Few bargains in luxury goods

While the continent is home to most of the best known luxury brands – including Christian Dior, Hermes and LVMH Moet Hennessy Louis Vuitton (LVMH) - it's the UK brands that have really shone this year. As well as taking the catwalks by storm, Burberry and leather goods manufacturer Mulberry have both seen their share prices rocket as foreign buyers developed a taste for Brit-couture.

The demographics of luxury demand

Stratospheric share prices reflect the attractiveness of the demographic developments driving demand. According to latest World Wealth Report from consultancy Cap Gemini, the number of high-net-worth individuals climbed by 17.1 per cent in 2009 to reach 10m, with an aggregate wealth of $39trln, 19 per cent higher than a year earlier. The fastest rate of growth in wealth came in Asia Pacific, which climbed 31 per cent in 2009, led by Hong Kong, India and, of course, China.

That means that, according to retail research specialist Verdict, the luxury goods market in Asia Pacific should double in size by 2015, with demand rising so fast that brand owners are opening stores in second-tier cities in China such as Xi'an and Chengdu. According to McKinsey, Chinese luxury sales are expected to double by 2015 as its government promotes domestic consumption, which would make it the world's largest luxury market.

Chinese shoppers are also highly active around the world - Harrods, for one, recently revealed that sales to Chinese customers virtually doubled last year, with visitors from the Middle Kingdom spending an average of £2,500 each visit on brands such as Louis Vuitton and Chanel. Visit Britain expects the number of Chinese visitors to the UK to rise by 89 per cent between 2008 and 2014.

Japan puts valuations under pressure

While the emerging affluent are important, the bulk of high-net-worth individuals (HNWI) are still found in more mature markets, in particular the US and Japan, which between them account for 45 per cent of HNWI’s worldwide, with 2.9m and 1.7m respectively.

Although, as analyst John Guy of RBS points out, Japanese consumers' share of global luxury goods market has fallen from as much as 50 per cent over the last decade, it's still a major demand driver accounting for 20-25 per cent. Because of this, the recent tragic tsunami in Japan has had a particularly damaging impact on share prices across the sector. "Periods of mourning and a broken infrastructure are not conducive to luxury goods spending or an increased appetite to travel", says Mr Guy.

Burberry, which generates 6 per cent of its sales in the country, saw its shares fall nearly 10 per cent in the wake of the disaster, but it’s by no means the most exposed. Around a fifth of Bulgari and Hermes’ revenues come from the country, while Richemont and LVMH make 12 and 10 per cent of sales there respectively. Burberry’s profit exposure is higher because a large chunk of its profits from the region come via a high-margin licensing deal. The company has the right to impose a €50m penalty on its Japanese partners if they miss targets, but that’s a course of action it’s unlikely to take given the circumstances.

Further support from M&A

In some respects, the sell off may be less about the Japanese tragedy itself rather than the reminder that, after a year and a half of exuberance, now might be a good time to take profits in the high-flying luxury goods sector. Even though the demographics driving the market point to further growth, share prices in the sector already fully reflect the rapid growth expected from important markets like China and Korea. "We would expect earnings to grow rapidly but that’s built into those valuations already," says Mark Watts, managing partner at buy-and-build specialist Marwyn, which recently announced the formation a new vehicle to snap up privately-owned and undervalued brands in the space.

The prospect of further merger activity, which has supported rising valuations over the past year, may also be diminishing. Although LVMH was able to buy out the controlling stake in upscale jeweller Bulgari, there are worries that the price it has paid - more than three times sales and 20 times cash profits - means there's not much more value that can be extracted.

"In a multi-channel and increasingly homogenous world, we think it is much easier and quicker to build strong brands", says analyst Simon Irwin at broker Liberum, pointing to the recent and rapid success of Mulberry and Burberry, both of which have been subject to takeover speculation. However, he notes that recent M&A valuations suggest PPR, which already owns a strong portfolio of luxury brands including Gucci and Alexander McQueen, is significantly undervalued.

Luxury valuations too aspirational for us

Source: Datastream