Demographic and economic factors signal Saudi retail market ripe for expansion

Saudi Arabia has a strong base of domestic consumers, strengthened by a growing population of young people and rising disposable incomes. With the sector remaining undersupplied, the opportunities for growth are substantial. While retail sectors in other GCC countries witnessed strong investment and expansion over the last decade, Saudi Arabia remained an underdeveloped retail market – but one that is now beginning to attract greater attention from a number of international brands and mall developers. Greater consolidation has been taking place since large foreign retailers began entering the market in the late 2000s, with licensed retailers controlling a growing share of sales.

Saudi Arabia offers a welcome contrast for retailers used to operating – for example – in the UAE, where they are dependent to a large degree on tourists and transit passengers to maintain growth. The underlying conditions in Saudi Arabia indicate there is a strong environment for retail expansion, including a large demographic base.

“Across the Kingdom we have a population of approximately 30m,” Mazen Qandeel, leasing manager at Hamat Property Company, told OBG. “In the main cities, it is about 13m. So we have 17m people outside these main areas that we can now focus on.” The firm is building mall developments in three regional centres, including the provincial city of Taif.

Standout Indicators

Indeed, the depth and breadth of the market in Saudi Arabia is unique within the GCC region. The population is growing at approximately 2% per year and is expected to reach 40m by 2025. Not only does the country have the largest population in the region, but it is also driven by a young demographic. In 2012, 30% of the population was under the age of 14. Although this figure is predicted to drop to 28% by 2017, it will translate into a larger working age population. In the decade to 2017, the working age population (aged between 15 and 64 years old) is expected to grow by three percentage points to 68%. As such, the majority of retailers will be looking at a growing target market.

It is not the population numbers alone, however, that is creating optimism in the retail sector. Saudi Arabia is viewed as a high growth market because it combines a large population base with growing purchasing power. “Private sector employees have increased by more than 50% as a result of the latest Saudiisation measures. This resulted in an increase in disposable income, which reflects positively on retailers,” Mohamed Tomalieh, a financial analyst and equity researcher, told OBG. “We expect to see double-digit growth at retail companies, especially those selling discretionary products.”

Although the drop in oil prices towards the end of 2014 and the beginning of 2015 has had an impact on economic performance, the private sector nonoil economy has been on a steady upward trajectory in the Kingdom. In September 2014 the HSBC Saudi Arabia Purchasing Managers’ Index, which measures output, prices and employment amongst private sector firms, reached a 39-month peak of 68.1. Although this had slid to 59.1 by October, it remained well above 50, the threshold rating above which the private sector is said to be expanding.

Strong Foundation

The broad expansion of the Saudi economy over the last five years has had a positive effect on the spending potential of the country’s consumer base. As of 2012, Saudi Arabia had surpassed the global average for disposable income, recording a figure of $7500. This is far ahead of the Middle Eastern average and has been increasing at a compound annual growth rate of almost 10%. While this is expected to drop to approximately 6% between 2012 and 2017, Saudi remains a standout country for disposable income in terms of the region and developing countries globally.

This becomes particularly pronounced when the top 10% of households are considered. Saudi Arabia ranks first amongst the largest 20 emerging market economies in this regard, according to Euromonitor International. With a figure of approximately $120,000 per household, the highest earning 10% of households in Saudi Arabia have a comparable income to those in Spain and the Netherlands. Furthermore, with these households only spending 35% of income on the essentials of food and housing, the top strata of Saudi society has substantial disposable income to spend on consumer goods.

The situation is similarly positive in terms of expatriate residents. The Kingdom ranks highest in the GCC in terms of expatriate wages, with an average of $12,126 per month, according to the Gulf Business 2014 Salary Survey. At the same time CEOs and managing directors in Saudi Arabia receive the best remuneration in the GCC region, averaging $22,737 per month in 2014. Salaries for executives and Western professionals, however, have declined since 2013.

The fallout from a weak oil price could reinforce this trend and, consequently, the moderate slowdown may give retailers some pause for thought. However, the slide in the oil price has also had positive side-effects. For the first 11 months of 2014 inflation averaged 2.7%, compared to 3.57% in the same period of 2013. By the end of November 2014 consumer price inflation was down to 2.5%, its lowest level since 2007, according to the Central Department of Statistics. These numbers will certainly be encouraging for retailers and could help bolster consumer spending in an already positive consumer environment. Indeed, in the third quarter of 2014, Saudi Arabia was amongst the top 10 most bullish countries in terms of consumer confidence, according to the Nielsen Global Consumer Confidence Index.

More Mature Market

All these indicators point to a market with strong potential for retail expansion. However, they do not fully capture the changing nature of the domestic retail scene. The success of Dubai, and the UAE retail industry more generally, is having a knock-on effect in the Kingdom.

“We are facing pressure from end-consumers, who are becoming more sophisticated as a result of what they see in the UAE and their travels in Europe and the US,” Qandeel told OBG. “We have to offer this level of experience, otherwise it is a cheap trip to Europe for these consumers.” This suggests the need for a more mature market, with increased demand for the international brands and formal retail settings found in Dubai and further afield.

While retailers and developers have been a little cautious in reacting to these shifting trends, the situation is now beginning to change. “The story we’re hearing from these retailers is that the market in the UAE is becoming increasingly mature and is only sustained by tourists and travellers. So they are really beginning to look at the domestic opportunities in the Saudi market,” Qandeel told OBG.

Store Expansions

A prime example of the push to sophisticate the local market was the announcement in December 2014 by United Electronics Company, a local retailer, that it would open the first Apple store in the Kingdom. Meanwhile, regional retail franchisees, such as Kuwait’s MH AlShaya and the UAE’s Al Futtaim Group, which holds the licence for brands such as IKEA, Carrefour and Toys “R” Us, are eyeing further expansion in Saudi Arabia. AlShaya, which operates a number of leading international brands including Starbucks, Shake Shack, H&M and Debenhams, already operates 600 stores in the Kingdom, and is readying itself for further expansion. As part of this process, the company, in partnership with the Human Resources Development Fund, has agreed to train 8000 young Saudi nationals over the next five years to staff its stores.

AlShaya’s main competitor is the local company group Fawaz Al Hokair. Fawaz Al Hokair manages upwards of 80 brands in Saudi Arabia, including Gap, Zara, Marks & Spencer and Banana Republic. Like its competitors, Fawaz Al Hokair is also embarking on a vigorous expansion programme. For example, in 2015 the company will introduce Gap’s Old Navy Store brand to Saudi Arabia. This follows the SR383m ($102m) acquisition of 42 women’s fashion stores from Al Danah Trading Group in September 2014.

The company signalled its intent to complete the acquisition when it announced plans to go to banks and the markets to seek funding in May 2014. Fawaz Al Hokair was looking to borrow SR1bn ($267m) from the banking sector before issuing its first riyal-denominated sukuk. The funding programme will help finance an agenda that includes 404 store openings around the world in the year up to March 2015, half of which will occur within the Kingdom.

On the back of these plans, NCB Capital stated that the company’s “earnings outlook remains strong, driven by aggressive store expansions and improved margins”. In the first half of 2014, Fawaz Al Hokair recorded a net profit increase of 7.7%, largely in line with NCB Capital’s growth forecast for the company of between 8% and 10% up to 2018.

Indeed, the prospects of the retailer seem to be largely in sync with the wider industry. The Economist Intelligence Unit (EIU), for example, predicts a compound annual growth rate of 7.8% for the sector up to 2018. Growth is likely to occur across the board with retailers from various segments remaining bullish in both the short and medium term. “Disposable income has increased and purchasing power has increased so the fashion segment will pick up,” Jayant Khosla, CEO of Landmark Saudi Arabia, which owns a number of fashion brands, told OBG. “We think the mid-segment brands will grow fastest.” Simon Marshall, CEO of Fawaz Al Hokair, shared this positive sector outlook. “With a young population and a growing number of women entering the workforce, the retail sector in this country is set to boom for the next 10 years,” he said.

Hungry For More

One area that is attracting greater interest is the food and beverage segment. “Fast food dining is where the big demand is,” Abdullah Al Munif, CEO of Al Munif Holding, told OBG. “But scheduled dining is also growing fast because of the lack of entertainment options in the Kingdom.” This is evident with plans for new shopping malls within Saudi Arabia. Qandeel told OBG that a new generation of shopping malls is in the pipeline, including Riyadh Park in the north of the capital, which will have at least 20% of gross leasable area (GLA) dedicated to food and beverage outlets, compared to a figure of 7-10% in existing malls. This is in line with general trends throughout the region. In the UAE, an additional 19,000 food and beverage outlets are expected by 2019, up from 6021 in 2014, according to Euromonitor International.

While the Saudi market is unlikely to experience quite so dramatic an increase, the growth in disposable income is expected to boost the demand for dining outlets, as well as support the growth of other consumer segments. There is a particular need for more supermarkets. Sari Ibrahim Al Mayouf, managing director of the National Agriculture Marketing Company, told OBG, “Compared to its population, Riyadh is lacking supermarkets because retail companies have been investing in hypermarkets to lower the price of real estate. Riyadh with its 8m population has only 1800 supermarkets, compared to Istanbul’s 19,300 supermarkets for 22m people in 2013.” At the same time, the general demand drivers should support the food and grocery sector, a long-time mainstay of the Kingdom’s retail industry. Saudis spend approximately 27% of their income on food, according to the Global Agricultural Information Network (GAIN) of the US Department of Agriculture. With both the population and incomes increasing steadily, food retailers have been reaping the benefits. Food sales in Saudi Arabia are expected to reach an annual figure of $45bn by 2017 (up from $40bn in 2013).

In 2013 the number of food retail outlets in the country increased by 15% to 40,435, according to GAIN. Although the grocery landscape is currently dominated by small-scale shops that account for 55% of all food sold in retail outlets in 2013, this looks set to change. The hypermarket segment, which accounted for 220 outlets and 22% of sales in 2013, is forecast to see rapid growth. Lulu Hypermarkets, an Abu Dhabi-based retailer, plans to open 15 new stores in the next five years, a substantial increase on its existing offering of three outlets.

Strong Growth

Similarly, the Tamimi Market Group has set a target of opening an additional 35 upscale supermarkets in Saudi Arabia by 2020, increasing its total operations within the country to some 60 outlets. According to the regional director for Lulu, Shehim Mohammed, there are particularly attractive retail opportunities outside of the main city centres. “The Kingdom’s smaller cities offer attractive opportunities for expansion, as they are currently under-served. The Kingdom’s border regions are especially interesting, as you have nationals coming from neighbouring countries to buy cheaper groceries in Saudi Arabia,” he told OBG.

Another of the leading local retailers is Al Othaim. NCB Capital forecast strong growth for the company on the back of store expansions around the Kingdom and better terms from suppliers. The supermarket retailer set a target of 15 new stores in 2014, which NCB Capital expected to translate into year-on-year revenue growth of 16.4%.

Mall Development

The strong performance of retailers across a number of sectors is leading to increased demand for dedicated mall space. “There is a dramatic change in the society of Saudi Arabia. It is becoming a consumer society, and retail space offers entertainment in a strict social setting,” Ahmed Bakarman, CEO of Raseel Properties Company, told OBG. Bakarman argues that quality supply is limited, with many street-facing developments failing to offer an appealing retail mix that is accessible without using a car. “Across the whole Kingdom, there’s potential for retail development,” he says. General visitor numbers in existing space seem to bear this out. In 2014 Hayat Mall and Panorama Mall, two of the most popular retail spaces in the capital, achieved footfalls of 10m and 6m, respectively.

According to JLL, there are currently 1.4m sq metres of GLA in Riyadh and 923,000 sq metres in Jeddah. In both cities, available supply is tightening, with retail vacancy rates falling by two percentage points year-on-year to 10% in Riyadh in the fourth quarter of 2014 and by one percentage point to 7% in Jeddah in the same period.

As such, both markets have substantial supply in the pipeline. In the capital, an additional 893,000 sq metres of space will enter the market in the next three years, while in Jeddah, an additional 296,000 sq metres will be brought to the market.

However, it is not simply about the volume of supply. “If you are building a mall in the main cities it has to be to a high standard and differentiated. But in the secondary cities it can be just a standard mall,” Qandeel told OBG. In the capital, for example, new mall developments are focusing on additional entertainment and food and beverage space, unique design, and an attractive tenant mix, including international brands new to the Saudi market, such as Galleries Lafayette and House of Fraser. “Existing malls in the south and south-west of Riyadh are less in demand and with new projects coming into the market, these malls will be affected in 2015 and 2016,” Qandeel told OBG.

Indeed, new mall space is expected to command a premium in the short term. Qandeel estimates that new retail space will command a 25% increase on existing rental rates in popular malls, such as Panorama Mall and Hayat Mall. In the fourth quarter of 2014, average rental rates in existing large-scale malls in Riyadh increased year-on-year by 2% to SR2836 ($756) per sq metre, according to JLL. In Jeddah, rents increased by some 10% to SR2990 ($797) per sq metre during the same period. Rental rates in the new Riyadh Park Mall, which is expected to open at the end of 2016, are forecast to range from SR2700 ($720) per sq metre to SR5000 ($1333) per sq metre. However, given the large inventory of supply in the pipeline in Riyadh in particular, rental rates could come under pressure in the medium term.

“I’m afraid that after a couple of years, supply will be huge and rents will soften,” Bakarman told OBG. “It will be the brands determining the rental rates in three to four years.”

Although the retail outlook remains positive, there is general agreement that supply will help to dampen rates moving forward. “The supply of commercial area in the pipeline is quite large, specifically in Riyadh. This is expected to lead to an increase in vacancy rates,” Tomalieh told OBG.

The existing rental environment presents a challenge for many retailers in the Kingdom. In some cases, rent is reaching up to 25% of sales revenue for tenants, although in the fast food segment it reaches a more manageable 15%. As the market matures, this situation should improve and mall operators and tenants may move towards revenue sharing agreements as a means of mitigating retailers’ risk. In the shorter term, however, rental outlay will remain a challenge. “The transparency of sales revenue from retailers here is very low. They refuse to divulge revenue and every time we increase the rent we are shooting in the dark,” Qandeel told OBG. “Accepting a concept of base rent and then a percentage of sales will take time. We’re doing this in very few cases and even anchor tenants are not leasing on a revenue sharing basis yet.”

Challenges

Beyond leasing terms, the main challenges for retailers are new operating regulations and labour issues. The Saudi cabinet is currently considering proposals to impose a new mandatory closing time of 9.00pm for retail outlets in the Kingdom. Such regulation would likely have a dramatic impact on retailer revenues. However, many retailers are remaining sanguine about its potential impact.

“Shopping habits in Saudi mean most people shop after 8.30pm, so habits will have to change to accommodate these regulations. We may be affected in the short term, but in the long term it will work itself out. We might see greater volumes on weekends for example,” Khosla told OBG.

A greater challenge is the government push for Saudiisation, or the replacement of expatriate workers with Saudi nationals, in the retail sector. Farouk Miah, head of equity research at NCB Capital told the local press, “We believe a slowdown in growth will continue to be recorded in the next few quarters due to the negative short-term impact of Saudiisation. These include 1m fewer expatriates, a slowdown in new store openings and higher staff costs for companies, leading to pressure on margins.”

One consequence of the shift away from an expatriate workforce is an increase in the cost of labour for retailers. “The main issue is labour sourcing and the price of labour, which has almost doubled in the last three years,” according to Al Munif. However, in the longer term, a push for Saudiisation could have a positive impact in the retail segment, supporting the general trend towards increased salaries and consumer power in the Kingdom.

Outlook

In all, the general mood in the industry is one of optimism. The fundamental conditions for retail growth are currently quite strong, despite oil price declines. While a prolonged oil price slump could hurt the economy, in the short to medium term the prospects of a young population and growing disposable income are leading to rapid retail expansion in the Kingdom. With international players and brands eyeing the under-served market, and mall developers bringing new space to the cities, the outlook is positive for all segments of the market.