January 2011

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BRIC Spotlight

Consumer goods sector in Russia: Winds of change

Fast Facts The Russia is rated the world’s 12th largest economy in terms of nominal value and is the seventh largest judged by purchasing power parity. The Russian economy is slated to become the second-largest in Europe after Germany by 2013. Combined with neighboring markets, Russia has about 300 million consumers who are affluent, and part of a growing middle class that boosts the consumer goods business in the country. Moscow is ranked the largest city in Europe, topping London. Starting from 1998, the consumer boom in Russia was the result of nearly eight years of economic prosperity, which was fueled by high prices of oil and natural gas in the country, and resulted in growth averaging 6.6 percent a year. Among the consumer-oriented sectors in Russia, retail occupies the prime place.

Russia has long been known as major resource exporter. Justifiably so, as the oil and natural gas sector contributes a lion’s share of the country’s exports and makes up a majority of its gross domestic product. Yet Russia has never been thought of as a nation of spenders, especially given its past crusades against capitalism. But some interesting statistics and a flurry of recent M&A deals in consumer-oriented sectors in the country would tell a different story. Russia, with a population of 142 million, is the largest consumer market in Central and Eastern Europe. What’s more, Moscow pips London as the largest city in Europe.

Starting from 1998, the consumer boom in Russia has been the result of nearly eight years of economic prosperity, a period fueled by high prices of oil and natural gas in the country, which resulted in growth averaging 6.6 percent a year. With this, the large newly-affluent urban population in Russia’s cities provided a big boost to the development of the retail market in the country. Now Russia has a mobile phone subscriber base of 215 million, which is the largest in Europe. Vehicle sales, another indicator of growing consumerism, are slated to reach 1.8 million in 2010.

Emergence of the Russian middle class

During the Soviet days, the general public had access only to basics such as tinned fish distributed by state-run ration shops. After the disintegration of the Soviet Union and the opening up of the economy, Russians craved foreign-made goods, but they did not have the wherewithal to purchase those items. Perhaps the launch of McDonald’s first store in Moscow in 1990 was the first rendezvous Russians had with a renowned international brand. Still, the presence of multinational brands and retailers was limited to metropolitan cities such as Moscow and St. Petersburg. Most likely, Putin’s accession to the presidency in the late 90s was a turning point in the emergence of a post-Soviet prosperous middle class, a new breed of consumers.

Source: Rossstat

The consumer boom in Russia has not only been the result of the country’s resource-driven economic prosperity over the past eight years. The low cost of housing and utility also put more money in the hands of the consumer. As well, political stability ushered in by the Putin administration after the chaos-ridden Yeltsin years helped boost consumer confidence. It has been pointed out that 70% of income earned by Russians is disposable, which compares with around 40% for Western consumers. This makes it a very lucrative market for food and beverage products, luxury goods, as well as fast-moving consumer goods. In fact, a study by Euromonitor International points out that over 50% of households in Russia, Kazakhstan, and Romania moved to the middle class category during the course of the last decade, the fastest growth rate among emerging economies. In fact, between 1998 and 2007, Russia climbed to the 53rd spot in global ranking of wealth from 72nd. Wages also increased commensurate to the economic growth, with disposable income increasing 26% a year.

The remarkable fact about the emergence of the Russian middle class, which began in the late 90s, was that those tell-tale signs of a consumerist society -- low-rise jeans, up market shopping malls, and bright spotlights – were on display in metropolises and smaller Russian cities alike. The rise of a new class of people with purchasing power and the will to enjoy a better life draws easy parallels with other emerging markets such as India. World Bank estimates that the number of middle class people will grow from 430 million in 2000 to 1.2 billion in 2030. Similar to other emerging markets, an assertive, educated middle class in Russia plays an important role in ensuring that the country is governed by the rule of the law. Notwithstanding concerns over Putin’s authoritarian tactics, overall, Russian consumers seem to acknowledge the fact that they have been better off under his rule.

Retail Sector: Rebounding after the crisis

Among the consumer-oriented sectors in Russia, retail occupies the prime place. Some interesting statistics throw more light on the importance of the sector. Monthly retail sales in Russia average about $50 billion, while the industry recorded revenues of $470.3 billion in 2009. Food retailers contributed about half of the total industry turnover last year. The past decade saw the sector growing at a scorching pace, with revenues increasing six-fold, creating five million new jobs. The launch of modern retail formats, which replaced traditional store front businesses, was the catalyst for this transformation.

The retail growth story was playing out well when the financial crisis struck. The recession, which saw the economy contract by 7.9% in 2009, was particularly bad for consumer-dependent sectors such as retail. The Russian government stepped in at the right time to help the retail sector, though the intervention was limited in scale compared to other major industries such as oil and natural gas, and mining. Russia’s largest food retailer, X5 Retail Group, received a loan from the government to the tune of $255 million to tide over the crisis. Magnit, another food retailer, also availed itself of a $91 million credit line from a government-owned bank. Besides the recession, equally damaging was the decision of French retailer Carrefour to pull out of Russia, which attracted a slew of bad press. Helped by the improving oil prices, the economy gradually recovered as consumers began spending again. Management consultants A.T. Kearney acknowledged the recovery in the industry, when it ranked Russia second in the Global Retail Development Index in 2009.

The Russian economy had managed to grow at a rate of 5.4% in the second quarter of 2010, when the country was struck by a severe drought, which resulted in unprecedented crop losses and a dramatic slowdown of the economy. A.T. Kearney was quick to push the country down to the tenth position in its 2010 ranking on retail development. The slowing domestic growth triggered a sudden rise in capital flight from Russia, as many companies found an opportunity to fund acquisitions abroad using the ultra-low borrowing costs.

Global Retail Development Index

Country	2010 Rank	2009 Rank
China	1	3
Kuwait	2	Not available
India	3	1
Saudi Arabia	4	5
Brazil	5	8
Chile	6	7
United Arab Emirates	7	4
Uruguay	8	Not available
Peru	9	18
Russia	10	2

Source: A.T. Kearney

Luckily for Russia, the second half of 2010 turned out to be a polar opposite of the dry spell that characterized the early part of the year. The Russian government, determined to turn things around, announced a second round of privatization of state-owned assets through the next three years. The proposed $32-billion sale of these assets helped to change investor perceptions about the business climate in Russia. Though the retail sector does not have any government-owned companies, the segment witnessed some hectic corporate activity, with the country’s biggest food retailer X5 Retail Group taking over smaller rival Kopeika for $1.65 billion. The acquisition was a small step in consolidating the country’s highly fragmented retail sector.

A Major Coup for the Russian Consumer Sector

However, the biggest ever deal in Russia’s consumer sector came in December when PepsiCo announced its $3.8 billion takeover of Wimm-Bill-Dann, the country’s biggest dairy products and juice company. The first consumer goods company from Russia to be listed on the New York Stock Exchange, Wimm-Bill-Dann was a home-grown company established in 1992 after the demise of the Soviet Union. The promoters of the company, lovers of Wimbledon Tennis, sought a westernized brand name to leverage the Russian consumers’ disdain for domestic manufactured goods amid the chaos following the Soviet collapse. As luck would have it, global brand PepsiCo turned out to be the perfect suitor for the dairy producer.

PepsiCo hopes the acquisition will help increase revenues three-fold from its nutritional segment by 2020. The deal will also make Russia Pepsi’s top international market, replacing Mexico. PepsiCo’s purchase comes after rival Coca-Cola acquired Nidan, one of the leading juice makers in Russia early in 2010. This is Pepsi’s second major acquisition in Russia after it took over Russian juice maker Lebedyansky for about $2 billion in 2008. The transaction will enable Pepsi make Russia the hub for the production and distribution of nutritional food products worldwide. PepsiCo CEO Indra Nooyi underlined the importance of the takeover when she said dairy products have the potential to bridge snacks and beverages. Ms. Nooyi said the deal offers an opportunity to “snackify” beverages and “drinkify snacks”, which she sees as the next stage of evolution in the food and beverage business.

The big-ticket acquisition is also significant in that it is one of the biggest foreign investments in the country outside the flagship energy sector. And the transaction could not have come at a more opportune moment as far as foreign direct investment in Russia is concerned. The deal was an eye-opener for foreign investors, highlighting that the consumer sector is comparatively free of state control.

The ripple effects of the takeover were felt in other consumer-oriented sectors in the country as well. A case in point was the Thomas Cook acquisition of a 50% stake in Russia’s biggest tour operator, inTourist. The Pepsi acquisition has also sparked renewed investor interest in smaller players such as electronic retailer M.video, food retailer Dixy, and vodka maker Synergy.

Food Retailers

The biggest food retailer in Russia is X5 RETAIL GROUP, majority owned by oligarch Mikhail Fridman’s Alfa Group. The company was formed by the merger of soft discount chain Pyaterochka and supermarket chain Perekrestok in 2006. Based in St. Petersburg, it runs over 1,500 outlets spread across Moscow and the Urals. After the Kopeika buy, the retailer received the go-ahead to acquire Moscow-based grocer Ostrov. X5 has adopted the inorganic route to growth, beginning with its acquisition of Paterson supermarket chain in December 2009.

MAGNIT OJSC is Russia’s second-biggest food retailer, which runs an expanding network of hypermarkets and discount groceries. Established in 1994, chief executive Sergei Galitskiy is the majority shareholder in the company.

Food retailer O’KEY, Russia’s third biggest grocer by sales, listed its global depository receipts in London recently. The company, which has been pursuing an aggressive expansion strategy over the past five years, operates more than 50 stores spread across 18 cities.

Russian food retailer DIXY GROUP, which runs discount chains, is controlled by Igor Kesayev through his Mercury Holdings. At the beginning of 2010, the company had 552 stores, an improvement from the 492 outlets it had a year ago.

Supermarket chain SEVENTH CONTINENT, based in Moscow, is majority-owned by Alexander Zanadvorov. The retailer took control of mid-sized Finservis Bank early last year to develop it as the company’s in-store bank.

Privately-held hypermarket chain Lenta, based in St. Petersburg, is embroiled in a shareholder dispute. Established in 1993, the company now runs some 36 stores in Russia. U.S. businessman August Meyer has a 36% stake in the company, while private equity firm TPG holds about 35% and European Bank for Reconstruction and Development owns around 11%.

Medium-sized retailer Victoria is planning to come out with an initial public offering this year, which would make it the fifth listed food retailer in Russia. Victoria runs about 230 stores in Moscow, Kaliningrad, and St. Petersburg, and is 35% owned by businessman Vlasenko.

White goods retailers

M.Video, a consumer electronics retailer, offers televisions, DVD players, and video cameras, among other similar goods. Chief Executive Alexander Tynkovan is the controlling shareholder of the number one electronics retailer in Russia. From its humble beginnings 17 years ago, the company currently runs 184 retail outlets. M.Video, which is listed on the Micex stock exchange, faces direct competition from Metro AG’s household appliances unit Media Markt. Unlisted competitors Mir and Tekhnosila are currently undergoing bankruptcy proceedings.

Moscow-based OOO Eldorado, which sells consumer electronics goods and household appliances, was established in 1994. Czech investment company PPF took over Eldorado in 2009, as the retailer defaulted on a $500 million loan taken against a controlling stake in the firm.

Major food retailers operating in Russia

Name of Company	FY 2009 Sales ($ bn)	Market Share	Listed/Unlisted
X5 Retail Group	$8.7 billion	26.3%	Listed
Magnit OJSC	$5.4 billion	16.2%	Listed
Auchan	$4.9 billion	15.3%	Unlisted
Metro AG	$4.2 billion	12.8%	Listed
O’Key	$2.1 billion	6.4%	Listed
Kopeika	$1.7 billion	5.4%	Unlisted
Lenta	$1.7 billion	5.3%	Unlisted
Dixy	$1.6 billion	5.1%	Listed
Seventh Continent	$1.3 billion	4.1%	Listed
Victoria	$1.0 billion	3.1%	Unlisted

Foreign forays into the retail segment

Since the beginning of the last decade, global retailers have been trying to gain a toehold in the lucrative Russian consumer market. Slowing sales in Western markets have lured big international players to seek expansion in fast-growing emerging markets such as Russia. While the likes of Wal-Mart seem to have given up for the time being, others such as France’s Auchan and Germany’s Metro have been hugely successful.

Germany’s Metro AG was among the early birds to arrive in Russia, setting up its first Moscow store in 2001. The retailer, which runs Metro Cash & Carry, and Real and Media Markt household appliances stores, operates more than 70 outlets in Russia. Around the same time when French retailer Carrefour decided to call it quits in 2009, fellow supermarket chain Auchan not only decided to stay entrenched in Russia but has been on an expansion drive ever since. Auchan started operations in 2002 and currently runs more than 30 hypermarkets.

Perhaps the most high-profile exit from Russian retail market was Wal-Mart’s recent decision to abandon its plans to expand in Russia. The world’s biggest retailer had planned to grow its business in Russia through the acquisition of local players. Apparently, Wal-Mart was eyeing retail chain Kopeika, which was later acquired by X5 Retail Group. Another potential acquisition target, privately-held Lenta, found itself entangled in a shareholder dispute. Close on the heels of these corporate developments, Wal-Mart said it was closing its Moscow office, citing lack of opportunities for acquisitions. For now, Wal-Mart seems to have shifted its focus to other emerging markets such as South Africa, by recently moving to acquire a majority stake in retailer Massmart Holdings. Swedish furniture retailer IKEA, which runs 12 stores in Russia since 2000, has often complained of increased bureaucratic interference and corruption and has said it has no plans to open new stores in the country in the next few years.

Despite the procedural hassles involved in setting up a business in Russia, many global retailers seem to have realized that Russia is too big a market to be ignored. Finnish retailer Kesko Oyj said it intends to launch its food business in Russia in 2010. The company, which currently runs more than 10 hypermarkets selling building materials in Russia, also anticipates making acquisitions to expand its presence in the country. U.S.-based footwear retailer Collective Brands Inc. and apparel retailer Limited Brands, known for its lingerie brand Victoria’s Secret, have their plans chalked out for the Russian market. Japanese clothing retailer Uniqlo, a unit of Fast Retailing, which set up shop in Russia in 2010, expects to open more stores in the country. And McDonald’s has a come a long way since setting up shop 20 years back, with almost 80% of the ingredients used in its outlets currently being supplied by private businesses in Russia. Consumer giants Kimberly-Clark and Anglo-Dutch conglomerate Unilever also intend to expand their presence in the fast-growing Russian market.

Besides retailing, foreign players have made direct investments in other consumer-oriented sectors such as automobile manufacturing, which is badly in need of modernization in Russia. French car maker Renault, for instance, has a 25% stake in Russian carmaker AvtoVAZ, known for its iconic Lada brand. Recently, German automaker Daimler said it plans to collaborate with Russian vehicle maker GAZ to produce Mercedes-Benz Sprinter vans. Moreover, the truck-making unit of Daimler has a minority stake in Russian truck manufacturer Kamaz and both companies have an agreement to manufacture and supply axles for commercial vehicles.

Room for Improvement

Unlike flagship sectors of the economy such as oil and natural gas, the retail sector does not have entities owned by the government. This has created a level playing field where home-grown retailers jostle for space with powerful multinational competitors. However, the Russian retail sector has a lot of scope for improvement.

According to a review by McKinsey, business processes should be thoroughly overhauled and dated store formats need to be replaced. The report points out that although Russia has made good progress in adopting modern store formats, they reflect a meager 11% of the jobs in the retail sector and 35% of retail sales in Russia. To put things in perspective, modern formats contribute 82% and 86% of retail sales in France and Germany respectively. To make the system work more effectively, Russia needs to boost the productivity of the sector. Staffing levels in Russian stores should be brought in sync with customer traffic, as is the case with retailers based in the United States. Employing part-time labor will help bring down the operating costs of retailers. Russian stores also need to make full use of information technology to streamline their operations.

The report also points out that logistics stand in the way of developing the country’s retail sector. The country’s road network remains underdeveloped and congested, which delays delivery of goods and pushes up costs of transportation. However, Russia’s successful bid to host the soccer World Cup in 2018 is expected to give a big boost to the country’s crumbling infrastructure.

Notwithstanding these shortcomings, the Russian consumer growth story continues to inspire and is likely to grow further as modern retail channels become the norm in the segment. The PepsiCo deal was a timely reminder to those global consumer goods companies dithering over doing business in Russia: Truth be told, the Russian consumer has finally arrived and is here to stay.