This month marks a watershed moment for luxury London-listed retailer Burberry (BRBY). The group’s creative visionary and boss Christopher Bailey is changing his role, and handing over the chief executive duties to Marco Gobbetti who joins the group from French house Céline. Mr Gobbetti is hoping to return Burberry to its former glory. For the past three years, Mr Bailey’s creative direction and reputation for digital innovation has been clouded by a seemingly poorer operational performance.
Thankfully, Mr Gobbetti’s reputation precedes him. At Céline, his role was specifically business orientated, while the creative flair was left to design chief Phoebe Philo. Between them, the two created one of the most prized jewels in owner LVMH’s portfolio of companies.
Time to buy
Mr Gobbetti’s arrival is well timed from a markets perspective too. Luxury retail stocks – the likes of Mulberry (MUL) and LVMH (Fr: MC) included – are trading on toppy multiples, demanding potential investors dig deep in their pockets to capitalise on high level of overseas earnings and an apparent insulation from the mainstream consumer economy.
This has been even more evident in the growing level of M&A at this end of the retail sector in recent months. It seems several companies are willing to pay out on high valuations for the underlying growth on offer at these groups. That, or as analysts at HSBC believe, the acquirers believe they can do a better job with the company than the current management team. Either way, it’s little surprising that this is where investment appetite lies considering the current health of mainstream retail, not to mention the state of the British high street. Companies such as DFS (DFS), Debenhams (DEB) and even one time stock market darling JD Sports (JD.) have fallen foul of squeezed margins this year as currency issues, the living wage and a change in business rates take a cumulative toll on cost bases.
It seems M&A activity is crossing borders, too. It’s believed trench coat maker Burberry spurned "multiple" takeover offers from US brand Coach (US:COH) at the end of last year, and now Coach has agreed a $2.4bn (£1.85bn) takeover of New York accessories brand Kate Spade. Luxury conglomerate LVMH also confirmed back in April it wanted to buy the remaining stake it didn't already own in Parisian couture house Christian Dior for £10bn, or €230 (£178) a share.
Shoe king Jimmy Choo (CHOO) is also up for sale. The brand - made famous by the hit TV show Sex and the City - was put on the market by its major shareholder, German investment group JAB Holdings, in April. JAB floated a quarter of Jimmy Choo at the end of 2014, and said a potential sale would be the best way to maximise value for shareholders. The decision comes as JAB transitions away from luxury goods and towards the coffee market, having bought coffee machine maker Keurig Green Mountain in 2015 for $14bn. JAB first bought Jimmy Choo for £500m in 2011, and the retailer's current market cap now stands at £799m. That’s going to require a hefty premium from any potential suitor, although analysts at HSBC argue that the incentive to sell is likely rooted in strategic challenges. From their point of view – and one we have shared in the past – Jimmy Choo has disappointed the market on both sales and profitability, particularly given its more nimble size relative to its London-listed peers and its ability to open more stores.
Getting active
There’s a third reason analysts at HSBC are interested in the luxury goods sector right now. Analysts have noted a pick-up in investor activism, calling for companies to perform better. Targets include US brand Hugo Boss and jewellery icon Tiffany. In February Jana Partners, which is run by well-known activist investor Barry Rosenstein, took a 5.1 per cent stake in Tiffany and placed three new independent directors on the board. Issues there include the product development pipeline, a potential redesign of the company’s retail stores and creating more “buzz” and “hype” around the brand to spark demand. Even at Burberry, Mr Gobbetti will have to learn to listen to Belgian investor, billionaire and LVMH board member Albert Frere who owns a 3 per cent stake in the business.
The one to beat
Priced above its high-end peers LVMH seems to be the company to beat. We advised buying the shares late last year (1,620¢, 17 Nov 2016), and since then the share price has risen by more than a third to 2,179¢. It owns positions in more than 70 brands and has €1.4bn (£1.23bn) in net cash – enough to make it market leader in many analysts’ view. It also has a solid track record for acquisitive growth, and sector specialists believe this means more M&A is likely this year. Possible areas of scale include skincare and make up. The group already has decent exposure to the lower-margin fragrance market but, as evidenced by cosmetics giant Estee Lauder, there’s plenty of growth on offer in these alternative areas of the beauty market. There’s also ‘hard luxury’ – specifically watches – where LVMH is currently out-performed by specialists like Swatch and Rolex. It could consider a bid for Tiffany, although HSBC believes the group might be reluctant to make a move given the group’s existing ownership of jeweller Bulgari and possible trepidation over piling into US assets given a number of retail struggles in that geography of late. Of course, the group could also consider a lateral move out of traditional luxury. Recent reports on the all-important Chinese consumer suggest that demographic hankers for more bespoke products, including travel opportunities, wine, art and health and wellness products.
IC VIEW:
In our view, there are plenty of reasons to find the luxury retail sector an attractive investment opportunity. True, valuations are high, but there’s a reason for this. The growth on offer is largely rooted in improved like-for-like sales metrics now that many of the larger companies have curtailed their physical store expansion. That’s a lot more than many traditional high street retailers can come up with at the moment. With consumer spending in the UK contracting at the steepest rate for four years during the second quarter of 2017, it’s no surprise that investors are tempted by extremes in retail. Luxury goods are insulated from the general squeeze given the nature of their clientele – high net worth and internationally spread. It’s worth pointing out here as well that as valuations rise, it ultimately becomes a seller's market, so holding some of these stocks for profit might not be a bad idea.
Favourites
It should come as little surprise that our clear favourite is conglomerate LVMH. The group is so diverse it needn’t rely on one product category or brand to see it through tough times. At the last set of results, the group reported 10 per cent sales growth across wine and spirits, fashion and leather goods, which helped buck up annual net profits by 11 per cent. For all its challenges, we’re still bullish on Burberry too. A management change has been a long time due, and we have faith in Mr Gobbetti’s track record. Much will depend on him striking up the same fortuitous relationship with Mr Bailey seen with former Burberry chief executive Angela Ahrendts, but there’s no reason to think this isn’t possible at present.
Outsiders
The biggest thorn in most luxury retailers' side at the moment is the US consumer economy. This has been particularly evident at Burberry, where wholesale business in that market has hit a stumbling block. Wholesale clients appear keen to discount items, suggesting retail appetite for luxury items is fading. But this could also be an issue tackled – or manifested – by companies directly. Burberry’s resistance to having stock on promotion has led wholesale clients to rein in orders, but Jimmy Choo, for example, has been working hard to prioritise retail sales over wholesale for some time. That’s worked to some extent but, a potential takeover aside, we still see Jimmy Choo’s position as precarious. The group is predominantly reliant on one product category, and growth in Asia remains a tricky task. Like many luxury retailers, figures are being flattered by the weak pound, both in translational terms but also in encouraging an influx of tourists to shop in the British capital.
The broker’s view:
A dear hunt
After growing for many years, luxury hit a speed bump in the second half of 2015. This led many companies to rethink their business models and resulted in a significant amount of management change. Indeed, this is one of the five key supportive themes we identified for 2017, along with the rebound in Chinese demand, the American post-election surge, digital, and corporate governance.
Recently, we’ve seen a return of investor activism in the sector and fresh talk of acquisitions. This is a logical progression: if management change doesn’t come from a company’s own initiative when a brand is struggling, it only seems natural for investors to push for change by other means. Or, if the asset is high quality, why not purchase it if it is available and you have the means to do so?
As we said in January, “luxury ain’t cheap”. But there’s a reason why: momentum has picked up somewhat since the third quarter of 2016, and we argue that this should continue this year. With theoretically high PE valuations, we make the case that the consensus metric is still likely too low. Management shake-ups through accepted change or activism is making market participants excited. And if M&A starts again given high valuations, it’s a sellers’ market and there is a lot of cash available, a combination likely to continue to support valuations.
Two words of caution, though. First, the recovery seen during the second half of 2016 remains fragile. The recent improvement in the 'feel good' factor of luxury consumers could prove short-lived in the case of renewed threats to travel, and/or unexpected political outcomes such as Brexit in the UK. Second, luxury stocks have moved: the European luxury sector was up 24 per cent on average in the second half of 2016 and up 14 per cent year-to-date in 2017. A rerating of consumer staples versus luxury stocks is also a risk for 2017, especially if staples also benefit from M&A action.
Erwan Rambourg and Antoine Belge are analysts at HSBC
