Brazil fashion retail
19 July 2014 - Suhail Suleman
In previous articles we have consistently spoken about our belief in the long-term fundamentals of Brazil as a future leading economy. We have also drawn parallels between Brazil and South Africa as two countries with similar histories of colonialism, inequality and substantial resources potential. In this article we explore the development of the fashion retail industry worldwide, compare this to our historic experience in South Africa and share our views on how we believe the industry will develop in Brazil.
Many leading fashion retailers worldwide have proved to be incredibly successful thanks to their business models. By outsourcing garment production, which is a low-margin business, and concentrating on design and brand building they have been able to grow earnings consistently in real terms for years, sometimes decades at a time. Returns to shareholders have been well above average over the period, due to their having avoided capital-intensive non-core activities like garment manufacturing and chosen leased store space over property ownership. Additionally, they have concentrated on ensuring they get their product design right, build desirable brands and manage their inventory levels to avoid excessive markdowns. Another inherent strength to some of their business models is the ability to generate cash. Large clothing retailers are able to pay their suppliers well after receiving the product, which means that if they sell the stock and collect cash from customers before they need to pay suppliers, their working capital requirements are effectively financed by their creditors. Many fashion retailers are faced with a choice between operating on a cash-only basis and foregoing sales to customers based on affordability, or offering credit terms and foregoing the benefit of self-financing working capital.
The direct result of success in fashion retail is that consumers desire your brand and products, and are willing to pay for them. This allows retailers to roll out additional stores at the expense of the informal (unbranded) market and the formal market who lack the scale to compete. Over time most countries’ clothing markets end up being dominated by just a few fashion retailers because for new entrants the barriers to entry become more difficult to overcome. In emerging markets this process is aided by rising disposable incomes as countries become wealthier and people become more brand and fashion conscious.
South Africa has been a typical example of the fashion retail industry dynamics playing out. The stability of the post-1993 economic environment relative to the turbulent 1970s and 1980s has allowed our large fashion retailers to steadily grow and consolidate the market. There is also a structural strength that comes with being a southern hemisphere fashion retailer – one can replicate successful fashion from the northern hemisphere as we are always one season ‘behind’ in terms of weather. This allows retailers to avoid fashion ‘mistakes’ and the resultant inventory markdowns. The six largest clothing retailers in South Africa today are PEP, Edgars, the Foschini Group, Mr Price, Woolworths and Truworths. Ten years ago they had combined revenues of $2.1 billion and installed selling area of 1.6 million m2. Today the figures read $9.6 billion and 4 million m2 respectively. Their success over this period has allowed them to branch out into different formats serving the same target customer, such as specialist home retail (Mr Price Home, @Home etc.). Shareholders have experienced truly remarkable returns over the period – for the four companies that remain listed (Foschini, Mr Price, Woolworths and Truworths), earnings have grown at a staggering rate of between 22% and 29% per annum for the last ten years, while the cash-generative nature of their business is best illustrated by the even higher dividend growth rate of between 25% and 36% per year over the same period.
When we look at fashion retail in Brazil today we are very much of the view that the industry is in a similar position to South Africa 10 to 15 years ago. The country has a popu-lation of 200 million people, four times that of South Africa, and its GDP is between four and six times higher depending on whether one uses market or purchasing power adjusted exchange rates. In contrast to South Africa’s persistent unemployment of 25%, Brazil has successfully reduced unemployment from 13% in 2003 to 6% today, which means there is a much larger pool of potential consumers for the retail industry. Brazilian retailers also share the southern hemisphere advantage referred to earlier. Given this data, one would intuitively expect the biggest fashion groups in Brazil to be several times larger than their South African counterparts. In actual fact, the opposite is true. Brazil’s six largest clothing retailers have less than one quarter the combined store numbers of South Africa’s six largest retailers and are similarly outsized on all the metrics shown below.
The potential of the Brazilian market is made very apparent by the fact that sales intensities are much higher – the annual revenue of the top six in Brazil is 65% of South Africa’s level, despite only having 32% of the store space.
To understand why the Brazilian market is so far behind South Africa it is important to consider the country’s economic history and the challenges posed by this. Despite reasonable economic growth from the late 1960s onward, the country experienced decades of very high inflation together with intermittent periods of hyperinflation. Only in 1994 Brazil finally brought inflation under control by adopting a balanced budget, wage indexation and a fixed currency. But even then economic growth was mediocre as interest rates remained high as the central bank sought to suppress inflation and attract capital flows to maintain the currency peg. Economic instability continued for much of the period through to 2003, when the administration of Lula da Silva took office amid fears of impending debt default. Confounding market fears, his administration continued the process of bringing Brazil’s finances under control and reforming the economy to make it more competitive and encourage investment. The country’s terms of trade also improved dramatically thanks to the Chinadriven bull market in Brazil’s primary exports – commodities. This period can thus be viewed as the start of Brazil’s emergence as a potential world power, and after eight years of decent economic growth Brazil now ranks as the sixth largest economy in the world, overtaking the United Kingdom in 2011, with unemployment officially much lower than that of most countries in the European Union.
A by-product of economic instability has been that Brazilian industry remains very fragmented. Most large private Brazilian companies (commodity and material producers aside) have a recent history of family ownership and predominantly operate in a single region or state. Since 2003, however, many of these firms have been able to raise capital from the public markets for the first time in order to expand their operations or extend their geographic presence. This description applies to many companies and industries, such as food retail, branded foods manufacturing, private education, health services and restaurants, in which we have invested (or considered investing) client funds. It also accurately describes the fashion retail industry in Brazil which, despite the potentially huge market, remains very fragmented.
We believe that 10 to 15 years from now there will be a few clear winners from industry consolidation in Brazil, much like there has been in South Africa and most developed economies. A compelling long-term driver for fashion retail is the upward migration of Brazilian consumers into the middle and upper classes. Over the last six years Brazil has steadily transformed into a middle class society (by their standards). The country today has over 100 million people classified as middle income (‘C’ class) from 60 million five years ago. The upper ‘A’ and ‘B’ classes now number 42 million and the lower ‘D’ and ‘E’ classes less than 50 million. Middle to upper income households will typically trade up over time.
Retailers are also assisting in the process of upward migration by offering credit to consumers. During the time of hyperinflation credit extension was minimal, while the period since then has been marked by some of the highest real interest rates in the world. Credit in retail stores is not cheap, but the ability to purchase products over several months paying a fixed monthly instalment is very attractive to most consumers and provides substantial additional income to retailers through fees and interest.
We currently own Lojas Renner and Marisa in client portfolios, with a total exposure of 5.5% of fund between the two. Both companies are primarily focused on women’s clothing and apparel, but Lojas Renner’s target market is predominantly ‘B’ class compared to Marisa’s ‘C’ class focus. The size of their respective target markets has doubled in the last five years, but there are still many cities and districts in which they have no presence at all. As an example, Lojas Renner had 167 stores at the end of 2011, almost all located in high-end malls. They are considered an anchor tenant for shopping malls, much like Edgars would be in South Africa, yet there are more than 100 existing shopping malls without a Renner store (and dozens more being built every year) that are big enough to accommodate them. In addition, Renner has recently started experimenting with smaller-format stores and has acquired a successful home store chain serving a similar clientele which they believe will complete their product offering.
We are even more positive about Marisa as its potential target market is both larger and traditionally neglected in favour of wealthier clientele. The company had 336 stores at the end of 2011, 40% of which has been in operation for less than the three years it typically takes for a store to reach a reasonable level of maturity. This means the current levels of both sales and profitability are well below our assessment of normal, while most of the capital expenditure required for these stores has already been spent. The company hopes to add around 15% additional selling space every year for the next few years, a target that is achievable as it does not require its stores to be in shopping malls – currently half are, in fact, outside of malls. Marisa has also adapted its store range to cater for different locations and now offers smaller stores and specialist lingerie stores. The company has historically struggled with collection of credit sales made via its store card, but has improved collection efficiency substantially in recent years and launched a co-branded store card with ItauUnibanco where credit risk is transferred to the bank, but the profits are shared.
The long-term prospects for both companies are very compelling and their valuations are very attractive. In our view these businesses will compound their earnings for a very long time period. This will grow their intrinsic values to well above their current share prices, a dynamic that is not captured when looking at short-term valuations. Such earnings potential and upside make these businesses amongst the most attractive within Brazil and emerging markets as a whole.
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Note to the editor:
Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multimanager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 29% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Mbabane, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange. As at the March 2012 quarter-end, assets under management total R296 billion.