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Luxury goods:

Richemont still sparkling

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David Lerche

Head of Equities

In March 2020, when the world was grappling with pandemic-related lockdowns, a major stock market crash and expected economic declines globally, the outlook for the luxury goods market had all but lost its lustre. What has happened in this industry since then, and to what extent have the macro events that have engulfed us over the past two years impacted our investment case for Richemont?

For many consumers, luxury goods represent an aspirational haven of quality and history, and JSE stalwart Richemont’s classic brands have been at the forefront of this market for more than a century, delighting those who can afford them with exclusive, elegant, stylish and enduring pieces.

As was the case in many industries, the events in the first quarter of 2020 had a significant impact on the fortunes of this premier luxury goods group. At the end of March of that year, 45% of Richemont’s stores were closed due to lockdowns, and the group had to place a substantial portion of its Swiss-based manufacturing workforce on furlough.

Management also instituted a hiring and salary freeze. The group’s sales in the quarter to the end of March 2020 were down 19% year-on-year, and the next quarter saw revenue fall by 47% year-on-year as store closures continued, global tourism came to a standstill and consumer sentiment cratered.

Given the fixed-cost nature of the business, and consequent high level of operating leverage, management battened down the hatches and focused on cash preservation, cost reduction – and survival. The difference between a minimum-wage store assistant at a budget clothing retailer and a motivated, specialised salesperson able to make things happen certainly became apparent – Richemont’s dedicated sales staff took the bull by the horns and found new ways to connect and engage directly with their clients.

A WELCOME SURPRISE

Amid the doom and gloom, what happened next took both the wider market and Richemont management by surprise. The market had underestimated – even early on during the pandemic – the strength of the shift in consumer spend from services that were no longer available towards goods. By the end of 2021, consumer spend on goods was running at 25% above trend, while spend on services was 5% below trend.

At the same time, the developed world enjoyed almost unprecedented levels of government support, particularly in the form of cheap money via low interest rates. This was positive for asset prices across the board, which had a disproportionate impact on the wealthier end of global society. The luxury goods market had a fantastic year in 2021 as we emerged from the doldrums of the pandemic, with strong equity markets, many new cryptocurrency millionaires, cheap money and a dearth of tourism options to spend it on.

Richemont was among the beneficiaries. The group’s sales for the year to the end of March 2022 were nearly 40% above pre-pandemic levels, with the jewellery division, the primary beneficiary, up over 50%. Similar trends are evident for the other major luxury players.

THE MOVE ONLINE

In the years before the pandemic, Richemont had been moving into the online space, first via its investment in YOOX Net-a-Porter and subsequently via its 2019 tie-up with Alibaba to sell luxury goods through the Feng Mao joint venture. The move was, however, slow, particularly for the higher-end products, where management was wary of damaging brand equity through ubiquitous availability.

The pandemic accelerated the move online in many industries, luxury goods being no exception – and companies with pre-existing capabilities benefited the most. Although most sales of luxury items still take place in-store, it’s clear that a greater proportion of wealthy customers are now making their purchase decisions online.

A more online-focused model makes good business sense for the luxury goods industry. The cost of delivery is a far smaller proportion of the total sales price and companies can save on expensive store space. Selling online provides easy access to customers who would previously have fallen outside the store network. It also allows luxury goods companies to slowly shift towards a model with more variable costs and fewer fixed costs, which is positive for earnings stability over time. Lastly, luxury goods work well in our modern Instagram celebrity world that encourages displays of wealth.

STRENGTH OF THE BIG BRANDS

A trend that accelerated throughout the pandemic was the strength of the largest brands in the luxury industry. There are likely multiple reasons for this, but key among them is that the bigger brands generally handled the transition to online more effectively. The more famous brands also benefit from people looking for goods online, where search typically remains within known brands.

Larger brands tend to have more in-country stores, particularly in China. Those with superior footprints in Asia therefore benefited on a relative basis from the decline of tourism – around half of the pre-pandemic luxury spend of Chinese nationals used to take place overseas.

Finally, the general trend within the industry is away from department store formats that sell multiple brands towards brand-owned stores. This reduces the chance of customers discovering new, competing brands.

NEW LEADING GEOGRAPHIES

Over the past two years, the exceptional growth of the luxury goods market in the US has surprised us. For many years, China was the primary driver of growth in this space, but since the pandemic, the US has become a more relevant growth driver. This could be partly due to the fact that the US reopened more quickly than other regions, but in our view, maturing tastes among older customers and the rise of younger cryptocurrency millionaires both supported the increased demand in 2021. How sustainable this is, remains to be seen.

This growth surprise drove the stock prices of luxury goods to record levels. At their November 2021 peaks, Richemont and LVMH were trading at 30 and 32 times forward price-earnings (P/E) multiples respectively, among their highest on record, and these were based on top-of-the-cycle earnings expectations. The market was essentially extrapolating the recent growth numbers into perpetuity.

DECLINING VALUATIONS

In our view, these price increases were not sustainable – and thus far in 2022, the combination of changing equity market sentiment and the end of cheap money has weighed on equity valuations. At the same time, the market has realised that consumer spend will likely slow given the potent cocktail of rising inflation and higher interest rates. Accordingly, the valuations of luxury goods companies have declined materially this year and the shares now appear more reasonably priced.

We retain our long-held view that the luxury sector has some excellent businesses. Simply put, it takes 100 years to build 100 years of brand history. This gives exceptional brands like Richemont’s Cartier, which is now 175 years old, an untouchable advantage in our disposable world.

We see luxury goods as a play on the continued rise of global inequality. On top of this, branded fine jewellery (for example, Cartier, Tiffany, Van Cleef & Arpels and Bulgari) makes up only about 14% of the total jewellery market, leaving a substantial growth runway available for the industry over the long term.

Recent share price declines mean that for the first time in a few years, great luxury businesses are moving towards price levels where they may also be good investments for our clients over the long term.

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