Russian Consumer - Inflation Uptick to Buoy Top Lines

Past episodes of elevated food inflation have been positive for big retailers' LFLs and margins. This time, however, we think profitability will show a more muted response due to proposed price caps on several goods and food retailers' stated intention to absorb higher producer prices. Lower prices at the public chains could trigger traffic inflow from small players, which are less able to hold down prices. This could boost the top line for both X5 Retail Group and Magnit in the important high season. Given the recent rally in Magnit shares, we downgrade the stock to HOLD. X5 is a BUY and our top pick in the sector. In terms of inflation and the consumer response, December should give an indication of what to expect in 1H21.> Food inflation has accelerated; large chains to invest in prices. Food inflation climbed from 2% in 1Q20 to 5.8% in November and could reach 6.0% in December. A poor harvest globally and the weakening ruble have pushed up producer prices for some soft commodities by more than 30% y-o-y, which is feeding into food CPI. Taking into account the government's proposed price caps for several items, we expect food inflation to come in at 5.8% y-o-y in 1Q21 and slow to 4.0% by 4Q21 thanks to the new harvest and high-base effect. In contrast to past episodes of elevated inflation, this time we think the effect on margins will likely be temporarily negative, as the large retailers are unlikely to pass on producer inflation to customers in full. > Holiday sales look promising for X5 Retail Group, Magnit. Smaller chains are unlikely to invest in prices, so the price advantage should drive traffic to the big chains. More people are celebrating the holiday at home this year and shopping has become more concentrated at the big chains, which augurs a strong end to the year for the public retailers. We expect 13.5% top-line growth for X5 in 4Q20, assuming strong results at Pyaterochka will mitigate a sales decline at the larger formats. Magnit is likely being supported by better assortment perception, so we pencil in 10.5% top-line growth for 4Q20, despite slow space expansion.> We downgrade Magnit to HOLD. We have raised our 2020 EBITDA forecast for Magnit by 10% to R109.5 bln and expect R45 bln to be distributed in dividends. For 2021, we now project 6% revenue growth and the EBITDA margin to remain at 7.1%. We raise our target price from $14.00 to $18.00 per GDR but downgrade our recommendation to HOLD. We intend to track the magnitude of the revenue slowdown in 1Q21 to gauge when to re-enter the stock.> X5 remains our top pick. We reiterate our projections, target price of $48 per GDR and BUY recommendation. At a 2021E EV/EBITDA of 6.4 (under IAS 17 standards), the stock is trading at a 9% discount to Magnit, while we assume stronger top-line growth in 2021 and potential further upside from the digital business.