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Retail - India
FDI in retail – arriving soon at
a store near you?
Foreign retailers participation in India to be a positive
With the gov’t of India (GoI) keen to allow Foreign Direct Investment (FDI) in
multi-brand retail, we analyze the likely impact of this move, using Porter’s Five
Forces and a China case study. We conclude that a phased entry of foreign
retailers, in partnership with Indian retailers, would be positive. It would accelerate
growth by infusing foreign capital and expertise and give time to Indian retailers to
scale up before the sector is completely opened up. The increase in the cost of
doing business from higher competition should be offset by improved profitability
and higher returns, riding on combined scale, experience, and systems and
processes of foreign and Indian retailers.
Current regulations: Limited participation allowed
Currently, in India, FDI is allowed up to 51% in single-brand retail and 100% in the
Cash and Carry format. Foreign retailers are not allowed in India to operate multibrand
retail outlets. This restriction has severely restricted the presence of large
global retailers like Wal Mart, Tesco and Carrefour, which are present only
through a few Cash and Carry stores. Also, the restriction on Foreign Institutional
Investors (FIIs) limits their holdings to 26% in a listed multi-brand retailer in India.
Expect opening up of sector in a phased manner
We believe that, initially, the modern retail sector will be opened with certain
restrictions, like: 1) only a JV with local retailers, capping the FDI holding to
49/51%; 2) limited segments like Food; 3) Minimum 50% of investment on setting
up back-end supply chain (Cold chains, warehouses, etc.), 4) Cities in which
foreign retailers can come in (e.g., 40 cities with population of more than 1mn),
and 5) a minimum percentage of sourcing would have to be from domestic SMEs.
Rise in competition not to hurt as growth picks up as well
We expect this move to drive growth in modern retail will ride on the capital,
expertise and aggression of foreign retailers. This should help the sector to realize
its potential of becoming a US$250bn industry by 2020 vs. the current US$10bn
size. So, while increased competition should raise the cost of doing business
(rentals and staff costs) and lead to market share fragmentation, it should also
improve profits by providing scale from a manifold increase in market size,
bringing in back-end efficiency and providing better bargaining power with
suppliers inherited from global relationships.
Pantaloon Retail should be a key beneficiary
We see Pantaloon Retail as an excellent Investment on this potential regulatory
change. It should benefit from potential partnership with a foreign retailer through:
1) funding for future growth, 2) improvement in profitability, especially for its Foods
division, and 3) access to better supply chain management to reduce high
inventory levels. The stock should also benefit from an easing of the FII holding
cap, which would make price discovery more transparent through unrestricted
trading amongst market participants.
FDI in retail – the four Ws
Restrictions on FDI in retail have led to the sector attracting FDI of only US$2.8bn
(2% of overall FDI inflow in India) over the last ten years, despite the high growth
potential that this sector offers. We analyze in detail the potential change in the
regulatory environment that is likely to open up the entry of foreign retailers for
Multi-brand retail in India.
We also do a Porter’s Five Forces analysis of the current industry and judge the
likely impact of allowing foreign retailers to enter India through / without
partnership with Indian retailers. This helps us to conclude that the phased
opening up of modern retail is beneficial for the current incumbents, but that the
direct entry of foreign retailers would hurt the incumbents.
We look at the key issues of 1) What are the likely changes; 2) Who are the
gainers; 3) Why we believe this could happen; and 4) When this could happen.
Porter’s Five Forces analysis
Key conclusions from Porter’s Five Force analysis are:
Key positives for the incumbents are:
Rising disposable income attracting consumers toward new categories and
driving overall consumption basket
Modern retail shopping experience attracts customers and drives footfalls
Benign competition focusing on overall growth and not on market share gains
Key negatives for the incumbents are:
Lower bargaining power with suppliers, due to low contribution to their sales.
Traditional trade continues to remain strong, with long-standing family
relationships and convenience of home delivery and credit.
Profitability is a key issue due to lack of scale and back-end efficiencies,
which are hurting margins.
Lack of good-quality real estate at convenient neighborhood locations is
constraining higher penetration of modern retail.
We now analyze how the industry structure will change with the entry of
foreign retailers in / without partnership with the incumbent Indian retailers.
How the phased entry of foreign retailers helps incumbents:
Bargaining power with suppliers will improve as they inherit their global
relationships and scale
Profitability should improve with the adoption of systems and processes for
the back-end supply chain – this should make up for the increase in the cost
of doing business, with increased competitive intensity for real estate, talent
and market share
Capital infusion will fund more aggressive front-end growth, leading to higher
penetration of modern retail and helping the sector realize its high-growth
potential.
How independent entry of foreign retailers hurts incumbents:
Suppliers will favor foreign retailers through higher margins and timely
supplies, due to global relationships and scale with most of them
Deep pockets and higher aggression to catch up with incumbents will result
in unfavorably high competition for real estate, talent and market share
Cost of doing business, in terms of rentals, talent cost and A&P spends, will
rise sharply, further impacting already low levels of profitability for
incumbents
Porter’s Five Forces Diagram - Now
Suppliers
Modern retail forms ~6-7% of trade for
suppliers limiting the bargaining power
Margins given by large FMCG players lower
for modern retail in some cases
Suppliers rely more on Modern retail for
certain new categories like Packaged Foods
Private label not yet developed completely to
form credible competition to Suppliers
Negative (- -)
Substitutes
Traditional retail with 8mn+ outlets still
accounts for 90%+ of trade
Long standing family relationships with
customers
Convenience of home delivery and purchase
on credit available in most cases
Stock lesser categories/variants/SKUs and
on premise shopping experience is poor
Suffer from inefficiencies of system wide
weak supply chain
Lack resources to scale up and support the
rapidly growing Indian consumption basket
Negative (-)
Industry competitors
Modern retail is fairly consolidated with ~3
players commanding most of the market
share in each format / category
Store roll pace has been slow and
manageable
Lack of profitability has resource constrained
most retailers from getting more aggressive
Competition for market share low as overall
consumption growth and Traditional to
Modern retail shift is supporting growth
Positive (+)
Potential entrants
Lack of capital and good quality real estate is
a constraint
Management expertise and experienced
talent is in short supply
Foreign retailers cannot enter into Multi
brand retail due to regulatory constraints
Poor profitability and folding up of business
of some past entrants is acting as deterrent
for future players
Positive (++)
Buyers
As incomes are rising, customers are
evolving to demand new categories/variants
Penetration rates remain low – novelty value
of Modern retail shopping experience
continues to attract footfalls
Inconvenience of traveling to Modern retail
outlets forces customers towards more
convenient traditional retail
Positive (+)
What are the likely changes
Based on the working paper issued by the gov’t of India, and the feedback given
by the retail industry, we believe the following recommendations are likely to
come through when the sector is opened up shortly to allow Foreign Direct
Investment:
Phased opening of sector: Initially, a JV with up to 49/51% FDI is likely to
be allowed. This will help to transfer the technology and global best practices
of foreign retailers to domestic retailers. At a later stage, in few years time,
this limit could be raised up to 100% ownership by foreign retailer.
Segment / category restriction: Allowance of foreign retail could be limited
to the Food segment, as this is the most critical segment / category. This
would limit the impact of foreign retailers on traditional retail and its impact
will act as a benchmark for opening other segments later on.
Limited geographical reach: There is likely to be a restriction on the cities
in which foreign retailers can enter - 40 cities with populations of more than
1mn. These cities already have a high penetration of domestic modern retail,
which has coexisted well with traditional trade. This would also help to
protect the bulk of India’s 8mn traditional retail outlets that are located
beyond the larger cities.
Focus on Supply-Chain efficiencies: With India losing a high proportion of
its farm produce due to highly underdeveloped supply-chain infrastructure,
the gov’t could expect foreign retailers to invest a minimum of 50% of their
investment on setting up back-end supply chain systems (Cold chains,
warehouses, etc.) in return for access to the customer-facing front end.
Protection for domestic economy: There is likely to be a regulation
stipulating a minimum percentage of sourcing that would have to be from
domestic SMEs to mitigate the risk of global retailers outsourcing
procurement to their lower-cost foreign suppliers. Also, an employment quota
for rural / local youth could be instituted to ensure that the development of
modern retail helps grow employment and also make up for any loss in
employment due to the closure of mom & pop shops.
On a negative note - Some of these restrictions could be imposed on
existing domestic retailers if the WTO finds it restrictive trade practice to
have these policies in place only for foreign retailers.
Who are the key gainers - Pantaloon
In case the sector is opened up through a JV route, we see the move as a winwin
situation for both incumbent Indian modern retailers and foreign retailers. It
will give foreign retailers access to the Indian market and give them the time and
opportunity to learn the nuances of Indian retail through their Indian partners.
Indian retailers will benefit from the capital infusion and best-practice adoption
from their foreign partners, while also giving them more time to scale up enough
to take on foreign retailers independently, as and when the sector is completely
opened up.
We see Pantaloon Retail (PFIAF, Rs249.45, C-1-7) as a key beneficiary in the
event that it enters into a JV with a large global retailer. Key reasons for this
are:
Capital infusion: Pantaloon will get more funding to further roll out its stores
aggressively and maintain its market leadership. This will help to improve the
capital structure of Pantaloon by cutting down its leverage levels and
reducing cash expenditure on interest costs.
Supply-chain efficiencies: Adoption of systems and processes used by the
global retailer with a higher expertise in supply-chain management will help
Pantaloon to drive back-end efficiencies. High inventory levels have been an
issue with the company and this move could help to resolve this.
Profitability improvement in Foods: While Pantaloon is one of the more
profitable Food retailers in India, it is barely managing to break even. Its
expertise in this category is limited compared to that in Apparels, which
Pantaloon manages better. A large global retailer is expected to bring in the
expertise to run the Foods format better and improve the profitability of this
segment, which is set to be more than half of Pantaloon’s business.
Competition likely to lag behind: As per our understanding based on
management discussions and media reports, key competitors like Reliance
Retail, Shoppers Stop and More are unlikely to rope in a foreign retail partner
at the outset. This would put Pantaloon at an advantage and help them
improve their dominance even further. We are not worried about Trent and
Bharti teaming up with foreign retailers (as reported), because of the
significantly smaller scale of operation of these businesses and the long time
it is expected to take before they can scale up to be meaningful competition.
FII limit easing to help Pantaloon the most: Pantaloon is the only listed
retailer in India that is owned close to 26% by FIIs, limiting their further
participation. So, we believe that the easing of this ownership restriction will
help Pantaloon’s price discovery mechanism more vs. other retailers, for
whom price discovery is not technically impeded as of now.
Why we believe changes are possible
Traditionally, participation of foreign retailers in modern retail has been a
politically sensitive issue. India’s traditional retail is run by 8mn mom & pop shops
and it supports the employment of 30mn people. It is feared that the entry of
foreign retailers would not only hurt this large population base, but also impact
other local industries that supply to the traditional retail, in the event that foreign
retailers outsource their procurement to their global suppliers.
However, we believe that now there is a strong case for the regulatory changes
allowing foreign retailers to go through. Our confidence is based on:
Removing bottlenecks to ease high food inflation: The move has been
positioned as a tool for controlling intermediaries (wholesalers, mandis) that
have been held responsible for creating artificial food inflation. Also, it helps
improve the supply chain and cut down on food wastage (pegged at 35%
right now), which is leading to supply constraints. By tying this up with rising
food inflation, which is the current area of concern, the gov’t of India should
be able to counter opposition from State Governments and other political
parties.
Beneficial for the masses: The supply chain set up by modern retailers will
help improve farmer realizations by ~50%, while cutting down end-consumer
prices, as intermediaries will be unable to make super-normal profits. It will
also help drive growth for SME suppliers, as foreign retailers will be
encouraged / forced to source a large part of their supplies from such
vendors.
Impact on Mom & Pop shops to be limited: With domestic organized retail
already in place a without significant negative impact on Mom & Pop stores,
this move is unlikely to have a major negative impact. The rate of closure is
seen at 2% p.a., which is deemed acceptable given the benefits of opening
up the sector. Access to 'Wholesale windows' within organized retail for
sourcing will cut costs for Mom & Pop stores. Also, with consumption likely to
grow significantly, there will be enough room for Mom & Pop stores to coexist,
as studies indicate that the share of modern trade is unlikely to go up
beyond 20%.
Support declining FDI in India: FDI inflow in India is running at a yoy
decline of 20%+ in FY11. While the gov’t of India believes this is not a
structural issue, by opening up new sectors like Retail, attempts could be
made to revive FDI inflow. Over last 10 years, a total investment of US$2.8bn
(equal to annual FDI investment in retail in China) has been made in modern
retail in India, accounting for less than 2% of total FDI inflows. The gov’t
could allow FDI in retail to realize the huge potential for investment that this
sector holds.
When are the changes likely
We believe the changes in regulation are likely to happen in the next few months,
as the gov’t of India has announced its intentions for this during the current Union
Budget. Also, the relevant ministry sources have gone on record in the media to
express their views in favor of this deregulation. The steps involved in this
deregulation are:
Working paper issuance: The gov’t of India, in July 2010, outlined its
thought process on deregulation and gathered feedback from the relevant
stakeholders.
Feedback from industry: Under a common platform, the retailers in India
provided their feedback, which was largely supportive of the indicated policy
in the working paper.
Inter-ministerial discussion: A group of ministries have been assigned the
task of discussing the modalities of opening up the sector. This discussion is
being coordinated by the Department of Industrial Policy and Promotion
(DIPP). It has been reported that the discussions are at an advanced stage.
The first set of new regulations is expected by 1st April 2011.
Discussion with State Governments: Since Retail is a State Government
subject in India, the proposal is likely to be discussed with State
Governments once the Inter-Ministerial group has finalized its proposal.
However, given that FDI is a Central Government subject, the discussion
with the State Governments could be for feedback and need not hold back
the rollout.
The key to note here is that legislation in Parliament may not be required for
the FDI rules to be relaxed. Hence, if the gov’t of India has strong will power
and is able to build a consensus within the government, it could roll out the
regulation change within the next few months.
Case study – How China successfully
ushered in Modern retail
We look now at the how the opening up of retail positively impacted the sector in
China and what are the key lessons that India can adopt to ensure that opening
up Modern retail not only helps to drive economic and consumption growth, but
also how, with proper policy and regulations, it can ensure that both Modern and
Traditional retail co-exist.
Key data to highlight success of Modern retail in China
China can be seen as a role model for creating a blueprint for opening of FDI in retail
in India. Some of the key points to be noted from the Chinese experience are:
9X rise in consumption: Since the opening of foreign retail in China, the
overall consumption basket has grown from US$200bn to the current level of
US$1.8tn. A significant part of this growth is attributable to strong economic
growth and the rising income level in China during this period – a phase India
is expected to go through over the next decade.
Traditional retail growth remains strong: The number of Traditional retail
stores has gone up from 1.9mn to 3mn over two decades. During this period,
0.4mn modern retail outlets have also been opened in China. This clearly
highlights that, in a growing economy, there is ample scope for both Modern
and Traditional retail to grow.
Employment generation moved up sharply: Before the sector was opened
up in 1992, retail employed ~28mn people. This number had already gone up
more than 2x within the following ten years, as Modern retail led to rapid
new- store rollouts, creating many more job opportunities.
Traditional retail still commands strong share: Despite significantly faster
growth for Modern retail, the share of Traditional retail is 65-70%. This
highlights that Traditional retail continues to thrive and remain relevant, even
after a prolonged period of successful existence by Modern retail
Key lessons from Chinese experience relevant to India
We believe the following are the key points that India can adopt from the Chinese
experience while opening up Modern retail to foreign players to maximize benefits
from this regulatory change.
Phased opening of the sector: In 1992, China opened retail for investors,
restricting their ownership to 49% and geographic reach to 6 provinces.
These restrictions were removed in a phased manner, with the total opening
of the sector by 2004. This gave enough time for Traditional retail to adapt
itself to successfully co-exist with Modern retail.
Ensure economic / consumption growth sustains: The key for success of
Modern and Traditional retail in China was rapid economic growth, as it
helped to increase the consumption pie at a CAGR of 12-13%. India is
expected to enjoy similar growth levels over the next decade or so and,
hence, this is the right time to allow in foreign retailers, as this kind of growth
in consumption not only gives enough opportunity for co-existence but is also
possible only with support of Modern retail.
Traditional retail has a role to play: In a country like India, which has a
huge rural population and the geographic reach is immense, Traditional retail
will continue to remain relevant as a point of access for a large part of the
population that does not provide large enough scale to be catered to by
Modern retail.
Modern retail can be a source of employment generation: Given that we
do not expect a loss of employment from the scaling down of Traditional
retail, the growth of Modern retail should be seen as a huge source of
employment generation. Along with front-end staff, Modern retail also needs
talent for allied services like Supply Chain, IT and back-end services. This
could be a significant source of employment, especially for an educated and
skilled labor force.
Price objective basis & risk
Pantaloon (PFIAF)
Our PO of Rs530 is based on a SOTP valuation comprising stand-alone retail at
Rs483, the Future Capital stake at Rs24 and the stake in Future Generali at
Rs23. Retail is based on DCF using a WACC of 11.1pct, a steady-state EBITDA
margin of 9pct from FY15E onwards and a terminal growth rate of 5pct. Future
Capital is based on a 20pct discount to its market price. Future Generali stake is
valued 12xFY12E NBAP.
Downside risks: Stiffer competition, slow down in consumer spending and store
cannibalization in retail.
Upside risks: Stronger-than-expected consumer demand.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Retail - India
FDI in retail – arriving soon at
a store near you?
Foreign retailers participation in India to be a positive
With the gov’t of India (GoI) keen to allow Foreign Direct Investment (FDI) in
multi-brand retail, we analyze the likely impact of this move, using Porter’s Five
Forces and a China case study. We conclude that a phased entry of foreign
retailers, in partnership with Indian retailers, would be positive. It would accelerate
growth by infusing foreign capital and expertise and give time to Indian retailers to
scale up before the sector is completely opened up. The increase in the cost of
doing business from higher competition should be offset by improved profitability
and higher returns, riding on combined scale, experience, and systems and
processes of foreign and Indian retailers.
Current regulations: Limited participation allowed
Currently, in India, FDI is allowed up to 51% in single-brand retail and 100% in the
Cash and Carry format. Foreign retailers are not allowed in India to operate multibrand
retail outlets. This restriction has severely restricted the presence of large
global retailers like Wal Mart, Tesco and Carrefour, which are present only
through a few Cash and Carry stores. Also, the restriction on Foreign Institutional
Investors (FIIs) limits their holdings to 26% in a listed multi-brand retailer in India.
Expect opening up of sector in a phased manner
We believe that, initially, the modern retail sector will be opened with certain
restrictions, like: 1) only a JV with local retailers, capping the FDI holding to
49/51%; 2) limited segments like Food; 3) Minimum 50% of investment on setting
up back-end supply chain (Cold chains, warehouses, etc.), 4) Cities in which
foreign retailers can come in (e.g., 40 cities with population of more than 1mn),
and 5) a minimum percentage of sourcing would have to be from domestic SMEs.
Rise in competition not to hurt as growth picks up as well
We expect this move to drive growth in modern retail will ride on the capital,
expertise and aggression of foreign retailers. This should help the sector to realize
its potential of becoming a US$250bn industry by 2020 vs. the current US$10bn
size. So, while increased competition should raise the cost of doing business
(rentals and staff costs) and lead to market share fragmentation, it should also
improve profits by providing scale from a manifold increase in market size,
bringing in back-end efficiency and providing better bargaining power with
suppliers inherited from global relationships.
Pantaloon Retail should be a key beneficiary
We see Pantaloon Retail as an excellent Investment on this potential regulatory
change. It should benefit from potential partnership with a foreign retailer through:
1) funding for future growth, 2) improvement in profitability, especially for its Foods
division, and 3) access to better supply chain management to reduce high
inventory levels. The stock should also benefit from an easing of the FII holding
cap, which would make price discovery more transparent through unrestricted
trading amongst market participants.
FDI in retail – the four Ws
Restrictions on FDI in retail have led to the sector attracting FDI of only US$2.8bn
(2% of overall FDI inflow in India) over the last ten years, despite the high growth
potential that this sector offers. We analyze in detail the potential change in the
regulatory environment that is likely to open up the entry of foreign retailers for
Multi-brand retail in India.
We also do a Porter’s Five Forces analysis of the current industry and judge the
likely impact of allowing foreign retailers to enter India through / without
partnership with Indian retailers. This helps us to conclude that the phased
opening up of modern retail is beneficial for the current incumbents, but that the
direct entry of foreign retailers would hurt the incumbents.
We look at the key issues of 1) What are the likely changes; 2) Who are the
gainers; 3) Why we believe this could happen; and 4) When this could happen.
Porter’s Five Forces analysis
Key conclusions from Porter’s Five Force analysis are:
Key positives for the incumbents are:
Rising disposable income attracting consumers toward new categories and
driving overall consumption basket
Modern retail shopping experience attracts customers and drives footfalls
Benign competition focusing on overall growth and not on market share gains
Key negatives for the incumbents are:
Lower bargaining power with suppliers, due to low contribution to their sales.
Traditional trade continues to remain strong, with long-standing family
relationships and convenience of home delivery and credit.
Profitability is a key issue due to lack of scale and back-end efficiencies,
which are hurting margins.
Lack of good-quality real estate at convenient neighborhood locations is
constraining higher penetration of modern retail.
We now analyze how the industry structure will change with the entry of
foreign retailers in / without partnership with the incumbent Indian retailers.
How the phased entry of foreign retailers helps incumbents:
Bargaining power with suppliers will improve as they inherit their global
relationships and scale
Profitability should improve with the adoption of systems and processes for
the back-end supply chain – this should make up for the increase in the cost
of doing business, with increased competitive intensity for real estate, talent
and market share
Capital infusion will fund more aggressive front-end growth, leading to higher
penetration of modern retail and helping the sector realize its high-growth
potential.
How independent entry of foreign retailers hurts incumbents:
Suppliers will favor foreign retailers through higher margins and timely
supplies, due to global relationships and scale with most of them
Deep pockets and higher aggression to catch up with incumbents will result
in unfavorably high competition for real estate, talent and market share
Cost of doing business, in terms of rentals, talent cost and A&P spends, will
rise sharply, further impacting already low levels of profitability for
incumbents
Porter’s Five Forces Diagram - Now
Suppliers
Modern retail forms ~6-7% of trade for
suppliers limiting the bargaining power
Margins given by large FMCG players lower
for modern retail in some cases
Suppliers rely more on Modern retail for
certain new categories like Packaged Foods
Private label not yet developed completely to
form credible competition to Suppliers
Negative (- -)
Substitutes
Traditional retail with 8mn+ outlets still
accounts for 90%+ of trade
Long standing family relationships with
customers
Convenience of home delivery and purchase
on credit available in most cases
Stock lesser categories/variants/SKUs and
on premise shopping experience is poor
Suffer from inefficiencies of system wide
weak supply chain
Lack resources to scale up and support the
rapidly growing Indian consumption basket
Negative (-)
Industry competitors
Modern retail is fairly consolidated with ~3
players commanding most of the market
share in each format / category
Store roll pace has been slow and
manageable
Lack of profitability has resource constrained
most retailers from getting more aggressive
Competition for market share low as overall
consumption growth and Traditional to
Modern retail shift is supporting growth
Positive (+)
Potential entrants
Lack of capital and good quality real estate is
a constraint
Management expertise and experienced
talent is in short supply
Foreign retailers cannot enter into Multi
brand retail due to regulatory constraints
Poor profitability and folding up of business
of some past entrants is acting as deterrent
for future players
Positive (++)
Buyers
As incomes are rising, customers are
evolving to demand new categories/variants
Penetration rates remain low – novelty value
of Modern retail shopping experience
continues to attract footfalls
Inconvenience of traveling to Modern retail
outlets forces customers towards more
convenient traditional retail
Positive (+)
What are the likely changes
Based on the working paper issued by the gov’t of India, and the feedback given
by the retail industry, we believe the following recommendations are likely to
come through when the sector is opened up shortly to allow Foreign Direct
Investment:
Phased opening of sector: Initially, a JV with up to 49/51% FDI is likely to
be allowed. This will help to transfer the technology and global best practices
of foreign retailers to domestic retailers. At a later stage, in few years time,
this limit could be raised up to 100% ownership by foreign retailer.
Segment / category restriction: Allowance of foreign retail could be limited
to the Food segment, as this is the most critical segment / category. This
would limit the impact of foreign retailers on traditional retail and its impact
will act as a benchmark for opening other segments later on.
Limited geographical reach: There is likely to be a restriction on the cities
in which foreign retailers can enter - 40 cities with populations of more than
1mn. These cities already have a high penetration of domestic modern retail,
which has coexisted well with traditional trade. This would also help to
protect the bulk of India’s 8mn traditional retail outlets that are located
beyond the larger cities.
Focus on Supply-Chain efficiencies: With India losing a high proportion of
its farm produce due to highly underdeveloped supply-chain infrastructure,
the gov’t could expect foreign retailers to invest a minimum of 50% of their
investment on setting up back-end supply chain systems (Cold chains,
warehouses, etc.) in return for access to the customer-facing front end.
Protection for domestic economy: There is likely to be a regulation
stipulating a minimum percentage of sourcing that would have to be from
domestic SMEs to mitigate the risk of global retailers outsourcing
procurement to their lower-cost foreign suppliers. Also, an employment quota
for rural / local youth could be instituted to ensure that the development of
modern retail helps grow employment and also make up for any loss in
employment due to the closure of mom & pop shops.
On a negative note - Some of these restrictions could be imposed on
existing domestic retailers if the WTO finds it restrictive trade practice to
have these policies in place only for foreign retailers.
Who are the key gainers - Pantaloon
In case the sector is opened up through a JV route, we see the move as a winwin
situation for both incumbent Indian modern retailers and foreign retailers. It
will give foreign retailers access to the Indian market and give them the time and
opportunity to learn the nuances of Indian retail through their Indian partners.
Indian retailers will benefit from the capital infusion and best-practice adoption
from their foreign partners, while also giving them more time to scale up enough
to take on foreign retailers independently, as and when the sector is completely
opened up.
We see Pantaloon Retail (PFIAF, Rs249.45, C-1-7) as a key beneficiary in the
event that it enters into a JV with a large global retailer. Key reasons for this
are:
Capital infusion: Pantaloon will get more funding to further roll out its stores
aggressively and maintain its market leadership. This will help to improve the
capital structure of Pantaloon by cutting down its leverage levels and
reducing cash expenditure on interest costs.
Supply-chain efficiencies: Adoption of systems and processes used by the
global retailer with a higher expertise in supply-chain management will help
Pantaloon to drive back-end efficiencies. High inventory levels have been an
issue with the company and this move could help to resolve this.
Profitability improvement in Foods: While Pantaloon is one of the more
profitable Food retailers in India, it is barely managing to break even. Its
expertise in this category is limited compared to that in Apparels, which
Pantaloon manages better. A large global retailer is expected to bring in the
expertise to run the Foods format better and improve the profitability of this
segment, which is set to be more than half of Pantaloon’s business.
Competition likely to lag behind: As per our understanding based on
management discussions and media reports, key competitors like Reliance
Retail, Shoppers Stop and More are unlikely to rope in a foreign retail partner
at the outset. This would put Pantaloon at an advantage and help them
improve their dominance even further. We are not worried about Trent and
Bharti teaming up with foreign retailers (as reported), because of the
significantly smaller scale of operation of these businesses and the long time
it is expected to take before they can scale up to be meaningful competition.
FII limit easing to help Pantaloon the most: Pantaloon is the only listed
retailer in India that is owned close to 26% by FIIs, limiting their further
participation. So, we believe that the easing of this ownership restriction will
help Pantaloon’s price discovery mechanism more vs. other retailers, for
whom price discovery is not technically impeded as of now.
Why we believe changes are possible
Traditionally, participation of foreign retailers in modern retail has been a
politically sensitive issue. India’s traditional retail is run by 8mn mom & pop shops
and it supports the employment of 30mn people. It is feared that the entry of
foreign retailers would not only hurt this large population base, but also impact
other local industries that supply to the traditional retail, in the event that foreign
retailers outsource their procurement to their global suppliers.
However, we believe that now there is a strong case for the regulatory changes
allowing foreign retailers to go through. Our confidence is based on:
Removing bottlenecks to ease high food inflation: The move has been
positioned as a tool for controlling intermediaries (wholesalers, mandis) that
have been held responsible for creating artificial food inflation. Also, it helps
improve the supply chain and cut down on food wastage (pegged at 35%
right now), which is leading to supply constraints. By tying this up with rising
food inflation, which is the current area of concern, the gov’t of India should
be able to counter opposition from State Governments and other political
parties.
Beneficial for the masses: The supply chain set up by modern retailers will
help improve farmer realizations by ~50%, while cutting down end-consumer
prices, as intermediaries will be unable to make super-normal profits. It will
also help drive growth for SME suppliers, as foreign retailers will be
encouraged / forced to source a large part of their supplies from such
vendors.
Impact on Mom & Pop shops to be limited: With domestic organized retail
already in place a without significant negative impact on Mom & Pop stores,
this move is unlikely to have a major negative impact. The rate of closure is
seen at 2% p.a., which is deemed acceptable given the benefits of opening
up the sector. Access to 'Wholesale windows' within organized retail for
sourcing will cut costs for Mom & Pop stores. Also, with consumption likely to
grow significantly, there will be enough room for Mom & Pop stores to coexist,
as studies indicate that the share of modern trade is unlikely to go up
beyond 20%.
Support declining FDI in India: FDI inflow in India is running at a yoy
decline of 20%+ in FY11. While the gov’t of India believes this is not a
structural issue, by opening up new sectors like Retail, attempts could be
made to revive FDI inflow. Over last 10 years, a total investment of US$2.8bn
(equal to annual FDI investment in retail in China) has been made in modern
retail in India, accounting for less than 2% of total FDI inflows. The gov’t
could allow FDI in retail to realize the huge potential for investment that this
sector holds.
When are the changes likely
We believe the changes in regulation are likely to happen in the next few months,
as the gov’t of India has announced its intentions for this during the current Union
Budget. Also, the relevant ministry sources have gone on record in the media to
express their views in favor of this deregulation. The steps involved in this
deregulation are:
Working paper issuance: The gov’t of India, in July 2010, outlined its
thought process on deregulation and gathered feedback from the relevant
stakeholders.
Feedback from industry: Under a common platform, the retailers in India
provided their feedback, which was largely supportive of the indicated policy
in the working paper.
Inter-ministerial discussion: A group of ministries have been assigned the
task of discussing the modalities of opening up the sector. This discussion is
being coordinated by the Department of Industrial Policy and Promotion
(DIPP). It has been reported that the discussions are at an advanced stage.
The first set of new regulations is expected by 1st April 2011.
Discussion with State Governments: Since Retail is a State Government
subject in India, the proposal is likely to be discussed with State
Governments once the Inter-Ministerial group has finalized its proposal.
However, given that FDI is a Central Government subject, the discussion
with the State Governments could be for feedback and need not hold back
the rollout.
The key to note here is that legislation in Parliament may not be required for
the FDI rules to be relaxed. Hence, if the gov’t of India has strong will power
and is able to build a consensus within the government, it could roll out the
regulation change within the next few months.
Case study – How China successfully
ushered in Modern retail
We look now at the how the opening up of retail positively impacted the sector in
China and what are the key lessons that India can adopt to ensure that opening
up Modern retail not only helps to drive economic and consumption growth, but
also how, with proper policy and regulations, it can ensure that both Modern and
Traditional retail co-exist.
Key data to highlight success of Modern retail in China
China can be seen as a role model for creating a blueprint for opening of FDI in retail
in India. Some of the key points to be noted from the Chinese experience are:
9X rise in consumption: Since the opening of foreign retail in China, the
overall consumption basket has grown from US$200bn to the current level of
US$1.8tn. A significant part of this growth is attributable to strong economic
growth and the rising income level in China during this period – a phase India
is expected to go through over the next decade.
Traditional retail growth remains strong: The number of Traditional retail
stores has gone up from 1.9mn to 3mn over two decades. During this period,
0.4mn modern retail outlets have also been opened in China. This clearly
highlights that, in a growing economy, there is ample scope for both Modern
and Traditional retail to grow.
Employment generation moved up sharply: Before the sector was opened
up in 1992, retail employed ~28mn people. This number had already gone up
more than 2x within the following ten years, as Modern retail led to rapid
new- store rollouts, creating many more job opportunities.
Traditional retail still commands strong share: Despite significantly faster
growth for Modern retail, the share of Traditional retail is 65-70%. This
highlights that Traditional retail continues to thrive and remain relevant, even
after a prolonged period of successful existence by Modern retail
Key lessons from Chinese experience relevant to India
We believe the following are the key points that India can adopt from the Chinese
experience while opening up Modern retail to foreign players to maximize benefits
from this regulatory change.
Phased opening of the sector: In 1992, China opened retail for investors,
restricting their ownership to 49% and geographic reach to 6 provinces.
These restrictions were removed in a phased manner, with the total opening
of the sector by 2004. This gave enough time for Traditional retail to adapt
itself to successfully co-exist with Modern retail.
Ensure economic / consumption growth sustains: The key for success of
Modern and Traditional retail in China was rapid economic growth, as it
helped to increase the consumption pie at a CAGR of 12-13%. India is
expected to enjoy similar growth levels over the next decade or so and,
hence, this is the right time to allow in foreign retailers, as this kind of growth
in consumption not only gives enough opportunity for co-existence but is also
possible only with support of Modern retail.
Traditional retail has a role to play: In a country like India, which has a
huge rural population and the geographic reach is immense, Traditional retail
will continue to remain relevant as a point of access for a large part of the
population that does not provide large enough scale to be catered to by
Modern retail.
Modern retail can be a source of employment generation: Given that we
do not expect a loss of employment from the scaling down of Traditional
retail, the growth of Modern retail should be seen as a huge source of
employment generation. Along with front-end staff, Modern retail also needs
talent for allied services like Supply Chain, IT and back-end services. This
could be a significant source of employment, especially for an educated and
skilled labor force.
Price objective basis & risk
Pantaloon (PFIAF)
Our PO of Rs530 is based on a SOTP valuation comprising stand-alone retail at
Rs483, the Future Capital stake at Rs24 and the stake in Future Generali at
Rs23. Retail is based on DCF using a WACC of 11.1pct, a steady-state EBITDA
margin of 9pct from FY15E onwards and a terminal growth rate of 5pct. Future
Capital is based on a 20pct discount to its market price. Future Generali stake is
valued 12xFY12E NBAP.
Downside risks: Stiffer competition, slow down in consumer spending and store
cannibalization in retail.
Upside risks: Stronger-than-expected consumer demand.
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