The tale of Indian retail

India's retail industry is more than $700 billion in size. However, less than 20 per cent of the industry is organised, even though it has been more than two decades since large-store pan-India retail formats (like departmental stores and supermarkets) started expanding, and more than three decades since small-store pan-India retail formats (like Bata) have existed in the country. The balance 80 per cent of the industry continues to be traditional mom-and-pop shop formats. Furthermore, over the past 10 years, only a small fraction of the organised retail industry in India has managed to deliver an ROCE (return on capital employed) more than the cost of capital, whilst also growing the retail network at a healthy pace.

Challenges faced by pan-India retail chains
There are multiple layers of challenges faced by retailers in India. Whilst the solutions to these challenges are obvious - higher footfalls, higher inventory turns and optimisation of various other aspects of retail execution - each of these solutions brings with it several more challenges, making it incredibly hard to scale up the retail network with high cash generation.

At a store level, the challenge starts with the high cost of commercial real estate and hence the need to drive high footfalls per unit of store space. However, this requires the retailer to have gone through a steep learning curve of optimising aspects, such as:

• Store size (e.g., is 1,000 sq ft good enough, or should it be 1,500 sq ft? Should 10 per cent of the store space be allocated towards inventory warehousing, or 5 per cent?)
• Store location (e.g., shopping mall or high-street? Corner of the high-street or centre of the high street?)
• Look and feel of the store (e.g., height of the ceiling, shape and size of the racks, number of pillars in a large format store, lighting, etc.)
• Hiring, training and retention (in an industry characterised by very high attrition rates) of an optimised number of sales personnel on the shopfloor who understand the merchandise and can convince a customer to buy it.

Another challenge at the store level is around optimising various aspects of the merchandise itself, like:

• Pricing, design and type of merchandise that will be most in demand for the kind of footfall that the store expects to attract
• Merchandise positioning across the floor (e.g., the amount of space between two racks, which type of products should be next to entrance and which ones should be next to the billing counters?)
• Mix of private-label products vs third-party products

Once store-level challenges have been addressed, a large part of the cash generated from a store needs to be reinvested towards opening of new stores to grow the retail network across the country. However, the expansion of a retailer's store network brings with it several more challenges, some of which are unique to India, like:

• Merchandise preferences change substantially across geographies, across demographics within a specific geography and over time within a specific demographic
• Inventory management for demand hubs across India that are often thousands of kilometres apart from each other. For instance, a retail format catering largely to, say, metro cities will need to manage inventory transit across Delhi, Mumbai and Bangalore.
• Merchandise procurement must deal with challenges such as absence of 'farm to fork' supply chains in perishable food, regulatory intervention in procurement of commodities like gold, lack of uniformity in merchandise quality of footwear and apparel, etc.

Poor efficiencies around the factors highlighted above leads to issues like: (a) poor customer experience due to stock-outs of SKUs at some stores, and (b) too much unsold inventory of SKUs at other stores and hence weak cash generation for the overall retail network. Furthermore, evolution of newer forms of retailing like e-commerce and omni-channel also calls for re-engineering of a retailer over time in order to stay relevant to its customers and to sustain competitive advantages to keep winning market share.

Finally, even if a retailer successfully surmounts all of the challenges discussed above, she then faces the conundrum of how to successfully re-deploy her free cash flows in a country where very few modern retail categories are truly mass-market, high-demand categories. The penetration and frequency of consumption of many categories significantly drops as one moves away from tier 1 cities and metros, towards tier 3/4 and rural cities. This lack of enough depth of consumption in India across various categories limits the number of stores that even a successful and dominant retail format can successfully open in the country at a given point of time. These limits then result in retailers deploying free cash flows from successful existing formats into new retail formats, which do not necessarily achieve success. For instance, Shoppers Stop's launch of HyperCity, Jubilant Foodwork's (Domino's) launch of Dunkin Donuts, Trent's (Westside) launch of Landmark Bookstores/Star Bazaar, etc., have not delivered high ROCEs.

How can investors choose retailers which can deliver value?

There are a few structural factors which reduce the intensity of the challenge highlighted above for a retailer. For instance:

• A small-store retail format (say 500 to 5,000 sq ft per store) gives more agility to the retailer to shorten the learning curve and revamp/shut down unviable stores, compared to a large-store retail format (say, more than 30,000 sq ft per store).
• A retail format selling merchandise which is utility-oriented (rather than luxury-oriented) might have a longer runway for growth before it reaches the limit of store count across the country.
• Merchandise with longer shelf life (like packaged foods vs fresh foods, or long-lasting apparel trends vs fast fashion) can help reduce wastage/shrinkage of unsold inventory at a store level.

However, relief through these structural factors is available to the competitors of the said retailer as well. As I have shown in my book 'The Unusual Billionaires' (2016), addressing the challenging aspect of a sector in a simple straightforward manner is not a sustainable way to build deep-rooted competitive advantages. Instead, as highlighted in the chart 'Indian monopolists' business framework', a solution which cannot be replicated easily by competitors is a far more sustainable way to consistently compound fundamentals.

A well-known retailer which we own in Marcellus' portfolios and which exemplifies how to build a deeply moated retailing franchise in India is Titan. The biggest challenge that Titan has addressed in jewellery retailing (Tanishq) is around the customer's trust regarding the purity of the gold sold by the retailer. Mom-and-pop retailers in jewellery have dominated the industry (about 70 per cent market share) through the relationship of being a customer's 'family jeweller'. However, since most of these mom-and-pop retailers derive their profit margins based on commodity prices, they have sold impure gold to the customer compared to the purity for which they have priced the product (e.g., selling 19 carat gold at the price of 22 carat). Titan has addressed this challenge by offering: (a) transparency on gold purity through karatometers in their stores; (b) 'trust'-oriented brand recall of being a Tata group company; and (c) selling jewellery to a customer based on superior product designs and shopping experience rather than as a commodity. When it comes to designs of its products, unlike most of its competitors, Titan's design team has complete control on the karigars and the manufacturing processes.

The next big challenge that Titan has addressed is around neutralising the exposure of its profit margins to fluctuation in commodity prices by procuring raw materials through 'gold on lease', 'gold exchange' and hedging instruments.

Another big challenge faced by pan-India jewellery retailers is that with wedding jewellery controlling almost 70 per cent of the total jewellery sales, customer preferences of designs of wedding-jewellery merchandise are highly localised and change substantially from one state to another. This then causes a massive adverse impact on inventory management and the working capital cycle of pan-India jewellers. Over the past three years, Titan has started to overcome this challenge by leveraging on its scale of operations within a locality and significantly improving its understanding of wedding jewellery merchandise preferences of local customers to an extent that almost a quarter of total jewellery sales for Tanishq are now derived from this jewellery segment, up from less than 5 per cent until a few years ago.

One of the biggest threats looming ahead for gold and wedding-oriented jewellers in India is a shift in customers to studded jewellery or low-caratage gold jewellery. An additional, and related, challenge is the ongoing rise of e-commerce as a way to access jewellery merchandise. On this front, Titan's May 2016 acquisition of a majority stake in Caratlane - an online jewellery franchise which is expanding rapidly, successfully and profitably across e-commerce, omni-channel and brick-and-mortar formats - has been an unequivocal success.

During every disruption - like demonetisation, GST and the ongoing COVID-19 crisis - Tanishq benefits massively through market-share gains from mom-and-pop shop jewellers whose business models struggle to deal with the impact of these disruptive events.

Finally, Titan keeps launching new retail formats such as eyewear (Titan Eyeplus) and sarees (Taneira), thus redeploying the free cash flows arising from Tanishq. Whilst none of these formats have been as successful as Tanishq, recently the firm has started to successfully turn around its eyewear business by making radical changes in product procurement, by launching an e-commerce interface and by revamping its brick-and-mortar offerings, including shutting down unviable stores.

Saurabh Mukherjea is the author of 'The Unusual Billionaires' and 'Coffee Can Investing: the Low Risk Route to Stupendous Wealth'. He's part of the Investments team at Marcellus Investment Managers, a SEBI regulated provider of Portfolio Management Services.