July 2021 Europe's Answer to the US Tech Giants? Find It in Your Favourite
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July 2021 Europe’s answer to the US tech giants? Find it in your favourite bag! Europe’s answer to the US tech giants? Find it in your favourite bag! It is hard to imagine a traditional European industry matching the fabulous performance Piers Nestler of the US tech giants. Welcome to personal luxury goods stocks, some of which have been Investment Analyst the most brilliant stars in the investment universe. This has been especially true of the three French heavyweights, Hermès, Kering (which we have held for the past five years) and LVMH. These now account for over a quarter of the global personal luxury goods market, with the early Covid‑induced fall of 20% in demand for luxury goods no more than a blip in the relentless uptrend of their share prices as the leading brands managed to gain further market share. In the space of just five years, the share prices of the three French luxury players have tripled or quadrupled. This is not far short of FAANG‑style performance. This came against a background of outstanding operating results. Growth has been spurred by the irrepressible spending power of Chinese shoppers, by new categories – such as high‑end sneakers and casualwear – and by lower opening price points for luxury goods. Even more impressive, perhaps, has been the expansion of the valuation multiples of these soft‑luxury producers, with investors rewarding growth stocks with hefty premiums, seemingly appreciating their shares just as much as the products they sell. This contrasts with the hard‑luxury segment represented by the watch and jewellery groups Richemont and Swatch (the latter a position Piers is an Investment Analyst at recently added to our portfolios), which has been trailing in every respect, especially since the S. W. Mitchell Capital, with a particular dramatic change in their fortunes following the anti‑corruption measures in China in the first focus on Continental Europe, especially half of the last decade. the German‑speaking countries. Piers joined SWMC in September, 2020 after 20 years as an independent equity analyst. Prior to that he was an analyst at various German banks, including B. Metzler and Landesbank Rheinland‑Pfalz, where he was head of research. He has worked closely with the SWMC team since the 1990s. Piers was born in Germany and educated at University College London, where he read Economics. Piers speaks German and English. In this report, we show that the valuations of the two watch and jewellery makers are most likely to offer some room for upside surprise. By contrast, the shares of the three soft luxury goods producers seem already priced to perfection. Short‑term momentum in the luxury goods sector has been characterised, as just noted, by a swift recovery in demand. Such a result was not obvious as Covid‑19 began to take a grip: before the epidemic, about two‑thirds of sales of luxury goods in Europe were driven by tourists, mainly from China and the US, and tourism‑related sales accounted for about 30% globally. Tourism, of course, collapsed, but with little opportunity to spend money on experiences such as travel and entertainment, those purchases were largely – and quickly – repatriated. It appears that luxury goods have undiminished appeal. The quick revival in demand is perhaps unsurprising given that, in spite of the pandemic, global financial wealth reached new highs in 2020. According to a report by Boston Consulting Group (BCG), it rose 8.3% as strong stock markets and a spike in savings fuelled a wealth boom. Europe’s answer to the US tech giants? Find it in your favourite bag! | July 2021 Please see full disclaimer on page 11 2 Europe’s answer to the US tech giants? Find it in your favourite bag! The recovery in luxury spending is driven to a large extent by China. This is a reminder that the rise of the Chinese consumer has been a truly transformative event for the global luxury goods industry. Chinese consumers are now said to account for around 70% of the growth in demand for luxury goods. What is more, China presents an opportunity rather than a threat to the luxury goods sector (unlike the situation in many other industries). This is because up to now a brand’s image in the luxury market has in large part been built on heritage, and heritage cannot be replicated overnight. That said, younger consumers are as interested in aspiration as in heritage. This is seen as one explanation for the huge success of Gucci’s strategic change of course in 2015 when a new creative director presented a collection which marked a radical break with the company’s past – almost overnight the brand became associated with sustainability and inclusiveness, resembling a creative cultural club rather than a traditional fashion group. Luxury is not a static concept. Growth Prior to the pandemic, both Hermès and LVMH enjoyed outstanding double‑digit compound annual growth rates (CAGR). These were twice the pace of the overall growth in the market for personal luxury goods which, according to the management consultancy firm Bain & Company, rose at a CAGR of 5.3% between 2011 and 2019. The winning formula of Hermès and LVMH has been diversification and product proliferation, while maintaining authenticity and exclusivity. Hermès has managed to diversify its traditional leather business into new ‘métiers’. The recent launch of the Beauty line brings its number of product categories to 16. At the same time, the group continues to expand existing product lines by widening its ranges while preserving their individual character. Bags, for instance, are available in an ever‑increasing number of combinations of size, colour and types of leather. LVMH, the world’s largest luxury goods company by revenues, is seven times the size of Hermès and more than three times larger than Kering. It has followed a similar strategy, and has been equally successful in driving its fashion and leather goods business to ever new heights under its Louis Vuitton label. While Kering’s sales declined between 2011 and 2015, this was entirely due to the deconsolidation of Redcats and Fnac, which had combined sales of around EUR 7.0bn. As a result, overall sales grew only moderately over the decade to 2019, with a CAGR of 3.3%, the lowest in the sample here under review except for Swatch Group. But revenues began to reaccelerate in the middle of the past decade with the spectacular reinvigoration of Gucci referred to above. This translated into a huge commercial success, with sales of the group’s flagship brand rising at a CAGR of about 25% between 2015 and 2019, lifting Kering’s average annual growth rate during that period to 8.2%. By 2019, Gucci accounted for more than 60% of the group’s total sales. Europe’s answer to the US tech giants? Find it in your favourite bag! | July 2021 Please see full disclaimer on page 11 3 Europe’s answer to the US tech giants? Find it in your favourite bag! Growth continued While the top‑performing French groups have gained substantial market share, the fortunes of the Swiss watchmakers Richemont and Swatch Group have not been as straightforward. In the early part of the last decade, they benefitted enormously from a Chinese‑induced boom, especially for premium and ultra‑luxury watches, a boom to a significant extent based on gifting. This improved their product mix and paved the way for successive price increases. At one point gifting was estimated to account for one‑third of the watch market in mainland China. The bonanza ended with China’s clampdown on corruption. This also had a profound impact on Hong Kong, which used to attract large numbers of Chinese shoppers looking for lower prices. Hong Kong was by far the biggest market for Swiss watch exports at that time, more than twice the size of China. More recently, the political turmoil in the former British colony has aggravated the woes of the Swiss watch industry in Hong Kong. To avoid damage to brand reputations resulting from retailers discounting unsold inventory, Richemont and Swatch Group had to clear the supply overhang through buybacks from and lower sell‑ins to wholesale partners. Swatch Group has also reduced the number of its own stores (from 92 to 38 in 2020). Richemont is expected to follow suit. At the same time, the growing popularity of smartwatches has dampened demand for Swiss watches, especially at the lower end of the market. This was an additional burden for Swatch Group, with its basic range segment (Swatch, Tissot) contributing to poor sales performance in the second half of the last decade. Swiss statistics show that exports of watches costing less than CHF 500, which represented around 13% of total export value in 2015, declined by around 23% over the following years, even as total watch exports rose by 1.3%. Capital efficiency Sluggish sales growth was not the only problem faced by the Swiss watch and jewellery makers. While Richemont’s sales actually grew from EUR 8.9bn in FY 2011 to EUR 14.2bn in FY 2020 (31 March), the increase in net assets far outpaced sales, rising more than threefold from EUR 8.6bn to EUR 27.0bn. There were several reasons for this: A disproportionally high increase in working capital, accounting gains, goodwill and intangibles arising from the acquisition of the multibrand e‑tailer platform YNAP, an increase in liquid funds of around EUR 5.0bn and a fairly strong rise in lease liabilities from less than EUR 1.0bn to EUR 3.2bn. Swatch Group’s asset base rose by a good 50% between 2011 and 2019, which was actually the lowest increase in the sample except for Kering.