Luxury retailing: Has haute couture lost its allure?

To a financially-minded investor, this probably sounds like fluffy stuff, and to some degree it is. But it also goes to highlight some important trends in the luxury retailing sector, which partly explain why the industry has been having a difficult time over the past couple of years - and why it might now be set to bounce back.

Rewind to 2013 and things started to look drab for luxury stocks as sales growth slowed. As the graph below shows, our representative basket of luxury stocks has lagged behind the MSCI World Index and fallen roughly 12 per cent since mid 2013, and by 10 per cent over the past 12 months, driven by the world's biggest fashion houses, including Prada, Kering, LVMH and Richemont - all public, overseas-listed conglomerates home to some of the most exclusive brands in luxury retailing.

The well-documented slowdown in emerging markets, most notably, China, is mostly to blame for this, given that the expanding middle classes in these regions have largely supported growth in the luxury sector: the emerging economies of Asia Pacific, Latin America, the Middle East and Africa accounted for 9 per cent of the luxury market in 2008. This figure leapt to 19 per cent in 2013, according to Deloitte. China is the fifth-largest luxury goods market in the world. Here, the government is cracking down on lavish gift-giving in a bid to appear to be cleaning up corruption among the political elite - they're the ones with all the money. Civil unrest in Hong Kong last year has also affected sales as it's a travel destination for wealthy Chinese shoppers.

Elsewhere, Russian oligarchs are known for their love of the most expensive brands and are still fabulously wealthy. But the imploding economy in the former USSR and its mercurial leader, Vladimir Putin, is terrible for sentiment. The rouble's devaluation will have certainly hurt spending, too.

Italian luxury goods maker Prada has been particularly hard hit by emerging market malaise: it reported a disappointing set of results in the year to January 2015. Sales fell for the first time since the financial crisis and were down 5 per cent in Asia. Prada said it would conduct a "major overhaul" of some of its production processes and would look to cut costs. UK-listed Burberry (BRBY) has also felt the pain: Asia Pacific is its largest revenue earner by region and growth there has fallen to the low single digits.

GLOBAL LUXURY GOODS V MSCI INDEX CHART

Fast fashion

But there are other factors at play, too. Luxury goods companies have been slow to adapt to online shopping, in the mistaken belief that cyberspace can't replace their flashy boutiques. Prada, for instance, has been investing heavily in bricks and mortar in an effort to drive sales growth. With demand slowing, margins are suffering and store openings are being scaled back. The internet has also made luxury more transparent and offered greater choice. Consumers can now compare prices around the world and from various third-party distributors. Fashion trends are also much shorter. They emerge as quickly as they disappear. And, in an increasingly connected world, where originality is hard to come by, wealthy fashionistas have grown tired of big names. Louis Vuitton, Hermes, Prada and Gucci have become too 'ordinary' for some big spenders. They want cooler, more exclusive products to differentiate themselves. Far worse, Chinese consumers, once desperate to be seen with any high-class western label, are becoming increasingly more discerning. The challenge for the big fashion houses is to up their game - and, to give them credit, many are now doing so.

Some designers have teamed up with the high street in a bid to appeal to a wider range of consumers: Karl Lagerfeld at H&M and Missoni at Target are two examples. This has been great for mainstream stores, but it has devalued the luxury brands. Moreover, Zara, owned by Spain-listed Inditex, is famous for getting catwalk fashion into its stores within weeks. You might not believe it, but this has had an impact on the high-end labels, says Deloitte: a luxury shopper can trade down sometimes to buy a Roberto Cavalli-inspired dress at Zara for $89 rather than the original for $2,100 and still have change for a Prada bag and Christian Louboutin shoes.

Price tags

Pricing is another issue. The recent fall in the euro has prompted many big names, the latest of which is Chanel, to slash prices in Asia in a bid to combat a grey market in luxury goods. Luxury brands sold in China are given a huge mark-up. The euro's weakness against the renminbi has widened this price differential, giving rise to middle men who flog 'European priced' luxury goods. The internet has facilitated this by making it harder for brands to hide price variations from Chinese consumers. Now, many fashion houses are standardising prices across the board.

The silk lining

Despite all these challenges, there is good reason to be upbeat on luxury. Since the start of the year, luxury stocks have picked up and forecasts suggest growth should rebound this year (see the table below). LVMH, for example, anticipates "very good" results in 2015, saying it will be a "very different year" for the fashion house.

Indeed, the big players are upping their game, by streamlining operations, improving pricing architecture and making their products more appealing and more niche for shoppers wanting to stand out from the pack. In the UK, that includes Burberry (BRBY) and Mulberry (MUL), both of which have reported reasonably upbeat trading since the start of the year. Mulberry in particular looks as though it might be turning a corner, following a string of profit warnings and a management shake-up. Meanwhile, social unrest in Hong Kong is settling down, while more competitive pricing and a weaker euro are boosting purchasing power, namely for the rich Chinese.

Long-term, macroeconomic trends also work in luxury's favour. As emerging economies grow richer, its citizens will naturally clamour to purchase products in line with their new social status. Emerging economies are projected to account for one-quarter of luxury goods consumption by 2025, driven by urbanisation and economic development. By 2018, China is expected to be the second largest market for luxury goods, after the US. Meanwhile, the improving economic situation in the US and the UK, and to some extend Europe, is boosting sales at home. Aspirational brands, such as Michael Kors (NY: KORS) and Ted Baker (TED) are benefiting from an uptick in consumer confidence as they offer affordable, yet distinctive, accessories and garments for affluent middle classes. Both have developed great online shopping tools.

Finally, there's real potential for M&A. "The appetite for European and American brands in emerging economies is strong and growing. Emerging market buyers and investment groups are seeking to acquire Western brands," says Deloitte. And, with a tight control of their supply chains - from the raw materials to the boutiques - the big players need to acquire in order to both grow and to leverage their operational base. Did you know Stella McCartney is part of Kering, Miu Miu is in the Prada family, while LVMH is home to Fendi? They'll want to continue to snap up such smaller, more exclusive brands to diversify their exposure. And they certainly have the cash to do so (see the table below). Analysts at Liberum Capital recently put out a note pinpointing Jimmy Choo (CHOO) as a potential acquisition target, as growth in luxury accessories and shoes is double that of the wider sector.

Favourites:

Ted Baker is well-managed, with a cautious approach to expansion, great products and is under-represented overseas. Meanwhile, Jimmy Choo makes for an interesting M&A play while Burberry (BRBY) looks to have weathered the emerging market storm reasonably well. It's also cash-rich, with a rating below the sector average and its brands have strong appeal. The company has been fast to adapt to online retailing and has previously been rumoured to be an acquisition target.

Outsiders:

Mulberry has a new creative director and chief executive. Initiatives to lower prices to win back alienated shoppers looks as though it might be working. But there's a lot of heavy lifting ahead and the brand is not out of the woods - yet.