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Sector in Focus: Luxury Goods

Robert van den Oever
Jelena Sokolova, CFA

Robert van den Oever: Welcome to Morningstar. Today, I talk to Morningstar Equity Analyst Jelena Sokolova about her new report on the luxury goods industry.

Welcome, Jelena. Can you please take us through the recent developments in the luxury goods industry?

Jelena Sokolova: Sure. So, the industry has been driven before by the high growth in the developing countries and store expansion in those regions. That has slowed in 2012. And even after the rise in demand last year, there are still many companies that are grappling with excess capacity and low profits. So, the industry went from selling the same iconic goods to new ranges of customers to basically addressing existing customers with innovation. That presents a challenge.

Oever: And now, we see the role of online getting bigger and bigger. What can you tell us about that?

Sokolova: So, online, the industry is finally warming up to online sales. Before it was quite reluctant to accept this channel. And we think it will be quite a profitable channel because the sales are full price. The transportation costs are clearly low as a percentage of the final merchandise and also, you don't have the fixed costs of running the store. We also expect revenue traction from this channel and the brands have to be there as we expect this channel to increase from around 8%, 9% currently to around 16% over the next five years. Although, it also presents challenges as online lowers some barriers to entry, especially in categories which we see more competitive such as apparel, for instance.

Oever: You mentioned the challenges, both in online and also the changes structurally in the industry. How can the luxury companies tackle those challenges?

Sokolova: We believe the companies with stronger brands are the best positioned to tackle the challenges. And we see the companies, the established brands in such long-lived and conspicuous categories as leather goods, watches and jewellery to be best-positioned. We also see the importance of being in control of your own distribution as it helps maintain pricing and avoid excessive discounting which can be adopted by wholesalers and which is long-term hurtful for the brands.

In this light, we see such companies as Hermes, LVMH, Richemont and Tiffany to be the strongest positioned and benefiting from wide moats.

Oever: OK. Now, if we look into the future, you have made some calculations for the future growth of this industry. Can you elaborate a bit more on the outlook for the coming years?

Sokolova: So, we expect the industry to grow at 4% over the next decade, which is a slight moderation from the 5% growth over the previous decade and the main driving forces are expected to be Chinese customers. The growth with this cluster is expected to be 6% to 7% as we expect the middle class, the upper middle class and affluent population to almost double from current levels.

Oever: You have looked into the companies and also the valuations of the companies at the moment. And one of the main conclusions of your report is that valuations are a bit on the high side at the moment. Can you take us through that and can you tell us also a bit about the companies that are attractively valued within the landscape?

Sokolova: Sure. So, we currently see that the market already incorporates better demand backdrop in China as well as profitability improvement and also some self-help initiatives in some firms. As a whole, we see the sector trading at around 15% premium to our fair value estimates. However, on a relative basis, we retain preference for hard luxury goods and rare purchase items and that is because those have less tailwind from the existing consumers but should benefit to a higher extent from the new middle class and affluent population coming into purchasing power.

We have a relative preference for Richemont Group as it benefits from a remarkable portfolio of brands in highly-conspicuous categories, watches and jewellery. It controls distribution in its jewellery business. The weakness that we are seeing is the lack of control over distribution in the watch business, but this can be addressed by curtailing the wholesale channels and also by growing online to a higher extent in the future.

Oever: OK. Jelena, thank you very much for your overview.

Sokolova: Thank you.

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