Pre-seen case study for CIMA Strategic level exams May & Sept 2012: Real life lessons

BPP subject specialists Doug Haste (F3), Daniel Clark (P3), and David Culley (E3) analyse the pre-seen case study for the May and September 2012 Strategic level exams by looking at the lessons to be learnt from the experience of real companies that are similar to B Supermarkets.

The pre-seen case study for the May / Sept 2012 exams is based around a company called B Supermarkets (B). This is a fictional company and it will be crucial in the exam to deal with the issues that you are presented with on the day of the exam on their own merits. However, it is interesting to note that B has some similar characteristics to real companies, notably Carrefour and Tesco. In the real exam, reference to a relevant example can add depth to your answer which can help to score marks but, more importantly, some industry knowledge can help steer your discussion towards making sensible, commercially realistic, suggestions. In this article we will briefly look at the background of these companies and then consider how their experiences can be drawn on to help add depth to your answers in the exam focusing on a few key themes that would appear to be likely areas for your examiners to focus on.

Companies similar to B
B Date founded Share performance
1963 Share price fell from 47.38 to 25 (approx 50%) in 2007; has risen every year since then Revenue 109,712m

Carrefour
1959 Share price fell from 49 to 25 in 2007 (approx 50%), recovered then fell from 29 to 19 in 2011. Revenue 90,099m
3 1

Tesco
1930s Share price fell from 4.75 to 3.50 (approx 25%) in 2007, then stabilised before falling dramatically in 2012 Revenue 73,117m
4 2

Competitive overview

% revenue from: Europe 82% Asia 9% North America 9% Over 15,000 stores

% revenue from: Europe 73% Asia 9% Latin America 18% Over 15,000 stores Primarily Europe, but also China, Brazil, Indonesia, Poland & Turkey Operating margin 2% Net margin 1% Beta factor 0.7 Dividend payout 220% Gearing 60%
7

% revenue from: Europe 82% Asia 17% North America 1% Over 5,000 stores Asia, possibly the US

Focus for future growth Key financial statistics

Other areas of the world, especially Asia. Operating margin 5.7% Net margin 3.3% Dividend payout 62% 6 Gearing 39.6%
5

Operating margin 6.4% Net margin 4.7% Beta factor 0.7 Dividend payout 41% Gearing 40%

1 2 3

FT.com market data, data has been rounded to the nearest euro FT.com market data, data has been rounded to the nearest euro Source 2010 Carrefour accounts (2011 data distorted by demerger), % revenue data ignores hard discounting 4 60,931 converted at 1.2 euros to the pound; data from FT.com; geographic data from Tesco 2011 accounts excl Tesco bank 5 Dividend per share 1.65 divided by eps 2.66 (3591 profit / 1350 shares) 6 Calculated as 15,744 / (15,744 + 24,019) 7 Carrefour accounts 2010, FT.com 2011 market data for beta and gearing, dividend payout based on a normalised eps of 0.5/share 8 Source FT.com markets data

Carrefour is the largest retailer in Europe, and the second largest in the world. Carrefour is a similar size to B Supermarkets, and in terms of its portfolio of store types; it has been a pioneer of overseas growth in this sector. Tesco will be better known to many of you; it is interesting that B shares Tescos financial strength. Tesco also has significant operations in the US (although these are loss making) and is starting to trial convenience stores in the US.

Issue 1 - Overseas expansion: relevant to all papers

Many supermarket groups have targeted overseas growth in an attempt to create competitive advantage through economies of scale. Tesco is targeting growth in Asia, where sales grew by 20% in 2011 and in Eastern Europe. They are continuing to grow successfully in South Korea, Thailand, Malaysia and India. There are particular opportunities in India because the Indian government has just (end 2011) passed legislation permitting overseas companies to own retail outlets (subject to a minimum investment of $100m). This strategic direction carries a number of risks. There may be economic risk in specific countries, for example one of Carrefours biggest markets is Greece and sales have fallen dramatically in this market due to Greeces well publicised economic difficulties. There may also be political risk in specific countries, for example in 2011 a proposed merger between Carrefour and a local Brazilian retailer collapsed because a state funded Brazilian bank removed the financing that it had promised after the deal became politically unpopular. Operating internationally brings currency risks, particularly the risk that the home currency appreciates against other currencies. This will reduce the value of the overseas earnings and will also bring translation risk, as overseas assets will reduce in value on the companys balance sheet. There is also the risk of failing to understand the needs of customers in a new country; for example Tescos Fresh and Easy stores have been criticised as being too clinical and are now being revamped to include wooden flooring. Many of the products are pre-packaged which is not popular with US customers. And on top of these risks there is the chance that management will become distracted from their existing markets. This has been the case at Carrefour and has led it to slim down its portfolio of international operations in recent years. Carrefours new corporate strategy clearly targets improving its position in its core European markets as its no.1 priority. In its international operations it is trying to focus on markets where it believes that it can create a market-leading position; recently Carrefour has pulled out of Japan, (2005), Korea (2006), Portugal (2008), Russia (2009), and Thailand (2010). So, in the exam make sure that you appreciate the logic of targeting the Asian markets but also the dangers of this strategic move. The experience of many retailers is that it is better to be strong in a few overseas countries than to be weak in many.

2. Methods of expansion: relevant to all papers

Entry into overseas markets can be achieved by acquisition, organic growth, joint venture or a combination of these approaches. Tesco have generally entered overseas markets by making a small acquisition, then they familiarise themselves with local shopping habits before expanding further by a mixture of organic growth (using local people to manage stores) and acquisitions with the aim of achieving market leadership. For

example, in 2003 they acquired the Japanese convenience store chain C Two-Network as they moved into the Japanese market. However, in 2010, Tesco opened 18 franchise convenience stores in South Korea, its largest market outside the UK. This is seen as a significant shift in strategy for the group. Tescos head of international operations said: "We have got an obligation to the communities that we serve. Some of those communities feel threatened because they feel that the arrival of modern, organised retail means that other small retailers close. This is a great way of helping them find another opportunity." Joint ventures are also used as a vehicle for market entry. When Tesco entered China they acquired a 50% stake in the Hymall chain, from Ting Hsin in September 2004. In December 2006 it raised its stake to 90% in a 180 million deal. Also when Tesco entered Thailand in 1998 it set up a joint venture with Charoen Pokphand and named the operation Tesco Lotus. This partnership was dissolved in 2003 when Charoen Pokphand sold its shares to Tesco. Start-ups are a riskier form of investment. The problems of Tescos Fresh and Easy operation have already been noted, Fresh & Easy has accumulated losses of 700m by Feb 2012. From this you should note that the use of overseas expertise would seem to be essential in moving into the Asian market where shopping habits will be very different from Europe. This can be accomplished by the use of franchise stores or joint ventures that ultimately result in a buy out.

3. Strategic issues in Europe: relevant to F3, E3

Carrefour pioneered the concept of the hypermarket and has been hit by the decline of this sector and the emergence of the convenience sector and discount store . Although Carrefour have recently started to invest in these sectors, they have also tried to shore up their hypermarket operations with an expensive (400m) revamp of their hypermarkets to improve their quality. The new Carrefour Planet outlets are less of a warehouse and more stores within a store. There are wooden floors and loud music in womenswear. There are sushi bars, cookery classes, a cafe/bar and a beauty bubble offers make-up advice, manicures and 10 haircuts. A nursery looks after children while parents shop & self-scanning devices help cut down queuing. After spending 400m of a projected 1,500m on these outlets, Carrefour have suspended the investment programme due to lower than expected returns. Any domestic investments for B will need to be carefully targeted to ensure that they are dealing effectively with the key opportunities and threats that B is faced with.

4. CSR issues: relevant to E3, P3

Because of the large size of the major supermarkets and their impact on the environment, there has been increased interest in recent years in their CSR credentials. For example, Tesco have stated their goal to put the community at the heart of what we do. There are 5 core commitments which each Tesco country must build into its own community plan: Active local support community champions exist to identify and support the issues that matter most to local customers Buying & selling responsibly Tesco was a founder member of the Ethical Trading Initiative (ETI) and expect all suppliers to meet the standards set out under the ETI Code and ensure their workers the rights within it. Care for the environment Tesco aim to control carbon emissions and have been named the top retailer in the Carbon Disclosure Projects 2010 UK FTSE 350 and Global 500 reports for carbon reporting and performance Recently Tesco have opened our first overseas zero-carbon store in the Czech Republic and have carbon footprinted over 1,000 and labelled over 500 everyday products in the UK Giving customers healthy choices fruit and vegetable promotions in-store, articles on healthy eating in Tesco Magazine Creating good jobs and careers

 Tescos hourly rate of pay for a customer assistant in the UK is around 7% higher than their three largest food retail competitors outside the UK, Tesco aim to pay staff between the median and the upper quartile compared to their competitors Unlike B, Tesco does not obtain an external audit or verification of its CSR data there is simply a comment from Forum for the Future, a body to which it belongs. Carrefour is more like B, and its auditors KPMG carry out verification of its data. B has specific non-financial objectives in its mission statement and strategic objectives, e.g. reducing carbon emissions. These will need to be considered alongside financial objectives when appraising future strategies. They will also need to be conscious of the risks involved in publicising their environmental credentials if they are involved in any controversy.

5. Supply chain & IS issues: mainly relevant to E3, P3

Like B, Tesco is placing increasing emphasis on locally sourced products. This is a step away from the traditional approach where suppliers would only be considered if they could supply enough produce to stock hundreds (or thousands) of stores. For example, in March 2012, Caithness Biscuits, a small manufacturer of handmade biscuits, secured a contract to supply 60 Tesco stores in Scotland. For Caithness Biscuits, this means a major new customer which accounts for 25% of their total business. For Tesco, it means a PR opportunity a number of its Scottish lorries have been re-decorated to emphasise this local link. However, this strategy will result in Tesco having to deal with an ever-increasing number of suppliers, with all the logistical and practical problems that come with them. This is where a single, integrated IT system becomes imperative. In pursuing a strategy of acquisition, Tesco inherited a vast array of legacy systems with the result that, in 2007, a major project had to be undertaken to implement a single, standardised IT system. B shares Tescos vision of working closely with local suppliers but clearly lacks the IT infrastructure to do this effectively. Its existing systems are not integrated and clearly causing stock-outs which, in turn, result in lost sales. It is also worth noting that it does not have an IT director. It is possible that a question will focus on issues caused by poor systems, or involved in the implementation of a new one.

6. Other issues F3
Questions are most likely to focus on acquisitions and/or overseas investment For any investment you will need to carefully assess the feasibility in terms of whether sufficient finance will be available. Note that a major investment may put pressure on Bs dividend policy and gearing target. Shareholders may be put off by the Bs poor record in shareholder value creation, with the share price still 24% below its level at the end of 2007. The gearing target is something that B may be able to relax, other companies in its sector operate with higher gearing levels Carrefours gearing is 60% for example. A valuation question could ask you to value a part of Bs business either to sell it or to demerge it and to list it on a stock exchange. In 2011, Carrefour demerged their discount store operation. rd Carrefours shareholders received one Dia share for each Carrefour share. Dia is the worlds 3 largest discount store. Note that you can estimate the cost of equity for B by using the dividend growth model:

Ke

D1 P0

g can be estimated using the historic dividend growth: 1+g = 1.017 i.e. g = 0.017

So Ke = (1.65 x 1.017) / 31.37 + 0.017 = 0.07 or 7%. You should note that B Supermarkets has faced unusual economic conditions over the past few years, so a dividend growth figure based on historic growth may not provide an accurate estimate of the cost of equity; you may be provided with other information to estimate the cost of equity on the exam day (e.g. a beta factor).

E3
As with F3, there is considerable potential for questions around overseas development. This could involve strategic evaluation of opportunities to expand into new markets (especially Asia) or, potentially, the withdrawal from underperforming markets. Any change resulting from any such opportunity could generate resistance by members of the workforce and / or other stakeholders. They will therefore require careful management. There are several references to generic strategies, and B is unusual in that it appears to be adopting both differentiation (in supermarkets / hypermarkets) and cost leadership (in discount stores). Can these opposite approaches be made to work within the same organisation? If they can, is the organisational structure (by geographic areas instead of store type) appropriate? The strategic planning approach taken by the main board follows the rational planning model in a bureaucratic and authoritarian style. Given the rapidly changing environment B is operating in, is this approach to planning too restrictive and, if so, could the emergent strategy model be made to work? Note that there is no reference to online retailing. Its true that some supermarkets (e.g. Morrisons) do not offer an online service, but it is unusual for a company of this size in this industry. Remember that one of the E3 learning outcomes is to evaluate contemporary developments in the commercial use of the internet.

P3
There will be financial risk in Q1 and Bs overseas operations offer plenty of scope for this. Bs corporate governance arrangements seem fairly standard, although the board is quite large, with 20 members, and may be unwieldy. Carrefours board comprises 12 members, 7 of whom are non-executives. Bs board exercises tight, centralised control, which may lead to dysfunctional behaviour, and leave them slow to respond to changing conditions. Surprisingly, Bs subsidiaries in Asia and North America appear to have been bribing government officials in order to gain approval to install improved information systems. There are faint echoes of this in a scandal in which Tesco was involved in 2008 - a local developer acting for them paid a government official to gain planning permission, although Tesco themselves were not involved. A group of Carrefour managers in China were also accused of taking bribes from suppliers in 2007. While embarrassing, neither company seemed particularly damaged by these incidents.

Summary
We hope that this article has helped to build your understanding of some of the issues in the preseen scenario by thinking about equivalent issues in the real world. Remember, this is not a research based exam; B Supermarkets is a fictional company a good answer will as always require you to focus on what you have been told in the scenario question in the real exam, and what you have been told in the pre-seen especially concerning B.