Brand republic

Growing wealth in emerging markets, particularly China, prompts a rise in consumer demand for designer clothes, expensive watches and flashy cars. Rodrigo Amaral examines the conditions that support the stellar performance of the luxury goods sector.

Economists and policy makers have been warning anyone who is willing to listen that a sustained period of austerity is imminent. But nobody remembered to tell the global luxury industry.

The austerity of the times seems to have largely bypassed a sector that relies on people being eager to spend large amounts of money on things that they do not really need. Paraphrasing Frank Sinatra, who appreciated top-quality craftsmanship, luxury groups can say that 2010 “was a very good year”.

”Sales of leading companies are higher, balance sheets are in a better shape, and profitability has probably reached the levels of 2007”

The latest set of results released by firms such as Burberry, LVMH, Rolls Royce or Richemont, indicate that not buying a signature shoe or a vintage wine is a luxury that some people cannot afford. Rolls Royce reported that it sold 2,711 cars last year, a 171% increase over 2009. Revenues were 27% up at Burberry, a British classic clothing manufacturer, in the fourth quarter of 2010. Swiss watchmakers have celebrated their performance last year as “spectacular”. At LVMH, the largest luxury group in the world, sales were 24% up in the first nine months of 2010, reaching €5.1 billion (£4.4 billion) even before the year was over. In total, sales of luxury goods were expected to have increased between 9% and 11% in the course of last year, according to Bain & Company, a research firm.

Stock prices have reflected their stellar performance. Shares of Bang & Olufsen, a Danish maker of top-quality video and music equipment, reached their highest level in 15 months when the firm reported a 16% year-on-year increase in sales in mid-January, while Polo Ralph Lauren’s shares also reached record highs in America by December. The shares of Burberry went up by 88% last year, boosting an index of European luxury stocks drafted by Bloomberg, which shot up by 60% in 2010. (article continues below)

Much of the good work reported by the luxury sector can be attributed to a natural catch-up from 2009, when, according to Bain, sales fell by 8% as the global crisis reached its nadir. But analysts contend that the sector has several competitive advantages that make it especially attractive even though the global economy is going through an upheaval. “In 2010, the strong performance of the luxury sector in the stockmarket reflects improvements in the fundamentals of the companies,” says Caroline Reyl, the manager of the Pictet Premium Brands fund. “At the end of 2010, luxury groups were in an even better shape than back in the peaks of 2007. Sales of leading companies are higher, balance sheets are in a better shape, and profitability has probably reached the levels of 2007.”

For starters, the luxury sector is profiting handsomely from the fast rates of growth being achieved by emerging markets in Asia and Latin America. Reyl notes that 40% of the sales of the industry can be attributed to consumers in places such as China, Russia and Brazil. “That is a huge share of sales,” she says. “Consumers in emerging markets have seen their spending power go up. They have been travelling more frequently. And they want to buy European luxury brands – those that have a long history behind them. It is something that does not happen with other consumer sectors.”

The emerging market business is particularly good for luxury brands because, unlike other kinds of products, they do not have to adapt much to local conditions. Producers of mass market items like tourism, cars and mobile phones have done their best to come up with low-cost articles to cater for consumers who still have less money in their pockets than their peers in the rich world.

But the wallets of people who buy luxury goods in emerging markets are as stuffed as those of their counterparts in America, Europe or Japan. “The products that are sold in emerging markets are exactly the same that luxury groups offer in the developed world,” points out Adeline Salat-Baroux, the manager of Edmond de Rothschild AM Premiumsphere fund. “Prices are also the same, and they often achieve better profitability because the infrastructure of their stores is less expensive in Asia than in the United States, for example.”

The weakening of the euro and the dollar against currencies such as the Brazilian real has also helped luxury brands to make inroads in emerging markets. Burberry reported that its sales in Asia increased by 68% last year. Richemont, the Swiss group that is particularly strong in the luxury watch market, said that sales to the Asia-Pacific region increased by 57% in 2010, being a main reason why the group’s revenues improved by a third in the same period. The industry is likely to keep riding the emerging market wave for quite a while. “This trend has a long way to go,” Reyl says. “Luxury brands have just started to penetrate markets like China.”

Bain, a management consultancy, estimates that the Asia-Pacific region, excluding Japan, already accounts for 17% of global luxury sales, after a 22% hike in 2010. If Bain’s forecasts are accurate, the region’s share of the market went up from 15% in 2009, while America’s share (30%) stagnated, and Europe’s (36%) and Japan’s (11%) fell one percentage point each. During the crisis and beyond, China’s luxury market posted a “super-performance,” according to the research firm, which says that in five years the Middle Kingdom will be the third largest market in the world, only behind America and Japan. And it is not the only high performer in the block. Bain estimates that sales in Brazil went up by 15-20% last year, with Russia, India and the Gulf states registering hikes of 5-10%.

It is no surprise, then, that the emerging world is also where investments by luxury groups are heading. Italy’s RDM Group, a large fashion retailer, has announced that it will open five luxury outlets in China, implying investments of more than $900m (£560m), according to the Xinhua news agency. Companies such as Burberry, Longchamp and Polo Ralph Lauren have recently acquired their distributors in the Chinese market, investing millions of dollars in the process. Cartier, a Swiss watchmaker, has announced its intention to add six or seven shops to the 34 it owns in China, and up to 20 others in places like Abu Dhabi. Burberry has also opened stores in Brazil and Mexico, and Prada, a venerable Italian brand, was reported to be considering a flotation, which could take place on the Hong Kong Exchange, to fund expansion in fast-growing markets such as China.

“Strong demand from emerging markets is a main driver of the performance of the luxury sector,” Salat-Baroux says. “But luxury brands are doing well in the United States and Europe too.” Luxury groups are able to take particular advantage of solid demand because they have an ability to dictate prices that few other industries can boast. “Luxury groups have a lot of pricing power,” Reyl says. “They can raise prices every year without hurting their sales. Several luxury companies have warned that they will be increasing their prices quite considerably,” she adds.

Luxury clients are unlikely to be deterred by price increases. Just the opposite effect may work sometimes, as a high price is a mark of exclusivity that can be important to wealthy customers. That is probably why companies are often far from shy to announce publicly that their prices are going up. For instance, higher prices, which should reflect the new heights reached by raw materials like gold and silver and the relative strength of the Swiss franc, were one of the main themes at a recent watch fair in Geneva. Several producers openly admitted that they will follow this route. Louis Vuitton, part of the LVMH group, has recently announced that prices would move up by 9% in the eurozone, despite the region’s stagnant economy. Such utterances must be music to shareholders. They are unlikely to hear the same things being said by firms in other consumer sectors, especially in times of a sluggish economy.

”They want to buy European luxury brands – those that have a long history behind them. It is something that does not happen with other consumer sectors”

Not many sectors can boast cases like Hermès, which manages multi-year waiting lists for some of its most sought-after handbags. Or like Louis Vuitton, which had to restrict opening times at some of its Paris shops last December, so that stocks would last out to the Christmas season, according to sources in the industry. “Demand in the luxury sector is higher than the offer of products, and that is good for companies,” Reyl says. “It helps to keep their productivity ever higher and allows them to increase their prices.”

The ability of luxury groups to be in control of what they charge their customers is one of the main reasons why results have been so positive, says Salat-Baroux. “Their growth has been driven more by price increases than by higher volumes,” she adds.

That is a useful trait too, as luxury firms can hardly afford to flood shops with products in a quest for revenue growth. “Luxury groups need to offer exclusivity, but if they are too exclusive, how can they grow and deliver dividends to shareholders?” asks Michel Phan, a luxury market expert at Essec, a French business school. “This is the tricky part.” Analysts argue, for instance, that groups like LVMH can afford to expand their production organically by something like 10%, but not much more than that, as they risk sacrificing one of their main assets. “Luxury companies need to keep control of the scarcity of their products, because if there are too many products on offer it affects their pricing power,” Salat-Baroux points out. “But most of them have a good strategy,” she says.

This is a reason why there is much expectation that mergers and acquisitions could take place. Adding brands to a portfolio looks like a winning strategy to achieve growth when putting machines to work at full throttle is not a wise move. But the recent episode involving the purchase of a stake at Hermès by LVMH shows that this is not an easy feat to accomplish. After LVMH surprisingly increased its stake in its French rival to about 20% of the capital, the family that controls Hermès acted to create an extra layer of protection to an already tight ownership structure that aims to prevent any takeover attempts.

Some small and mid-sized companies could benefit from being part of a larger group. Often the major obstacle to their development is the difficulty in reaching new markets. The behemoths can offer them worldwide distribution networks, especially in the new frontiers of growth. “A company cannot have a single strategy for different markets like China and Russia,” says Phan. “Distribution networks are different, consumer habits are different.” So enjoying some well-tested expertise could be a bonus for smaller firms. But many independent luxury makers have been owned by families for generations, and their tradition of autonomy is fiercely defended.

“There are some companies that are looked at by the large groups, although they are not for sale at the moment,” Reyl says. “Of course, everything has a price.” Investors would certainly like to hear more independent entrepreneurs sound like Richard Mille, the owner of the eponymous watch brand, who recently declared that he is open to offers for his highly regarded, although relatively young firm. “We expect that a few M&A operations will take place in the spirits sector, and also some deals involving brands are in the hands of private equity investors,” says Reyl. “It would be logical for brands which have financial difficulties to become part of larger quoted groups.”

Observers of the luxury market have stated that the most likely targets for acquisitions would probably be found among the numerous small and medium-sized Italian companies that have carved themselves strong names in the market. An executive from Salvatore Ferragamo, which produces some of the most coveted shoes in the world, has told the Brazilian media that the firm could float on the stockmarket to raise money to expand its business and avoid becoming a target for larger predators.

Multinationals would jump at any opportunity to buy emerging market brands with an established following among their domestic clients. In 1998 Richemont bought a controlling stake in Shanghai Tang, a company founded in Hong Kong four years earlier by a Chinese fashion designer. But there are few of them in the luxury sector today, as most lack the long tradition and reputation that consumers demand from luxury brands. That could lead other firms to follow the example of Hermès, which set up from scratch its own luxury brand, Shang Xia, in China.

It might be the case that opportunities can be found in activities that are associated with luxury goods, rather than producers of them. For instance, a strong name in the Chinese market is Hendgeli, a local firm that distributes 30% of the luxury watches that are sold in the country. On the other hand, some people see Chinese and other emerging market companies propping up their international operations with the good results achieved at home. Ports Design, a Chinese-based fashion brand, has started to pursue international expansion. Its designer clothes can already be bought in Harvey Nichols, in London, and in Canada.

”Their growth has been driven more by price increases than by higher volumes”

According to Phan, the emergence of new competitors is one of several factors that the established luxury industry is set to face if its wants to keep going strong. “Some brands have emerged in the past few years without any real heritage and they are challenging companies with long histories in the luxury market,” he says. “There is a change of the dynamics in the industry going on today,” he adds. “The frontier between what we call luxury and what we call non-luxury is changing and getting somewhat blurry. Traditional luxury brands are starting to make products more affordable for the masses.” For instance, Bruno Sälzer, the chief executive of Germany’s Escada, told the Wall Street Journal that he wants consumers to visit the firm’s stores “five times a week”, rather than “three times a year”. “And non-luxury market producers have been trying to break into the luxury sector by launching lines created by famous designers,” Phan points out. H&M is an example, with its lines of affordable party dresses designed by celebrity faces. An additional symptom of change in the market is the popularity of outlets that sell discount luxury articles, which, says Bain, have been “mushrooming” in Europe.

Experts also note that another issue being tackled by the sector is the adaptation to emerging technologies and the increasing use of new sales channels that defy the prevalence of the traditional stylish shop staffed by snooty assistants. Phan notes that brands like Prada and Burberry are already making good use of smartphone applications, social media, augmented reality technology and other novelties to promote and sell their products online. For some, web-based retailers like Zappo, an American online shoe store, are pointing the way for the industry to reach customers who are younger than previous groups of consumers and more keen on experimenting with alternative ways to acquire their luxury goods.

For Bain, luxury consumers are increasingly sophisticated and are likely to cherry-pick across ­categories, brands and channels. The consultancy argues in its latest study that the success of web-based and traditional retailers “is proving that engaging consumers in a bi-directional and entertaining relationship is the key to organic growth”.

“Some companies are advancing at a fast pace into the digital age, others are moving slower,” says Phan. The purchase of Net-à-Porter, an online magazine and retailer, by Richemont last year provided evidence of this trend. The fact that the price paid by the Swiss group valued the website at more than $500m indicates that the transition is unlikely to take place on the cheap.

It all could be bad news for stuffy shop assistants, but maybe not so for the sector as a whole, which in any case is set to carry on going strong in 2011. Analysts do not suggest that growth figures will be as impressive as last year, as the low comparison point will be missing. Experts highlight 2009 as the worst year on record for the industry. But Bain still maintains that the industry will achieve an average growth of 3-5% by the end of the year. Shoes, leather goods an­d jewellery were the star performers of 2010, but analysts say that good results could be achieved across the sector in 2011. The consultants note that brands are investing heavily in male consumers, who still represent only 38% of the luxury market.

Analysts say that, even after a strong 2010, the valuations of luxury companies were in line with their historical trend. A small tumble in January, as investors sold their holdings to consolidate profits, has enhanced the attractiveness of luxury stocks, in the view of some analysts. It can be argued that investing in them is a good way to keep those designer shoes and champagne magnums coming.