Prosperity Analysis, 20 Feb 18

Founder exits 29.1% stake in Magnit to VTB

The Russian investment and food retail communities were left surprised by Mr Sergey Galitskiy’s announcement on Friday 16 February 2018 that he would sell a 29.1% stake in Magnit to the Russian state-owned bank VTB for RUB 138bn (c. USD 2.45bn).

Following the transaction, Galitskiy will retain only a 3% stake in his food retail juggernaut and will have no formal involvement in the businesses’ operations.

Galitskiy has gained somewhat of a cult-status in Russia, having grown the company that he founded in 1998 and took public in 2006, into one of the country’s leading food retailers. By 2015, Magnit was delivering RUB 55bn (over USD 1.1bn) in net income and since 2012 the company has been paying out substantial dividends, with a payout ratio in the region of 40% to 60% generating over USD 2bn in dividends for investors in the period between 2012 and 2017.

Amongst Russia’s wealthiest, the self-made multi-billionaire Galitskiy used his proceeds not only for private consumption, but also in the focused development of social projects in his and Magnit’s home city of Krasnodar, including the founding of a youth football academy, the development of a stadium and considerable investments into the city infrastructure.

Whilst generally well-managed, Magnit was not a perfect corporate governance citizen. When the company floated, Galitskiy agreed that Mattias Westman, Prosperity’s founder, should join the Board of Directors, but in those duties, it soon became obvious that Galitskiy had little interest in the company having a properly functioning Board of Directors and as a result Mattias left that post in 2010, with no real evolution of this structural weakness at the company since. Nevertheless, as long as the market allowed and the management team remained intact, Magnit developed reasonably well - until a few years ago, the company enjoyed the highest margins and return on capital amongst its peers.

The January 2016 departure of Mr Vladimir Gordeichuk, Galitskiy’s long-standing business partner and Magnit’s de facto CEO, proved to be somewhat of a watershed moment. In a meeting with Galitskiy a few months following Gordeichuk’s refocusing on investments into medical healthcare, we were told that Galitskiy felt the need to return to the day-to-day operations of Magnit and that whilst he undertook a search for a replacement CEO, the business would be led by two of his deputies, the company’s former CFO and its head of sales, under Galitskiy’s daily supervision. It is now obvious that that strategy did not work. Magnit’s net income has fallen by c. 30% over two years, despite the company's growing sales by 20% in that time. Whilst part of this deterioration can be attributed to more aggressive competition and a then weaker macroeconomic backdrop, the largest share is apportioned to poor management decisions.

A few months ago, Galitskiy admitted as much, noting that Magnit’s dual management structure and limited Board of Directors supervision were a clear error of judgment. It was our understanding that Galitskiy was considering a radical reshaping of the organisation, with a view to turning Magnit around and regaining its lost customers. In the end, however, it would seem that Galitskiy was unwilling to undertake this naturally challenging and time-consuming process and that he elected to sell the company instead - a decision that we find to be regrettable.

VTB has had a long involvement with Magnit from both an equity and debt perspective. Indeed, Galitskiy joined VTB’s Board of Directors and certain VTB personnel have previously served on Magnit’s Board of Directors. VTB itself is a fairly weak bank with suboptimal returns that has consumed considerable state capital. It has built itself on the model of Goldman Sachs or Deutsche Bank with ambitions to develop private equity alongside commercial banking. In fact, VTB’s private equity team is known to have made a certain number of good investments and exits, though these are not comparable with the group’s overwhelmingly negative experience in industrial assets, such as gas and telecommunications.

Viewed from VTB’s perspective, Magnit can be seen as a turnaround candidate entered at a fairly low price (we estimate that the company was bought at c. P/E 12x) that could well prove to be a good investment with the introduction of enhanced management, a serious Board of Directors and the provision of financial resources for industry consolidation. With that said, there are of course risks; VTB has limited retail experience and the failure to properly reform management and governance, the introduction of unnecessary bureaucracy, misallocation of capital in expensive acquisitions and complicated partnerships, for example, could well lead to further deterioration at Magnit.

Whilst state-owned companies are not always efficient operators, in Russia there are now plenty of success stories, like Aeroflot and Sberbank which are world-class businesses. However, one can also bring to mind the case of Tele2, acquired by VTB from Kinnevik in an attempt to develop a fourth telecommunications operator, which is a rather sad three-year long investment story for the Russian state bank.

It is worthwhile noting that we regret the structure of the transaction, which sees VTB acquire a stake marginally below the mandatory tender offer threshold of 30%. Whilst no rules have been breached, there are certain murky elements to the process, including the stated timeline of negotiations and the (at the time confusing) accelerated capital increase of USD 800m that saw Galitskiy’s then 36% stake in Magnit reduced to 32%, with the proceeds eventually being allocated to repay debt to VTB rather than the reasoned enhanced CAPEX stated at the time of the SPO. Whilst within the letter of the law, it does cast somewhat of a corporate governance shadow on those involved and it will therefore be important that the over 70% free float investors in the company seek to ensure that proper governance standards are upheld going forward, with the implementation of a strong Board of Directors being a priority for the business in our view. We are watching closely.

Prosperity’s investment in Magnit is rather small, less than 2% of firm-wide assets.