Here is an excerpt from a recent note by Itau BBA’s research team:

“Updating models for Arezzo and Hering; downgrading both names to market perform. Despite weaker sales performance at Hering and a heavier cost structure at Arezzo, both stocks are again trading near their all-time highs (7.7% and 3.4% below, respectively). After revising our models for the latest results and new macro assumptions and rolling over our fair values to the end of 2013, we just do not find enough upside potential to sustain our long-standing outperform recommendations on both stocks.”

Shorting opportunity, perhaps?

“We are downgrading Hering to market perform, with a new YE13 fair value of BRL 52.2/share, implying a 16.3% upside potential for a stock trading at 19.7x P/E 2013. We are also downgrading Arezzo to market perform, with a new YE13 fair value of BRL 40.6/share, implying a 17.7% upside potential for a stock trading at 23.1x P/E 2013.

Revisiting the strong potential of the franchisee model. In this report, we also lay out a sensitivity analysis of the return potential for the franchisee stores under different scenarios. While profitability for the franchisees was made much easier with the increase of the ceiling for the use of the SIMPLES tax regime (to BRL 3.6 million from BRL 2.4 million), there is a common misconception about the impact this could have on the companies’ growth opportunities. According to this argument, which we believe is flawed, franchisees will not want to sell more to avoid being excluded from the SIMPLES tax system. Our dynamic profitability analysis shows, however, that while the drop in profitability is indeed significant, small adjustments in markup (among other measures) can help franchisees bridge the gap much faster, with only limited impact on companies’ profitability.

Reassuring. Clearly, our franchisee-return analysis does not give us definitive answers. But the results suggest that the companies still have a lot of room to maneuver, and that with small changes to their margin structure, they could unlock significant additional growth, by either making new stores viable or making existing stores more aggressive (carrying higher inventory levels) and potentially selling more. Hering is not even under pressure to change, as 75% of its stores are currently under SIMPLES. Arezzo is in a slightly less comfortable situation, especially with its Schutz stores, but it has already started to act.

Arezzo’s high multiples. The expense structure for Arezzo’s new growth opportunities – the roll-out of Schutz’s long-term growth strategy, still in its initial stages, and the potential upside from Arezzo’s go-to-market strategy (reinforcing its presence in multibrands) – has already been laid out, but the impact on revenues and bottom line is still some time away from being felt. In the meantime, margins and ROIC are being diluted and the revenue opportunity already seems to be priced in.

Hering’s lower growth. Based on our experience with Brazilian retailers, we are firm believers that if there is demand, supply will find its way. A major characteristic of the franchise model is that these cycles are more pronounced, as franchisees tend to replicate the current demand outlook when buying for the future (deciding now how much they will buy, and thus sell, in the Christmas season). So the valleys are lower and the peaks higher than for average retailers that operate their own stores. In our opinion, there is no structural problem behind Hering’s sharper deceleration – it is just a reflection of a more pronounced cycle. Nonetheless, incorporating these results into our numbers did reduce our long-term estimates.”

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