Harnessing Operational Efficiency: Achieving Sustainable Retail Success Summary of 2016 Working Capital Management Study for Retailers in China Acknowledgment

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Harnessing Operational Efficiency: Achieving Sustainable Retail Success Summary of 2016 working capital management study for retailers in China Acknowledgment

Special thanks to the below interviewees for their sharing and contributions to the development for this report.

Professor Stuart Gilson Steven R. Fenster Professor of Business Administration Harvard Business School Professor Ananth Raman UPS Foundation Professor of Business Logistics Harvard Business School Sun Weimin Vice Chairman Suning Commerce Group Yuki Habu Chairman & CEO AEON (China) Gao Shulin President Rainbow Department Store Chopinter Wang Group VP, Food BU GM Better Life Commercial Chain Sam Guo Food & Supplies Division General Manager Yonghui Superstores Peter Yu GMM of HL Dept., National Commercial Center China Resources Vanguard Hang Yan Chain Store Education Foundation

Project committee

Expert advisory board China Chain Store & Franchise Association: Guo Geping, Pei Liang, Chu Dong, Zhu Fang PwC: Carrie Yu, Michael Cheng, Kevin Wang Renmin University of China: Professor Liu Xiangdong Beijing College of Finance and Commerce: Professor Wang Chengrong

Editorial board China Chain Store & Franchise Association: Wang Ruida, Guo Yujin PwC: Mark Gilbraith, Ken Zhang, Michael Gildea, Steven Zhong, Susan Eggleton, Kurt Xu, Joan- na Chen, Veronica Zheng, Esther Mak

2 PwC Summary of 2016 working capital management study for retailers in China 1 Foreword

In the 2016 Report on the Work of Government, Li Keqiang, Premier of the People’s Republic of China, discussed China’s emphasis on supply side structural reform in order to drive sustained growth. Retail, as the intermediate link between manufacturing and end consumers, its development progress directly reflects the efficiency of supply-side in meeting consumers' demands. Thus, understanding the relationship among all retail stakeholders - including shareholders, community, government, and consumers - will enhance cooperation and help drive the healthy development.

In this context, the Ministry of Commerce delegated China Chain Store & Franchise Association (CCFA) to conduct a study on 2016 Commercial Relationship Survey under the context of Supply-side Reform which covers the emerging retail trends, relationship between retailers and suppliers, retail price ‘mark-up’ and working capital management.

CCFA enlisted PwC to help conduct the study on retailers working capital management. PwC has many years of experience with working capital management solutions in the retail sector. The report delivers insights to corporate executives, the academic community, and various institutions. It also delivers findings, makes comparisons of listed companies’ key indicators and suggests recommendations for effectively optimizing working capital.

The report will allow retail operators to compare industry indicators with their company’s own results, providing a solid benchmark against the industry.

China Chain Store & Franchise Association April 2017

2 PwC Summary of 2016 working capital management study for retailers in China 1 Executive summary

Retailers’ path China’s retail sales Understanding the value to business and profit growth of working capital transformation have declined A company’s working capital not only The retail industry in China has In China, supermarket sales growth is reveals whether resources are wisely witnessed rapid growth during the at single-digit levels. Some larger utilised but also affects the company’s past two decades, and that growth has department stores and multi-format profitability and risks. It is a critical tended to cover up many inherent retailers are even recording decreased building block for business growth. problems in the retail industry itself. revenue. Supermarkets registered a net Executive management must However, given the more recent profit ratio of 1.3% in 2015, compared understand the value of working slowdown of growth, changes in to 2.1% in 2014. The net profit ratio of capital as well as the underlying consumption patterns and the rise of department stores also declined from operational issues and risks, while e-commerce, challenges in all aspects 4.8% in 2014 to 3.8% in 2015. An seeking to improve efficiency. of operations management have exception is apparel retail, which become more critical. Today, against reported a net profit ratio of 11.2%. Inventory turnover is a the backdrop of the government’s Home appliance chains only registered supply-side reform, retailers have net profit of 0.8%(Figure 1). key performance begun to explore a path to business indicator (KPI) in transformation in order to increase Chinese retailers have always relied their overall competitiveness and drive on credit from suppliers as an Europe and United sustainable development. This is important source of external funding. States – but not in China necessary as some Chinese retailers In recent years, suppliers’ credit terms Inventory turnover measures the have started to experience decreases in have been continuously stretched, and number of days it takes to pay for and sales, and certain companies are in any room for retailers to alleviate generate cash from the sales of a financial difficulty. For retailers in working capital pressure by further company’s products. The retail China, topics such as cash flow and deferring payments to suppliers is industry in Europe and the United working capital management no longer limited(Figure 2). Supermarket chains States uses this to measure inventory remain only within the finance and apparel retailers have faced performance, as well as the overall department, but have gradually especially great challenges as cash is health of the company and the become part of the CEO agenda. locked up with the slowing down of inventory turnover. performance of management. Retailers in China typically do not

2 PwC Summary of 2016 working capital management study for retailers in China 3 focus on working capital management. can cause stores to lose market appeal • Get win-win solutions by In most cases, operating revenue and since the products are supplier centric managing strategic supplier profit margin are taken as the rather than consumer centric. In order relationships important and only measures for to hold ground, department store Encourage resource sharing and evaluating retailer performance. This operators need flexibility in their achieve win-win by managing reflects a common style in which top operating models in order to meet the strategic supplier relationships management focuses on results but not increasingly diversified needs of • Increase inventory turnover on the process and neglects the consumers. However, this is a step using category-based planning significant lost opportunities from change as it requires strengthening Strengthen merchandising and improving operational management to procurement capabilities, category category-based inventory planning generate new business and improve management and inventory planning. to proactively manage business financial results. changes and inventory turnover With unsustainable business Better inventory fundamentals and broad geographic management yields • Support better inventory coverage, supply chain management decisions with IT and data including inventory management has better results analytics become a common challenge for Strengthen IT system and data Many proactive retailers are focusing retailers in China. Supermarkets in the analytics capabilities to support on inventory management, especially United States maintained an average better inventory decisions category management and inventory 30 day inventory turnover rate, as planning. We believe better inventory compared to China’s 50-day rate from management processes are key to Research methodology 2013 to 2015(Figure 3). The average thriving in this competitive market. supplier payment term for the retail This report is based upon research industry in China is as long as two to Harnessing conducted jointly by China Chain four months, while in the United Store & Franchise Association and States it is just 1.5 months(Figure 4). operational efficiency: PricewaterhouseCoopers (PwC). It It’s clear that there is room for Achieving sustainable summarises our views on operational improvement here. management for Chinese retailers and Through this report we hope to retail success provides insights on improving encourage retailers to begin to focus Effective working capital management operational efficiency. Our research on the concept of working capital is essential to financial and operational included information from three management and its tools, as success. It requires driving major sources: these are building blocks of collaboration across the value chain, Interviews: We interviewed successful performance. building a portfolio of quality professors at Harvard Business School, suppliers, integrating resources and as well as senior executives of the Top Inventory strategically managing suppliers. It 100 retail chain stores in China. management critical also means focusing on inventory Questionnaires: We conducted a planning and category management survey with 21 Chinese retailers, most For supermarkets, improving their and continuously driving improvement of them in the Top 100 retail chain ability to quickly respond to change in in inventory turnover performance. By stores in China. demand is critical. Management has to doing so, Chinese retailers will Listed company data: Our reduce the gap between the frequent transform from the traditional model quantitative analysis, including changes in market demands and that places high reliance on suppliers financial indicators, was based on corresponding response to meet these rebates and credit terms to an publicly available data for retailers listed demands(Figure 5). If the forecasting operating model that drives in Mainland China and Hong Kong. The mechanism is insufficient, retailers profitability from revenue growth and sample consisted of 86 companies, and will have a difficult time addressing savings from operating effectiveness. the formats included department stores, changes in consumer behaviour and In this report, we offer these supermarkets, multi-format stores and seasonality demand factors. Likewise, recommendations: specialty stores. lack of inventory planning and pre- • Optimise working capital to warning mechanisms will hinder drive business growth effectiveness in inventory Collaborate across the retail chain to management(Figure 6). optimise working capital and drive Department stores often operate jointly business growth with suppliers, and suppliers have designated concessionary counters for • Enhance forecasting of future their merchandise. This can reduce demand inventory risk and increase turnover, Work with business partners to but such traditional operating models enhance forecasting and collaborative planning of future demand

2 PwC Summary of 2016 working capital management study for retailers in China 3 Interview with Professor Stuart Gilson Steven R. Fenster Professor of Business Administration Harvard Business School

4 PwC Q: Can you please tell decisions. Finance brings discipline to rules that affect the measurement and us about your financial decision making, and helps managers recognition of revenues and expenses. management background understand when a decision or choice Often times these do not directly and research focus? will create real long-term value. translate into cash flows – and sometimes the gap can be quite large. I joined the Harvard Business School But that said, I think it is really important Growth in the net working capital can be faculty in 1991, following three years as to assess investment opportunities and a big contributor to this gap. So it is really a professor at the University of Texas at challenges from multiple business critical as a manager of a business that Austin. My teaching, research and perspectives – to look at every situation you focus not only on how the business consulting activities are centered around through “multiple lenses.” I always teach generates earnings, but also on how your how companies can create value through my students that while finance can be decisions in managing the business better financial management, with a critically important in driving good impact your balance sheet (and the use particular focus on value creation business decisions, it is also important to of short term assets and liabilities). through corporate restructuring. For evaluate any opportunity through the lenses of strategy, operations, marketing, almost 20 years I taught my course Q: What is the most effective etc. When an executive evaluates a “Creating Value Through Corporate role that a CFO can do? Restructuring” in the MBA program. problem or opportunity from multiple Since then I’ve been teaching the perspectives, he or she will be in a better The most effective CFOs that I have Financial Management course full time position to make the most informed choice encountered are effective partners with in the school’s Advanced Management that leads to the greatest creation of value. the non-finance areas of the business. Program (AMP), which is our flagship They don’t just deal with budgets, long executive program. Q: What are the biggest forecasts, and treasury functions, but mistakes you see that they “burn shoe leather” and get out of My research has been published in companies are making when their offices to meet and interact with leading academic and management people outside of Finance. They also visit journals, and I have written over 60 case managing their business, as a Professor in Finance? the factory floor; they meet with studies and teaching notes. I published a important customers and suppliers; they number of my case studies in my book, I think one of the biggest challenges engage with and understand the “Creating Value Through Corporate that companies can face is in managing company’s corporate strategy, and how Restructuring: Case Studies in their “net working capital,” which is the the strategy drives value creation. Bankruptcies, Buyouts, and Breakups” difference between a company’s (John-Wiley), now in its second edition. I short-term assets and its short-term The most effective CFOs often make very currently serve on the board of directors liabilities used in its operations. good CEOs because of this deep of Advanced Alloy Processing. I also Excessive growth in net working capital understanding of and appreciation for provide expert testimony on valuation, can be a significant drain on a what drives superior performance in a restructuring, and financial analysis in company’s cash flow. For example, business. It’s not just about managing business litigation, and have taught increases in customer receivables or data, setting budgets, and monitoring custom executive education programs inventories represent a use of the compliance, but also connecting and for a variety of companies and company’s cash. Managers who have communicating with the rest of the organisations around the world. the direct responsibility for the profit organisation, including operations, and loss statement of their businesses strategy, and marketing. The ability to Q: How important is it for a can be at risk of becoming too narrowly communicate here is key. This means CEO to look at financial ratios? focused on profits, and losing sight of being able to speak in plain simple terms, how their decisions can impact the free of jargons, and not overwhelming I think it is extremely important for company’s balance sheet, which can the listener with spreadsheets and senior executives to consider financial materially impact its cash flows. From a numbers, which can be intimidating to ratios and metrics – of both their own financial perspective, value creation is those for whom finance is not their companies and their competitors – in ultimately determined by a company’s primary language. It also means being making capital expenditure and ability to generate cash flows. able to listen and understand the allocation decisions, and managing their speaker’s perspective. Ultimately, businesses. Finance provides CEOs with A related issue is that sometimes there is effective CFOs are those who are able to a set of tools and concepts that can be a disconnect between a business’s profits build bridges that lead to greater used to evaluate opportunities, measure and its cash flows. Reported profits are transparency, collaboration, and sharing performance, and make better business based on the application of accounting of information.

Summary of 2016 working capital management study for retailers in China 5 Interview with Professor Ananth Raman UPS Foundation Professor of Business Logistics Harvard Business School

6 PwC Q: Can you please tell us a Retail in China has been incredibly operationally efficient. What little about yourself and your successful during the last few decades, opportunities do you see for interest in retail? reflecting the success of the Chinese Chinese retailers in managing economy more broadly. We have their inventory better? I joined the faculty of the Harvard witnessed tremendous growth in the Business School in 1993. My teaching sector, and some very innovative and The financial costs of carrying excess and research focuses on operations successful retailers have emerged. My inventory are considerable. Inventory management. I currently teach in the sense, from reading and listening to imposes additional financing costs and Owner/President Management other people, is that in the next few also drives other costs, such as the cost Program, one of the school’s years retailing in China will probably of storage, handling and shrinkage. comprehensive leadership programs not grow as rapidly as it did in the last Most retailers have discovered that for executives. few decades. Moreover, many retail they can make a number of small and I started studying retail supply chains firms that were startups a couple of large changes that collectively enable in my doctoral thesis. Over time, this decades ago, have now become the retailer to operate with less interest transitioned into a more substantially larger firms. Under such inventory. There is reason to suspect systematic research program, and an circumstances – when firms become that Chinese retailers can increase industry-academia partnership larger, or when the economy slows their inventory turns. In PwC’s sample consortium, the Consortium for down – firms have to become more of Chinese retailers for example, the Operational Excellence in Retailing. mature. They have to demonstrate that average supermarket operated with 53 I have written many articles, not only can they deliver top-line days of inventory. Contrast this with case-studies, and a book on growth, they can also operate what would be fairly typical in the US; retail operations. efficiently. To operate more efficiently, Albertsons (Albertsons LLC.), operated I work closely with multiple retailers in retailers will have to improve both with 38 days of inventory. Moreover, different continents, and serve on the planning and execution of their note that the slower inventory turns for board of directors of Cumberland Farms, operations. The words of a successful, Chinese retailers cannot be explained a large convenience store chain in the serial entrepreneur probably sum it up by higher gross margins. Supermarkets US. I am also co-founder and director of in my mind, “Out of chaos comes in the PwC sample operated with 18% 4R Systems, a firm that helps retailers revenue, out of discipline comes gross margin, significantly lower than plan their inventory better. profit.” Retailers in China have to ask the 28% gross margin that Albertsons. Q: How do you see the retail themselves: Are you ready to become While the costs of carrying too much more operationally efficient? Can you inventory is considerable, retailers sector evolving in China? do so without compromising your should also be wary of carrying too organisation’s entrepreneurial little inventory. Every year, I get calls capabilities? In other words, can you from multiple retailers, who ask for integrate “chaos” and “discipline” in help because they have “an inventory your organisation? problem,” a euphemism for “we have too much inventory.” In almost all Q: Inventory management is these case, the costs of excess an important aspect of being inventory is swamped by the cost of stockouts. Most retailers that I know do a very poor job of tracking the sales lost due to stockouts, even though stockouts are rampant in retailing. In fact, I think retailers should not think of inventory management as an “inventory reduction problem” but as a problem of matching supply with demand! Q: What can Chinese retailers do to better match supply with demand?

Summary of 2016 working capital management study for retailers in China 7 There are a few levers that managers firm to be more disciplined without have available. I will list them briefly significantly sacrificing the here because I have discussed these in entrepreneurship and “chaos” that considerable detail elsewhere, including enabled his or her firm to be successful in my co-authored book, The New Science in the past. This will require many of Retailing. One, is to improve demand changes. The transition will require forecasting. Another is to rely on injection of new kinds of talent, for responsiveness in your supply chain; example, in areas such as supply chain your business is less dependent on management and information accurate forecasts if your supply chain technology. The challenge for the CEO can respond quickly with new or is not the injection of new talent per se additional product. A third lever for but, ensuring that the new talent is managers is to invest in better inventory integrated with the organisation’s planning tools. Changes in information old talent. technology have enabled retailers to In the short-term, CEOs should start make substantial progress in using each tracking stockout, days of inventory, and of these levers more effectively. inventory spoilage or obsolescence at a In addition, retailers should also focus micro level. Inventory – too much or too on two other aspects that affect little – is a symptom of underlying inventory management. One, they problems in the organisation. CEOs should look for perverse incentive should also invest in multiple misalignment within their firms experiments to produce a few small (especially across different functions) “miracles” that can motivate and point and with their supply chain partners. the way forward for their organisation. Two, they should focus on superior Most important, in my mind, is for execution of their plans and strategies. the CEO to recognise that the path to operational discipline is a Q: What should a Chinese “marathon,” not a “sprint.” CEOs retail CEO focus on, under have to be patient and ensure that the circumstances? their organisations, including the board and investors, stay patient and The CEO needs to enable his or her do not lose faith. Once the long-term (e.g., 3-5 year) goal is established, the CEO should then translate those to short-term (e. g., monthly) targets.

8 PwC Summary of 2016 working capital management study for retailers in China 9 Appendix

8 PwC Summary of 2016 working capital management study for retailers in China 9 Figure: 1 Analysis of net profit margin of the retail industry

20%

1%

10% .6% .% .2%

%

0% 201 201 201 ggregate epartment stores Supermarkets

pparel and ousehold appliances Multi format stores footwear stores stores

The retail industry still faces cost and profit challenges. Rising rent and labour costs are increasing operating costs and further reducing profit margins. In the meantime, e-commerce is impacting physical retail businesses, squeezing their profit margins.

Figure: 2 Composition of funding sources of retail companies

Financing from financial institutions

1.% Operating surplus 1.0% 2.%

26.0% 12.0%

Other 26.% liabilities 16.% 1.% 14.7% Inner circle: 2013 Centre circle: 2014 Outer circle: 2015

16.% 21.% 1.% 1.% .6% 1.% Share capital 1.% .% and capital reserve

Accounts 6.6% payable

Advance receipts

10 PwC Summary of 2016 working capital management study for retailers in China 11 Figure: 3 Days inventory-Supermarkets

100% 60

0%

60% 6 6

0%

20% 2 2. 2.

0% 0 201 201 201

060 days 600 days verage

Figure: 4 Days payables outstanding

2013 to 2015 average

10 120

0 60

0

0 epartment stores Supermarkets pparel and footwear stores ousehold appliance stores Multi format stores

10 PwC Summary of 2016 working capital management study for retailers in China 11 Figure: 5 Challenge in inventory turnover management

ncreased difference in the 0% demand in low % and high seasons

Changes in the 60% buying habits of consumers 0%

ack of planning 0% in inventory management 6%

verstock caused 0% by upgrade of merchanise 6% bstructed communication 0% of inventory 0% information

ncompetence 20% of managers 1%

elivery by 20% suppliers not timely 1% Supermarkets epartment stores

Figure: 6 Causes of challenge in inventory turnover

Main causes of challenge in inventory turnover management as perceived by respondents (%)

0%

% % ack of effective ow visibility of demand forecast inventory mechanism 60% management

% ack of planning ack of and early warning collaboration for inventory in inventory management

% 0% 0%

10%

1% 1%

elivery not timely nreasonable in procurement deployment of and supply warehouse and logistics 0%

Supermarkets epartment stores 12 PwC Summary of 2016 working capital management study for retailers in China 13 Contact us

Michael Cheng Kevin Wang Asia Pacific & Hong Kong/China China Retail and Consumer Leader Retail and Consumer Leader +86 (21) 2323 3715 +852 2289 1033 [email protected] [email protected]

Carrie Yu Mark Gilbraith Retail and Consumer China and Hong Kong Retail and Assurance Partner Consumer Consulting Leader +852 2289 1386 +86 (21) 2323 2898 [email protected] [email protected]

Ken Zhang Steven Zhong Advisory Partner Consulting Director Deals-Transaction Services Operations +86 (21) 2323 3120 +86 (21) 2323 5349 [email protected] [email protected]

Michael Gildea Advisory Partner +852 2289 1816 [email protected]

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