Economic Cycle – New Chapter in Retail

The long-term opportunity for modern retail in India was keenly questioned over the past fiscal as incumbents weathered a cyclical economic slowdown. As with any cycle, some players emerged as winners while there were some survivors and a handful of bankruptcies.

Organized retail in India is beset with certain structural issues, which were sharply exposed in the economic downturn. Primary concerns are with retail cost structures – viz. 1) the investments in store capex, and 2) inventory holding costs (a reflection of hyper growth and limited logistics support) and poor working capital management.

Going forward, two key trends are emerging in the Indian retail segment,

Consolidation At a macro level, expectations – and forecasts – have become far more realistic even at the cost of scaling down their store opening ambitions.

Additionally, smaller formats have been increasingly pressured by larger formats for two reasons: A) larger formats are typically in malls – the bargaining power is with the retailers, rather than the mall developers, given the oversupply of malls/developer-related crises. B) Smaller formats (notably convenience stores) have to compete for retail space with banks, kirana stores (indigenous retail format), auto retail, et al.

Franchising is becoming a preferred model for growth, but only for the smaller players that have relatively weaker balance sheets. Shoppers Stop and Pantaloon are certain that they need to control the front end and the overall shopping experience. Given their relatively stronger balance sheets, they see little need to resort to franchising. For the smaller players, especially in convenience stores and also mono line retailing (e.g., Koutons) franchising has several advantages: a) Pilferage, which is typically around 2% of revenues, declines with the franchisee model.

Working Capital Management: The working capital/sq foot for modern retail in India is almost US$30/sq foot – extremely high vs. formats in Asia where the rates range from US$3-7/sq foot. This is essentially on account of: A) Because of inter state taxes, there are more in-state distribution centers, which results in inventory levels being higher than required. SKU variety is greater than required, essentially to cater to very diverse customer tastes and preferences. Over the last 2-3 years, overall supply chain costs have declined from ~2% of revenues to around 1% of revenues, but it is difficult to envisage them declining further, given the market structure in India.

The confluence of low asset turns and low margins has resulted in sub-optimal returns on capital employed for Indian retailers. With the introduction of uniform GST and other measures by the Central Government, hopefully things will improve for retailers.