By Samantha Hartard, Portfolio Manager, SA Equity & Multi-Asset
The demand for luxury goods can be traced back to ancient Roman and Greek times. While the concept of luxury goods has expanded through the ages from scarce spices and foodstuffs to include items such as jewellery, watches, perfume and pens, the meaning of the word ‘luxury’ has endured through time. The Oxford dictionary describes it as:
1.2 An inessential, desirable item which is expensive or difficult to obtain
1.3 A pleasure obtained only rarely
The demand for personal luxury goods is rooted in the ‘the feel good’ factor associated with owning such items. While the industry has its origins in small artisan family-owned businesses, the firms that have survived and thrived are those with strong brands that have captured the imaginations of affluent and aspirational consumers. One such company is Richemont, a global conglomerate that produces and sells luxury goods. It owns a stable of very powerful luxury personal brands that have successfully endured the highs and lows of business cycles over many years. Richemont’s brands include Cartier (170 years old) and Van Cleef & Arpels (121 years old).
Richemont is one of the largest holdings in the Investec General Equity and Investec Balanced strategies and has been a key contributor to performance year to date. The company went through a tough time over the last three years, but we realised that the earnings tide was turning for Richemont, and in January we initiated a position in the stock. Our investment philosophy is to invest in companies receiving positive earnings revisions and that are reasonably valued. Richemont has met our investment criteria of receiving positive earnings revisions, and we believe the company will enjoy further earnings upgrades. One of the key considerations in the outlook of a company’s earnings potential, is to understand the business cycle and demand drivers for a company’s goods, and how that business has positioned itself in the market it serves.
The historic growth of global personal luxury expenditure has undoubtedly been strong over the last three economic cycles that have spanned 22 years. According to estimates by Bain1, the global personal luxury goods market reached a value of €251 billion in 2015. Since 1994, the industry has achieved a compound annual growth rate of 6.1%. The growth achieved after the global financial crisis can primarily be attributed to Chinese consumers entering the market. Chinese consumers had accounted for less than 5% of luxury expenditure in the world in 2000. By 2015, Chinese consumers comprised 30% of luxury goods expenditure. In turn, this translated into higher earnings for luxury goods companies. From 2010 to 2015, the average revenue growth of locally listed luxury goods companies had accelerated to 1.83x global nominal GDP growth (versus 1.22x over 2000-2008), with record earnings delivery for most luxury goods stocks.
Swiss watchmakers increased production and exports to meet the rise of Chinese luxury demand after the 2008 global financial crisis. But luxury sales growth began to slow in 2014, and it seemed that the long runway of new Chinese consumers entering the luxury market was starting to tail off. The result was that the market was left with an oversupply of Swiss watches. The industry faces a multi-year inventory destocking cycle to address excess supply, particularly in Hong Kong.
This has had a knock-on effect across the world. Global Swiss watch exports for watches valued above SFr3 000 (Richemont’s luxury watch brands fall in this category) have had flat to significantly negative growth since 2013, deepening to an average 12% decline in 2016. In Richemont’s 2017 financial year, the company bought back specialist watchmaker and Cartier watches to the value of €223 million from its wholesale partners across the world, with a focus on those in Hong Kong. To give this value context, Richemont’s specialist watchmaker division’s operating profit in the year was €226 million.
By the end of 2016, Richemont had been receiving three years of consistent negative revisions for its forecast earnings in its 2016, 2017 and 2018 financial years. The weakness of watch sales was a key driver of the group’s negative earnings revisions. In the second half of the 2017 financial year, the specialist watchmaker division’s operating margins retraced to a low of 2.7%, as illustrated in Figure 1.
Figure 1: Specialist watchmaker operating margin
Source: Company results, 2017.
The last two years of buying back watches from wholesale partners and revising production plans are the start of a multi-year overhaul and repair process the industry will face. We believe 2017 was the trough year for the division, and the toughest due to the watch buybacks the group had to do over the last two years. Going forward, the focus will be on improving internal operational efficiencies and the distribution channel. We believe the managerial changes the group has announced bodes well for an overhaul of the division’s structure.
While Richemont has gone through some tough times, we believe its prospects are improving, which is reflected in recent earnings upgrades. The macroeconomic environment has become more supportive for rising luxury spending. Consumer confidence recovered over the course of 2016. After the world digested the Brexit vote and Donald Trump’s election as US president, political uncertainty reduced. Equity markets, estimated to account for up to 70% of US household wealth, rallied into year-end, while Chinese consumer confidence was underpinned by supportive government policy of stabilised growth and a buoyant property market. Global tourism also made a recovery toward year-end.
We did not have exposure to Richemont for a number of years. However, at the beginning of the year we took an active overweight position relative to the FTSE/JSE Shareholder Weighted Index (SWIX), as we forecast improving earnings expectations (Figure 2). The market had become overly bearish in the negative spiral of earnings revisions, thereby missing the changing economic environment, the improvement in consumer sentiment and potential jewellery sales. We were overweight Richemont by the time the first earnings upgrade had taken place, and we believe there is room for further positive revisions.
Figure 2: Richemont – a high conviction holding
Source: Investec Asset Management, Bloomberg May 2017.
Jewellery has become an increasingly important part of Richemont’s business. Jewellery sales now account for 39% of group revenue, up from 20% in 1999, as shown in Figure 3. Where watches were a key driver in the previous cycle’s recovery after the global financial crisis, our analysis shows that jewellery will be the driver of earnings revisions in this cycle.
Figure 3: Richemont’s group sales by product
Source: Company results, 2017.
Most of Richemont’s jewellery business is housed within its Jewellery Maisons division, which comprises the Cartier and Van Cleef & Arpels brands. There are no clearly defined product boundaries as Cartier sells jewellery and watches, and there is some jewellery sold in other divisions, such as the watchmaking and jewellery house, Piaget. Jewellery is structurally a more attractive market than specialist watchmakers and Richemont has already achieved great success in the market, as illustrated in Figure 4. Between Cartier and Van Cleef & Arpels, Richemont is the largest publicly listed luxury branded jewellery company in the market.
Figure 4: Jewellery sales by company
Source: Company data, SBG Securities, LVMH includes Bvlgari revenue from 2000-2011
Despite the strong growth already achieved, the branded jewellery market is still in its infancy. Only 20% of jewellery sold today is estimated to be branded. This makes jewellery one of the most underpenetrated personal luxury products. With jewellery sales forecast to expand at a compound annual growth rate of 6% over the next five years, branded jewellery sales should exceed average market growth as the sector increases market share.
We believe market penetration of branded products is an underappreciated factor in luxury market analysis, where rarity, quality, heritage and expense are all hallmarks of the appeal of luxury goods. It leaves plenty of room for branded jewellery players to grow their market share and further carve out their brand identity. The exclusivity factor in being a luxury brand is also an advantage to Richemont and creates high barriers to entry. It takes decades to build the aura of luxury and brand awareness, as illustrated in Figure 5.
Figure 5: Brands that have stood the test of time
Source: Morgan Stanley research.
Once brand status is achieved, it allows for extraordinary pricing power. The potential for luxury brands to expand margins is far higher than that of retail brands. Beyond the attractive top line growth, the group has also delivered on operating profits. In the face of strong growth, the Jewellery Maisons division did not overstretch its store network to match its sales growth. While remaining disciplined and expanding the footprint at a compound annual growth rate of 1.5% from 2009 to 2017, there was a clear emphasis on keeping the distribution channel to majority in-house control over externalised store management. This helps to maintain control of brand image and it also provides better visibility to any changes in consumer behaviour. In addition, there is no ‘intermediary’ delaying the company’s ability to react to changing market conditions.
Figure 6 highlights two business cycles the Jewellery Maisons division has experienced since the early 2000s. The chart clearly shows how trough margins (light blue bars) were higher than in the previous business cycle lows, and that the last cycle’s average operating margin (orange line) was higher than that of the previous cycle (pink line). This is testament to excellent delivery by the group in executing on its strategy. It also highlights that jewellery has grown to offset any weakness that the Cartier and Van Cleef & Arpels brands may have experienced in respect of watches.
Figure 6: Jewellery Maisons operating margin
Source: Company data, 2017.
We believe the market is underestimating how quickly operating margins can rebound in this coming cycle. This is expected to lead to further positive earnings revisions in the second and third forecast years.
Investors became overly negative about the prospects for the luxury goods sector and investor sentiment had also turned bearish towards Richemont. We recognised that the macroeconomic environment had become more favourable for luxury goods producers. We saw this as a rare opportunity to buy a good quality business at an attractive valuation where we expect earnings forecasts to be revised higher. While Richemont’s specialist watch division is taking strain, our analysis shows that the jewellery division will remain a key driver of earnings revisions and we believe there is room for further positive revisions. We believe Richemont’s position in the jewellery market is superior to competitors. In our view, the market is underestimating the operating profits that Richemont’s Jewellery Maisons division can deliver in the coming cycle. While jewellery goes from strength to strength, the specialist watches division has experienced its trough margin year. Although we do not expect a strong performance from the division over the next three years, as the industry faces a major repair process, there is plenty potential for improvement.
1 Bain Luxury Study, 2016.
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Investec Asset Management is an authorised financial services provider. Issued by Investec Asset Management, June 2017.