Description

No country in the world is more hated/feared right now than Brazil, and no retailer in Brazil is more hated/feared right now than Cia Hering, a leading retailer.  Given the currently depressed valuation of Cia Hering, we think there are multiple ways to win over a multi-year time horizon.

I. Business Description

Cia Hering, founded in 1880, is a Brazilian apparel producer and retailer. Today, the company sells its products under five brands:

Cia Hering’s products are sold via multibrand stores (48% of 2014 revenues), franchised stores (38%), company-owned stores (13%) and online (1%).  This mix has been stable for quite a while now. As of 1Q 2015, Cia Hering store chain included 79 company-owned and 746 franchisee-owned stores, all but 17 of which were located in Brazil.

Despite its strong historical track record, Cia Hering trades at a steep discount to its peers:

II. Sell-side consensus

Cia Hering failed to keep up with competitors’ increasingly sophisticated approach to brand strategy and in-store customer experience. Management was good at introducing a lot of new products in the mid- and late-2000s but did not notice how Brazilian consumers’ tastes and demands had evolved over time. As a result, once the company stopped introducing new products in 2011, same store sales dynamics deteriorated. “Manufacturer’s mindset” is currently the most widely cited company-specific risk.

On top of that, the market believes that Cia Hering is more vulnerable to Brazil’s macroeconomic woes than peers because of a) its reliance on multibrand stores and franchisees for distribution (86% of 2014 sales), b) its much larger exposure to small towns, which were hit harder, and c) the more discretionary nature of its products (despite the same price point).

III. Variant view

Cia Hering’s competitive edge is based on its large scale manufacturing capabilities in the broken and isolated Brazilian apparel market and its 135 year old brand. Both remain intact.

Cia Hering is one of the few companies in the Brazilian apparel market with large scale in-house manufacturing facilities. Most big retailers don’t want to deal with Brazil’s extremely poor infrastructure. Storage, power supply, transportation, and procurement are much more challenging in Brazil than in most other countries. For instance, one large retailer in Brazil prefers to deal with more than 2,000 small suppliers than to do any manufacturing itself. On the other hand, hefty import tariffs (more than 100% for some products), different seasonality vis-à-vis the Northern hemisphere, and cheap currency make imported apparel prohibitively expensive.

Since 2014, Cia Hering has been making progress in its efforts to improve its brand positioning. In the past, all types of products were managed by just one person. Now, the company’s marketing department has more than 100 people whose responsibilities are split by product line. Store-related capex increased by 150% last year. The Hering-for-you brand was launched. Dzarm. was repositioned from being unisex to women’s only. Management openly acknowledges its brand vulnerabilities and seems determined to address it in a very proactive way. Hering brand consistently ranks high in the rankings of Brazilian brands compiled by Interbrand and Millward Brown, global brand consultancies. Strong 1Q 2015 sales in company-owned stores and online support our assessment of Hering brand’s appeal.

This is why we believe that long-term prospects of the company are solid. Net cash and a flexible distribution model should help Cia Hering navigate the ongoing macroeconomic crisis without incurring losses, in our view. The short-term prospects of the Brazilian economy are uncertain, though, but that.is why this opportunity exists in the first place. Investors hate the uncertainty that surrounds Brazilian retail sector in general and Cia Hering in particular.  

The sell-side consensus is that Cia Hering’s brand and EBIT margins are permanently impaired. In contrast, we believe that 20% EBIT margins are likely to be sustainable in the long run. We also expect slightly faster topline growth in 2017 because of the leverage provided by Cia Hering’s distribution network and the recent introduction of two new brands.

IV. Valuation

V. Risks

1) Brazil’s current account deficit is still more than 3% of GDP. Coupled with the possibility of interest rate hikes by Fed, this creates room for further depreciation of the Brazilian real;

2) Turnaround in Brazilian consumer spending may take a few years because of considerable household leverage amid tight monetary environment and high wages as a % of country’s output.

Catalyst

1) Turnaround in Brazilian consumer spending in 2016-17;

2) Rapid growth of new brands’ sales is 2016-17;

3) Reduced SG&A expenses in 2016;

4) Improved inventory management in 2016.