Retail in therapy

By bne IntelliNews June 26, 2009

Ben Aris and Nicholas Watson -

The crisis has been a disaster for nearly everyone, but a few retailers are thanking their lucky stars for the global train wreck that has driven up sales and made the acquisitions they need in order to expand cheap.

Economies across the region are in freefall. Russia's economy shrank by just under 10% in the first quarter and Ukraine's is now three-quarters of the size it was at the start of the year, according to Ukrainian President Viktor Yushchenko. But GDP figures are an aggregate and say nothing about how the pain is spread across the economy. The irony of the crisis is that money hasn't disappeared, just that those who have it aren't spending it. Indeed, in somewhere like Russia there is more cash available to be spent than ever before; the Kremlin has been studiously sterilising the inflowing petrodollars over the last decade, siphoning it off into the lockbox of the strategic reserve fund in an effort to contain inflation and prevent an over-appreciation of the ruble, but since the start of this year over $200bn has been transferred from the Central Bank of Russia's coffers into the accounts of banks and companies. Russia is awash with liquidity.

The governments of Russia and elsewhere that have been busy priming the pumps with cash have been largely disappointed, though, as all this cash hasn't got things moving again. The reason why is that most of the growth until last September was fuelled not by cash spending, but by credit, and now the consumer spending credit bubble has popped, it's left everyone with soap in their eyes. "Russia's growth in the past years was fueled not only by strong export revenues, but also by rapidly expanding lending. Russian banks borrowed too aggressively on global markets in order to saturate booming local demand for credit. As a result, foreign debt rose faster than the economy was able to grow and signs of overheating became very visible; for example, construction expansion of around 20-30% was not sustainable. People borrowed too much to buy cars as well," says Evgeny Gavrilenkov, chief economist at Troika Dialog.

With virtually no leverage, the peoples of emerging Europe had been gorging themselves on credit. In the West, disposable incomes are as little as 20 cents out of every euro after things like mortgages and utility bills are paid; in Eastern Europe the amount of "beer money" in a wage cheque can be as much as 80 kopecks from every ruble. Able to afford even the most extortionate interest rates, shoppers only looked at the monthly repayment sums when deciding if they wanted to buy a new plasma TV on the never-never. White good retail chains like M-Video in Moscow reported that up to half their sales were made on credit until last summer and staff of the consumer credit banks working in the stores could outnumber the store's own staff by as many as four-to-one. "The story in advanced economies was largely the same. Wealth creation - wealth inflation would be a better term - relied heavily on borrowed money. Household debt/GDP ratios rose in many countries, including the US, UK and many others," says Gavrilenkov. "The recent economic crisis caused not wealth destruction, but stimulated wealth correction."

Cold, hard cash

Cash is king and credit has been slayed. In the last six months, banks have universally axed car loan programmes or stopped issuing mortgages. The few banks that still offer these products have made them harder to get and a lot more expensive. However, what's really doing the damage isn't the unavailability of credit, but the reluctance of punters to borrow even if they can get a loan. The crisis has induced a "siege" mentality amongst shoppers who have gone back to budgeting for the cash they have in their pocket rather than the multiple they can borrow on their salary. And this is how the crisis will make the biggest difference. Governments in places like Serbia are subsidising loans on the assumption that if credits are cheap, enough people will borrow and buy. However, the crisis is changing the way people shop.

The most obvious beneficiaries of this change in mentality are the discount retailers. In June, Russia's leading discount supermarket Magnit reported a 34% increase in sales over the first five months of this year to RUB65bn ($2bn) - a stunning result for an economy that has shrunk by nearly a 10th over the same period. The crisis has not only passed Magnit by, it has put money in its pocket as Russians changed down from expensive imported Kalbsleberwurst to plain old kolbasa in an effort to save a few pennies. Magnit is on a roll and has been opening one new supermarket every day since the start of this year in an effort to keep up with demand. And it is not just Magnit: the same phenomena can be seen across the entire CEE region.

Dariusz Milek, the founder of NG2, Poland's largest footwear retailer, and one of its richest men, told the FT in June that he sees nothing but opportunity ahead for his low-cost shoe company, which makes most of its products in China and India. "People are counting their money now. Paradoxically, that helps us," he told the paper, predicting that this year's profits and his plan to open another 132 discount shops this year would be unaffected by the crisis.

Zdenek Skala, the retail research director for the Prague-based consultancy INCOMA Research, notes that in addition to a shift from 'A' brands to 'B' brands, people have also begun to limit their hotel/restaurant/café expenses. "This can help to grow some dry grocery categories and fast food," he says.

Amrest, the largest independent restaurant operator in Central and Eastern Europe, is benefiting from this shift. Whereas before Europeans - both in the east and the west - would have gone to the local Trattitoria for dinner nine months ago, now they are more likely to grab a burger at Burger King, or food at one of Amrest's other franchises like KFC or Pizza Hut.

The economic slowdown has bitten into these businesses and the slower pace of shopping mall development is forcing Amrest to rein in its expansion plans for this year. Nevertheless, analysts say it will still manage to open 47 new locations in the region this year, followed by around 20 new restaurants in 2010-11 and another 10 in 2012-13. "We expect fast-food brands to highly outperform casual dining ones," says Magdalena Jagodzinska, a retail analyst with Erste Bank in Warsaw. "For the former, we assume same-store sales growth at 2.5% in 2009 and 2-1% in 2010-13, whereas for the latter we see minus 3% and 0-1%."

Prudence pays

Booming food sales is one of the few bright spots in an otherwise gloomy economy, but no amount of burger-eating will dent the collapse in the sales of big-ticket items. Retailing in Central Europe has, like the rest of the region, suffered hugely from the crisis, though at first glance recent macroeconomic data offers some glimmers of hope. Though Hungary is mired in a particularly vicious and long-lasting downturn, retail sales data for April for the Czech Republic and Poland picked up slightly from the month before.

Poland cemented its reputation as a crisis-star by putting in actual retail turnover growth of 5% from March and even eked out a 1% rise from the year before. The Czech Republic was also in positive territory with a 0.6% month-on-month gain, but was down 1.7% on the year. In general, the wider EU27 retail sales data shows a broadly similar trend: in the 27 EU member states, sales rose an average of 0.5% month-on-month, but were down 1.4% on the year.

Crashing car sales have done the most damage. Traditionally a big export earner for the region, car sales have proven to be particularly vulnerable to the crisis. New car registrations have fallen for 12 consecutive months over the whole of Europe, with April seeing a 12.3% fall from a year earlier. The fall in registrations in the new EU member states was even more severe, down by 21.4% over the same period.

Rising retail sales have been one of the "green shoots" analysts have eagerly grabbed onto in recent months as evidence the crisis is bottoming out. But other, more cautious, voices have argued that these sprouts of growth are actually little more than weeds pushing up through the rubble of destruction.

In Poland, for example, April's rise in retail sales was driven mainly by food, compensating for the large falls in sales of cars and household appliances, but analysts caution that Easter - which fell in April this year rather than in March last year - distorted the results. "Retailers publish their own results on a monthly basis and we have already seen the May data and it was again really, really weak - almost the same result as February and March. The April data can't be perceived as a good indicator of future performance," says Erste's Jagodzinska.

What has particularly marked out Poland's NG2 and Russia's Magnit is that they they avoided being infected with the "growth at any cost" fever that gripped most retailers in emerging Europe over the last few years. They have come out of the crisis so well because they didn't overreach themselves during the boom years. NG2 held back from a headlong regional expansion, preferring instead to concentrate on its home market and a measured expansion into the Czech Republic, where it has opened 29 shops compared with the 585 shops it has in Poland. For other retailers, though, the sudden economies collapse has brought them to their knees because, even though sales might be increasing, they borrowed so heavily in the last few years that they are drowning in debt.

One of the most obvious victims in Russia has been Pharmacy Chain 36.6 (the number in the name refers to a healthy body's temperature in degrees Celsius), which almost went bust at the start of this year. Dominating Russia's lucrative consumer medicine sector, the company was forced to increase its charter capital 10-fold in March with a new share issue and even then didn't raise enough money to cover its $194m debt. Since then, the company has been living hand to mouth. It offered its bondholders an unattractive deal in May where it would redeem only 15% of its outstanding debt this year and put most of the rest off until 2012. More recently things looked up a little when it successfully issued a RUB2bn ruble bond to raise some fresh operating cash.

Czech user-car retailer AAA has been another big loser, taken down more by overextending itself than simply seeing sales of used cars tank. AAA opened outlets in Slovakia, Poland, Hungary and Romania in recent years before being forced to pull out of the latter three countries when the crisis hit. "These closures were part of its strategy of favouring profitability growth over sales volume increases. To that end, AAA has now focused on its strongest markets, the Czech Republic and Slovakia, and its most profitable models," says Business Monitor International in a recent research note.

Other firms have been reportedly selling off stores and other assets at fire-sale prices in an effort to raise enough cash to keep the ship afloat. Of course, for those with money these distressed sales represent a golden opportunity to buy big chunks of some of the most attractive firms on the market. Pharmacy 36.6 found a willing buyer in the Marshall Capital Partners Fund, a CIS specialist private equity fund with big investments in the real estate sector, which spent $60m-$70m for a blocking stake in the company in March.

Most retailers find themselves in a similar position, but unlike Pharmacy 36.6, which is a big company in a well-defined market niches, they are struggling to find white knights willing to bail them out. "Many companies had 100, 200 newly opened stories and no sales. On top of that most stores were opened when rentals were at the peak, at crazy high levels, and many contracts were even denominated in euros, which is hurting companies as the zloty has weakened," says Erste's Jagodzinska.

This "perfect storm" has pushed many retailers' backs against the wall and kick-started a process of consolidation in the region's still-fragmented markets. Dariusz Pachla, the CFO of Poland's leading clothing retailer LPP, which suffered a net loss of PLN7.8m (€1.7m) in the first quarter as the weaker zloty raised the cost of imported materials and rented space, told local press in May that he was getting calls every day from smaller retailers who fear they can't survive in the current environment. LPP for its part recently acquired rival Artman.

The retail sector will almost certainly be amongst the first sectors to emerge from the crisis, but the severity of the downturn means it will be at least another year before family outings to the mall at the weekend become routine again.

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