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There are 2 ways to play an innings.
On one end, we have the Virender Sehwag way of playing big shots from the word-go to put the bowler under pressure to resort to defensive bowling tactics, which is a high-risk fast-growth strategy. On the other end of the spectrum, the Rahul Dravid way of slowly settling in, playing defensively, and taking very few risks until settling down.
We can draw the same parallels to businesses that have long innings(size of opportunity) ahead. One, start aggressively expanding with little care for profit until attaining high market shares, driving other similar players out of the industry through sheer deep pockets and speed of execution. This is typical of Reliance and a number of other internet companies today. The other way, the more conventional way, is to slowly perfect the model at a small scale before expanding aggressively. D-Mart falls into this second bucket, slowly building a successful offline grocery retail business, along the way building a level of efficiency to envy about, and now trying to follow a similar style in building their grocery e-commerce business.
Organized retail is a large market, hugely under-penetrated in India. Overall, organized retail is only 10% of the total retail market and within food & grocery, only 3% of the market is organized. So, there is a huge opportunity out there for the right players to grow. The overall pie is growing at a healthy rate given 1/3rd of spending by the Indian population being on food & grocery. On top of that, the shift from unorganized to organized is a multi-decade opportunity.
Within organized food & grocery retail, the different types of formats broadly are given below, with DMart focused on the Hypermarket format whereas some players try to play across the different formats like Reliance.
By an account of the management and research analysts’ estimates, the potential for DMart in terms of Number of stores could be around 1200, if not more. That is easily close to 6x of current stores.
Though the opportunity size is huge, the industry is a challenging one to execute given wafer-thin operating margins. The only way for a company to win in retail is being extremely efficient thereby maximizing operating margins in comparison to competition and laser-focused on optimizing asset turnover(maximizing sales/assets). There have been more failures than success stories in Indian organized retail some of which are highlighted below.
Given this context, let us try to understand why the D-Mart model is so successful, why investors are ready to give upwards of P/E 200 and why it is so difficult to overthrow D-Mart in its journey towards building a large offline grocery retail business in India.
“I am delivering a very-very functional service. I am not giving you top-class experience when you come into my store. I am just giving you great products at a good value. Everything else is very transactional.”
– Neville Noronha, CEO, Avenue Supermarts (D-Mart), FY21 Analysts Meet
The lines above explain the D-Mart model so clearly. How have they built an organization so focused on building this one thing, without being concerned about competition, loyalty programs, or any of the other external factors not related to the mission above?
High cost of capital, regulatory challenges(approvals, minimum wages), value-conscious customers, and the ability to not charge beyond MRP despite high rents mean only very efficient retailers survive, unlike in the West. So, in India, retail is all about efficiency. Efficiency across costs, working capital, CAPEX, and financing the capital requirements. This efficiency leads to good margins and eventually cash flow, which helps in funding the growth. D-Mart has optimized each of these parameters in order to get the goods at the lowest cost in comparison to the competition and hence, sell it at the lowest price in the market, still earning enough returns to satisfy the shareholders.
Stable gross margins maintained by passing on cost benefits to consumers and improving EBITDA margins through efficient operations
D-Mart has chosen to be in a format that is in between a regular Supermarket and a Hypermarket.
Broadly D-Mart sells 3 categories of items.
- Food FMCG
- Non-food FMCG
- General merchandise (incl Apparel)
D-Mart’s model is to get footfalls by selling food & grocery, which are low gross margin categories, and then upselling higher gross margin general merchandise to these customers. This is where higher sq ft help in selling more of their general merchandise.
Over the years, D-Mart has been slowly increasing its mix towards general merchandise. This is against other competitors who have been cutting down from their initial store sizes.
With stores maturing and the brand value of D-Mart increasing over the years, D-Mart has successfully stepped up their revenue per sq ft to more than 2.5x over the last 7-8 years.
D-Mart is a value retailer focused on the value-yearning middle and lower-middle-class population of India with a promise to deliver great products at the cheapest prices in the market. A comparison with the other organized retailers shows that they have the best discounts and prices in the market.
They do this through one thing that is fundamental to why the DMart model works.
Right Assortment: D-Mart is a master of assortment. The assortment is basically the breadth of product categories and the depth within categories (number of brands and SKUs within a product category). D-Mart focuses on those product categories which sell out the fastest and within each category sticks to the top brands, not giving customers too much choice, but the best-selling ones. This helps in getting more volume for the SKUs stocked, selling them out faster, resulting in better inventory turns and reducing wastage. The assortment is also customized to local taste, resulting in limiting lost sales due to the lower number of SKUs stocked.
D-Mart runs a very tight ship and has maintained their working capital days very stable around 20-25 days. And the best part is that this is majorly driven by tight control on inventory days vs payable days. High inventory turnover means a higher quality of execution vs lower payable turnover, which just means that the company is able to strangle the suppliers for longer payment terms.
With tight working capital management, a low number of SKUs, and high volumes, they are able to get better rates from the manufacturers, probably better than any other player.
Also, any operational efficiency is passed on to the customer in order to just maintain their 15% gross margin and provide the customers with a better offer.
D-Mart has the best-operating margins in the industry. D-Mart has the lowest gross margin, which is by design. They compensate for low gross margins by having extremely low rentals, salary, employee, and other opex spends to deliver best-in-class operating margins.
Cost of goods sold: Retailers purchase goods from manufacturers or distributors, mark up the price, and sell it to the customers. The difference between what the customers pay and what the retailer buys it for is the gross margin that the retailer makes. D-Mart’s competitors have a gross margin of around 25%, even the global value retailers have a gross margin of 25% or above, whereas D-Mart has a gross margin of 15%. That doesn’t mean D-Mart is inefficient. In fact, the opposite. Given their large volumes and lesser number of SKUs, D-Mart gets the best rates from the customers. Also, D-Mart pays its suppliers within a week, against the common practice of 30-45 days. With this early payment, D-Mart is able to get better rates. It is a conscious call to maintain gross margin in this 15-16% range. Whenever the company is able to get cost efficiencies to earn a better margin, they pass it on to the customer.
Rent: Rent is the biggest operational cost driver for retail businesses, especially grocery retail. D-Mart has taken the route of owning the land and buildings(owns 80% of the stores) against the general practice of leasing. Hence, they are able to convert the single biggest cost bucket as % of sales(usually 3-5%) into depreciation cost(1% of sales). This gives an operational cost advantage over the competition, with the constraint that this is a capital-intensive strategy.
Salary: D-Mart hires a mix of permanent and contract labor, gives high levels of authority at store level and hence low corporate salary costs, has strong internal policies, preferring people with humble backgrounds and hard-working nature. Also, the company empowers employees and runs a strong ESOP policy (35% of employees covered at the time of IPO), driving strong ownership.
Advertising & Sales Promotion: D-Mart has 0 advertising budget. Yes, that’s right. The company doesn’t advertise. They rely entirely on giving customers great value, running a tight efficient ship, and leaving it to customer word-of-mouth to drive footfalls. The company doesn’t run a loyalty program to give special benefits to select customers too.
“We do not run a loyalty program, our basic philosophy of the business is that all customers are the same and treat everybody equally”
A cluster-based strategy is one in which most of the stores are situated close to each other. This results in strong supply efficiencies. From a supply perspective, they can have larger warehouses and better utilization of warehouse space, efficient sourcing of goods from supplier and distribution to stores resulting in lower freight and warehouse costs. From a customer perspective, cluster-based expansion helps in better brand awareness and drives word-of-mouth, also helping in a lower need for advertising.
Tight control on CAPEX and depreciation by avoiding busy high-cost land parcels: D-Mart is very particular about getting real estate in good locations, at the same time in areas that are not in costly areas, with clean titles at moderate rates. It is hard to find a DMart in a mall or on the high street. More often than not, it will be closer to residential areas, than commercial areas.
Just a look at the store economics of DMart points us to the suppressed return on capital by having an owned-store model vs leased-store model. DMart can almost double their return on capital from their already high 25% by opting for a leased model. But, it is one of the moats of DMart to push away the competition by having lower operational costs instead.
DMart has also never shied away from investing heavily into technology very early in order to gain operational efficiencies over the long term, be it their investments into building ERP systems 15 years back, or their inventory management systems and procurement systems.
With COVID-19, the shift towards grocery e-commerce is a reality even though grocery is amongst the least disrupted categories worldwide. But, now we have a number of companies competing for this huge slice of pie i.e. Big Basket, Grofers, Swiggy, JioMart, Amazon, etc. DMart had chosen to not concentrate too much on their e-retail strategy earlier, but now with the situation demanding, they are focusing their efforts on perfecting an e-retail model, which can at best be profitable but at the least, lose less money than the competition. In short, be the most efficient player in business in e-retail just like how it is offline.
Let us try to understand the model in comparison to the service offerings by the competition. Unique to the industry, DMart runs D-Mart Ready stores(small size - roughly 250 sq ft primarily in Mumbai, though they have recently started expanding into other cities in Maharashtra and Gujarat) which act as pick-up points. These stores are located in and around the residential areas, so that any Mumbaikar need not go beyond 300 m to locate the closest DMart Ready store. DMart has around 225 Ready stores in Mumbai currently.
DMart also has an option to deliver directly to customers wishing to have home delivery. These 2 models are run independently of each other. In each case, the order is dispatched from the fulfillment center. But, in order to cover their delivery costs and in general, discourage customers from opting for home delivery, DMart charges Rs. 79 delivery charge. So, it is quite clear that DMart sees its Ready stores as the more sustainable model from their perspective. Why is it so?
For the home delivery model, the main cost drivers are the delivery partner salaries and fuel costs. The delivery partner salary is fixed cost and the fuel cost is variable depending on how many km have to be traveled to deliver. Operational efficiencies kick in if the number of km per order can be minimized and the delivery partner can deliver more orders in a day. Still, the level of operating leverage built into the model is limited, as the number of km per order can’t be increased beyond a point. What DMart is trying to do is replace the variable fuel cost with another fixed cost driver, which is Building rent, in the case of DMart Ready. This means that it is more difficult for a Ready store to break even than a home delivery model. But, what are the benefits?
There is practically a very high ceiling in terms of the number of orders that can be fulfilled by each store personnel. If you can connect the dots, this is a very similar strategy to what DMart is doing in their offline model. By converting variable building lease costs into fixed owned and depreciation costs, they ensure that they get higher operational leverage when they get more footfalls. So, once a certain scale is built, the moat gets further strengthened with incremental orders per store. We already see that DMart Ready has been able to avoid excessive cash burn in spite of the increase in the number of stores and revenues.
A rough unit economics check of DMart Ready store also points out that, for store-level profitability, roughly 78 lakh revenue is expected per month. This works out to roughly 22 orders per day. As pointed out earlier, even if the number of orders goes up to 100 orders per day, it could be managed with incremental salary costs only. That’s the inherent power of the business model being built.
The biggest challenge to the success of the model is on maintaining the cheapest prices in the market, thereby getting higher loyalty from the customers to do their regular purchase from DMart. This is where the online challenge seems to be bigger than offline for DMart. With the deep pockets of the online grocers, remaining the cheapest-priced player online has been tough for DMart. JioMart has been quite aggressive on price and has been undercutting DMart on a number of products.
In the coming few years, it will be interesting to see if DMart could still be Rahul Dravid playing conventional shots in T20 and still turn out to be successful.
The above exercise is to understand the business genius of DMart and not to present it as an investment idea at this valuation. DMart is definitely a business built to last, but a very good portion of the long growth runway and robustness in the business model is priced in, in the valuation today.