The Central Government’s decision to allow 51 per cent foreign direct investment (FDI) in multi-brand retail is likely to stimulate investments in the organised retail industry. If all the big States implement the decision (at present, only nine States and two Union Territories have agreed to open up multi-brand retail to FDI), we estimate $2.5-3 billion will flow in the form of FDI of the total expected investments of $10 billion in the retail industry over the next five years,

Bulk of the FDI in retail is likely to flow into the food and grocery (F&G) vertical as organised retail penetration (ORP) in this vertical is the lowest. The F&G segment, which stands at $300 billion, accounts for two-thirds of the Indian retail market but has organised retail sales of only around 2 per cent. This highly price-sensitive segment will gain the most from the scale, technology and investments in the back-end that would accompany FDI in retail.

According to the FDI policy norms, the minimum investment by a foreign retailer should be $100 million, and 50 per cent of this amount has to be channelled into the development of back-end infrastructure in the first three years. This minimum investment can typically fund the establishment of around one million sq. ft. of front-end store space, equivalent to 10-15 hypermarkets or department stores. We do not see this clause as a hurdle as we expect foreign retailers, who intend to achieve scale and efficiency of operations, to invest significantly larger amounts.

Back-end infrastructure would include investment made processing, manufacturing, distribution, design improvement, quality control, packaging, logistics, storage, warehouse, and agriculture produce infrastructure. This clause will ensure adequate capital expenditure in the back-end supply chain, and help significantly reduce wastages in fruits and vegetables. An efficient supply chain will enable direct sourcing of fruits and vegetables, which will boost farmer realisations by 10-15 per cent; and still bring down retail prices by 15-20 per cent.

In 2011-12, organised retail penetration was just 7 per cent of the $430 billion domestic retail industry, the remainder being held by small, unorganised retailers (mom and pop stores). Without FDI in multi-brand retail, we believe ORP will increase to 9 per cent in 2016-17; on the other hand, even if all States permit FDI, ORP will be only a modest 100 basis points higher at 10 per cent in 2016-17. The same has been arrived at taking into account the likely supply of quality retail space and the current ORP in large cities.

Further, the lead time for organised retailers to identify appropriate store locations and address issues in rolling out back-end infrastructure will limit the pace of growth in ORP. China opened up its retail sector to FDI nearly 15 years ago. Today, organised retail in China accounts for 20-25 per cent of total retail sales. The share of foreign retailers in organised retail is 25-30 per cent.

Our estimate of FDI inflows indicates that foreign retailers are unlikely to gain a dominant market share in multi-brand organised retail in the next five years. Depending on whether foreign retailers buy into existing retail chains or set up new joint ventures, their share in multi-brand organised retail would vary between 10 per cent and 15 per cent by 2016-17. We believe that domestic players will have to modify their operational structures before entering into joint ventures with foreign retailers as at present all States have not agreed to the policy.

The restructuring exercise will be of either creating a State-wise special purpose vehicle (SPV) or segregating the front-end and back-end operations. Domestic organised retailers can also capitalise on the decision to allow FDI to build fruitful joint ventures with foreign retailers.

To improve profitability in F&G, retailers need to control their supply chain costs and build scale. Every percentage point reduction in supply chain cost and resultant gain in earnings before interest, tax, depreciation and amortisation margin can improve equity IRR (internal rate of return) of an F&G store by 250-300 basis points.

On their part, foreign retailers, with their access to capital and technology, are well placed to leverage this opportunity.

(The author is Director, Crisil Research, a division of Crisil)