Description

Via Varejo (VVAR11)

Executive Summary

• The year 2015 was Annus Horribilis for the Brazilian economy, as falling commodity prices and the Petrobas corruption scandal resulted in a leadership crisis and precipitous fall in both investor and consumer confidence, resulting in a recession that had persisted into 2016.
• Via Varejo was a casualty being exposed to the highly discretionary consumer durables sector. However, with consumer confidence stabilizing in Brazil, the share price is up 89% YTD, and the valuation remains very attractive. The company is positively leveraged to a recovery in the Brazilian economy and the stock has excellent risk-reward characteristics and multi-bagger potential.
• The company is the dominant market leader in Brazil, where scale confers multiple competitive advantages across procurement, supply chain and brand awareness. Meanwhile, Via Varejo’s strong balance sheet should allow it weather further potential economic turbulence without raising equity. 

Introduction to Via Varejo:

• Via Varejo (‘VV’) is the largest consumer durables (consumer electronics, household goods and furniture) retailer in Brazil, with a market share of 25% and substantially larger than its nearest competitor, Magazine Luiza (~9%). The company is controlled by GPA, Brazil’s largest retailer, which in turn is ultimately controlled by the French-listed Casino Group, a major international retailer with large operations in its domestic market as well as controlling stakes in publicly-listed retailers in Brazil (GPA/VV), Thailand (Big C) and Columbia (Exito) (further detail on corporate structure in Appendix 1). 
• VV also owns a 22% stake of NASDAQ listed e-commerce durables retailer CNova, which is also controlled by the Casino Group. Cnova was created to consolidate and spinout all of Casino’s e-commerce operations and was IPOed in 2014. At the time of IPO, its revenues were split roughly evenly between France, where it is the market leader and Brazil, where it is the #2 player, behind B2W. Casino Group has currently proposed a voluntary tender offer on CNova’s free float, conditional of VV shareholders exchanging their 22% stake in Cnova for the entire Cnova Brazil operation (further details on Cnova and the proposed transaction are in Appendix 3)
• VV was formed in 2013, after GPA purchased Brazil’s largest consumer durables retailer, Casas Bahia, and merged the company with its existing holding of Pontofrio. Casas Bahia and Pontofrio operate as two distinct brands with Pontofrio targeting Brazil’s middle-upper class, whilst Casas Bahia targets the middle-lower class. Casas Bahia accounts for the majority of VV’s revenues/earnings.

• Casas Bahia has an interesting history and its rise to dominate the Brazilian household durables market was written up as a business school case study by strategy guru CK Prahalad in 2004 (whilst dated, the document is definitely worth a read for a primer on Casas Bahia and evolution of Brazilian durables market – google ‘Prahalad Casas Bahia’ to find it). Prahalad uses the company as an example of a local champion that successfully conducted business with low-income individuals, who were ignored by multinational corporations. At a time when many Brazilians had low access to credit and no formal wages, Samuel Klein (the founder) pioneered a model of consumer financing which took into account informal income declarations in order for lower-income households to purchase previously unaffordable consumer durables via an installment payment book (typically monthly payments between twelve to eighteen months). However, with credit availability growing substantially in the decade the case study was written, the payment book now only finances 13% of VV’s sales, with majority via third party credit cards. VV has slightly less than 1,000 stores, with the majority located in the economically significant South-Eastern part of Brazil. 

Brief history of Brazilian consumer durables segment and recent troubles 

• From 2001 to 2013, the Brazilian consumer durables sector has benefitted from extraordinary growth (over 10% CAGR during the period) due to i) strong economic growth during this period, driven by the commodities boom and sound economic policies instituted in the previous decade ii) equitable distribution of the country’s increased wealth across socioeconomic classes, lifting millions of Brazilians from poverty, iii) increased access to consumer credit for the emerging middle class and iv) government policies that subsidised loans on both household formations and purchase of household furnishings.
• However domestic economic conditions substantially worsened following VV’s secondary listing in December 2013, most acutely in the second quarter of 2015. The government had to reign in spending to lower the deficit (and risk further deterioration in Brazil’s sovereign risk), whilst the central bank didn’t have much room to manoeuvre on interest rates and tackle rising unemployment, given Brazil’s high inflation. Add to this the blow to business confidence around the Petrobras corruption scandal, low commodity/oil prices hitting Brazil’s balance of payments and record-low confidence in Dilma Rousseff’s leadership and it’s no surprise that consumer and investor confidence in Brazil took a nosedive. The situation remains fragile, with the Brazilian economy remaining in recession, although recently consumer confidence has improved and Brazilian share market/ currency have performed well YTD.

• VV reported horrific Q2 2015 results, with SSS down 24% YoY and a minor net loss on the income line. VV’s results have remained poor since and whilst sales have improved from the trough levels of late 2015, this has been driven by promotional activity that has adversely impacted gross margins. In Q2 2016, VV reported SSS +2.6% YoY and a minor profit (R36mn) for the bricks & mortar operation.

So, to summarise the bearish case on VV: 

• Macro: Exposure to Brazilian consumer durables at a time when Brazil’s economy is contracting and consumer confidence, whilst improving, remains low. The bearishness on top-line growth, combined with the high operating leverage of the business (large fixed costs of rent, wages and supply chain distribution centers) will continue to be detrimental to VV’s bottom-line. Furthermore, as VV’s customers finance most sales via third party credit cards, lower credit availability by local banks going forward would further curtail demand.
• Credit Risk: VV directly finances ~13% of consumer purchases via its self-funded payments book, in an environment where Brazilian household finances will be strained due to a combination of high levels of indebtedness and rising interest rates/unemployment. This book is likely low credit quality, as it is typically composed of households that don’t qualify for bank credit cards. As at 30th June 2016, VV had over BRL2.5bn in accounts receivables associated with payment book.

• E-commerce: Rising threat of E-commerce players (such as B2W, Magazine Luiza, CNova) taking market share from traditional bricks and mortar retailers in commoditized household goods, as has been the trend in Western economies.
• Klein stake: Overhang of potential sale of Klein family’s (Casas Bahia founders) remaining 27% stake in the company, which could create huge technical pressure given the illiquidity and short trading history of VV shares (discussed further in Appendix 2 below).

Whilst the broader macro picture is currently poor, the underlying microeconomics of the company remain favourable and it is well positioned to weather the current economic turbulence.

Strengths of VV:

• Market leader: VV has a dominant position in the Brazilian consumer durables market (25% market share), with next largest competitor Magazine Luiza having only 9% market share. This confers huge negotiating leverage to VV when negotiating deals with suppliers, both in pricing and payment terms as well as funding the large fixed cost associated with national advertising campaigns on traditional media.
• Secular growth: Notwithstanding the strong growth trajectory of consumer durables over the past decade in Brazil, penetration rates in several key product lines remain very low compared to Western households, representing a long-term source of secular growth (for example, only 28% of low income Brazilian households own a washing machine). Furthermore, VV is underrepresented in the poorer Northern parts of Brazil (only 6% of total stores). The company has recently stated that it looking at both organic and non-organic M&A growth opportunities. Now would appear to be a good time for VV to purchase smaller Northern retailers on the cheap and consolidate market power. 
• Brand recognition: Casas Bahia in particular benefits from a very strong brand amongst Brazilians and is perennially rated top of mind in household appliances by Folha de Sau Paulo and Interbrand rankings, where it polls well ahead of any of its durables peers.

• Balance Sheet: VV continues to retain a rock solid balance sheet, holding a net cash position of BRL1.2bn, when excluding debt associated with funding the payment book. Furthermore, VV currently has BRL897mn of unfactored credit card debt currently on its balance sheet. VV’s TTM Net Debt/EBITDA is only 0.7x, even when including the BRL2.6bn debt load associated with the payment book and assuming factorization of credit card debt.  

• Hidden asset: VV owns a 22% stake in publicly-listed e-commerce retailer CNova, currently worth US$512mn (or BRL1.65bn) . CNova is currently loss-making and recognized on VV’s earnings as an equity-accounted loss. As mentioned in the introduction, ultimate parent Casino is proposing a tender offer transaction for the remaining float of Cnova, conditional on VV minority shareholders agreeing to exchange their 22% stake in Cnova for 100% of CNova’s Brazil operations (more on valuing Cnova stake in valuation section below and further details of the proposed tender offer in Appendix 3 ).

 • Potential acquisition target: Following the CNova tender offer/exchange transaction, I believe this would make VV a much cleaner target for a potential acquirer. Also, Casino Group (the ultimate parent) has recently come under pressure to reduce indebtedness at the parent company level, following a downgrade in its credit rating to junk status. It has recently undertaken a number of asset sales to reduce debt levels, and therefore it remains feasible the group may look to sell VV, although this remains speculation on my part. In terms of interested parties, I also note that Klein family was very much interested in acquiring all of VV prior to IPO, although I remain unaware of their current intentions.
 

Valuation

• It is difficult to determine an appropriate level of normalised earnings for and therefore value Via Varejo. This is both a function of the favourable tailwinds resulting in a decade-plus long boom in consumer durable purchases since 2001, as well as the macro woes  impacting its most recent results. However, I believe the very difficulty in normalising earnings with precision is why several traditional value investors have eschewed this space.
• VV’s current market capitalization is BRL2.65bn. If we assume a conservative P/E multiple of 8x, we would need to believe that VV’s bricks & mortars business could generate normalized earnings of BRL330mn going forward, without ascribing any value to VV’s stake in CNova (currently worth BRL1.65bn at current market price). This earnings number is only one-third of VV’s peak earnings (FY2014 net income BRL964mn). Furthermore, in economic conditions that continue to remain depressed, in VV’s most recent Q2 results, the bricks and mortar business achieved annualized and normalized earnings of BRL144mn.

• Given Cnova Brazil is currently loss-making it would be too speculative to place a value on it. The current market value of the stake is reflective of the proposed tender offer (explained in greater detail in Appendix 3), therefore not particularly relevant to VV. I would prefer to look at it as a free call option on the recovery of this business. I also thought it interesting to note that, notwithstanding the recent issues with Cnova Brazil (outlined in appendix 3), it still accounts for 40% of CNova’s Q2 2016 net revenues, whereas VV is swapping a 22% stake in Cnova for 100% of CNova Brazil. Also given the deal requires the approval of VV’s minority shareholders (including Klein family), with parent company GPA abstaining from voting, there appears to be incentive for the offer to be attractive to VV shareholders.

• For those patient value-oriented investors that believe that Brazil can resume secular growth in consumer durables following this period of weak macroeconomic conditions, Via Varejo shares represent an excellent risk-reward at their current valuation, should earnings recover to anywhere near pre-crisis levels. Furthermore, the call option on the Cnova Brazil business should also become more valuable in this scenario. Clearly there is the potential for further short-term pain in earnings and negative technical pressure on the stock (refer Appendix 2), however I believe VV’s market leadership and strong balance sheet should allow it to successfully navigate this environment and benefit from the subsequent recovery should macro conditions stabilize.

Appendix 1: Corporate Structure

The Capital stock of Via Varejo is represented by 1,290,799,012 shares of which 655,840,722 are common shares and 634, 958, 290 are preferred shares. The preferred shares have similar economic claim to the firm as the common shares, but without voting rights.

VVAR11 (which is the security I am recommending) was created via a secondary offering in December 2013 (more information on this in Appendix 2). This resulted in the distribution of 123,696,984 units, each representing one common share and two preferred shares issued by the company. Below is a full description of Via Varejo’s ownership structure:

*Free Float is made up mainly by 123,696,984 units (VVAR11), distributed upon December 2013. The remainder related to the previous free float before the secondary offering (trading under the ticker VVAR3 and VVAR4), which represent tiny amount of shares outstanding that trade with very poor liquidity.

Shareholder Structure

·      Via Varejo’s controlling shareholder is GPA, which has a 43.3% economic interest in Via Varejo, but controls 62% of the voting rights. GPA, a publicly listed company (PCAR4 BZ), is the largest retailer in Brazil, engaged in businesses across food, general merchandise, electronic goods and home appliances.

·      GPA is controlled by Groupe Casino (CO FP), a French listed retailer with both domestic and international operations. Casino directly controls 50% of the voting rights in GPA, whilst having a direct 22.5% economic interest. Exito (a Columbian retailer and fully-controlled Casino subsidiary) owns the other 50% of GPA’s voting rights, effectively giving Groupe Casino full control over GPA.

·      Groupe Casino is controlled by Rallye (RAL FP), a French-listed investment holding company whose primary investment is its holding of Casino share. Rallye controls over 60% of the voting rights of Casino shares, whilst it has a 48.4% economic interest.

·      Rallye is controlled by by Fonciere Euris (over 50% economic and voting rights), an investment vehicle controlled by Jean-Charles Naouri, a French retailing magnate. Jean Charles Naouri is also the CEO and Chairman of Groupe Casino and actively involved in managing its operations, as well as those of its subsidiares.  His ownership of Groupe Casino shares represents the majority of his net worth.

Appendix 2: Description of Secondary offering process

• On December 2013, VV undertook a secondary offering in order to float 29% of the company. The offer effectively served as VV’s IPO, given the company’s previous free float was negligible (0.6%). The offering reduced GPA’s economic stake from 52 to 43% and Klein Family’s stake from 47 to 27%, however GPA remains in control, holding a majority of voting right shares.
• The offering took place in a weak market and the deal priced at BRL23 per share, well below the initial expected range of BRL26-34. News reports suggest that one of principal drivers for the offering was to provide the Klein family with an exit opportunity following a dispute with GPA management over the valuation they received when merging Casas Bahia into VV. Furthermore, the liquid market created in VV stock would provide the Kleins with the opportunity for further divestment down the road. Analysts also noted that this potential Klein divestment post the lock-ups expiring was another factor in the low secondary pricing, given the negative technical it would create.
• However given the share price performance of VV since the offering, the Klein family have held onto their remaining stake after all lock-ups have expired (Lock-up structure was 100% of shares until 11 June 2014 and 60% shares until 8 Dec 2014).  In 2014, there were reports in Valor (Brazilian business newspaper) that Klein family had no plans to sell, given VV’s low market valuation (and this at a time when the share price was multiples of the current traded price). Nevertheless, the low liquidity of VV shares and uncertainty of Klein family future actions continue to add negative technical sentiment towards the stock and may also act to create a short term price ceiling in a price appreciating scenario.
• Whilst I suspect a Klein sale at current prices remains unlikely, the probability of such an event cannot be discounted. It would not be surprising for an entrepreneurial family to prefer investing their funds where they have exercise control. Whilst this would be detrimental to VV’s share price in the short term, I would view this as a liquidity event and not economically motivated selling, which represents an opportunity for the value-oriented investor. Also, as mentioned in the write-up, the Klein family could also be potential acquirers of VV, following the Cnova transaction.

Appendix 3: Background on CNova

·      Cnova was formed in mid-2014 when Casino Groupe and its controlled subsidiaries, CDB and Via Varejo agreed to merge their two major e-commerce operations, C-Discount and Nova Pontocomm. The company subsequently listed on the NASDAQ later in the year.

·      C-Discount is France’s #1 e-commerce retailer, predominantly selling consumer durables. The business is split roughly evenly between deliveries and click-and-collect. The click-and-collect operation takes advantage of Casino Group’s store network, with over 15,000 collection points. Roughly 15-20% of C-Discount’s GMV is generated from third party sales. Prior to the merger, C-Discount generated EUR1.4bn sales in 2013.

·      Nova Pontocom is Brazil’s #2 e-commerce retailer (behind B2W), operating under Casas Bahia, Pontofrio and Barateiro banners. Only ~5% of Nova Pontocom’s GMV was generated from third party sales. Prior to the merger, Nova Pontacom generated EUR1.5bn sales in 2013.

·      Both operations currently do not meaningfully contribute to bottom-line earnings, being focused on generating sales growth and market share through margin investment. Both companies are also seeking to generate large growth in their marketplace (third party) revenues and have made strong progress to date. The marketplace business has better economics than the direct sale of consumer durables as almost all the revenues fall to the bottom-line. Both companies hope that the traffic generated through sale of low margin consumer durables will attract third party merchants to their site. Management stated that they hope marketplace accounts for 40% of total GMV by 2020.

·      Casino’s rationale for the creation and IPO of Cnova was i) share e-commerce best practise amongst all Casino online businesses, ii) have an e-commerce focused/incentivized management team, iii) to realise joint procurement synergies across platforms and iv) give the market better visibility as to value of the online businesses (given these businesses are usually valued on EV/sales, rather than profitability initially).

·      When Casino was initially looking at IPO-ing CNova, there was a lot of hype around the deal and the initial price range being discussed was for $12.50-$14.00 per share, implying a Cnova valuation in excess of US$6bn. However, the final deal ended up pricing at $7 per share, well below the initial guidance. Still, market expectations were high, particularly for Brazil, where the hope was that revenues growth would benefit from the twin secular tailwinds of consumer durables and e-commerce growth - both starting from very low bases (In JP Morgan’s Cnova initiation report, they forecast Brazil revenue growth between 2015-17 at 30%).

·      However, the dreadful macro environment in Brazil, combined with some recent company specific issues (including a fraud perpetrated by Cnova Brazil employees) and poor execution has seen Cnova Brazil’s materially suffer over the past twelve months. In its most recent Q2 results, sales were down 28.6% YoY in constant currency terms.

·      Casino Groupe recently proposed a voluntary tender offer transaction to current minority shareholders of Cnova (excluding Via Varejo). They have agreed to purchase outstanding shares at a price of US$5.50, which represented a premium of the previous traded price of 82%.  This is conditional on a reorgainsation of Cnova’s Brazilian operations, whereby Via Varejo would exchange its current 22% stake in Cnova for 100% of Cnova Brazil’s assets. In addition Via Varejo would repay a US$157mn shareholder loan that Cnova granted to Cnova Brazil. The reorganization is expected to take place in Q4 2016 and subject to approval of VV minority shareholders (ie, public shareholders and Klein family). GPA, the parent company, will abstain from voting.

Risks:

• Macro

• Longer-term impact of e-commerce: Growth in durable sales may occur disproportionately through online channels at the expense of bricks and mortar stores. Partially mitigated by VV’s 22% stake in Cnova/ 100% expected future stake in Cnova Brazil.

• Minority risk: Casino Group ultimately controls VV

• Potential Klein exit: Partially mitigated by the fact that Kleins stated they would wait for better valuation in 2014 before selling (at share price level well above current levels). Furthermore, if provided underlying fundamentals remain the same, this would merely be liquidity event and should provide excellent buying opportunity for the long-term value-oriented investor.
• FX risk    

Catalyst

No obvious hard catalyst (with perhaps exception of possible takeover following Cnova Brazil re-org). Ultimately the catalyst will be a recovery in Brazilian economy and company earnings. Frankly, I believe the lack of a near-term hard catalyst contributes to compelling valuation.