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quality at a price
Head of Equities
Feb 28, 2017
Richemont has long been a core holding in many South African portfolios. Investors are attracted to the group’s collection of iconic luxury brands, exposure to affluent customers and rand-hedge qualities. Most of the brands have more than a century of history – the flagship is Maison Cartier, the more than 170-year-old producer of high-end jewellery and watches. For example, Cartier’s iconic love bracelet costs between US$6 500 and US$60 000.
The other main brands include Piaget, IWC Schaffhausen, Panerai and Vacheron Constantin in the watches space, with Purdey, Dunhill, Montblanc and Chloé producing a variety of other luxury goods.
In the world of deluxe watches, brand equity is vital to maintaining high prices, as customers pay for exclusivity. Hard luxury remains the favoured way to display wealth. In cities such as London, Hong Kong, Shanghai and Tokyo, where even the affluent now travel to work on public transport, a top-end watch is the only way to differentiate oneself elegantly.
Given that there’s little risk of technological obsolescence (digital watches have been more accurate than mechanical ones for over 30 years), the industry has attractive barriers to entry, which supports high selling prices. While less than 10% of the world’s watches are made in Switzerland, they account for around two thirds of global sales value.
The rise of the smartwatch allowed Apple to generate more revenue from watches in 2015 than any other global brand, with the exception of Rolex. In our view, however, this poses a greater risk to mid-tier manufacturers like Swatch, rather than Richemont.
A further attraction of Richemont relative to the group’s peers is that whereas buyers of watches between US$1 000 to US$5 000 tend to operate using an ‘either/or’ budget – where the watch is purchased in lieu of another luxury item – buyers of watches costing more than US$20 000 are often able to purchase multiple luxury items simultaneously.
A key aspect of our investment case for Richemont and to understanding the group’s prospects for growth is its exposure to the affluent Chinese market. Even though mainland China accounts for only a third of Richemont’s sales, Chinese tourist spending around Asia and Europe is such that just over half the group’s revenue comes from Chinese customers. The number of Chinese high net worth individuals (those with more than US$1 million of investable assets) is growing three times faster than in the US and Europe.
The Chinese government’s clampdown on ‘gifting’, which was always an essential part of business deals, particularly in the public sector, has had a negative impact on watch sales in greater China (including Hong Kong and Macau) over the past three years. This now appears to have stabilised and shouldn’t be a headwind going forward, as evidenced by Richemont’s first volume growth from the region in three years in the quarter to December 2016.
The luxury goods industry is by nature cyclical, which is why Richemont has a conservative balance sheet, with cash accounting for around 15% of its market capitalisation. This cash also distorts the valuation picture – at first glance, Richemont’s forward price-earnings (P/E) multiple of 24 times appears demanding, but adjusting for the cash, this comes down to 21 times. This is in line with the group’s peers.
Richemont’s margins have come under pressure over the past two years, with the 15.5% expected earnings before interest and taxes (EBIT) margin for the 2017 financial year set to be the lowest since 2005. What makes the share different is that the market typically punishes disappointing earnings with a lower PE, while in Richemont’s case, the market is pricing in a rapid recovery to around 20% EBIT margins.
Richemont is in the midst of a management shake-up, with executive chairman and controlling shareholder Johann Rupert recently stating that he wanted to see ‘fewer grey-haired men and fewer grey-haired Frenchmen’ at the top of the business. While management changes usually take time to have an impact, we expect the group to become more innovative going forward.
Purely from a valuation perspective, Richemont shares appear expensive, but we note that from a portfolio perspective, the case for selling one’s shares is more clouded. Investors on the JSE are able to gain exposure to the growing Chinese middle class via Naspers, but not to the growth in luxury spend. South African investors who want exposure to this growth will have to pay up.
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