Russian food retailers hungry for land

By bne IntelliNews December 14, 2007

Graham Stack in Moscow -

The greatest challenge that Russian retail chains are facing is competition - not for customers, but for locations.

"It's basically a land grab, with chains trying to acquire as much real estate as possible, trying to grow as fast as they can manage," says Brady Martin, retail and real estate analyst at Alfa investment bank.

"Real estate is the major challenge in cities, especially Moscow and St Petersburg," confirms Andrei Nikitin, an analyst at UralSib investment bank. "There's a deficiency in every class of real estate. You're not just competing with other retailers, you're also competing with residential development and office space and hotels."

Martin points out that in terms of shopping centres, the planned construction in 2007-2008 is equal to the current stock, so there's an enormous pipeline. "Regarding retail chains, X5, the largest player, plans to open 140,000 square meters of selling space. Magnit, a regional play, are opening around 300 stores, 100-120,000 square metres. All in, the listed retailers will open 350,000 square meters. But there are also plenty of stores that are not in the data, such as Metro, who don't say much about what they are doing. There are tonnes of small companies in the regions, it's a cash business, profits are higher than in other segments, so they're opening up as much as they can," Martin says.

Going hyper in the regions

With St Petersburg and Moscow - where supermarkets enjoy market shares of 53% and 71% respectively - nearing saturation, the race is on to conquer the regions and hypermarkets are the steed of choice.

"Hypermarkets appear to be the main theme for next five years for larger Russian food retailers, many of whom are already developing this format. We forecast hypermarkets will account for 35-60% of selling space growth in publicly traded retailers in the next five years," says Nikitin. "At this point there is no truly federal food chain in Russia. The closest is probably Magnit, which is present in six out of eight federal districts and whose share of regional shares exceeds 90%. For the other listed retailers, the majority of their sales are in Moscow and St Petersburg, and most of them have already formally communicated their plans to expand into the regions. Cities of population from 250,000 to 500,000 will be the main theme for the sector over the next 7-10 years."

However, regional hypermarkets are a sort of hybrid. "Hypermarkets target the rapidly expanding middle class," Nikitin explains. "But most retailers do not build hypermarkets on the city outskirts, as is the case in the US, but try to build them between city centres and dormitory areas, so as to cater to both categories of customers, those with cars and those who rely on public transportation. This format is said to be successful because it offers lowest prices, but a large product assortment. The supermarkets that are so successful in large cities they charge a price premium that is out of reach for the regional population, whose incomes are still relatively low."

M&A is tomorrow's news

Retailers are competing for land on which to build their stores, but inside them there is still next to no price competition between chains; a can of beans costs the same no matter which shop you go into. The lack of price competition means there is unlikely to be a wave of M&A for the time being.

"Price competition is still rather benign. Although we expect price competition to intensify in the next three years - as the market consolidates (currently the top-five retailers control less than 6% of the market share) and retailers implement price cuts, which will inevitably lead to some margin erosion - we do not foresee price wars anytime soon," says UralSib's Nikitin.

Martin agrees. "Apart from Seventh Continent, which has underperformed for lots of reasons, the other three listed retailers are growing 40-50% this year. It's not a competitive market, the Russian market is still underserved, there's a lot of possibilities. They're able to charge whatever they want."

The lack of competition is also due to the late entry of global retail chains. While Germany's Metro has started operations in Russia, other retail giants have been testing the waters, but are yet to take the plunge.

"The biggest chains, Walmart and Carrefour are not yet here. Two weeks ago Tesco said they were opening stores in Russia. Walmart have been looking at the market, Carrefour look like they're set to enter, they're buying up land, and the first store will soon be opened. These are three of the four largest retailers in the world, and they're not here yet, but we expect them soon," says Martin.

"Some of the Russian companies see themselves as takeover targets, but they have a good position, a good base, strong brands, the apparatus to open stores and to grow. But there's definitely huge investor interest, there are all kinds of rumours, especially regarding foreign players. It's an attractive market," says Martin.

Nikitin also believes that foreign competition poses "no major threat" at this point. "Foreign retailers - Carrefour, Tesco, Wal-Mart - missed the opportunity of large-scale, unobstructed entry into Russia's retail in the 90s, and now face an uphill struggle to gain entry in a market where domestic players have a strong foothold at national and regional levels. This - coupled with Russia's inadequate infrastructure, real-estate related challenges, and administrative red tape - makes multinational retailers hesitant of building their own networks from scratch," he says.

"Although foreign players are increasingly considering acquisitions of established Russian retailers, the high market fragmentation undermines the validity of such ventures for the sake of market share. While we might see isolated acquisitions and organic launches by foreign retailers in 2008, Russian retailers appear set to enjoy a 2-3 year grace period," he says.

Apart from growing number of regional acquisitions, there are a number of large Russian M&A deals in the offing as well, which is likely to see growth laggards such as Seventh Continent being taken over. Recently, the private equity firm Texas Pacific Group signed a preliminary agreement to buy a majority stake in Seventh Continent. Texas Pacific has a track record of successful turnarounds internationally (eg. Debenhams and Burger King) and has previously owned stakes in Russian companies. The deal, says Nikitin, will likely involve changes in management and strategy.

The largest deal will take place if X5 goes ahead with a call option on Karusel, Russia's largest hypermarket chain, operating 22 stores with sales totalling $343m. The call option can be exercised from January 1, 2008 to June 31, 2008 and will, according to UralSib, cost $750m in cash.

However, the clock is ticking. "Adverse market conditions have led X5 to postponement of an SPO till at least 2Q08," says Nikitin. "Based on the view that investor nervousness on the outcome of Russia's parliament (December 2007) and presidential (March 2008) elections will create unfavourable market conditions until then."

The past week's political events might have cleared the air for X5 to take the risk - before a foreign competitor cuts in ahead of them.

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