A Love Letter to Innature Berhad (5295.KL) - The Body Shop of Malaysia/Vietnam

A primer on the immense pricing power intrinsic to the Branded Retail sector

Few middle-class consumers and above will be unfamiliar with The Body Shop brand. Founded in 26th March 1976 by the effervescent Anita Roddick, she managed to raise the perfume and skincare retailer - which was at first accused of being insulting to funeral parlors - into an FMCG brand monolith, which proudly bore the torch of environmentalism & fair trade long before the Statue of Lib-ESG held her own in the business zeitgeist.

If there’s one thing you should understand about the power/moat behind The Body Shop brand, it isn’t the efficacy of its bestselling Shea Butter Moisturizing Cream - but the fact that since the product’s inception, a small percentage of all sales proceeds have gone towards supporting the village mothers in Ghana who cultivate the beans that go into its production.

Anita Roddick, the founder of The Body Shop, posing for a photo at a The Body Shop storefront

And that’s the story of Innature Berhad (‘Innature’) as well. While I don’t have any hard data on this, it’s not hard to imagine that most of its domestic clientele tend to occupy the upper quintile of the income distribution - considering that I can get a generic Tesco-brand shampoo that does the same job for a unit cost of 8x less. And yet the utter lack of value-for-money characteristics in The Body Shop’s products do naught to deter its loyal, long-standing customers. I was just as surprised to learn that Innature had a 50% recurring revenue base, with 50% of that consisting of just 4-5 SKUs - all of which were coincidentally handcrafted by the late founder herself. (I even interviewed store employees to double-check, it’s true)

From an investor’s perspective, there’s really nothing much you need to know about Innature the company specifically, beyond the Body Shop brand. You can visit their Investor Relations website yourself or download their latest analyst presentation deck here for pretty much everything you need to know about them. All you really need to materially gather from public documents is that:

1. Their revenue is split into 75% Malaysia, and 20% Vietnam

2. The market thinks they have basically zero earnings growth visibility in Malaysia (as they have already saturated all the urban city-center malls)

3. They have a small outfit in Cambodia and a small but growing e-commerce presence, both of which are entirely discounted by the market

4. They have in excess of 35 years of history in Malaysia, but only recently listed in Jan 2020

and… that’s kinda it. Their financial statements are quite straightforward and unremarkable.

INtroduction to INnature’s INdustry

Now I’m not going to bore you with the myriad intricacies of Innature’s business structure or financials - instead choosing to focus on what makes this stock tick. Which I’m sure is what most of you are interested in anyway.

In order to understand the attractiveness of The Body Shop brand, one first needs to recognize the difference between the Normal Retail industry and the Branded Retail industry. In Normal Retail, the business is completely commoditized, as the product is pretty much undifferentiated from competitors. Hence, customers will only care about getting the lowest price, and the business model devolves into a price war.

In a sense, you can draw a comparison between Normal Retail’s business model to the LTV/CAC model of the SaaS industry. You start off with a steady-state pool of customers, which will experience an organic level of churn over time. In order to maintain revenue without raising prices, the business has to replace the lost customers by acquiring new customers. Quite straightforward, right?

The problem with the above is that it is common knowledge that acquiring a new retail customer can be up to 5x more expensive than maintaining an existing customer. Hence, even at the beginning of the Growth stage, a B2C business needs to prioritize minimizing churn above all else - including growth. That’s why churn metrics like SSS (same store sales) or NRR (net recurring revenue) are so highly-prized in these industries.

In the Normal Retail landscape, this usually manifests as shifting customer loyalties depending on who offers the lowest price (e.g. ever switched to another e-commerce seller simply because their price for the same product was a penny less?). As a result, industry players have to cut their prices to the bone in order to compete, which results in the industry’s infamous razor-thin margins. Churn is high as the price war keeps rebalancing the customer pool between competitors, and companies launch radical sales & advertising (S&A) activities to try and attract new customers to offset the loss from churn.

However, the razor-thin margins puts a cap on the extent of these S&A operations, resulting in the equilibrium above never being disrupted. Normal Retail businesses hence find themselves constantly fighting for the next gasp of air, with life becoming a perpetual downward spiral. This is why after several market cycles, the entire industry consolidates into just 4-5 players holding 80% of the entire industry’s market share - because without economies of scale, they are bound to a life of servitude to both their customers and suppliers (i.e. price takers).

However, the tables are completely flipped in the Branded Retail industry. Branded Retail businesses are usually able to command some form of pricing power, as the customer perceives value not just inherent in the product but in some form from the brand as well. E.g. in The Body Shop’s case, recurring customers tend to strongly believe in environmentalism or fair trade on a personal level, and want to support businesses which further those causes.

Due to this customer allocation of idiosyncratic value to the specific brand, its products become unique and are generally able to command a higher price than the market average. This higher price leads to higher margins, which enables greater S&A activities that steals market share from Normal Retail competitors and offers further brand-building opportunities - leading to even higher margins. Thus, the business model is upwardly spiralling and self-sustaining, whose momentum is only dampened by other Branded Retail competitors whose brand happens to encroach on the same value proposition (rare).

A great case study of the enormous advantages of Branded Retail can be seen in McDonald’s. To digress slightly, I like to break down Branding into two components, which I endearingly term the ‘Twin Cisters’ - Consistency and Credibility. Whenever you visit a McDonald’s establishment anywhere in the world, you know for a fact that you’re going to get the same, reliable cardboard McChicken taste - i.e. Consistency. And you’re willing to pay a slight premium for it, rather than risk being disappointed by a burger from a hole-in-the-wall; or risk possible diarrhea - i.e. Credibility. (There’s actually a third Cister - Cool - but only the world’s biggest brands possess that and it’s not relevant here. Maybe I’ll do a separate article on Branding sometime)

Because of that, your local McDonald’s joint typically sees a long line of cars piling out of the drive-thru come rain or shine, and they can raise prices in a very volume-inelastic manner. In Malaysia particularly, the cheapest budget set offering (i.e. McValue Lunch/Dinner) has seen prices go up by 5.8% CAGR since its introduction 8 years ago; yet I still order it at the same frequency.

Think about what a 5.8% CAGR price increase with no loss in volume means. Assuming conservatively that McDonald’s net margins are 10%, a 5.8% revenue CAGR that falls completely untouched to the bottom line means 58% earnings CAGR (i.e. 5.8% / 10%) - attributed to price increases alone. Most business owners would give an arm and a leg (and perhaps their unmentionables) to obtain a guaranteed 58% earnings CAGR. And if that net margin is lower than 10%, that CAGR would be even higher.

This is what Buffett meant when he mentioned the following quote:

“The single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you've got a terrible business.”

This is what the power of Branded Retail can be encapsulated into - pricing power. And Innature has that in spades - they’ve been raising prices consistently with inflation, with minimal impact to volumes.

Valuation

A running tap in one of The Body Shop’s stores for patrons to wash their hands after trying samples

For the aforementioned low-risk and earnings visibility reasons, Branded Retail stocks tend to command relatively high valuations for the Retail sector of about 25-30x. For reference, the local Starbucks (Berjaya Food: 5196.KL) and 7-11 (SEM: 5250.KL) listed entities are currently (and have consistently) trading at 30x and 25x pre-covid earnings respectively, without any significant growth catalysts in sight.

In contrast, Innature currently trades at merely 15x FY19 normalized, pre-covid earnings (25x FY20 earnings). They also paid a 1.5% and 4.5% dividend yield, based on FY20 and FY19 dividends respectively. Hence, this thesis boils down to simply waiting for valuations to revert to the mean (i.e. 60% upside at 25x FY19 P/E, or RM 1.00 target price) when the next retail upcycle rolls along, while getting paid an above-average bond yield to wait.

Why do I make reference to ‘bond yield’? Because their cash flows are highly robust and the company is in a net cash position, making their dividends bond-like. Here are some stats to satiate your inner nerd:

FCF = (OCF - Depreciation) ; Adjusted FCF = (FCF - lease liability accruals)

As we can see, the company’s FY20 Adjusted FCF was only barely in the red (Adjusted FCF margin: -0.97%) even in the Year of the Lockdown - where the urban malls that Innature’s stores are mostly located in experienced half of their pre-pandemic footfall. Given that FY20’s e-commerce sales were only 20% of revenue, I’d wager that the bulk of the robustness of cash flows could be attributed to the recurring customer base. On top of that, they managed to achieve 15% ROE in FY20 without any debt. 15% ROE in a downcycle!

The numbers start scaling to preposterous heights when you turn your attention to their pre-pandemic ROI figures. FY19 ROA of 19% and FY19 ROE of 35% (in the absence of debt) are dreamlike qualities for an offline retail FMCG storefront business model. I’ll be honest, part of me wondered whether things were too good to be true at first sight. But a cursory check of cash flow double-entries didn’t raise any red flags, and their cash flow credibility is also bolstered by its cash-based transaction model.

Also, I’d like to draw your attention to their (Ad+Promo)/Sales ratio being consistently <3%. See what I mean by the power of Branded Retail?

May The Force Be With You (ESG)

Innature’s business motto is elegant in its simplicity - Business As A Force For Good. The underlying theme is of course ESG - but if you’re familiar with The Body Shop’s brand, you’ll know that this isn’t just a newly institutionalized message meant to entice institutional investor capital. Innature has been pursuing ESG right from the start, long before it was cool.

Innature is one of the rare small-cap Malaysian listed companies which actually go out of their way to show that they care about Sustainability. Literally 1/3 of their analyst deck is dedicated towards their voluntary societal contributions over the past year, and it is clear when talking to management that the effort comes from the heart.

Personally, it heartens me to see the motto ‘Business As A Force For Good’ being used, as it encapsulates the way I feel about ESG as well. To me, ESG is the bridge between corporations and governments - where the societal role of corporations is to optimize scarce resources, while the societal role of government is to provide for indispensable social needs even if they may not necessarily be sustainable.

ESG tries to pull companies closer to the middle by enabling the sustainable provision of social needs, resurrecting the premise of the social contract - where the immense resources of the private sector are lent towards performing some of the heavy lifting in society. It also harkens back to the ancient days of old, before the corporations’ sole duty was purely in the service of maximizing shareholder returns.

Miscellaneous

In wrapping things up, I’ll just add a couple other thoughts I have about Innature:

1. The shareholder float is very thin, with the founder and her family owning nearly 75% of outstanding shares.

2. I know at least 5 institutional investors who own roughly 1% of outstanding shares each, which brings the actual public float closer to 20%. I won’t hide it, this is a difficult stock to accumulate as an institutional investor.

3. Their FY20 AGM will be held on 2 June 2021. There’s still time to sign up for it as a shareholder if you wish to participate.

4. Vietnam is not central to the investment thesis. Sure it’s great to have the upside optionality - but from what I’ve heard from other local companies with a presence there, running a business in Vietnam as a foreign entity is an operational hellhole that sucks money like a reverse firehose.

5. Neither is e-commerce central to the investment thesis. I understand concerns about offline retail going the way of the dodo, which will continue to lose market share to e-commerce over time - but it won’t go extinct. There is still a place in society for malls, and an omnichannel presence can serve as a moat against pure e-commerce players (e.g. Apple stores serve as a form of free advertising for iPhones).

6. The incoming Natura business is still too nascent (and practically non-existent) to assign a valuation to it.

7. The investment thesis is simply that the current share price (RM 0.64) is trading at a discount to the value of the low-risk Malaysian operations alone - there are no valuation gymnastics to be performed here. Cash flow risk is lower than Gandhi’s ego, and being paid a normalized dividend yield of 4.5% while waiting for valuations to revert to mean at least offsets inflation. I am willing to stake my reputation on this company not going bankrupt.

Innature financial information: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=5295

Innature Investor Relation website: https://innature.com.my/investor-relations/financial-highlights/

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