Luxury brands sure to suffer as consumers trade down

Kathleen Brooks
THE LUXURY brands sector finished 2009 on a high note. Luxury goods groups including Burberry, Richemont and Swiss watch-maker Swatch all reported strong sales growth in the last three months of the year and stock prices have duly headed north as consumers snapped up handbags, jewellery and watches to beat the recession blues.

But there are signs that the market has got ahead of itself relative to fundamentals. Demand in the west is expected to lag as wage growth remains sluggish, Japan – one of the largest markets for luxury goods – is facing deflation, and emerging markets are not yet ready to pick up the slack.

Valuations look stretched and stock prices are, in some cases, at multi-year highs, which makes this a good time to short the sector. For example, Burberry’s share price is at a two-year high after reporting healthy earnings for 2009. But economic headwinds could derail this growth story.

Sluggish wage growth in the West and a tightening of credit conditions in China make the stock look expensive at 20 times earnings forecasts for this year.

Analysts at Morgan Stanley believe that Swiss watchmaker Swatch and Richemont, the Swiss luxury brands group that owns Mont Blanc and Cartier, are the most exposed to a correction in their share price. In a research note released last week, the investment bank predicted that profit margins will be lower this year as companies find it difficult to increase prices in a low-inflation environment. It does not expect firms to regain pricing power until 2011.

But it’s worth doing your research and picking individual companies to short, as Morgan Stanley expects there wil be a variation in stock price performance. It thinks that PPR, the owner of Gucci and Puma among other brands, should outperform its peers. It believes that Italian fashion house Gucci, best known for its monogrammed handbags, could continue to do well because of its status as a well-established brand. It also expects sports brands that come under the PPR banner to perform well in the run-up to the football World Cup later this year.

Another attraction of PPR is that its stock price lagged the overall luxury sector in 2009, yet it pays a relatively strong dividend of 3.3 per cent. This compares with Richemont, where the dividend was 0.3 per cent.

The re-balancing of the global economy could also dent demand for luxury brands. Debt-laden consumers in the US and the UK in particular, are going to be more constrained going forward as sluggish wage growth, rising taxes and continuing weakness in the labour market weigh on their ability to spend on fancy goods. Sales of Richemont brands fell 4 per cent in Europe, 2 percent in the US and 12 per cent in Japan in the last three months of 2009.

But it is questionable whether the emerging market consumer has the muscle to pick up this slack. Luxury brands have moved heavily into emerging markets in recent years, trying to capitalise on rapid growth and an increasing middle class population willing to spend money on high quality goods. However, China’s total consumption is only a little over that of France at $1.2 trillion per year, lower that of Germany and Japan and nearly 10 times lower than the US.

Although consumption rose in 2009 it remains at a low level. One reason for this is low consumer credit growth and a weak social safety net. This accounts for the high savings rate, which stands at close to 12 percent of income.

While it is likely that consumption will continue to grow, it will be a long time before it has anything like the appetite for luxury brands relative to the US, Europe and Japan.

Another weak spot for the luxury goods sector is the Middle East. Charles Stanley analyst Sam Hart says that sales in the Middle East could remain sluggish for the next 18 months following the Dubai debt crisis at the end of last year. However he notes that the “Middle East is a long term growth market”.

After a strong run at the end of 2009, momentum could be maintained at the start of this year. But as we progress through 2010, the outlook may not be so rosy and sales growth could slow as consumers reign in spending and demand in emerging markets fails to live up to expectations. In this scenario current valuations look over-priced. It’s time to sell luxury.

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Colombia had its weakest quarterly coffee harvest for 35 years at the end of 2009, according to the International Coffee Organisation. This caught the coffee market off guard. On top of that, heavy rain fall also affected harvests in Central America and Brazil which has left supply very tight. This comes at the worst time – just as global demand for coffee has exploded led by massive growth in the popularity of the hot drink in emerging markets.

Coffee futures are fairly volatile but have risen by more than 25 per cent in the last 12 months. Tight supply could fuel further gains.