The Chinese Wear Prada

Luxury goods are positional or Veblen goods. The more expensive they are, the more people want them. One such brand that is taking advantage of its Veblen goods is Milan-based Prada. Prada is also seen as a proxy for the booming luxury goods market in Asia, especially China. With a market value of US$26 billion and one-third of global sales coming from East Asia excluding Japan, my bet is that the Chinese will continue to wear Prada. Prada shares, listed on the Hong Kong stock exchange, nearly doubled in 2012 and are currently hovering around HK$72.70. Yet investing in Prada is not just about its excellent exposure to Chinese demand for luxury goods; it is also about the broader luxury goods industry trends that an investor can tap into.

Luxury goods sector

Luxury goods can be divided into ‘hard luxury’ describing products such as watches, jewellery and pens, and ‘soft luxury’ describing handbags, wallets, and shoes. Whilst watches and jewellery are often considered together, their distribution structures are actually quite diverse. Watches are primarily wholesale-driven, because consumers want to compare designs, brands, prices and functionality. Jewellery is often retail-driven – companies sell their own jewellery in their own stores. As a whole, the luxury goods sector is characterised by high operating margins, substantial emerging market exposure and strong cash generation. China’s rapid wealth creation, currently with 3 million people holding assets worth 10 million yuan (roughly £1 million) and projected to treble by 2016, means its accounts for about 60% of all growth in luxury goods sales worldwide. Indeed, China recently overtook the USA as the country with the highest demand for branded luxury watches. Yet, there is a worry that as China’s economic growth rate slows, the luxury industry’s growth will also follow. In fact, some analysts are worried that the luxury goods market may experience a bubble, yet I contend that these luxury goods are less prone to bubbles (than property) given their customer base and the fact that the equity of many luxury goods brands are tightly controlled by founding families who take a long-term approach to running their companies.

In the last two years, luxury goods sales have soared by 30% and the shares of their producing companies, such as Prada, have followed suit. One thing for investors to bear in mind is that as a momentum sector, multiples expand when earnings estimates are raised, and vice versa. Luxury goods companies tend to trade on forward-looking price/earnings ratios due to their businesses not being very capital or debt-intensive. Therefore, historically the luxury sector has traded at a 50% premium to the market. Yet there are several determinants that may affect the demand for luxury goods:

1.      Investors need to analyze high-end consumer behaviour, which differs from the rational average income consumer – luxury goods demand is considered to be directly linked to GDP growth. Yet, this may not always be the case as demonstrated by the growth in luxury demand in Japan during their recession in early 2000s as well as growth in luxury demand in Western Europe in 2010 and 2011 despite decreasing consumer confidence.

2.      Concept of trading up or trading down – With luxury goods, high-end consumers tend not to trade down when times are tough as they would rather postpone buying a Breitling watch than trade down to a Swatch.

3.      Growth of counterfeit luxury products – larger amount of counterfeit luxury products of a certain brand, the less demand there is for the brand from high-end consumers. Hence the tight control exhibited by many of the luxury brands.

4.      Pricing power – luxury brands do not compete on price but on design and desirability (related to difficulty of acquisition). Luxury brands therefore are able to maintain their prices despite economic downturns, and during recovery phases they tend to launch higher-priced and higher-margin products as well as raise prices.

One of the trends opening up a new market for luxury brands to exploit is the move by companies specializing in ‘soft luxury goods’ into ‘hard’ luxury by launching jewellery and watch collections. Louis Vuitton, Salvatore Ferragamo, Versace, Bottega Veneta, Hermes, Ralph Lauren, Chanel, Gucci, Prada, and Dior are all moving into this market due to the enormous opportunities. The jewellery market worldwide is worth approximately US$150 billion. Furthermore, jewellery with a brand name attached to it currently represents just 18% of this market (compared to branded leather goods representing 50% of their market and branded sunglasses and glasses representing 38% of their market). These luxury brands are seeking to capture a fraction of that market share to open up a new market in a potentially high-growth area.  

Prada store in Chongqing

Prada are well-positioned to continue capturing market share in the Asia-Pacific region. Their profit in 2012 was US$805 million, a 45% increase from 2011. Moreover, despite the crackdown on corruption and ostentatious gifts in China at the end of 2012, Prada have managed to maintain strong growth in profitability. Prada’s performance and reasons for continued growth in their share price are:

·         Prada regularly unveils new collections in order to remain in vogue and to avoid brand weariness among consumers;

·         Prada has just started its expansion into emerging markets in Asia, the Middle-East and South America, as opposed to its competitors Gucci and Louis Vuitton – meaning there is ample room for growth of its brand;

·         Having just started expanding in Asia whilst maintaining higher price points for products, despite lower average incomes for local consumers, Prada are well-placed to experience continued sales growth. This is stark contrast to Burberry who came into China with a democratic luxury sales strategy which entailed adjusting product prices for the local market – this has blown up in their face during the economic downturn. In addition, Burberry derives the majority of its sales from its apparel business – more sensitive to slowdown in spending than Prada’s sales from leather goods;

·         Prada have retained their core strength in the European market by recording 54% sales growth in 2012 despite the economic downturn – other brands such as Burberry have not been able to do this;

·         Prada’s focus on leather goods is proving profitable – leather goods sales increased 47% last year, providing 64% of Prada’s sales. During a downturn, consumers look to leather products more as they see them as more durable and a better store of value;

·         Prada’s less-intrusive logos keep its brand’s cache strong, as does its higher price points for its products. Some brands’ logos, such as Louis Vuitton, have become too ubiquitous in Asia;

·         Prada is more family-owned than other brands, such as Burberry, with 80% of the company’s equity held by the Prada family and other senior executives – this means Prada’s management and shareholders will be taking a longer-term approach in their growth strategy.

Luxury goods stocks historically have shown strong growth, trading at a premium valuation to the market. The key concern is the sustainability of their growth, and the key question for Prada is how close the brand is to being mature. Prada still has millions of potential customers to satisfy in Asia and their fast-innovation should ensure that the Chinese continue to wear Prada. I would wait for Prada shares to decrease slightly to around HK$60 before buying to sell at around HK$90 by October this year.