During a recent research trip to Russia, we gained valuable insights into the country’s new economy. As the nation’s economic recovery begins to splutter despite a backdrop of higher oil prices, we ask: can Russia’s tech sector provide much-needed balance to the economy?
Cyber-espionage accusations against Russia, state sanctions and poor governance have dominated news flow in recent years. The fundamentals of the country’s technology sector have been overshadowed by the state’s alleged interference in the 2016 US presidential campaign and hacking of state secrets and corporations.
Russia’s tech sector pales in comparison to the country’s oil and gas industry in size, which produced an average of almost 11m barrels per day in 2017 – the highest level since the collapse of the Soviet Union in 1991. But despite higher oil output and prices, the country’s economic recovery from its 2015-2016 recession remains anaemic. Russia’s economy grew 1.5% in 2017, undershooting its 2% target, after industrial production unexpectedly fell in November due to a slowdown in Russian defence spending. Consensus forecasts point to 1.9% GDP growth this year. Furthermore, at 7.5%, the Bank of Russia’s key interest rate further constrains growth.
We have followed and invested in the Russian stock market throughout cycles. During a recent research trip to Moscow, we visited technology companies that we view as competitors to current holding Mail.Ru. Looking beyond persistent headlines of alleged hacking and oil- and gas-driven growth, we found a burgeoning tech sector.
Mail.Ru: ‘Russia’s Tencent’
Mail.Ru spans social networks, advertising, online gaming and food delivery, and it has often been compared with Chinese tech conglomerate Tencent, which is one of its shareholders.
We previously had a position in Mail.Ru from September 2013 to December 2016. In February 2017, we decided to initiate our current position in the company, due to its exposure to structural trends such as increasing mobile and fixed data usage, a shift from offline to online advertising, and developments in artificial intelligence. Since then, Mail.Ru has delivered a total return of 49%, outperforming the benchmark MSCI EM index by 16%.
Figure 1: Mail.Ru’s performance versus the benchmark MSCI EM index since February 2017
Source: Bloomberg as at January 2018
The migration of online advertising from search to social media has helped Mail.Ru outpace the growth of its main rival Yandex. Its social network is enjoying a healthy increase in average revenue per user and the group is launching new video games in both domestic and international markets. In addition, Mail.Ru is diversifying further by entering the rapidly growing esports market.
With more than 200m esports enthusiasts around the globe, the industry has experienced a meteoric rise in worldwide popularity in recent years. Global esports revenue reached $1.5bn in 2017, and the industry’s growth shows no sign of slowing down: revenue is projected to reach $1.9bn by 2020 as esports attract a more mainstream audience.
Recently, Mail.Ru announced its acquisition of ESForce, one of the companies we visited during our research trip, for $100m less any outstanding debt and a further KPI-related payment of $20m at year-end if specific financial targets are met. ESForce owns esport cyber-games clubs, an esport arena, and an eplaying room. It derives its revenue from advertising, arena tournament ticket sales, sponsorship deals and merchandise sales.
ESForce’s potential synergies with Mail.Ru’s gaming business were – and continue to be – evident. Therefore, we were not surprised by the recent acquisition.
ESForce’s esport tournaments have the potential to extend the shelf-life of Mail.Ru’s own video games’ popularity beyond the industry average of three years and to appeal to players of other games. For this reason, the tie-up should prove beneficial.
Following the acquisition of ESForce, Mail.Ru will now focus on its next phase of growth. These plans are likely to include:
- Youla, the group’s consumer-to-consumer advertising site, which posted a 10% uptick in monthly active users in Q3 2017 compared to the previous quarter;
- Beepcar, its ride-sharing venture, which enjoyed a 121% increase in the number of app installations in the third quarter of 2017; and
- Delivery Club, Mail.Ru’s meal-delivery, which recorded an 84% year-on-year increase in the number of monthly orders in the third quarter of 2017.
However, many analysts do not assign any value to Delivery Club, despite its impressive rate of growth, citing its status as a start-up. But they should look west to learn how fast these businesses can grow: London-listed takeaway app pioneer Just Eat has a market capitalisation of £5.5bn, having floated at £1.6bn in 2014, and Delivery Hero is worth about €6.2bn.
Furthermore, Mail.Ru is considering acquiring a minority stake in Fasten, Russia’s largest taxi-hailing company by the number of rides. There are potential synergies with Mail.Ru’s VK, OK, Maps.me, Delivery Club and Beepcar. However, Fasten is currently under investigation by the anti-trust authority. Meanwhile, rival Yandex.Taxi has a market share of about 11% but recorded a loss of $56.3m in 2016. These figures suggest that profitability might not be an imminent feature for Fasten, despite sales of $30.2m.
A new breed of tech companies
Other companies that we identified during our research trip compete with Mail.Ru in the following segments of the Russian tech sector:
Food delivery: One of the competitors we visited was Foodfox, a food-delivery company which delivers from more than 2,000 Moscow restaurants. It is similar to Deliveroo, Just Eat, or Delivery Hero in Europe. In late December, Yandex.Taxi, a subsidiary of Yandex, announced its purchase of Foodfox.
The food-delivery sector faces obstacles in Russia, including adverse weather as deliveries are usually made on foot due to snow and traffic congestion. Customers do not pay for the delivery; restaurants bear these costs, enabling the delivery companies to compete on costs. Foodfox currently charges restaurants 30% of the food order, contrasting with Delivery Club which charges between 20% and 25%.
Taxi hailing: In Russia, online cab-hailing companies have claimed a 15% share of the total taxi market. There are a number of app-based taxi-hailing companies operating in the country, including GETT, Yandex.Taxi, and Fasten, and they are all expected to continue growing rapidly. Chinese giant Didi might also consider entering the Russian market through investments in a local player.
During our trip, we met Shahar Waiser, global chief executive of GETT. The on-demand taxi app plans to undergo an IPO in two-to-three years’ time. Sales have reached $150m and the number of its drivers is growing at an annual rate of 40%. However, GETT is profitable in just one country – Israel, where it launched in 2011. Furthermore, Waiser believes driverless cars could transform the future of on-demand taxi apps, predicting a 40% fall in the price per ride.
Mobile: Megafon is a telecommunications company which also offers mobile banking, remote medical advice, Netflix-like television packages and a messenger app. It has evolved with customer preferences and, as such, offers solutions required by the new economy. Megafon also has a stake in Mail.Ru, allowing it to follow technology trends very closely.
During our research trip, we met with the new solutions team at Megafon. It launched a television service, akin to Netflix, one year ago. Today, there are 3m registered users paying 10 cents per day – and it is profitable. The group’s banking arm boasts 250,000 users, while customers can also subscribe to a health service that provides medical advice remotely within 15 minutes. This service has a monthly charge of $2.70, and rivals Yandex’s Doc+. However, Doc+ charges $8.90 per call and provides access to 200 doctors, compared to Megafon's offering of 1,000 doctors from across a variety of disciplines.
Balancing oil with tech innovation
Russia’s economic health has long been determined by swings in energy prices. Diversification is key to the country’s prosperity, particularly in a world where the role of energy in GDP growth is diminishing.
Today, technology is vital to the nation’s economic growth. Greater consumption will make the economy less reliant on oil. For investors, however, the question remains: can Russia diversify?
This, of course, hinges on opportunities outside the oil and gas industry. At Hermes, we believe the tech sector in Russia shows promise. Tech companies are evolving with customer needs and preferences and offering services required by the new economy. It is therefore possible that that the tech sector may play an integral role in the nation’s diversification.