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Morningstar | Concerns About Chinese Demand Bring Luxury Valuations Closer to Our FVEs; Richemont Attractive

While the luxury sector has been battered over the past few days, we're maintaining our fair value estimates for the firms in this space. We believe the sector valuations are now returning to more palatable levels, after being materially overvalued for most of 2018. While many valuations are still stretched, the sector sell-off has created a few opportunities for long-term investors. We consider wide-moat Richemont a top pick in the space, trading in the 4-star territory at a 20% discount to our valuation.

The main reason for the sell-off is the concern over the health of Chinese consumers. China has led the sector recovery since mid-2016, with Chinese luxury spending growing in double digits, versus 3% elsewhere. Chinese spending now accounts for 20%-50% of revenue among companies under our coverage (with the lowest exposure for U.S.-based Tiffany and the highest for Swiss watchmakers).

So far, China-U.S. trade tensions have materialised in a Chinese stock market decline and currency weakness but have yet to meaningfully dampen luxury demand. LVMH, the first luxury company to report third-quarter results, saw only slight deceleration in Chinese global spending in its biggest fashion and leather goods unit from a mid- to high-teen growth rate.

However, luxury industry valuations reached their 10-year peak levels around midsummer, with no cyclical risks priced in. With geopolitical risks mounting, it should not be surprising that the sector is rerating and perhaps there is more to come, as it is still trading at an average 8% premium to our fair value estimates (with most stocks in a 3- or 2-star category). Our preferred play on the luxury space is wide-moat Richemont, due to its strong brand portfolio in the long-product-cycle industries (watches and jewellery) with both conspicuous and investment value. We remain cautious with Moncler and Hermes, which still trade at a meaningful premium to our fair value estimates.

According to luxury companies' management teams, Chinese consumers are getting younger and are self-purchasing, with graft demand largely eliminated (we note, however, that it can be difficult even for industry insiders to estimate this portion of demand). Chinese luxury buyers spend a higher proportion of their income on luxury goods than their Western counterparts, which has likely resulted in more cyclical demand. We believe this explains why the names that enjoyed strong performance with younger, potentially more price-sensitive clientele, such as Kering, have sold off more than a less cyclical Hermes, which caters more to high-net-worth individuals.

Exacerbating China fears have been the rumours of Chinese government cracking down on luxury goods imports, confirmed yesterday by LVMH. We believe the Chinese government’s actions are aimed at supporting local spending and came following the import duty reductions earlier in July (to which most luxury companies responded by cutting local prices). Although regional price differences persist, those are significantly lower than several years ago, after the industry’s efforts to rein them in. According to Jing Daily, luxury goods in China were only 16% more expensive than global averages in 2017, versus a 68% gap in 2011. Moreover, in 2017, luxury buying in mainland China outstripped Chinese global buying with 15% growth, according to Bain Capital, supported by decreasing price differentials. We believe that the actual location of Chinese purchases has become less relevant, given the established local retail infrastructure in China. The key variable is the overall demand backdrop. Our forecasts are calling for a more moderate high-single-digit growth rate in Chinese consumer demand.