Luxury goods stocks have been good performers this year…
The stocks of luxury goods companies have been stellar performers during 2009, despite the fact that the companies are showing unusually sharp declines in revenues and profits. This apparent disconnect is not peculiar to luxury goods, but instead is a characteristic of stocks in general, where buyers are doubtless anticipating a sharp bounceback in corporate earnings in a more normal economy in 2010.
…but will expectations be fulfilled?
There are several reasons, however, to think the expected surge in revenues and earnings may not occur for luxury goods in the way it has in the past.What are luxury goods?
First, though, let’s make a couple of distinctions. I’m writing about the luxury goods companies that make and market the products and who may own retail outlets dedicated to the company’s brand, not the department stores that may rent space for luxury goods outlets or themselves run in-store luxury goods boutiques.
luxury vs. “affordable” luxury
I also want to distinguish between “luxury” and “affordable luxury.” I think the latter, typified by Coach or Tiffany (in its below $1,000 range) have, and have exercised, much more flexibility in moving price points up and down as circumstances change. I understand “luxury” goods to be clothing, leather goods and jewelry/watches, where a representative item costs $3,000 or more and where price points remain unchanged through the business cycle. Luxury goods producers would be typified by LVMH or Hermes.
A typical luxury goods customer would make multiple purchases during the year, spending at least $10,000 in total.
core vs. aspirational buyers
Luxury goods consumers can be divided into two segments: core customers and aspirational buyers.
The former are truly wealthy. For them, a $5,000 suit, a $3,000 handbag or a $10,000 watch is a “normal,” regular purchase. The price point is low enough for this segment that it merits little more consideration than the average consumer would give to a loaf of bread or a t-shirt.
The second category, aspirational, does not have the wealth of the first. For the aspirational buyer, the purchase of a luxury good involves some financial calculation and sacrifice. Nevertheless, she/he buys luxury goods because she/he dreams of achieving the attributes the luxury brand articulates–wealth, leisure, glamor–and wants to appear to others as already possessing them.
This distinction is important because of the different responses of core and aspirational buyers in bad economic times.
1. Aspirational buyers disappear. They quickly return to buying items that don’t stretch the budget so severely.
2. Core buyers continue to spend at the same rate as before during mild downturns. During very bad economic circumstances, like we have had over the past year, core buyers typically ration purchases. They may “only” buy a handbag every six months, instead of every three. Or, although they may make the same number of shopping trips, they may only buy one or two items at a time, rather than the three or four they would have bought in a sunnier economy.
The investment case in favor of luxury goods makers is simple:
The brand names have enduring value. The downturn in sales is temporary. As world economies begin to recover, aspirational buyers will return in surprisingly strong numbers to their favorite luxury brands. Core buyers will no longer ration their purchases–in fact, they may buy at an accelerated rate for a while to make up for purchases they have forgone during the economic slump.
Causes for worry
There are three reasons why I think this optimistic case may not unfold this time, as it has in the past:
US and UK
1. The obvious one is that aspirational buyers in the US and UK may not return as quickly as usual. Both countries were centers for the creation of toxic financial products, an endeavor that ended up severely damaging both economies. This probably equates to an extended period of fewer domestic buyers of luxury goods both in London and New York.
2. As many sources have reported over the past six or nine months, there’s been a sharp falloff in Japanese buying of luxury goods this year (the New York Times has a good recent article.). This is particularly worrying news, because:
a. A very large portion of the Japanese population has traditionally bought luxury goods. If, say, 10% of the people in the US are luxury goods consumers, the figure in Japan is 30%-50%.
b. The prices of luxury goods in Japan are much higher than in most other places. Selling prices can be up to 50% more in Japan than in Europe for the identical item. So sales there are unusually profitable, despite higher operating costs. Because of the dependability of Japanese demand, luxury goods manufacturers have also made large investments in retail stores there, to capture the wholesale to retail markup. A prolonged buyers’ strike in Japan would call these property investments into question.
c. Japanese customers bought steadily throughout the “lost decade” of the Nineties, when Japanese economic performance was especially grim.
Why are Japanese buyers staying home? I don’t think anyone really knows. It may be that the lull is just temporary.
On the other hand, given the intense nature of Japanese luxury buying, there have been worries for years that at some point the market would finally be saturated. If so, luxury good firms may be a similar situation to the one Starbucks faced a year or two ago, when, after defying doomsayers for years, the market for new company coffee shops suddenly dried up.
Given the sharp rebellion of a younger Japanese generation against a highly structured traditional society–which has the luxury goods culture as a byproduct–it may be we’ve hit a tipping point, where more long-time luxury buyers are retiring and not being replaced by younger counterparts.
In any event, if this new pattern in Japanese buying behavior persists, it’s a risk to the profits of the highest-end luxury goods firms.
3. On the surface, China is an unadulterated positive for luxury goods companies. The economy is expanding rapidly. The population is so large, at 1.3 billion, that even if only 1% or 2% can afford luxury items, this is still a very large market. And, like Japan, prices of luxury goods in China are high.
The real threat from China is on the production side–the development of a manufacturing base of skilled craftsmen to produce high-quality luxury products at relatively low cost. Most luxury goods today are very labor intensive and produced by craftsmen in the euro area, where labor costs are high. But the rise of a parallel manufacturing industry is already under way.
Coach, for example, already makes all its leather goods in China.
The rapid evolution of China’s textile industry (China has always bought the finest machinery available; the question has been one of getting skilled operators) means extremely high-quality fabrics, previously available only from relatively expensive European sources, are now easily accessible to Chinese manufacturers. So far this output has only been making its way into retailers like Macy’s, Marks and Spencer, or Aoki and Aoyama Shoji. (I first saw the Aoyama offerings about five years ago. The fabrics in their $300 suit in Tokyo would only be seen in a $1,000+ suit in the US.)
But the story is beginning to get out. There have been a number of recent news reports about Dayang Trands, a Dalian-based clothing manufacturer who now boasts Bill Gates and Warren Buffett as customers for its made-to-measure suit line. Trands suits may be great, but they depend for their pricing on having domestically produced high-quality fabric.
China is not a near-term dollars-and-cents threat to European luxury brands. But the realization that there may be a credible Chinese challenge to today’s price/cost equation for luxury goods would likely be a reason for price-earnings multiples to shrink.