Is the Russian Consumer Sector Still the 'Belle of the Ball?'

Consumer and retail companies have been among the top performers since the beginning of the year (the RTS Index is up 86.2 percent YTD and the RTS consumer and retail index is up 114.5 percent YTD), with the consumer sector thus far proving to be the most resilient to the current economic downturn. Despite rapidly deteriorating consumer market fundamentals and a severe credit crunch, some companies are reporting surprisingly strong 1Q09 results amidst encouraging trends. So, how do we pick the winners, separate the wheat from the chaff? As in many things in life, the key is to focus on quality.

As promising as the recent consumer sector activity portends, the key question that we must ask is whether enthusiasm for the sector is well-founded or premature. In essence, are these new valuation levels sustainable? In order to answer that question with any level of certainty we need a fuller understanding of the changes that the past 10 months have wrought for the operating environment and for the companies within it. For starters, the crisis has dramatically altered the fundamental landscape of the consumer market, such that the consumer confidence index has reached its lowest point since it began being published in 2002. According to data from the Russian Statistics Agency, the index dipped to -35 points in the first quarter of 2009,with real disposable income down 1 percent YoY. The first quarter also witnessed a steep rise in unemployment (9.5 percent in 1Q09), accompanied by drop in retail trade of 1.1 percent YoY in real terms. One needs to go back as far as 2000 to see such low levels.

Unsurprisingly, these factors will have a negative impact on the consumer and retail companies that have to navigate such perilous economic straits. It certainly will be challenging for them to operate in an environment characterized by negative or zero disposable income growth, which is forecast for the next few years, and to muddle through to the period of moderate (2-5 percent) growth levels predicted thereafter. Because signs of improving consumer market fundamentals have yet to emerge, and are not anticipated to materialize over the next couple of quarters, it seems that too much optimism at this juncture would be misplaced.

Moreover, companies in the consumer sector have been pursuing aggressive expansion strategies using both equity and aggressive leverage. With equity markets closed for new placements for the time being, debt loads reaching levels of 3x-4x debt/EBITDA, and borrowing rates soaring to 18-22 percent for reputable corporate borrowers, aggressive expansion has become more difficult. Furthermore, the strongest credit squeeze of the decade meant that aggressive leverage levels shook up some companies and caused collateral damage to others. Since high interest rates are likely to remain in medium run, the surviving companies should become more conservative in their debt funding. This, in turn, will result in slower growth rates than those observed in 2004-2008.

So, where are the most favorable investment opportunities? So far the retail trade has been the most resilient sector of the economy, outperforming other sectors. For example, in 1Q09 industrial production is 14.3 percent lower YoY, while manufacturing is down 20.8 percent and transportation has declined 17.8 percent over the same period. However, Rosstat figures show retail trade being down just 1.1 percent in real terms for the same quarter. Inflation, currently running at 13-14 percent p.a. for the 1Q09 and unlikely to decelerate significantly in 2009 or 2010, is also a supporting factor for consumer sector companies. Most importantly, some of the stronger cost pressures faced by consumer companies in the recent years (such as labor and rent) have eased during the economic crisis, allowing the more efficient companies to show surprisingly strong 1Q09 results. Furthermore the crisis has created massive M&A and market consolidation opportunities for the industry's strongest companies and some of the top Russian consumer companies trade at discounts to their international peers. Consequently, despite the tenuous overall economic environment, investors should focus upon quality, that is, on consumer names with strong track records, time tested management excellent corporate governance standards and winning strategies.

So, the smart money will take positions in those Russian major consumer stocks (such as X5, Magnit, Wimm-Bill-Dann, Pharmstandard, and CEDC) that will take advantage of the economic downturn in order to emerge as larger, stronger, and more effective companies, that reflect positive implications for shareholder value.