Hermès Shares Could Rally as Sales Improve
More sales of Kelly and Birkin bags could get the French luxury-goods company back in the saddle, with upside of almost 20%.
Like the handbags it produces, Hermès International is expensive—in this case, on a price/earnings basis. But the luxury-goods company’s earnings and cash-flow growth could drive its shares even higher.
Hermès (ticker: RMS.France) fetched 311 euros ($356) at the close of trading Friday. The stock is flat for the year to date, but down about 8% in the past 12 months. Even so, it trades for 27 times next year’s estimated earnings, well above the Stoxx Europe 600 index 12-month forward P/E of 15.7.
Hermès’ historical multiple is even higher, at 31.5, reflecting the premium that investors are willing to pay for a company that consistently delivers high-quality profits. Assuming the stock could command that multiple again—a good bet given demand for the company’s products, and smart financial management—Hermès could be worth about €365, 17% above its recent price.
Based in Paris, Hermès has delivered total shareholder returns of about 18% annually for the past 10 years. The company also trades in the U.S. via American depositary receipts (HESAY), 10 of which are equivalent to one ordinary share. The ADRs were priced at $35.61 Friday.
Hermès manufactures ready-to-wear collections, fragrances, and accessories, including silk scarves, but 47% of revenue comes from leather goods, including storied bags such as the Kelly, named for Grace Kelly, and the Birkin, named for British singer Jane Birkin. The company added two production facilities in France last year to meet growing demand, particularly for leather accessories. Sales in that segment rose 15% in the first quarter of 2016.
Hermès sells its products worldwide through luxury department stores and 307 stand-alone boutiques, 210 of which it operates directly. More than a third of sales come from the Asia-Pacific region (excluding Japan). Europe and the Americas each contributes less than 20%.
Total revenue growth could be challenged this year, due to a stuttering global economy, terrorist attacks in France and elsewhere that have curbed tourism and store traffic, and the strength of the euro. Sales growth is likely to fall short of the company’s medium-term goal of 8%, although gains of 6% would be a creditable performance.
Management is conservative in its financial and business practices. Capital expenditures totaled just €267 million last year, relatively modest for a company with €4.84 billion in 2015 sales. Half that outlay was earmarked for the construction of 20 new branches, store refurbishment, and distribution improvements. Hermès’ balance sheet had net cash of €1.61 million at the end of last year.
The company has been careful to avoid saturating the market and diluting the strength of its brand. Exclusivity has allowed it to raise prices by mid-single digits annually. Sales have more than tripled in the past 10 years, and are forecast to reach €6 billion in 2018.
Hermès boasts best-in-class profit margins among luxury-goods makers. Last year, operating margins edged up to 31.8% from 31.5% a year earlier. The company is expected to earn €1.11 billion, or €10.55 a share, this year, on €5.17 billion of revenue. Analysts have projected earnings per share of €11.55 in 2017. Hermès could generate almost €1 billion this year in free cash flow, for a yield of 2.9%; cash return on invested capital is impressive, at 20% and growing. “That combination in a low-growth world is scarce and increasingly valuable,” says Gary Paulin, founding partner at Aviate Global, which owns the shares.
HERMÈS’ SOLID PERFORMANCE is built on a foundation of stable ownership and management. Chief Executive Axel Dumas is a member of the sixth generation of the Hermès family, which founded the company in 1837 and has run it since.
In 2014 family members pooled their stakesin a holding company that controls 52.5% of Hermès. The move came in response to a challenge from LVMH Moet Hennessy Louis Vuitton (MC.France) boss Bernard Arnault, who had accumulated a more-than-20% interest in Hermés since 2010. LVMH sold its shares in 2014, but Arnault’s family holding company retains an 8.4% stake, making it the second-largest shareholder. The Hermés shareholding pact prevents any share sales for 20 years, effectively blocking unwanted takeover offers.
At the current valuation, Hermès looks attractive, says George Evans, chief investment officer for equities at OppenheimerFunds and portfolio manager of the Oppenheimer International Growth fund, which owns the stock.
The high multiples shouldn’t faze investors, he says. “Quite often, high-quality companies can support P/Es that look eye-wateringly expensive,” Evans says. The market has a tendency to be cautious about companies that “make fat margins over three years and beyond,” but some can sustain and even improve those returns, he adds.
There seems little chance that Hermès will fall out of fashion anytime soon.