Equities: Is The Luxury Sector Making a Comeback?

Luxury groups enjoyed ideal conditions for several decades (opening of new markets, little competition and solid prices). The sector saw market growth of 5% per year and survived numerous economic and financial crises. And yet, investors ignored this sector for three years. We analyse this sector undergoing massive changes.

Until recently, the luxury "engine" was clearly hampered by several negative factors:

1) Sluggish economic climate
 

• Global deflationary fears.
• Difficult conditions in the emerging markets. China’s anti-corruption policy, introduced in 2013, penalised European luxury groups. In Hong Kong, a prime shopping hub for Chinese tourists, sales slowed in the wake of major demonstrations in 2014, and the appreciation of the local currency against the yuan.
• Geopolitical concerns over terrorism, populism, and so on weighed on industry sales. After the spout of terrorist attacks in Europe, world demand for luxury goods fell by around 30%.

2) Major structural changes: Substantial pricing power that luxury groups had previously benefited from waned. The latter had to deal with a certain degree of price pressure due to tougher competition and greater price transparency linked to the growing importance of digital technology. The Generation Y is also less loyal to blockbuster brands in the luxury industry. Consequently, the massive selling of these brands tapered off.

In this challenging environment, "hard" luxury stocks, with a focus on jewellery and watches (Swatch, Richemont, Tiffany, for instance) were more severely hit than diversified "soft" stocks (such as LVMH or Kering). Indeed, "hard" stocks struggled more than "soft" stocks to adapt to economic fluctuations in view of their high fixed costs. Furthermore, they suffered more from the shift in behaviour of the new generation. To illustrate this, Richemont’s earnings, published in May, revealed that the luxury group has not avoided the watchmaker crisis.

However, the situation has stabilised in recent quarters, enabling most luxury stocks to rebound in the equity markets.

Luxury groups have implemented a survival ("self-help") strategy:
 

• Cost control and Capex control
• Optimisation of retail networks. Companies have reduced the number of identical large stores worldwide and have focused on new and better targeted concepts (concept stores). This strategy is increasing the return on capital employed (ROCE).
• External growth. Luxury groups often have solid balance sheets and little debt. Without necessarily envisaging mega M&A deals, luxury goods consider bolt-on mergers as a way of consolidating their position by adding brands to their portfolio.
• Rollout of innovations. Some groups have adapted their products to meet the needs of their diverse clientbase. The Generation Y has new aspirations, and the Chinese middle class can afford less than the previous waves of new clients from the Middle East or Russia.
• Ramp-up of online sales. Like most consumer sectors, luxury groups have had to find a balance between the physical network and the emergence of e-commerce. Online sales require less investment.

The economy has improved over the past few quarters. Very recently, sales in Asia have started to pick up. After a long unfavourable period, the fundamentals of emerging economies have stabilised thanks to a rebound in commodities, their strong currency, and for some, slower inflation. Promising markets (India, South-East Asia) also represent new growth drivers.

Geopolitical concerns have faded in recent weeks thanks to less turbulent Sino-American relations.  President Trump’s less protectionist dialectics is certainly good news for the sector.
 

Thanks to the more favourable economic climate, particularly in emerging market countries, luxury groups should have good times ahead.  However, it is essential to measure, case by case, the ability of companies to adapt to the transformations taking place in the industry, but also to assess their valuation metrics.  Indeed, like many cyclical stocks, luxury goods companies are trading at high multiples. A selective stock-picking approach is now essential.

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