Russian Food Retail - Betting on Resilience

> We believe the current economic situation is most similar to the one in 2014-15. Back then, ruble depreciation caused food inflation to spike, and consumers started stockpiling. Despite modest EPS downgrades, the food retail sector's overall financial performance was decent, with aggregate EBITDA and the combined market cap expanding 19% and 21%, respectively, in 2014-15 (in ruble terms).> Our downgraded economic assumptions have not caused us to lower our ruble forecasts for the sector. Weaker consumer demand should be offset by higher inflation and consumer stockpiling. We still expect food retail turnover to grow 6-7% this year in ruble terms.> Conceivably, we could see the introduction of measures to restrict traffic to grocery stores. However, retailers could capture revenues from the dining-out segment (which has been closed) and non-food retailers, and all public chains are on the government's list of vitally important institutions, so they would likely continue operating even if other businesses were to close. Globally, food retail has outperformed as a sector, even in countries where a strict quarantine is in place.> We have incorporated actual 2019 results into our models, though this has had a limited impact on our forecasts. In addition, our ruble numbers have not changed despite our new macro assumptions. But with the exchange rate assumption (USD/RUB 75) we reduce our target prices to $35.00 for X5 Retail Group and $10.00 for Magnit. We retain a BUY recommendation on X5 and a HOLD on Magnit.> The sector's aggregate market cap has shrunk 28% YTD, taking the sector EV/EBITDA down from 6.3 to 5.6; the sector now offers a 7.2% dividend yield in rubles. The discount to global peers has only widened, despite the sector continuing to outperform the benchmark RTS Index. Fundamentals have limited relevance during massive selloffs, but they should regain a foothold once the market starts to stabilize.> We think the major risk facing the sector lies not with external events, but with how the companies will behave in this volatile environment, as the chances of their taking counter-productive steps will rise. For example, if one chain decides to expand market share by not passing inflation on to consumers, the whole sector could feel margin pressure. Our sensitivity analysis shows that the sector should be fairly priced once the average EBITDA margin declines 70 bps. In the current environment, we think the market will be more sensitive to margin rather than revenue performance.