Innature (Part 2): The Perfect Hedge Against BOTH Inflation + Deflation
The Fed Hiked Rates 0.75% Amidst +8.6% US Inflation... will it lead to a Recession? Here's a stock which is BOTH An Inflation + Deflation Portfolio Hedge.. INNATURE! (The Body Shop Malaysia + Vietnam)
INNATURE’s shares at today’s share price are the optimal portfolio hedge - The Body Shop Vietnam has pricing power and LT growth prospects (Vietnam GDP growth until 2030: +7%), and at current share prices their normalized dividend yield is 5.7%. This protects the shareholder from BOTH Inflation & Deflation - a truly unique portfolio hedge cocktail in these uncertain times.
Their fundamentals are great - with a healthy balance sheet in a Net Cash position and robust FCF, generating a normalized ROIC of 27%. Their LT earnings growth is estimated at roughly 10% - 12%.
These amazing fundamentals are currently being offered at a wonderful price of 11.6x normalized PE - with an estimated Margin of Safety of 50% from intrinsic value. INNATURE’s MD purchased 300,000 shares after Innature’s share price recently fell by -15%.
The organic earnings growth inherent in pricing power makes businesses in the Branded Retail sector unique - and provides a strong competitive moat. This makes Innature paradoxically a high quality stock being offered at cigar butt prices - a wonderful business at a wonderful price.
In summary, Innature has low fundamental risk, strong cash flows and is Net Cash - it has decent growth prospects, sports an inflation-protected normalized dividend yield of 5.7%… and is priced attractively at 11.6x normalized PE.
INNATURE (i.e. The Body Shop of Malaysia + Vietnam) is looking extremely juicy right now - not only from a fundamental perspective, but also from a portfolio positioning perspective. With a high normalized dividend yield of 5.7% (based on FY19 dividends paid), it is a good deflation hedge.
At the same time, their Vietnam expansion and the inherent pricing power of The Body Shop’s (TBS) business model make them a good inflation hedge. It might not have the most sensual growth in the world; but it sure is incredibly well-placed to serve as the asymmetric risk:reward ace in a portfolio - especially amidst these highly volatile market environments, when macro has an outsized contribution towards share prices.
Do refresh your memory by reading my previous Innature stock report below - which can be read for absolutely free!
Check out this insightful recent interview with Innature’s MD, with excerpts below:
“But, coming back to April and May — it was fantastic. Traditionally, Ramadan [the fasting period for Muslims] has always been a very poor month for retail sales, but we were up 27% versus last year. And, this Hari Raya versus the last one, we were up 100%,” she says.
“We are expecting better profitability with better turnover, from the second quarter onwards,” Cheah-Foong says, adding that this is provided there are no more unexpected movement restrictions to be had.
She says the company’s progressive price hikes — an average of 15% across roughly 120 product lines — aimed at offsetting rising input costs, remain on track. The price increases started with TBS’s body butter product range late last year.
“Customers are unlikely to stop using the products that they like and have been using for years, for example, tea tree oil or shower gels. Instead of buying two shower gels like they would before, they now buy one and then come back to buy another when it finishes,” she says.
InNature lost the bottom-40% customer segment, who would aspire to buy TBS products, early on in the pandemic as they downtraded to cheaper products, Cheah-Foong says. “These are the people who would aspire to buy our products as birthday treats, for example. However, in mitigation, we found that people who used to buy more expensive products have now switched to us.”
InNature has 77 stores in Malaysia, 40 in Vietnam and two in Cambodia. Going forward, Cheah-Foong says the company hopes to open at least two stores a year in Malaysia, six a year in Vietnam, and four within three years in Cambodia, depending on the availability of suitable locations.
“We are going back on track as per what we said during our initial public offering [in February 2020]. The only caveat being that we are dependent on our landlords [and] developers to continue with their development plans,” she says.
Stock exchange filings show that Cheah-Foong bought 300,000 InNature shares – or a 0.0425% stake – at 52.97 sen each on May 27, via the family private vehicle Pelagos Sdn Bhd, raising her indirect interest in the company to 74.8%. Her son Daryl Foong, a non-independent, non-executive director at InNature, is also a shareholder of Pelagos.
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The Case for The Body Shop - Macro Hedge & The Power of Branded Retail
Innature, being The Body Shop (TBS) of Malaysia & Vietnam, offers shareholders to main advantage: 1) being the perfect macro hedge, and 2) being situated in the Branded Retail sector. We’ll talk about the latter first, which will subsequently justify the former.
If you’ve read my earlier Innature report written in May 2022, you’ll know that The Body Shop benefits from occupying perhaps one of the best sectors in the world - Branded Retail. The reason why the Branded Retail sector’s reputation is so storied amongst the investor community is because it has what Warren Buffett describes as “the single most important decision in evaluating a business” - pricing power. His full quote can be found below:
“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.” - Warren Buffett
Anyone who has started a small Retail business before should be extremely familiar with the importance of pricing power - if your value proposition to customers is undifferentiated/commoditized vs. competitors, the only way to become competitive is by offering lower prices. Of course, this is usually countered with a similar response by your competitors - ultimately depressing the entire sector’s margins in a price war. We can see this phenomenon manifested in the majority of commoditized sectors - e.g. Financials, O&G, Logistics, Airlines, Media… and yes, Retail.
However, Branded Retail stands in stark contrast to its much more regular cousin - being one of the most attractive businesses to own from an investor’s perspective. Think about companies like Apple, Starbucks, Hermes, McDonald’s, Coca-Cola, Toyota - all of them are household names with prices far in excess of the market average.
This is because the value proposition that these businesses offer their customers goes far beyond the product alone - it extends to the attributes that the brand stands for, whether that is self-expression, environmentalism, social progressiveness, a commitment to quality… or all of the above. A much tortured analogy of this phenomenon is the infamous saying, “customers buy Tiffany’s for the box, not the jewelry”.
In that sense, a Brand represents the elemental human-to-human connection between the business owner and the customer - a social contract, if you will. This is quite clearly much more than just a product or service being sold - there is an intangible promise being exchanged, which theoretically has unlimited potential. And in our current capitalistic society with no faces, brands are the closest societal institution that we can associate with as being human today.
Just to drive the point home, think about what customers are really paying for when they patronize each of the aforementioned brands. McDonald’s is selling consistency, Starbucks is selling the Third Place, Apple is selling ‘technology that just works’, Hermes is selling self-expression, and Toyota is selling reliability. Notably, these aren’t burgers, coffee, smartphones, handbags or cars - they’re all attributes which we associate with human beings, closer in nature to the soul rather than goods grounded in the tangible world.
Perhaps the CFO of LVMH, Jean-Jacques Guiony, put it best when he described in this sterling podcast hosted by the Norges Bank Investment Managment CEO Nicolai Tangen how a Brand is basically composed of two things: 1) a Name, and 2) certain Attributes associated with the product. You can listen to the podcast in its entirety below - more than one person I’ve shared this with has already told me this was an excellent listen:
In The Body Shop’s (TBS) particular case, the Attributes inherent in their social contract are quite obvious - Environmentalism, Gender Equality and Fair Trade. Customers who pay a premium for The Body Shop skincare products aren’t doing so because they’re superior to similar products by L’Occitane or The Ordinary - they’re loyal repeat customers because the company procures their ingredients from conscientious sources, or because part of the premium prices they pay go towards supporting Kenyan villages mothers and saving baby turtles. Again, very human.
It’s also worth highlighting here how none of the things that allow TBS to command its premium prices have much to do with skincare at all - they are values which can be cultivated distinctly from the base product. This means that it is likewise possible for any small business to cultivate a Brand independently of its base product - we can see this in practice with how Coca-Cola engenders an image of camaraderie by spending millions of dollars on ads about polar bears; which has nothing to do with soda. But importantly, once these values have been cultivated and entrenched in the brand, it can be sold as a separate product in and of itself - with the associated premiums.
How does this all benefit the investor of a Branded Retail business? While a company’s product tends to be quite commoditized, the values that a Brand stands for tend not to be. It’s quite easy to say that Blue Bottle’s coffee tastes better than Starbucks - but it’s much harder to put a price to the value of Starbucks’ commitment to fair trade, as compared to say Folgers. To use a crude human analogy, it’s much easier to assign a number to someone’s outward appearance as opposed to the value of their personal intelligence or character.
As a result, The Body Shop’s products tend to command quite an excessive premium over its competition. I’ll be honest, their skincare products don’t spark any more joy in me when using them as compared to Tesco’s whitelabel face wash - and yet on a unit basis, the former is easily found in stores at a >500% premium to the latter. This is because while it is easy to find a competing product which cleanses your skin just as well, it’s not so easy to find one where women empowerment also appears in their Mission Statement.
As alluded to by Buffett’s quote above, this gives the company the ability to raise prices without necessarily invoking a negative feedback from its customers - i.e. Pricing Power. In Innature’s particular case, active members (defined as customers who make at least two purchases over a 12-month period) represent over 50% of the company’s revenues. While this is not the B&M Retail equivalent of ARR (as found in the SaaS sector), it is still far superior to the average 25% consumer churn rate of the B&M Retail sector.
This sort of inelastic demand allows Branded Retail businesses to raise prices with impunity, without fearing backlash from unacceptable consumer churn. As we shall see later, consider how Innature recently started broadly raising their prices by ~15% in 1Q22 to keep up with inflation - yet only saw a -10% YoY drop in quarterly revenues from 1Q21. The same interview above mentions that “it could be another 9 months before you see that 15% hike overall in the shop” - which implies that they’ve only just begun raising prices, and that 15% hike has not been fully rolled out yet. For any retail company, being able to announce a broad 15% price hike and only lose -10% of its sales in the same quarter is an astounding feat. Keep in mind also that for a globally established brand like TBS, their sales volumes are more than capable of eventually reverting back to the mean.
As I’ve discussed in my previous Innature article, here’s one oversimplified way to think about pricing power. Assume that TBS is able to hike its prices by +15% and eventually recover to its pre-hike sales volumes. In theory, this means that the entire +15% revenue growth should drop straight to the bottom line - since hiking prices do not involve any associated costs. If they are able to maintain their average historical net margin of 15%, that implies 100% earnings growth (15/0.15) from price increases alone. If you allow for this rate of price hikes once every 5 years, that’s an earnings CAGR of roughly 15% from price hikes alone.
While this is a grossly oversimplified example, it does illustrate the immense latent energy hiding within the pricing power inherent in Branded Retail. While not an apples-to-apples comparison, consider how Apple raised the price of the latest model of its M2 MacBook Air by +20% - without reducing the price of its previous model (M1 MacBook Air). It usually does the opposite with annual refreshes - and yet I’m not expecting any dropoff in consumer demand for MacBook Airs anytime soon.
Anyway, I think I’ve made my point - the business of Branded Retail is a growth powerhouse. Unfortunately, this fact is also well-recognized by most market participants - which is why the shares of the US-listed Coca-Cola and McDonald’s trade at 25x PE respectively; despite having relatively flat-growth expectations into perpetuity. Part of the reason behind why businesses in the Branded Retail sector can command such premium multiples is because as a company’s business starts to mature, its earnings growth tends to flatten out while its cash flows become much more predictable. This tends to result in the composition of the investor base shifting away from growth-oriented investors towards yield-oriented investors - the latter of which would tend to bid share prices up to a minimum dividend yield in order to simulate a riskier bond yield. As an example, Nestle Malaysia’s shares are currently trading at nearly 55x PE as their cash flows have been proven to be historically stable.
In contrast, Innature with its Emerging Market GDP+ growth profile (i.e. Vietnam) and very reasonable risk is currently being offered for just 11.6x normalized PE today (based on pre-covid FY19 earnings). Assuming their average historical dividend payout ratio of ~70% holds, that implies a normalized dividend yield in excess of 6%.
Macro - BOTH An Inflation & Deflation Hedge
Now that we’ve understood the immense potential of Pricing Power, let’s consider how INNATURE’s shares are both an inflation & deflation hedge at the same time. For a company with legitimate pricing power, raising prices allows you to keep up with rising costs due to inflation without breaking a sweat. This is independent of their expansion strategy into Vietnam - which their MD points out in the interview below is continuing on track, as per their initial IPO plans announced in Feb 2020 (right before the pandemic).
At the same time, INNATURE pays a normalized dividend yield of 5.3% (based on FY19 dividends paid). Their historical average dividend payout is ~70%, which implies a retention ratio of ~30%. Pair this with their average historical ROIC of 20%, high FCF and Net D/E of negative -23% (i.e. Net Cash) - and you can begin to see how their TBS business serves as an excellent deflation hedge as well.
Note: Innature is also the operator of TBS Cambodia, which I accidentally ommitted before due to its negligible Group contribution.
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