Is a Hand-Made Hermès Bag a Better Long-Term Investment than Its Stock?
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What’s interesting about Hermès is that it is still owned by the family (now in 6th generation)
Highlights:
- Competitive moat allows for sustainable high margins
- Intended scarcity creates excess demand
- Asia is a vital market for luxury brands to realize growth
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Revenue breakdown 2021
Competitive moat allows for sustainable high margins
- Hermès has consistently delivered a massive gross margin over time
- It is almost 3x higher than the average Consumer Discretionary company
The company follows a differentiation strategy
- HMRS has developed a vision of developing high quality products
- It only manufactures its products in France
- Hermès can operate in price categories where customer sensitivity is relatively low
- Its luxury collections provide high sustainable margins with high pricing power
Intended scarcity creates excess demand
- As of 2021, Hermès operates only 303 stores globally, which is less than in the past
- For comparison, LVMH has more than 5,500 stores
- Exclusivity and difficult access to its products make the brand so desirable
- It creates intended scarcity and has long waiting lists of several years for its bags
- The higher the price, the higher the demand
Increasing price to increase demand sounds very odd
- For the majority of goods, we observe that overall demand decreases when price increases
- People tend to switch to cheaper variants or look for substitute products
- However, there are a few products where the law of demand does not hold
- Economists call them “Veblen goods”
- If luxury products become cheap, they lose the premium status as more people can afford it
- Raising the price helps to keep exclusivity
Low marketing costs compared to competitors
- Unlike its competitors LVMH (Louis Vuitton) and Kering Group (Balenciaga, Gucci, Yves Saint Laurent), Hermès has much lower SG&A and marketing costs
- The difference is that Hermès does not rely on brand ambassadors or celebrities promoting the brand
- For its competitors, such ambassadors is key for its marketing, but also very expensive
Asia is a vital market for luxury brands to realize growth
- Between 2010 and 2021, revenue from Asia has increased 5x
- Its home market Europe only increased 2x over the same horizon
- Luxury products in Asia are a representation of high status
- Craftsmanship and artistry are widely associated with the upper class
- It’s the main market for Hermès to focus on to continue realizing growth
Consensus is divided
- The majority of analysts stays on HOLD, as current share price might be too high
- Analysts predict strong margins to continue as Hermès has a high pricing power
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P&L – Hermès
- Net profit could stay on heightened levels as it record strong demand growth for its products
Balance sheet – Hermès
- Hermès has a strong cash position as it generates huge cash flows on an annual basis
- Hermès has low leverage with a liabilities-to-assets of 30%
Ratios – Hermès
- Strong bottom line ensures consistent high profitability measured by ROE
- Cash conversion cycle is very long but is not a risk given the strong cash position and cash flow generation ability
Free cash flow – Hermès
- CAPEX requirements are relatively low as it does not expand aggressively in physical stores
Value estimate – Hermès
- I am a bit more cautious about the revenue growth prospects are China’s demand might be lower than expected
- I value the company by using FCFF and a terminal growth rate of 4%
Key risk is brand damage
- Failure to adopt to changing consumer demands
- Mean reversion of temporary heightened margins
- Failure to comply with growing ESG standards could lead to reputational damage
Conclusions
- Competitive moat delivers best-in-class margin
- Asia continues to provide ample growth opportunities
- Lucrative company but at an expensive price
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