A Study of Luxury Companies
Chanel, Louis Vuitton, Ferrari, Rolex. We know luxury when we see it, but can we cleanly categorize what’s luxury and what’s not? In this post, we will discuss some thoughts on luxury goods and services, and of course a few luxury stocks. We mention LVMH (MC.PA), Hermes (RMS.PA), Brunello Cucinelli (BC.MI), Ferrari (NYSE: RACE), and others.
“Luxury” can mean different things to different people. According to Merriam-Webster, it means (1) a condition of abundance or great ease and comfort: sumptuous environment; (2) (a) something adding to pleasure or comfort but not absolutely necessary; (b) an indulgence in something that provides pleasure, satisfaction, or ease.
It’s easy to argue that all luxury goods and services are expensive. A condition of abundance, having more than we need, indulgences – these things cost a premium relative to normal, everyday life. However, not all expensive goods and services are luxurious. Here’s a simple contrast. A Bugatti Veyron costs at least $1.7 million and up to $20 million. But for a mere $3.4 million, you could own a Caterpillar 797 Mining Truck!
The buyer of a Bugatti knows he or she is being indulgent. The buyer of a mining truck is paying $3.4 million to put it to work and earn a return. Expensive does not always denote luxury.
There are a few elements of luxury companies that are commonly tossed around when thinking about luxury companies:
Expensive goods and services relative to category averages
Elements of exclusivity
Exceptional quality
Brand values and heritage
In some cases, there are elements of shrine worship that are important to luxury brand consumers. Touring Ferrari’s factory in Maranello or visiting Solomeo, Brunello Cucinelli’s charming hamlet – these are the shrines these brands’ customers want to visit. Organized trips and events for brands’ customers are often used as enticements to engender more loyalty and affection for brands over time. Those that can successfully cultivate those relationships over the long-term can build a large base of reoccurring revenue that grows over time.
Let’s discuss the elements of luxury in a little more detail.
1. Expensive goods and services relative to category averages
I can buy a Casio watch on Amazon for $16. Or an Apple watch for $300. Or a Rolex for $50,000. They all tell the time. Digital watches tell time more accurately than analog watches. But when we move into the timepiece world, with complications and sophisticated instrumentation powering winding movements, beauty and art supersede time-keeping functionality. Luxury items elevate the value proposition to customers from purely functional to artistic and symbolic. It’s pretty easy to appreciate the artistic value of the $45,000 Vacheron Constantin watch below vs. the $16 Casio shown below.
Once a company creates value for customers in artistic and symbolic realms, it has the ability to set prices well in excess of typical competitive margins in the category.
2. Elements of exclusivity
Exclusivity – real or imagined – is important for luxury companies. One cannot simply buy the Ferrari of his choosing by walking into a dealer, nor can any random customer walk into an Hermes store and purchase a Birkin bag. They must be invited to purchase, and even then – they might not have the privilege of buying the items they want! But they take what they can get in order to be at the top of the list next time.
Luxury fashion companies sometimes manage their inventory aggressively to maintain an air of exclusivity. Some have been known to burn their unsold goods rather than clearing them through discounted channels. The last thing a seller of $2,000 sweaters wants is for its core, full-price customers to feel cheated by others buying the same garment for $400 at TJ Maxx. Discounting may help financial performance in that period, but it cheapens the brand for its core customers and ruins pricing power longer term. That pricing power is incredibly difficult to regain.
Exclusivity is managed by restricting supply and by maintaining high price points that are inaccessible to everyday consumers.
3. Exceptional Quality
Luxury companies are known for providing high-quality goods and services. Typically, these means using the finest manufacturing components and processes. For example, Loro Piana is known for procuring the highest quality textiles in the world, as we talked about in our prior post about the cashmere supply chain. Where it matters, products are often heavily man-made, bringing artisanal handiwork to consumers surrounded by machine-made goods. Personal attention to detail matters to brands providing artistic and symbolic value to customers – in both build quality and in customer service.
Even for product companies, luxury extends beyond the quality of the goods themselves. Personalized customer service matters. Being able to directly call or text a company representative is luxurious. Think about having a private banker vs. calling an 800 number at Wells Fargo to get a debit card replacement – one is pleasant and luxurious, the other is stressful.
In many cases, the artistic and symbolic qualities of luxury companies are used to exhibit to the world the taste and sophistication of the brands’ consumers. These customers don’t just want to buy the luxury items for superior build quality and their artistic and symbolic values – they want to be associated with what the brands stand for. This leads to the next point.
4. Brand Values and Heritage
It is nearly impossible to create a true luxury company from scratch today. New brands have no heritage and their values are unknown to the market. It doesn’t mean that new luxury companies cannot be created, but they necessarily start as premium providers of goods and services until the broader base of buyers comes to appreciate the quality, craftmanship, and brand values over a longer arc of time. Gary Friedman at RH talks about this journey often – what he refers to as “climbing the luxury mountain.” He describes this journey regularly:
“We have a deep understanding that our work has to be so extraordinary that it creates a forced reconsideration of who we are and what we are capable of, requiring those at the top of the mountain to tip their hat in respect. We also appreciate that this climb is not for the faint of heart. And as we continue our ascent, the air gets thin and the odds become slim.”
(Despite our positive view on RH longer term, we do not think it qualifies as a luxury brand today. It is closer to Mercedes-Benz than to Ferrari. It also operates in a mostly unbranded landscape in which almost nobody can identify the maker of a piece of furniture.)
Looking at the portfolio of brands at LVMH highlights the importance of heritage. Its wine brands were founded from 1365 to 2020. Its fashion and leather goods brands span from 1846 to 1984. Louis Vuitton, its flagship and most important brand, was founded in 1854. Its jewelry brands were founded from 1780 to 1980. One cannot simply wake up and create a luxury brand – it takes time.
Luxury brands must evolve carefully over time, staying true to their heritage but also evolving in ways that are consistent with all the elements discussed above – providing superior quality goods and services that are exclusive and create value via artistic and symbolic characteristics. Some brands are tempted to grow too quickly or democratize the brand in a way that reduces their exclusivity. Others may sacrifice long-term brand equity in exchange for short-term financial performance. That is why the air is thin – it is hard to cross the chasm into the true luxury category. Once a brand has been cultivated carefully with loyal customers who love, value, and appreciate the brand, it has an opportunity to run the luxury business model, which we will talk about next.
Luxury Business Model
Now, let’s talk about the financial characteristics of luxury brands and holding companies. In short, true luxury companies have wonderful economics that are very similar to software companies when run correctly.
First, let’s talk about revenue performance, which directly feeds into profitability. The best luxury companies always grow consistently, owing to their superior brand management, inventory management, and related pricing strategies. Enzo Ferrari is famous for proclaiming that “Ferrari will always deliver one car less than the market demand.”
Through proper supply and demand management, luxury brands create positive pricing power in their businesses. They offer goods and services that are largely disassociated from changes in input costs (with 90% product margins, swings in the 10% of direct products COGS don’t move the needle much). This allows them to price above inflation indefinitely, leading to a long-term growth formula consisting of brand expansions (more stores, more categories, more geographies), like-for-like pricing growth, and same-store volume growth, all of which powers steady margin expansion.
Over the long arc of time, this has allowed a brand like Hermes to operate at a revenue CAGR in the low double-digits since 2000 (11% through 2022). If we decompose its growth, 80% of it has been derived from higher revenue productivity per location, which is a combination of pricing power and same-store volume growth. This is the beauty of the model – it becomes very capital-light after a brand becomes fully distributed.
Interestingly, per the chart below, we can see that Hermes’ growth CAGR accelerated meaningfully in the last decade (largely due to China’s contributions) and its composition evolved over time from store growth to same-store growth, driving powerful earnings growth from operating leverage. Since 2000, operating margins have expanded from the mid-20% level to the low-40% level.
Source: Hermes, Recurve Capital Estimates
Next, let’s talk about profitability.
Brunello Cucinelli has over 70% gross margins. Ferrari has 50% gross margins. As a group, LVMH has nearly 70% gross margins. However, these brands have varying operating margins based on differences in scale.
By our estimation, Louis Vuitton is the world’s single largest luxury brand. While hard to know for certain, we believe it has ~50% operating margins, largely owing to its massive global distribution and roughly $25 billion revenue base. We estimate that it contributes roughly 50% of profits to the whole LVMH group. By comparison, Hermes, a $15b brand, generates 70% gross margins and low-40% operating margins. Cucinelli generates >70% gross margins but high-teens operating margins with about $1.2 billion in sales. Differences in scale matters, but we believe incremental margins for the best true luxury brands are above 50%, consistent with where Louis Vuitton is today.
To recap, well-managed luxury brands and their holding companies generate consistent revenue growth and operating margin expansion over time. Their brands generate demand growth in excess of supply growth which leads to volume gains and healthy pricing tends.
We assessed the performance of a handful of these companies by looking at stock performance vs. year-end 2019 compared to expected operating profit growth for 2023 vs. 2019. See the chart below.
Source: Company Reported Financials, Recurve Capital Estimates
This chart exhibits some interesting insights. Namely:
Burberry and Kering are notable underperformers fundamentally. Their operating profit growth was abysmal compared to luxury peers. Kering at +3% operating profit growth since 2019 is notably bad, particularly due to strong margin contraction – not a characteristic consistent with true luxury.
Burberry, Kering and Moncler experienced declines in operating margins over the period.
Investors clearly pay up for growth + margin expansion (no surprise). Brunello Cucinelli and Hermes are the two best performing stocks. Not surprisingly, both companies carry the highest valuations in the group (BC at 43x 2024 P/E, Hermes at 43x 2024 P/E).
It’s worth noting that there has been a deterioration in growth across the luxury complex for most companies over the last year. Ferrari, Hermes, and Brunello Cucinelli have been standout performers with superior demand resilience. Parts of LVMH have held up well, but other parts have been drags against the broader group.
Now, let’s quickly touch on the importance of China to the luxury market.
China’s Impact
While global growth has been healthy, Chinese consumers have contributed significantly to the luxury market. Hermes’ “Asia ex Japan” business has grown from €186 million in 2002 to over €6 billion in 2023, an 18% CAGR, the majority of which is attributable to China. This is 2x the CAGR of the rest of Hermes’ business. The region has grown from 15% of sales to roughly 50% over that time. LVMH’s Asia ex Japan business grew from €2 billion in 2000 to €25 billion in 2023, a 12% CAGR, although due to LVMH’s acquisition strategy it is hard to determine the organic CAGR over that time. After decades of strong growth, China is now the largest individual swing factor in global demand for many of the world’s most renowned luxury companies.
Interestingly, brands with deep heritage in Europe do not automatically resonate and succeed with Asian consumers. This quote from a call with the CEO of Ferrari in China was enlightening:
“I think China is, to a certain extent, partly a developing country, so there is still not full recognition of certain iconic brands; at least what the Western world considers iconic brands. Their approach to the brand is a bit less emphatic. They take the brand, they use it. Sometimes it looks good and they keep it, tick the box. Done; what’s next? There is multi-experiencing of different brands. There is no historical heritage. There is no loyalty. At least, there was no loyalty or heritage. Now it is changing somewhat.”
He went on to describe how Chinese consumers would buy try out a number of brands, see what they liked, and then consider what they would repurchase in the future. International luxury brands in developing countries are known reputationally for the status they convey to others (i.e. a Ferrari is expensive and therefore prestigious), but not as known for the craftmanship and artisanal qualities that appeal to the brands’ most loyal customers which keep bringing them back. This pushes the brands to be at their very best in new frontier markets to compete for customer loyalty, which is incredibly valuable. If a brand’s quality, service, or other attributes do not meet customers’ expectations, even a strong global luxury brand with deep heritage in Europe may end up underperforming in China and other developing countries where loyalty must be earned.
Because brands must earn their way into the market and because of the Chinese market’s size, there is potential for a wider dispersion of outcomes between established European luxury companies as they enter and grow in that market. For example, clearly Hermes has been wildly successful with roughly 50% of revenues coming from Asia ex Japan, but a brand like Brunello Cucinelli has only <15% of revenues originating from China. Brunello’s small Chinese business can be seen as an opportunity (our view since they entered only in 2010) or as a disappointment, depending on one’s judgment of the company’s management and execution.
Conclusion
Luxury companies have been some of the best performers in the stock market in all of history. Hermes has produced a 350x return since its IPO. LVMH has returned 30x since its IPO. Brunello Cucinelli has returned 7x during its much shorter life. Luxury companies, when managed well, are almost bond-like in their consistency, and benefit from capital-light growth from consistent demand growth in excess of supply growth; healthy, above-inflation price increases; and growth-oriented expansions that increase the surface area of the brand without diluting the quality, artistic characteristics, or heritage of the brand. Luxury brands are cultivated over decades, not created in a flash. Creating one requires restraint and extreme discipline – qualities that are typically at odds with the short-term nature of modern capitalism.
We hope this was an interesting exploration into a class of companies we find interesting.
