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NOVEMBER 7, 2018 RUSSIAN RETAIL – DISRUPTED BY SPECIALISTS

Sector Valuations

SECTOR 12M FORWARD EV/EBITDA AT RECORD LOW, BUT ROIC STABILIZING

Russian food retail remains an underperforming sector, both in local and global terms. In 2017, it lost 20% despite decent performance from X5 Retail Group, compared with a 3% decline for the RTS Index and 25% growth for global peers. This year has been even worse, as the sector has lost 45% YTD in comparison to a 2% increase for global peers and a 3% decrease on the RTS.

Valuation multiples have consequently dropped to uncharted territory. Prior to the 2014 economic downturn, the sector was trading at a 12m forward EV/EBITDA of 8 10. It de rated to 6 8 in 2014 16 as the entire Russian market re rated, though it remained above the DM average. In fact, the recent correction has moved the average down to 4.5, almost half that of DM peers (based on Bloomberg).

90% 60% 30% 0% 30% 60% 90%

Source: Bloomberg, Sberbank CIB Investment Research

In previous reports we have discussed the reasons for this move, which are primarily related to overexpansion. We do not consider the market to be overpenetrated right now, but we think the pace of expansion is excessive given that household demand is currently weak and the emergence of specialist retailers has intensified competition. The food retailers have had to offer heavy discounts to attract consumers to new stores. This has diluted revenues and margins at existing stores and has caused opex to climb. ROIC dropped to 17% in 2017 from 24% in 2013.

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At a 2019E EV/EBITDA of 5.2 and P/E of 10.7, the sector offers massive discounts to global peers. The Russian food retailers are still exhibiting higher growth and offer an average 2019E dividend yield of 4.3% (just X5 Retail Group, Magnit and O’Key), above the DM average of 2.4%.

Valuation multiples

Note: As of November 6.

* we have calculated potential dividends in the event that Lenta distributes R11.8 bln instead of buying back shares (however, we have not included them in the sector average)

Source: Sberbank CIB Investment Research

The sector’s FCF and dividend capacity deserves a much higher valuation, in our view. We compare aggregated capex with the aggregated market capitalization of the top three public companies (X5 Retail Group, Magnit and Lenta): the ratio is currently strikingly high, at 16% versus just 7% in 2014 15. In simple terms, were the companies to distribute cash to shareholders rather than undertake capital investments, the sector dividend yield would jump to 16% this year. In such a scenario, the terminal growth rate used in discounting would be 4 5%, while space growth would decelerate and LFLs would climb above 4%.

Ratio of capex to market capitalization for top 3 retailers

Source: Companies, Sberbank CIB Investment Research

In reality, things are not that straightforward, as the companies incur maintenance capex and must spend to renovate stores. Adjusted for this, we calculate the sector could generate R99 bln in “ex growth” FCF in 2019, suggesting a 10% potential dividend yield.

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NOVEMBER 7, 2018 RUSSIAN RETAIL – DISRUPTED BY SPECIALISTS

Source: Sberbank CIB Investment Research

Obviously, the market is pricing in another round of margin compression and ROIC movements. Our sensitivity analysis suggests that a 150 bp margin squeeze would wipe out the upside from the sector and render it expensive based on both P/E and EV/EBITDA. We stress that this is not our base scenario. But the market will need margins to stabilize and LFLs to recover gradually to ensure that the risks have faded. We are unlikely to see evidence of this in the 4Q18 results, so the sector lacks positive triggers for now.

Valuation multiples assuming 150 bp lower EBITDA margin