E-Commerce in Russia — the Outlook for 2015

At the precipice: Russia's e-commerce outlook for 2015

At the precipice: Russia’s e-commerce outlook for 2015

The collapse in the Russian ruble which occurred in late 2014 and the forthcoming dislocations in the Russian economy as a result of externally- and internally-imposed sanctions will undoubtedly have a strong impact on the Russian e-commerce market in 2015 and beyond.

As digital marketing consultants and operators of several Russian e-commerce projects, we have observed the initial impacts first hand.

Below, we briefly outline the trends and expectations for the short-term in various sub-sectors of the Russian e-commerce market.

Economic backdrop

From a macro perspective, the major challenge for the Russian economy is the ban imposed on US and European banks from extending long-term credit to Russian borrowers. There is simply not enough capacity to replace these banks with alternative lenders from Asia or other regions. Ultimately, the Russian central bank will have to step in, in order for these companies to pay off their foreign debts, and will thus force a major decline in Russia’s official foreign currency reserves. That is, it will be the case if the Russian corporate borrowers don’t default directly. They are basically dependent on the Russian state to bail them out, at least for those highly-leveraged borrowers such as banks which don’t have the ability to pay off their debt from internal resources. The Russian government may well make selective rescue efforts or at the very least put pressure on foreign lenders to share in the pain. Either way, liquidity will be scarce in 2015.

However, as a nation Russia is eminently capable of weathering this economic storm. The country remains a net exporter and does not have material foreign currency debt at the sovereign level. The modern Russian state has faced far more severe economic shocks. Indeed, there is historical precedent to fairly reliably understand the impact on retail and consumer behaviour.

The impact on Russian e-commerce

In the short term, Russian consumers are seeking to lock in some kind of value for their rapidly-depreciating rubles. The preferred store of value has traditionally been capital assets such as foreign cars and big-ticket items like furniture, although more recently imported electronics such as iPhones and iPads have been very popular too, especially since Apple and their local dealers did not react quickly to update ruble prices with current exchange rates.

Referring specifically to e-commerce, the economic shock will have an uneven impact on e-commerce sellers depending on their business models.

1) Cross-border sellers

Major cross-border sellers such as ASOS, Yoox, Amazon, etc. do not price in Russian rubles but rather convert their base currencies to rubles at the current exchange rate solely for the informational convenience of Russian shoppers. Many cross-border sellers from the US use BorderFree’s software to perform these calculations automatically, and thus their prices are “marked to market” daily. The underlying transactions are in foreign currencies and Russian buyers pay at the exchange rates charged by their banks or credit card providers.

These types of sellers will be losers in the short-term, even moreso if the products they sell are also available from local (Russian-based) retailers. A major reason why Russians shop on foreign websites is for the cost savings on equivalent items — they are able to save the 18% Russian GST and also benefit from the EUR1000 exemption in import duties.

At this time in the purchasing cycle the local sellers have the advantage because they have generally not adjusted prices on their existing inventories to reflect the ruble devaluation. Thus, there are temporary anomalies in prices for equivalent goods, which Russian consumers are exploiting. However, as Russian-based retailers replenish stock in future these differences will dissipate and cross-border e-commerce sellers will once again have the upper hand in selling branded goods.

Given that Russian consumers’ foreign currency buying power has basically been halved, lower sales are expected for both cross-border and local retailers of foreign branded goods, particularly in the luxury sector.

Another consequence is the relative gain by Chinese e-commerce sellers. While they don’t supply equivalent goods, their lower prices are still advantageous compared to US and European online sources. While Chinese sites have always been popular with Russian buyers, Chinese online sellers have taken an even greater share of the Russian online retail market in 2014, with AliExpress ranking as the #1 e-commerce site for Russians, ahead of any of the local players.

2) Local sellers of imported soft goods

Local e-commerce retailers like LaModa and KupiVIP which focus on soft goods have invested heavily in warehousing and logistics in Russia, in the belief that these would constitute lasting competitive advantages versus cross-border sellers.

Not only have they tied up capital in physical facilities, but they are also “traditional” stockists in the sense that they employ buyers and commit to seasonal bulk purchases, and must then clear and store their goods in Russia. In this sense, the online retailers of soft goods are very similar to their physical retailing counterparts, many of which are experiencing severe disruptions in their operations as the ruble crisis affects their ability to plan.

Since the purchase terms for imported goods generally mandate cash at shipment point, in the short term these sellers have locked in their purchase costs at historical ruble rates and can sell without raising ruble prices and still show a trading profit on their acccounting books, although in economic terms they are surely losing on the plummeting ruble value of their inventories. In the short-run, as with the physical retailers, online sellers benefited from a surge in sales. But once their stocks wind down, they will have to confront the new reality that mainstream Russian consumers can no longer afford the brands they have come to adore. This is now the case.

Another big pressure point for these sellers is their dependence on foreign capital. None of these companies are profitable (in terms of net income) and they have raised large rounds of foreign venture capital to subsidize their operational losses and invest in fixed assets and customer acquisition. To sustain their operations they will have to look to Russian investors, while also undertaking restructuring to focus more on cash flow rather than growth.

3) Local sellers of imported electronic goods

Electronics and computers constitute the largest segment of the Russian e-commerce market.

Russian e-commerce retailers focused on this segment, like Ulmart and Utinet, are some of the largest online sellers in Russia. In line with the “durable” nature of their products, they have experienced a surge in sales in 2014. To a large extent, this short-term buying will displace sales in 2015 because they were largely driven by panic buying.

The large physical retailers such as M.Video and Eldorado have agreements with the Russian distributors of major electronics brands which essentially guarantee them a margin regardless of the ruble exchange rate. While they contend that the exchange rate risk has effectively been offloaded to the distributors, it remains to be seen whether any of the distributors have been caught with an unhedged exchange rate risk. This could possibly disrupt the market for certain brands but would be isolated to those distributors who had been taking risks with their financing.

The outlook for Russian Internet stocks

Advertising-driven stocks like Yandex and Mail.ru have been buffeted in recent years by well-funded local and international players channelling money into customer acquisition campaigns. This momentum is now reversing. While overall traffic growth will not taper off, the prices that advertisers are willing to pay certainly will.

This has a dual effect on offshore investors — profits translated into US dollars or Euros will essentially be cut in half purely as a result of the currency devaluation. At the same time, advertising rates in local currency terms are also poised to fall, as the the major players take a pause to understand how the market will stabilize and as the “hot” money which has been pouring into Russian customer acquisition and brand building dries up.

Qiwi, as a financial services and marketing company, will also face profit pressures but not nearly to the same extent as the more advertising-driven players. A big portion of the company’s business is “cleaning” cash generated outside of the formal economy by Russians and migrant workers from Central Asia. While the ruble payments processed through Qiwi kiosks will not decline, once the accounting figures are translated into foreign currency for Qiwi’s financial reporting, the company’s aggregate revenues will show a substantial decline. The ancillary revenues which the company has been developing (such as advertising) will also suffer in the same manner as Mail.ru and Yandex.

As the chart below shows, the stocks of Yandex and Qiwi took a severe beating in 2014, with Yandex down 59% and Qiwi down 63%. The chart also compares their performance to Baidu (the leading search engine-based company in China) which was up 23%, and global Internet stalwarts Google (-10%) and eBay (+5%).

russian internet stocks vs international peers

(click to enlarge)

 

Venture investing in the Russian e-commerce sector

The big players in the Russian e-commerce sector — Ozon, KupiVIP, Ulmart, and LaModa have all raised substantial venture capital funding.

While these companies don’t have debt per se, they will face a less enthusiastic investor base and there is a possibility that those with weaker finances will be forced into seeking to sell or otherwise realize the value of their customer database.

LaModa is part of Rocket Internet AG, which went public in Germany in October 2014, so their operating metrics will be publicly disclosed going forward. It will be very interesting to observe how the Russian economic crisis has affected their growth and overall profitability.

It’s quite likely that we’ll see consolidation in the Russian e-commerce space as a result of the market dislocations of 2014. As the saying goes “… when the tide goes out, we’ll see who’s been swimming naked”.

The upshot

The secular drivers of the Russian e-commerce market’s positive outlook — increased broadband penetration, familiarity and comfort with online shopping — remain in place.

However, the purchasing power of Russian consumers has been significantly curtailed, and this will have an impact on overall e-commerce market growth until the situation in the economy stabilizes.

For the time being, Russians have not cut back on their online or offline purchases — quite the opposite. But this is a short-term effect, fostered by a fear of loss in purchasing power.

An important offsetting factor is that Russian buyers will now have a greater incentive to shop for better values, which will lead to greater awareness and activity for online retailers which can adapt by offering a value-oriented range of products. We see this effect already, in the prominence of Chinese e-commerce sellers.

Unlike in other sectors of the Russian economy where the lack of foreign buying options will encourage domestic production, the retail sector suffers from a lack of Russian manufacturers and desirable brands. Multinational corporations operate Russian-based factories in the food, consumer products, pharmaceutical and automotive sectors. Apart from the food sector, these factories largely rely on imported inputs and thus there is limited scope to gain a competitive advantage by producing locally.

Russian epiphany ice dip

Is now the time to dip your toe into the Russian e-commerce market?

Is now the time to commit new investments to the Russian e-commerce sector? The answer largely depends on valuations and time horizons. It is certain that Russia will be the most significant consumer market in Europe and brand building will be less costly now that new foreign companies are hestitating to enter or expand their presences.

Large foreign companies such as Amazon, which have been eyeing the Russian market, may be presented with acquisition opportunities of local companies facing a crunch in their finances.

At the same time, companies looking at new international e-commerce markets will have difficulty justifying why they should invest in Russia as opposed to other large emerging markets such as China, India or Southeast Asia, which are not experiencing anywhere near the economic and political uncertainties of Russia, and which hold the promise of far larger total market sizes. Ultimately, Russia’s e-commerce opportunity (vis-a-vis other emerging markets) is limited by the country’s relatively small population, high transportation costs, and weak business/legal environment.

About Leighton Peter Prabhu

I am a partner in Interstice Consulting LLP and head of the Russian office. My practice focuses on e-commerce business and marketing consulting, especially for foreign e-commerce brands entering the Russian market. I also serve as a consultant to some of the largest international portfolio investors in Russian equities (both public and private). You can find out more about my background and business interests on LinkedIn. You can also connect with me on Twitter and on Google+.

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