The luxury goods industry operates in a rather peculiar way at first glance. One of the core principles of its operation is the scarcity induced by the luxury brands themselves. While in conventional business, the balance of supply and demand shifts naturally, luxury brands intentionally create a supply deficit, thereby making their products desirable. This clever trick creates the prerequisite for strong pricing power and has rewarded investors with high returns for centuries.
What does this mean in practice? In the case of Hermès, for example, it is important to offer one Birkin bag less than the market demands. When a company controls the supply of goods, it is possible to create a situation where the product is so exclusive and desirable that its price on the secondary market is even higher than when purchased new. Therefore, luxury items can also be treated as investment objects, which is not the case for ordinary consumer goods.
Luxury brands like LVMH and Hermès prefer to use a vertically integrated business model, which plays a very clear role in maintaining exclusivity. A vertically integrated business model means that the supply chain is under the companies' own control as much as possible, as this makes it easier to ensure high quality for the end consumer. For example, Hermès owns exclusive leather processing workshops and farms, ensuring access to the highest quality leather in the world. LVMH owns vineyards (e.g., in the Champagne region) that produce exquisite champagnes. In addition to raw materials, it is characteristic of luxury brands to control the distribution and sales network as well. Control over pricing is one of the most important aspects of the industry – luxury brands generally do not offer discounts; instead, they raise product prices by more than inflation. It can be argued that the post-COVID-19 era provided a very vivid proof of this.
Boom and Bust
The years 2021-2023 were characterized by a consumption boom in luxury goods along with aggressive price increases. The consumption boom was caused by savings accumulated during the coronavirus pandemic, as well as the trauma experienced, which was now boldly being alleviated with luxury items. The Chinese consumer played an especially large role, with their share of the global luxury goods market reaching approximately one-third.
For the Chinese consumer, the situation changed dramatically with the bankruptcy of Evergrande in 2021, which caused a historical real estate crash in China. Since then, real estate prices in China have been in a downward trend, and the fall from the peak has been approximately -22%. There has been no such long real estate price decline cycle in China's recent history; prices have fallen for the fifth consecutive year, and since most household wealth is in real estate, consumer confidence has suffered a lethal blow. Instead of buying luxury goods, capital is accumulating in savings accounts, waiting for better times.
LVMH & Hermès
The crisis is also reflected in share prices – the market value of both companies has decreased by nearly 40% since the beginning of the year. This year, the companies' valuation multiples have fallen to levels not seen in the last 10 years. Has luxury lost its glory, or is this an attractive opportunity for an investor?
Upon closer inspection, it turned out that these seemingly similar companies are quite different in substance and do not behave in the same way. More specifically, the target group for Hermès' production is primarily the ultra-wealthy, whose consumption habits are not affected by the state of the economy. The consumer base for LVMH, however, is broader and includes the aspirational buyers, who in better times allow themselves a luxury item, but who are not immune to the economic climate, which is why they stop buying luxury goods during tougher times. The vulnerability of LVMH's target group is the main reason that has led to a three-year decline in the company's revenue. Hermès, however, has weathered the crisis significantly better. While the revenue growth rate has slowed in recent years, it has not fallen.
Powered by Sametist.io
| Period | RMS.PA YoY Growth, % | MC.PA YoY Growth, % |
|---|---|---|
| 2016 | 7% | 5% |
| 2017 | 7% | 13% |
| 2018 | 8% | 10% |
| 2019 | 15% | 15% |
| 2020 | -7% | -17% |
| 2021 | 41% | 44% |
| 2022 | 29% | 23% |
| 2023 | 16% | 9% |
| 2024 | 13% | -2% |
| 2025 | 5% | -5% |
| 2026 | 4% | -1% |
| 2027 | 8% | 4% |
| 2028 | 7% | 5% |
Return on invested capital provides further confirmation of the exceptional quality of Hermès' business model. The capital efficiency of the two companies differs by orders of magnitude. Last year, Hermès' return on invested capital (ROIC) was 48%, while LVMH's was only 10%. LVMH's low return on capital stems primarily from capital-intensive acquisitions of other luxury brands, which drags down the ROIC. Hermès' strategy has been to grow organically with one brand, and they have been very successful in this.
Hermès' business model superiority is also reflected in the company's pricing, as it currently trades, and has historically traded, at a significant premium relative to LVMH. Today, Hermès trades at a price-to-earnings ratio of 30x, while LVMH is at only 17x. However, if one looks at the valuation of both companies relative to their own history, these are among the most favorable entry points of the decade. I also performed discounted cash flow models for both companies: the fair value for Hermès came to €1,225 (Hermès International Société en commandite par actions) and for LVMH €479 (LVMH Moët Hennessy - Louis Vuitton, Société Européenne), which shows that based on this, Hermès is fairly priced and LVMH is slightly undervalued. However, since Hermès' business model is of higher quality, one can expect more fair value growth for Hermès than for LVMH. For an investor with a longer investment horizon, Hermès might still offer a higher return at current price levels. This assumes that the quality of the business model does not deteriorate over time.
