Shares in luxury goods group Richemont (CFR) are down around 20% over the past 18 months, but Morningstar analysts say the poor sentiment is unjustified. Richemont is the company behind a suite of well-known luxury brands including Cartier and Mont Blanc and online retailer Net-a-Porter.
Shares in the firm have dropped from around 92 Swiss Francs a year ago to 74 Swiss Frances today, and Morningstar analysts say that is an excellent opportunity to buy one of the strongest players in the market.
Driving the price weakness is investors' fears about the Chinese market, explains Morningstar equity analyst Jelena Sokolova. But that fear is likely over done.
China accounts for around 40% of Richemont's sales - higher percentage than most of its competitors. As a result, investors' worries are taking a harder course at Richemont's price than at competing luxury goods companies, as the following price chart shows:
Corruption tackled
Concerns ramped up when the Chinese government tackled corruption and bribe practices in 2012. This had a negative impact on businesses whose goods could serve as gifts, particularly Richemont watch brands such as Vacheron Constantin, Jaeger LeCoultre and IWC. The Cartier brand, known for its watches and jewelry, also felt the negative effect.
The sudden fall in demand as a result of the crackdown on corruption led to overcapacity in the luxury watch market. This led to less price-setting power, higher inventories, and currency fluctuations - all of which have affected profit margins.
Historically, margins in Richemont’s watchmaking division, which accounts for 20% of group revenue, were around 20% to 25%. They started to slide in 2013/14 when the effects of slowing demand started to be felt. In the 2017/18 tax year, margins were around 10%.
But competitors such as LVMH (LVMH), Hermes (RMS) and Kering (KER) have been less affected because their brands are positioned slightly lower in the market. Their sales volume have held steadier than those of ultra-luxury Richemont items,k which may only be purchased on special occasions.
Nevertheless, the brands from the Richemont stable are particularly strong and in the long-term this offers an advantage over the competition. Strong brands have pricing power. As well as that, Richemont has its production and supply chain well organised. Production efficiency and sophisticated marketing and distribution by independent retailers as well as via own sales channels contribute to the strength of the brands and their results. The table below shows that Richemont scores positively on the five most important elements, while various competitors score negatively on some of those elements:
Pricing power is a particularly important strength of Richemont for analyst Sokolova. She has learned from conversations with the company that it has been somewhat cautious with price increases over the past few years. However, the company's 100-year history shows that those increases are indeed possible, something which contributes to the Wide Moat rating that the analyst assigns to the share.
Embracing Online
One major structural change the luxury good industry has had to get to grips with is the rise of online shopping. Jewellery in particular is increasingly finding its way to the customer via the internet. Until now, luxury goods has lagged in the online space, but it is now starting to gain ground. This is partly because (younger) customers choose online because it is easy and anonymous. In the meantime, the luxury companies are embracing online as an important sales channel that can serve a new target group.
These consumers still want the same things: appealing, big names and quality, and this offers opportunities for growth. For providers, meanwhile, online distribution can be more efficient and cheaper than having a network of stores in expensive shopping streets across the world.
Online accounted for 6% of the total turnover in the luxury industry in 2018, up from just 2% in 2013. The share of the total is therefore still small, but the percentage growth is substantial.
Fears are Unfounded
The luxury goods industry is inherently cyclical in nature and when there is a fall in demand in the top segment, it immediately cuts into turnover and margin. This is shown in the graph below:
But Sokolova says the fear that investors have displayed in recent months for a downturn in China is unfounded, certainly for the long-term. In fact, the growth in prosperity in Asia is a positive for Richemont as middle- and high-income groups grow and consumption increases, more people are able to afford watches and jewellery from Richemont's brands.
In the longer-term, per capita income growth is likely to be 3.3%, which could see consumption of luxury goods grow by 4.2% over the next 10 years, analysts say. That could boost revenue up to 6% revenue growth in this region alone in the longer-term.
There are also more optimistic scenarios based on 8-10% growth in luxury consumption per year until 2025. In any case, the Chinese market will contribute to the growth of the luxury goods industry and Richemont can compete in it benefit most.
The total revenue growth for the company for the next 10 years could, according to Morningstar projections, be in the range 5 to 7%, and that's without factoring in the growing online business. Analyst Sokolova comes has a Fair Value of 91 Swiss francs per share for Richemont.
If the most optimistic growth scenario comes true, then that could rise to 123 Swiss francs per share. In a more pessimistic bear scenario, in which revenue growth stays below 5% and margins do not pass 18%, the Fair Value is estimated at 60 Swiss francs per Richemont share. The stock has a Wide Moat rating because of the strong brands that have proven and will retain their appeal to consumers.
