Auto industry: Divorce, Russian style

Why Oleg Deripaska dumped Magna.

Vladimir Putin, Russia’s current prime minister and former president, is a man of few words. They tend to be words that matter, though. So when he visited the massive GAZ car factory northeast of Moscow last July to take Russia’s newest sedan, the Volga Siber, for a test drive, the carmakers listened closely. “It takes off fast, and they’ve increased the clearance,” Putin said admiringly as he climbed out from behind the wheel. “It will be fine for our roads.”

It was a happy day for Magna International Inc., which sent about 150 experts to help build the Siber. The Canadians were there due to a deal last year giving GAZ’s Russian owner, billionaire oligarch Oleg Deripaska, joint control over Magna — which is Canada’s sixth-largest company by revenue, with 82,000 employees in 23 countries — in return for a US$1.54-billion investment in Magna stock (TSX: MG.A). At the time this arrangement was agreed to, Deripaska’s strategy director, Alex Filatov, labelled Magna’s hitch to GAZ a “perfect marriage” of Canadian technology and Russian opportunity. The Siber was the couple’s first offspring. But the new car was barely in the dealerships before the Russians filed for a hasty divorce.

The divorce notice came in the form of early-October news from BNP Paribas, the Paris-based bank that lent Deripaska the money used to purchase an 18% equity stake in Magna. In the weeks after Deripaska bought his 20 million shares for US$76 each a year ago, their value spiked upward to US$100. But since May, as carmakers’ distress deepened in Detroit and Europe — where Magna makes and assembles parts and cars for virtually every brand — Magna shares have floundered. In late September, they dropped below BNP’s comfort level. When the bank made a margin call on its loan, Deripaska instead forfeited the shares to BNP. “We were losing, losing, losing, losing on the investment,” an unnamed Deripaska associate told the Financial Post. Magna officials have said little. Daniel Witzani, Magna’s European spokesman, says Deripaska’s four nominees will remain on the Magna board until the next shareholder vote, and that “Magna’s strategies for Russia are unchanged.” In a press release, Siegfried Wolf, Magna’s co-CEO, said the relationship with Deripaska “assisted us in accelerating our growth in the Russian market.” Even though Deripaska lost an estimated US$600 million on his Magna gamble, the Canadian company says it hopes to continue doing business with him.

Kirill Tachennikov, a Moscow-based analyst who follows GAZ for Otkrytie Financial, agrees that the relationship will likely continue. “Magna and GAZ have a lot more to do,” he says. According to Tachennikov, Deripaska’s decision not to put more collateral behind his investment and wait for Magna’s fortunes to improve, was forced by the recent collapse of the Russian stock market, which has plunged as much as 70% below last year’s highs. Deripaska is estimated to have lost US$16 billion — more than enough to raise concerns about his debt-to-asset ratio. In recent years, the Russian has borrowed billions to diversify his industrial assets; along with the Magna purchase, last year he acquired a billion-dollar stake in Strabag, an Austrian construction company active in Russia. In April, Deripaska borrowed US$4.5 billion for a 25% stake in Russian mining giant Norilsk. And his main holding, the aluminum giant RusAl, is estimated to have borrowed US$14 billion. But in recent weeks, Norilsk and RusAl have been dramatically devalued, calling into question their bankability, and requiring Deripaska to choose what to save and what to jettison as interest rates for retailers reach as high as 35%.

“Deripaska has been leading a very aggressive expansion in a number of sectors, automobiles being just one,” says Ivan Bonchev, a specialist on the Russian car industry who audits both Magna and GAZ for Ernst & Young in Moscow. “His traditional minerals and metals interests seem to have prevailed.”

At the time Deripaska bought into Magna, which booked sales of about US$26 billion in 2007, he described it as a world-beating company that would clear a path for GAZ, a 70-year-old Soviet relic that produces most of Russia’s light trucks and, until recently, the Volga, an iconic but unreliable sedan now replaced by the Siber. “Magna is going to be a US$50-billion company, and I want be there when that happens,” Deripaska told a gathering of Canadian reporters in Moscow last year.

On its side of the marriage, Magna was counting on a breakthrough in Russia to counterbalance its sagging prospects in North America and Europe. Since the wedding, Magna has purchased a Russian plastics supplier and commissioned two plants for stamping and plastics near St. Petersburg. At the time the union with Deripaska was announced, Magna said that rising incomes and a low level of car ownership “make Russia an attractive market for Magna. More than two million cars were sold in Russia in 2006, a 20% increase compared to the previous year.” The partnership with Deripaska, said Magna chairman Frank Stronach, “will accelerate Magna’s growth in Russia and surrounding countries, markets that we see as holding significant opportunities.”

Although that assessment was endorsed by many investment analysts who watch Magna closely, Peter Sklar, who follows the company for BMO Capital Markets in Toronto, noted that Magna shareholders might question why Stronach would change his ownership interest and grant joint control to a total outsider “just to entrench a partner for the Russian market, one of the smaller of the global automotive markets.”

As Sklar noted when Magna first proposed to offer Deripaska joint control, the Canadian company was already working with another Russian carmaker, AvtoVaz, with which it had seen no need to forge new ownership relationships. More than a few questions remain unresolved about Deripaska’s past business practices, which could worry shareholders, Sklar noted. But then, “there is a common view that Magna has been lacking in its corporate governance standards,” Sklar also added. Concerning a side element to Magna’s deal with Deripaska through which Stronach was personally paid US$150 million to grant the Russian equal access to his management fees — which for many years have amounted to 3% of Magna’s pretax profit, or about US$30 million a year — Sklar raised the question “of whether there are other more significant motivations underlying the transaction” than the stated intention of taking Magna into Russia under Deripaska’s well-connected guidance. To be blunt, suggested Sklar, Stronach may have been “motivated to monetize as much of this fee stream as possible due to concerns about the sustainability of the fees.”

Other analysts tracking Magna agree that Stronach’s US$150-million fee amounted to a substantial inducement to do a deal that seemed otherwise inexplicable. “Magna’s objectives could have been accomplished without selling a portion of the company’s equity,” noted UBS Investment research analyst Fadi Chamoun last year. And the side deal for Stronach’s fees was far from benign, he warned. “These fees would have returned to Magna shareholders once Frank stopped providing consulting services to Magna,” Chamoun said. As it was, the deal with Deripaska perpetuated “a highly controversial management fee structure” — one that risked becoming permanent.

Seen in this light, Sklar now thinks the failure of the deal — despite the substantial further hit it caused Magna’s share price, and even though the Canadian company will now operate in Russia without the protection that Deripaska’s ownership stake guaranteed — “will be positively perceived by Magna investors.”

But worries about Magna’s focus on Russia won’t cease with Deripaska’s departure. As the company ramps up its investment in new Russian plants, the car market has spluttered in recent months, largely due to the credit crisis that has pushed car financing rates as high as 20%. “Credit is drying up,” says U.K.-based Carol Thomas, who tracks Russia and eastern Europe for JD Power Automotive Forecasting. “People want to buy, but they can’t.” Faced with this market disruption, in August, Toyota cut its Russian growth forecast from 15% to 5%, says Thomas. “Everything is changing very quickly,” she warns. “It’s very competitive, and a lot of the big suppliers have announced plans to build in Russia.”

Maybe Magna needs a Russian oligarch on its team, after all.