Melon Fashion Group: Russian H&M Might Consider IPO On MOEX (2024)

Introduction: My macro take on the Russian stock market

Since I have some understanding of the Russian stock market, I sometimes write articles about companies that interest me, about which there is little information on English-language websites, and about which ordinary American investors, therefore, know either nothing or very little.

My last 2 articles on this emerging market generated a lot of interest - some SA readers even wrote to me on LinkedIn to find out what other Russian companies I think they should pay attention to.

Unfortunately, due to recent trends in geopolitics, the Russian stock market (ERUS) has sunk quite deeply since the beginning of this year - significantly lower than the US market (SPY):

As a result, many of my Russian picks have not worked out so far - Mercury Retail Group, which I wrote about in early November, has postponed its IPO due to market conditions, and Sberbank (SBRCY) - one of my top picks from late October - fell ~33% from the highs:

However, I am sure that this drawdown is temporary because the main pressure driver is geopolitics. Why am I so sure of this? It's all about the dynamics of commodities, which show phenomenal growth in recent months.

As we know, Russia is a resource-rich country, with resource exports accounting for 25-30% of GDP in pre-COVID years:

Most of these exports are mineral resources, oil, natural gas, iron ore, and other commodities:

That is why we are seeing a strong divergence from how the Russian stock market and the price of oil behave.

Geopolitics usually lead to strong mispricing, as we are experiencing right now. We saw the same thing in March 2014 when Crimea was annexed - after markets stopped panicking, the correlation between ERUS and the average oil price returned to its place:

Now, we live in a slightly different time - possible sanctions against Russia could be much stronger than in 2014. Cutting off Russia from SWIFT, for example, will deal a severe blow to the Russian economy. However, the chance of this actually happening is very small - not only Russia but also the West will suffer from such measures. Therefore, new sanctions (if any) will most likely turn out to be personal again - against Putin and his close friends - and will therefore have about the same significance for the Russian economy as they did back in 2014-15.

Moreover, the energy crisis has not disappeared and it is much more difficult to refuse Russian gas today than 6-8 years ago. That is why, in my opinion, the rhetoric of European countries has softened recently - Germany, which not long ago expressed itself quite aggressively against Nord Stream 2, has recently shown itself to be neutral. Moreover, in a recent meeting with Putin, the French President announced that he had received a "promise" from Putin not to attack Ukraine and to withdraw troops from Belarus as soon as the joint exercises between the two countries are completed (by the end of February), which has given some optimism to the Russian stock market and the ruble - the Russian national currency.

Of course, a full resolution of the conflict is still a long way off - Putin's spokesman, Dmitry Peskov, said that the Financial Times, which first reported the French claims, had "simply written incorrectly" and that Putin and Macron couldn't reach an agreement because France is not the leader of NATO, which would need to accept any agreement. However, some improvements are already evident, and investors in Russian equities should not rush to fix a loss in Russian blue chips, in my opinion. I think now might also be a good time to buy the dip on some Russian stocks - a risky but potentially highly profitable investment idea, as the Russian market is quite undervalued due to recent events, despite reasonable monetary policy (unlike in Turkey) and large exposure to commodities.

With all of the above in mind, I suppose that in a few months geopolitics will fade into the background and mispricing will gradually disappear - ERUS will follow oil and gas prices as it did before. But it is not certain that this will instantly affect the multiplies of Russian companies - this will most likely take more time to occur. This creates many opportunities for retail investors.

So what's my investment thesis?

Melon Fashion Group, the leading fashion retailer in Russia, has already found underwriters (Sberbank CIB, VTB Capital, Goldman Sachs (GS), and BofA (BAC)) to go public on the MOEX (Moscow Stock Exchange) in 2022.

I believe that this company, with a solid business model and great operational/financial performance, has every chance to soar after the IPO, as the market now sees the country risk as much higher, and therefore the underwriters will most likely underprice this offering. Given the idiosyncratic nature of the company, which I will discuss below, I think this IPO should be watched closely - I will try to buy some shares through Interactive Brokers immediately after their placement.

What is Melon Fashion Group?

Melon Fashion Group (or just "MFG") is a leading Russian fashion retailer, that owns 4 clothing brands - ZARINA, befree, LOVE REPUBLIC, and sela. MFG operates 845 stores in 181 Russian and CIS regions as of December 2021.

It may seem that fashion retail is a rather special choice for investment in Russia because it is by no means a commodity industry in which the world's largest country has a competitive advantage. However, in my opinion, when buying a retail business, an investor limits himself in terms of

a) geopolitical risks (the macro issues that I discussed above has practically no effect on the operating activities of retail companies - only indirectly, through market sentiment) and

b) operational risks (the retail sector, unlike the commodity sector, is much less susceptible to serious contingencies - just think of the major fuel leak like the one at Norilsk Nickel (NILSY), or the flooding of a mine at ALROSA (ARRLF)).

Among the founders of the company, you will not see people affiliated with the authorities - another advantage over the classic heavy industries for Russia, where most of the owners are already subject to sanctions.

Speaking specifically about the company, it is worth noting its unprecedented operational growth during the pandemic.

We all remember how the global fashion retail industry suffered in 2020 amid restrictive measures related to the worldwide spread of the coronavirus.

Undoubtedly, the COVID-19 pandemic has brought a severe crisis to fashion retailers as a social crisis. During the pandemic crisis, a number of U.S. retailers, for instance, Neiman Marcus, J.C. Penney, and J. Crew, filed for bankruptcy because significantly fewer customers shopped in stores due to social distancing and lockdowns during the COVID-19 pandemic (Wahba, 2020). According to Tyko (2020), a number of retail stores (e.g., Macy's, Nordstrom, H&M, and Ralph Lauren) have closed temporarily due to quarantines and governmental orders since the pandemic situation became serious (Isidore & Meyersohn, 2020). The quarantine measures also hit the European market. Due to travel restrictions during the pandemic, the sales and tourist numbers for the European luxury market dropped significantly (Thompson, 2020).

Source: From the study by Fashion and Textiles

At the same time, Melon Fashion Group managed to show some growth in almost all key unit economic and financial metrics:

Source: Compiled by the author, based on MFG's Annual Report 2020

That is, while the industry was in decline globally - competitors such as H&M, Zara, and others in the sector were closing their stores - MFG was able to increase sales by 9.7% (and EBITDA by 3.2%) compared to 2019.

The company has been actively developing online since 2017 and its market share grew twofold annually. In this regard, at a time of severe constraints, the company actually became an online retailer and was able to quickly adapt to the new working conditions.

In 2021, as pent-up demand began to make itself felt, MFG could not help but grow significantly - in the first 9 months of 2021, the company's revenue grew by 59.15% and operating profit increased from 4.2 billion rubles to 57.8 billion rubles year-on-year:

Over the past 9 months, the company has also improved its balance sheet:

• cash volume increased by 21.3%;
• inventory increased by 14.56%, which indicates a high demand for MFG's products (trade and other payables by 10.56% - orders on credit are growing);
• the balance of the borrowings decreased to 0, and short-term lease liabilities decreased by 20.35%;
• long-term lease liabilities decreased by 29.04%.

MFG's net income was so strong in 9M 2021 that management decided to pay $11.6 million in dividends despite >60% CAPEX growth:

In my view, the growth described above is just the beginning, because according to Statista, the fashion market in Russia is going to grow at a CAGR of 26.48% (2022-2026), and the basis of this growth is the "Apparel" segment - the main target market for MFG.

According to the same study, the share of online sales in this market will increase from 13.2% in 2022 to 23% by 2025. In this respect, MFG already has an advantage - as I wrote above, the company was forced to accelerate the development of this sales channel, thereby gaining an edge over the rest of the market.

By the way, if we talk about the fashion retail market, the question seems logical: how does MFG compare to other market players?

Peer analysis

Considering the size of the company and the breadth of its brand portfolio, I do not think it makes sense to compare MFG with other Russian counterparts - MFG plays on a different level and has ambitions to expand globally - the company launched sales under the "befree" brand on the world's largest e-commerce platform Amazon. Following the results of the first weeks, large numbers of orders fell on European countries - Germany, Italy, France - where there are much more generous buyers than in Russia. Therefore, the sample for comparison will be the following:

• LPP SA (OTCPK:LPPSY);
• H & M Hennes & Mauritz AB (OTCPK:HNNMY);
• Industria de Diseño Textil, S.A. - Inditex (OTCPK:IDEXY);
• Lojas Renner S.A. (OTCPK:LRENY);
• Grupo de Moda SOMA SA (ticker "SOMA3" in Brazil);
• CCC SA (not traded OTC, ticker "CCC" on Warsaw Stock Exchange);
• Fast Retailing (OTCPK:FRCOY).

It is noteworthy that MFG has grown significantly faster than all of the above competitors over the past 2 years:

We see a similar superiority in terms of revenue growth since the beginning of 2021:

In addition, growth superiority is complemented by a higher EBITDA margin (23.8% vs. average 19%):

For retail, one of the most important metrics is the return on invested capital (ROIC), which is calculated as NOPAT divided by average invested capital, where NOPAT is EBIT less income tax, and average invested capital is calculated as average equity, loans, bonds, and lease obligations at the beginning and end of the period. In terms of ROIC, MFG also has a clear advantage over its competitors:

Given the geopolitical risk to which I have devoted much of this article, I believe the company has tremendous upside potential if the underwriters indeed underprice MFG at a P/E ratio of 20 or below that. The closest peer, LPP, has a P/E of 27, but it is a Polish company, so I assume a fair discount to the MFG multiple of ~26%.

Risks to consider

• Geopolitics, as I said, has a strong influence on the stock and on the likelihood of this IPO in general. If Putin decides to invade Ukraine after all (which I highly doubt), MFG will most likely postpone its plans to go public, and the country risk for the overall Russian stock market will become even higher;
• Despite the huge growth in revenue and operating profit, it should be understood that MFG is exposed to supply chain risks, as it orders 85.5% of all raw materials from China, according to the latest Sustainability report (2020). Any delays in deliveries can seriously affect the company's operations;
• The population of Russia is quite poor compared to, say, Poland (a difference of 55.21%, according to countryeconomy.com). This fact significantly affects the average check per customer and limits the potential turnover of MFG;
• Regulatory risks also play an important role - this is one of the reasons why it is quite difficult for Western companies to do business in Russia. If your business can be taken away or a heavy fine imposed in case you do not follow "the advice of the power", this can only cause concern;
• My whole thesis is based on the high probability that MFG will be underpriced when it goes public because of geopolitics. If it is overpriced when it goes public, my whole thesis will make no sense.

The takeaway for Western investors

We do not yet know the key details of the potential IPO. However, we do know one thing for sure - MFG is a fast-growing fashion retail company that could use the example of the crisis events for the industry in 2020 to prove that its business model is very stable and can grow in all conditions. Also, Melon Fashion Group has well above average margins and profitability ratios compared to its closest peers. And such a high-quality value and growth juggernaut will most likely go public at a steep discount due to political gamesmanship. That's the beauty of emerging markets - market efficiency is far lower than in the West, and therefore there are more opportunities for abnormal returns.

The modern age of globalization and the digitization of brokerage offers the opportunity to exploit the inefficiencies of emerging capital markets. In any case, the largest American and European brokers offer such an opportunity to their residents. That is why I am writing about this company here on Seeking Alpha.

I recommend keeping an eye on Melon Fashion Group - if the company is truly valued significantly lower than its international peers, it would be a great investment opportunity.

Happy investing and stay healthy!

Daniel Sereda is chief investment analyst at a family office whose investments span continents and diverse asset classes. This requires him to navigate through a plethora of information on a daily basis. His expertise is in filtering this wealth of data to extract the most critical ideas. He runs the investing group Beyond the Wall Investing in which he provides access to the same information that institutional market participants prioritize in their analysis. Learn more.