
Asia Awards: Operational Value Add – Yonghui Superstores
Headland Capital Partners invested in Chinese supermarket chain Yonghui Superstores in 2007 and helped turn the regional player into a sector outperformer with a national footprint
As it grew at a rapid pace, Yonghui Superstores, a Chinese supermarket chain backed by Headland Capital Partners, had to prove itself in battle against a bigger rival. It had a store literally next door to French retailer Carrefour in Chongqing, separated from its rival by just a wall. "Everyone was saying ‘This will be the Waterloo of Yonghui," says William Shen, senior partner and head of Greater China at Headland. "They're doing well but it's a domestic chain."
But Headland was confidentYonghui would win. The firm had recently agreed to increase its stake in the company, from 20% to 24% at three times the previous valuation, on the very day that Lehman Brothers collapsed in 2008.
The confidence came from the company's strong focus on fresh produce, which attracts a high volume of foot traffic.
"It's important because people buy it every day," Shen explains. "If a customer comes into a store to buy fresh produce, he will pick something up else as well."
Yonghui's revenue jumped from RMB3.7 billion ($607.2 million) in 2007 to RMB24.7 billion in 2012, a compound annual growth rate of 46.4%, as it rapidly accumulated market share. EBITDA increased six-fold to RMB1.3 billion over the period as the company rose to become the seventh largest grocery retailer, moving up from 26th place.
Of this income, 45% derives from sales of fresh produce compared to 15-25% for most other supermarket chains.
When Headland first invested almost $40 million in the company in 2007, 80% of fresh produce in China was sold through wet markets - establishments that not only present hygiene issues, but also start early in the day, which means most goods are sold by the time white-collar workers shop in the evening.
However, change was imminent. In most mature markets, 70-80% of fresh produce is sold through modern retail channels and the government in Fujian province, Yonghui's primary market, was already offering financial incentives to transform wet markets into supermarkets. Headland saw potential in this transition, and Yonghui's fresh produce section was set up to replicate the product range of a wet market, but in a clean environment.
"Yonghui was the pioneer in creating best practice for this wet market transformation, partly because all the founders come from humble roots in the countryside," Shen says. "They understand the importance of fresh produce, and how that helps draw foot traffic, but also how to sell it at a competitive price compared to wet markets."
The competitive pricing came from direct sourcing - instead of relying on an existing supply chain, Yonghui went straight to the farmers. It created an entire logistics infrastructure, with agents paying cash to source the best available fresh produce at the best available price.
The direct approach
This helped reduce input costs, but that was only one part of Yonghui's value equation - the other being direct operation.
"Even if Yonghui and a competing store get the same input price, Yonghui will be able to get a higher margin than the rival, because it has very detailed in-store operating standards," Shen explains. A lot of retailers use a concession model for fresh produce, recruiting vendors or merchants and charging them a monthly lease or share of the revenue. But it becomes difficult to control wastage, so all of Yonghui's stalls are operated by its own employees.
Headland wanted to stay focused on these core competencies and pursue a timely, cross provincial expansion strategy to turn the company into a national player. It managed to drive margins and sales up while pushing into new markets.
When the PE firm invested in 2007, Yonghui had a dominant market share in Fuzhou, the capital of Fujian. It operated 54 stores in the province and had just set up four outlets in Chongqing. Instead of expanding quickly into multiple provinces, the company worked on establishing a sizable and sustainable business in Chongqing and then moved into Beijing, Anhui and other markets. As of June 2013, the chain had grown to 259 stores across 17 provinces.
Yonghui was the only domestic player that managed to build a national presence through pure organic growth.
One of the reasons for this is supply contracts for fast-moving consumer goods (FMCG). Wal-Mart, Tesco and Carrefour have national sourcing contracts with companies such as P&G and Unilever and can lower costs by placing larger orders across provinces. When a domestic company launches in a new province, it has to deal with the provincial or even local distributor, paying a higher price than the dominant local player which sources the same products at higher volume.
In addition, it might use discounts to attract customers but the dominant player can discount further because of its lower buying price. The new entrant will lose money, so it is difficult for a domestic player without national supply contracts to expand across China. Yonghui does not need to discount daily necessities to attract foot traffic because its fresh produce draws customers in.
However, although sales rose from RMB3.7 billion in 2007 to RMB8.5 billion in 2009, when daily necessities as a proportion of revenue also grew, gross profit margins were not increasing. The company responded by negotiating national FMCG supplier contracts.
"Before listing in 2010, though Yonghui was well established and enjoyed a great deal of reputation in Fujian, we were not well known and recognized by multinational suppliers," says XieXiangzhen, director and general manager of Yonghui's FMCG department. "The procurement channels were fragmented, and we had to negotiate with suppliers in different regions, resulting in higher procurement costs and negative impact on our cash flow and profit."
Since the retailer now had a footprint across three provinces and could benefit from economies of scale, Headland leveraged its connections to offer Yonghui access to executives at world-leading suppliers. Coca Cola was the first to sign on in 2009, its contract including different subsidized promotions for which special packaging was launched.
"When other suppliers saw that the Coke deal was a success, they also came in to sign contracts," says Raymond Wong, principal at Headland. "P&G, Unilever and Kimberley Clarke also came on board." By the end of 2013, 38% of Yonghui's total FMCG sourcing is expected to be through national contract, significantly reducing costs.
Willing landlords
Another hurdle to organic growth is real estate. Wal-Mart and other foreign supermarket used to be welcomed by government officials with tax credits and receive 3-5 year rent free holidays from property developers because their stores attract customers. But when Yonghui moved into a new province they needed to work hard to convince the leading developer to work with it.
Headland helped put together data from property developers in Chongqing to demonstrate that the supermarket was doing really well in the regions in which it operated. They asked questions about the impact of the store opening on real estate - how fast other commercial property could be leased out, whether there was a positive impact on sale and purchase agreements for residential units.
Once the developers visited the stores, they were convinced. When the company listed on the Shanghai Stock Exchange in December 2010, to raise RMB2.64 billion, there was more traction. Headland sold its holding down to 20.56% for an 8.8x return multiple in the process.
The chain's Bravo premium supermarket format was also instrumental in helping form alliances with major developers. In order to differentiate Yonghui from the Carrefour next door, Headland suggested adding sections such as a bakery and wine cellar to attract new consumers.
"When we opened the first true Bravo store in a Wanda mall, it really impressed the chairman," says Shen. "We didn't realize at the time that this could be a make or break to get Wanda on board. We just thought it was important to experiment with this format so that we understand how to attract premium shoppers and some of the learning could be applied in our regular stores."
Wal-Mart had a deal with the developer for space in every Wanda mall but now Yonghui takes one third of all Wanda new mall openings. The supermarket chain also has strategic alliances with Longfor and Wanke, among other developers.
The company's rental expense is expanding dramatically as it opens new stores but that is offset by rental income. The retailer launched new stores in the hypermarket format in 2010, the key benefits being additional income from subleases to specialist retailers such as McDonald's or KFC, better brand presence when entering new provinces and stronger negotiation power against suppliers.
Rental income covered 32% of rental costs in 2012, and this is expected to reach 40% in 2013.
To further improve revenue and margins, Headland started work on category management last year, with an in-depth category management analysis of the underperforming FMCG division.
In order to optimize the product mix offered to customers, the study divided products into four categories to distinguish the star performers, which attract foot traffic and also generate significant margin, from the foot traffic builders, which do not have much margin. The other two categories are margin contributors, which do not generate foot traffic, and complementary products, which do not bring foot traffic or margin, but a store needs to stock.
The second step is price bands - does the store offer enough representation in the high, mid and low-end band to match the targeted demographic of the store?
Usually 80% of sales are generated by one quarter of stock keeping units (SKUs) in a store. Yonghui is using technology to track which items are selling so that it can get rid of the slow categories and free up space for high-end or fast-moving products. As a result, the company managed to release more than RMB400 million of cash flow from operations in the first half of 2013. The gross margin return on inventory has increased by 30% over the past year.
While most of Headland's work has been on store operations and the FMCG section, the GP has looked at opportunities to further strengthen the fresh produce section. When Shen chanced upon a possible arbitrage in growing imported varieties of produce locally, the firm discussed launching private label products at Yonghui.
Food quality and safety are major concerns in China, so it made sense for a trusted brand such as Yonghui to sell an own brand product similar to high-priced imports. "I can see huge room for higher-income category to pay a premium for this," says Shen. "It just shows that even when the company is strong, there is room for fresh ideas."
Aiming higher
According to Goldman Sachs, Yonghui could become one of the top three supermarkets in China. Retail has been in a down cycle in the country since the last quarter of 2010 due to a weak economy, supply-demand imbalances, cost pressures, and e-commerce. However, despite the macro environment Yonghui's same-store sales growth was well above peers in 2012, and it posted strong year-on-year growth in the first quarter of 2013.
Meanwhile, its foreign rivals are still in the trenches. Carrefour's top line growth in China was almost zero last year, Wal-Mart has decided to close 9% of its store network, and Tesco is merging with state-controlled China Resources Vanguard.
Rising rent and labor costs have put pressure on the bottom line. The average hourly wage for an employee of a foreign-invested enterprise was RMB55 last year, compared to RMB30 in 2007, according to government statistics. Property rental prices have gone up eight-fold in the last 10 years, making China one of the most expensive commercial real estate markets in the world.
On top of this, the sweetheart deals local governments and property developers offered to foreign investors have been withdrawn. Even the national sourcing contract advantage is leveling out as more domestic players such as CR Vanguard and Yonghui develop direct relationships with suppliers.
The Yonghui store next door to Carrefour in Chongqing is the company's top performing outlet in the city in terms of revenue and operating profit, Shen adds. By contrast, Carrefour is struggling.
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