Doing Business : Bloc-Buster Deal : Pepsico’s $3-billion-plus Soviet expansion was the ‘deal of the century.’ Then, the deal crumbled along with the country. Here’s how Pepsi put it back together.

The deal was one of the biggest that a U.S. company had ever signed with the Soviet Union, and as far as Pepsico Inc. was concerned probably the best.

Over 10 years, Pepsi-Cola International would double its soft-drink sales here, open two dozen new bottling plants and launch its Pizza Hut restaurants in the country’s biggest cities.

To finance the expansion, Pepsico would increase its sales of Russian vodka in the United States and begin a new venture selling and leasing Soviet-built ships abroad.

The retail sales of cola and vodka alone were to total more than $3 billion, according to Pepsico’s estimate in 1990, and the ship sales were likely to be worth at least $300 million.

“It was an agreement that people in East-West trade dream about,” Karl G. Nigl, a Pepsi-Cola vice president for Russia and Eastern Europe, recounted almost rhapsodically. “Steady growth was locked in over a long term, there was good technology transfer, our partners were able to add value to their exports all along the way, financing was built in. . . .

“It was barter, sure, but there was profit at very step, and structurally it was beautiful, assuring us convertible currency for our profits while financing a massive expansion.”

But when the Soviet Union disintegrated late last year, with it went what Pepsico had called its “deal of the century.”

The shipyard that was building the double-hulled tankers that Pepsico was selling to finance its Pizza Huts and new bottling plants in Russia was now in a different country, Ukraine, and the new Ukrainian government wanted the revenues from the ship sales.

The chemical plant that was to produce plastic two-liter bottles to expand Pepsi sales was in Belarus, also now independent, but the bottling plants that were to fill them were mostly across the border in Russia.

And the mozzarella cheese needed by the two newly opened Pizza Huts in Moscow had become a very expensive import--it was coming from Lithuania, which wanted to sell the cheese elsewhere or at least to be paid in dollars.

“All of a sudden, the whole thing was in pieces--hundreds of pieces,” Donald M. Kendall, Pepsico’s retired chairman, who had put the original deal together, said in an interview during a recent visit here. “We had a multibillion-dollar contract with a nonexisting entity--the Soviet Union.

“Put another way, one of our biggest partners, the Soviet Union in this case, had just gone out of business, and that’s a major problem for any company.”

While Pepsico has been able over the past six months to salvage its deal, Western business people say that scores of others collapsed along with the Soviet state.

And even in success, Pepsico’s efforts illustrate the difficulty that American and European companies are having in doing business in Russia and the other former Soviet republics as those independent new states emerge from a single, centrally planned, state-run economy.

Selling to the Soviet Union, as well as other socialist countries, was always difficult because the ruble was not an internationally accepted currency and Moscow’s foreign currency holdings were limited. So companies like Pepsico engaged in barter or counter-trade arrangements, taking payment in commodities that it could resell, such as cola syrup for ships.

On top of that longstanding problem, the collapse of the Soviet Union means that old contracts often are simply no longer valid under new regulations. The former Soviet partners may be bankrupt or unable to get raw materials; perhaps they have lost their managers. Suppliers and customers are now frequently in different countries, with tariff barriers going up almost every day. And taxes are imposed at rates that can turn an attractive profit into a serious loss.

Daimler-Benz AG, Germany’s largest manufacturing company, for example, signed contracts in late 1990 to produce 2,500 buses a year outside Moscow. With Russia’s economy continuing to contract at a rate of more than 15% a year and the country’s foreign earnings almost totally consumed by old Soviet debts, Daimler-Benz’s partner cannot pay the $132-million fee for the production license and technical assistance, and only limited production is under way.

“We have signed contracts, but they have told us they cannot stand up to the financial commitment,” Edzard Reuter, the Daimler-Benz chairman, told a conference on Russian trade this month. Counseling patience, Reuter added, “It is in our interest to do what we can. . . . It’s a dramatic transition.”

Chevron Corp. had to renegotiate an agreement it had signed with the former Soviet government to develop the Tengiz oil field in Kazakhstan after the republic became independent--and in the process had to accept a 20% share of after-tax profits compared to the 28% it had originally won. Chevron will now invest about $10.9 billion over 40 years to develop a field likely to produce 700,000 barrels of oil a day and generate $5 billion a year in revenues.

“Chevron will make money in Tengiz, but not nearly as much as it expected,” the Moscow representative of another U.S. oil company commented. “What’s more, its investment will have to be greater. . . . All in all, it’s an OK deal because Tengiz will be another ‘Alaska’ (as a rich new oil region), but it took a heck of a lot of work to put it back together.”

In Pepsi’s case, both Nigl and Richard M. Norton, a Vienna-based vice president of Pepsi-Cola International, concluded that the underpinnings of the original counter-trade deal were still sound--that an expansion of company sales here could be underwritten by the increased, profitable export to Western nations of agricultural products and the ships. But the arrangement would have to be divided into separate deals for Russia, Ukraine, Belarus and the other former Soviet republics.

Pepsi negotiated new contracts with a variety of partners--individual bottling plants now owned by their employees, local corporations suddenly freed from Moscow’s control, governments of the newly independent republics and a dairy farm in southern Russia that could produce the mozzarella.

It also found its way through a maze of often conflicting laws, regulations and policies adopted by the new governments in Russia, Ukraine and other former republics, each of which has its own program for economic reform.

And it dealt with the broadening collapse of the old Soviet economy, a liquidity crisis that has left customers and suppliers alike unable to pay their bills, and the government’s virtual seizure of all foreign currency coming into the country to pay $80 billion in debts.

“We had no option,” Norton said. “After two decades of investment and effort to develop business in the Soviet Union, we were not going to walk away. And while we did not have to start from scratch, everything had to be redone in an environment where the only constant was change. . . .

“We had to restructure all the elements of the 1990 contract so that we had the appropriate deal in each republic,” Norton said, shaking his head both in disbelief at the speed with which everything fell apart and in amazement at the way it was slowly put back together.

“We were no longer dealing with a highly centralized government in Moscow,” Norton continued, “but with new partners in 15 different countries, all independent and sovereign, each with its own policies and approaches to economic reform.

“That has meant, for example, expanding our business much faster in Ukraine--we are bringing in prefabricated Pizza Huts there--in order to use the revenues from the ship construction. But we are really going to have to work to expand our vodka sales in the United States and to buy more apple juice and other products in order (to generate enough cash) to meet the demand for Pizza Huts in Moscow and St. Petersburg.

“And we are looking very hard at what we can buy from Kazakhstan and from other former Soviet republics--timber, tomato paste, fruit juice, industrial waste, cotton, oil maybe--in order to do business in other places. The basic principle is the same, but the partners are different and the business environments are totally different.”

There are other problems, according to Norton. “To the major and continuing problem of finding goods we can buy and export to pay for the equipment, services and products we sell, we now must work through dozens of new regulations, tax laws, import and export tariffs and almost daily amendments to them all. With each change, we have to reassess to ensure we are within the law--and still profitable. This is a place you must make sure you don’t fall asleep.”

Russia, for example, virtually priced its vodka exports out of world markets in January with a new export tax introduced as part of the government’s economic reforms. Pepsi warned, as did other Western buyers, that Russian vodka sales would drop to zero unless the tax was cut by three-quarters--and it was.

“The direction in which they are headed is good, and our business will grow as a result,” Kendall commented, “but there are many, many missteps along the way.”

Lawrence S. Eagleburger, the American deputy secretary of state, warned the Russian government in a recent speech to a business conference here that American businessmen were finding “their ability to contribute as partners to economic recovery is severely, if not fatally, hampered by regulatory and fiscal practices at all levels of government.”

A survey of American companies doing business in Russia and the other former Soviet republics by the U.S. Commerce Department last spring concluded: “Firms see high risks and costs . . . but not large profits.

“And they are concerned,” the report continued, “that the governments (of the newly independent states) believe the opposite: that (foreign) investors face little risk and can make large profits overnight.”

Business executives, economists and government officials attending a top-level meeting here of the World Economic Forum told Russia’s new leaders that they had far to go before the country would attract the foreign capital it needs to grow, diversify and compete internationally.

“Russia is a vast potential market, one of the great markets of the future,” participants said in a letter sent to the Russian government last week, “but it is not an easy one to penetrate, and it is unlikely that there will be a magic moment when it will suddenly open.”

Calling for “a more stable, certain business environment,” the group made several recommendations--”a clear indication of who is in charge and who can commit to an agreement,” sound commercial laws and courts, a “welcoming” environment for foreign investment through “incentives that justify the risk” and removal of the obstacles to operating a business here.

Reforms must go much faster and deeper if Russia is to develop an economy driven by market forces and entrepreneurship, participants said. They urged the government to abolish the many state controls that remain on the economy, to end the virtual monopolies prevalent in most industries and to accelerate the selloff of state-owned enterprises.

Kendall, a pioneer in Soviet-American trade, agrees on the need for reform. “Clearly, a vibrant, robust, market-oriented economy is the most attractive place to trade in and invest in,” he commented. “It will take years, but once we are through this period of upheaval, Russia and the other former Soviet republics are going to look even better to companies like Pepsico than they did before.”

He is particularly enthusiastic about opportunities for U.S. companies in agriculture, food processing and distribution. “These are areas where our companies have solved the problems that face Russia,” he said, adding the energy sector as another attractive area. “We have solutions we can sell. The trick will be structuring the deals.”

Kendall argued, however, that U.S. firms should not wait for everything to be in place, but forge ahead, helping to shape the business environment.

“A lot of people are worried about the political and economic stability here, and they are hesitant to come in,” Kendall said. “But if you wait for everything to come right, for a convertible currency, for all the growth curves to head up, then the French, the Japanese and the Germans will be in here so tight Americans won’t find a place.

“Truly, the best way we can help Russia is by coming in and doing business. With the trade agreement ratified, small and medium-size companies can get financing from the U.S. Export-Import Bank, guarantees from the Overseas Private Investment Corp. and most-favored-nation tariffs. And those small- and medium-size businesses will liven things up and get people the management training a market economy will require.”

Kendall recalled how in the early days of Soviet-American trade he would come to Moscow, negotiate with the Soviet minister of foreign trade and be received in the Kremlin by Prime Minister Alexei N. Kosygin. Later, he dealt with Prime Minister Nikolai I. Ryzhkov on reselling Soviet-built ships to pay for increased Pepsi sales.

“Two, three guys made all the decisions at the top, and the deal was sealed in the Kremlin,” Kendall said. “Now, the focus will be narrower--’What can we do here, what can we do there?’ But this will let smaller companies get into the market, companies that don’t have $19 billion in sales a year, but that can make some money for themselves and, in the process, help Russia.”

Bartering Billions Pepsico’s complex deal with former Soviet Union includes: CHEESE FROM RUSSIA--Company obtains mozzarella from southern Russia to supply its Pizza Huts in Moscow. COTTON FROM UZBEKISTAN--Pepsico buys and then resells farm product to finance sales of cola syrup and equipment. Above, Pepsi stand in Uzbekistan. SHIPS FROM UKRAINE--Sale of double-hulled tankers helps finance Pizza Huts and bottling plants in Kiev and expansion of Pepsi sales in Ukraine.

Diagram of a Deal PRECEDE: PepsiCo’s operations involve interlocking contracts with nations carved out of the defunct Soviet Union. Some highlights:

WHAT PEPSI DOES

1 In Russia

Runs 16 bottling plants for Pepsi, Diet Pepsi, etc.

With Moscow city government, operates two Pizza Huts.

With partners, manufactures Tanez, an orange-flavored soft drink, and Fiesta, a lemon-flavored soft drink, for Soviet market to get ruble income

Developed bottles, caps, labels used for export production and brought in equipment for the distilleries.

2 In Belarus

Joint venture with Eastman Chemical Co., Chimvolokno and Mposht Textile Mill at Mogilev manufactures polyethylene terephthalate resin, used for new, two-liter bottles of Pepsi. Half of production goes to Eastern and Western Europe; balance to Belarus and Russia, which supplies the raw materials for the Chimvolokno plant.

3 In Ukraine

Runs 7 bottling plants for Pepsi, Diet Pepsi.

WHAT PEPSI GETS 4 From Russia

Stolichnaya, Cristall and Priviet vodka for resale in the United States to compensate for its supply of cola syrup and bottling equipment to Russians.

Miscellaneous oil products in payment for equipment sent to Russia.

Buys tomato paste in southern Russia for use by Pizza Hut and Kentucky Fried Chicken outlets in Western Europe. Also purchases apple juice for use in its products in Western Europe.

5 From Ukraine

Double-hulled tankers, built at Kherson for resale by Pepsi and a Norwegian partner on world market. Proceeds to finance Pizza Huts in Kiev and expansion of Pepsi sales in Ukraine.

6 From Baltics

Buys waste plastic products, which are resold for recycling in Europe, to finance cola and equipment sales.

7 From Uzbekistan

Buys cotton and resells to finance its sales of cola syrup and equipment.

8 From Kazakhstan

Buys miscellaneous industrial products for resale to finance its cola and equipment sales.

Pepsi’s bottling plants PepsiCo uses 42 bottling plants in the former Soviet Union; some are owned jointly. All cities marked on the map have plants.

SOURCE: PepsiCo