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RUSSIAN RETAIL – DISRUPTED BY SPECIALISTS NOVEMBER 7, 2018

Forecast Changes

In light of the market environment, the companies have finally started ratcheting down their expansion plans. We welcomed this and hoped it would take place earlier (see our May 14 note, “Russian Retail: Value Destruction in the Sector”). We incorporate new USD/RUB forecasts and plans for new openings in our forecasts, and we also fine tune our models to take account of the 3Q18 financials, which indicated softening top line growth. On average, we cut our 2019 revenue forecasts by 5% and our EBITDA forecasts by 6%.

X5 Retail Group

X5 Retail Group’s 3Q18 financials showed revenue growth declining from 19.3%in 2Q18 to 17.6%, mainly on the back of slower store expansion. Meanwhile, the gross margin improved from 23.7% in 3Q17 to 24.6% and the EBITDA margin rose to 7.4% from 7.0% in 3Q17. Revenue growth reached 16% in the first half of October, and we do not expect any acceleration this quarter. We therefore pencil in 15.6% revenue growth for 4Q18, which would take revenues to R418.3 bln, assuming LFL growth stays flat Q o Q at 0.5%. We make slight changes to our 2018 estimates, adjusting revenues and EBITDA (due to a higher gross margin but lower operating costs). More notably, we cut our full year net income forecast by 12%, reflecting higher depreciation.

During the company’s recent capital markets day, the management guided 2,000 gross store additions in 2019, including 1,800 Pyaterochkas (down from the current year target of 2,500 gross openings by X5), though it kept its margin and ROIC guidance intact. Accordingly, we now assume 1,860 net openings in 2019 and cut our 2019 revenue growth projection by 4 pp from 17.1% to 13.8%, anticipating a top line of R1,738 bln. With a higher gross margin and lower share of immature stores, our full year EBITDA margin forecast now stands at 7.0%, for EBITDA of R122.4 bln (1.6% below our previous forecast). The most notable change involves our USD/RUB forecast, which now stands at 66.0, up from 60.5 before. As a result, we reduce our target price from $38.00 to $31.00 per GDR (implying a target EV/EBITDA of 6.0). This still warrants a BUY recommendation.

X5 Retail Group forecast changes, R mln

		2018E			2019E			2020E
	New	Old	Diff	New	Old	Diff	New	Old	Diff
Revenues	1,527,272	1,546,606	1%	1,738,406	1,811,554	4%	1,954,510	2,061,567	5%
Gross income	370,114	369,527	0%	423,021	430,991	2%	475,179	489,979	3%
Gross margin	24.2%	23.9%	–	24.3%	23.8%	–	24.3%	23.8%	–
SG&A	(319,605)	(315,972)	1%	(367,664)	(369,624)	1%	(410,862)	(419,985)	2%
EBITDA	108,021	107,765	0%	122,454	124,446	2%	140,722	141,653	1%
EBITDA margin	7.1%	7.0%	–	7.0%	6.9%	–	7.2%	6.9%	–
Operating income	60,178	63,346	5%	66,362	72,836	9%	76,691	83,045	8%
Operating margin	3.9%	4.1%	–	3.8%	4.0%	–	3.9%	4.0%	–
Net income	32,479	36,959	12%	38,780	45,687	15%	47,475	56,014	15%
Net margin	2.1%	2.4%	–	2.2%	2.5%	–	2.4%	2.7%	–
OCF	81,039	83,739	3%	103,632	109,213	5%	118,960	123,704	4%
Investing cash flow	(83,040)	(71,055)	17%	(75,370)	(72,268)	4%	(79,791)	(70,326)	13%
Net debt	190,709	175,844	8%	185,808	154,553	20%	174,397	120,130	45%
EPS, R	119.7	136.2	12%	143.0	168.4	15%	175.0	206.5	15%

Source: Sberbank CIB Investment Research

Lenta

Hypermarkets are now in a more vulnerable position than before. Ticket pressure is an industry wide trend, but for hypermarkets it has meant less traffic. In practice, this works in the following way. A number of chains expand, and the customers now visit more stores. But this dilutes the ticket, as the number of items purchased during a single visit declines. Once customers have shopped in their

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NOVEMBER 7, 2018 RUSSIAN RETAIL – DISRUPTED BY SPECIALISTS

convenience and specialist stores located close to them, the list of items left over for purchase in a hypermarket has narrowed considerably. Some then decide to skip the hypermarket, as the potential savings on certain items do not warrant the time invested. This situation could change: we consider hypermarkets to be prime beneficiaries if real incomes bounce, for example, but we see no signs of this happening right now.

Lenta reported 12.5% y o y revenue growth for 3Q18, significantly below our forecast of 15% and materially down from the 16.6% growth seen in 2Q18, mainly due to LFL ticket growth declining from 2.0% in 2Q18 to 0.3% in 3Q18. We had been expecting ticket compression but an improvement in traffic. We do not anticipate any relief in either 4Q18 or 1H19 and expect revenue growth to slow relative to 3Q18. Therefore, we cut our revenue forecast for 2018 by 2%, for 14.4% growth y o y. Meanwhile, the share of rented stores is growing, as hypermarket openings have been shifted to the beginning of next year. This is causing operating expenses to climb as a percentage of revenues. Hence, we project an EBITDA margin of 9.1% for 2018, down from our previous forecast of 9.3%.

Beyond 2018, we have trimmed our forecasts on a large scale, as the company now expects to open significantly fewer stores in 2019 (the number of new hypermarkets could be half the number of 2018 additions). We cut our revenue forecasts by 9% and 13% for 2019 and 2020, respectively, and anticipate top line growth of 8.3% in 2019 and 7.9% in 2020. The higher share of rented stores drops our EBITDA margin projections for both years from 9.4% to 8.8%on average. We therefore reduce our target price from $8.00 to $5.50 per GDR (which includes the impact of our weaker ruble forecast), but we keep the stock as a BUY. We think the ongoing share buyback is fueling demand for the stock, and in light of reduced capex (on fewer store openings) the stock offers a 2019E FCF yield of 10.6%. However, top line growth sliding from 17% in 1H18 to 8 9% in 1H19 could deter growth oriented investors and spark a selloff.

Lenta forecast changes, R mln

		2018E			2019E			2020E
	New	Old	Diff	New	Old	Diff	New	Old	Diff
Revenues	417,698	426,319	2%	452,251	496,021	9%	488,178	559,149	13%
Gross income	89,628	91,407	2%	97,143	106,435	9%	104,938	120,006	13%
Gross margin	21.5%	21.4%	–	21.5%	21.5%	–	21.5%	21.5%	–
SG&A	(65,853)	(66,100)	0%	(72,547)	(76,651)	5%	(78,912)	(86,651)	9%
EBITDA	37,994	39,819	5%	39,991	46,668	14%	42,645	52,388	19%
EBITDA margin	9.1%	9.3%	–	8.8%	9.4%	–	8.7%	9.4%	–
Operating income	27,503	29,111	6%	28,632	34,210	16%	30,383	38,344	21%
Operating margin	6.6%	6.8%	–	6.3%	6.9%	–	6.2%	6.9%	–
Net income	14,578	14,088	3%	15,179	17,733	14%	17,465	22,119	21%
Net margin	3.5%	3.3%	–	3.4%	3.6%	–	3.6%	4.0%	–
OCF	24,607	24,420	1%	27,492	31,518	13%	30,746	37,571	18%
Investing cash flow	(28,135)	(30,104)	7%	(15,276)	(26,283)	42%	(15,214)	(27,197)	44%
Net debt	96,327	98,483	2%	84,111	93,247	10%	68,579	82,873	17%
EPS, R	30.0	29.0	3%	31.2	36.4	14%	35.9	45.5	21%

Source: Sberbank CIB Investment Research

Magnit

Magnit’s revenue growth rose from 6.5% in 2Q18 (with a 5.2% decline in LFL sales) to 8.4% (with a 2.0% decline in LFL sales) in 3Q18. The company has announced that it climbed to 9% in the first 20 days of October. With this in mind, we have slightly nudged up our revenue projection for 2018, but we have cut our EBITDA forecast by 4% due to gross margin pressure.

The company recently announced that its focus will be on efficiency and renovations over the medium term, while 2019 openings should be in line with those of 2018 (i.e. around 2,200 gross across the three formats, including 1,400 in convenience, which is less than we projected and below the figures contained in the company’s long term strategy). This should be complemented by 2,000 pharmacy openings inside existing convenience and cosmetics stores. Hence, we cut our revenue projections by 4%

24	SBERBANK CIB INVESTMENT RESEARCH

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for 2019 and 2020. For the same reasons, we cut our EBITDA projections for the same periods by 9% and 5%, respectively. Adding in our weaker ruble projections, we lower our target price to $17.00 per GDR and keep our HOLD recommendation. The stock is not expensive, but we are concerned by the gross margin decline, which is now being addressed by the reduction in opex.

Magnit forecast changes, R mln

		2018E			2019E			2020E
	New	Old	Diff	New	Old	Diff	New	Old	Diff
Revenues	1,235,523	1,231,295	0%	1,359,046	1,408,539	4%	1,545,542	1,601,770	4%
Gross income	303,923	328,021	7%	339,414	376,824	10%	387,884	428,924	10%
Gross margin	24.6%	26.6%	–	25.0%	26.8%	–	25.1%	26.8%	–
SG&A	(259,153)	(279,277)	7%	(292,391)	(322,037)	9%	(326,999)	(363,914)	10%
EBITDA	89,399	93,493	4%	96,828	105,906	9%	115,788	121,508	5%
EBITDA margin	7.2%	7.6%	–	7.1%	7.5%	–	7.5%	7.6%	–
Operating income	52,728	54,850	4%	55,777	61,279	9%	70,840	71,913	1%
Operating margin	4.3%	4.5%	–	4.1%	4.4%	–	4.6%	4.5%	–
Net income	34,075	34,145	0%	35,599	39,361	10%	47,499	49,698	4%
Net margin	2.8%	2.8%	–	2.6%	2.8%	–	3.1%	3.1%	–
OCF	73,249	77,449	5%	76,623	83,920	9%	89,185	91,600	3%
Investing cash flow	(57,861)	(51,568)	12%	(62,668)	(59,938)	5%	(55,764)	(49,752)	12%
Net debt	98,921	98,958	0%	110,822	82,327	35%	98,761	49,386	100%
EPS, R	66.9	67.0	0%	69.9	77.2	10%	93.2	97.5	4%

Source: Sberbank CIB Investment Research

O’Key

O’Key is also prone to the sector wide trend of customer outflow from big boxes, which has been precipitated by overly eager expansion in the convenience store format coupled with the emergence of specialized stores. With regard to O’Key’s supermarkets, the company has already transferred its remaining four stores to X5. The company managed to improve its gross margin in 1H18, though this was offset by rising operating expenses and resulted in an almost flat EBITDA margin of 4.4%. As September and October were abnormally warm, we think LFL traffic will be negative in 2H18 as well. Coupled with the sale of the supermarket division and reduced store opening guidance for this year, we now expect revenues to slide 8.9% in 2018 and the EBITDA margin to come in at 5.4%.

The management has guided that the sales density at the big boxes will increase by up to 10% by 2020, with costs decreasing by at least 10% and the EBITDA margin reaching 8%. We think these plans are too ambitious. We now project an average EBITDA margin of 5.6% in 2019 20, versus our previous forecast of 5.8%. Factoring in our weaker ruble assumption, we reduce our target price to $1.50 per GDR and maintain our SELL recommendation.

O’Key forecast changes, R mln

		2018E			2019E			2020E
	New	Old	Diff	New	Old	Diff	New	Old	Diff
Revenues	161,675	166,287	3%	168,727	182,507	8%	177,487	202,114	12%
Gross income	37,557	37,742	0%	39,346	41,678	6%	41,545	46,419	11%
Gross margin	23.2%	22.7%	–	23.3%	22.8%	–	23.4%	23.0%	–
SG&A	(33,485)	(33,253)	1%	(34,501)	(36,174)	5%	(35,801)	(39,561)	10%
EBITDA	8,655	8,812	2%	9,231	10,248	10%	10,145	12,112	16%
EBITDA margin	5.4%	5.3%	–	5.5%	5.6%	–	5.7%	6.0%	–
Operating income	4,453	4,489	1%	4,845	5,504	12%	5,744	6,858	16%
Operating margin	2.8%	2.7%	–	2.9%	3.0%	–	3.2%	3.4%	–
Net income	933	716	30%	1,331	1,374	3%	2,105	1,941	8%
Net margin	0.6%	0.4%	–	0.8%	0.8%	–	1.2%	1.0%	–
Operating cash flow	2,544	8,891	71%	5,689	6,421	11%	6,481	7,572	14%
Investing cash flow	2,024	(6,294)	132%	(4,894)	(8,827)	45%	(5,063)	(9,650)	48%
Net debt	23,252	25,824	10%	23,936	28,444	16%	22,915	30,933	26%
EPS, R	3.5	2.7	30%	4.9	5.1	3%	7.8	7.2	8%

Source: Sberbank CIB Investment Research

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