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EQUITY RESEARCH CONSUMER AND RETAIL

Russian Consumer and Retail Update

Smart Expansion Trumps Greedy Growth

FIVE LI								BUY
Target price							$31.6
Potential upside							29%

MGNT LI								BUY
Target price							$18.0
Potential upside							27%

MGNT RX								BUY
Target price						RUB4 970
Potential upside							34%

LNTA LI								HOLD
Target price							$4.0
Potential upside							9%

OKEY LI								SELL
Target price							$1.4

Potential upside							-10%

		MGNT		FIVE		LNTA		O'KEY

Price (GDR,$)		18.0	31.6			4.0		1.4
Market Cap	7 068		6 675		1 810		425
($mn)	7 068		6 675		1 810		425
($mn)
Free float (%)		65%	41%			58%		20%
Free float mkt	4 594		2 737		1 050		85
cap ($mn)	4 594		2 737		1 050		85
cap ($mn)

Financials 18E		MGNT		FIVE		LNTA		O'KEY
RUBbn		MGNT		FIVE		LNTA		O'KEY
RUBbn
Revenue		1 235	1 530			416		168
EBITDA	91.6		107.6		38.1		7.8

EBIT		57.7	61.1			26.8		3.3
Net income	36.6		33.4		13.7		0.2

		MGNT		FIVE		LNTA		O'KEY
P/E (x)	12.8		13.2		8.8			n/a

EV/EBITDA (x)		6.3	6.0			5.9		7.7
EV/Sales (x)	0,5		0,4		0,5		0,4

RoIC (%)		12.7%	13.2%			12.4%		5.6%
Performance		MGNT		FIVE		LNTA		O'KEY
1 month (%)		4%	19%			6%		6%
3 month (%)	-16%		-6%		-26%		-19%

YTD (%)		-49%	-35%			-36%		-37%
52-week high,$	30		44.6		7.3		2.8

52-week low,$		12	19.1			3.2		1.4
		Source: Bloomberg, ATON Research

Figure 1: Russian retailers’ stock performances

20%
0%
-20%
-40%
-60%
Nov-17	Feb-18	May-18	Aug-18	Nov-18

MGNT LI	MGNT RX	FIVE LI

LNTA LI	OKEY LI

Source: Bloomberg, ATON Research

Russian Grocers: Downgrade Cycle Coming to an End. Time for a Fresh Look?

The Russian grocery sector has been among the Russian stock market’s worst performers in 2018 with share prices declining between 35% and 49% YtD vs a flat overall market. Derating multiples, earnings falling on record-low food inflation, and expectations deteriorating as the sector’s promo activity soared explain the weak stock performance, but we believe this is mostly priced-in. Key food prices have finally started to climb (wheat + 17% YoY, pork +10% YoY, sugar +41% YoY), promotion activity is stabilising, and sector companies are much more focused on improving efficiency, suggesting that they will enjoy tailwinds in 2019. Earnings growth (14% to 20%), decent dividend yields (3.5% and 5.5%) and historically high valuation discounts will increasingly attract investor attention, and in turn further buoy its performance.

Industry Maturing, But Risks of Stronger Competition Overstated

The share of modern retail now exceeds 70%, a sure sign of Russian grocery market maturity. However, sector concentration is low: the top five players’ combined market share is only 29%. As a result, investors’ concerns that sector companies do not have scope for expansion, are exaggerated, in our view. While space growth will be slower (on average 23% in 2018-21 vs 90% in 2014-17), companies with scale and proven business models will still be able to expand, and market leaders Magnit and X5 will extend their market share leadership margins. At the same time, growth will have to be

“smarter” and mainly focused on differentiation and higher customer loyalty.

Valuations in Deep Value Territory, Positive Catalysts Increasingly Likely

The sector is trading at significant discounts to its historical levels (23-48%) – distressed levels, which we do not regard as justified given the sector’s fundamentals and growing FCF. The companies’ scale and their slower growth have already been reflected in positive FCF (yields of 4.3% to 14.9% in 2019) prompting more generous dividends (RUB38bn paid out in 2018) and buybacks (RUB34.3bn announced YtD).

Uneven Performances, Hypermarkets the Laggards but to Pay Higher Dividends

Growth in Russia’s maturing market will have varying implications for the different formats. Hypermarket segment growth is coming to a halt, and we see this segment as the key drag on the sector’s performance. Mounting competition with smaller formats

(convenience stores and supermarkets – mainly on pricing) as well as booming e- commerce will increasingly divert traffic from hypermarkets. Consequently, greater hypermarket exposure will increasingly be considered a risk. Nonetheless, hypermarket retailers’ poorer growth prospects may actually drive more aggressive return on capital to shareholders thanks to dividends and buybacks.

Top Picks: X5 Still Our Preferred Exposure: Balanced Growth and Efficiency in Focus; Magnit a Likely Turnaround Story…But Still in its Early Days

X5 has outlined a more balanced openings approach (2k gross in 2019E vs 2.5k in 2018E), and shifted its focus to retaining loyal customers and improving internal efficiency. With 83% of supermarkets refurbished as of 9M18, an extended product range, in-house production and innovative technological solutions, we expect the company to outperform peers operationally in 2019. We are cautiously optimistic about

Magnit’s turnaround but the implementation of its new strategy should eventually yield results. The low base of 2016-2018 and higher inflation should boost its financials.

We have incorporated into our model a higher risk-free rate (8.5%) and the new USD/RUB exchange rate. Our updated model results in BUYs for X5 retail Group and Magnit (TP of $31.6 and $18.0, potential upside of 29% and 27% respectively), a HOLD for Lenta (TP of $4.0; 9% upside) and a SELL for O’KEY (TP $1.4; 10% downside).

Victor Dima		Anna Butko
+7 (495) 213-03-44	+7 (495) 777-90-90, Ext: 3661
Victor.Dima@aton.ru		Anna.Butko@aton.ru

vk.com/id446425943		2
EQUITY RESEARCH	CONSUMER AND RETAIL

Challenging Macroeconomic Outlook: No Easy Gains

No relief in 9M18; tough macro persists. Retailers’ 9M18 performances remained under pressure. Russian real wage growth was 8.2% in the period, but despite this, retail sales softened after a promising acceleration in 4Q17 (average growth of 2.6% in 9M18). Food retail sales growth fell even lower (1.8% average for 9M18). Food CPI remains low, but did improve significantly in 3Q18 (from 0.4% in 2Q to 1.6% in 3Q). We believe that a more benign macro environment and a greater level of confidence is required to boost the consumer staples market.

Figure 2: Food CPI turned negative in 2Q18 while consumer CPI in	Figure 3: Retail food sales remain in positive territory supported
Russia indicated slight QoQ acceleration	by real wage expansion

8%		8%
6%		6%
6%
		4%
4%
		2%
2%		0%
		0%
0%		-2%
Jun-16	Oct-16 Feb-17 Jun-17	Oct-17 Feb-18 Jun-18
	CPI	Food CPI (RHS)

12%				6%
10%				4%
10%
8%				2%
8%
				0%
6%
				-2%
4%				-4%
				-4%
2%				-6%
				-6%
0%				-8%
Oct-16	Mar-17	Aug-17	Jan-18	Jun-18
	Real wage growth		Retail sales food (RHS)

Source: Bloomberg, ATON Research

Figure 4: … though Russian customers remain price sensitive with

Figure 5: We expect CPI to correspond with PPI dynamics with a

respect to grocery sales

lag

Share of grocery sales in

37%

total consumption

14%

17%

12%

-2%

-4%

-6%

Germany

Japan

Russia

Dec-16 Mar-17

Jun-17

Sep-17

Dec-17 Mar-18

Jun-18

PPI Food Production

Russia CPI Food

Source: BCG Consumption survey, ATON Research

Source: Bloomberg, ATON Research

Food CPI should continue to accelerate later in the year supported by improving soft commodity prices. The latest soft commodity trends point to the very low food inflation cycle coming to an end. With CPI dynamics catching up with those of PPI with a lag, we expect to see further CPI food acceleration later in the year.

Figure 6: The Russian export wheat price has begun to grow (+16% since end of June)

250

230

210

190

170
Oct-16	Feb-17	Jun-17	Oct-17	Feb-18	Jun-18

Wheat 12.5% FOB Novorossiysk spot

Source: Bloomberg, ATON Research

Figure 7: Meat prices also expanding (pork +5% since end of June)

195

180

165

150
Oct-16	Mar-17	Aug-17	Jan-18	Jun-18

Moscow pork wholesale price incl VAT

Source: Bloomberg, ATON Research

vk.com/id446425943		3
EQUITY RESEARCH	CONSUMER AND RETAIL

High share of promotions still key disruptor for mass market grocers. A 30-40% share of promotions in total SKUs remains the key challenge for mass market grocers. The respective companies do not see this share growing YoY, but unwinding this elevated share will not be easy as it will require market discipline from all the main players.

Figure 8: Major retailers experiencing falling sales density…	Figure 9:… focusing on internal efficiencies to support margins

350	327	328	326
	327	328	326	318
				318	312
					312	307	304		301	301
						307		301			299


300	276	274
	276		272	271	270	269	267
			272	271	270	269		265	262	259
								265			257
											257
250	238	235	233	229
250		235	233		224
						221
							217
								213	211
										208	207


200
	1Q16	2Q16	3Q16	4Q16	1Q17	2Q17	3Q17	4Q17	1Q18 2Q18		3Q18
ths RUB per sqm			X5		Magnit			Lenta

41,6	40,7	40,5		40,8

38,7	38,1	37,7		38,9

				36,4
35,2		34,9	36,1
	34,2			34,9

32,2

1H16		2H16	1H17	2H17	1H18
X5	Lenta	Magnit	SG&A excl rent and utilities per sqm

Source: Company data, ATON Research

Russian retail industry entering maturity, but still offers plenty of growth opportunities for select players with scale and proven business models. The share of modern retail exceeded 70% in 2017 in Russia, while the concentration level remains low (the top-five players account for only 29% of the market). That leaves plenty of scope for major players to gain market share and expand in the key regions.

Figure 10: Russian food retail industry entering maturity with restricted growth opportunities and tough macro environment…

20														20%
						16%						15,5	15,8	16,2
16						16%					14,7	15,5	15,8	16%
16									13,2	14	14,7			16%
										14
							12	12,5
						11,7		12,5
12					10,8	11,7								12%
					10,8

		7,9	8,7	9,7
	7	7,9	8,7
8	7													8%
8														8%
	7%	8%		7%	8%		7%
4	7%			7%			7%							4%
4			5%											4%
			5%					4%		4%		4%		4%
								4%		4%		4%		4%
0														0%
	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020	2021	2022	2023
			Russian grocery retail market (RUB trn) ex. VAT					YoY Retail growth (RHS)					CPI (RHS)

Source: Bloomberg, Companies presentations, ATON Research

Figure 11: Though there is still room for modern retailing expansion and industry consolidation…

100%

80%

60%

40%

20%

Modern grocery retailers, % Market share of major retailers

Source: Infoline, Company data, ATON Research

Figure 12:…with the top players accounting for 29% market share

29%

32%

68%

Russia

Moscow

St. Pete

Other

Magnit

Auchan

Dixy

Lenta

Meto

OKEY

Source: Company data, ATON Research

	Internal efficiencies in focus. The major players are currently reconsidering their
	strategies, shifting from rapid expansion to targeting efficiency in order to support
	margins. Operating efficacy will be tackled first, starting with renegotiating lease rates,
	raising productivity, improving logistics, and lowering shrinkage. However, we see the
© 2018 ATON LLC. All rights reserved	most potential in enhancing personnel efficiency.

vk.com/id446425943
	EQUITY RESEARCH						CONSUMER AND RETAIL
	Figure 13: Russian retailers have room to improve internal efficiency

per		0,05			Perekrestok
					Perekrestok

											Kaufland
employees		0,04									Kaufland	Lenta
		0,04		DA!			Lenta		Karusel			Lenta
		0,04		DA!			Lenta		Karusel			hypermarkets
		0,04		Pyaterochka			supermarkets
		0,03		Pyaterochka
		0,03
numberof sqm		0,03		Carrefour							Carrefour hypermarkets
		0,03		Convenience store							Carrefour hypermarkets
		0,02		Convenience store
		0,02		Small Lidl
		0,02					Carrefour		Carrefour		Real Germany
											Real Germany

Average							supermarket	mini-hypermarkets
Average		0,01		ALDI			Large Lidl
		0,01					Large Lidl
		0,01
							Smaller formats
		0,00
		0,00	-30			20		70		120	170	220
			-30			20		70		120	170	220
									Average number of employees per store

O'KEY

Larger formats

270

Source: Company data, ATON Research

Online no longer a side strategy… Though the online share of grocery sales is still small, it is growing fast and is set to become one of the main drivers of Russian e-commerce. X5 has made the greatest progress in the development of the omni-channel business model, culminating in the launch of Perekrestok online (number of orders per day estimated to reach 2.5k by YE18) and plans to expand the pilot to St. Petersburg (Pyaterochka is to follow starting from 2019). Magnit indicated its intention to develop the omni-channel concept by 2Q19, while O’KEY is exploring the viability of dark stores in order to boost the number of orders processed from the current 150-200 per store.

Figure 14: With the Russian e-commerce market’s growth estimated at 20.2% in FY18, e-commerce penetration remains the lowest among all FMCG categories and represents a vast opportunity for key retailers with efficient logistics

28%

E-commerce penetration, %

				7%	7%	8%
				7%	7%
	3%	4%	4%
<1%	3%
<1%

Grocery	Pharmacy	Petcare	Beauty and	Kids	Fashion	Home and	Electronics&
			wellness			Garden	computers

Source: eMarketer, ACIT, ATON Research

vk.com/id446425943																																		5
	EQUITY RESEARCH			CONSUMER AND RETAIL
	Figure 15: Russian retailers comp’s sheet
	Company			CUR			Price	Mcap, USDmn				P/E					EV/EBITDA					EV/Sales							EPS Growth				Div Yield

											2018E		2019E		2018E					2019E		2018E			2019E		2018E				2019E		2018E		2019E
											2018E		2019E		2018E					2019E		2018E			2019E		2018E				2019E		2018E		2019E

	X 5 RETAIL GROUP			USD		24.5			6675	13.2			11.0			6.0				5.3		0.4		0.4			6.5%				20.3%		4.5%		5.5%
	MAGNIT PJSC			RUB	3720				5733	10.4			9.0			5.3			4.6		0.4		0.4			3.1%				15.9%		4.4%		4.5%

	MAGNIT PJSCGDR			USD		14.18			7068	12.8			11.0			6.3				5.4		0.5		0.4			3.1%				15.9%		3.4%		3.5%
	LENTA			USD	3.68				1810	8.8			7.7			5.9			5.5		0.5		0.5			3.3%				13.9%			n/a		n/a

	O'KEY GROUP			USD		1.56			425			n/a	29.8			7.7				6.8		0.4		0.3				n/a			n/a		7.3%		1.3%
	RUSSIA									11.9			10.6			5.9				5.2		0.4		0.4			4.2%				17.1%		4.2%		4.4%
	SHOPRITE			ZAr		19811			8132	18.4			17.9			11.1				10.3		0.8		0.7			1.1%				n/a		2.7%		2.8%
	PICK N PAY STORES			ZAr	7265				2558	22.7			19.8			10.9			9.9		0.4		0.4			13.6%					n/a	3.0%		3.4%

	SPAR GROUP			ZAr		18917			2522	17.2			15.4			11.4				10.4		0.4		0.4			7.9%				n/a		4.0%		4.5%
	WOOLWORTHS			ZAr	5621				4092	14.4			13.4			8.7			8.3		1.0		0.9			-4.5%					n/a	4.8%		5.1%

	SOUTH AFRICA									17.9			16.8			10.5				9.8		0.7		0.7			2.6%				n/a		3.4%		3.7%
	MIGROS TICARET			TRY	16.13				533			n/a	64.5			6.3			5.3		0.3		0.3			-179.3%				-109.0%		0.0%		0.0%

	BIM BIRLESIK			TRY		77.7			4309	21.4			18.1			13.5				11.4		0.7		0.6			29.4%				18.2%		2.8%		3.4%
	BIZIM TOPTAN			TRY	7.05				77	22.6			17.3			2.4			2.0		0.1		0.1			-167.5%				30.8%		0.8%		0.8%

	EUROCASH SA			PLN		20.3			763	24.9			18.2			9.0				7.6		0.2		0.1			37.0%				36.7%		3.4%		3.3%
	JERONIMO MARTINS			EUR	10.815				7760	16.3			15.0			7.5			7.0		0.4		0.4			-1.0%				9.2%		4.3%		3.9%

	SAVOLA			SAR		27.85			3964	39.2			24.1			18.9				14.6		1.0		1.0			-56.5%				62.7%		2.9%		2.6%
	ABDULLAH AL			SAR	70.5				1691	15.2			14.4			12.5			11.0		0.8		0.7			26.8%				5.2%		2.6%		3.5%

	MENA/EMERGING EUROPE									22.7			19.0			11.7				9.9		0.6		0.6			-7.4%				19.9%		3.3%		3.5%
	CP ALL PCL			THB	68				18551	29.3			25.6			18.0			16.5		1.5		1.4			7.4%				14.2%		1.7%		1.9%

	PUREGOLD PRICE CLUB I			PHP		43			2250	18.3			16.4			10.8				9.7		0.9		0.8			7.0%				11.4%		0.9%		1.1%
	DAIRY FARM			USD	9				12174	24.8			21.8			18.0			16.1		1.1		1.1			0.0%				13.8%		2.6%		2.9%

	SUN ART RETAIL GROUP			HKD		9.56			11653	28.8			27.3			9.5				9.1		0.7		0.6			1.4%				5.4%		1.4%		1.5%
	PRESIDENT CHAIN STORE CORP TWD				324.5				10992	32.7			30.1			16.1			15.1		1.3		1.2			-63.5%				8.8%		2.6%		2.8%

	E-MART INC			KRW		208500			5200	12.8			12.4			7.8				7.3		0.5		0.5			-19.6%				3.4%		0.9%		0.9%
	EMERGING ASIA EX CHINA									27.1			24.5			14.9				14.5		1.1		1.0			-10.4%				10.4%		1.9%		2.1%
	CENCOSUD SA			CLP		1448.3			6185	18.59			16.0			9.9				9.5		0.7		0.7			-5.4%				16.2%		2.5%		2.1%
	WALMART DE MEXICO			MXN	54.07				46586	26.44			24.5			15.0			13.8		1.5		1.4			4.2%				8.1%		3.0%		3.1%

	LOJAS AMERICANAS			BRL		17.6			6724	48.18			31.3			12.2				10.6		1.8		1.9			79.0%				53.9%		0.4%		1.3%
	ORGANIZACION SORIANA			MXN	29.49				2616	12.02			10.5			6.5			6.5		0.5		0.5			-3.2%				15.0%		0.0%		0.3%

	EMERGING AMERICAS									27.4			23.8			13.8				12.7		1.4		1.3			11.0%				14.2%		2.5%		2.8%
	AVERAGE EMERGING MARKETS												21.3			12.9
										24.0										12.0		1.0		1.0			0.3%				13.8%		2.7%		1,6%
										24.0										12.0		1.0		1.0			0.3%				13.8%		2.7%		1,6%
	CONTINENTAL EUROPE												15.4			8.1
										18.8										7.2		0.4		0.4			13.0%				22.4%		2.4%		3.1%
										18.8										7.2		0.4		0.4			13.0%				22.4%		2.4%		3.1%
	USA												20.2			10.9
										21.9										10.8		0.7		0.6			9.1%				8.0%		1.9%		1.9%
										21.9										10.8		0.7		0.6			9.1%				8.0%		1.9%		1.9%

				Revenue										EBITDA																Net Income
		2018E					2019E					2018E								2019E					2018E								2019E
		ATON	vs cons				ATON		vs cons			ATON	vs cons					ATON			vs cons				ATON				vs cons			ATON			vs cons
	X5	1 529 876	-0.3%				1 762 035		-0.6%			107 593	0.4%					121 940			-0.5%				33 432				-0.2%			40 218		-0.3%
	Magnit	1 235 455	-1,8%		1 355 742				-1.7%	91 670			0.0%			106 199					3.8%		36 649			1.8%						42 468		3.8%

	Lenta	416 342	-1,5%				453 341		-3.4%			38 071	-2.5%					40 638			-4.6%				13 702				-7,2%			15 608		-8,6%
	OKEY	167 947	-5,8%		175 546				-8,3%	7 819			-23,0%			10 159					-12,3%		171						n/a			948			n/a
																											Source: Bloomberg, ATON Research

vk.com/id446425943

EQUITY RESEARCH CONSUMER AND RETAIL

X5 Retail Group

Efficiency Surpasses Growth as Key Focus

FIVE LI						BUY
Target price					$31.6
Potential upside					29%

FIVE RX
Target price					RUB 2 093

Potential upside					29%
SHARE DATA
No. of ordinary GDRs (mn)					271.6
3M average daily t/o shares ($mn)					7.7

Free float (%)					41%
Market capitalisation ($mn)					6 675

Enterprise value (RUBmn)						645 043
Major shareholder
Alfa Group						48%
FINANCIALS		2017		2018E		2019E
(RUBmn)		2017		2018E		2019E
(RUBmn)
Revenue		1,295,008	1,529,876			1,762,035

EBITDA	96,193		107,593		121,940

EBIT		57,758	61,102			71,938
Net income	31,394		33,432		40,218

EPGDR, RUB		115.6	123.1			148.1
DPGDR, RUB	79.8		73.9		88.9

Valuation
P/E (x)	14.1		13.2		11.0

EV/EBITDA (x)		6.7	6.0			5.3
EV/Sales (x)	0.5		0.4		0.4

RoA (%)		6.0%	5.6%			6.1%
RoE (%)	22.0%		20.3%		22.3%

RoIC (%)		14.9%	13.2%			13.9%
Performance
1 month (%)						19%
3 month (%)					-6%

YTD (%)						-35%
52-week high ($)					44.6

52-week low ($)						19.1
	Source: Bloomberg, ATON Research

Figure 16: X5’s stock performance

16 Nov-17 Feb-18 May-18 Aug-18 Nov-18

FIVE LI

Source: Bloomberg, ATON Research

Recently X5 Retail Group’s top management held a Capital Markets Day at which it shared its view on the further development of the group, and each format in particular. Overall, the presentation outlined a more balanced approach to opening pace (2k gross openings expected in 2019 vs 2.5k planned for 2018) with the focus shifted to attracting a greater number of loyal customers (target level of 15%) and ironing out internal efficiencies. We agree that a greater share of refurbished stores (83% of supermarkets as of 9M18), an extended product range, in-house production, and innovative technological solutions would be well-received by clients and increase X5 Group’s NPS score.

X5 sees its revenue rising 15-20% in FY19 (ATON estimate 15.2%), but its adjusted EBITDA margin is expected to remain at 7%+ (7% ATON). While the group does face execution risk, its new initiatives, commitment to its dividend policy, and better macroeconomics may support its share price. X5’s stock is currently trading at a 13% and 16% discount to its 2Y historical BF P/E and EV/EBITDA multiples. We reiterate our BUY rating and 12-month target price of RUB2,093 per share/ $31.6 GDR implying 29% of potential upside.

Key Takeaways from the Presentation

More balanced approach to openings is sensible, hints at maturing grocery space. X5 guides for 15-20% revenue growth in FY19, supported by 2k (gross) store openings, which is a significant drop from 2017 (3k stores opened). We think this is a sensible shift in priorities by Russia’s largest retailer, and affirms that ROIC and profit trump growth alone. X5 says it will be pickier in terms of locations in order to maintain the current returns and profitability levels (target EBITDA 7%+). Low market concentration gives key players the opportunity to further consolidate their market shares.

Market still offers growth opportunities for players with proven business models; proximity stores remain the key format. X5 estimates that the Russian grocery market will grow 19% from 2017 to 2021 (to RUB17.2trn), aided by the further expansion of modern trade (from 72% in 2017 to 80% in 2021). In total, supermarkets, discounters, and hypermarkets will account for 76% of the total market, with proximity stores and discounters set to show the fastest growth of 49% in four years.

Improving customer loyalty to become a more relevant sales driver. High-value customers with loyalty cards constitute 11% of the group’s total customer base but contribute 39% of revenue. A 1% increase in the number of customers categorised as

‘loyal’ would add 2.7% to sales, and X5 plans to expand the share of ‘loyal’ customers to 15%. In order to achieve this target, the group is working on its CVP, assortment mix, in-house production, a greater number of private labels (at Pyaterochka to up to 20-25%, at Karusel to 10% from the current 4%), and targeted promo campaigns.

Identifying the right omni-channel strategy is important for long-term growth. After the launch of Perekrestok online, net retail sales per omni-channel customer have increased 70% in Moscow with average NPS exceeding 80%. The company plans to further develop Perekrestok online, boosting the number of orders per day to 2.5k by the end of 2018, and expanding the pilot into St Petersburg. Pyaterochka also plans to launch an online channel in 2019, and is currently considering several options: either delivering to local customers from local stores or using postamats.

Trading 23% below its two-year historical average on BF P/E and 30% on BF EV/EBITDA, with the estimates downgrade cycle likely behind it (after an over 32% downgrade on FY19 EPS over the past 12 months). We see improving results and the dividend declaration due in Mar 2019 (expected yield over 4.5%) as possible catalysts for re-rating.

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EQUITY RESEARCH	CONSUMER AND RETAIL

Format-Specific Strategies

Discounters to remain key business driver, but there will be fewer openings and a greater focus on efficiency. Discounters remain the key pillar of X5’s business, contributing approximately 80% of consolidated revenue as of 3Q18. X5’s new development strategy is based on several priorities listed below, with the main emphasis being customer loyalty and employee engagement:

1)Smart expansion. 1.8k stores are set to be opened in 2019 (or 37% less than in 2017). Pyaterochka will focus on its existing regions of presence in order to capitalise on its recognised brand, and will maintain the ROIC of new openings

(the Group’s IRR threshold is set at 19%).

Figure 20: Among X5’s three key formats, proximity stores are expected to show the fastest growth pace

Russian food retail formats’ expected expansion

6,7
4,5	4,0						4,0
							4,0
3,4				2,3			3,5
				2,3
		2,1
						0,8
						0,4

Proximity	Supermarkets		Hypermarkets			Other formats	Traditional trade
			2017		2021
			2017		2021

Source: Company data, ATON Research

2)CVP. Pyaterochka sees an opportunity in focusing on loyal customers whose spending is approximately 5x higher than regular customers. To attain this goal it will increase the number of fresh categories offered at its discounters, raise the share of private label products (to 20-25%), and improve the pricing process and the efficiency of its promotional campaigns, while maintaining the current promo level (around 30%).

3)Operating efficiency will be enhanced by decreasing shrinkages, further development of the multilayer logistics infrastructure, and optimisation of rent costs.

4)Innovations. In 2019 Pyaterochka plans to launch pilots for its online services. Currently the segment is considering several options of the omni-channel model including the possibility of delivering directly from its stores or using postamats.

Figure 21: Discounters will be the fastest-growing segment of	Figure 22: Focus on loyal customers will boost Pyaterochka’s
modern retail; Pyaterochka’s share in X5 sales up to 80% in 2021	revenue; +10% of spending of loyal clients = +3.8% to sales

			6,7
7,0			6,7		100%
6,5			CAGR 10.4%
6,0			CAGR 10.4%		80%
6,0	75%	77%		80%	80%
5,5	75%	77%
5,5
5,0		4,5			60%
		4,5
4,5	4,0	CAGR 11%
	4,0	CAGR 11%
4,0					40%
3,5			39%
3,0	29%	31%			20%
	29%
2,5
2,0					0%
2,0	2016	2017	2021		0%
	2016	2017	2021

63%	The most contributing
	The most contributing
	category - loyal customers;
	target share - 15%
42%						39%
						39%
		26%
				19%
						11%

Regular customers			Regular customers with			High value customers
without loyalty cards			loyalty cards			with loyalty cards
			Customers		Revenue

Proximity segment Share in grocery Pyaterochkas'a share in X5 sales

Source: Company data, ATON Research

Supermarkets is the fastest-growing segment in X5’s format family and the only segment to generate positive LfL traffic since 1Q16. Customers appreciate the high share of refurbished stores (83%+), where average post-recovery LFL sales growth is

14-16%. The launch of online sales boosted clients’ average spending per month by

vk.com/id446425943																						8
		EQUITY RESEARCH				CONSUMER AND RETAIL
											63%, albeit somewhat at the expense of offline spending that contracted 19%. X5
											anticipates that in 2019 the Perekrestok chain will grow at a rate comparable to 2018.
											As with X5’s other formats, supermarket operations will be optimised, including the
											rollout of a regional model, logistics improvements with a focus on shelf availability,
											and the exploration of synergies with Pyaterochka in remote regions.

	Figure 23: We expect Perekrestok sales growth at a CAGR17-21 of														Figure 24: Perekrestok is the only format to show positive LfL
	11.7% (almost 3x higher than the segment average)														traffic since 1Q16
4,5		23%							23%					8%
						23%								8%


4							CAGR 4.1%		22%
									22%
									4,0					4%
									4,0
3,5
3,5				CAGR 6.3%		3,4
				CAGR 6.3%		3,4
3		3,2							18%
3		3,2												0%
2,5			15%											0%				1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18
																		1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 3Q18
							14%		14%					-4%
							14%		14%
2										13%
2
1,5												10%		-8%					LfL traffic Pyaterochka		LfL traffic Perekrestok
		2016				2017			2021

																			LfL traffic Karusel		LfL traffic X5
		Supermarket segment			Share in grocery			Perekrestok's share in X5 sales											LfL traffic Karusel		LfL traffic X5

						Source: Company data, ATON Research														Source: Company data, ATON Research
											Differentiation via assortment as the key means of improving CVP. In order to
											support further its format development, Perekrestok will prioritise enhancing its
											assortment, with a particular emphasis on fresh foods, and the opening of a kitchen
											factory (that will add 800 SKUs to the assortment). The project will be launched in
											1H19 and will focus on fresh and ready-to-eat products with targeted output of 120
											tonnes per day.
											Perekrestok online development remains a priority. While Perekrestok online is still in
											its infancy, the results are already visible. The group plans to increase the number of
											SKUs to around 50k (via extending its online offering to include hypermarket’s and
											partners’ assortments), improve its mobile app, and launch the ‘click and collect’ pilot.
											Loyal customers will become the major focus. As is the case for the group as a whole,
											Perekrestok will focus its energies on bolstering the number of loyal customers (loyal
											customers’ average ticket at Perekrestok is 37% higher than for the average client).
											Perekrestok plans to double the number of active loyalty card users from 5mn
											currently by 2020, and expand loyalty card penetration to 70%.

											Figure 25: Perekrestok plans to double the number of active loyalty cards, at the
											same time increasing the penetration rate
													12									75%
													10							70%		70%
													10
													8									65%
													8
																	60%					60%
													6							10
																				10		55%
																						55%
													4									50%
																						50%
													2				5
													2									45%
																						45%
													0									40%
													0				3Q18			2020F		40%
																	3Q18			2020F
																Active cards, mn				Turnover penetration
																Active cards, mn				Turnover penetration

																				Source: Company data, ATON Research
											Karusel susceptible to larger format risks… Hypermarkets are the slowest growing
											segment in the Russian retail landscape with the estimated average compound growth
											rate from 2017 to 2021 being 2.9% (Infoline), and expected to further cede market
											share to smaller formats. We estimate Karusel’s growth in line with the market average
											and consequently forecast that its contribution to X5’s top line will dip from 7% in 2017
© 2018 ATON LLC. All rights reserved											to 5% in 2021.

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EQUITY RESEARCH	CONSUMER AND RETAIL

… though efficiency to be dramatically improved that will translate into higher sales densities. The initiatives that X5 has announced, including further enhancement of its assortment mix (increasing the share of private label products from the current 4% to 10% by 2020) with a focus on healthy food and fresh produce, as well as the development of food services (in-store pizza points, cafeterias, and restaurants) together with further operating optimisation should raise Karusel’s sales density (+7% expected by 2021). Together with heightened personnel efficiency and shrinkage cost reduction, the improved sales density should benefit the format’s margins.

Figure 26: The hypermarkets’ top line CAGR17-21 will be 1.8x	Figure 27: Sales density of Karusel will improve at fastest pace
lower than the CAGR16-17	among X5 formats

2,4					14%		15%
		14%	14%		14%
		14%	14%		2,3
					2,3
2,3				CAGR 2.9%
				CAGR 2.9%
2,2	8%						10%
	8%		2,1
2,1		CAGR 5.1%	2,1
2,1	2,0

2,0			7%		4%		5%
					4%

1,9
1,9
1,8							0%
1,8	2016		2017		2021		0%
	2016		2017		2021
	Hypermarkets segment		Share in grocery			Karusel's share in X5 sales
	Hypermarkets segment		Share in grocery			Karusel's share in X5 sales
			Source: Company data, ATON Research

360
320
	315				304
280
	258				259
					253
240
	231
200
2016	2017	2018	2019	2020	2021

Pyaterochka Perekrestok Karusel

Source: Company data, ATON Research

Figure 28: X5 financials snapshot

INCOME STATEMENT, RUBmn	2015	2016	2017	2018E	2019E	2020E
Revenue	808 818	1 033 667	1 295 008	1 529 876	1 762 035	2 001 220
Gross profit	198 390	249 985	308 938	367 170	424,651	481 294

Operating profit (EBIT)	34 449	45 631	57 758	61 102	71 938	82 856
EBITDA	55 233	76 267	96 193	107 593	121 940	136 409

EBITDA adj	59 413	79 519	99 131	109 622	124 070	138 539
EBITDA margin	7,3%	7,7%	7,7%	7.2%	7.0%	6.9%

EBITDAR	91 598	123 287	156 273	182 271	206 872	231 376
Profit before income tax	17 930	28 653	41 816	44 576	53 624	64 430
					53 624	64 430
Profit for the period	14 174	22 291	31 394	33 432	40 218	48 322
BALANCE SHEET, RUBmn	2015	2016	2017	2018E	2019E	2020E
Property, plant and equipment	189 000	232 316	278 928	311 873	333 009	346 545
Total non-current assets	293 410	343 409	405 985	443 643	466 462	481 442

Inventories	57 887	73 801	99 300	118 680	140 174	163 471
Total current assets	108 705	130 076	159 273	186 828	221 500	247 588
					221 500	247 588
Total assets	402 115	473 485	565 258	630 471	687 963	729 030
Total equity	104 718	127 040	158 442	170 250	190 409	214 600
					190 409	214 600
Long-term borrowings	101 545	110 865	135 622	176 197	196 197	193 197
Total non-current liabilities	106 517	119 075	142 641	183 528	203 528	200 528
					203 528	200 528
Total current liabilities	190 880	227 370	264 175	276 693	294 026	313 901
Total equity and liabilities	402 115	473 485	565 258	630 471	687 963	729 030
					687 963	729 030
Key data	2015	2016	2017	2018E	2019E	2020E
ROE	14,5%	19,2%	22,0%	20.3%	22.3%	23.9%
ROA	3,8%	5,1%	6,0%	5.6%	6.1%	6.8%
					6.1%	6.8%
ROIC	13,9%	15,8%	16,7%	13.2%	13.9%	14.9%
					13.9%	14.9%

Source: Company data, ATON Research

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	EQUITY RESEARCH	CONSUMER AND RETAIL

	Target Price		Valuation
	Target price per GDR (DCF),$	32.6

Target price per GDR (multiples),$	30.7
Average Target Price per GDR,$	31.6

Potential upside	29%

Source: Company data, ATON Research

Figure 29: Fwd P/E FIVE LI

8 Oct-16 Mar-17 Aug-17 Jan-18 Jun-18

FIVE LI Equity Multiple (BF P/E) Multiple Average (2 Years)

Source: Bloomberg, ATON Research

Figure 30: Fwd EV/EBITDA FIVE LI

12M target price. We used both DCF and multiples-based approaches to value X5 Group, and our combined valuation yields a 12-month target price of $31.6 price per GDR in 2018, implying 29% upside potential to the current market price (CMP) and we reiterate our BUY rating for the name. In 2018 X5 commenced trading on Moscow Stock Exchange, and for FIVE RX our target price is RUB2 093, implying 29% of potential return on the current market price.

Multiples valuation. With respect to our multiples valuation, we used the 12M forward

P/E and EV/EBITDA ratios of X5 Group’s global emerging markets peers (12.9x and

22.9x, respectively), as well as a 45% discount to the target multiples The marketbased valuation resulted in a target price of $30.7 per GDR, implying 25% upside potential to the CMP.

X5’s Cost of Capital was calculated using: 1) the Russian corporate tax rate of 24%, 2) the RFR offered on 10-year OFZ, and 3) our assumption of a 5% debt premium and ERP of 5%. Using the current debt–to-equity ratio we calculate X5’s weighted average cost of capital to be 13.7%.

4 Oct-16 Mar-17 Aug-17 Jan-18 Jun-18

FIVE LI Equity Multiple (BF EV/EBITDA) Multiple Average (2 Years)

Source: Bloomberg, ATON Research

Figure 31: X5 EPS 2019 estimates fell 32% over 12m

2600

	230
2200	210
	210
1800	190
	190
1400	170
	170
1000	150
Nov-17 Feb-18	May-18 Aug-18
Price	BEst Standard EPS adj 2019

Source: Company reports, ATON Research

Figure 32: X5 EBITDA 2019 est decreased

13% over 1 yr

2600

2200	140000
2200
1800
	130000
1400
1000	120000
Nov-17 Feb-18 May-18 Aug-18
Price	BEst Standard EBITDA 2019 A

Source: Bloomberg, Company, ATON Research

DCF. In order to calculate the terminal value we assume that after 2026 future cash flows will grow at a constant rate of 5%. Given our DCF model we calculated a target price of $32.6 which implies 33% upside potential to the current price per GDR.

Risks

Downside risks

Lower-than-expected economic growth in Russia: constrained consumer spending may slow the consumer recovery and put pressure on X5’s top line growth.

A faster turnaround and Magnit’s new strategy: Magnit is currently putting immense effort into reconquering Russian retail market leadership. While the turnaround will take time, the success of X5’s main competitor may negatively affect the latter’s business.

Less aggressive openings pace may result in weaker top line growth and market share contraction while not guaranteeing a better operating performance.

Upside risks

Accelerating inflation: faster acceleration of food CPI should result in quicker top-line growth.

Higher dividend payout. A strong balance sheet position may see X5 paying out higher dividends. This would put it at a distinct competitive advantage, taking into consideration that Magnit has decided not to pay a final dividend for 2017.

M&A: With greater opportunities for M&A, X5 may accomplish more respective transactions and accelerate its growth.

Greater-than- forecast upside from new technological pilots and faster development of online. Currently X5 has 68 projects that are being piloted and it has also arduously developed the omni-channel business model in all its formats. At this stage it is difficult to evaluate the effect of the new projects on X5’s business, and we see their successful development as another potential upside risk.

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