Thanks to relative political stability and strong oil and gas prices, Russia's retail turnover more than quintupled from 2001 to 2011 and now exceeds US$600 billion annually. Data suggest that this sector is entering the steepest part of its growth curve. How will Russia's retailers face the challenges of this critical period of expansion? Will foreign retailers manage to get a slice of this growing pie?

Despite the widely held notion that the majority of Russia's GDP comes from extractive industries, this sector accounted for less than 12% of GDP in 2011 according to Rosstat, the Russian Statistical Bureau. The wholesale and retail sector, in contrast, amounted to more than 16%. As the per-capita income of Russia's 140 million consumers continues to rise, the retail sphere is becoming more important than ever.

Russia's enormous size and level of economic development mean that the retail market is currently divided among many players. While large retail chains dwarf the majority of competitors in market capitalization, their market share is relatively small. The X5 Retail Group, the largest food retailer, for example, controls only 5.6% of the market, and the top 10 food retailers comprise less than 20% of the market. This is in stark contrast to the developed markets of Western Europe, where leading food retailers hold a quarter of the market or more -- e.g., Tesco (30% market share) in the U.K. and Edeka (26% market share) in Germany.

This opportunity for consolidation is fueling a pitched battle among Russia's retail chains to establish regional and national market share. Which chain prevails as top dog will depend on how well it can confront the logistical challenges of the country's decaying infrastructure, responsibly manage expansion and successfully navigate an uncertain regulatory environment.

The Name of the Game: Logistics

Russia's road network stands at 610,000 miles, of which only 482,000 miles are paved. (In comparison, the U.S. has four million miles of roads, of which 2.7 million are paved.) Russian spending on infrastructure increased from US$7 billion in 1999 to US$111 billion in 2010 (from 3.5% to 7.4% of GDP), but, due to bureaucracy and corruption, the country gets far less bang for its buck. 

In addition, there is a lack of quality warehousing in the country. There are 81 million square feet of industrial space in all of Russia, while the Chicago market alone houses 537 million square feet. Industrial rental rates in Russia average about US$11 per square foot. In comparison, operators in Chicago -- one of the most expensive warehouse markets in the U.S. -- charge US$4 per square foot.

All the leaders in Russia's retail sphere are rapidly modernizing their logistical operations. Retail chain Magnit is currently recognized as the cutting-edge logistics innovator. As a result, it is rapidly closing in on X5's lead as Russia's largest retailer in terms of revenues. Its profits more than doubled in the first half of 2012 compared to the previous year, while X5's profits over the same period dropped 20.6%. Magnit's main advantage over its competitors has been its effectiveness in bringing the supply chain completely in-house and cutting out the middle men. Today, Magnit runs a fully independent supply chain, with over 3,900 of its own vehicles and a proprietary network of 15 distribution centers totaling close to 3.9 million square feet. 

Technology has played a key role in Magnit's emergence as a leading retailer in Russia. When the company entered the retail market in the 1990s, the information revolution was just beginning to have an impact on how business was conducted in Russia. Magnit transitioned to a technology-driven development model early on, utilizing enterprise resource software from SAP and then hiring in-house specialists to refine its logistical models. 

Window of Opportunity: Closed for Good?

The Russian retail market is heavily saturated, and barriers to entry are high. The two foreign chains that have found success have one thing in common: They struck when the iron was hot. German retailer Metro and the French chain Auchan entered the Russian market in the early 2000s, before competitors became well-established. Of the top-10 leading food retailers, Metro and Auchan have been the only non-Russian firms to command a leading position in the retail sector.

Notably absent from the Russian market are Carrefour and Walmart, although both had attempted to enter. Carrefour, one of the world's largest hypermarket chains, opened its first store in Moscow in 2009, followed by a second one in Krasnodar. Yet after only four months, the company announced plans to abandon all operations in Russia, because of “the absence of sufficient organic growth prospects and acquisition opportunities in the short- and medium-term that would have allowed Carrefour to attain a position of leadership." The global crisis was felt most acutely in Russia in 2009. Carrefour entered the Russian market in the only year in the past decade in which the retail sector shrank.

Walmart also waited until the late 2000s to make a move. After Carrefour's failed attempt, Walmart ruled out a greenfield investment and decided to concentrate on acquisition for its market entry, focusing on Kopeika, Russia's largest discount chain. When it lost out to X5, which purchased Kopeika in late 2010 for US$1.1 billion, Walmart closed its representative office in Moscow.

Both Carrefour and Walmart failed to enter Russia when the timing was right. As Oleg Goncharov, director of investor relations for Magnit, explained, "the time for organic development of these large retailers has passed. They simply cannot enter the Russian market through organic growth, only by acquisition. Acquisition is the only platform [through which] a Western food retailer can enter this market now."

The Regulatory Fog of War

The retail sector faces an additional challenge to its continued consolidation and growth: an unpredictable regulatory environment.

On February 1, 2010, a new trade law went into effect that specifically targeted retail chains. It set a market-share ceiling of 25% in a single territory, said that contractual agreements between suppliers and retailers that include "excessively long repayment" periods and/or "excessively large wholesale discounts" are illegal, and empowered regulators to set the prices of "socially important goods." The opaque nature of Russia's legislative process makes it difficult to determine the major political force behind this legislation. 

The example of developed markets in Western Europe, where leading retailers control more than 25% of the national market but continue to deliver low prices to consumers, casts a shadow over the reasoning of the Russian lawmakers.

The unpredictable nature of Russia's regulatory environment -- and uncertainty about who is driving such regulatory changes -- makes it very difficult for retailers to control their own destinies. Thus, they tend to plan for the short- to mid-term only. Investments that may take more than two or three years to show a return are simply too risky.

A Maturing Market's Long-term Perspectives

The retail sector's rapid expansion will likely be the main narrative for the next several years. But this will not last forever. As the market matures and is penetrated by modern-style retailers, what are the prospects for continued growth, and what are likely to be the biggest challenges facing retail chains in the future?

Logistics is currently the primary source of power in Russia's retail sector, but the future of brick-and-mortar sales will likely hinge on successful segmentation of a more mature market. This is underway to a certain degree, as X5, Magnit and others recently acquired or created discount and convenience brands to capture additional consumer segments at the small-transaction end of the market. Russian consumers are still extremely price-sensitive, so the gains to be made here are limited. As disposable income increases, however, there will be additional opportunities to tailor stores to consumers in different social, economic and age groups. Among discount retail chains, a split in the market could develop similar to that in the U.S., where Walmart focuses intently on low prices and markets itself accordingly ("Low Prices -- Always") and where Target attempts to position itself as the upscale discount retailer ("Expect More -- Pay Less").

Even though Russia became the largest Internet audience in Europe in 2011, with more than 53 million users, e-commerce there remains in its infancy. Consumers are highly skeptical of making purchases online and are uncomfortable with transactions in which they cannot inspect products beforehand. The logistical challenges of regular door-to-door deliveries remain unsolved. The federal mail system has a poor reputation for parcel service, and the market for home delivery has been too small for large parcel delivery services to expand nationwide. These trends are underscored by the fact that Russia's current leader in e-commerce, OZON.ru, relies primarily on pick-up points rather than home delivery and still conducts 80% of its transactions in cash.

Source: http://knowledge.wharton.upenn.edu/article.cfm?articleid=3162