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Luxuriating in the face of a Chinese slowdown

Concerns over a slowdown in consumer spending in Asia are bearing down on the luxury retail sector
May 6, 2016

Fears over another global slowdown, rooted in slower Chinese growth, are hitting one sector harder than most. Luxury retailers have come to rely on customers from the Far East to fuel most of their growth, but as consumers start to tighten their belts all over again, investors' fears are mounting about companies operating in this rarefied atmosphere.

There aren't too many of these companies actually trading in London, and so most UK-based investors are likely to have minimal exposure to these stocks. Those that do trade here are also all in various states of health due to their own individual management strategies, which means navigating a slowdown in the Far East will be more difficult for some than others.

 

We recently had to call time on our buy advice on American luxury retailer Coach (US:COH) as US-based companies have been some of the hardest hit. That's because a consumer recovery in North America remains elusive. The share price performance between 2013 and 2015 was particularly disappointing, but US investment banks have recently praised the retailer's efforts to turn itself around through more effective marketing campaigns, cost cutting (specifically jobs) and reshuffling the management team. Since the start of the year the share price has started to react more positively, although how long this can be sustained against a backdrop of such economic uncertainty is unclear.

Analysts are also turning more positive on the future for Michael Kors (US:KORS) having once heavily criticised the company for expanding too fast and moving too middle-market, both in terms of pricing and product quality. During the third fiscal quarter, Michael Kors reported total revenue of $1.4bn (£956m), a rise of 6.3 per cent from $1.31bn in 2015. Revenue from retail, wholesale and licensing all rose too, and EPS rose from $1.48 during the third quarter last year to $1.59 this year. Numbers are moving in the right direction, but whether this improvement is sustainable against tightening markets remains to be seen.

What stands these two companies in better stead these days boils down to two things: they're not overly reliant on Asia for generating future sales growth; and their respective management teams are well aware of the need to remain vigilant and proactive in relation to internal issues such as quality and pricing. It's worth noting that analysis from BNP Paribas revealed that out of 25 luxury brands worldwide, Michael Kors has the least exposure to China in terms of number of stores (Coach didn't feature as part of the research).

The importance of the pricing point also applies to British company Mulberry (MUL), a point borne out by its recent spectacular fall from grace. Interestingly, macroeconomic factors associated with the 2008 credit crunch were not to blame; it's well-known that luxury consumers aren't always the ones reining in spending at times of financial unease. The company's mistake lay in hiring Bruno Guillon from French leather goods house Hermes as its new chief executive in an ill-judged move upmarket. His plan to increase the quality of Mulberry's leather products - which pushed prices skyward - only alienated Mulberry's once-loyal customer base and failed to appeal to the world's small number of elite customers for whom the brand didn't resonate as real luxury. In the two years that Guillon was in charge, Mulberry's share price fell by more than two-thirds. Since his resignation, and the hiring of Johnny Coca as the company's new creative chief towards the end of 2015, the share price has retraced by around 6 per cent - there's still someway to go.

So while self-help measures are in full force at a number of luxury retailers aiming to find their perfect target market, one of the groups with the biggest task ahead is British heritage brand Burberry (BRBY). It's in this case that the Asia growth story becomes extremely relevant. Over the past decade, perhaps longer, Asian customers have fuelled much of the sales growth for labels like Burberry. Its extensive rebranding efforts in the mid noughties registered well with Asian customers, who approved not only of the tradition associated with Burberry products, but its new and up-to-date fashion spin, largely credited to creative director Christopher Bailey. So successful were Bailey's designs, Burberry promoted him to joint creative and chief executive director in 2013 when Angela Ahrendts defected to US tech giant Apple. This proved controversial. In luxury retail creative and business decisions are usually kept separate. Mr Bailey has now assumed both roles, although speaking from personal experience, he remains conspicuously absent from the group's financial results media conferences, which are handled by finance chief Carol Fairweather.

According to a study conducted by Bain & Company, Chinese consumers account for nearly a third of global luxury spending, up from only 1 per cent in 2000. In the past decade, thanks largely to Chinese domestic demand and its legions of shoppers abroad, the luxury goods market worldwide has expanded by nearly three-quarters. It's hardly any wonder luxury retailers deliberately chased these customers via marketing campaigns, specially tailored customer service programmes, and a slew of new store openings. The same BNP Paribas study showed 13 per cent of Burberry's stores are located in China, compared with just 5 per cent of Michael Kors' stores. Some brands, such as Louis Vuitton and Gucci, are now closing stores in China, and regime leader Xi Jinping's anti-corruption policies have deterred brands from using underhanded marketing efforts involving getting high-level officials to promote products.

The problems, even at this stage, are obvious. But the solutions are not. Analysts have recommended companies focus on exclusive collections, together with the development of digital platforms and pricing, in order to remain competitive. It seems Mulberry is taking pricing in hand, and Burberry's biggest strength is its level of digital engagement. It was one of the first brands to stream its once-exclusive, invitation-only, fashion shows online and has just announced a new policy known as 'buy now, wear now' which means fashionistas will be able to purchase clothes right after the show instead of waiting the usual six months for them to appear on retail floors.

 

IC VIEW:

Internal problems associated with product quality and pricing can be worked on, but other factors such as the credit cycle and terror attacks - both of which deter tourist shoppers - are less controllable. However, aside from the stocks themselves, some analysts have observed the investment accrued from luxury products themselves. A study by online retailer Baghunter found a Hermes Birkin bag has increased in value by 500 per cent in the past 35 years, which is a faster rate than gold or the US stock market. It may seem bizarre, but verifiable luxury goods might provide a viable alternative asset class for those interested in truly diversified holdings.

 

Favourites:

Our top pick from the London-listed luxury groups is still Burberry. It's the only brand with a fairly untarnished record in terms of management mishaps, while its prevalence in the digital space is almost unrivalled. Sure, the shares don't come cheap, but the market is pricing in a significant amount of recovery potential and seems to have confidence in the board to reignite sales growth in Hong Kong in the near future. Our other - riskier - bet might be Mulberry. There's a long way to go in terms of re-establishing a loyal customer base, and the stock's free-float is pretty limited, but the share price performance since the start of the year has been encouraging.

 

Outsiders:

For now, our outsider remains shoe king and relative market newcomer Jimmy Choo (CHOO). Most of the group's future growth plans rely on further penetration in Asia - specifically Japan. But the economic and consumer outlook in the region remains foggy and, as this report has covered, customers are tightening their belts daily. Jimmy Choo's offering is also less diverse than most luxury retailers and doesn't offer other product categories outside of shoes and a small selection of handbags.