Russia, a treacherously attractive retail market
Backed by annual increases in wages of 34 per cent between 2000 and 2005, Russia’s retail sector has been growing by an average of 24 per cent per year, reaching US$244 billion in 2005. Stunning growth figures that are expected to continue for the years up to 2010. Analysts from both Deutsche UFG and Renaissance Capital predict an average annual growth rate for the years up to 2010 of some 18 per cent.
On a macroeconomic level, private consumption has become Russia’s key driving economic force as industrial production and investment growth are slowing down. “We are convinced that the consumption-driven growth pattern is sustainable for the Russian economy,” Renaissance Capital stated in a note published in March 2006. Russia also ranks second – after India – in A.T.Kearney’s 2005 Global Retail Development Index, which qualifies it as one of the most attractive retail markets for international investors.
Vitaly Podolskyi, CFO of the Russian retailer Pyaterochka, supports the view that with continuation of current developments Russia may well be Europe’s largest food retail market by 2010. Last month, however, he cooled off expectations – especially from foreign investors – by stating that Russia is too fragmented a market for foreign entrants who quickly need to establish scale to reach levels needed for a profitable business. “The only feasible route to market entry is an acquisition, but the top three retailers in Russia only have six per cent of the market,” he said late September this year during an investors’ meeting in St. Petersburg.
Immature and underconsolidated
The Russian food retail market is still dominated by traditional channels such as open-air markets, kiosks, pavilions and small mom & pop grocery stores. Even in Russia’s cities with a population of at least 100,000, modern retail channels only account for 20 per cent of the market.
According to Podolskyi, the Russian market needs modernisation and consolidation. His company is the proof that this process is happening right now as the discounter Pyaterochka merged early 2006 with the supermarket retailer Perekriostok to become Russia’s largest retailer.
“Indeed, the Russian retail real estate market is immature and underconsolidated. Growing retail chains organically is a very time consuming, difficult process which requires retailers to often deal with hundreds of landlords who are unwilling to sell properties and who expect that rents will keep going higher,” says Natasha Zagvozdina, deputy head of equity research at Renaissance capital. “Another obstacle for foreign retailers to enter Russia is the risk that they will not be able to get as many professional and loyal mid-level managers, especially in the remote locations, to run the extensive network.”
This situation plus the fact that road infrastructure – a key requirement in a country as large as Russia – is in a poor condition, explains the absence of leading multinational retailers (e.g. Wal-Mart, Carrefour, Tesco, Schwarz Group) despite Russia’s impressive growth figures. “Hypermarkets were non-existent in Russia five years ago and even now the number of operating hypermarkets in the entire country does not exceed 150 (!) for a population of 144 million,” says Zagvozdina. “It means that foreign hypermarket retailers either have to come to Russia and build hypermarkets first – as the French retailer Auchan did; Auchan had a revenue of US$1.48 billion in Russia in 2005 with only six hypermarkets in Moscow and generated a net margin of 4 per cent – or they have to be able to buy a chain of hypermarkets from existing operators. I, however, don’t think that any of the domestic hypermarket operators (like Lenta, O’Key, Karousel, Megamart, Mosmart, Seventh Continent, Perekrestok) will be willing to sell their businesses because hypermarket operations allow for extensive growth of retail operations.”
The development of modern retail formats needs to be financed and Renaissance Capital expects several of the local retailers to go public in the (near) future or aim to be acquired in the longer term, after increasing its operations and optimising its acquisition price (e.g. hypermarket retailer Mosmart).
The list of food retailers that are currently private but may go public in 2006-2007, include Kopeyka (discounter chain), Tander (discounter chain), Dixy (discounter chain and hypermarkets), Perekrestok (supermarket, hypermarket and convenience store chain), Paterson (supermarket chain) and Viktoria (discounter, hypermarket and convenience store chain).
Among the companies that have not clearly stated their intention to turn to the equity market for capital are Ramstore (supermarket and hypermarket chain), Lenta (hypermarket chain), Mosmart (hypermarket chain) and Marta (supermarket and hypermarket chain).
Opportunities for discounters
The first supermarkets opened in Moscow in 1991-3 and Seventh Continent was the first chain in Moscow to provide open area food stores similar to Tesco or Carrefour. Shortly afterwards, the local retailer Alfa Group began to develop the Perekriostok chain. Migros Türk entered Russia in 1996 with a 50-50 joint venture, Ramstore, followed by Metro and Auchan after the 1998 financial crisis. SPAR started trading in Russia in 2000 via a local, Moscow-based franchiser and in late 2001, a SPAR franchiser (wholesaler Sladkaya Zhizn) started trading in the Volga region. German retailer Rewe entered the Russian market in late 2004 through Billa Russia, a 75-25 joint venture with Moscow-based retailer Marta, while domestic entrepreneurs built discount chains from scratch – Magnit, Pyaterochka, Dixi and Kopeika. Finnish retailer Kesko operates DIY stores in Russia and recently announced to be setting up a grocery business in Russia. It has so far not disclosed a time frame.
Modern retail structures in Russia are developed via the three known formats:
• discounters – developed by Magnit, Pyaterochka, Dixi and Kopeika. They feature a limited assortment (up to 4,500 SKUs), selling space of 250-1,000 m², and a gross margin of 17-24 per cent. They are normally located in residential areas.
• traditional supermarkets – developed by Seventh Continent, Perekriostok, Ramstore, Rewe and, recently, by Auchan, with locations in city centres, along highways and in residential areas. Typically they generate a gross margin of 25-32 per cent and have an assortment of up to 20,000 SKUs
• hypermarkets – developed by Auchan, Metro, Perekriostok, Mosmart, Lenta, Karousel and Seventh Continent – with selling space from 4,000-16,000 m², 15,000-40,000 SKUs and a gross margin of 13-20 per cent.
Most of the supermarket and discounter chains are growing either by acquiring or leasing space from existing Soviet-style groceries. According to Deutsche UFG, this is a good business model as it avoids the need to create new capacity. Due to their strong purchasing power and the positive impact of the open area format on sales, supermarket and discount chains can pay more in rent to the former owners of groceries than the latter would have made in net profit from retailing in the old store.
Renaissance Capital states that discounters – especially hard discounters – who are currently non-existent in Russia, are the most attractive formats to generate a return on invested capital (ROIC). This due to their relatively low cost of per store opening (US$0.2 million to US$0.35 million) and a lean operating cost structure. The discounters’ low inventory levels (15 to 20 days on average) and low SKU numbers are easier to manage, while their high purchasing volumes ensure favourable credit terms from suppliers.
Hypermarket development is much more complex, due to the need to deal with local government over land, planning permission, etc. This format requires higher capital expenditure as often real estate should either be developed or purchased. By comparison: Renaissance capital calculates that construction of a hypermarket with 10,000 to 15,000 m² of total space requires US$15-30 million in investments. This sum would be sufficient for a discounter to open 25 to 40 stores under lease agreements.
Russia: a collection of regional markets
The current low penetration level of modern formats in Russia allows supermarkets and discounters to generate abnormal returns (according to Deutsche UFG a ROIC of 30-60 per cent), given that both margins and sales per m² are high while investments per store are low. Analysts of Deutsche UFG aggregated the opening plans for all operators currently present in the market, which allows them to calculate both selling space per capita and demand per selling space. Their model points to a potential nine per cent like-for-like sales increase per year between 2005 (US$3,787 per m²) and 2010 (US$5,918 per m²).
They stress, however, that these numbers for operators have been mixed so far: from -3 per cent to +16 per cent. According to them, this points more to company-specific issues, rather than to industry supply problems. They conclude that although all serious players are attempting to build national chains, Russia is effectively a collection of regional markets for food retailers. Reasons for this are that national suppliers are active in a limited number of categories, there are 11 time zones and long distances in the country, and finally all local governments have their own rules. Despite the relatively low share of modern trade in Russia as a whole, some of the cities (St Petersburg and Kaliningrad in particular) already feature fairly intensive competition and a high share of modern trade.
In St. Petersburg modern trade accounts for 81 per cent of food retail trade. An extremely high percentage when compared to Russia as a whole (21 per cent). Even in Moscow – next to St. Petersburg known as a key market for modern retail development – modern trade accounts for only 28 per cent of food sales. Moscow is, however, a much bigger market than St. Petersburg. According to Deutsche UFG, the Moscow market still has room to absorb another 30 hypermarkets, 300 to 400 supermarkets and 600 to 700 discount stores before the share of modern trade reaches 50 to 60 per cent.
Moscow today, Russia tomorrow
However slow, change is happening as the central and northwestern regions gradually lose share in the total Russian retail market while the southern, Volga, Ural and Siberia regions are gaining. This is in line with the per capita income growth trend in the regions. Although household incomes in the regions remain well below Moscow levels, their growth and local market sizes present lucrative opportunities. In the regions with double-digit growth rates, competition is often less intensive compared to the central region, which attracts retail chains. According to Renaissance Capital, however, it is a myth that retail competition in the regions is non-existent. In fact, many regional retail chains like Holiday Classic (2005 sales US$230 million in the Novosibirsk area), Kirovskij (2005 sales of US210 million in Ekaterinburg) or Edelweiss (2005 sales of US$120 million in Kazan) have become quite sizeable. Their annual turnover exceeds hundreds of millions of dollars and their operating efficiencies are often at par with Moscow retailers. This because regional chains better understand the supply side of regional markets and deal more effectively with property issues.
According to Renaissance Capital, Moscow today is a good approximation for the Russian food retail profile by formats in seven to ten years’ time. This means that by then hypermarkets and supermarkets will account for 50 to 55 per cent of sales, discounters for 25 to 27 per cent and convenience stores for 15 to 17 per cent. By then foreign retailers can also be assured of acquisition prices having gone up as attractive businesses come at a price.
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