Lessons for the Kenyan Retail Sector, & Cytonn Weekly #6/2018
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Lessons for the Kenyan Retail Sector, & Cytonn Weekly #6/2018 Focus of the Week According to the Kenya National Bureau of Statistics (KNBS), wholesale and retail trade is the 5th largest contributor to Kenya’s GDP and the 3rd largest contributor to private sector employment. In 2016, wholesale and retail trade employed 238,500 Kenyans and accounted for 8.4% of Kenya’s GDP. Moreover, according to Nielsen, a leading global information and measurement company, shifting consumer trends has driven growth in formal retail, with 30.0% of the Kenyan population now shopping in formal retail establishments compared to 4.0% in Ghana and 2.0% in Cameroon and Nigeria. This is the second highest in Sub-Saharan Africa after South Africa, which has a formal retail penetration of 60.0%. Given the recent challenges faced by two local players, this week’s Focus Note examines what led to their current distress and then draws lessons learnt, by looking at the following areas: A. Overview of Kenya’s Retail Industry, B. Analyzing the Drivers of Kenya’s Retail Industry, C. The Current State of Kenyan Retail, D. The Trouble with Rapid Growth / Growth by Default, and E. Providing a Path to Success for Kenyan Retailers. A. Overview of Kenya’s Retail Industry Years of robust GDP growth, increased purchasing power, and shifting consumer habits have accelerated transformation of the Kenyan retail market. Kenya’s largest chains, Nakumatt and Uchumi, were positioned to be the main beneficiaries of the economic trends that drove more Kenyans into formal retail. Both chains owned flagship stores in Nairobi, Mombasa and Kisumu’s major catchment areas and served as the largest distributors for local consumer goods manufacturers. However, the opportunity in Kenya’s retail market attracted continental and international brands, spurring competition in the sector. As competition intensified, both chains drove aggressive expansion plans; often at the expense of their suppliers and shareholders. Beyond the main larger chains, outfits like Tusky’s, Naivas and Ukwala appealed to the average customer with outlets close to matatu and bus terminals. While these chains were financially successful, they all aspired to the traffic, footprint and prime locations to match Uchumi and Nakumatt. The industry is currently well represented by both local and international franchises, some of which are highlighted in the table below. Key industry players include Carrefour Kenya (a franchise owned by Majid al Futtaim Group of the UAE), Tuskys, Nakumatt, Uchumi, Massmart (trading in Kenya as Game), Choppies (which acquired Ukwala Supermarkets), Naivas, and many local brands such as Mulley’s, Eastmart, Quickmart and Cleanshelf. The entry of Carrefour, Game, and Choppies has in part been aided by the recent woes facing Nakumatt and Uchumi. Retailers Operating In Kenya Store Count (Jan Name of Retailer Percentage of Total 2017) Tusky's 58 29.1% Nakumatt* 45 22.6% Naivas 39 19.6% Uchumi 25 12.6% Choppies / Ukwala 10 5.0% Eastmart 9 4.5% Chandarana Stores 8 4.0% Carrefour 4 2.0% Game Stores (Massmart) 1 0.5% Total 199 100.0% Source: Cytonn Investments Research *Nakumatt has been updated for branches closed B. Analyzing the Drivers of Kenya’s Retail Industry Having got an overview of Kenya’s retail sector, we now analyze the key drivers of the retail sector in Kenya. The growth of the retail industry in the decade to 2017 has been driven by; GDP Growth boosting disposable income & consumer spending - Kenya’s economy grew by 5.8% on average between 2012 and 2016, lifting household incomes and increasing consumption expenditures. The average value of a shopper’s basket increased by 67.0% to USD 20 (Kshs 2,016) between 2011 and 2017, making Kenya the fastest growing retail market in Sub-Saharan Africa. Additionally, according to KNBS, private consumption expenditure accounted for 79.0% of Kenya’s GDP in 2016. It increased from Kshs 3.3 tn (USD 38.5 bn) to Kshs 5.7 tn (USD 55.4 bn) during the same period, an average annual growth rate of 11.3%. Real Estate Investment - Real estate investments, notably residential malls and mixed-use developments, have driven the expansion of the Kenyan retail sector. In 2017 alone, Nairobi’s available retail space grew by 41.6%, from 3.9 mn square feet in of space in 2016 to 5.6 mn square feet. Moreover, mall operators preferred larger chains such as Nakumatt and Uchumi as anchor tenants, reasoning that they would attract more foot traffic. Changing consumer tastes & preferences, and globalization- The increase in disposable income that has come with GDP growth has also made Kenyan shoppers more aware of global retail trends and more demanding of the local shopping experience, goods and services. Key Profitability Margins in the Industry: In order to drive the retail business, supermarket chains rely on selling large volumes of goods at small margins. Consequently, gross and operating margins across the industry are low. Chains create value for owners primarily by adding new stores (growth) and improving their operations, distribution and supply networks to improve margins. Successful retailers are able to maintain reasonable operating and net margins while executing their growth strategy. Below are some of the operating margins of some industry players: FY 2016 Operating Results Continental Retailers International Retailers Shoprite Costco Margin Uchumi Choppies Massmart Target Corp Stores Wholesale Gross Margin 15.2% 21.2% 24.0% 19.0% 13.3% 29.7% Operating (30.8%) 1.6% 5.5% 2.9% 3.2% 7.2% (EBIT) Margin Net Margin (44.1%) 0.8% 3.9% 1.4% 2.1% 3.9% Choppies entered the Kenyan market with the acquisition of Ukwala Supermarkets Ltd Game Stores represent Massmart in Kenya with an outlet in Garden City From the above table, it is key to note that: Gross, Operating and Net Margins are low across the retail industry, Thin margins leave little room for any inefficiencies if a chain is to maintain profitability, and, Value is created by minimizing operating costs (increasing the EBIT margin) and growing volumes by adding stores. C: The Current State of Kenyan Retail For decades, it was business as usual for Kenya’s largest retailers - Uchumi and Nakumatt. There was little competition and plenty of room for expansion as long as competitors had little geographical overlap. Suppliers had little choice but to extend favorable terms as they had few alternatives in their distribution networks. Forgoing one large chain in favor of another meant ceding precious revenue to the competition. High end and middle-class consumers also had few options; either make several trips to the neighborhood kiosk or visit one of two large chains at which everything could be found. Beyond the large chains, then smaller outfits like Tusky’s, Naivas and Ukwala competed for the average customer with outlets close to matatu and bus terminals. While smaller chains were financially successful, they all aspired to achieve the traffic, footprint and prime locations to match Uchumi and Nakumatt. Ambition, ample opportunity and tolerant investors provided the fuel for growth in the retailers’ expansion strategy. Between 1997 and 2004, Uchumi borrowed Kshs 3.6 bn to double its store footprint, growing from 10 outlets to 25 across Nairobi, Mombasa and Kampala. Nakumatt Supermarkets also grew from 10 outlets in 2002 to 42 in 2013 and 64 in 2016. In the same period, Tusky’s and Naivas also grew to 60 and 40 outlets, respectively. In 1997, Uchumi pioneered the hypermarket concept with Ngong Hyper, showing that larger footprint stores with embedded retailers could be successful. Uchumi subsequently replicated the concept in Lang’ata Hyper. Rapid expansion without realizing their return on investment led to Uchumi’s insolvency in 2006 and the subsequent suspension from the Nairobi Stock Exchange. Uchumi’s 2006 insolvency should have warned the industry that such a growth model was unsustainable. However, banks continued to lend to Uchumi while investors offered more capital in subsequent rights issues. In 2005 and 2014, Uchumi shareholders oversubscribed to rights issues that added a total of Kshs 2.0 bn (Kshs 1.2 bn in 2005 and Kshs 0.9 bn in 2014) to company accounts while cumulatively diluting their holdings by 33.0% in 2005 and 28.0% in 2014. The funds were subsequently used to plug losses in Uchumi’s Tanzania and Kampala operations as well as to repay suppliers in Kenya; this was despite investment memoranda that stated they would be used in expanding the store footprint. Rapid growth has posed the following challenges for Kenyan retailers: Thin margins and poor capital management make it difficult to expand without borrowing, Saturation makes selecting catchment areas to launch new stores a challenge, Competition limits traffic growth for new stores as areas become more saturated, High borrowing costs make it difficult for new stores to achieve profitability, Thin working capital cushions often mean that retailers have to choose between paying off debt and making payments to suppliers, Investments in fixed real estate strain returns to shareholders (Returns on Equity), and, Poor governance and oversight ensures that the same mistakes are repeated. D: The Trouble with Rapid Growth/ Growth by Default Uchumi and Nakumatt were not prepared for the new phase of growth initiated by real estate expansion. Years of mismanagement had left them with no internally sourced funds (retained earnings). As such, the only alternatives for funding new stores were internal cash flows (generated by delaying supplier payments), and bank debt. Delaying supplier payments was the preferable source of funding because late payments accrued no interest. However, because short-term funds were used to fund long-term capital expenditures (a duration mismatch), chains required adequate liquidity (either from new loans from banks or commercial paper) or from stores that quickly ramped up sales to remain liquid.