Economics and Finance (PM008) Case Study, Spring 2015

Economics and Finance (PM008) Case Study, Spring 2015;

Background Information
OmegaMart plc (OM) is a discount grocery retailer which has been in business for several years. It operates a large store-base across Europe with a significant presence in the UK, where it currently operates over 500 stores. OM has steadily increased its market share within the UK retail industry in recent years. This growth is particularly heightened in period of economic recession as disposable income shrinks and household expenditures become more price sensitive. A key driver of OM’s success has been the low prices, enabled by a lean efficiency focused operating model.
According to a recent retail analysis, UK grocery shoppers are increasingly relying on more channels than ever before and in response, retailers are developing new store formats that cross traditional boundaries. For instance, superstores such as Tesco have successfully moved into convenience (Tesco Metro) and online shopping.
As consumers are increasingly leading busy lives, “convenience” has been identified as the key to future growth in the UK grocery retail sector.

The Problem
Despite increase sales in recent years, the board of directors are now concerned about maintaining such growth in the future, especially as the bigger supermarkets are actively seeking to narrow the price gap and win back customers through various strategies (e.g. loyalty cards). Following the publishing of the retail analysis, the board met to discuss how to improve the customer experience by offering more convenient shopping outlets.
They are prepared to invest up to £10 million obtained by raising a new share issue. Additional funds will be sourced by borrowing.
Two options are currently being considered:
A)    Expand o city locations and compete with other convenient stores
B)    Offer online shopping platform
Each of this options offers a route to reach more customers, who shop by convenience thereby allowing OM plc to continue its growth story.

Convenience stores
For discounters, such as OM, the key challenge is how to make their low cost model viable in high-cost urban locations and to tailor their product offer to city shoppers who shop for near term needs rather than undertake a full weekly shopping.
Opening compact stores in central locations means they need to find ways of squeezing their range into a smaller space while minimising the higher operating costs associated with city stores. The assortment also needs to be adapted and product offering must be appropriate to local shoppers which clearly presents challenges to retailers such as OM, used to working with uniform store formats.
It is estimated that this option will involve opening of additional 20 stores in “city” locations within the next two years.
This is estimated to involve an initial investment of £9.5m in 2014. This was used for additional buildings (4m), furniture and fixtures (3m), vehicles (1m) and other operating costs including consulting and legal fees (1.5m). Additional expenses to be incurred from 2015 when the new stores begin operation are:
Marketing expenses should increase by £0.5m per annum
Direct labour force for new staff should cost £1m per annum
Other operating costs associated with this option, including rental of some premises should be £2.5 per annum.
This option ensures that OM’s customers have quick and easy access to its offerings regardless of whether they live in dense metro areas or the outskirts of town. Additional sales from this investment are expected to be in the region of £20m in 2015 and should increase by 5% for the first three years and additional cost of goods sold should be £15m yearly.

Online Shopping:
The UK online grocery sector is still relatively small and competition is fiercer. This sector is currently led by larger supermarkets who are able to invest in providing excellent delivery service and innovative technologies. Despite these challenges, the rationale to move towards online shopping is strong. It provides the chance to reach shoppers more often, capture a larger share of their expenditure and encourage greater loyalty. The board is confident that the ‘discount’ model will be equally successful in an online platform. Thus, it is expected that beyond the sales increase from the traditional stores format, additional sales will be generated from the online platform as follows: £18 for the first year, and increasing by 5% in second year and increasing by 10% thereafter.
The costs associated with this course of action include:
–    A significant investment in upgrading the current website for online shopping – Initial investment in operating cost of 5m in 2014 and annual maintenance fee of 1.5m from 2015
–    Increased marketing costs to encourage use of this new channel £1.5m per annum from 2015
–    A £1m increase in labour cost for distribution staff and additional in-store staff to pick customers’ orders from 2015
–    Investment in delivery vehicles  – about 5m in 2014 plus an additional 0.2 million for annual maintenance from 2015
–    Other operating costs should increase by 1m and additional cost for goods sold £13 in the first two years from 2015.

The Financial Details
The trend of annual sales of the Company has been fairly constant over the last few

However the profitability in each year has been variable. The Income Statement and the statement of Assets and Liabilities and are presented below.

You are required to evaluate both proposals and make a recommendation to the Board of Directors of OM plc as to which course of action to follow.
Your analysis should commence with an appraisal of both proposals using appropriate investment appraisal techniques. The financial performance and strength of the business should be evaluated using appropriate financial ratios. This will involve comparing the ratios before and after the investment and explaining the impact of the investment on the financial ratios. This will also require forecasting some element of the financial statements for the next two years based on the information provided.
Your analysis should be presented in the form of a report and you should amplify your answers by incorporating suitable charts, graphs and appendices. Any assumptions that you make should be fully justified and explained. Sources should be cited where appropriate.
Your discussion should consider the general economic outlook, changing consumer spending patterns and the market structure of the UK grocery retail sector in general.