Key Takeaways
- Europe’s luxury stocks look compelling despite the sector taking a hit from the Iran war, according to Morningstar senior analyst Jelena Sokolova.
- LVMH and Richemont rank among the most undervalued luxury stocks, according to Sokolova, while overhaul strategies remain ongoing at Kering and Burberry.
- Luxury brands’ dependence on heavy assets, individual craftsmanship and exclusivity suggest the sector could be a hedge against the first round effects of AI disruption.
Karen Gilchrist: Europe’s luxury stocks have taken a beating since the start of the Iran war, as a worsening economic picture has weighed on consumer cyclicals, and threatened the sector’s long-awaited recovery. Still, could that be pockets of opportunity in luxury stocks? Or, indeed, could they provide the ultimate anti-AI trade? To discuss this and the luxury outlook, I’m delighted to be joined by Morningstar senior analyst Jelena Sokolova.
Now, Jelena, I understand that you consider many luxury stocks to be undervalued right now, and I really want to dive into that. But let’s first start with the picture in the Middle East. What have we garnered so far from the luxury earnings that we’ve seen, in terms of the impact of the war on Middle East sales, whether domestically—of course the Middle East being a big market for some of these brands—or indeed on travel spend in regions like Europe?
Jelena Sokolova: Yeah, so it definitely has been a hit. The sector is not massive in terms of revenue contribution—it’s from 5% to 10% for those companies—but it has been growing quite nicely before. And also it impacts the travel flows, as you mentioned. So, so far in the Q1, we have seen that, due to the Middle East war, the companies that have reported so far lost about 1% to 1.5% of their revenue. So it’s not massive, but you can feel it, especially when overall sales trends are not very strong.
Karen Gilchrist: How about the picture that we’re seeing in other key markets such as the US and China? Of course we’ve long awaited a recovery in that Chinese market. What sort of trends are we seeing there so far?
Jelena Sokolova: Yes, so the US is getting stronger. It started on the recovery trend from Q3. Q4 was sort of mixed. Q1 again is quite strong and we don’t see the spillover from the Middle East conflict. Importantly on the sentiment in this market. China remains still quite subdued for most players that have reported so far. So the real estate markets remain very weak, and they are weighing on the confidence.
Karen Gilchrist: Now talk me through some of the secondary impacts of the war. We do, of course, have these concerns about inflation and that potentially pushing up interest rates. Higher input costs as well. And, of course, if people have less disposable income, particularly on the wealthy side, that could suppress demand. So what do you consider potentially some of the ramifications we could see if this does turn out to be a very prolonged conflict?
Jelena Sokolova: The first one kind of echoing from 2022 is the inflationary shock, right. Because the energy prices that are feeding through to a lot of final goods, and then you have the impact on the fertilizers, etc., so that would be the first fact. That means that with interest rates, there is less room for lowering interest rates as well. Hit to the markets, that could be an important leading indicator, specifically for the US consumers, so another kind of and negative here.
LVMH and Richemont as Top Undervalued Luxury Picks
Karen Gilchrist: Now let’s get a little bit more, granular. You’ve mentioned, as I said, that some of these stocks you consider undervalued. Where are you seeing the pockets of opportunity here? Which ones do you think have the the greatest potential growth and which ones are potentially areas of vulnerability?
Jelena Sokolova: Yeah, so I think the sector looks quite underpriced and quite attractive from a long-term investor perspective, because we essentially now have lapped the second year of weakening of revenue, the cyclical weakness. We’re nowhere near the top of the cycle based on margins, based on profitability. So you have these lower valuations on top of earnings, which are not near the peaks. From a long-term perspective, I think the sector story still holds. And in terms of pockets of valuation, right now, I would rather go for quality names. So, LVMH LVMH is my top pick and I also like Richemont CHF at these valuation levels.
Karen Gilchrist: Interesting. Is that because we’ve still got greater appetite perhaps from some of the highest-end markets? You mentioned Richemont, that’s famously one of the upper-end of these brands. Or do you think it just is on a company by company basis there?
Jelena Sokolova: First of all, these companies have the widest moats, so to say, in the industry, right? So we have three companies that are wide moat rated: Richemont, LVMH and Hermes RMS. So the strength of the brands is there. They have also the financials to reinvest behind the brands to make sure that the brands are on top of the mind. And definitely balance sheet flexibility to also survive and thrive in this environment. So that is my first consideration.
LVMH is kind of more exposed to the consumers one might consider aspirational. With Richemont, they have performed stronger because of that exposure to more affluent consumers, as you mentioned. Of course, Richemont will be more hit by the tensions in the Middle East because it has one of the highest exposures to this market. But we think that, you know, from a long-term purchasing perspective that is also transitory.
Turnaround Plans Present Hope for Kering and Burberry
Karen Gilchrist: Understood. And what of some of the turnaround strategies we’re seeing from these big names, for instance, Kering’s KER plans with Gucci and then Burberry BRBY? What more would you like to see from some of these companies?
Jelena Sokolova: So with Kering they have recently held their CMD [capital markets day], of course. They tried to present themselves as kind of a more diversified group. But, all investors’ attention is on Gucci, and whether the Gucci story, you know, whether they will be able to turn the brand around. So first stop is kind of around creative direction around, the new design energy under Demna.
So that is still, I would say, early days to see if that is working or not. And then they have operational improvements in place, like closure of the underperforming stores to restore the profitability, working on the simplifying product assortment, and also working with pricing, which makes more sense on the investment and quality, of course, starting around to take time. And it’s a question how much runway sort of for trying the current management has. So I would say it still is a work in progress. The shares are still undervalued. But probably there are upside risks as well as the downside.
On the Burberry side, I think, what they are doing now is quite good. We see kind of early results of the strategy working. And what I like about the strategy is that they are returning the focus on where the brand is the strongest. So, outerwear, English Heritage, you know, scarves, etc. Focusing on where the brand is the most differentiated, and that seems to be resonating more with consumers now.
Luxury Stocks as an Antidote to AI Risks
Karen Gilchrist: Finally, with concerns about AI afflicting really most industries, some have suggested that luxury stocks could provide the ultimate hedge. Their emphasis on assets and the craftsmanship is not the type of thing that can necessarily be replicated by AI. What’s your position on that? Do you think it really is the sort of antidote to AI?
Jelena Sokolova: On one hand side, yes, I think the barriers to entry remain high. There is very little kind of improvement in terms of technology. A handbag is still a handbag, right. And it’s also not easy to replicate what these brands stand for. So, the status symbol. These brands are status symbols. To be a status symbol, the brand has to be known. That takes a lot of time, a lot of investment. So that’s why we see relatively low risk from both technological obsolescence and also increasing competition. That’s why this brands are moaty.
The only thing where I do see a risk is the implications of AI for jobs, especially the high-wage jobs, because those are the future consumers of luxury, and we have already seen that, you know, the numbers of luxury consumers are going down. It’s a more polarized market. So, the reduction of this future pipeline of consumers could be a risk for the sector.
Karen Gilchrist: Fascinating, and one to be closely watched. Jelena, thank you so much for your time. For Morningstar, I’m Karen Gilchrist.
