DOING BUSINESS IN AN INDUSTRY WITH DIFFICULTECONOMICS—FOOD MASTER'S EXPERIENCE IN DAIRYPROCESSING AND MARKETING IN KAZAKHSTAN

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Introduction

This Discussion Paper used the following quote from investor, Warren Buffett, as part of

the framework for analyzing the experience of Food Master (a dairy processing and

marketing firm) in Kazakhstans dairy business []




When a management with a reputation for brilliance tackles a business with a

reputation for poor fundamental economics, it is the reputation of the business that

remains intact.

Findings relating to favorable and unfavorable economics provide insights about dairy

marketing and processing conditions in Kazakhstan. Food Master, a dominant dairy

processing and marketing firm in the Almaty region of Kazakhstan, and an important dairy

firm in Astana (Akmola region) has found itself in a business with difficult fundamental

economics. And despite having excellent top management and doing many things correctly,

this case firm lost money in 1 and was forced to restructure. While there have been

positive developments for the business in 000 and 001, the firms long-term profit

prospects are uncertain.

The paper provides background information on Food Master, describing the firms excellent

top management, what the firm did right, what went wrong in the late 10s, why Food

Master will continue to face difficult economics, and lessons from Food Masters

experience for investors and Kazakhstans government agencies.

Background Information on Food Master

The ownership of Food Master is split between Developed Technology Resources, Inc.

(DTR) and Agribusiness Partners International (API), both U.S. firms. DTR owns a 0%

share and API a 70% share of Food Master.

Food Master owns a controlling interest in eight dairy firms, five in Kazakhstan, two in

Moldova, and one in Ukraine.

The firm has a 50% to 55% market share of fluid milk sales in the Almaty region and lower

market shares in the Akmola region.

The origins of Food Masters operations in Kazakhstan began in Almaty, Kazakhstan in

15 as a joint venture between DTR and the Kazakh firm, Ak-Bulak Dairy.

In March 17, DTR and API formed Food Master. DTR contributed its dairy businesses

in Almaty, Kazakhstan and API contributed U.S.$6.0 million in cash to create Food Master.

Food Master reported its first profitable year in March 18. Company sales in

Kazakhstan totaled U.S.$14 million in 18 and were projected to be substantially higher in

1.

However, in April 000 Food Master reported losses of U.S.$6. million for 1. The

losses were deep and spread across the firms dairy operations in Kazakhstan, Moldova, and

Ukraine.

Mr. John Hupp, President of DTR, attributed the losses to sales reductions associated with

the economic crisis that hit Russia in August 18 and spread to Kazakhstan, Moldova, and

Ukraine, negatively affecting Food Masters dairy operations. The crisis saw the

Kazakhstan tenge fall in value from 8 to one U.S. dollar in December 18 down to 1 to

Saulesh Esenova, a native of Kazakhstans Almaty region, was employed as a researcher for the

Global Livestock CRSP and Ph.D. student at McGill University in Canada when this research was

conducted. W.D. Dobson is Professor of Agricultural & Applied Economics, Co-Director of the

Babcock Institute, and Director of the Renk Agribusiness Institute at the University of Wisconsin-Madison.

Doing Business in an Industry with Difficult Economics�Food Masters Experience in Dairy Processing

and Marketing in Kazakhstan

Babcock Institute Discussion Paper No. 001-1

one U.S. dollar at the end of 1 (over 60%), reducing the dollar value of the firms

earnings and increasing the price of imported inputs.

In mid-1, Food Master began to restructure by eliminating certain dollar-denominated

expenses and by adopting rationalization measures.

Food Masters Excellent Top Management

Food Master experienced problems in Kazakhstan despite the presence of strong top

management for DTR and Food Master. The strength of the top management for the two

firms derives from the background and experience of Mr. John Hupp and Mr. Erlan

Sagadiev.

Mr. John Hupp, DTR President, has good Russian language skills and had extensive

business experience in Russia and the former Soviet Union before joining DTR.

Mr. Erlan Sagadiev, General Director of Food Master in Kazakhstan, is fluent in Russian

and English. He is a native of Kazakhstan who completed a graduate education in the U.S.,

has a prestigious family background, and possesses good political connections in

Kazakhstan.

Hupp characterized Sagadievs value to the firm as follows Erlan Sagadiev is the real

reason that DTR went into Kazakhstan. It was Erlans honesty and connections that made

Food Master a reasonably successful business. This success came about because the

company

�Entered via a joint venture with a Kazakh firm.

�Made a well-timed entry.

�Gained potential advantages from entry and exit barriers.

�Made extraordinary efforts to maintain a suitable milk supply.

�Chose effective marketing practices for the firms products.

However, these actions did not shield the firm from incurring losses in 1 and the need to

restructure.

Whether Food Master will achieve above normal profits (or even normal profits) over the

longer-run will depend on whether the firm can consistently overcome challenges associated

with operating in an industry with difficult economics.

What Went Wrong in the Late 10s?

DTR attributed the losses incurred by the firm in 1 mainly to a demand-depressing

regional economic crisis that culminated in devaluation of the tenge.

While the problems encountered by Food Master in the Almaty and Akmola regions that

stem from macroeconomic conditions are arguably transitory, the firm faces other

conditions that will cause difficult economics to persist in Kazakhstans dairy industry.

Why Food Master Will Continue to Face Difficult Economics

The firm will continue to face difficult economic conditions because

�Capable middle and lower-level managers will remain in short supply.

�Quality milk will remain scarce.

�The Akmola region presents unique problems.

�Credit constraints exist.

�Corruption.

Problems associated with obtaining an adequate supply of quality milk and corruption are

likely to be deep-seated, long-term problems for the firm. Milk production declined % in

Kazakhstan from 10 to 18 in response to adverse developments that�for the most

part�still persist.

The dearth of capable middle and lower managers, problems in the Akmola region, and

credit shortages should be manageable, intermediate-term problems.

It is too early to tell how profitable Food Masters operations will be in Kazakhstan over the

longer-run. Despite the persistence of problems, there is little reason that DTR and Food

Master should, in the language of Warren Buffett, change vessels rather than continue to

patch leaks.

There is an encouraging sign for Food Master�DTRs shares, which trade as a NASDAQ

BB stock in the U.S., rose in price during February 001.

What Are the Lessons for Investors in Kazakhstans Dairy Industry?

Food Master was probably positioned better than most foreign-Kazakh joint venture firms

to succeed in Kazakhstans dairy industry. Therefore, other investors should be prepared to

encounter problems at least as difficult as those experienced by Food Master in

Kazakhstan.

Lessons for investors, ranked in order of importance, are as follows

�Dependable supplies of quality milk will be difficult for many processors to obtain for

the foreseeable future.

�Corruption will be a problem for foreign-based processors that fail to employ a politically

well-connected Kazakh in the business.

�Dairy processing and marketing firms will need to devote substantial efforts to training

programs to give employees management and marketing skills needed to operate under

market conditions in Kazakhstan.

�Credit and equity capital for use in Kazakhstans dairy businesses will remain scarce

and/or costly.

�Due diligence inquiries will assume importance for dairy processing and marketing

investments in all parts of Kazakhstan.

What are the Lessons for Kazakhstans Government?

Certain problems affecting Food Master and the firms domestic competitors have

implications for government agencies wishing to foster sound investments in Kazakhstans

dairy processing and marketing businesses, and in dairy farming. These relate mainly to

credit availability, milk supply, and corruption.

�Credit problems will defy easy solution by government agencies. The problem is both

one of lack of available credit for dairy processors and dairy farmers and, at times, high

real interest rates.

�A possible cost-effective way for Kazakhstans government agencies to ensure that more

credit becomes available to dairy processing and marketing firms, and to dairy farmers

would be to expand guarantees of credit provided by banks and other commercial

lenders.

�Infusions of capital and skilled management into dairy farming will be needed to foster

an environment where mid-sized and larger dairy farms can be established with

reasonable prospects for success. Expansion of credit guarantees, business management

assistance to farmers, and improved terms of trade for dairy farmers are called for to deal

with this problem.

�Corruption is an impediment to foreign investment in dairy processing and other

agricultural businesses in Kazakhstan. This problem must be addressed by government

if it is to be reduced.

Doing Business in an Industry with Difficult Economics�Food Masters Experience in Dairy Processing

and Marketing in Kazakhstan

DOING BUSINESS IN AN INDUSTRY WITH DIFFICULT ECONOMICS�

FOOD MASTERS EXPERIENCE IN DAIRY PROCESSING AND MARKETING

IN KAZAKHSTAN

Saulesh Esenova and W. D. Dobson

Introduction

When a management with a reputation for brilliance tackles a business with a reputation for

poor fundamental economics, it is the reputation of the business that remains intact.

Warren Buffett []

This simple point describes an important part of the management philosophy of Warren Buffett,

one of the worlds most successful investors. Interestingly, Buffetts comment provides a useful

framework for analyzing the experience of Food Master (a dairy processing and marketing firm

discussed at length in this paper) in Kazakhstans dairy business. In short, Buffett contends that

investors should avoid businesses with difficult economics. He adds that Should you find

yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more

productive than energy devoted to patching leaks [, p. 47]. Buffett concedes that businesses with

good fundamental economics cannot be identified with engineering precision. However, he

provides guidance on this point, suggesting that securities in companies selling commodity-like

products should come with a warning label that, competition may prove hazardous to human

wealth.

Buffett emphasizes that management foibles, which he labels as the institutional imperative,

can exacerbate the effects of difficult economics [, pp. 5-6]. In this connection, he argues that

(a) as if governed by Newtons first law of motion, an institution will resist any change in its current

direction, (b) just as work expands to fill available time, corporate projects or acquisitions will

materialize to soak up available funds, (c) any business craving of the leader, however foolish, will

be quickly supported by detailed rate-of-return and strategic studies prepared by his troops, and

(d) the behavior of peer companies, whether they are expanding, acquiring, setting executive

compensation or whatever, will be mindlessly imitated.

Michael Porter, a well-known business strategist at Harvards Business School, offers similar

arguments relating to good fundamental economics and difficult economics�albeit in less colorful

language, pointing out that [16, pp. -4]

Not all industries have the same potential. They differ fundamentally in their ultimate

profit potential as the collective strength of the forces (driving industry competition) differs;

the forces range from intense in industries like tires, paper, and steel�where no firm earns

spectacular returns�to relatively mild in industries like oil-field equipment and services,

cosmetics, and toiletries�where high returns are quite common.

Porter indicates that the four primary forces affecting industry competitors and rivalry among

existing firms are (a) bargaining power of suppliers, (b) threat of new entrants, (c) bargaining power

of buyers, and (d) threat of substitute products or services. In an earlier paper, the authors found

that lack of bargaining power of milk suppliers has an important impact on competitive conditions

in Kazakhstans dairy industry []. Most milk suppliers in Kazakhstan have so little bargaining

power that it is difficult for them to stay in business.

What do the arguments about favorable or unfavorable fundamental economics have to do

with dairy marketing and processing in Kazakhstan? Quite a bit it turns out.

Food Master International (Food Master), a dominant dairy processing and marketing firm in

the Almaty region of Kazakhstan, and an important dairy firm in Astana (Akmola region), has

found itself in a business with difficult fundamental economics. Despite having excellent top

management and doing many things correctly, the firm incurred losses in 1 and was forced to

restructure. Food Masters experience provides important lessons for other firms planning to invest

in Kazakhstans dairy businesses and for government policy to encourage sound investments in

Kazakhstans dairy industry.

This Discussion Paper provides background information on Food Master. It describes the

firms excellent top management, what the firm did right, what went wrong for the firm in the late

10s, why Food Master will continue to face difficult economics, and lessons based on Food

Masters experience for investors and Kazakhstans government agencies. The paper reflects

insights gained by the authors from interviews conducted in Kazakhstan in the summer and fall of

000.

I. Background Information on Food Master

The ownership of Food Master (a limited liability company) is split between Developed

Technology Resources, Inc. (DTR) and Agribusiness Partners International (API), both U.S.

firms [4]. DTR owns a 0% share and API a 70% share of Food Master. Food Master currently

owns a controlling interest in eight dairy firms�five in Kazakhstan, two in Moldova, and one in

Ukraine. Food Masters dairy plants in Kazakhstan are located in Almaty (Kazakhstans largest city

and former capital), Yessyk, Chimkent, Kurdai and Astana (Kazakhstans new capital). Figure 1

shows the location of the cities of Almaty and Astana.

The firm has a 50% to 55% share of fluid milk sales in the Almaty region. Food Masters

market shares are lower in Astana�about 45% of the fluid milk market, 0% of the kefir market,

and 1% of the ice cream market in the winter [4]. The firms market shares for fluid milk items

in the Akmola region, in particular, decline in the summer when farmer-distributors become strong

competitors.

The origins of Food Masters operations in Kazakhstan�the main focus of this paper�began

in Almaty, Kazakhstan in 15 as a joint venture between DTR and the Kazakh firm, Ak-Bulak

Dairy. The joint venture business began with the production of yogurt and expanded into kefir,

fluid milk, fluid cream, sour cream, ice cream, cheeses, fruit juices, and snack foods. Food Master

subsequently bought the kefir business of the joint venture partner, reducing the contribution of Ak-Bulak

Dairy to the business.

More detailed information on the evolution of DTR, API, and Food Master and selected

financial data for the firms appear below [4,6]

March 17 DTR and API formed Food Master. DTR contributed its dairy businesses in

Almaty, Kazakhstan and API contributed $6 million in cash.

March 17 Food Masters operations in Astana, Kazakhstan were established.

October 17 Food Master Kazakhstan revenues grew from $.7 million in 16 to

$8.18 million in 17.

March 18 DTR reported the first profitable year in its history. Company sales in

Kazakhstan totaled U.S.$14 million in 18 and were projected to be substantially higher in

1.

October 18 API committed an additional $6 million for expansion of Food Master.

August 1 The European Bank for Reconstruction and Development (EBRD) became

an investor in the firms Kazakhstan operations. The EBRD investment provided working

capital to complete Food Masters state-of-the-art fruit juice and milk packaging plant in

Kazakhstan.

April 000 Food Master reported losses of $6. million for 1. The losses were deep

and spread across dairy locations in Kazakhstan, Moldova, and Ukraine.

Mr. John Hupp, President of DTR, attributed the losses to a regional economic crisis, as

follows in April 000 [1]

The economic crisis that hit Russia in August 18 significantly affected our businesses

in Kazakhstan, Moldova, and Ukraine in late 18 and early 1. The crisis saw the

Kazakhstan tenge fall from 8 tenge to the dollar in December 18 to 1 to the dollar at

the end of 1, with similar devaluations in Moldova and Ukraine. The crisis occurred at

the same time Food Master was investing in new dairy assets, including our state-of-the-art

aseptic juice and milk packaging factory in Kazakhstan. Unfortunately the currency

devaluation was not matched by internal inflation within these countries, making it impossible

to raise prices sufficiently to maintain margins (emphasis supplied). Demand dropped with

price increases, creating overcapacity and difficulty in covering overhead expenses, many of

which were dollar denominated expenses.

Hupp described the restructuring that was undertaken to deal with Food Masters losses, as

follows [1]

In mid-1, some initial restructuring began, with the elimination of some of the ex-patriate,

dollar-based employee expenses. In the summer of 1, more than 00 employees

at our Ukraine operation were terminated to bring expenses in line with reduced margins. In

November of 1, DTR and Agribusiness Partners International agreed to eliminate the

overhead in Minneapolis and move the management to the local levels. Further cuts in ex-patriate

employee wages were made in December.

Hupp described Food Masters problems as stemming mainly from a regional economic crisis.

This was clearly an important cause of the firms losses. However, as noted later, the problems

facing Food Master extend beyond those associated with the regional crisis.



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