Russian Food Retail:Downside risks look limited,risk reward balance appears favourable

Macro backdrop is finding a bottom; risk-reward balance now favourable

    The macro backdrop for Russian consumers appears to be finding a bottom, following the recovery in oil and the RUB and the slowdown in food inflation. A meaningful recovery does not appear to be imminent. However, limited downside risks from here suggest a favourable risk-reward balance. The long-term growth potential of the market is less attractive than it was in the previous decade, but the market still presents decent growth opportunities for companies under our coverage that have superior value propositions and management teams. Their valuations suggest attractive entry points, we believe. We upgrade Lenta from Hold to Buy while keeping our ratings for X5 (Buy) and Magnit (MGNT LI: Hold, MGNT MM: Buy).

    Magnit: earnings visibility is relatively lower with higher exposure to macro, although the market misunderstands/downplays the entry into food production

    Higher exposure to low-income regions; acceleration of selling space growth during the downturn; and slow reaction to the dynamism of some of its main competitors have hurt Magnit’s operating performance in recent quarters. With purchasing term improvements, cost discipline and favourable base of 2H, the potential miss on management’s 2016 revenue and profitability guidance is likely to be limited. On the other hand, we welcome Magnit’s entry into food production and disagree that this is a deviation from its core competencies. We believe that, through vertical integration (similar to Bim’s main shareholders, who have created one of the best discounters globally), Magnit could potentially boost its private label sales, and this could be a game-changer in the sector. GDRs trade at 2017E P/E of 12.4x, which does not appear particularly attractive given the low visibility on near-term earnings and peer comparisons. We rate GDRs as Hold and prefer local shares (Buy).

    X5: Pyaterochka’s attractive value proposition and good regional exposure suggest continuation of strong results throughout 2016; maintaining Buy

    Higher exposure to affluent regions, Pyaterochka’s attractive value proposition and well managed promotion strategy, a successful refurbishment programme that was initiated with fortunate timing, and a strongly executed turnaround strategy are likely to sustain strong results for the retailer throughout 2016-17. Trading at 2017E P/E of 10.3x, the valuation ignores its relatively superior growth, higher visibility and fewer execution risks. Also, its improving ROE suggests a re-rating potential. We maintain Buy.

    Lenta: low-cost, low-price model and strong execution; upgrading to Buy

    Mainly due to its low cost-low price model and management’s strong execution, Lenta has posted one of the fastest revenue growth rates among major players without harming its margins. The continuation of a weak consumer environment that puts pressure on basket size, owing to higher ability to trade down at hypers, has been seen as a major risk for the retailer. However, as evidenced in its recent results, as a hypermarket operator, it also has greater flexibility in expenses and therefore has effectively controlled costs, while the down-trading trend has been stabilising in recent months. The weak market has indeed presented opportunities to the retailer to increase its market share. Trading at 2017E P/E of 12.7x, the valuation is attractive. We upgrade our rating on Lenta from Hold to Buy.

    Valuation and risks

    Our target prices are DCF-based. Risks include further deterioration in the macroeconomic environment, irrational competition, deviations from operating strategies and unfavourable regulatory changes. Stronger-than-expected LFL and profitability are the main upside risks for Magnit GDRs.