Britain's decision to leave the European Union triggered significant declines in most of our luxury coverage. Wading through the post-volatility prices and valuations, we still see Swatch Group and Richemont as the most undervalued, and Burberry, Prada, LVMH, and Kering are all rated four stars, meaning that they are trading at a discount to their fair value.
The impact on Burberry's fair value is neutral, since costs in pounds are offset by store operations that are global
We believe that overall, both the near- and long-term implications of Brexit, whatever timeline and ultimate rules are implemented, should have a minimal net impact on long-run luxury demand. While uncertainty in Britain may cause some local consumers to delay purchases, the lower pound and weak euro have in the past proved positives for luxury goods companies that have significant local costs and production. Increased purchases by foreign tourists, particularly Chinese and American, should also more than offset drops in local British demand in our view.
Burberry (BRBY) is the one name we cover that is actually headquartered in London and reports and trades in pounds and pence, and we think the impact on its fair value is neutral, since costs and overhead in pounds are offset by sourcing in euros and revenue and store operations that are global. Operating expenses are about two thirds in pounds, 10% in euro, and the rest of global operations more closely follow the dollar. Cost of goods is more largely in euros because of leather, while high-end outerwear is still produced in pounds. Finally, on the revenue side, more than 50% of revenue is dollar-related, thus magnified if sterling is weak relative to the dollar.
French luxury companies LVMH (MC) and Kering (KER) are very global and have large businesses in the Americas and China, and likely less than 5% of global revenue in the U.K. Of greater concern is the tourist season in France and the Continent, which is at risk given reports of cancellations due to security concerns.
As for the two Swiss watchmakers we cover, Swatch (SWGAY) and Richemont (CFR), Brexit's implementation will probably take a very long time, and although both companies have a greater exposure to revenue in U.S. dollars – nearly two thirds for Swatch, we think the risks are already largely priced in.
Swiss watch companies have been dealing with destocking in Hong Kong and Macau for several years now, as well as exchange-rate volatility and now dealers will eventually have to restock and prices have gradually been rebalanced globally. The 2015 surge of roughly 20% in the Swiss franc, subsequent rise and fall of the dollar in Swiss franc terms, and overall weaker euro and yen have caused both companies to examine costs, and raise prices in weaker currency areas.
Now Europe, which was a bright spot in 2015, appears to be still suffering from a decline in tourism after terrorism attacks in Paris and Brussels, and the recent attack in Turkey likely contributes to fears, but we also note that the euro has net appreciated year over year compared with the franc. Japan, which had seen growth while the yen was weak could also see a stall as the yen has recently re-appreciated with the global de-risking around Brexit.
Obviously, these scenarios and discussions of currency comparisons do not contemplate some sort of global financial crisis triggered by the Brexit vote. Yet with the two-year clock to make the separation happen not even ticking, we suspect that luxury companies' operating results will be minimally affected by Brexit and worries in the stock prices could prove overdone.
