Outlook on the retail sector for 2007

2007 will be a year of expansion and growth for the organised retail sector, from both existing and new entrants. The economic outlook for India remains strong, supporting continued growth in incomes and positive demographic shifts. In order to take advantage of this growth, retailers across categories are ramping up their store networks aggressively. With shortening investment cycles, leading retailers are set to embark on aggressive expansion plans over the next two to three years in order to maintain market dominance.
Companies are consolidating their presence in existing locations and moving into smaller Tier II and larger Tier III cities, while regional players are attempting to expand their geographic footprint. Many firms are also attempting to establish a foothold in new sectors, pre-empting their competitors and stealing an advantage.

2007 will also see retailers strengthening operational strategies to differentiate themselves from competition and retain customer loyalty. A key difference between this and earlier investment cycles is the increased focus on developing the supply chain, measures that will benefit the sector as a whole.

While the potential tightening of consumer credit markets has been highlighted as a threat to this growth, other potentially limiting factors include the continued lack of availability of quality retail space, paucity of quality manpower and a need for greater legislative changes, such as uniformity of state-level taxes.

Food and groceries to see strong competition

The three nameplate entries into organised retail - Reliance Retail, the Aditya Birla Group and Bharti Retail (through a 50:50 joint venture (JV) for supply chain and a wholly-owned front-end) with Wal-Mart Stores Inc ('AA'/Stable/'F1+') - have all chosen the food and groceries category as their debut sector. This is due to the easy scalability of network and operations and the substantial opportunity in this space.

This segment has the lowest penetration of organised retail (estimated at 1%), and therefore the highest supply chain inefficiencies. It is also less susceptible to cyclical fluctuations as it follows the basic, more stable demands of consumers. These three retailers have all chosen the "small box" format for their preliminary entry into the sector, using this to establish their supply chain network.

Having established themselves in this sector, these new entrants have plans to enter the hypermarket format as well. Existing retailers, including Subhiksha (discount supermarket), Piramyd (Trumart), Godrej (Nature Fresh), RPG Retail (Spencer's Daily, based in the south), Nilgiris (supermarket, based in the south) and Pantaloon Retail (India) Ltd (Big Bazaar and Food Bazaar), have all announced large investments over the next few years. However, increased competition in this field is unlikely to have a major effect on broad-level operating metrics of existing retailers in the immediate-term, given the low penetration of organised retail.

That said, in larger cities where penetration levels are higher, losses at the store level could result from growing competition and higher operating costs.

However, given the substantial opportunities available in the Tier II and Tier III cities, the full effect of competition will only be felt in the medium- to long-term. Retailers will find it necessary to have at least a limited presence in larger cities despite higher costs, primarily for strategic and brand purposes.

Over the medium term, hypermarkets will have more competition. The Indian market is large enough to support around four to five major players, though survival will depend on retailers' ability to deliver tangible value to the customer and their supply chain efficiencies. Maintaining lean operating levels will become increasingly critical, and are required to manage margins. The longer term could also see a scenario of margins shrinking as growth rates slow.

Supply chain improvements

The supply chain will see substantial investment over the short-term. Reliance has announced plans to invest up to 25% (over Rs 6,000 crore) of its retail investments in improving its supply chain while the JV between Wal-Mart and Bharti Retail is focused solely on supply chain, with the front-end being owned and managed by Bharti to ensure compliance with prevailing regulations. These investments, coupled with those of existing retailers, will result in a marked improvement in the supply chain, facilitating higher efficiency, better inventory management, and lower waste. The food and groceries category, which is one of the most fragmented, will benefit the most from these initiatives, enabling retailers to offer better prices to customers and suppliers alike. With regards to other categories such as durables and apparel, Fitch expects a greater focus on private labels for the purpose of margin enhancement. Another noticeable trend is the focus on improving store-level operations, for example, in visual merchandising and point-of-purchase. These customer-facing developments are designed to improve the retail experience, with the ultimate goal of boosting loyalty and repeat visits.

Real estate pressures to continue

The substantial increase in real estate costs has impacted margin growth for retailers across the board. However, leading players have tried to mitigate the impact by:

• Advance real estate booking at lower prices;

• Revenue sharing pricing with fixed and variable components;

• Negotiating advantageous rates from real estate providers using their "anchor tenant" status.

Retailers must also compete for quality retail space, which remains in relatively short supply.

While many large new retail real estate developments have taken place recently, many of the new malls have been ill-planned, and created with a view to quick profits through sale, rather than long-term sustained revenues through leases. As a result, some of these malls are already witnessing a decline in footfalls. With the creation of 150 million sq ft of retail space, provisionally scheduled for 2010, and with the increased contributions from reputable builders, Fitch anticipates greater availability of quality retail space in the medium-term. However, to meet the current expectations of 12-15% penetration and to support an ongoing growth rate of around 30-35%, the required real estate for the organised sector alone is estimated to be around 400-450 million sq ft. To meet this figure, the sector would need to invest between $8-10 billion, in addition to ongoing expenditure. As a result, we expect the availability of retail space to remain a constraint for retailers, continuing to impact margins in the near term due to the expectation of firm prices in the short- to medium-term.

Acquisitions and expansion

For the first time (barring the small acquisition of Fabmall by Trinethra), the Indian retail sector has also experienced M&A activity over the past six months. New entrants are finding it easier to pay a premium and acquire regional players in order to rapidly scale up their operations and establish a footprint in the sector. Examples include the recently concluded acquisition of Trinethra by the Aditya Birla group and the acquisition of Nilgiris by a private equity fund. Market sources indicate that other regional players could also be looking to exit the market in light of increased competition and the attractive valuations which currently prevail.

It is believed that this activity will intensify in the longer term, once the impact of higher penetration and slower growth rates is felt. In the interim, existing mid-sized players are expanding to gain the maximum footprint possible in the shortest time frame using routes such as the capital markets.

An example can be seen in Vishal Retail which plans to raise Rs 110 crore from its proposed initial public offering (IPO), while Pantaloon Retail (India) Ltd 'F1 (ind)' has raised funds through the sale of equity in its Home Solutions Retail Ltd to private equity funds. Existing retailers are expected to also raise additional debt to finance their expansions, likely to result in higher gearing, partly offset by the higher earnings expected from these investments.

Source : Financial Express