 4% next year; non-food still performs much better than food.

Nominal wages were among the highest in the world six months ago at 15% but have fallen to about 11% now; with infl ation falling to 6% soon, this means that real wages will average 5% this year and next.

Unemployment stayed close to record-low levels at 5.4% in June; this means that in some towns and cities there is effectively zero unemployment.

Consumer confi dence indicators in Russia were historically booming in the 2000s at +6 but collapsed to -35 in 2009. Since 2011, they have recovered to about -6, which actually means that Russians (with Turks, Swedes and Germans) are among the most “confi dent” in Europe.

The ruble bounced down this summer along with all emerging market currencies as the markets overreacted to possible higher US interest rates next year. The ruble will probably stay in a softer corridor of about 32.2 to 32.8 to the US dollar for the next 6 to 8 months. But the ruble could come under more downward pressure in the medium term as shale gas developments kick in. We could see the ruble possibly weaker than 33.2/33.5 to the US dollar in 18 to 24 months, but shale gas effects are diffi cult ones to predict. Having said this, the Russian Central Bank has enough reserves (over US$500b) to prevent a ruble crash.

With China growing over 7% and maintained risk in the Middle East, the oil price looks set to average US$98 to US$104 per barrel over the next 12 to 24 months (this is also the consensus view), which should ensure that Russian GDP stays within the parameters noted above.

1. All facts in this section of the report are sourced from DT Global Business Consulting GmBH. The views of third parties set out in this publication are not necessarily the views of the global EY organization or its member fi rms. Moreover, the views should be seen in the context of the time they were expressed.

3Conserving value in a changing environment

Executive summaryRussia remains an attractive market for consumer products companies, but the days of double-digit growth and large profi ts with little effort belong to the pre-fi nancial-crisis era. In the brand new order, today’s Russian market is a challenging environment, which is changing and maturing in many ways. Companies are positive about the future in Russia, but “business as usual” is no longer enough: new thinking and a step change in the way business is conducted are required.In July 2013, EY hosted an industry roundtable for country leaders of some of the world’s largest consumer products companies operating in Russia. A number of key themes emerged:

• Most executives faced a slowdown in the fi rst half of 2013 in Russia, which for some came as a surprise. A number have been caught in the “budget trap”: having set budgets when the outlook was more promising.

• Managing global HQ expectations remains a key challenge. Facing sluggish growth in developed markets, global HQs are looking to squeeze additional profi t from Russia, but this is now far more diffi cult to achieve as the market slows and costs continue to rise.

• Retailers are pursuing volume growth on an unprecedented scale. On-shelf availability is becoming a real issue in some categories because of the increase in promotion. One executive expressed his concern by saying: “The reaction of retailers and manufacturers is overly aggressive and is destroying value.”

• Executives continue to feel pressure to adapt to the changing and increasingly varied needs of the Russian consumer, highlighting the split of the middle class and differences across regions in Russia.

• In this challenging environment, executives agreed that they need to address the basics by focusing on portfolio, pricing and distribution. They need to be more granular in understanding the consumer and take different approaches to their business. Executives recognize the need to bring in people with different mindsets and capabilities. As one executive explained: “It is all about people.”

Executives have been aware for some time of the challenges of dealing with Russia’s maturing consumers, its diffi cult retail market and the demands of global HQ. In this context, they accepted that they needed to work harder — and smarter — to compete effectively. Over the last 18 months, they have made some changes to their business, perhaps focusing on the low- hanging fruit. However, the environment has become even tougher in the last six months. Executives now recognize that they need to take a different, more disruptive approach to all aspects of the business. In addressing these issues, executives are asking themselves a key question: “How do you manage the short-term demands on the business without damaging its long-term future?” Finding the answer will be critical to long-term success.

Emmanuelle RomanGlobal Consumer Products Markets Leader eroman@uk.ey.com+44 20 7951 1651

Dmitry KhalilovCommonwealth of Independent States Retail & Consumer Products Leaderdmitry.khalilov@ru.ey.com+7 495 755 9757

4 Conserving value in a changing environment

Managing global HQs’ expectations in a slowing market

Adapting to more mature and sophisticated consumers

Most consumer products companies reported a slowdown in Russia this year. For some companies, the slowdown was apparent in the latter part of 2012. Others, however, were taken by surprise by the suddenness and depth of the slowdown, and its underlying causes remain unknown. At the same time, the cost of doing business — from staff costs to demands from distributors and retailers — continues to increase in Russia. Despite this, executives are facing pressure to maintain or even increase profi ts.

The middle class in Russia is changing; it is becoming more polarized, with consumers migrating up toward premium goods for some products and dipping down into value ranges for others. There is still a strong market in Russia for western luxury brands, but for many consumers, Russian brands are now an acceptable, ‘‘good enough’’ and even a desirable choice and are providing more competition.

The growing sophistication of the Russian consumer means that companies need to be more sophisticated in their approach to the market and need to understand the nuances of different consumer segments. The trend toward greater sophistication is expectedbut needs to be met with a proper value proposition, and companies are moving away from being ‘‘order takers’’ and are becoming strategic marketers.

Before the recession, Western consumer products companies were focused on premium brands at the top end of the market. However, building a long-term business solely on premium is not possible. Companies have had to start targeting other areas of the consumer pyramid and address the challenge of making the equation work for affordable products in a high-cost-of-business environment. As one executive noted: “The key is to innovate at the higher end but to keep the base moving as well.”

To help drive innovation, consumer products companies recognize the need for better collection and analysis of market data. As one executive explained: “It’s not just to see the numbers but to understand them as information and have a strategy based on it.”

It is clear that “the next phase of growth is the regions” and many companies are starting to look at Russia as “seven countries” in one. Management of the business needs to become more sophisticated to address these regions in Russia because a “one size fi ts all” approach is no longer suffi cient: each ‘‘country’’ across Russia has different needs, different price considerations, different value expectations and requires different distribution models.

Managing these global HQ expectations is one of the biggest, and most time-consuming, problems faced by country CEOs. Explaining why performance has fallen short of expectations is made more challenging because, although available third-party data covers the top of the market and modern retail, it lacks the in-depth insight of traditional trade and regional markets that would provide a truer picture of on-the-ground market reality.

Consumer products companies are caught between trying to drive volume and protect profi t at the same time. Under pressure on both sides and facing targets that were set when the economic outlook was more promising, some companies are struggling to meet performance expectations. “We are caught in a ‘budget trap,’’’ said one major player. “We’ve made promises to HQ on profi t, yet we are trying to protect volumes here at a scale I have not seen in my seven years in Russia.”

Despite the weakness of the current economic climate, global HQs are trying to squeeze more profi t from Russia, which refl ects both the limited potential of many other markets as well as the expectations created by past performance. Historically, companies invested in Russia by redirecting profi ts generated from premium products in developed markets. Profi ts are under pressure in Europe and the US, but Russia is still expected to deliver without this investment. While there is some recognition from global HQs that achievable growth rates are now lower, the pressure to increase profi tability remains.

“ The cost of business is on the rise here, and I’m having to look at operations and restructure under enormous pressure to deliver more profi t.”

“ Managing HQ is my hardest job. Their appetite to squeeze what they can from Russia is enormous.”

“ The middle class is splitting up. People are still looking for brands, but many more others are now looking for value for money.”

“ We used to run central promotions in Russia. We see now that we need to run separate programs across the country and attack region by region. We need to get it right one by one.”

5Conserving value in a changing environment2. Profi t or lose: balancing the growth-profi t paradox for global consumer products companies and retailers in Asia’s emerging markets, EY3.

Companies moving into the regions need to expand in a very focused way. A key message from the forthcoming EY publication Profi t or lose,2 based on a survey of Asia-based consumer products and retail executives, is that traditional scaling approaches are increasingly challenged in emerging markets because of higher-than-expected levels of competition and consumer variance. This fi nding has applicability for Russia; companies should consider creating scale by adopting a portfolio approach across multiple market niches and fl anking particular market segments.

Generally, retailers in Russia are viewed as unsophisticated. One executive noted, for example, that there had been little progress in many areas of category management over the last decade, partly because of a short-term focus. Retailers, however, are expected to mature, allowing the development of more collaborative relationships with consumer products manufacturers.

Evolving consumer needs are likely to provide impetus for change and lead to signifi cant shifts in the retail and channel landscape. One executive reported, for example, that one retailer had recently split its discount and upper retail segments from a supplier management and team leadership perspective.

Also, retailers are driving into Russia’s eastern regions and are therefore providing new outlets to drive consumer products business eastward as well.

An opportunity exists for manufacturers to work with those retailers, which are willing to adjust to evolving market and consumer conditions, and forge win/win relationships through the sharing of best practices and point-of-buying strategies.

“There is much more to be done with retailers, such as grow the category and go to the regions.”

The reaction of retailers to the slowing Russian market, particularly those not performing as well as expected, has been to compete more aggressively on pricing and promotions. This approach reverberates down to consumer products manufacturers through an unrealistic squeezing of terms, backed up by a threat of destocking. Many manufacturers still feel they have a win/lose relationship with retailers, which has become more diffi cult recently because of the sluggish demand conditions. One executive summarized the situation succinctly as follows: “There is no trust today between manufacturers and retailers.’’

Evolving from win/lose to collaborative retailer relationships

“ The current reaction of retailers to the dip in the market is beyond imagination. The price promotions and giveaways are destroying value and chipping away at our investment in the brands.”

“ Retailers here will look like Germany and France in a few years. They’ll want private label. We’ve got some time here to plan the strategy and get it right.”

Retailers are “taking product promotions into their own hands” and in some cases destroying brand value; for example, by offering 50% off or “buy one get one free” on products that the manufacturer would never offer to the consumer under these conditions. Many manufacturers believe that retailers have the power to “ruin the business” if this behavior continues over a longer period of time. Having said this, there are also examples of brand erosion led by manufacturers that are protecting share and cost absorption in their operations.

Looking ahead, some of those attending the meeting believe that it is only a matter of time before retailers move into private label in a big way. The question for consumer products companies is whether to participate in private label as a manufacturer or to try to fi ght it.

Views from Ivan Butyagin, Consumer Products Advisory Leader, CISWholesalers and cash and carries are destabilizing the market in ‘‘traditional trade’’ channels because of their aggressive price policy, which is harming the margin level of consumer products companies’ distributors and putting their shelf control at risk. Companies can respond by:• Assessing distributors’ effi ciency and consolidating them with a

view to eliminating the weakest • Boosting distributors’ maturity in supply chain and customer

service• Assessing trade spend effi ciency with a view to getting the right

balance between “modern trade” and “traditional trade” channels• Differentiating trade marketing approaches by region across

the countryWe would also suggest that companies pay special attention to regional retailers since they have become signifi cant players on a regional level and are very often more effi cient than federal players in their “home” region.

Despite the current issues, executives at the meeting were optimistic about the longer-term future of retailer relationships. One executive felt that the ‘‘equilibrium’’ would be restored at some stage in the future.

6 Conserving value in a changing environment

Disrupting the business to meet the new market realityAs the Russian market matures, consumer products companies recognize that their strategic and business approach must also mature and become more like the approach taken in developed markets.

An ongoing focus on greater effi ciency is one aspect of this change. As one executive noted: “When we were growing at 20% no one was worrying about a few rubles. Now we are under much more scrutiny. Our spending here has become visible and obvious.”

However, adapting to a market that is no longer growing at a double-digit pace requires more than just cost cutting. “Our teams carry on doing what they have always done, and it is wasted,” said one executive. Companies, therefore, are looking at restructuring and disrupting the way they are doing business, recognizing that a more segmented strategy is needed to cope with a maturing consumer and widely differentiated regional markets.

One key message from the meeting was that companies need to address the “basics,” from portfolio through pricing to distribution, as well as take a more granular approach to understanding the consumer. Companies that are prepared to look differently at the market and disrupt their business are reaping the rewards. As one executive explained: “We invested heavily in each initiative that our analysis identifi ed as a potential performance accelerator in the new market environment. We grew faster than expectations in the fi rst half of 2013 because of the investments we have made in digital activity, rural penetration and relevant local innovation.”

There are a number of strands to the changes companies are making to their strategy:

Strategic planning and marketing

Companies believe that they need a more sophisticated approach to strategic planning and marketing. They must start applying best-in-class portfolio management to strike the right balance between portfolio and pricing and must look at their distribution models. A more segmented approach will be vital, with a mix of brands in each category and offers at different price points for different consumer segments.

“ We are going back to really understanding what brings value to the consumer at a certain price point.”

“ I need rowers, not surfers, but I have surfers. They are not the same people.”

Human resources

To take the business to the next level of growth requires a shift in what is expected from staff in consumer products companies and, there was agreement at the meeting that a general upgrading is needed.

A different mindset as well as different capabilities is required. People who guided the business while growth and profi tability were relatively easy to achieve may not have the necessary mindset for the new increasingly tough environment. One executive said that: “For a little too long I trusted people with 10 to 15 years’ experience but who had not had to do anything diffi cult.”

To tackle the challenges ahead, companies are looking for motivated and skilled workforces with the right capabilities. There is a real need for real marketers, data crunchers and strategists.

In some cases, compared with their counterparts elsewhere in Europe, staff in Russia is now not “up to scratch.” There is also concern that it is becoming more diffi cult to retain talent, certainly in Moscow, and the remuneration offered by Russian companies and their increasing sophistication poses a competitive threat. A number of executives mentioned that they had a much easier time fi nding good female talent.

Looking for talent beyond Moscow and St. Petersburg is a must. On a positive note, there was agreement that motivated, talented and cheaper labor is available in greater Russia if companies are prepared to look for it.

Some companies, rather than just tapping these new talent pools for individuals, are taking the more disruptive step of moving entire departments to different areas. Potential also exists to move certain back-offi ce functions out of Moscow. One executive, for example, said that: “I’ve moved some back-offi ce functions to Siberia. There is a good university there for talent, and the people cost four times less.” This is likely to become a growing trend as more companies embrace the need for a step change in their approach.

7Conserving value in a changing environment

“ In the past, we didn’t need to learn, we just had to sell. Now we need analytics to understand why something is selling, or not, and what exactly is happening in the channels.”

“ The internet is bigger than TV in Moscow, TV viewing is down, and publications are down by 20%. E-commerce is coming!”

Companies are hopeful that technology and POS scanners may help provide more accurate market data, and there could be scope to develop an industry-led technological solution.

Messaging to consumers

Russia is experiencing the same long-term media trends as developed markets: print media is dying, and internet viewing is growing at the expense of TV. At the meeting, it was claimed that in 2013 internet viewing has outstripped TV for the fi rst time although there was no mention of how this was measured.

Most companies around the table, however, have not signifi cantly invested in social media, although most fi rms said they had a social media manager. This is clearly an opportunity for forward- looking fi rms.

Questions executives are asking

• How do you manage demands from global HQ to grow volumes and profi ts without damaging your future?

• The next phase of growth is the regions — do you centralize or decentralize?

• How can we develop a win/win relationship with retailers and avoid potential brand value destruction from excessive promotional activity?

• Should we fi ght the trend toward private label or participate with retailers?

• Where can we fi nd the motivated and skilled workforce with the right mindset that the business needs?

• Should we build in-house data analytic capability to deepen our understanding of the maturing consumer?

7

Data and data analysis

Meeting the needs of a maturing consumer requires good data, which must then be turned into insights to be used in strategy. There is a growing recognition that, given the shortcomings of available third-party market data, taking the signifi cant step of developing proprietary data could drive competitive advantage. One company present at the meeting, for example, had created an in-house data analytics group.

Conserving value in a changing environment

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How EY’s Global Consumer Products Center can help your business Consumer products companies are operating in a brand new order, a challenging environment of spiraling complexity and unprecedented change. Demand is shifting to rapid-growth markets, costs are rising, consumer behavior and expectations are evolving, and stakeholders are becoming more demanding. To succeed, companies now need to be leaner and more agile, with a relentless focus on execution. Our Global Consumer Products Center enables our worldwide network of more than 18,000 sector-focused assurance, tax, transaction and advisory professionals to share powerful insights and deep sector knowledge with businesses like yours. This intelligence, combined with our technical experience, can assist you in making more informed strategic choices and help you execute better and faster.

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This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

The views of third parties set out in this publication are not necessarily the views of the global EY organization or its member firms. Moreover, the views should be seen in the context of the time they were expressed.

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