Luxury brands limp towards recovery

Recent news of a profit slump, management shake-up and possible job cuts at Johann Rupert’s luxury goods group Richemont sent ripples of fear and anxiety through investors in the historically defensive luxury sector. 

The sector has felt pressure since the 2008 global financial crisis, but there have, more recently, been new challenges which have thrown it into a new era of cutbacks and consolidation. 

Instead of the external environment improving, as was hoped, it has continued to deteriorate and Richemont, which is one of the luxury goods groups that is most exposed to watchmaking, has been among the most affected, says Fairtree Capital’s Jean Pierre Verster. 

“The first issue to affect luxury goods groups over the last decade was the post-2008 economic environment, the second was the clampdown on gift-giving in China since 2012 [by government, as part of its anti-corruption campaign], and the third has been a generational or technological issue – the advent of the smartwatch, which has been a disruptor in the industry.”

Luxury watches have always had an additional use apart from their timekeeping utility – they represented value, signifying the status of their wearer. To get some idea, Richemont’s Piaget Altiplano costs more than $91 000 and its Vacheron Constantin $150 000.

But the smartwatch now has functionality that a luxury watch has not been able to add, forcing the hand of companies like Richemont. “This is a structural industry issue, which luxury watchmakers have had to grapple with, and they are now cutting back on production, retrenching and cost-cutting, so really it is a torrid time, especially for Richemont, which derives 40% of revenue from watches,” says Verster.

Richemont’s results were a shocker. Sales fell 13% to €5bn, operating profit dropped 43% to €798m and profit slumped 51%. The group had to make some radical adjustments including buying back slow-moving stock from retailers and “optimising” (closing) some stores, reflected in one-time charges of €249m. 

Chairman Rupert announced a big management shake-up, which included getting rid of the CEO position. The group is also looking at hiring freezes, early and voluntary retirement and retrenchments. 

It is not just watches. Across the sector there have been reminders of the challenges ahead. Hermès, which makes Birkin handbags, scrapped its 8% sales target and the UK-based Burberry, which is fighting off a takeover bid by US rival Coach, saw its half-year profits slump 34%. Swiss watchmaker Breitling is reportedly for sale.

Trouble in China

After a period in which luxury goods companies clamoured to open stores everywhere they could in China, they are now closing some down. 

Investment Week said luxury goods companies “have to rethink strategies as the implosion of the gift-giving bubble, the store openings euphoria, and shifting consumption patterns have led to an increasingly competitive landscape”.

But, it said, their balance sheets are strong and China remains a growing market. China accounted for 30% of luxury goods purchases, according to Bain & Co. Although this is down, recently, from 31%, Chinese purchases were only 1% in 2001.

Bain expects the market to grow between 2% and 3% a year between now and 2020, and Bloomberg points out that the sector will, for the first time, not grow above GDP.  

Cobus Cilliers, investment analyst at 36ONE Asset Management, says the effect of anti-extravagance measures in China “was very pronounced for the Swiss watch industry, as well as high-end cognac and scotch industries in China. These clients are not buying luxury goods for gifting purposes anymore, but now only for personal consumption. Terror attacks in France and Germany have also led to lower tourism numbers, which affected luxury sales.

“The supply channel is also overstocked, hence Richemont’s buying back inventory from some suppliers. Swatch has not done the same, which is a little concerning.”

Richemont’s reaction to its poor results is significant, says Verster. “It is trying to respond quicker to changes in the market and trying to be closer to the market, to try find out what the customer wants and what offerings it should be making to the customer. It has, for example, talked about the development of a smart strap.”

He says Richemont is buying stock that is not moving instead of seeing it discounted by retailers. “This is an extreme reaction. It wants to control the route to market to maintain the exclusivity and rarity of its products.”

Cilliers adds that time will tell if these changes will be positive or negative, but “we believe it will be positive in the long run. We are optimistic that Mr Rupert will be guiding the company out of the difficult times it is facing today. This will take time and he takes a very long-term view on these matters, which is good for the company longer term.”

Market disruptions

Luxury goods groups need to align their businesses with changes in their markets. 

While technological disruption has caused a trend from luxury to smartwatches, other trends are less clear. However, says Verster, there has been a decrease in the appetite for conspicuous consumption and a crackdown on bribery and gifting as well as on tax havens, so many people no longer want to stand out or flaunt their wealth as it will attract attention, leading, for example, to tax audits or other crackdowns.

By opening a large number of stores, especially in China, luxury goods groups saw their products lose some of their status as premium products.

“They always run the risk that if they grow too quickly and their products are available too widely, they are not seen as that exclusive anymore. This has happened in luxury luggage where discounting and availability can make them mass affluent products rather than luxury products. Michael Kors and Coach are such examples. Luxury goods groups have opened lots of stores in China and are now starting to close some,” says Verster.

Cilliers says the Chinese are buying more locally, whereas before they used to purchase luxury goods while travelling. “We are seeing more local buying and in mainland China, Macau and Hong Kong luxury sales coming back.

“There also seem to be pockets of growth for some companies,” he says. “Gucci (Kering) is doing very well, while TAG Heuer (LVMH) is also doing well despite the slowdown in the Swiss watch sales numbers.”

Outlook

Despite the challenges, there is hope for the luxury goods sector. 

First, it has not been all bad. LVMH, the world’s largest luxury goods group, said revenue in the third quarter, which had improved since earlier this year, was up 6%. Second, LVMH said in its results that demand from China, which was flat in the first half, has picked up considerably.

And with luxury goods groups sitting with strong balance sheets, they are likely to weather the storm, but not without some pain.

Bain, in its most recent luxury market research, says this sector has reached a maturation point. “Brands can no longer rely on low-hanging fruit. Instead, they really need to implement differentiating strategies to succeed going forward.”

Verster expects some merger and acquisition activity as the sector consolidates. “The market is not going to die but it is changing and the addressable market is smaller, so they need to rightsize their cost base, which is exactly what they are doing by retrenching and cutting back production and closing some facilities. This is not easy because companies naturally focus on growth. But these are the right steps to follow for now.

“Rupert is a strong leader and has street smarts, and he sees the writing on the wall and is driving the process of shrinking. The silver lining is that they have lots of cash on the balance sheet, which allows them options,” according to Verster.

Cilliers says they are a bit cautious about the current price of Richemont. The share, trading at around R90, has lost 16% this year but is on a forward price-to-earnings ratio of 27. 

“But the dividend is still attractive, the balance sheet is rock solid, but if you look at the share price it looks like it is pricing in a little too much. With the most recent Swiss watch export number update for the month of October (down over 16%), we are still a little concerned that the recovery that everyone might be pricing into the share is not there yet,” he says. 

This article originally appeared in the 15 December edition of finweek. Buy and download the magazine here.