Due Diligence In Retail Set To Increase

The right time, right price and right quantity are considered the three ”Rs” of retailing that determine success.

Rapid store expansions by players looking to cash in on increased consumer purchasing power and improved consumption patterns propelled the growth of multi-brand retailing companies between 2005 and 2007. With the onset of the global economic slowdown in 2008 and news of few retail players struggling to stay afloat, a more cautious approach was adopted, with companies focusing on improving operational efficiencies and de-leveraging rather than profitability. Industry experts believe that the Indian retail growth story is still secure, and that the industry is just facing its first macroeconomic slowdown. The slowdown has impacted the debt servicing burden of several retail companies, which are now looking to raise capital for debt repayment, working capital as well as store rollouts.

The Indian retail growth story has always interested global retailers as well as foreign private equity investors. According to the recent Press Notes 2, 3 and 4, the investment in an operating company by an Indian investing company “owned” and “controlled” by resident Indian citizens or Indian companies would not be treated as FDI. However, the industry is expecting the government to clarify that these Press Notes should be equally applicable if the operating company mentioned is engaged in multi-brand retailing.


With deal activity levels in the retail sector expected to increase, retailers will need to also prepare for an extra and cautious due diligence carried out by investors before investing. While most investors buy the India consumption story, investors are likely to want the focus of the due diligence process be on providing answers to some of their concerns.

Some of the key matters that investors typically look out for are:

Revenue and margins

· Retailers could be selling a single product/category or multiple products and private labels as well as vendor-owned brands. As such, investors would like to understand the growth drivers of revenues and margins by brand, format, geography or product category. Since the margins in private labels are higher, investors are likely to express interest in the mix of revenues and margins between private labels and vendor brands. While the margins for private labels are generally higher, brand-building costs and servicing issues may affect them.

· Retail outlets may be owned, rented, shop-in-shop, franchisee, or a mix of more than one outlet structure. Franchisee agreements are fairly prevalent in the case of single-brand retailing and not so common for hypermarkets and supermarkets. Contribution to the revenues and margins of each model are important to understand.

· Investors prefer to understand revenue and margin from the same and new stores separately year on-year. Same-store growth is driven by an increase in foot falls, the ability to convert footfalls into customers and to increase the ticket size of stores opened in a previous comparable period. Same-store growth is generally considered to be a better representation of growth.

· Overall, revenue appears to have grown by 35% in Year 2 and by 61% in Year 3. However, same store sales growth shows a decline from 10% in Year 2 to 6% in Year 3.

· The key performance indicators (KPIs) that an investor is likely to focus on would include revenue per sq. ft, store level and overall EBITDA per sq. ft, revenue and margins per store and by category, average ticket size, gross margin return on inventory (GMROI) and gross margin return on footage (GMROF). The revenue KPIs are examined separately for each geographical segment such as tier1, tier-2 and tier-3 cities.

· The retailer’s ability to generate and sustain alternate revenue models is also important. Such revenues may include space leasing, co-branding initiatives, vendors’ promotional activities and institutional sales.

3R's of Retailing : right time, right price and right quantity

The right time, right price and right quantity are considered the three ”Rs” of retailing that determine success. Merchandising and procurement play a key role in ensuring that a store stocks the right quantity, at the right time and at the right price for the customer. Investors may raise specific queries around the planning and procurement process, arrangements for returns/discounts with vendors, dispute with vendors, credit terms and overdue payables.

Low Net Margins

Investors like to know if there have been any standalone and non-recurring items contributing to revenues or expenses, so that its impact can be normalized. Since the net margins are typically low, investors prefer to exercise caution before normalizing such items.

Mark-downs and discounts

Retailers offer many varieties of discounts to increase merchandize churn. These include end-of-season sales, volume and bulk discounts, customer loyalty discounts and promotional discounts. Mark-downs refer to the forced selling of goods at lower prices to clear old, obsolete or stocks nearing expiry. Investors want to understand the various categories of discounts on offer and their impact on revenue and margins.

Store and corporate overheads

Collectively representing expenses recorded between gross margin and EBITDA, store and corporate overheads are analyzed separately. Store overheads are mostly fixed and primarily comprise rental, staff and electricity costs. Most companies do not provide of a composition of store and corporate overheads in their financial statements. As such, diligence teams may insist on MIS reports for such analysis. While most modern retailers are likely to have decent storelevel margins, after considering corporate overheads, net margins could shrink.

Leveraged position

Many retail companies are in fund raising mode primarily for expansion as well as de-leveraging their balance sheets. Investors are interested in understanding the debt profile, which includes interest rates, available security, financial covenants and repayment obligations in the immediate future.

Inventory management

The importance of inventory management in retail companies cannot be over-emphasized. It is the single-most important area of focus for every investor. Investors want to understand the company’s inventory management systems, controls, inventory valuation policy, provisioning policies (viz. mark-downs, shrinkages, dump and the like) the frequency of physical verification and existing system for dealing with deviations. The extent of stocks that are slow-moving/nonmoving and their liquidation plans are also important given their impact on margins in the near future.

Forecasts and business plans

Generally, a retail company prepares a business model covering its rollout plans, historical revenues and cash flows as well projected numbers. Investors may require the diligence team to examine the assumptions and comment on the reasonable quotient of such business plans in view of the company’s historical trends and current financial position.

Store rollouts and financing
Investors prefer to understand the ramping up and financing of stores through lease deposits in a historical context. Moreover, they are expected to understand trends in capital expenditure (capex), the cost per sq. ft for various formats by geography and store format. An analysis of the total historical store-level capex by separating maintenance and expansion capex is generally required.

Why a vendor due diligence? Does it help?

Gives an early warning of issues so they can be set right before a prospective investor arrives
Verifies IM numbers as part of the process, which provides investors with more comfort over the numbers
Speeds up the sale process as prospective investors are better prepared, thereby– enhancing competitive tension in the disposal process
Provides greater control over the disposal process and flow of information during the process,which helps to maintain competitive tension
Keeps investors/buyers away from management, thus enabling management to continue focusing on business performance
Helps to prepare management for investor meetings and queries

SUNIL GANGWAL, ASSOCIATE DIRECTOR, ERNST& YOUNG