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

Russians have a saying: “Our country has two main problems: bad roads and fools.” The cost of solving the first problem appears to support the truth of the second. 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. A 2010 study by Russian news agency RIA Novosti indicated that one mile of road in Russia costs approximately three times as much as a mile of road in the U.S. — a factor that increases rapidly as construction gets closer to large cities, especially Moscow. For example, the first 27 miles of the planned 415-mile highway between Moscow and St. Petersburg alone are projected to cost US$1.2 billion (over US$44 million per mile). Macquarie, a global investment banking and financial services group, reports that Russia’s road network increased only by 1% between 1995 and 2008, while passenger cars increased by 125%.

In addition, there is a lack of quality warehousing in the country. Colliers International reported that there are 81 million square feetof industrial space in all of Russia, while the Chicago market alone houses 537 million square feet, according to real estate service firm Newmark. 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 ?rst half of 2012 compared to the previous year, while X5’s profits over the same period dropped 20.6%. X5 appears to be playing catch-up in logistics. During this period, its margins were hit by the high costs of opening a new distribution center and the set-up costs related to adopting a direct-import model.

How has Magnit approached this common problem and what is the source of its success? The company began in 1994 as a wholesale distributor of household chemicals in the Krasnodar region before entering the retail market in 1998. Located in southwest Russia, Krasnodar is the third most populous region in the Russian Federation and benefits from better infrastructure due to its importance in energy exports from both greater Russia and the Caspian Basin.

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 who previously added costs and delays. 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. It continues to expand this network, opening a new facility in late May 2012 to serve the Volga region and expand eastward.

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. This team simulates consumer demand based on a series of economic inputs, such as population density in a certain region, income per capita and the availability of disposable income. These data are fed into an automatic stock-replenishment system, thereby effectively managing inventory levels.
Because this lead in logistics will not last forever, Magnit will need to capitalize on its advantage in the short term to gain maximum market share and to exploit its relative cost savings.

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, stating its “decision to sell the Group’s activities in Russia and pull out of the market, given 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 and had to watch, from the sidelines, Metro and Auchan’s 30% year-over-year growth in this market. After Carrefour’s failed attempt, Walmart ruled out a greenfield investment — i.e., building a manufacturing or production plant in an area, such as a “green field,” where no such structures currently exist — 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. By the mid-to-late 2000s, the retail market was developing rapidly but was already too well-established to permit an entry “from scratch.” 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.”

Walmart is already looking at a second attempt to access this market, having recently hired former X5 CEO Lev Khasis and appointing him senior vice president for international operations. Khasis was key in positioning X5 as the Russian market leader and grew the company to annual revenues of US$15 billion. He will likely be the strategic player for Walmart’s eventual entrance into the sector.

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 (and often myopic) nature of Russia’s legislative process makes it difficult to determine the major political force behind this legislation. Publicly, the Federal Antimonopoly Service and then-Prime Minister Vladimir Putin came out strongly in favor of the law, ostensibly as a way to defend consumers from the power of big retailers.

On June 24, 2009, Putin addressed the law’s drafting committee, noting, “It is hard to imagine a trade markup of more than 70% in a country with a developed social and market system. This is too much. We have looked at some food together with producers and representatives of trade chains. On average, meat products are marked up 45%-50%…. In general, retail prices do not depend only on the settlement of problems between the producers, processors and retailers…. We understand that each link has its own difficulties. Nevertheless, by regulating relations within the chain –producers, processors and retailers — we could make a substantial contribution to stabilizing the retail market. It is important to find the right balance between them.”

Economists in Russia, however, disagreed with this approach. On November 5, 2009, more than 30 leading economists (among them former Prime Minister Yegor Gaidar) supported an open petition against the law’s passage, citing the harm that contracting restrictions and an artificial market-share ceiling would have not only on retailers and suppliers, but ultimately on consumers in the form of higher prices. 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, also casts a shadow over the reasoning of the Russian lawmakers.

Nevertheless, this is the new regulatory environment for large retailers in Russia. The rules may be the same for all the players but may impact them unevenly due to current market positioning. No single player has anything close to 25% national market share, but Magnit has a large regional market share in southern Russia. Under current regulations, the company is capped at this limit in this region and thus must seek expansion in other regions where its competitors are already firmly established. X5, the national market-share leader, has a more evenly distributed regional presence and, as a result of this legislation, can target competitors that have the new disadvantage of high regional market share.

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,, relies primarily on pick-up points rather than home delivery and still conducts 80% of its transactions in cash. This is largely a question of critical mass. Once electronic transactions and deliveries become more common, faith in their security and reliability will increase. A virtuous cycle would likely fuel very fast growth in e-commerce when the market ripens.

Beyond the practical challenges of segmenting markets and executing e-commerce, Russia’s retail future is in the hands of Generation Y. This population, most of whom have no direct memory of or connection to Soviet Russia, has grown up in an era of rapid economic expansion and an explosion of consumer choice. What social, political and cultural decisions will they make? What does “the good life” mean to them? The retailer that can respond to these needs will have the best chances for long-term success.

This article was written by Marina Donova, Max Horsley and Jonathan Weber, members of the Lauder Class of 2014.