Behind Future-Bharti retail merger: Big e-tailers are eating Kishore Biyani's lunch

India is rewriting the big retail script. Even as Wal-Mart waits at the front-door gate (the back-end gate is already open), consolidation and marriages of convenience are becoming the order of the day. Last Sunday (3 May), Kumar Mangalam Birla decided to merge two of his fashion retail formats – Pantaloons and Madura Garments – and the next day Bharti Retail decided to get acquired by Kishore Biyani’s Future Retail.

Smaller M&As have been happening sporadically. Aditya Birla Retail bought Jubilant Retail’s Total hypermarket in Bengaluru, and Kishore Biyani himself bought the southern Nilgiris food chain. The Future-Bharti merger will create two companies – one for the front end and another for the back end – once the merger is put through by the financial year-end. It will leave Kishore Biyani as the No 2 retailer with possibly Rs 15,000 crore of turnover, just behind Reliance Retail’s Rs 18,000-20,000 crore estimated turnover by March 2016.

The Future-Bharti deal, once it clears the regulatory hurdles, will effectively see the partial exit of Bharti from retail, though the merger will leave the latter with around 9-10 percent of stock in the combined entity (and possibly 15 percent after some bonds get converted to equity).

Speaking about the merger, Biyani mentioned “scale and efficiency” as the main rationale for it. The merged entity would have 571 stores between them (against Reliance Retail’s 2,621), but the plans are to expand to 4,000 by 2020.

However, the reality is more complex. These mergers, and future ones, have been precipitated by several factors, including the delay in allowing full-blooded FDI in multi-brand retail, the high debt accumulation in most retail companies, the high cost of urban retail space, the kirana store fightback, the opening up of payment banking to all comers and – most important – the rise of online retailing. Online retail is taking off like a rocket, thanks to heavy funding from venture and private equity players with deep pockets and long-term payback horizons.

The funding may not last, nor may be the euphoria, but make no mistake: it is the rise of online that is putting the fear of god in brick-and-mortar big retail. They have suddenly realised how vulnerable they are.

Consider just two numbers: Flipkart, the big daddy of Indian online retail, was last valued at $11 billion – and looking to raise this to $15 billion (Rs 96,000 crore) in the next round of funding. Snapdeal, which recently failed to tieup with Alibaba, is looking at valuations of $6-7 billion , when the latter was looking at $4-5 billion. Jabong, last valued at around $400-450 million   by one of its investors, could already be worth half a billion dollars. A two-year old startup which is years from making money – housing.com, which has been more in the news for its CEO’s brash letter-writing skills than anything else – got its last dollop of funding that valued at the company at a quarter billion dollars – around Rs 1,500 crore.

Now cut to Indian Big Retail: all the listed companies put together, from Pantaloons to Future Retail to Trent and Shoppers’ Stop and several tiny companies, are valued at Rs 15,000-and-odd crore. Just about $2.4 billion.

Next, consider the snowball rolling down the consumer mountain: Mint quoted a report by Knight Frank India (a property consultant) and the Retailers Association of India as saying that by 2019, online retail may nearly have caught up with brick-and-mortar retailers, with the former’s share of sales rising from two percent to 11 percent of the Indian retail market, and the latter’s dropping from 17 percent to 13 percent.

More than just achieving scale and efficiency, what worries physical Big Retail is that it is puny in the valuation stakes. High valuations give you the currency for acquisition. At current valuations, the Flipkarts and Snapdeals can eat Indian Big Retail for lunch. Biyani may be less worried by Wal-Mart and more about the likes of Flipkart.

The delay in the entry of the Wal-Marts, Carrefours, Tescos and other big global retailers has meant that players who would have wanted to sell at high exit valuations now have no option but to merge and survive to fight another day. In the case of Bharti Retail, for example, it has had to virtually write off Rs 1,800 crore of accumulated losses to retain a value of Rs 500 crore in the merged entity. Future Group, to bring down its debts, had to sell off its Pantaloons fashion garments format to Aditya Birla Group, and, to facilitate the merger, it also had to split its existing debt into two parts – with the bulk of it being offloaded (Rs 3,500 crore out of its total debt of Rs 4,700 crore) to Future Enterprises, with a new entity being created to handle back-end operations.

The only thing common to the online retailers (e-tailers) and the physical format retailers is that neither of them has ever made money – at least nothing compared to the money and time invested in their businesses. The P&Ls of the e-tailers are worse than that of Pantaloons and Future Retail, but that does not matter for now. Jabong, a fashion e-tailer, made a loss of Rs 293 crore on revenues of Rs 438 crore in 2013-14 – which means for every Rs 100 of sales, it loses Rs 33. It will probably take years to break even.

But right now growth is what they are chasing, not profits. And as long as investors are gung-ho, they can continue to grow, Big Retail will find its customer base getting yanked right from under its noses.

Apart from debt, the big lead ball attached to brick-and-mortar retailers is the high cost of land and rentals. Given the extraordinary prices of real estate in the big metros, the Wal-Marts, even if they enter, will not be able to find large-enough spaces at viable prices in the foreseeable future. They will take years to break even. For cash-strapped Indian retailers, this is nothing short of a future death-warrant. The e-tailers are scoring over them because they do not have to invest in land – their warehouses can be located in cheaper places, and even logistics can be outsourced.

More important, the humble kirana store-wallah, to protect whom Wal-Mart has been held back, is now discovering a new friend in online retail. Kiranas have seen the writing on the wall, and they are mutating to compete better. They are doing two things: better funded store owners are buying out their neighbours and metamorphosing into mini departmental stores that mimic big retail in smaller formats; and, two, they are tying up with the big e-tailers to become local delivery points for them. The e-tailers get the orders online, and the kirana store delivers the goods in its neighbourhood.

This alliance between kirana and e-tail is most prevalent in the new hyper-local grocery formats that are mushrooming in big cities. Grocery websites like BigBasket, LocalBanya, Zopnow, PepperTap, Grofers, Zoppers and Jiffstore are now supplying all the basic things that everyone needs – from toothpaste to staples to packaged foodstuffs and fresh veggies, and their entry in metros like Mumbai, Delhi, Bangalore and other places has completely changed the game, both for the regular retail chains, and for the local kirana store itself.

The new alliance of kirana and e-tail makes them frenemies, not real friends. E-tailers are anyway hiring hundreds of delivery boys and small transport vehicles to deliver orders made over the internet (including mobile phones) to homes within two or three hours. This is a huge convenience for households, especially where both husband and wife are working and have no time to waste on everyday shopping, but a long-term threat to the kirana shop.

Earlier, small-ticket demand was met by kirana stores, who often took orders over the phone and delivered small items, but if e-tailers get into the game in a big way, they could lose, as e-tailers can always stock more goods than them.

On the other hand, the e-tailers also face a constraint. Since grocery deliveries can be costly, tying up with the kirana store offers lower costs of delivery. They also need to hold less inventory themselves. Companies like Zopper have tied up with large numbers of kirana stores to use their stocks to serve customers. BusinessLine notes that Zopper has tied up with over five lakh small retailers to deliver everyday necessities in local areas of Delhi, Mumbai and Bangalore.

This is how it works. While the e-tailer takes orders directly on its website, the order is then passed on to the local kirana store nearest to the home where it has to be delivered. PepperTap positions delivery boys next to kirana stores, and when the order is received, they go and deliver it to homes.

The big retailers like Wal-Mart are known to buy in bulk from farmers and suppliers, and creating huge warehouses from where they deliver goods to their stores; Indian grocery e-tailers are, on the other hand, using the existing capacities of kirana stores to deliver faster. This is win-win, where both the e-commerce player and the kirana store benefit. They share the margins.

If the Wal-Marts bring in large-scale supply efficiencies by cutting out middlemen, the Big Baskets, ZopNows and PepperTaps are revolutioning local logistics and giving business to kirana stores. They are effectively improving the local, existing supply chain in cities.

Another development – in banking – is also becoming vital to success in e-tailing and retailing. Currently, payments in physical stores are easily done by credit or debit cards, but in e-tailing, credit card usage is considered risky. This is where payment banks, which facilitate small-ticket payments for everything from cabs to grocery, can check in.

The big telcos – Airtel and Idea Cellular among them – all plan to float payment banks to provide seamless services through mobile payments. This is where the Bharti-Future group merger is strategic – even while being defensive in relation to the e-tailers. Given its small but strategic stake in Future, Airtel could use its payments bank and mobile networks to facilitate grocery payments in Future stores.

It is difficult to predict where competition will take Indian retail, but clearly the delayed entry of Wal-Mart has allowed new retail ideas to flourish. It has benefited online retailers and sidelined the brick-and-mortar retailers.

Biyani has a tough fight ahead, no matter what.