We may be facing a perfect storm in luxury goods. This report aims to give a sense of how far
valuation floors are from present levels in case background risks play out, so that investors can
make an informed decision based on their views of the contingent and cyclical unknowns.
There seems to be a “perfect storm” closing in on the luxury goods sector
Structural, contingent and cyclical adverse elements converge: (1) fewer opportunities to increase
# POS (Retail Convergence), slower GDP growth in China moderate the structural support (Fallen
Angel); (2) turmoil in Eastern Europe depresses Russian spend abroad; protests in HK dampen a
major luxury market (10–20% of global luxury sales); a new war in Iraq and Syria, a fragile truce in
Israel, cast a shadow over the Middle East; (3) falling property prices, reduced liquidity for Chinese
corporates negatively affect consumers feel-good factor, leading them to moderate their spend.
Perfect storms create value opportunities in the luxury goods sector
Luxury is a high fixed-cost business – leading to material operating de-leverage as sales growth
goes south. To make matters worse, luxury goods companies – albeit with some b differences from
one another – need significant organic growth to keep EBIT margins flat, as they are still in “buildup”
mode. When we add adverse FX impacts from most of FY14, EBIT margin compression in
FY14e becomes a near certainty. This creates a double whammy negative, as lower EBIT margin
and EPS typically go hand in hand with multiple compression. The risk of protests and police
confrontation escalating in HK brings a tail risk of a SARS-like share valuation scenario.
LVMH, Hermès look most promising as we look at how far they are from “worst case” floors
LVMH and Hermès are most likely to outperform from a sector relative viewpoint. Additionally,
Luxottica seems well placed. Hard luxury names, yet attractive from a structural viewpoint (9ST),
are most likely to see things get worse, before they get better, given materially higher exposure to
Hong Kong and higher operating leverage. Swatch, in particular, would additionally suffer from
concerns about smart watches and likely further deterioration in NWC at the end of FY14e –
continuing to stoke investors’ concerns.