China’s economic slowdown and anti-corruption crackdown on gift-giving is hitting some areas of the luxury export market – French wine and spirits, Swiss watches, British cigarettes. However, at least one high-end segment may be holding its value – handbags and luggage. We look at two key competitors who are carrying a lot of baggage.
View our corresponding infographic to find out more on this topic.
LVMH Moët Hennessy Louis Vuitton (LVMH.PA) and Hermès International SCA (HRMS.PA) make the bulk of their money from leather goods and bags. In early September, they called a truce in their share-ownership wars, as reported in this Reuters story, but they are still fierce competitors in the retail markets.
Geographically, 33% of Hermès’ revenue is generated in Asia, and bags and luggage continue to be their strongest driver (exhibit 1). As other retailers pull back in China, Hermès is continuing to open stores, with the premiere of an extravagant four-story outlet in Shanghai, followed by two more planned in Beijing and Chengdu this year.
Exhibit 1: Hermès Business Segments
Source: Eikon
LVMH courts Chinese customers
Similarly, 30% of LVMH’s revenue comes from Asia (excluding Japan). The high-end Chinese consumer is known to travel abroad to flagship stores for a bigger selection of goods than in the mainland. Fendi, a division of LVMH, recently opened a pavilion in Paris with a Chinese look and feel.
LVMH and Hermès’ bags are also sold at luxury department stores and on e-commerce sites. It’s important to note that these premium bags are almost always sold at full price – no discounting. We discovered this in a collaboration with StyleSage Co., which analyzes retailers, brands and products across the globe.
Richly Valued
As an equity investment, Hermès looks as expensive as its Birkin bag. Our StarMine Intrinsic Valuation (IV) model accounts for the systematic biases that our quantitative research team found in sell-side estimates. Thus, the faster the expected growth rate, the more optimism bias. And more-distant estimates are more optimistically biased than nearer ones.
For Hermès, after adjusting LTG estimates for optimism bias, the StarMine IV model places fair value at €148 per share. In contrast, the market price is €243 per share. Plugging in today’s price and solving for growth suggests that investors are optimistic. Hermès market expectations are high with an implied 10-yr CAGR of 13.5%.
Exhibit 2: Hermès Intrinsic Valuation
Source: StarMine
Return on equity
Digging deeper into the data, we look at ROE, a measure of how well retailers use capital to generate profits. Industry-wide, ROE is a robust 21.2%. The analysts’ mean forecast is that Hermès is expected to generate 27.9% return on equity this year, while a highly rated StarMine analyst with a very accurate rating suggests a figure closer to 28.3%. That’s considerably stronger than LVMH, where the ROE estimate is 12.6%, below the industry mean. Hermès strong ROE means they are well positioned for long-term growth.
Exhibit 3: Hermès ROE
Source: Eikon
Analysts like Hermès
Hermès appears to be leading the luxury market from a position of relative strength. Its StarMine ratings look robust, with a score of 83 on the StarMine Analyst Revisions Model (ARM), indicating that there is a modest chance that analysts will boost their earnings estimates. However, LVMH sports a score of 15, a sign that analysts may become bearish and lower earnings estimates.
Exhibit 4: Hermès StarMine Analyst Revisions Model Score
Source: StarMine/ Eikon
No discounting
Selling at full price means that profit margins are less likely to be hit. As a result, we look at LVMH and Hermès’ gross margin, operating margin and net margin. On trailing half-year margins, Hermès’ gross margins have remained somewhat stable over the past three years. Currently, it is 69.5%, matching the industry average, while LVMH has been slightly above the industry average over the past year.
However, when looking at net margin performance, Hermès has been significantly above the industry average, while LVMH has been on par or slightly below the industry. A solid gross margin will usually lead to efficiency in net margin. For Hermès, this means the ability to pass on high-quality leather material and labor costs to its elite shoppers.
Exhibit 5: Gross Margin, Net Margin for Hermès and LVMH
Source: StarMine
Operating efficiency
Operating margin indicates how efficiently management is generating results on its assets. Hermès Return on Net Operating Assets (RNOA) is the highest in five years at 65.3% and substantially higher than the 30.6% RNOA mean for other luxury retailers within the industry.
Exhibit 6: Hermès Return On Net Operating Assets
Source: StarMine
Cash flow picture
Hermès’ operating cash flows are the strongest in five years. From the graph below, it is evident that the company performs the strongest during the holiday season. For the most part, Hermès continues to report stronger cash flows from operations. This is reflected in net income, also the highest in five years.
Exhibit 7: Hermès Cash Flow from Operations vs. Net Income
Source: StarMine
Good quality earnings
Moreover, Hermès scores an 83 out of a possible 100 on the StarMine Earnings Quality Model. This suggests that its profits remain of high quality, meaning they are more likely to be sustained in the coming quarters. This is evident when looking at the graph below, which suggests that its earnings are backed by strong cash flows, and are more sustainable going forward. LVMH sports a lower score of 38, a sign that its profits may not be coming from sustainable sources.
Exhibit 8: Hermès StarMine Earnings Quality Model Score
Source: StarMine
Here’s why
Although LVMH’s operating profit margin has remained steady for the most part, it fell in the last reporting cycle. LVMH operating profit margin is now 18.4%, the lowest showing in six years, and slightly above the industry average of 17.1%.
Exhibit 9: LVMH and Hermès Operating Profit Margin
Source: StarMine
Cash flow issues at LVMH
LVMH has also seen weak cash flow. Despite posting positive net income in the past reporting cycle, cash flow was weaker. This translates into poor earnings quality and while it still has the biggest market share in the industry, it is definitely facing more competition from the likes of luxury conglomerate Kering. The difference is that Hermès isn’t feeling the pinch as much, due to its strong brand and pricing power which are boosting its margins and earnings quality. This suggests that its iconic Birkin bag might be bulletproof after all.
Exhibit 10: Hermès Free Cash Flow vs. Net Income
Source: StarMine
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