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M<br />
FOUNDATION<br />
Online grocery penetration is higher in most large global markets,<br />
with South Korea (~9%) leading the way. High penetration in South<br />
Korea reflects a variety of factors:<br />
1. The country has a high degree of urbanization (~83% vs.<br />
~82% in the US) and its relatively small geographic layout<br />
makes last mile economics more affordable.<br />
2. Consumers are digitally savvy, with nearly 95% smartphone<br />
penetration.<br />
3. Grocers also have attractive offers with free delivery, wide<br />
product assortment, and attractive prices.<br />
Although online remains underindexed to fresh, generally favorable<br />
online conditions have caused rapid growth in nonperishable groceries.<br />
Behind aggressive investments in logistics by key players such<br />
as E-mart (covered by Morgan Stanley analyst Kelly Kim), fresh foods<br />
have been driving the current leg of accelerating grocery penetration<br />
since 2016.<br />
Grocery retail in India is inherently a ~15% gross margin business. If<br />
the penetration of higher-margin private label increases, retailers can<br />
push margins to ~18%, in our view. In addition, the current basket size<br />
(influenced by the relatively lower consumer price of products in<br />
India) is ~Rs,1000.<br />
Online grocery retail is likely loss-making at the EBITDA level – not<br />
a surprise for investors that track this business globally. Based on our<br />
estimates, fulfillment cost per transaction (trucking, delivery,<br />
back-end, etc.) is ~Rs120, which implies ~12% variable cost. Add to<br />
this overheads and advertisement costs (which together imply ~8%<br />
variable cost), and the result is -5% EBITDA margins (as a percentage<br />
of AOV) ( Exhibit 18 ), based on our estimates.<br />
However, as basket size increases, the cost of delivery for a retailer<br />
is only marginally higher, driving significant leverage on fulfillment<br />
cost. In addition, for a nascent business – which online grocery is at<br />
this stage – ad expenses are >5% of AOV.<br />
…but the path to profitability is hazy...<br />
Online grocery retail is likely loss-making at the EBITDA<br />
level in India – not a surprise for investors who track this<br />
business globally.<br />
So what will have to change to drive profits higher? In<br />
our view, two key variables will be flexed in the future –<br />
basket size and advertisement expenses (customer<br />
acquisition costs).<br />
If average basket size rises to ~Rs,1500, gross margin can rise to 18%<br />
(vs. ~15% currently) and if advertisement falls to ~2%, then EBITDA<br />
margins can rise to ~6% (as a percentage of AOV) – similar to those<br />
of offline retailers at this point.<br />
However, high competitive intensity by foreign retailers and<br />
entrenched domestic players will challenge this equation, in our<br />
view. For instance, In its 2QF19 release, Avenue Supermarts reported<br />
180bps decline in overall gross margin, to 14.3%, highlighting that<br />
during the quarter it continued to lower prices across categories.<br />
However, there's a challenge: high competitive intensity<br />
by foreign retailers and entrenched domestic players.<br />
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