Russia Food and Drink Report Q2 2008

Russia's consumer sector is a long way from saturation, but 2008 will see tough challenges after eight years of rapid expansion among the country's leading mass grocery retail (MGR) chains. It is much the same for multinationals and the largest domestic food processors. Costs are a major factor, including rising domestic and world raw materials costs, overheated real-estate markets, record advertising rates and a jump in labour costs. With retailers in particular having pushed in to regional markets in earnest since 2005, many are finding themselves stretched and explaining to investors how they will bring down the ballooning cost elements eating in to profits. With price tags such as the roughly US$300mn paid by Wrigley for confectionery maker Korkunov last year, the price of entry is also very high.

On top of these macroeconomic factors, Russia's MGR players face the extension of the 'voluntary' price-freeze accord reached in October 2007 in a bid to bring down inflation as a whole and, of course, socially explosive rises in the price of many staple foods. The freeze will continue, at a minimum, until May 1 2008, seeing the country through the presidential elections. Inflation hit 11.9% in 2007, after being forecast at around 8% and food-price inflation was one of the culprits. Some regions have been harder hit, with the Nizhegorod region reporting a startling 16.1% inflation spike. In addition, regulatory risk looms for retailers in the form of the draft Law on Retail, with its potentially draconian limits on opening hours and other restrictions targeted at chains.

Such worries did not stem rapid growth among the country's largest retailers, such as X-5 Retail, which at the time was expected to report sales of over US$5.25bn in 2007. However, investors note that the company put off some store opening plans for 2008 and the group needs capital if it is to exercise its existing option to acquire hypermarket group Carousel, spun off by management in 2005. A US$1.1bn syndicated loan announced in late 2007 appears to deal with any short-term liquidity worries, but more may be needed down the line. Number three retailer, discount-focussed Magnit was reportedly eyeing a secondary public offering to raise as much as US$500mn to fund expansion. But with global stock markets in turmoil, it is not clear how easily local players will be able to raise capital at attractive rates.

As retailers report their full-year 2007 results, investors will be watching to see if the big chains have hit their store-opening targets without seeing major declines in profitability growth.

Moving forward, to contain costs, retailers will need to squeeze food processors, themselves under pressure from record raw material costs. With number two global retailer Carrefour due to open its first stores in H108 and Auchan reportedly buying stores from Turkey's Migros Turk, the pressure on local chains will only intensify. The broader squeeze could push some smaller and over-extended retailers to sell out to bigger local players or multinationals and usher in a long-awaited period of consolidation among Russia's largest MGRs, perhaps beginning in 2009. One issue to watch is whether Russia's regulators will intervene to prevent multinational retailers from dominating the marketplace.