OTIS RUSSIA

Case Developed By

Dr. Julian E. Gaspar, Director Center for International Business Studies

Lowry Mays College & Graduate School of Business Texas A&M University

College Station, Texas 77843-4116 United States

and

Dr. Valery Katkalo, Dean and

Dr. Andrei Panibratov School of Management

St. Petersburg State University St. Petersburg, Russia

January 2002

This case is prepared as a basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation. Support for this case was provided by the U.S. Agency for International Development (USAID) through the Eurasia Foundation in Washington, D.C. for which we are very grateful. We would like to express our gratitude to the management of Otis, in particular, Messrs. Jeff Eaton, Kurt Fruhbauer, Vladimir Marov, and Tom Whelan for their participation in discussions and provision of materials without which this case study would not have been possible. Copyright © 2002 by Dr. Julian Gaspar, Dr. Valery Katkalo, and Dr. Andrei Panibratov

1

OTIS RUSSIA

I. Introduction The days immediately following the August 1991 coup in the Soviet Union were

filled with decisions for Otis Elevator’s USSR team based in Paris, France. One member of that team, Jeff Eaton, an MBA from the Sloan School of Management in MIT had been recently promoted to the position of Deputy General Manager for the company’s Leningrad Joint Venture. Jeff had been working for the last two years with George Channin, who was the Senior Area Director for Otis operations in the USSR. Together with a small team that included an industrial engineer and an elevator design engineer they had been working to develop relationships with Soviet partners and customers while shaping an evolving strategy that would need to be endorsed by senior Otis management both in Paris and in Farmington, Connecticut, United States.

The headquarters for Otis operations in Europe, the Middle East and Africa was called ETO (European and Transcontinental Operations) and was based in Paris. The President of ETO was Pierre Fougeron who reported to the Otis Worldwide President based in Farmington, CT named JP Van Rooy. George David who was at that time a Senior Executive VP for United Technologies for the commercial businesses that included both Otis and Carrier was believing that Otis had great potential in the Soviet Union and was consequently very supportive.

By August of 1991 the Paris based USSR team also included Pierre Laboisse who was a Director for Manufacturing and Sourcing, a project manager for Ukraine, a Deputy General Manager for the recently signed Scherbinka Otis joint venture, a financial manager for the USSR and two more project managers for joint ventures being negotiated and for addressing sales and marketing and field operations issues. On the second day of the coup the USSR team met in Paris to address the following: • What would become of the two team members who were currently in Kiev with

whom we could not communicate? • To what degree should we scale back our product strategy and our manufacturing

sourcing strategy? • What impact would the coup have on the economy and our ability to develop local

suppliers? To what degree would this change our existing perspective of “make vs. buy” in the USSR?

• Should we buy existing service companies right away to generate more immediate earnings vs. growing our service base through the products we would manufacture and install in the USSR?

• What about Russian partners and their roles? Do we need them? Want them?

When the USSR team began doing market research in 1989 they learned that in the late 1980s, the market for elevators (lifts) in the former USSR was estimated to be about 40,000 elevators/yr. This was considered to be the world’s largest elevator market.

2

During the same period of time the market in the North America was about 27,000units per year.

The majority of this demand was for passenger elevators in apartment buildings and was driven by Mikhail Gorbachev’s goal that every family have their own apartment by the year 2000. At that time, in large cities like Moscow and Leningrad, as many as 40% of families lived in communal style apartments. This meant that from between three and seven families might be sharing one kitchen and one bathroom.

II. Otis Elevator Company Elisha Graves Otis initiated a new industry in 1852, when he invented the first

safety elevator in Yonkers, New York in the United States. A year later he founded Otis Elevator Company, which was the first elevator manufacturer in the world. Over the past century and a half, Otis has grown tremendously and has remained the global leader in the elevator business.

Otis Elevator Company (see Exhibit 1: Otis), a wholly owned subsidiary of United Technologies Corporation (see Exhibit 2: United Technologies Corporation), is the world’s largest manufacturer, installer, and servicer of elevators, escalators, moving walkways and other horizontal transportation systems. Otis sells approximately 50,000 vertical transportation systems annually – roughly 22 percent of the world’s new equipment market – and employs nearly 63,000 people globally, of which 55,000 of them are employed outside the United States. Elevator modernization is a $3 billion worldwide market in which Otis is an active player. Over 22,000 Otis mechanics service 700,000 elevators, escalators and moving walkways worldwide. A comprehensive range of maintenance, communications and service dispatching networks, which remain unmatched in the industry, supports them. Indeed, Otis remains very much a global company. Its products are offered in more than 150 countries and territories, and Otis maintains manufacturing facilities in the Americas, Europe, Asia and Australia, and engineering and testing centers in the U.S., Japan, France, Germany and Spain. (see Exhibit 3: Company Milestones). Otis’ management considers servicing elevators/escalators as one of the keys to the company’s success. Other factors that have contributed to Otis’ success are:

Reliability: Otis products go through stringent quality control.

Service Agreement Options: Prices for maintenance services were based on the type of service contract signed by the client, i.e. from full service, to service provided on call.

Preventive Maintenance Agreements: To keep elevators operational at all times, Otis also provides regular preventive maintenance of elevator equipment. While using this service Otis will fix any problem with its equipment as well as those of other manufacturers “on call” in the shortest time possible. Because of the numerous components that go into assembling an elevator/escalator, Otis has developed an

3

elaborate preventive maintenance service system that minimizes equipment breakdown thereby keeping operating costs low.

Quality Service: Otis constantly upgrades its service quality by incorporating the latest technology available thereby reducing elevator operating costs as well as downtime.

In addition, Otis Elevator Company’s global success (see Exhibit 4: Key Success Factors) can be attributed to the following factors:

Global Orientation: Otis is a company with operations spread all over the world. In addition to sharing company ideals, Otis instills its global vision among employees. This extends to approaches in service, engineering and manufacturing since resources are shared globally by various divisions of the company.

Job Satisfaction: Otis strives for perfection in everything it does from manufacturing to service. The company believes that each employee should be proud of his work and do the best job possible. To achieve this goal Otis provides various incentives that lead to job satisfaction.

Research and Development: Otis continuously tries to create better and more efficient products that minimize total operating cost and are extremely competitive in the marketplace. To achieve this goal Otis allocates significant amounts of resources towards R&D.

Speed: Otis reacts fast to customer needs by adapting quickly to changing environmental needs on a global scale.

III. Russia: An Economy in Transition Centuries of repressive czarist rule followed by more than 80 years of

communism has left Russia ill prepared to meet the needs of a democratic free market system. Nevertheless, in less than 10 years since the fall of communism in 1991, the country has made relatively significant strides in developing some of the institutions and infrastructure necessary for economic, political and social stability. While Russia’s financial, legislative, judicial and executive institutions are largely being set up through structural adjustment reforms (through IMF and World Bank loans), most of these institutions are dysfunctional for practical purposes. Manipulation and gross mismanagement of institutions have led to a lack of transparency and steep operating cost especially for foreign-owned businesses. Russia’s bureaucrats gobble up both money and time. Reforming the post- communist system of government has been hard. For Russia, a country that is almost unmanageably vast and has little experience in the rule of law, private property or public participation, the task is awesome.

The early 1990s brought hyperinflation, and food panics (Lucas, E., A Survey of Russia, The Economist, July 21, 2001). But there were also high hopes, fuelled by the thought of vast quantities of underutilized brainpower and raw materials that were now

4

joining the world economy. Some talked about a coming boom that might take Russia’s per capita income above Spain’s by 2010. Such wishful thinking led to the financial bubble of 1997-98, when hot money from abroad piled into weak stocks and bond markets, culminating in the default, devaluation and banking collapse of August 1998. So the main question before Russia is not whether the government and central bank can manage the country’s finances sensibly, but whether Russia can become a long-tem home to successful, competitive companies. In the early 1990s foreign investors where cheated. Business basics such as contracts, proper book-keeping and customer satisfaction were widely ignored. Barter was rampant. The Financial Crisis of August 1998

An acute shortage of foreign exchange reserves caused by a worsening balance of payments situation led to the collapse of Russia’s economy in August 1998 when Russia was unable to service its large external debt. The causes of Russia’s financial crisis are clear. As can be seen in Exhibit 5 and 6 (Russia: Key Economic Indicators), Russia’s consistently large budget deficits were unsustainable . Fiscal deficits increased from 69.5 million rubles in 1995 to 147.6 million rubles in 1996 and 150.4 million rubles in 1997, which led to the build up of short-term dollar liabilities that when coupled with falling foreign exchange reserves led to debt service problems. Along with capital flight, the level of foreign exchange reserves fell, which eventually led to the massive devaluation of the ruble in August 1998. To shore up its finances, Russia was asked to reduce the budget deficit by raising tax revenues and cutting government expenditures. To support the restructuring of short-term debt and the new macroeconomic program, the IMF and Western donors pledged a loan package of $17 billion. This did help stabilize the value of the ruble and move toward greater market reform.

The crash of the Russian ruble and the subsequent economic collapse seemed to confirm the worst fears about the country: It is too unstable to operate in Russia (NY Times, May 1, 1999). While some foreign companies like Pizza Hut and Hershey pulled out, others contemplating on entering Russia, just shelved their plans. Yet, a third group of multinationals like Nestle, Lucent Technologies and Caterpillar deepened their presence and increased localization. The key choice facing investors in Russia, just as in the case of most large emerging market economies, is the short-term versus long-term profit objective. This can only be answered by Russia itself. While Russia did reach an agreement with the IMF on a $4.5 billion loan in May 1999 to prevent default on its debt to the Fund, the jury is still out as far as honest implementation of IMF conditions and reform program is concerned.

Even before the economic collapse of 1998, few foreign investors had the nerve to invest in Russia. Most businesses, domestic and foreign were treated with indifference by the government. They were burdened with onerous taxes, hostile and corrupt bureaucracies and ever-changing, non-transparent regulations. That attitude has seeped into the local level too. Yet, many multinationals realize that Russia, stable or not, is ultimately too big a market to ignore. There is strong pent-up demand for quality consumer and industrial products as Russians shy away from shoddy, unappealing domestic goods. With the collapse of the ruble it became obvious to foreign investors

5

that most Russians could ill afford imports and multinationals were forced to consider localization. Local production made sense as it reduced foreign exchange risk, utilized domestic resources and encouraged potential exports. Recent Developments and Future Outlook

Experts argue that firmer stance is necessary since the chaotic liberalization of the Yeltsin era. They believe that Russia is too big a developing nation to be governed exactly like a western country. Democracy is fine in principle, but it must be managed. To prevent chaos and gradually get people to respect the law, it is necessary to first establish a sense of order and authority. Only a tightly run state can push through liberal economic reforms, which in turn will create a strong middle class , which will eventually become the foundation for a solid democracy and the rule of law. The changes implemented so far have, however, done little to create the conditions for sustainable development, i.e., efficiency, accountability and transparency. Most of the people in a position to make changes are those who benefit from things staying pretty much the as they are.

Change in Russia is only a matter of time. Yet, a recent survey of Russia by The Economist (July 21, 2001) asks a thought-provoking question. Is Russia under President Putin heading for regeneration, stagnation or decay? The survey argues that Russia is going in all three directions at the same time. Most people who are knowledgeable about Russia agree on the economic and political direction the country has to take: it must embrace the free market system, private property, a stable convertible (at least in the current account) currency, regular elections and freedom to travel. Reforming the post communist system of government is hard. For Russia, a country that is almost unmanageably vast and has little experience in the rule of law, private property, and public participation, the task is awesome. Russia today is relatively calm both economically and politically. Russians attribute this stability to Vladimir Putin, the president whom they see as its architect. Unless this stability can be reflected in sustainable economic growth stagnation or decay will be the result.

Russia’s new leaders have made three big changes in the way the country is run. The first is to recentralize government, such as tax authorities, the security service, the police, and the prosecutor’s office under the control of the Kremlin, which helps to counteract local barons. The second big change has been to clamp down on tycoon-politicians to curb fraud and embezzlement. The third change is referred to as political “consolidation” – a political system that is recognizable to the West, but works from the top down rather than from bottom up. Mr. Putin’s reforms appears to have made the state a little stronger and quite a lot more stable, but not noticeably more efficient, and certainly no more accountable or transparent --conditions necessary for sustainable economic development. This is largely due to the fact that people in the position to make changes are precisely those who benefit from things staying pretty much as they are.

Russia’s economy is still dominated by state-sanctioned monopolies in energy and uncompetitive industries that receive various forms of state protection. The gas and electricity monopolies are forced by the government to provide low-cost services to

6

unproductive firms, which undermine the more-productive companies that do not receive the same support. Combined with high tax rates, the implicit subsidies create a lack of transparency in accounting practices and entail high social costs. In addition to sustaining an inefficient arrangement in which businesses largely pay each other and the government in kind rather than in cash, the Russian system breeds corruption and uneven enforcement of tax laws, since most large firms negotiate their dues to the state.

The uncertainty and chaos occurring in Russia today largely reflect the drastic changes in the economic and political landscape of the country since the fall of communism in 1991. Although almost a decade has passed since the monumental change in the country, most Russian managers have not been able to adjust their mindset to a free-market system. Nor have they had the time or inclination to acquire the business skills (such as in accounting, finance, management, marketing, and operations) necessary to function effectively in a free-enterprise system. The transition –from a passive order taker to a more proactive business manager-- continues to be a challenge for most Russian businessmen. In addition, American companies face legal and labor problems in Russia with high turnover of key personnel. Despite the transition process, i.e., movement from the command economic system to one based on the free enterprise system, Russia’s business culture is still heavily influenced by its national history and totalitarian roots (mistrust stemming from the Stalinist era). Russian managers score low in future orientation, low in uncertainty avoidance, and very high in “power distance” or authoritarianism. The reason is not lack of intelligence, but a lack in those behaviors that are linked to society-in-transition factors: uncertainty avoidance, human relations or power distance.

Because of Russia’s vastness and diverse culture, there are at least three different business cultures in the country. First, is the traditional culture --one in which companies are quite successful under a paternalistic, state-run system. They are not interested in any kind of social policy, and managers are more interested in prosperity and survival of their business. Second, is the predatory culture --cheating on the state, cheating on partners, and cheating on consumers. Here the rule is profiteering and growth at any price with no role for business ethics. Finally, the socially responsible culture --businesses that are trying to build loyalty and support of customers and employees. One could argue whether these business cultures in Russia are a result of the country's totalitarian past or a function of dysfunctional institutions and half-baked economic reforms.

IV. Russia’s Elevator Industry Russia, despite its economic malaise, is a big elevator market. The national

market for elevators (to be installed in green field projects) was $78.4 million in 2000, of which Moscow was $37.2 million and St. Petersburg $8.5 million. In addition, 200 million rubles ($7.2 million) per year was spent on maintaining existing elevators and another three billion rubles ($108 million) on replacing dysfunctional elevators that are too old (Bratersky, A. Elevator Industry Seeks a Lift, The Moscow Times, August 4, 2000). In summary, Russia is among the top ten elevator markets in the world with a demand of some 4,200 passenger elevators in 2000.

7

Structure of Soviet (Prior to 1991) Elevator Industry

During the Soviet period, several government institutions handled all aspects of the elevator business from manufacturing and installation to service. However, different government agencies handled each of these functions independently. In a nutshell, the industry was not integrated. The Soviet elevator industry consisted of several hierarchically functional levels:

1. Elevator Production

Manufacturing operations were managed and supervised by Liftmash, Mosstroikomitet, Lenstoikomitet, and the Ministry of Heavy Machine Building. Liftmash was the leading enterprise responsible for manufacturing elevators in the Soviet Union, and it reported to the Ministry of Construction and Road Building (Minstoidormash). Liftmash’s Shcherbinka factory, located near Moscow, had 1,400 employees and operated four shifts. In 1989 the factory produced 3800 complete elevators and 24,000 doors. Liftmash’s Sverdlovsk factory located in the Ural Mountains has 820 employees and manufactured some 2,500 elevators a year by the end of the 1980’s. Liftmash’s other factories were in Armenia (Spitak), Belarus (Mogilev) and Uzbekistan.

Mosstroikomitet (City of Moscow) included the Karacharovo facility with 1500

employees produced 6,500 freight elevators in 1989. Lenstrokomitet is a major producer of various construction materials of which elevator production accounted for 20% of its revenues. It had 1300 employees and built 500 elevators in 1989. 2. Elevator Installation

Elevators were installed by Moslift and Mosliftmontage of Moscow, and Soyuzliftmontage, Liftmontage-I-Naladka, Trest No 27 (Leningrad), ect., of Leningrad (present day St. Petersburg).

3. Elevator Service

Maintenance service was provided by Rosliftremont, Mosliftremont, Soyuzliftremont, Liftmontage-I-naladka, RSU-3, RSU-4, RSU-5, and RSU-6 in Leningrad. Similar companies provided elevator maintenance service for other regions of the country. At the present time because of consolidation, only companies in Moscow are still in business. They changed their names and have become less important than during Soviet times. In addition, several new players have entered the elevator maintenance service business, especially in St. Petersburg.

8

Liftmash

Ministry of Heavy Machine Building

Elevator installers, spare part su

Ministry of Construc

Russia’s Elevator Industry Since 1991

Since the fall of communism and breakthere has been significant consolidation in Ruselevator manufacturing companies have either In addition, in the service sector there has behaving firms that dealt with installation or macompanies have combined their installation anothers have fully integrated their operationinstallation and service. With the entry of forcompetition has also increased.

A major source of concern to property metal components and other easily removable pmarket. For example, St. Petersburg’s city govin 2000 fixing elevators that stopped working bwere removed from government buildings anIndustry Seeks a Lift, The Moscow Times, Augu

There are only two domestic elevator msignificant players in Russia’s market. TShcherbinsky and Karacharovsky. Foreign brwhich is the only foreign company with domintegrated operations. Shcherbinsky has abcompared with Otis’s 15%. The key to Shcher(company’s product costs half that of Otis eleva

9

tion and Road Building

Mosstroikomitet

Lenstoikomitet

ppliers and maintenance technicians

up of the Soviet Union starting in 1991, sia’s elevator industry. Several Russian collapsed or merged/acquired by others.

en some vertical integration. Instead of intenance alone, several elevator service d maintenance functions together. Still s to include elevator manufacturing,

eign companies into Russia, the level of

owners is that some Russians try to strip arts from the elevators to sell them in the ernment spent some seven million rubles ecause certain vital elevator components

d sold as scrap (Bratersky, A. Elevator st 4, 2000).

anufacturers who could be considered as hese local elevator manufacturers are ands include Schindler, Kone and Otis, estic manufacturing facilities and fully out 20% of Russia’s elevator market binsky’s success is price competitiveness tor). Shcherbinsky produces some 1800

elevators per year and has numerous customers in the CIS (Commonwealth of Independent States).

The other significant domestic player in Russia’s elevator market is Karacharovsky Elevator Factory, which produces around 2000 elevators annually and has a very strong position in the Moscow market (around 80% of the buildings are equipped with these elevators). Moslift, a Russian company, restructured since 1991, is responsible for installation and maintenance of elevators. Liftremont currently provides a complete range of service (maintenance, modernization, replacement, installation, and commissioning) for Russia made elevators.

Liftremont is a competitor of Otis in the maintenance and repair sector of the elevator business. Liftremont does not manufacture elevators, but it provides maintenance, and installation service. In 1993 its maintenance portfolio consisted of 1900 elevators of Russian and former Soviet Union origin. Today Liftremont’s maintenance portfolio consist of around 9000 elevators and escalators. Liftremont is considered the third largest elevator service company in the Moscow region.

Schindler (world’s largest escalator and second largest elevator manufacturer) of Switzerland supplies imported elevators essentially to banks and offices. Since January 1997, Liftremont became the exclusive distributor for Schindler Group in Moscow and Moscow region. Liftremont also provides service for elevators and escalators built by Schindler. Schindler is striving to become the leading supplier (not of service) of elevators and escalators in Moscow and the Moscow region. Schindler is a serious foreign competitor to Otis in the Russian Market.

Kone of Finland sells its imported elevators to hotels and entertainment complexes. Kone ships elevators from Finland and because of its proximity to Russia it seeks to become a major player in developing Russia’s elevator market. Both Schindler and Kone have their representative offices in Russia, and supply imported spare parts to local dealers.

V. Otis in Russia Otis’ relationship with Russia goes back over a hundred years (see Exhibit 7: Otis

Russia – Milestones) to 1893 when it first installed elevators in St. Petersburg during the Alexander III period. Now, some 100 years later, the company has again returned to Russia by establishing four joint ventures for the manufacture, installation, and maintenance of elevators. During the 1991-1993 period, Otis built three factories in Russia: one in St. Petersburg for manufacturing modern “Europe 2000” passenger elevators and two in Moscow for manufacturing components and spare parts. The three factories began operations in 1993. Otis is the only fully integrated (see Exhibit 8: Otis Facilities in Russia) elevator company in Russia and it also services all brands of elevators, domestic and foreign. Otis Russia now provides maintenance service for over 73,000 units and has some 4000 employees. With an initial investment of $50 million, Otis set up its operations (see Exhibit 9: Otis Russia – Operations) in Russia by dividing

10

the country into six operating areas (see Exhibit 10: Russian Regions). Each regional branch offers fully integrated elevator installation and service.

6 OPERATING AREAS/ REGIONS

Otis Russia – H.Q. Moscow

MOSCOW N.- WEST CENTRAL SOUTHERN URAL SIBERIA & FAR EAST

Otis Russia’s strategy was to “think global and act local”, which meant manufacturing most elevator parts locally and importing key technical components like semiconductor control panels from abroad and assembling, installing and servicing the elevators in Russia. Russia’s government appreciated Otis’s approach because of the company’s long-term commitment to the country. Otis in Russia and Ukraine (one of the largest former Soviet republics) combined has over 14,000 employees. The plants in Russia and the one in Ukraine are integrated and manufacture major components for elevators such as winches and door systems. Otis Russia started in 1993 by manufacturing eight models of passenger elevators each capable of carrying a passenger weight of 1000 kg. primarily for Russian apartments. These models are similar to those built by Otis in Europe, but adapted for installation on standard Russian shafts. The elevator doors and cabins are made of steel, which is fire resistant and meets European safety standards. The elevators are designed to provide smooth and silent rides contributing to passenger comfort. From a technical standpoint, Otis’ elevators are 10-15 years ahead of the competition. Today, over a hundred models are offered with different car linings, e.g., Standard, Business and Deluxe as well as elevator cars with dual entrances and hydraulic systems. As the first modern elevator manufacturer in Russia, Otis introduced “vandal-proof” elevators along with microprocessors unlike the bulky Russian systems. With a speed of 1.6 meters/sec. and telescopic doors, Otis elevators are “state of the art” in Russia. Otis elevators are capable of operating over 17 floors and the company is the recognized leader in elevator technology in Russia. Among Otis’ major customers (see Exhibit 11: Otis Russia –Major Customers) are the Construction Departments of Moscow and St. Petersburg, Russia’s Central Bank, and major construction companies such as Skanska Oy, Alarko, Lemminkainen, Puolimatka, Soyak, Gasprom and Lukoil.

Otis Russia has its headquarters in Moscow and has four companies with 34 branches (divisions) to serve Russia which is divided into six geographical regions:

11

1) Mos Otis (with 5 branches), 2) Otis St. Petersburg (renamed “Otis Lift” in Summer 2001, with 4 branches), 3) Rus Otis (with 25 branches), 4) Shcherbinka Otis (an elevator component manufacturing factory)

OTIS RUSSIA

MOS OTIS MOS OTIS

OTIS ST. -PETERSBURG

OTIS ST. -PETERSBURG

RUS OTIS RUS OTIS SHCHERBINKAOTIS (componenfactory

SHCHERBINKA OTIS (component factory)

t

)

Because of regional differences (population, buildings, economic activity, ect.), Otis Russia segmented the Russian market into six distinct operating regions. These include: (1) Moscow city, (2) North-West Russia (including St. Petersburg), (3) Central Russia, (4) Southern Russia, (5) Ural-Volga region, and (6) Siberia- Far East (see Exhibit). In addition, all operations – engineering, manufacturing, sales, installation, maintenance and modernization –are provided by three divisions of Otis Russia, viz., (1) Mos Otis, (2) Otis St. Petersburg, and (3) Rus Otis. Shcherbinka Otis is essentially an elevator components fabricator and supplier that was established to make operations profitable. However, because of the artificially strong ruble, local components sometimes were more expensive than comparable imports from Spain.

While some 35,000 elevators are serviced by Mos Otis in Moscow alone, Otis Russia services some 74,000 elevators in the whole country. In August 2000, Mos Otis was certified to have met Russian Standard of Quality similar to ISO 9002. Shcherbinka Otis and Otis St. Petersburg received ISO-9001 certification in Summer 2001. Thus Otis became the first elevator company in Russia to be certified for quality. It is Otis Russia’s hope that the certification will help promote sales. All branches of Otis Russia generate a lion’s share of their revenue and from technical maintenance. Otis Russia’s goal is customer satisfaction. To fulfill this objective Otis Russia is dedicated to building quality elevators and escalators that can be delivered at the building site on time for installation to the customer’s total satisfaction. Otis St. Petersburg

Otis St. Petersburg (see Exhibit 12: Otis St. Petersburg) is one of Otis Russia’s four divisions that offer strong competition to the local elevator manufacturers. Otis services every fourth elevator in St. Petersburg, although it installed only 475 of the city’s 55,910 elevators. Vladimir Marov, director general of Otis- St Petersburg, who has worked in the elevator industry since Soviet times, believes that Otis’ success in the Russian market it primarily due to the fact that Otis Russia is the first and only Western-

12

style, full service elevator company in the country. Otis St. Petersburg has completely integrated operations and it offers the customers delivery, installation, and preventive maintenance service on a “turn-key” basis. Otis St. Petersburg services Russia’s Northwest region including St. Petersburg, Leningrad area, Republic Kareliya, Pskov, Novgorod, Murmansk, Arkhangelsk, and Vologda areas.

Otis St. Petersburg is a joint stock company (JSC) that is responsible for Otis

Russia’s elevator operations in North-West Russia. Otis St Petersburg has a manufacturing plant and also provides elevator installation, sales, and service. In particular, Otis St. Petersburg does the following: . Assists construction engineers in the layout necessary for elevator hoist ways . Clears Russian customs for imported elevator components . Manufactures and installs elevators on site for Gosgortechnadzor inspection . Provides maintenance service and modernization of elevators

Otis St. Petersburg was established in 1991 to meet the elevator need for new construction as well as for the replacement market. With 470 employees, Otis St. Petersburg is the only company that manufactures European standard elevators in Russia. Since it commenced production in 1993, the St. Petersburg plant has shipped more than 3,000 elevator units to CIS (Commonwealth of Independent States) countries and other Russian regions of which over 475 elevators have been installed in the North West region alone. Otis St. Petersburg’s most important revenue generating activity is elevator maintenance. Currently some 11,200 elevators are under Otis’ maintenance contract in the North-West region of which 8,300 are in St. Petersburg alone. Elevator maintenance is performed round the clock with the help of modern transportation, communication and testing equipment. Otis’ maintenance network covers the whole city of St. Petersburg and service is provided to all brands of elevators. Otis St. Petersburg could also distribute elevators made at its European factories. However, these elevators would be priced in dollars as compared with those built by Otis in Russia that are priced in rubles and are correspondingly less expensive. Otis elevators have been installed in such landmark buildings as “Nevsky Palace Hotel” and in banks like “Credit Lyonnais”, “St. Petersburg Bank” and “Sberbank” among others.

VII. Otis Russia’s Performance The economic crisis of 1998 had a severe impact on Otis Russia’s operations (see

Exhibit 13: Income Statement Summary) and (see Exhibit 14: Balance Sheet Detail). The turbulence in Russia was a reminder that this transition economy is still a long way to go to achieve a free-market system. Nonetheless, Russia is too important to ignore. The prospect of Russian economic emergence led many U.S. firms like Otis to initiate business operations in Russia, and trade and investment flows were expanding rapidly till the 1998 financial crisis. It is likely that Russia’s growth and investment will resume again, barring the advent of a hostile government.

A close analysis of Otis Russia’s income statement (see Exhibit 14) clearly shows that gross sales of new elevators, spare parts and maintenance service grew rapidly,

13

barring the lagged impact of the 1998 financial crisis on demand for elevators in 1999. Gross sales more than doubled in 2000 over those in the previous year. An interesting issue to analyze is how the three components of gross sales performed as it offers some valuable sub-sector insights. While the gross profit margin remained relatively stable over the 1997-2000 period, the cost of sales of new elevators, spare parts and maintenance service rose at different rates, which reflects varying profitability of Otis’ three operating segments. Otis Russia’s operating income improved significantly since 1998 despite the fact that SG&A expenses as a percentage of total sales revenue have dramatically increased since 1997. Non-operating expenses, which consists primarily of non-interest expenses (depreciation) were largely brought under control by 2000 and losses before taxes dropped from 130.5 million rubles in 1999 to 11.2 million rubles in 2000. Overall, net loss after interest and taxes have declined from a peak of 153.1 million rubles in 1998 to some 68.5 million rubles in 2000. If this trend does continue, Otis Russia is likely to show a turn around and become profitable in 2001.

An analysis of Otis Russia’s balance sheet (see Exhibit 15) indicates that the company is relatively strong. However, there are a several areas of concern that Otis Russia would need to address to improve its balance sheet and profitability. While Otis Russia’s cash position was strong by 2000, its cash flow has been negative. The allowance for bad debt does not appear to be under control and the trade receivable has kept growing because of non-payment and arrears of government agencies. With the collapse of the ruble in 1998, the construction industry almost came to a halt. Otis’ inventory level has been growing, which to an extent reflects unsold spare parts and work in progress. A clearer picture emerges when the level of inventory is considered relative to its total sales. A huge amount of money is tied up in construction in progress (CIP) activities that are yet to come on stream and become productive. An interesting item in the balance sheet to note is the level of long-term debt outstanding that was reduced from 200.8 million rubles in 1999 to 18.9 million rubles in 2000. At the same time the level of inter company loan payable increased from 42.9 million rubles in 1999 to 463.5 million rubles in 2000. Salary and benefits liabilities increased over 40 fold over the 1999-2000 period.

Since the collapse of the ruble in 1998, Otis Russia has taken a diverse set of actions to stabilize output. Cities in northwest Russia ran up accounts payable of 40 million rubles to Otis Russia that before the crises were worth $7 million and after August 17, when the ruble was devalued, the accounts payable was worth only $2 million. Soon after, Otis laid off about 10 percent of its St. Petersburg staff. In the fall of 1998 Otis St. Petersburg did not sell a single elevator, and the factory was idle for a month. It also closed its maintenance offices in a few branches and was struggling to get the city of St. Petersburg pay 23 million rubles in debt accrued before the crisis. “No one had any experience with such a sudden fall, but we survived the best we could,” Mr. Morov said. “The questions came up among our Otis leadership in the U.S. and Germany about whether we should continue. And we decided we should, because the potential is so big and things will calm down at some point.”

14

Inadequate financial control coupled with Russia’s economic downturn led to rising ruble debt and wage costs, which in turn led to lower sales and rising operating losses. And internal audit of Otis Russia clearly revealed the strengths and weaknesses of the company’s operations in Russia. Among the weaknesses identified in the audit were poor price controls and poor management especially in the branches. Despite these operational problems Otis Russia’s profit potential lies in its market for elevator service (preventive as well as on call), and modernization (refurbishing) of old equipment. Given Otis Russia’s extensive sales and service network in Russia, as well as it perceived service quality, the potential for growth in sales and profitability appears promising.

After analyzing Russia’s economic crisis of 1998 and its impact on Otis Russia, the company’s headquarters in the U.S. decided to restructure the Russian operations. Otis Russia was to tighten financial operations of its branches and improve Otis’ national image through even better service. To restructure its Russian operations, Otis Russia sought and was provided $2.8 million loan from the company’s world headquarters in the U.S. The basic terms of the loan were as follows: . Timely repayments of debt per repayment schedule . Better control of budget and operations in general . Better human resource management especially in the area of safety on the shop

floor . Ethical business practices

The real issue, of course, is how Otis Russia will perform in the future. Otis Russia’s 1997-2000 financial performance is mixed. While the massive devaluation of the ruble in August 1998 was the major external factor contributing to its poor performance in 1998-1999, there are a number of strategic issues that the company needs to address to recover from the ruble collapse and the subsequent slump in market (for new elevators as well as maintenance service) demand. A financial analysis of the company’s operations will be most helpful to determine Otis Russia’s future course of action.

15

Discussion Questions

1. Taking a long-term (10-15 years) view, does Otis’s strategy to enter Russia’s elevator market make business sense? What was Otis Russia’s strategy to begin with? What are the pros and cons of the strategy?

2. Russia is a transition economy. What are the major challenges that foreign investors face while entering Russia? What is country risk in the Russian context?

3. Given Otis’s corporate and historical background, what are the chances for Otis Russia’s success? What are the reasons for this conclusion?

4. For businesses to be successful in a free-market democratic system, rule of law, transparency, and disclosure are fundamental requirements. How does Russia fare in this context? What is the direction in which Russia is moving? Given the global opportunities available to Otis, is Russia a good choice?

5. What is Otis Russia’s competitive advantage in Russia’s elevator market? Has the structure of Russia’s elevator industry changed for the better since Soviet times? If so, how? Who are the winners and losers in the present environment? What is the economic impact of developments in this sector on Russia?

6. How does Otis’s strategy in Russia differ from those of its competitors? Who are Otis’s major competitors, and why are they following strategies different from those of Otis Russia?

7. A close look at Otis Russia’s financial statements (Income Statement and Balance Sheet) for the 1997-2000 period provides interesting information. How has Otis Russia performed over that period? Why? How did Otis Russia react to economic developments in 1998?

8. What is the outlook for Otis Russia? Should Otis Russia shut its operations? If not, why? Based on a detailed analysis of Otis Russia’s income statement and balance sheet, devise a corporate strategy for the company’s management that would strengthen Otis Russia’s financials.

16