How to do Business Analysis of Organised Retail Companies

The current article aims to highlight the key aspects of the business of organized retail companies. After reading this article, an investor would understand the factors that impact the business of retailers and the characteristics that differentiate a fundamentally strong retail company from a weak one.

Key factors influencing the business of organized retail companies

1) Different segments of retailers behave like different industries:

Even though the role of all the retailers is like a trader who buys things from wholesalers and sells them to the end consumer without any value-addition; however, still, the business dynamics of retailers operating in different segments are completely different.

A value retailer focusing on food & grocery will have different dynamics than a lifestyle retailer focusing on apparel, consumer durables etc. A discount store will face different business challenges than a high-end premium electronics store.

For example, food and groceries are essential items whose demand is stable across economic cycles. Whereas demand for branded, fashion apparel and consumer durables can easily be postponed by customers during economic recessions. Therefore, the value retailer segment sees a very limited effect of cyclicity whereas lifestyle retailing is impacted by economic cycles. In addition, some products have seasonal demand like cooling devices in summer and heating devices in winter.

Rating methodology – retail by ICRA, July 2021, page 3:

a value retailer focused on selling essentials is more likely to demonstrate stability in operations vis-à-vis a lifestyle retail outlet as it is less prone to cyclicality in the macroeconomic scenario, though the latter segment entails higher gross margins. Then, certain products, like some of the consumer durables (heating/cooling devices) witness seasonal demand, thereby resulting in uneven cash flow generation.

Therefore, while analysing any retailer, first, it is important to determine the segment in which it operates. Only, afterwards, one can understand in depth how the business will perform in different situations.

Advised reading: How to do Business Analysis of a Company

In this article, while describing each parameter, we will see how different segments of the retail industry behave differently on each parameter.

2) Intense competition in the retail industry:

The retail industry is highly fragmented due to low entry barriers and political interference to protect the sector for small-unorganised mom-and-pop/neighbourhood kerana stores.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 14:

The industry is characterised by intense competition from other organised retailers, local stores and the recently booming e-retailing segment.

Intense competition in the retail industry is true globally. Even in developed countries, the retail industry has intense competition.

Key credit factors for the retail and restaurants industry by Standard and Poor’s (S&P), November 2013, page 3:

retail industry is highly competitive and fragmented with few barriers to entry,

Entry barriers in the retail industry are low because a new entrant does not require any specialized skill or technology to enter this business.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 7:

We consider entrance barriers to be low. The retail sector does not generally suffer from restrictive legislation or the need for significant industrial know-how or patents.

As a result, in India, organized retail, both brick & mortar as well as e-commerce is about 16% of the overall retail market (brick & mortar retail: 12% and e-commerce: 4%).

Rating methodology – retail by ICRA, July 2021, page 1:

The sector is largely dominated by the unorganised segment comprising local kirana stores or mom-and- pop stores, with the brick-and-mortar organised segment accounting for ~12% and e-commerce accounting for ~4% of the total market size.

As mentioned previously, different segments of the retail industry face different business dynamics. Competition in the value retailing segment (food and groceries, discount shops) is very high because these are commodity goods where a consumer can easily switch products from one manufacturer to another.

On the other hand, lifestyle retailers (branded apparel, consumer durables etc.) require brand-building, marketing etc., which raises entry barriers, brings in customer loyalty and limits competition to some extent.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 15:

Value retailing, which is built on price-based value propositions, may face higher competition as against lifestyle retailing, which requires strong brand and customer franchise; this takes a longer time to build and thus acts as a strong entry barrier.

Nevertheless, even for lifestyle retail, there are numerous suppliers for each product segment like fashion apparel, electronics and consumer durables that the customer is spoilt for choices.

Most retailers, except brand showrooms, sell goods from other manufacturers; therefore, a customer can easily buy the same good from any of the multiple retailers. As a result, customer loyalty or stickiness to retailers is low.

Retail industry – key success factors by Pefindo, Indonesia, November 2022, page 2:

Customer continuity and stability are somewhat low.

As a result, the intense competition among retailers for customers’ mind space and wallet-share results in players competing on price, which reduces profit margins for the industry as a whole.

Further advised reading: How to analyse New Companies in Unknown Industries?

3) Low-profit margins of the retail industry:

As mentioned earlier, the retail industry simply trades its goods by buying them from wholesalers and selling them to end customers without any value addition. This combined with intense competition between players leads to the low-profit margins for retailers.

In addition, due to access to the internet, customers can easily compare prices of goods across different retailers and can easily go to the retailer who provides the same good at the cheapest price. In addition, online, customers can easily compare features of related goods from different manufacturers and can make pricing-related decisions.

As a result, all the retailers face intense pricing pressure from the customers, which forces them to offer goods at a lower price than their peers, which reduces their profit margins.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 10:

Due to fierce competition between retailers and the ease with which customers can compare prices nowadays, the profitability of retailers is lower than in most other industries. Retailers do not create, transform or generate an intrinsic value for the product sold, leading to slim margins and low cash flow.

As retailers have very little pricing power over their customers; therefore, they put pressure on their suppliers to provide goods at lower prices so that retailers can earn profits. Those retailers who can get a better deal from manufacturers/wholesalers are at an advantage over their peers.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 10:

when pricing power over customers is limited, sourcing capabilities can lead to differences in gross margins between comparable companies.

To exercise bargaining power over suppliers and to get good discounts on products, retailers with a large size and market share are in an advantageous position.

Therefore, all retailers try to grow large both by organic growth or inorganic means (mergers and acquisitions).

Advised reading: How to do Financial Analysis of a Company

4) Large size and market share is the best competitive advantage in retail:

When retailers grow in size and scale, then they can get better prices from suppliers because they now become large buyers for them. Apart from suppliers of goods, real estate owners also provide good deals to large retailers as they provide visibility and customer footfalls to shopping places like malls etc.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

Size not only boosts the bargaining power of a retailer while accessing quality real estate or ‘anchor tenant’ status but also provides it with better bargaining power with its suppliers

In addition to a higher bargaining power over suppliers, large-sized retailers are also able to buy goods directly from manufacturers, which leads to the removal of many middlemen from the supply chain and in turn helps the retailer earn more margin.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2018, page 7:

Also, the retailer’s ability to approach the producers directly for procurement will help in reduction of procurement costs through the elimination of middlemen margin and other associated costs.

It permits retail stores to offer low prices to the customers and in turn, strengthen their competitive advantage over peers.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 17:

shortening of supply chain which enables efficiency in procurement, reduction in wastages, improved margins for participants in the chain and low prices for the final consumer

Apart from getting a good price from suppliers, getting a preferred price from real estate owners is also important for retailers because rental expense is one of the major costs for them, apart from employee costs. In the past, there have been instances where real estate rentals have increased to such an extent that at certain locations, the retail business became unviable.

Rating methodology – retail by ICRA, July 2021, page 6:

Rental cost is one of the key determinants of the breakeven level for a store. For instance, despite higher sales per square feet, stores with high rental levels would take a relatively longer time to achieve breakeven. In India, a growing demand for retail space, coupled with lack of alternatives with supporting infrastructure, has pushed commercial rentals in many locations to uneconomical levels.

Therefore, a large size of a retailer puts it in a very advantageous position while managing its costs.

In addition, a retailer with a large size of operations also benefits from economies of scale where fixed costs are spread over a large number of sold products and bring in cost efficiencies.

Retail industry – key success factors by Pefindo, Indonesia, November 2022, pages 1 & 2:

Generally, larger players have competitive advantages, as they have stronger bargaining power and economies of scale in transportation, logistics, purchasing and advertising.

Rating methodology – retail by ICRA, July 2021, page 4:

Generally, a large revenue base leads to economies of scale in terms of cost efficiencies in procurement and administrative functions, thereby supporting the operating profit margins (OPMs) of the retailer.

Due to the benefits associated with a large size, most retailers tend to focus on obtaining high market shares. In developed countries, many retailers have limited the product categories in their stores to achieve a higher market share in their categories of operations.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 9:

Most retailers’ business models focus on a single product category and obtaining high market shares.

As large retailers gain a competitive advantage in sourcing and costs due to their higher negotiating power and economies of scale benefits, they pass it on to offer a better value to customers. Such practices bring sustainability to the business model of retailers by making them more resilient to competition and adverse business conditions.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 17:

Sustainability of retailing businesses, especially in models such as supermarkets, depends on the player’s ability to price products at a discount and still maintain profitability.

This ability of large-sized retailers to sell goods at a lower price puts tremendous pressure on small retailers and in turn, makes it difficult for them to earn a reasonable profit margin.

Key credit factors for the retail and restaurants industry by Standard and Poor’s (S&P), November 2013, page 4:

Big-box category killers with high volume sales per store also put intense pressure on smaller players.

Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors

Nevertheless, apart from the size, various other parameters impact the profitability margin of any retail store.

5) Key factors affecting the profit margin of a retailer:

5.1) Value vs lifestyle retail segment:

One of the biggest factors affecting the profit margin of a retailer is the segment in which it operates. For example, retailers focusing on value retail (food, groceries, discount stores) have a lower profit margin than those retailers focusing on lifestyle retail (fashion, branded apparel, electronics, consumer durables).

Rating methodology – retail by ICRA, July 2021, page 6:

type of retail format operated by an entity is typically the most important determinant of gross margins, while scale brings operational efficiencies. For instance, supermarkets have a much lower gross margin as compared to lifestyle retailers.

The main reason for such a difference in profit margins of these two segments is that value retail primarily deals in commodity products and a meaningful price difference is sufficient for a customer to switch to a different retailer. Therefore, a value retailer has to keep its prices as low as possible to get customer footfall.

Rating methodology – retail by ICRA, May 2017, page 2:

This is especially so in case of commoditised products where a meaningful price difference between players can result in switching of customer loyalties.

On the other hand, a lifestyle retailer can create a brand and customer franchise and in turn, charge a premium for its products to earn a better profit margin.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

Value Retailing is a high-volume but low-margin business. In contrast, Life-style Retailing is a high-margin and low-volume business and also fosters higher customer loyalty with relatively low substitutes and high entry barriers.

5.2) Sale of private labels:

Retailers get an opportunity to showcase their private labels i.e. store’s brands to customers when they visit the stores. These private labels offer a higher profit margin to the retailers because they are produced at a lower cost than the competing goods provided by large branded manufacturers like multination corporations producing fast-moving consumer goods (FMCG-MNCs).

MNCs spend a lot of money to create brands and customer awareness, which adds to the cost of their products. On the contrary, the sale of private labels in retail shops happens due to visibility in the shelf space and a lower price than branded goods. As a result, the sale of private labels is more profitable for retailers.

Rating methodology – retail by ICRA, July 2021, page 3:

Another factor taken into consideration is the mix of private label and external brand sales. Retailers with a high proportion of private label sales enjoy higher gross profit margins owing to better control over costs and inventory

However, private labels can generate only limited sales because retailers are not able to spend a lot of money on their advertisements and brand-building. This is because, if retailers spend significant money on promoting private labels, then these products will lose their cost advantage over third-party products of MNCs.

Rating methodology – retail by ICRA, May 2017, page 2:

While private label sales do offer retailers higher gross margins, sales volumes are generally limited on account of the low marketing / promotion.

Nevertheless, retailers need to keep in mind that it is the presence of branded third-party products that bring customers to their stores. The sale of private labels is a corollary, which value-conscious customers make. If a retailer stuffs too many private labels on its shelves at the cost of branded goods, then the store may lose the attraction for customers and may hurt the business of the retailer.

Therefore, keeping a balance between private labels and third-party branded goods is essential for every retailer.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

Nevertheless, the Lifestyle retailer needs to have a judicious mix of private labels so as not to dilute the offerings as regards other brands.

Apart from size, retail segment and sale of private labels, another factor, which is important in determining the profitability of any retailer is its inventory management skills.

5.3) Inventory management:

Retailers take the goods from wholesalers and sell them to end-consumer. This business requires them to stock a large amount of inventory for several items to serve the customer when she needs any item.

In this activity, the retail stores face a dilemma because, if they keep every possible item in the store, then they will have to invest a lot of money in inventory and all the items may not be sold leading to inventory losses. On the contrary, if they keep only the most essential items in the store, then a lot of customers will not find the items they need in the store, which will lead to a loss of business and a fall in the reputation of the store.

Rating methodology – retail by ICRA, July 2021, page 3:

maintaining optimal levels of the right kind of product inventory is critical…This is because inventory has an associated carrying cost and too much inventory can strain a retailer’s working capital position as well as increase the risk of obsolescence, while too little of it increases the risk of stock-outs, thereby risking loss of customers.

Inventory risk is more for items, which have a short shelf life like perishable goods (dairy and seafood etc) or items with fast-changing customer preferences (fashion, apparel), technological changes and seasonal requirements.

Rating methodology – retail by ICRA, July 2021, page 3:

Inventory risk further increases for product categories, which have high fashion, technological and obsolescence risks. In addition, there are certain product categories like dairy and seafood products, which are exposed to perishability risk.

Rating methodology – retail by ICRA, May 2017, page 2:

Similarly, in industries that are dependent on products where the availability of raw materials is seasonal, the cash flow generation from such products is uneven…In such industries, large inventory holding accentuates the risk of inventory write-downs

Inventory write-downs are significant losses that bring down the profitability of retailers. Therefore, retailers need to manage their inventory positions with utmost care.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 17:

Players, therefore, need to optimise their inventories so as to minimise working capital levels, while ensuring the ready availability of stocks at all times; this is a critical factor as it can significantly impact the profitability of the retailing entities.

Advised reading: Inventory Turnover Ratio: A Complete Guide

To reduce the inventory risk, stores use many different approaches:

5.3.1) Arrangements of return, and liquidation of unsold inventory with suppliers:

Some retailers can negotiate return/liquidation arrangements for unsold inventory with their suppliers. This takes the inventory risk off their shoulders.

Rating methodology – retail by ICRA, July 2021, page 3:

its arrangement with brand owners for inventory liquidation and return policies, among others.

However, only the largest retailers with a strong market share can get such arrangements from suppliers.

Moreover, such a reduction in the inventory risk also comes at a cost because suppliers charge a premium for supplying products to retailers under such an arrangement, which hurts the profit margins of the retailers. On the contrary, retailers following an outright purchase model for inventory get a discount from suppliers and in turn, report a higher profit margin.

Rating methodology – organised retail companies by CARE, December 2022, page 3:

Although the ‘Private label portfolio’ and ‘outright model’ have higher margins vis-à-vis other business models, they entail higher working capital requirements and carry inventory obsolescence risk.

5.3.2) Investment in the technology-enabled supply chain to minimize inventory and wastage:

Retailers invest in technology to manage their supply chain where software helps them manage stock in the store and simultaneously communicate with suppliers regarding the availability of their goods in the store on a real-time basis. As a result, the suppliers can restock the store whenever the stock of goods falls below critical levels.

Such a real-time flow of stock status between the store and the suppliers helps in minimizing the inventory holding at the store as well as reducing the stock in transit. This, in turn, frees up working capital for the retail store as well as the supplier.

Rating methodology – retail by ICRA, July 2021, page 3:

Another enabler is the use of technology, which aids in optimising order cycles and order quantities for various products, better inventory management and shorter delivery times.

However, implementing a technological solution is a costly proposition. It requires a lot of upfront investment as well as frequent subsequent investments for the upgradation of software.

Rating methodology – retail by ICRA, May 2017, page 4:

While significant upfront investments on technology and the subsequent costs associated with upgradation may impact profitability of a retailer…benefit from the cost savings arising from the efficiencies generated by usage of technology are crucial.

Nevertheless, not every retailer can make large investments in technology to streamline its supply chain. This is another area where large retailers with a lot of resources have a competitive advantage over smaller retailers.

Rating methodology – retail by ICRA, July 2021, page 4:

A large retailer is also better positioned to…leverage the use of technology on account of its bigger scale of operations.

Better inventory management is a huge competitive advantage for retailers as it helps them earn a better profit margin.

Rating methodology – retail by ICRA, July 2021, page 3:

A retail entity that manages its supply chain in a manner that supports optimum inventory levels at its warehouses, in a cost-effective manner, is better placed to face competition and is also likely to generate better margins.

Advised reading: Operating Performance Analysis: A Simple & Complete Guide

5.4) Shop-in-shop, bringing in speciality retailers within their store (subleasing), revenue sharing with owners:

As discussed above, rental and employee expenses are major expenses for retail companies. Therefore, to reduce their rental costs, many retailers sublease a part of the store to other speciality retailers like food outlets etc. at a higher lease rental.

Many retailers skip paying a fixed monthly rental cost and instead enter into a revenue-sharing arrangement with the real estate owner. Such an arrangement reduces the fixed costs for the retailer and helps it face economic downturns better.

Rating methodology – retail by ICRA, July 2021, page 6:

Retail is a high fixed cost business—with its two major costs being employee costs and rentals. Given this, several retailers are working on different strategies…including sub-letting space to speciality retailers at higher rentals (to bring down overall rental cost), entering into revenue-sharing agreements with shopping centre owners, and acting as anchor tenant in malls at lower rentals.

6) Capital-intensive nature of organized retail business:

Even though the retail industry is dominated by neighbourhood kirana/mom-and-pop stores, which do not require a lot of capital to set up; however, setting up organized retail stores requires a significant amount of investment.

A large amount of funds is needed to set up new stores as well as regular investment in the refurbishment of existing stores. This is true globally including in India as well as overseas markets.

Key credit factors for the retail and restaurants industry by Standard and Poor’s (S&P), November 2013, page 3:

Retailers also need to continually invest in new stores, undertake costly renovations of existing properties to maintain existing sales, and expand geographically to drive sales growth. This makes the business capital- and borrowing-intensive.

Rating methodology – organised retail companies by CARE, December 2022, page 3:

Retailers require significant funds for expanding stores’ network as well as for refurbishment of the existing stores.

In case, existing stores are not refurbished as per changing customers’ preferences, then they lose their appeal to the customers and their competitive advantage.

Key credit factors for the retail and restaurants industry by Standard and Poor’s (S&P), November 2013, page 3:

Also, outdated and/or poorly maintained stores are susceptible to material sales erosion.

Rating Methodology by Sector – Department Stores by Rating and Investment Information, Inc. (R&I), Japan, August 2022, page 2:

once the competitiveness weakens, it will quickly begin accumulating losses and returning to profitability will be an uphill task

Apart from a large initial investment for setting up a new store, retailers need to invest significant money in working capital for the day-to-day operations of stores as well.

Rating methodology – organised retail companies by CARE, December 2022, page 3:

retail business is highly working capital intensive in nature mainly on account of high level of inventory required to be maintained to ensure ready availability of stock,.. Lifestyle retailers need even more working capital funds due to the big-ticket items held as stock.

As discussed previously, retail companies invest in technology to streamline their supply chain operations to bring efficiency to working capital management. However, investment in technology and software is also a capital-intensive decision.

Key credit factors for the retail and restaurants industry by Standard and Poor’s (S&P), November 2013, page 4:

Technology to support online operations and an efficient supply chain also require sizable capital investment.

Even when an organized retailer has opened new stores and stocked them up with required inventory and implemented technology solutions, still, the store will take a long period to become cashflow positive. Until the long-gestation period of a new store is over, it will require a regular infusion of funds to run the store. This long-gestation period of retail stores increases their capital-intensiveness.

Rating methodology – retail by ICRA, May 2017, page 5:

long-gestation nature of business, results in negative cash flows for the initial few years of operations, and thus requires regular infusion of funds.

The capital-intensive nature of organized retail acts as an entry barrier for new players because any new players must spend a large amount of capital to set up the store network, supply chain, marketing, and promotions and establish the technological backbone of operations.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 15:

Thus, any new player entering the retailing industry will require very large capital outlay to compete with the existing players. This can constrain the number of new players likely to enter the segment.

Also, the amount of capital and effort required for the development and implementation of a good supply chain management system successfully, in case of value retailing, will also add to the challenges for a new entity.

The regular capital requirement for running an organized retail business is so much that retailers need to continuously monitor their stores for signs of weakness. If any store has lost its competitive edge and is losing money, then the retailer needs to shut it down quickly so that it does not drain the scarce capital resources of the business.

Rating Methodology by Sector – Department Stores by Rating and Investment Information, Inc. (R&I), Japan, August 2022, page 7:

If a company is slow to close stores that are no longer competitive, or if it continues unprofitable businesses, its capacity for investments such as new store openings or floor area expansion and interior renovation will eventually wither, a development that could weaken its competitiveness.

Advised reading: Asset Turnover Ratio: A Complete Guide for Investors

7) Diversification provides a competitive advantage to retailers:

Organized retail players benefit from diversification in their overall business across all the stores as well as diversification in the product range within each store.

7.1) Mix of segments of retail stores:

As discussed earlier, value stores sell essential items (food and groceries) at a low-profit margin but sell a higher volume of products whereas lifestyle stores sell discretionary items (fashion, branded apparel, electronics, consumer durables etc.) at a high-profit margin but sell lower volumes. In addition, value stores are less impacted by economic cycles as they witness stable demand whereas lifestyle stores see a decline in business during economic downturns.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

CARE Ratings also analyse the share of revenue from food and grocery products and non-food products to see stability of cash flows.

Therefore, a retail company, which has a healthy mix of value and lifestyle stores can streamline its profitability as well as stability in revenue across economic cycles.

In addition, within these segments, retailers who have a maximum range of products and brands in their stores can offer a better value to the customer, thereby, increasing footfalls and revenue.

Rating methodology – retail by ICRA, January 2015, page 2:

We believe a retailer with wide range of products across categories would be better placed to cater to a customer’s requirements more effectively.

In addition, such stores are relatively protected if any particular brand is not doing good business.

Rating methodology – retail by ICRA, July 2021, page 3:

The revenue potential of a retailer is closely linked to the range of products offered and on product pricing, which in turn drive footfalls / enquiries…a retailer with diversified brand offerings will be less impacted by loss of business from a particular brand vis-à-vis a retailer with a concentrated portfolio.

7.2) Geographical diversification of stores brings stability to the business:

The location of the store is one of the most important parameters for the success of any brick-and-mortar retailer. Location is the primary determinant of customer footfall in any store leading to revenue.

Retail stores located in densely populated areas, and central business districts are a big competitive advantage for any organized retailer.

Rating methodology – retail by ICRA, July 2021, page 4:

location of the retail outlets is a critical aspect driving footfalls and sales volumes. A retail outlet located in a fairly densely populated area is likely to experience higher footfalls as against one located significantly away from the populated areas or in the outskirts of a city

Businesses of retailers that have stores spread across different geographies are relatively protected from regional disturbances like natural disasters, socio-political issues, economic downturns etc.

Rating methodology – retail by ICRA, July 2021, page 4:

geographical spread of the retail outlets—a well-diversified portfolio of real estate assets imparts greater long-term stability to earnings and cash flows of an entity

In addition, if the stores are spread across different socioeconomic regions (urban, semi-urban, rural etc.), then the retail business is protected from a demand slowdown limited to a specific customer segment. For example, a poor monsoon impacts demand in rural areas whereas an economic slowdown impacts demand in urban areas.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 16:

CRISIL Ratings also factors in the entity’s business model and business location — urban, semi-urban, or rural.

Advised reading: How to do Business Analysis of a Company

7.3) Diversification across sales channels brings in competitive advantage:

Retail companies which are present across different store formats in the business are at a competitive advantage because they can serve different segments of customers effectively.

Rating methodology – organised retail companies by CARE, December 2020, page 2:

Moreover, presence across different formats (specialty stores, department stores, supermarkets, hypermarkets) and multiple segments provides the retailer with a competitive advantage.

In addition, retailers who have a mix of brick-and-mortar store outlets as well as sell goods online are relatively more protected from the downturn because they can cater to a large group of customers across a wider geography. In the situation of changing customers’ preferences for shopping mediums from physical to online, such a store will be able to serve most of the customers.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

Diversification by way of…sales channels mitigates the impact in a particular…sales channel and provides edge to the retailer over competitor. Additionally, CARE Ratings also analyse the revenue share from online sales

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 9:

A broad range of product categories, distribution channels and geographical exposures can offset negative macroeconomic swings for retailers.

7.4) Diversification in the supply chain is a competitive advantage:

A retailer that has a diversified supplier base is protected from disruption in operations if any one of the suppliers faces challenges.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

diversified supplier base is preferable to ensure smooth operations in the event of failure at supplier’s-end.

Therefore, an organized retail company, which has diversification built into different aspects of its business presents strong competitive advantages over its peers. New players are cautious before entering into the market served by such a retailer.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 9:

High diversification also protects against new competitors entering a market (products or regions) in which the retailer operates.

7.5) Diversification in store ownership model:

Retailers take possession of their store outlets usually under three models: outright purchase of the premises, lease/rental model and revenue sharing model with the owner.

Each of these models exposes the retailer to different challenges. Ownership of stores helps the retailer with lower day-to-day premises costs. As a result, the store can continue to work even during economic downturns when sales slow down. It helps in business continuity. Ownership of the store also reduces the challenges associated with lease renewals.

However, if a retailer focuses on ownership of stores as its core business model, then it involves very high capital investment. At the same time, if the retailer decides to close down the store, then it may have to bear heavy losses if it is not able to sell the store premises at a good price.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

Ownership of the stores ensures business continuity especially in case of strategic locations and reduces the uncertainties of renewing re-negotiating of lease contracts. However, own stores require higher initial capital cost per square feet and entail larger exit cost (compared to lease option).

On the other hand, if a retailer focuses on leasing its stores, then it can grow its business quickly without the need for a very large amount of capital and it can also close down nonprofitable stores with comparative ease.

Rating methodology – organised retail companies by CARE, December 2022, page 2:

Retailers with access to low-cost, quality real estate enjoy a considerable competitive advantage, both in terms of saving of major cost components and also the ability to expand more quickly.

Also read: How to do Business Analysis of Real Estate Companies

A leasing-based model also exposes retailers to credit risk. Retailers have to give a security deposit to the owner of the premises, which the owner has to return at the end of the lease term. However, over the long term, the owner’s financial position may deteriorate and it might not be in a position to repay the deposit amount leading to losses for retailers.

Rating Methodology by Sector – Retail, Japan Credit Rating Agency, Ltd (JCRA), May 2020, page 6:

a large amount of guarantee money is deposited when a store is established based on a long-term lease contract…In fact, there have been cases in which the deposits were not returned or were reduced as a result of the party’s bankruptcy or insolvency.

Due to the benefits associated with both store ownership models, retailers with a diversified mix of owned and leased stores are in a better position.

The retail division of companies that have real estate operations within the group is at a competitive advantage because they can get easy access to premium outlet space.

Rating methodology – organised retail companies by CARE, November 2019, page 2:

retail companies with access to real estate through group holdings enjoy an advantage over others

Having in-house real estate operations puts retailers at a significant advantage because delay by real estate developers in handing over store premises to retailers is one of the key risks faced by them.

Rating methodology – retail by ICRA, July 2021, page 6:

However, delays by developers in handing over properties is a significant risk, which can result in delays by retailers in launching their stores.

Many retailers attempt to expand quickly by growing via franchise stores. However, it has been observed that a franchise model puts a cap on the overall profitability that the retailer can achieve from such stores.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 10:

a high share of franchised shops usually dilutes the total addressable profitability of the stores and therefore could indicate low profitability

Advised reading: When a company should sell all assets and invest money in FDs?

8) Regulatory risks:

The retail industry is one of the largest employment generators in India. As per CARE, Nov. 2019, its share in overall employment was 8%.

Rating methodology – organised retail companies by CARE, November 2019, page 1:

It contributes about 10% of the country’s Gross Domestic Product (GDP) and around 8% of the employment

As a result, any policy impacting the retail industry has a direct impact on a large section of the population. As a result, any change in the industry comes with a big political risk. Therefore, successive govts have been very cautious about opening the retail industry to competition from large corporations including MNCs.

Even if India has relaxed the regulations for the retail industry; still, its implementation has been challenging due to various conditions and state-level implementation authorities.

Rating methodology – retail by ICRA, July 2021, page 2:

The retail industry has been facing political roadblocks in attracting foreign investments, which has restricted the benefits arising from access to capital, transfer of technology and increased supply chain efficiencies…it includes a set of riders, complicating its implementation. Furthermore, most of the compliance requirements for FDI in organised retail continue to remain a state subject and, consequently, there is less uniformity in implementation.

Therefore, the retail industry in India has seen very less corporate/institutional investment from both Indian as well as overseas investors.

Rating methodology – retail by ICRA, July 2021, page 1:

While the investment requirements remain sizeable, so far it has been able to attract only limited domestic capital.  Foreign direct investment (FDI) inflows have also remained minuscule, with retail trading receiving a nominal 0.65% of the $529.6 billion total equity FDI inflows between April 2000 and March 2021.

Due to low institutional investment, the retail industry in India suffers from infrastructural challenges in the supply chain, warehouses and cold storage, which is impacting the efficiency and growth of the retail sector.

Rating methodology – retail by ICRA, July 2021, page 1:

Adequate supply chain infrastructure, especially warehousing and cold storage as well as availability of quality space are major bottlenecks for the segment.

Apart from regulating institutional investment, govt. also controls other aspects of the retail industry. For example, in drug/medicine retailing, govt. has put pricing controls over many drugs, which are part of the National List of Essential Medicines (NLEM). It stops drug retailers from earning an excessive profit margin.

Rating methodology – retail by ICRA, July 2021, page 3:

prices of certain products are regulated to a large extent, thereby restricting the scope for margin expansion by a retailer. A case in point here is the implementation of the Drug (Price Control) Orders and the National List of Essential Medicines (NLEM)

Another example of regulatory control over retailers’ operations is the business of alcoholic beverages. In the recent past, authorities banned the sale of alcohol in certain areas, which impacted the business of retailers of alcoholic beverages.

Rating methodology – retail by ICRA, June 2019, page 1:

Regulatory restrictions such as a ban on the marketing of alcoholic beverages limits to some extent the volume growth potential of the industry…Furthermore, a ban by the Hon’ble Supreme Court on the sale of liquor within 500 metres of state and national highways, impacted the sales of entities retailing alcoholic beverages

Therefore, if an investor is analysing any organised retail company, then she should always keep a close watch on the developing regulations around the product categories dealt with by the retailer. Any adverse change in the regulations may have a significant impact on its business.

Further advised reading: How to analyse New Companies in Unknown Industries?

9) Ratios to analyse the business of retail companies:

Retail companies are primarily a collection of different stores where each store acts as an independent selling unit. Therefore, analysis of each store in terms of business performance becomes essential for understanding the performance of any retail company.

A retail store represents a fully functional unit of the whole company. Therefore, store-level analysis of business helps an investor to understand the strength of the business model of the company.

To understand the store-level business performance, an investor needs to focus on the following parameters:

Same-store sales growth: it represents the ability of the company to grow profitably across economic cycles. If it is facing immense competition and is losing its edge, then same-store sales growth will decline as pricing, as well as sales volume, will decline. On the contrary, if the company has a strong market position, then it will improve. (ICRA, July 2021).

Store level contribution of profitability: it is a good parameter to assess the profitability of a retail company at the store level. (ICRA, May 2017).

An analysis of same-store sales growth is essential because otherwise, a retailer may continue to show overall growth in business by continuously focusing on opening new stores and in turn, may mask the weakening competitive position of existing stores. Only when an investor analyses same-store sales growth, then she might uncover the declining business of individual stores.

CRISIL ratings’ criteria for the organised brick and mortar retail industry, February 2021, page 16:

an entity may have strong overall revenue growth on account of addition of new stores, but same store revenue growth may be low highlighting the risk of slowdown in revenue growth if new store additions reduce.

In fact, in the past, there have been instances (e.g. Subhiksha) where the company grew too fast without establishing the profitability of its existing stores.

Rating methodology – retail by ICRA, May 2017, pages 5 & 6:

There have been several instances in the past where a few retailers have been very aggressive in store expansion, yet fail to achieve long-term viability, and they have to subsequently shut shop.

As a result, retailers should balance their focus on opening new stores and on improving the profitability of existing stores.

Store-level performance is further broken down into per-customer parameters to further do a granular analysis:

• Number of customers
• Spending per customer
• The average price of products sold
• Number of products sold per customer

These help in the identification of any factor leading to changes in sales. This analysis will illustrate whether a company is losing its edge to customers due to competition (declining footfalls), price competition is taking a toll on the company or its product strategies need a relook. (JCRA, May 2020).

There are other parameters, which provide store level deeper understanding of the business dynamics of retailers (ICRA, July 2021; ICRA, May 2017; CARE, December 2022; CRISIL, February 2021):

• Rental per square feet vis-à-vis sales per square feet, the rental cost to total sales
• Capital expenditure per square feet
• Debt per retail outlet
• The proportion of stores that have achieved break even, time to break even for new stores
• Growth in footfalls, conversion rate
• Average selling price, average transaction size
• Share of private labels
• The proportion of sales under the customer loyalty program

As working capital management, especially, inventory management is an essential part of a retailer’s operations to maintain profitability; therefore, an investor must assess the operating efficiency of the retailer. For this, one of the key parameters is an assessment of the cash conversion cycle (CCC).

Usually, retail companies with a strong market share can maintain a negative CCC because they can sell goods on an immediate payment basis (very low debtor days) whereas they get a long credit period from their suppliers (long payable days). Therefore, retailers can fund their working capital using suppliers’ credit.

Advised reading: Receivable Days: A Complete Guide

Instances, where the CCC is changing from a negative to a positive number of days and the credit period from suppliers, is reducing, indicate that the suppliers are worried about getting timely payments from the retailer. This is one of the signs that the market reputation of the retailer is taking a hit. On the contrary, if the payable days are increasing and the CCC is turning negative; it indicates that the business position of the retailer is becoming stronger.

Retail and wholesale rating methodology by Scope, Germany, April 2022, page 11:

all things being equal, a positive cash conversion cycle driven by a low days payable outstanding tends to show that suppliers are tightening commercial terms with the retailer, implying a loss of confidence regarding the retailer’s ability to pay bills. On the other hand, a downward trend in the cash conversation cycle level reflects supplier perception that the retailer’s credit worthiness is improving.

Another proxy for good working capital management is the gross margin of the retailer. This is because any deterioration in working capital management in the form of inventory write-down & losses will hurt the gross margin of the company.

Key credit factors for the retail and restaurants industry by Standard and Poor’s (S&P), November 2013, page 10:

A consistent trend of gross margin indicates strong working capital management. This is particularly more important for seasonal retailers.

10) Employee costs:

The cost of employees along with rental expenses is one of the major costs for a retailer. Companies need to manage their employee costs efficiently; otherwise, it might take a longer time for the store to break even and it might lose its competitive advantage.

Rating Methodology by Sector – Retail, Japan Credit Rating Agency, Ltd (JCRA), May 2020, page 2:

Retailing is a labor-intensive industry, and, in general, personnel expenses comprise the largest portion of selling, general and administrative expenses. Retailers operating chain stores, in particular, need a large number of employees to work the cash registers, display merchandise, and implement in-store processing among other tasks.

The retail industry works on very thin margins; therefore, it has to be operationally very efficient to generate healthy profits. In such a situation, retailers need the best talent to run their stores as the margin of error is small. In such a situation, there is a high demand for talented employees, which increases their costs to the employers.

Rating methodology – retail by ICRA, July 2021, page 6:

retail industry faces high attrition and there is a dearth of key talent, the employee cost is also high for retaining talent.

In such situations, large-sized retailers with a strong market position, having significant resources can retain good employees and in turn can maintain their competitive advantage.

Rating methodology – retail by ICRA, July 2021, page 4:

a strong market position is better placed to attract and retain the right talent / skilled workforce, which in turn drives operational efficiency.

To reduce costs, retailers hire temporary, on-contract employees for managing ground-level operations in the stores. It reduces the scope for further cost reduction.

Rating Methodology by Sector – Retail, Japan Credit Rating Agency, Ltd (JCRA), July 2011, page 3:

While retailers hire low-paid part-time and temporary workers to reduce their labor expenses, the room for drastic cost cuts through improved productivity is smaller than in other industries

Nowadays, to reduce costs, retailers tend to resort to technological solutions to minimize human intervention in the selling process by employing automated solutions like self-checkouts.

Rating Methodology by Sector – Retail, Japan Credit Rating Agency, Ltd (JCRA), May 2020, page 2:

retailers are reducing in-store workload by introducing self-checkout or semi-self-checkout registers

Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors

Summary

The retail industry is one of the most diverse in terms of product ranges; therefore, different segments of the retail industry face different business dynamics. Value retailing is a low-margin, high-volume business with stable demand and low cyclicity. At the same time, it has low entry barriers. On the contrary, lifestyle retailing is a high-margin, low-volume business with demand fluctuations across phases of economic cycles. It requires brand-building and has a high barrier to entry.

Nevertheless, the retail industry faces intense, price-based competition leading to low-profit margins compared to other industries. To improve profit margins, retailers focus on growing in size and benefiting from economies of scale and better bargaining power over their suppliers. Large retailers are also able to make suppliers take back unsold stock; thereby, reducing inventory losses.

Due to intense price competition, retailers tend to make their operations highly efficient to reduce wastage, which makes inventory management very important. Large retailers invest in costly technological solutions to streamline their real-time inventory position with suppliers to minimize working capital costs.

Retailers rely on private labels to improve their profitability because they are high-margin alternatives to third-party branded products. However, a heavy reliance on private labels may take away the appeal of the store to customers who mainly come to the stores to buy branded goods of MNCs and private label sales are mainly incidental.

To improve profitability, retailers bring in other specialty retailers in their shops as it reduces their store operating costs. Otherwise, the high fixed-cost business of retailers with significant rental and employee costs can hurt the retailers.

To stabilise the operating performance, retailers focus on diversification in multiple aspects like the different formats of stores with a wide product selection across categories. A large number of stores spread across different geographies targeting diverse customer segments like urban, semi-urban and rural provides a competitive advantage.

Diversity in sales channels with a mix of physical and online sales is an added advantage for retailers. Similarly, increasing the number of suppliers as well as brand associations protects the retailers’ business from disruptions.

A mix of self-owned stores and leased stores helps the retailer in ensuring business continuity as well as expanding quickly by staying asset-light.

Retailing business is labour-intensive and requires access to highly skilled personnel to run an operationally efficient business. This increases the cost of hiring and retaining a talented workforce. At the ground level, retailers employ low-wage, contract labour, which limits the scope for further cost-cutting. As a result, nowadays, retailers focus on employing technological solutions to automate the buying process with self-checkout processes.

Organized retail is a capital-intensive business with significant upfront investment and continued recurring investment in the refurbishing of stores. However, due to the political consequences of changes in the retail industry, govt. has been cautious in opening it for corporate investments. As a result, the sector is yet to benefit from efficiencies in the supply chain.

An investor should keep a close watch on the regulatory changes in the product categories served by an organised retail company to avoid any negative surprises.

Apart from an overall financial assessment, an investor should always do an in-depth analysis of store level growth and profitability as well as customer level spending and purchases as well as per square feet level sales, costs, and debt analysis to understand the true business situation of the retailer.

Therefore, an investor should always keep in mind these multiple aspects of organised retail companies to understand their business position.

• Different segments of retailers behave like different industries
• Intense competition in the retail industry leads to low-profit margins
• Large size and market share is the best competitive advantage in retail
• The sale of private labels and better inventory management ensures good profitability
• Organized retail is a capital-intensive business
• Diversification provides a competitive advantage to retailers
• The industry is a politically sensitive area and therefore has regulatory risks
• Employee costs are an essential component that needs to manage efficiently

We believe that if an investor analyses any retail company by keeping the above factors in mind, then she would be able to assess its business properly.

Regards,

Dr Vijay Malik

P.S.

• Subscribe to Dr Vijay Malik’s Recommended Stocks: Click here
• Mumbai “Peaceful Investing” Workshop, July 27, 2025: Register here
• To learn stock investing through videos, you may subscribe to the Peaceful Investing – Workshop Videos
• 25% savings on buying our Stock Analysis Excel Template and all ebooks together: Analysis Package: Excel Template + All eBooks (25% savings)
• To download our customized Stock Analysis Excel Template for analysing companies: Stock Analysis Excel
• Learn about our stock analysis approach in the e-book: “Peaceful Investing – A Simple Guide to Hassle-free Stock Investing”
• To learn how to do business analysis of companies: e-book: Business Analysis Guide
• To pre-register/express interest in a “Peaceful Investing” workshop in your city: Click here

Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.