At GAM Investments’ latest active thinking forum, Swetha Ramachandran reflects on the strong pricing power of luxury brands, as well as the longer-term trends supporting the sector.
Luxury stocks experienced a downturn in the first half of the year, which we believe was a function of the macro environment; Firstly, we saw the rotation from growth to value at the start of the year. Since then, luxury stocks have been driven down by the trajectory of interest rate hikes. Now, in our view, the worst is behind us as luxury brands continue to meet, and even beat, earnings expectations. In many cases, we think a return to fundamentals will be rewarded in the next six to nine months. If we look at the long term, the growth of many luxury companies is benefiting from a lower cost of capital generated by virtue of their higher than proportionate exposure to emerging markets, given that Asia on average accounts for about a third of the sector’s revenues overall.
Sector profitability is continuing to rise
Many luxury companies made hay during the pandemic and have continued to do so as they benefit from higher-than-normal pricing power which allows them to pass through price increases well ahead of inflation. We see this as margins continue to expand. This is highly unusual in the current macro backdrop where companies are impacted by higher labour costs and higher energy costs. This sector is in a sweet spot where, because of its high gross margins, those cost pressures are much less of an issue and the companies’ ability to pass through pricing as a result of the appeal of their brands is quite high. It is important to differentiate between companies with pricing power and those without. Price increases so far have not been met with volume declines. Indeed, there has been very little resistance from consumers. Over the last 18 months, we saw brands increase prices at the height of the pandemic. This had an almost contrary impact where prices increases led consumers to purchase due to the expectation is that pricing will always be higher in the future because the stronger brands do not tend to indulge in promotional activity or discounting. We can measure pricing power quantitatively through gross margins. The sector on average earns between 70 and 80% gross margins, while the average for the MSCI World Index is close to about 50%, including the tech heavyweights.
We are seeing margins and profitability go up, but valuations going down. The sector now trades at a meaningful 20 to 30% discount to five or 10-year averages. We are seeing companies in the sector upgrading their earnings. A reason for this is the benefit of a weaker euro, given that many of these companies are euro listed but generate earnings in currencies such as the US dollar and the Chinese renminbi and about 80% of earnings are non-euro denominated.
Furthermore, the sector is seeing its profile improve structurally as a result of the cost cutting measures taken during the pandemic, meaning that margins are now increasing and free cash flow is substantially higher than it was two years ago, which has meant that the sector is actually net cash positive today versus 2019. That gives a lot of balance sheet optionality and the net cash positions also insulate the sector from the worst of interest rate rises.
One of the long-term trends for the sector is the expanding middle class, with five people joining the middle class every second. 80% of the next billion additions to the middle class are expected to come from China and India. The spending power of the global middle classes provides the long-term underpinning for the luxury sector, which has grown in revenue terms by about 6% per annum over the last 25 years. This growth is well ahead of global GDP and particularly eurozone GDP. This revenue growth has also driven quite attractive shareholder returns, which are well ahead of global returns overall over the same period. However, other driving factors of revenue growth include demographic shifts, where millennials and Gen Z consumers are expected to drive about 70% of sector demand by 2030. Younger generations are especially relevant to luxury growth at this point in time, particularly in the US market. The younger generation of consumers is also driving sustainability within the sector. In a lot of other sectors, sustainability is a top-down trend. However, within the luxury sector, sustainability is being led by consumers.
There has been a lot of concern about the US consumer. To many people’s disbelief, the US luxury market continues to go from strength to strength. We see this in Q3 results, such as Moncler which noted that the American cluster accelerated for the brand which is remarkable given the current backdrop. This includes sales to Americans abroad, primarily in Europe, because clearly both the weak euro, as well as the first proper summer of travel in the last two years has resulted in an increase in Americans shopping and travelling in Europe.
Excess savings, which is the stock of savings US households built up over the pandemic, are coming down because inflationary pressures are mounting and people are spending more to maintain their living standards. However, excess savings are still healthy. Excess savings peaked at about USD 2.2 trillion last spring as the last stimulus checks hit US households. They have now come down to about USD 1.7 to USD 1.8 trillion, which is still well in excess of savings before the US went into the pandemic. It is important to note that there is a distributional effect where higher income households, who are predominantly target luxury consumers, benefit disproportionately from the stock of excess savings than the lower income households. Households earning over USD 100,000 have been drawing down on their savings over the last three months but at the pace at which they have been spending their savings, it would take higher income households about a year and a half to even three years to exhaust excess savings. As a result, US consumers remain resilient and we have not yet seen a slowdown in spending. As referenced, we have seen the US consumer spending more outside of the US, primarily in Europe. This is not negative for the sector as the European store base will benefit in terms of operating leverage given it has the highest fixed cost base of any of the regions for the sector.
China is the second most important market for the luxury sector today but we expect it will resume its status as the most important driver for the sector within the next five years. At the recent Party Congress, the market was looking for signs that the government might indicate policies on wealth and higher earners, such as the common prosperity policy imposed last year. This policy caused a knee jerk reaction towards the luxury sector, which had been quite negatively impacted by the anti-corruption campaign of 2012 and 2013. Our view is that common prosperity is very different from the anti-corruption crackdown. Common prosperity is all about expanding the size of the pie. The government is quite clear they want to expand the size of the middle class from 400 million people to 800 million people by the end of the current decade. This is not necessarily going to come from redistribution but overall growth and development. We saw no noise from the party congress or any officials speaking negatively on the luxury sector. We do not anticipate any new surprises targeting luxury because the pandemic essentially repatriated Chinese consumption back home. Pre-pandemic, over half of the spending on luxury by Chinese nationals was taking place outside of the mainland, which meant the government was losing out on tax receipts, on employment and on retail infrastructure. Now in the last two years, with the virtual absence of overseas Chinese tourism, that spend returned home, which started to benefit the Chinese government in terms of the duties paid domestically by various companies. As a result, we do not think that the government has any interest right now in killing the goose that laid the golden egg. As long as China can maintain a policy where, alongside the return of overseas tourism, the domestic retail infrastructure can also continue to benefit, these companies will be important tax contributors to the exchequer overall.
While American and Chinese consumers are the biggest drivers of sector revenues, we are increasingly noticing that companies are mentioning markets outside of these two core markets in terms of the runway for sector growth. Clearly the Middle Eastern consumer, although only about 4 - 5 % of the global total has benefited strongly recently. We are also seeing companies increasingly refer to markets in Southeast Asia, such as Indonesia with more than 300 million people or Vietnam with a population of 100 million and a growing middle class. The growth of the middle class and mass affluent is continuing in many markets outside of China and the US.
We are also seeing a shift in spending away from goods to services. During the pandemic, consumers were deprived of services such as travel, leisure, entertainment. The shift of spending to goods increased to a record high. Before the pandemic the balance of spending between services and goods was about 70 to 30. During the pandemic, it shifted to about 60 to 38. We are now seeing a gradual reversal back to experiences and services as people are starting to go out, travel more and eat out more. We are seeing services inflation as there is a lot of pent-up demand for travel as people have not been able to avail of for the last two years and as a result, in some cases people are relatively insensitive to the headline pricing increase on hotel rooms. We see that experiential luxury in particular is recovering quite strongly. The sector as a whole is well positioned for the return of experiences because people like to replenish their wardrobes, which they have been doing in the last six months, as they start to travel or go out more, while cosmetics and skincare are also set to benefit.
Overall, the sector has seen an aggressive derating and we have seen valuations come down quite meaningfully. There is a wide dispersion here, with some companies having derated more aggressively than others. In a decelerating macro backdrop, consumers concentrate their share of spending in brands and products that are particularly iconic or where they see investment appeal, and where those products will retain their value over a longer period of time. This is why stock selection will be key to driving returns from the sector.
The sector has seen these ups and downs in the past, for example, during the financial crisis or the anti-corruption crackdown. Every subsequent pullback has seen the sector recover to its prior peaks. We expect this time to be no different.
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