Europe Promising, but Cost Is High

The rush is on. A new investment frontier has opened in Eastern Europe, now teeming with “experts” from the West, Japan and South Korea, eagerly seeking “deals.”

Territory considered barren only a year ago is now considered to be the land of opportunity. Expectations are rising, and many chief executives are feeling pressure to do something (in some cases, anything) to get involved.

Although not entirely comparable, Mexico, China and the Middle East (during the heydays of the Organization of Petroleum Exporting Countries) each generated similar excitement. These earlier experiences taught that direct or joint venture investment in a new and unsettled regional market must support the long-term strategic programs of all parties.

For the U.S. partner, this means investment should yield a strong competitive position in an attractive market. For the Eastern European partner, the venture should be a vehicle for sponsoring its fledgling entry into the global economy.

The stories of GE/Tungsram in Hungary and GM (Adam Opel) in East Germany illustrate these points.

For $150 million, General Electric bought 50% plus one share of Tungsram, a $300-million light bulb manufacturer and leading Hungarian exporter. The price paid by GE, about $1 per dollar of sales, would traditionally reflect the valuation of a AAA-quality company.

Yet Tungsram reportedly has had flat sales in recent years (despite 30% annual inflation), is grossly over-staffed and has serious labor relations problems. In February, Forbes magazine reported that the company is at the edge of insolvency and that GE’s price was at least 99 times earnings.

Be that as it may, this partnership has excellent strategic logic for both partners. GE finds features in Tungsram that are rare among Eastern European companies: decades of export experience in Western Europe, an established distribution network with 12% current share of the Western European light bulb market and experience with private ownership (previous owners were several Western European banks). Of course, Tungsram also offers inexpensive labor--about $4 per day minimum wage.

Moreover, GE will bring its state-of-the-art technologies and management systems to bear on Tungsram, transforming the Hungarian company into a world-class player. Within just a few years, GE/Tungsram expects to establish a strong position in the Western European lighting market against Siemens and Philips. At the same time, GE will be positioned to pursue a secondary strategy of developing the more speculative markets of Eastern Europe over the long term.

While GE is focusing on the lower-risk markets of Western Europe, General Motors is taking a more aggressive approach by establishing an early position within the Eastern European automotive marketplace.

GM plans to gain majority control of East Germany’s Automobile Works Eisenach, state-owned maker of the Wartburg. Similar to Volkswagen, Fiat and Mercedes, GM will build an entirely new facility in East Germany to produce cars that will be sold in Eastern Europe and the Soviet Union. GM and other auto makers expect the unit volume of the Eastern European auto market to double over the next 10 years. GM’s view is that this kind of growth potential is simply too attractive to ignore and that now is the time to establish a strong position on the ground floor.

GM is pinched for capacity in Western Europe and therefore will lose sales opportunities in Eastern Europe unless it invests in new capacity. As the new Opel plant gains experience and demonstrates its ability to supply quality products, it may graduate into a swing plant producing exports for the West. In the meantime, soft currency earnings from the venture may be used to pay for the light castings and forgings imported from Hungary and Romania by GM assembly plants in Western Europe.

However, Eisenach will not provide GM with a low-cost manufacturing site, as East German labor costs are expected to reach parity with the West soon.

After enthusiastically deciding that a move into Eastern Europe makes strategic sense, a company is likely to be disappointed during its search for an acquisition candidate or partner. The quality of socialist enterprises is almost uniformly dismal.

The typical state-owned enterprise is an old, tired operation that probably deserved to die long ago. Buying a company (or a share of a company) usually amounts to no more than buying factory space or the right to manufacture. To expect more from a partner may only lead to disappointment.

The strength of the business sector in Eastern European economies will be found in those precious few enterprises that have grown and operated free from government dependence. Typically, these will be businesses that have been parented by strong families or close foreign affiliations. Any company with export or hard-currency earning experience should be coveted and courted enthusiastically.

The objective of the search is to avoid a money pit. An obvious question to consider is whether the necessary efficiency improvements can be made at the target company and the deal still make financial sense. It is important to note that GE and GM are paying dearly to establish competitive manufacturing facilities, even after paying top dollar to buy into their joint ventures.

Finally, chief executives should note that there is no Eastern Europe strategy independent of Western Europe.

GM’s willingness to stake big money on its joint venture is based on the strong position that it has established in Western Europe. The Opel facility will cut its teeth in Eastern Europe but may eventually graduate into servicing the more quality-conscious market in the West, where GM needs additional capacity. The GE strategy is to establish a previously unattainable position in Western Europe by using its joint venture in Hungary as a low-cost manufacturing platform. Firms that can integrate their Eastern and Western European programs in this manner will find the best risk/return trade-off on their investment.