Slower growth is here to stay
Over the past five years the global luxury goods sector delivered 8% CAGR. We
now expect this to fall to c4% from here due to four headwinds:
1. In HK/China, the anti-corruption campaign and slower GDP growth.
2. Consumer spending growth is anaemic across the EU.
3. Demand growth is softening in the US.
4. Weaker growth in commodity driven markets: Russia, Middle East and Latam
We are very cautious on Watches and expect a decline in Swiss shipments in
FY16 to rebalance HK inventories. The latest KOF survey suggests negative
sentiment for key 4Q. We are also growing slightly more cautious on jewellery.
Shift to a new normal will bring margin pressure
The global luxury goods industry needs c2% organic growth to match cost
inflation and protect margins. Furthermore, we do not believe market appreciates
the increase in operational leverage, a result of 10 years of expansion in retail
distribution. This increase in capital intensity does not show on the balance sheet
but in a significant increase in operating leases: Rent/Sales went from 5% to 8%
FY10 to FY15E. Any sales decline will likely to result in material margin declines.
Key Recommendations: Stick with quality and self help
Negative operating leverage has already manifested in profit warnings in HK
jewellery retailers where we remain negative on Chow Tai Fook (U/P;
PT:HK$4.10). The persistently weak luxury environment means we remain
negative on Prada (U/P; PT:HK$25) and Samsonite (U/P; PT:HK$19.10). We
initiate Richemont with a non-consensus U/P (PT: CHF65), and are similarly
negative on Swatch (U/P; PT: CHF325) as they struggle the most given the
Swiss watch trends. Our EPS is 7%/9% below cons for Richemont/Swatch.
We initiate LVMH as an O/P (PT:€184) as we believe it deserves a meaningful
premium to sector, given its diversity of products/geography and highest FCF
yield of 5% that our Quant analysis identifies as the key driver of returns.
There is nonetheless only one name in Europe which we expect to see earnings
upgrades in FY16: Kering, our top pick (O/P; PT:€198). We believe the market
undervalues: 1) Gucci turnaround; 2) the second phase of Bottega Veneta
growth; and 3) the growing importance of “Other Luxury Brands” where little
disclosure exists. Our EPS is 3%/4% higher than consensus for 2016/17,
respectively. Upgrades and re-rating should deliver 20% upside.
We reiterate our long term O/P ratings on Tiffany (PT:US$103) and Ralph
Lauren (PT:US$155). In 1Q16, we lap the meaningful strength of the US$, which
reduces a key headwind for US companies. For Tiffany, we will start to see the
benefit from lower precious metal costs. Ralph Lauren's restructuring is
proceeding as planned, and we believe it potentially benefits significantly from
the Trans-Pacific Partnership next year.