Arvind Singhal: An avoidable conflict

MARKETMIND

A few days ago, one of India's leading retailers took a rather unusual step of shooting off a letter to many leading FMCG companies in India (and more surprisingly, made the contents public to business media as well), demanding an additional 5% margin to help it make up its higher operating expenses and on account of its belief that it offers superior exposure to these FMCG companies' brands in its stores. This retailer went on to issue a very clear message to the recipients that in case they fail to appreciate this request, they should be prepared for an adverse reaction. While regular negotiations between buyers and suppliers are an accepted fact of business life, this rather public exposure of the otherwise business confidential matters took many by surprise. I have no idea what the response of the recipients has been, but I doubt if a majority shook in their boots at the prospect of losing business from this particular account.

This sort of a tussle is not new even in India. Some years ago, a leading department store group in India and a leading branded apparel clothing company got into a similar rush of adrenaline and after some sabre rattling, decided to part ways. Similarly, an upcoming discount supermarket chain operating in South India has had its share of skirmishes with a few leading FMCG players.

Is this kind of tussle for margin a shape of things to come in the near future as the current retail businesses acquire more muscle, and many new players, including some real giants, make their presence on the scene in the next 12-18 months? Is there a business case for modern retailers to expect and demand more gross margin compared to the traditional, fragmented, unorganised retailers? Is it given that brand owners""manufacturers and marketers""are destined to lose their pricing power and be made to dance to the tune of their channel partners, i.e. modern retailers? The answers, in my view, are not entirely intuitive.

There is certainly a case for higher margin expectations by modern retail businesses. They pay market rents (which seem to be shooting up almost every month each time a new property is to be leased out) against practically no rents by most of the traditional retailers; they have much higher upfront start-up costs including superior retail store fit-outs and IT backbone; they have to bear higher operating costs both in terms of superior service; and they do provide better visibility to brands through more appealing displays that encourage more impulse purchasing for trials. Some of these costs can be made up by superior retailing efficiency and better financial performance in terms of sales per square foot but not entirely. Having said so, it is also a fact that the entire modern retail trade accounts for less than 1% of the total FMCG market in India and hence its performance has practically no impact on almost any of the major FMCG giants.

It is also a fact that FMCG companies operating in India, especially multinationals, have historically enjoyed exceptional operating margins compared to their own counterparts in more developed countries. However, they have built this position of dominance on account of having invested heavily in having a countrywide presence, product development and innovation, superior logistics, and state-of-the-art information technology support in many cases. Their higher margins, they can argue, have been earned the hard way while the modern retail businesses in India have just made a start. Having said so, it is very likely that FMCG companies' brand dominance may be loosening a bit on account of the demographics of India that has, almost all of a sudden, seen onset of a new young generation of consumers""many of whom are first-time consumers and hence have no "memory" of the past and hence no brand loyalty to start with. At best, they may have a recall of some of the brands.

Hence, in my view, while the upcoming modern retailers have to acknowledge that while their ambitions may be huge, their current size and scale remain minuscule and hence it is therefore premature to lock horns with their brand-leader supplier partners. The retailers could lose more heavily if some or all of those FMCG companies who receive such missives decide to hit back by entirely withdrawing their products from the shelves. Instead, these retailers should for the time being focus on generating better operating results through more efficient retail business operations while biding time to attain a scale and a customer loyalty that allows them to successfully introduce more private labels and thereby achieve overall better gross margin.

FMCG companies should, on the other hand, take this as a warning of things to come. They should invest more on R&D to develop even more superior products and increase their marketing spends to create a stronger brand pull. It may also come as a surprise to many to learn that notwithstanding the huge investments expected in the Indian retail sector, over the next 10 years, the number of traditional retail outlets across India, including grocers and chemists, is likely to rise by as much as 35%, compared to current levels and hence they would be committing a cardinal mistake if they were to ignore the increase in importance of the so-called unorganised retail in the immediate future.

arvind@technopak.com