In the first in a new series in which Flagship Asset Management’s global fund managers compare the investment case of a South African company versus one of its global peers, Kyle Wales argues the case for choosing Capri over Richemont.
Richemont versus Capri
Since its founding in 1988, Swiss listed luxury goods company Richemont has been a staple in South African investment portfolios. It is currently the third-largest luxury goods company in the world after French listed LVMH (the largest) and Kering (the second largest).
Rising Asian demand and an increasing cohort of middle and upper-class consumers in the western world bode well for the prospects of Richemont. However, is Richemont the best way for South African investors to gain exposure to this promising global theme? Because it is the only listed luxury goods company on the JSE, many South African investors ignore the myriad of alternatives if they just expanded their field of sight globally.
The luxury goods industry is divided into “hard luxury”, which consists of jewellery and watches, and “soft luxury”, which consists of accessories and apparel. Like luxury watchmaker Swatch, Richemont competes in the “hard luxury” space, with almost 60% of its revenues generated by its “jewellery Maisons” segment, led by flagship brand Cartier. The balance of revenue comes from a myriad of smaller Swiss watch brands and online luxury platforms Yoox and Net-a-porter.
The economics of “hard luxury” vs “soft luxury”
Unfortunately for Richemont, “hard luxury” has underperformed “soft luxury” by a considerable margin over the past five years. Although Richemont’s latest (FY21) results were very favourably received by the market, resulting in a 10% rally in its shares, the total return Richemont has been able to deliver over the last five years is 20% p.a. in US dollars, which pales in comparison to the 38% and 33% p.a. delivered by its “soft luxury” peers LVMH and Kering have been able to deliver respectively.
According to Dan Loeb, of activist hedge fund Third Point, which recently acquired a stake in Richemont, some of this underperformance can be attributed to missteps by Richemont management. This, however, is not the only reason.
The economics of “hard luxury” simply do not stack up that favourably next to “soft luxury”. Richemont’s margins are far lower than its “soft luxury” peers. Its cash flow dynamics are also worse. Richemont’s cash conversion cycle, or the time it takes from investing in inventory to receiving cash in its bank account, sits at over 400 days, while LVMH and Kering sit at around 200 days.
Neither of these factors is set to change. On the one hand, Johan Rupert holds 51% of Richemont’s voting rights through a control structure, which means any overtures by activist investors are likely to prove fruitless. On the other, it is tough to change the economics of an industry.
Like other luxury goods companies, Richemont trades at a lofty valuation of roughly 29 times blended forward earnings1, which is just shy of industry leader LVMH, which trades on a blended forward multiple of 31 times.
“Soft luxury” at a reasonable valuation
Given these rich multiples, finding a luxury goods company at a reasonable valuation is becoming increasingly difficult (although not impossible).
One Company that is an exception to this rule is Capri Holdings.
Capri generates the bulk of its revenue from “accessible luxury” brand Michael Kors, with the balance generated by high end brands Versace and Jimmy Choo. While Capri shares many of the characteristics of its “soft luxury” peers, it trades on a modest multiple of 11 times earnings. In our view, this is because the market incorrectly underestimates the extent the Michael Kors brand has rejuvenated post its restructuring in 2019.
Looking beyond the Michael Kors brand, Capri believes it can double revenues from Versace from $1bn to $2bn and Jimmy Choo (from $500mln to $1bn) by 2024.
While these targets are ambitious, they are looking more and more plausible as the Versace brand, in particular, delivers blistering year-on-year growth.
With the Versace brand in particular, we believe $2bn in annual revenues is only scratching the surface of its potential. Only 25% of its revenue comes from leather goods today versus 75% for many of its peers and bringing this ratio in line with its competitors would mean that doubling annual revenues to $4bn would not be out of question for the brand.
Many people are becoming increasingly concerned by the overall valuation of markets and what that means for equity allocations. Growth stocks and high-quality stocks, in particular, are looking expensive. However, at Flagship, we believe good value can still be found in attractive industries without compromising our quality requirements. All it means is casting one’s net a little wider than the limited opportunity set that is available on the JSE.