Luxury loses some lustre amid emerging market woes

Increased wealth creation and the burgeoning middle class population in emerging markets, particularly China, have been key growth drivers for luxury brands over the past few years.

Against the broadly bleak European backdrop of recent times, luxury brands have flourished, having enjoyed three years of exceptional revenue growth from 2010 to 2012, benefiting from governments’ large stimulus programmes and China’s booming economy.

But with fears of emerging markets slowing down and concerns around China’s reduced demand for luxury goods, what is the outlook for the sector going forward?

China’s government crackdown on corruption announced by President Xi Jinping in late 2012 and attacks on lavish spending has hit some sub-sectors of the luxury space hard, such as watches and high-end spirits, preferred gifts among high-ranking officials. But clothing and jewellery have been much less affected and, more importantly, the structural growth story of the luxury market remains intact, insists Scilla Huang Sun, portfolio manager of the Julius Baer Luxury Brands Fund at Swiss & Global Asset Management.

“The genuine appetite of the Chinese people for Western brands continues,” she states.

The Chinese account for around 30 per cent of the total demand for luxury and for 46 per cent of its growth, according to the Swiss firm, and will remain one of the most important drivers of luxury goods. China’s middle-class influence is undoubtedly growing and, according to management consultants McKinsey, around 54 per cent of China’s urban population will be upper-middle class by 2022 compared with 14 per cent in 2012.

Also, Chinese are the biggest global tourist spenders and higher incomes, more vacations and easing visa restrictions are fuelling growth of Chinese tourists outside Asia. The potential is huge. In 2012 only 5m out of 83m Chinese tourists travelling abroad went to Europe, “the natural home of luxury”, and the US, where brands are bought at significantly cheaper prices than in mainland China.

Global demand

While China will continue to dominate, emerging economies in general – accounting today for 50 per cent of total demand for luxury goods up from 30 per cent in 2008 – fuel increasing demand, with wealthy regions like the Middle East and countries like Indonesia, Malaysia, Thailand being some of the brightest spots.

And Africa’s growth potential should not be underestimated. Wealthy Africans in 2013 spent approximately €3bn on luxury goods, though often outside the continent, and the number of high net worth individuals (HNWIs) in Africa is set to double over the next five to seven years, according to Ledbury Research.

However, with growing competition and China consolidating, it is important to identify future winners. “The winning brand needs to have a global reach, needs to expand and not only have the financial capacity but also the know-how to operate in different markets,” says Ms Huang Sun.

Also, increasingly crucial is the ability to reach the consumer though multiple distribution channels. E-commerce today represents only around 3 per cent of total luxury sales, according to Swiss & Global.

“While this is a small number so far, a ‘complete’ brand positioning is becoming more and more important for luxury brands,” she says. This ‘omnichannel’ approach includes store presentation, internet presence, e-commerce and social media, including Facebook and Twitter. Luxury brands cannot afford to age with their customers but need to attract young people, she explains.

Another trend of the past few years is the significant growth of vertical integration through manufacturing and distribution, with brands like Burberry or Hugo Boss considerably increasing their retail exposure. This enables luxury firms to control the brand by controlling the entire value chain, not only the production or manufacturing but the access to the client, thus avoiding depending entirely on wholesale partners and running the risk of seeing their product prices slashed in difficult times, which can destroy the brand.

“The biggest challenge for any firm wanting to grow, especially in the luxury space, is to keep the brand exclusive, and not stretch it too much or cheapen it, not only in terms of products sold but also in terms of distribution channels,” explains Ms Huang Sun.

Her fund’s main focus is on jewellery, represented by brands like Richemont and Tiffany, selected mid caps Michael Kors and Hermes, companies with margin improvement potential such as Ferragamo and Hugo Boss and affordable luxury that Chinese consumers like, including Nike and Swatch.

Picking stocks

Luxury brands have been outperforming the rest of consumer goods for years:  they enjoy higher revenue growth and higher profitability due to their pricing power – often perceived as ‘emotional products’ – and boast a healthy cash flow generation, says Caroline Reyl, manager of Pictet Premium Brands fund since launch in 2005. This means, and it is especially true today, they do not have to rely on debt or bank credit but can fund their own growth.

But increasing reliance on emerging markets and China over the past five to seven years in particular, has to be taken into account by stockpickers. If in good times, the fact they play the emerging market consumer growth story is incredibly favourable, because the penetration of luxury brands in emerging markets is still relatively small – when times get tougher it is important to be even more selective, warns Ms Reyl.

For example, companies such as Louis Vuitton (LVMH group) and Gucci (Kering group) are mature brands in the region. Having aggressively opened new stores in China, they are experiencing a significant slowdown.

The Chinese consumer is increasingly sophisticated and fascinated by smaller brands. “Even though we like LVMH and Kering as companies, as they have a nice portfolio of leading brands, we would tend to prefer smaller names these days, where we see more growth and opportunities,” says Ms Reyl.

Moncler, which has recently launched an IPO, has “tremendous momentum globally and the Chinese are crazy about it”.

Ms Reyl also favours the so-called hard luxury sectors, the jewellery segment, which continues to do well in India and China, and likes stocks such as Tiffany, Richemont, with the leading Cartier brand, as well as Breguet and Omega within the Swatch Group.

The significant correction of the luxury sector in January, due to fears about emerging markets growth, also offered interesting buying opportunity for certain stocks,
for example the Swatch group, which fell by 11 per cent.

Although the sector overall looks cheap, says Ms Reyl, there is increasing dispersion of valuations. While Kering for example is trading well below its historical multiples, smaller companies with higher growth prospects, such as Tod’s, Moncler or Ferragamo, are trading at significantly high multiples.

“It’s always very important to consider the multiple you pay in relation to the growth you expect the company to generate, and we prefer companies that look cheap relative to the growth they can generate,” she says.

Luxury brands have a strong heritage, having been around for centuries, they are at the forefront of innovation and creativity and “they need to be trend-setters”. High entry barriers protect their pricing power. Over the period from 1976 to 2013 prices of luxury goods rose by 6.3 per cent per annum versus CPI rising 3.9 per annum, according to Forbes.

Their ability to raise prices is particularly important to face potential depreciation of emerging market currency, but perhaps more importantly US dollar and Japanese yen depreciation versus the euro, which is a key concern in 2014, according to Citi.

“With a cost of production largely denominated in Euros, luxury companies have no other option but to increase prices in local currencies to offset adverse currency moves,” says Thomas Chauvet, head of luxury goods equity research at Citi. “This has worked well in Japan last year, for instance.”

Many interesting “younger” brands are also emerging, with the potential to become more established luxury marques. Pictet’s fund invests in 41 stocks, of which nine have less than $1bn (€730m) of market capitalisation.

Private Bank Coutts, which has a holding in the Pictet Premium Brands fund, saw the underperformance of the luxury sector versus emerging markets in January as a buying opportunity.

“We like the luxury sector and in particular those companies that have exposure to both America and China, and we prefer brands that have a large and stable market share,” says James Butterfill, global equity strategist at the UK private bank.

 “Particularly with tapering and a strengthening dollar, you could see some of the slack created by China taken up by the US,” says Mr Butterfill, reporting that according to company Global Blue, the Americans represent 31 per cent of luxury goods sales, more than Asia Pacific consumers.

Credit Suisse is also very positive on luxury companies, states Andreas Tomaschett, analyst, equity research at the private bank. Of the three major market cap companies covered, including Richemont, Swatch and LVMH, the first two are considered “really attractive”.

“Their valuations recently decreased and we expect them to have an earning per share growth rate of 10 per cent, and generate almost 2 per cent dividend yield this year,” he explains. The bank is neutral on LVMH.

One of the factors to monitor in consumer brands, and luxury companies in particular, is marketing spend. A reduction would lead to higher margins in the short term, but a very high risk in the mid-term, says Mr Tomaschett.

Marketing includes not only advertising but also opening a flagship store in the right high street, and selecting effective ‘ambassadors’, such as actors, to convey the message of brand and exclusivity to the consumers.

Top brands

In the Best Global Brands 2013, the annual study conducted by consultancy firm Interbrand, 10 luxury brands made it into the top 100. These are Louis Vuitton (17), Gucci (38), Hermes (54), Cartier (60), Porsche (64), Prada (72), Tiffany (75) Burberry, (77), Ralph Lauren (88) and Ferrari (98).

Four of them, Burberry, Prada, Cartier and Hermes saw their ‘brand value’ (based on financial analysis, role of brand and brand strength) increase by 20 per cent, significantly outperforming the top 100 brands, which on average increased their brand value by 8 per cent. To be included in Interbrand’s top global 100 brands, amongst the other criteria, companies need to source more than 30 per cent of their revenues from outside their domestic market.

Observing the results, Neil Duffy, managing director at Interbrand London notes many of them are “long-established brands, have a very strong sense of heritage and of what makes them unique. They are also savvy when it comes to the adoption of new technology, and how they manage the brand in the 21st century.”

Burberry, the “most connected brand in luxury” according to the Financial Times, has managed to negotiate a delicate balance between concrete and digital sales, he says.

“Luxury brands look for exposure to a very wide audience, speak in a pretty democratic way, but they are now using technology to really drill down into their key high net worth customers,” says Mr Duffy. This enables them to have a more personal relationship with them, looking to find a “nice juxtaposition” between the universality of the brand and the exclusivity of it. “It’s a combination of old fashioned, high service quality and modern technology.”

The key concept is that luxury has to be desired by many, but consumed by few.

 “The big danger for luxury brands is that by increasing their sales and consumer base, they decrease exclusivity, and also run the risk that people will start to see them as vulgar,” he explains.

For example, Burberry and Ralph Lauren had very loose licensing arrangements, which increased sales but diminished brand power. Over the years, they have limited those agreements and regained brand control.

 “The current trend for luxury brands is to try and actually cut back on their target audience and concentrate more on a select, smaller customer base,” says Mr Duffy.

Similarly, many “got overexcited” about new markets opening up, such as China, but as growth and consumer spending slowed, companies have become more discerning about target markets.

Over the last years, many luxury businesses opened large scale flagship stores, whose purpose is not necessarily to make a sale but to serve as a shop window to the brand, says Mr Duffy, a tactic that plays well with an increased digital presence and ecommerce strategy.

In-store experiences, indeed, remain crucial for luxury consumers to learn about the brand through engaging with sales representatives, absorbing the ambience and having a touch and feel of the products, which is not fully replicable online yet, according to Ledbury Research.

From the firm’s recent UK Luxury Benchmark it emerges that directly operated stores are still the channel which consistently generates the highest proportion of revenue for British luxury brands. Online remains the most popular channel to reach the end consumer and is expected to continue to rise in importance, despite generating less than 20 per cent of revenue. Also, m-commerce has a great potential, given the ubiquity of smartphones nowadays, and 39 per cent of brands use this channel currently, although it contributes less than 10 per cent of total revenue.

Age segmentation

Recognising the increasing importance for luxury brands to integrate digital communication and ecommerce in their distribution strategies, Pictet invests in a small Italian company, Yoox, specialising in selling luxury brands on the internet. The firm, which partners with luxury brands in defining their e-commerce needs and internet presence, has seen “tremendous growth over the past four years,” reports Ms Reyl.

One important factor in determining the communication strategy of firms is the age group of the client segment. If the brand is positioned to attract young customers, then it is key to have an excellent digital strategy, but this is less important if the customers are fifty plus, she says. French brand Hermes, for example, has a very strong heritage and tends to be very traditional in the way it operates.

US brand Michael Kors, which has been able to successfully penetrate the saturated European market, has been extremely dynamic in targeting younger people, in particular, and its whole strategy is built around digital communication.

However, there often tends to be a disconnect between the youthful models in glossy magazines and luxury brand’s older customer target, according to Interbrand’s Mr Duffy. It is the older customers that have the time and  money to buy luxury goods and the retail and marketing community cannot neglect them, he says.

Looking forward

Macro risk reduction and industry consolidation have supported the luxury sector’s share price performance in 2013, however it underperformed the broader market and the consumer discretionary space for the first time in six years, says Citi’s Mr Chauvet.

Following three years of exceptional revenue growth (2010-2012) and strong double digit earnings growth, there has been a marked normalisation in global demand last year, with circa 7 per cent revenue growth, 40bp operating margin contraction and mid single digit EPS growth.

“This normalisation of growth has a lot to do with the continued softness in China which is unlikely to recover strongly this year,” he says, predicting 8 per cent revenue growth for the luxury sector for 2014-15.