Russian Retail - Higher Consumer Spending Power, Easing Competition in Sector

After years of lagging GDP growth, food retail sales have started to outpace the economy. Further disinflation this year may allow for trading up, while the increase in social spending should boost consumption. The competition between large players has eased, as has the pressure from specialists. However, risks are emerging from the hard discounter Svetofor and Magnit carrying out what appear to be counterproductive promos. Meanwhile, sector multiples remain close to record lows. We cut our sector EBITDA projections for 2020 and 2021 by 7% and 2%, respectively. X5 Retail Group is our top pick and our only BUY. We reiterate our HOLD for Magnit and Lenta and our SELL for O'Key.> Improved macro backdrop. After lagging GDP for years, food spending grew 6.7% in 2019 in nominal terms, versus nominal GDP growth of 4.8%. We expect food retail sales to continue outpacing GDP with growth of 6.1% in 2020. An ease in food inflation to 3.1% should cause trading up and hence not hurt LFLs. > Upside from social spending. An additional R460 bln is to be spent by the government to support low-income families and expand maternity benefits in 2020. We estimate the boost for food retailers at R96 bln, translating into a 60 bp increase in their LFL sales growth. There is the potential that another R350 bln could be spent on social programs in 2020, though it has not been detailed yet. > Big players coexisting with established specialists. We expect 1.2 mln m2 of modern space to be added in 2020, a big step back from the 1.8 mln m2 in 2019 and 2.1 mln m2 in 2018. This corresponds to 3% space growth, which should be below the industry's revenue growth this year, providing a tailwind for LFL sales. The top two retailers should account for 65% of the space added going forward. Specialists have slowed their expansion and have not been cutting prices further. > Hard discounter Svetofor a new threat. The chain already overlaps with 15% of Magnit and Pyaterochka stores, offering lower prices but a narrow assortment. We think it might have already captured at least 2% of Pyaterochka's revenues. At the current pace of expansion, it could trim 50 bps from LFL sales growth of both X5 and Magnit this year and also pressure prices. > Stocks cheap on cash-flow basis. The total capex of R158 bln we project for the three public chains in 2020 equates to 14% of their total market cap. Hypothetically, if the companies were to distribute all capex as dividends, this would imply a 14% dividend yield. A stop to expansion would also be followed by a bounce in LFLs and margins, as it would push industry space growth below 1%. > Forecast and target price updates. Our 2020 sector revenue projection is little changed, but we cut our EBITDA forecast by 7%, with the most notable revision being for Magnit. X5 is our top pick and only BUY among food retailers (TP raised from $37.00 to $41.00), Magnit (unchanged at $12.50) and Lenta (cut from $3.50 to $3.00) are HOLDs, and O'Key (unchanged at $1.50) a SELL.