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A Luxury Goods Makeover

by | Oct 30, 2024

At Sprucegrove, we seek companies that have sustainable long term competitive advantages whether it be from a cost perspective and/or differentiated brand and service. As such, we have long had an affinity for the luxury goods sector given the strength of the brands and their associated pricing power, while still being cognizant of the valuations these businesses have garnered over time. This year, the entire sector has come under pressure as spending slowed after the post-pandemic frenzy, particularly in China, with certain brands proving more resilient than others.

In our experience, the business models for many of these luxury groups begin with a few common traits.  Firstly, they possess brands with long histories and cultural heritages that are difficult to replicate. One or two of their brands are typically outsized contributors to their group’s financial results- think Gucci in the case of Kering or Cartier with Richemont. As well, they pride themselves on having vertically integrated operations whether it is a finely handcrafted Louis Vuitton handbag made in France or a high-end Vacheron Constantin watch assembled using Swiss craftsmanship and precision engineering that further feeds into a brand’s carefully cultivated narrative.

Possessing these characteristics on its own we would stress does not guarantee success in this industry, which we can unfortunately speak to firsthand.  Other factors must be present like scale and a strong management team.  Scale has become increasingly important in this industry given the growing costs to both compete and standout.  Look no further than LVMH spending $500m to renovate Tiffany’s flagship store that reopened in New York last year.  Meanwhile the management teams of these businesses need to be adept at striking the right balance between growing and nurturing their brands.

Below we provide some of the rationale behind our recent portfolio activity as it relates to the luxury sector starting with the elimination of Swatch for quality reasons, the ongoing reduction of Richemont due to valuation and the more recent initiations of new positions in Kering and LVMH as their valuations became more attractive.

Swatch Group is the world’s 2nd largest watchmaker. It has the widest portfolio of Swiss-made watches (18 brands) including Omega, Longines and Tissot, its three largest brands, along with the eponymous Swatch brand. It also owns high-end jewelry brand, Harry Winston. The company is highly backward integrated for owning its brands in addition to supplying watch making componentry to its peers.  While the company has admittedly encountered several headwinds over the last decade at no direct fault of their own– the Chinese government’s clampdown on gift-giving, the emergence of smartwatches and a strengthening Swiss Franc– our decision to ultimately divest this holding came down to management execution. Management’s missteps ranged from the lagging performance of their flagship Omega brand to questionable decision making around inventory management and the tepid performance of their prestige watch brands (e.g. Breguet and Blancpain).

Richemont is a luxury goods company with an outsized exposure to the hard luxury subsegment (i.e. jewelry and watches) of the market.  Within its portfolio, they own high-end jewelry Maisons Cartier and Van Cleef & Arpels and notable watch brands Vacheron Constantin, IWC, Jaeger-LeCoultre, Piaget, Panerai and Baume & Mercier.  Richemont’s high-end jewelry Maisons performed extremely well through the pandemic and have held up better in recent times, which has been reflected in its valuation. Furthermore, we would also be remiss not to acknowledge one of management’s astute decisions. Similar to Swatch Group, last decade when the Chinese government clamped down on gift giving, they were left with excessive inventory in the wholesale channel.  Management responded by repurchasing and then destroying €300 million of surplus watches to both assist its retail partners and avoid their brands ending up in the ‘grey channel’ where they risked being tarnished by discounting. Perhaps in hindsight, we should have been more critical of Swatch Group’s reluctance to follow suit given their inventory issues and lagging performance today.

Kering is a luxury goods conglomerate. The company’s flagship brand is Gucci but over time the group has made steady progress building out a tail of mid-sized and profitable brands including Yves Saint Laurent, Bottega Veneta and Balenciaga. We believe Gucci is a brand with a unique and advantaged position due to its credibility for both its craftsmanship and fashion. The uniqueness of the brand allows Gucci to address a massive market across most luxury categories and geographies, while also catering to both male and female clientele.  In recent times, Gucci has been experiencing outsized struggles given a greater exposure to China and self-inflicted wounds during a period of rapid growth.  We have seen the brand experience bouts of poorer performance over its history, given its more fashion forward approach, making its current challenges not unfamiliar territory. Furthermore, after several in-depth discussions with management, we believe there is a credible path to reinvigorate its brand and improve its stability over the long-term.

LVMH is the largest global luxury group with a collection of 75 brands. Its largest brands include LV, Christian Dior, Moet Hennessey, Bulgari & Tiffany, along with retailer Sephora. LVMH has delivered a remarkably high and consistent level of profitability over recent decades in part due to it being the most diversified luxury goods company with exposure to fashion and leather goods, watches and jewelry, perfume and cosmetics, wines and spirits and beauty retail. The business is controlled by Bernard Arnault, who built the company through M&A, while also pioneering important principles in the luxury industry. In addition to its diversification benefits, its vast portfolio of brands provides them with unrivalled scale and the ability to both attract and retain talent as they regularly cycle them across the portfolio.  In our eyes, LVMH is truly a standout and warrants the above average price we paid to initiate a position in an excellent business.

NP/E (x)* P/B (x)* Proj ROE (%) F/L (x) Most Noteworthy Brands YTD Portfolio Activity
Swatch Group 9.7 0.8 8.0 1.2 Omega, Longines, Tissot and Harry Winston Exited in Q3
Richemont 31.9 4.2 13.0 2.1 Cartier and Van Cleef & Arpels Trimmed in Q2 and Q3
Kering 8.5 2.1 25.0 2.8 Gucci, Yves Saint Laurent, Bottega Veneta and Balenciaga Initiated in Q2 and added in Q3
LVMH 22.1 5.3 24.0 2.2 Louis Vuitton, Dior, Bulgari, Tiffany and Sephora Initiated in Q3

* Valuations based upon Sept. 30th
Holdings and Dividends are subject to change. All holdings are available upon request. Projected ROE for the holdings is not a prediction of future results for the Fund.
Note: (x) indicates multiple

[1] Source: Sprucegrove, MSCI, FactSet

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