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Supply chain evolution in a crisis: Case studies from Russia
Russia, the "R" in the BRIC group of major emerging economies, has long been an important growth market for global firms. With a population of 148 million, per-capita gross domestic product (GDP) of US $15,500 in 2013, and a long-term economic growth rate of more than 5 percent per annum, it is easy to see why the Russian market is, in the words of consultancy A.T. Kearney, "too big and important for retailers to ignore."1
For much of the 21st century, Russia's economy has benefited from high global energy prices. The country's huge oil and gas sector accounts for 20 percent of GDP and 65 percent of its exports. In 2014, however, the country faced an abrupt reversal in its economic fortunes. The collapse in the oil price (from more than US $100 per barrel to less than $30 by the end of 2015) slashed export earnings. Sanctions applied by the United States, the European Union, and other nations in response to Russia's relations with Ukraine compounded the economic challenges. GDP fell by almost 5 percent in 2015, and the rapid devaluation of the ruble (which lost two-thirds of its value against the dollar by the end of 2015) drove up the price of imports, pushing down consumption of imported goods and services by more than 25 percent.2
The depth and severity of the crisis hit companies hard, causing many international players to reevaluate their Russia strategy. Some elected to slim their retail networks and scale down their expansion plans or, like the U.S. carmaker General Motors (GM), to drastically reduce their presence in the country.
Other multinationals, however, see today's tough conditions as a strategic opportunity. They have chosen to ride out the crisis, sticking to long-term development plans. Moreover, the economic situation in the country has created a highly favorable environment for certain kinds of supply chain investments.
In particular, the real estate infrastructure companies need in order to serve Russian markets has become dramatically cheaper and more accessible in recent years. Vacancy rates for warehouse and logistics facilities in the Moscow area reached 13.6 percent by the third quarter of 2016,3 the highest since 2009 and a dramatic shift in a region with a structural shortage of industrial space. In 2012 and 2013, by contrast, vacancy rates in the area hovered below 2 percent, and developers could not build fast enough to meet demand.
Today the vacancy level in Moscow is over 1.5 million square meters (about 16 million square feet), the highest in the market history of the region. Speculative real estate construction projects started before the economic crisis have struggled to find occupants. As a result, rents have fallen by around 30 percent, to well below the levels recorded during the 2008 financial crisis.
Tough market conditions also meant companies with existing facilities in Russia could renegotiate leases on favorable terms, or take advantage of additional capacity in the market—and the resulting commercial flexibility—to reconfigure their operational footprints to better suit their current and anticipated future needs.
Since 2009, for example, U.S. agricultural equipment maker John Deere has operated one of its global strategic spare-parts depots alongside a manufacturing operation in a 76,500-square-meter (823,000-square-foot) facility outside Moscow. In 2015, John Deere reconfigured its existing operations into a reduced footprint of around 50,000 square meters (538,000 square feet) while simultaneously relocating its Russia headquarters from central Moscow to the same facility. The change has allowed John Deere to maintain full functionality while enjoying increased operational efficiency at a greatly reduced real estate cost.
As part of its Russia restructuring efforts, Adidas has purchased outright the distribution center in the south of Moscow that it had previously leased. Adidas acquired the 120,000-square-meter (1.3-million-square-foot) building at a relatively low price from a landlord in need of capital, a less costly option for the sportswear company than its previous U.S.-dollar-denominated long-term lease contract.
I asked executives at three international companies that have elected to maintain and grow their presence in Russia to share their experiences, with a particular focus on the impact of the crisis on their supply chains. Here are their stories.
The bricks-and-mortar retailer: Leroy Merlin
Throughout the economic crisis, the Russian division of French do-it-yourself (DIY) and gardening retailer Leroy Merlin did not slow the pace of its ongoing expansion plan. That plan involves around 20 new store openings every year, and the company opened its 59th store in Russia in the final days of 2016. The retailer is also expanding its geographical scope. It will open its first store in Khabarovsk, which is 9,000 kilometers (5,600 miles) from Moscow by road, in 2017; Vladivostok, a city on Russia's Pacific coast, is scheduled to follow in 2018.
Eric Poulet, director of supply chain at Leroy Merlin in Russia, notes that while the average Leroy Merlin store in France sells around 3.4 million items per year, Russian stores sell between 16 and 19 million. In France, the company's supply chain moves around 470 million items per year. In Russia, that number is now over 1 billion.
To support its network, Leroy Merlin prefers to build and run its own distribution facilities where possible, using a standard format optimized for cross-dock activities. During 2015 and 2016, the company partnered with a developer to construct a 100,000-square-meter (1.1-million-square-foot) facility to the south of Moscow. It is currently developing a second warehouse of a similar size in the north of Moscow, which will take over from an outsourced facility on completion in 2018. Eighty percent of the company's domestic suppliers are located in the Moscow area, Poulet explains, making the region an important one for both its inbound and outbound supply chain activities.
Leroy Merlin runs two other, smaller distribution centers today, one in Russia's third-largest city, Novosibirsk in Siberia, and the other in Samara in the Volga region. In 2018, the company will open additional facilities in Rostov-on-Don in the south of the country and St. Petersburg in the north. When demand in eastern Russia is sufficiently high, the retailer plans to open another distribution center in Vladivostok.
To protect their purchasing power during the crisis, Russian families switched to cheaper products wherever they could. For Leroy Merlin, that meant a big acceleration in its lowest-priced, "basic" product categories, says Poulet. For a company that already operates on an "everyday low price" basis, that meant increased pressure to keep supply chain costs down.
That's always challenging across such a widely distributed network. The company can move inventory between its warehouses in France according to demand, says Poulet, but that approach isn't economic in Russia. "We need to be creative and low-cost in the way we organize our transport," he says. As the network gets larger, finding more ways to reduce the cost and carbon emissions associated with transport has become a major focus for the company, which is working with universities in the country to explore novel approaches.
Leroy Merlin has also worked hard to accelerate its supply chain, doubling the share of inventory that passes through its cross-dock operations to 43 percent this year, with plans to increase that to 55 percent in 2017.
When it comes to road transportation, the crisis has created some unexpected challenges, says Poulet. The weak ruble and resulting collapse in the sales of imported goods meant there were fewer trucks transporting merchandise from ports in the north and south of the country to Moscow. That led to a reduction in available capacity in the opposite direction, creating a capacity crunch for Leroy Merlin, which ships a significant volume from its main Moscow distribution centers to stores in those regions. "The cost of transport increased a lot on these routes," he notes.
Some transportation challenges had causes unrelated to the crisis. The rollout of a new national system of road tolls has increased costs and administrative complexity for transport companies, especially for the small owner-operated motor carriers that still dominate the market in Russia. That change took a lot of capacity out of the market and pushed up prices in 2016, Poulet says.
Other regulatory changes have helped the business, however. The closure by municipal authorities of informal open-air markets in many regions, for example, is encouraging more customers to switch to organized retail channels, Poulet says.
Leroy Merlin imports about half of its merchandise, with goods arriving via multiple routes, including ports at Vladivostok, Rostov-on-Don, and Riga (Latvia), as well as via road freight from Europe. The remaining 50 percent of the products sold in Leroy Merlin's Russian stores are sourced inside the country, and the company aims to increase the share of local products to 80 percent. The push for local sourcing is important, Poulet says. "As a big company, it is our duty to develop the community, but more local sourcing also reduces our exposure to currency risks."
A growing local supply base has implications for inbound logistics. The company is working with its suppliers to introduce new concepts here, like "milk-run" collections and drop-offs between its warehouses and multiple stores and suppliers.
Another key long-term focus is the increased use of rail transportation. Today, only 6 percent of the retailer's goods travel by rail, but the company has plans to rapidly ramp that up to 25 percent. Ultimately, says Poulet, 90 percent of shipments to the far eastern region of the country will travel by rail. "The further you go, the more train you use," he says. To achieve its ambitious targets, however, Leroy Merlin will need to overcome infrastructure shortages, especially the limited availability of refrigerated containers for temperature-sensitive products.
For an international business like Leroy Merlin, Poulet says, there are few other markets in the world with the same growth potential as Russia. In fact, despite the challenges, Leroy Merlin has managed to grow its market share during the crisis period, putting it in a strong position as the economy returns to growth. "Things are harder, but we have a leading position and the brand is widely recognized in Russia," Poulet says. "Now is not the time to slow down."
The e-commerce player: Next Group
In September 2011, Russia overtook Germany as the country with the largest number of Internet users in Europe. By the end of 2015, more than 70 percent of Russian adults had access to the Internet, up from 37 percent in 2010. As in the rest of the world, an explosion in the use of mobile devices is accelerating uptake: 42 percent of the adult population accessed the Internet from a tablet or smartphone in 2015.4
Internet commerce has continued to grow strongly during the crisis. The e-commerce market for domestically sourced physical goods reached 800 billion rubles (US $12 billion) in 2016, up 23 percent from the previous year. Cross-border sales, particularly from China, are important too, passing the US $4 billion mark in 2016.5
United Kingdom-based clothing retailer Next extended its "Next Directory" mail-order business into Russia in 2011. For the first few years of operation, the company filled orders for Russian customers from its distribution center in the U.K., but rapid growth in the region, which became the company's largest export market, soon led to a change in strategy.
The decision to establish an e-commerce fulfillment and call center within the country was driven by two objectives, says Olga Evteeva, site manager for the company's 10,000-square-meter (108,000-square-foot) fulfillment center south of Moscow, which also houses a Russian-language call-center operation. "First, we wanted to improve delivery times, and we had reached the limit of what was possible using express air freight from the U.K.," she explains. "Second, we wanted to protect ourselves against a reduction in the duty-free limits for Russian consumers ordering from overseas, which would have affected our ability to compete with local companies."
Next opened its new facility in March 2015, when the country was in the depths of its economic crisis. "It was a nerve-wracking time," recalls Evteeva. "The fall in the ruble forced us to put our prices up, and we had to look for cost reductions from our logistics service providers and other partners in the country."
Establishing a local presence allowed the company to make the best of tough conditions, however. "Everybody else had to increase their prices too, and even when there is less money to spend, clothing is something everyone needs," Evteeva says. In fact, while the company's sales volumes in Russia fell during the facility's first year of operation, Next still maintained its market share. From August 2015 to July 2016 the facility shipped 2.2 million items.
Improved speed and flexibility certainly helped Next maintain its competitive position. The company is working hard to replicate the extremely high service levels it provides elsewhere. Customers in most parts of the U.K. can place orders any time before midnight for delivery the next day, for example. In Moscow, they can expect next-day delivery for orders placed before 11 p.m.
Some customers remain tricky to serve, however, and Evteeva notes that the main factor limiting speed is the distance of the end customer from a suitable airfreight hub. "We can offer a two-day service to customers in Vladivostok, but for most rural locations, it can still take up to two weeks to deliver a package," she notes. "In those cases, we find that absolute speed is less important than clear communication about when the customer's order will arrive."
For 2017, says Evteeva, the feeling is considerably more optimistic. Russia remains one of Next's top five export markets. The company is reviewing its internal processes and working with logistics service providers to push the next-day cut-off time for Moscow customers to midnight, and the company has plans to offer a wider range of delivery options this year. Next is also exploring the possibility of using its Russian hub to serve Belarus and other neighboring countries.
The fulfillment specialist: Arvato
An organization with long experience of Russia's e-commerce challenges and opportunities is Arvato, the services arm of the media giant Bertelsmann. Arvato, which operates in 40 countries around the world, entered the Russian market in 1997, establishing a small distribution center to handle work for a single customer.
"Back then Russia was the 'Wild, Wild East,' and a lot of things were very chaotic," recalls Michael Poetschke, chief executive officer (CEO) of Arvato's Russian business. "Now we have a lot of experience of this market and its volatility. Over the past 20 years we have been through three deep economic crises."
Arvato's Russian operations are diverse. Today the group operates three businesses there: a warehousing and fulfillment services operation, a book-printing plant, and a disc-replicating business for the software industry. The company has 75,000 square meters (807,000 square feet) of warehouse and production space. It stores around 50 million individual items for about 45 customers, primarily Western e-commerce businesses. It dispatches 50,000 to 60,000 parcels a day, making it the biggest independent fulfillment provider in Russia.
"Being a family-owned German company, we may move slowly, but when we have made a step, we have a lot of patience to stay and try to develop," Poetschke says. "Usually we invest in a crisis, because we are sure that the crisis will eventually end, there will be another spring, and our services will be in more demand."
That policy continued during the most recent downturn. The company's latest investment is an ultra-modern 10,000-square-meter (108,000-square-foot) warehouse facility at its site in Yaroslavl, 250 kilometers (155 miles) northeast of Moscow. Arvato has also continued to invest heavily in extensions and improvements to its information technology (IT) infrastructure to meet customer demand for increasingly sophisticated control and monitoring capabilities.
From an operational perspective, Poetschke says, Arvato's experience of the most recent crisis has been like the last, in 2007 to 2008, when online commerce benefitted from a downturn in the bricks-and-mortar retail sector. "The e-commerce businesses we serve tend to grow in these crisis conditions. Traditional retail saw steep declines, especially outside Moscow, and many stores closed or reduced their selection." But even if their purchasing power has stagnated, people still have money, and they want to spend it, he observes. "If they can't find the things they want in the stores, many turn to the Internet."
The net result of that shift was stable volumes for Arvato during the latest crisis, although Poetschke notes that Arvato's expansion has slowed during the period, as big Western companies that had aimed to enter the Russian market have shelved or postponed their plans.
As the economy returns to growth, Poetschke is optimistic that new business opportunities will return. "We are always looking for new customers, and we will grow our facilities to accommodate them," he says. The company is also exploring structural changes. It currently offers next-day services to Moscow from its Yaroslavl base, but a growing appetite for even shorter delivery times, especially among Moscow's wealthy and sophisticated population, may justify investment in a facility closer to the city, he suggests.
Building a successful supply chain in Russia
Even without the additional burden of an economy in crisis, Russia is a demanding place to operate a supply chain, a point emphasized by every executive I spoke with. "Any company operating in Russia has to understand that everything is different there," says Arvato's Michael Poetschke. Those differences span almost every aspect of the supply chain.
Take supply chain real estate, my own area of work. Over and above the normal demands of identifying ideal locations and delivering large construction projects within time, quality, and budget constraints, developing property in Russia comes with its own challenges, which should not be underestimated. Key considerations include securing utility capacities, development entitlements, and construction permits for connecting all necessary utilities to the land site; managing the cost and timing of establishing such utility connections; and ensuring reliable, cost-effective, long-term utility supply. When my company embarked on the development of a new warehouse park close to Moscow, for example, we had to evaluate dozens of different sites before finding one with suitable road connections, robust utilities, and a business-friendly municipality. In addition, it is laborious and time-consuming to ensure—and document—compliance with the appropriate fire-safety, security, and environmental performance standards, especially when working with contractors who are unfamiliar with internationally accepted construction practices.
Logistics service providers capable of delivering a consistent, high-quality service remain hard to find. "The growth in e-commerce has encourage rapid expansion in the logistics sector, but we now have thousands of providers all offering the same, low-quality service," comments Poetschke. "It is difficult to develop sustainable and stable partnerships." Tactical challenges include integration with providers' IT systems and establishing appropriate performance indicators for lead times and on-time delivery performance, he adds.
Then there is speed. Poor road links and a population spread across nine time zones mean delivery times can be long by Western standards. Leroy Merlin's Eric Poulet, for example, notes that his company expects a lead time from order to delivery of one month at the eastern edge of its network, with most of those goods shipped by rail.
Rapid fulfillment of e-commerce orders can be equally challenging. "You only have to look at a map to realize that next-day delivery is not going to be possible from a single distribution center," says Poetschke. "If someone orders late in the afternoon in Vladivostok, it will already be the next day when the product is picked and packed in Moscow."
Where e-commerce companies can't achieve absolute speed, they can compensate with clear communication, however. Like Olga Evteeva of Next, Poetschke emphasizes the importance of setting reasonable delivery expectations, and then meeting them. "The final client wants to know when his parcel will arrive," he says. "If a company says it will arrive within three to five days, and it does, he is happy."
In early 2017, things appear to be turning a corner. The price of oil has risen to a level that favors Russia's producers, and the ruble has strengthened in response. Forecaster Oxford Economics predicts that the country's economy will return to growth this year. The new U.S. administration may take a different approach in its policies and approach to Russia than its predecessor did. Economic challenges arise and are overcome while the modernization of Russia continues; for those international companies with the stamina and flexibility to ride out the tough times, the future looks increasingly encouraging.
1. A.T. Kearney, "The 2015 Global Retail Development Index, Global Retail Expansion: An Unstoppable Force" (2015).
2. Organisation for Economic Co-operation and Development (OECD), Trade in goods and services indicator (2017) (accessed February 1, 2017).
3. JLL, "Moscow & Moscow Region Warehouse Market Overview Q3 2016."
4. East-West Digital News, "E-commerce in Russia" (January 2017).
5. JLL, "Moscow & Moscow Region Warehouse Market Overview Q3 2016."
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