A sharp rise in footfall fueled growth, and Tata Group’s consolidated net profit for the June quarter almost doubled year-on-year. The retailer’s shares rose 10% to a record high after the results were released. Trent has also embarked on a hiring spree – its headcount more than doubled in fiscal 2022.

Indian retail is set to undergo a major transformation. According to a report by JLL, retail space could grow from 89 million square feet in 2024 to 134 million square feet by the end of 2028.

Across seven cities – Mumbai, Delhi-NCR, Bengaluru, Hyderabad, Pune, Kolkata and Chennai – 88 new retail projects totalling around 45 million square feet are expected to come up over the next five years. Of these, 12 are large-scale projects of at least one million square feet each, accounting for 37% of the total new space expected by 2028.

Is a retail boom imminent?

Retailers are expanding aggressively as the sector is witnessing strong growth driven by increasing urbanisation and demand for organised and high-quality retail space. Thanks to social media, this demand is extending to tier 2 and 3 cities as well.

All this underscores India’s emergence as a major player in the global retail market. According to BCG, retail space for electronics, fashion, food, jewelry and quick-service restaurants (QSR) is expected to grow rapidly in the coming decade.

More importantly, BCG believes that Indian retailers’ operating margins in these categories are slightly better than their U.S. peers. Using a hybrid model (online and offline), most major retailers in India have gained a foothold in the hinterland without losing market share in metropolitan cities.

Volatile industry

However, retail is inherently volatile. Retailers make money by producing goods, marking them up and then selling them to individual customers as their own or third-party brands.

Some retailers own their stores to control costs and brands. Others operate their business in rented stores or under a franchise model.

A lean workforce is one of the first signs that a retailer’s margins are under pressure. While some retailers have increased their headcount over the past two years, others have chosen to operate with a smaller workforce.

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AccordinglyThe business newspaperTwelve publicly traded lifestyle retailers, grocers and QSRs have cut their workforces by around 26,000 jobs over the past two fiscal years as they slowed store expansion.

In addition to store operating or rental costs and labor costs, there are two key variables that determine a retailer’s profitability prospects – the proportion of discount sales and inventory turnover. Retailers who do not keep these fixed and variable operating costs under control will see their fundamentals deteriorate.

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As Warren Buffett wrote in his 1995 letter to shareholders:

“Retail is a tough business. During my career as an investor, I have observed many retailers that experienced tremendous growth and excellent returns on equity for a period of time, but then suddenly crashed, often going bankrupt. This shooting star phenomenon is far more common in retail than in manufacturing or the service sector.

“That’s partly because a retailer has to stay smart day in and day out. Your competition is constantly copying and then outperforming everything you do. Shoppers are now being lured in every possible way to try a range of new retailers. In retail, resting on your laurels is a failure.”

Yet, valuations of most retail stocks in India continue to defy gravity. In particular, valuations of Trent, Jubilant Foodworks and Avenue Supermarts factor in an unrealistic growth pace.

It is therefore important for investors to separate the wheat from the chaff and only invest in stocks that offer a certain degree of security.

Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com