* Sector still over-valued in light of increased risk
The BofAML Luxury Goods sector is up 10% in 2015 YTD, underperforming the broader
European market by 3%. It trades on a P/E of 21.6x 12m fwd earnings, a 30% premium
to the market. While this is down from its 40% P/E rel in June (when we argued for a
sector de-rating), we see further risk to Luxury’s premium valuation given sub-market
earnings growth and increasing risk associated with Chinese consumption. We reiterate
our negative view on the sector and see our U/P ratings on LVMH, Richemont, Prada &
Swatch as the best way to gain exposure to this theme.
* Structural changes to result in lower profitability & returns
In our awaiting a derating report we identified five structural changes taking place in the
luxury goods industry: [1] revenue growth moderating, following super-normal China
growth phase; [2] reduced pricing power; [3] Hong Kong (where product gross profit is
50% above Europe) losing its appeal & ability to over earn; [4] mix benefit on gross
margin largely done, now limited to FX tailwind (soft luxury only); and [5] ongoing rent
inflation in premium real estate likely to result in retail deleverage. In our view the
combination of all these factors creates significant risk to historic margins, earnings
growth and returns. We believe consensus remains too complacent on the structural
changes occurring in the sector. BofAML is 7-10% below consensus 2015-16 EPS.
* Increased risk associated with Chinese revenues…
We believe the recent Chinese Yuan devaluation has been priced into Luxury sector
share prices, however the risk of further devaluation has not. As a minimum, we believe
this increases the risk for the luxury goods sector, given devaluation would result in a
lower FX tailwind (on this basis UHR, SFER, CFR & BRBY would be most impacted).
However the more significant risk would be that a weaker CNY starts to impact Chinese
consumer offshore consumption and is not fully repatriated (on this basis CFR, LVMH,
TODS & SFER would be most impacted). In this report we outline FX exposure by
revenue, COGS & operating costs for each company under coverage, provide FX markto-
market and sensitivity to CNY devaluation. A 10% devaluation in CNY would reduce
sector EBIT by 7% (this does not include impact of lower tourism spend).
* …. Still not reflected in valuation
History suggests consensus is too optimistic on luxury sector earnings growth (2016
EPS revised down 16% in 18 months). We see current expectations for 12% 3-year EPS
CAGR as no different. Our forecasts imply 5% earnings CAGR in the next 3- years, below
the broader European market. A weaker CNY removes some FX tailwind and may
eventually impact offshore consumption. As such, we consider the current sector
valuation as unjustified. P/E relative stands out at a 30% premium, while history
suggests that current return and relative growth justifies a valuation range between
parity and +10%.