Luxury Goods Sell-Off Presents Opportunity

Morningstar analysts say luxury sector valuations have improved as fears over Chinese consumer confidence have weakened share prices of firms like Burberry

Jelena Sokolova 12 October, 2018 | 12:17PM
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Burberry Shoppers in China

Shares in FTSE 100 fashion retailer Burberry (BRBY) fell this week amid concerns over waning Chinese consumer confidence and the ongoing effects of Beijing’s crackdown on the gifting of luxury goods to officials.

While the luxury sector has been battered over the past few days, Morningstar analysts are maintaining their fair value estimates for the firms in this space. We believe the sector valuations are now returning to more palatable levels, after being materially overvalued for most of 2018.

While many valuations are still stretched, the sector sell-off has created a few opportunities for long-term investors. Shares in Burberry are now trading just below their fair value of £17.90, having started the week round £19 a share – and having traded above £23 in late August 2018.

The main reason for the sell-off is the concern over the health of Chinese consumer. China has led the sector recovery since mid-2016, with Chinese luxury spending growing in double digits, versus 3% elsewhere. Chinese spending now accounts for 20%-50% of revenue among companies under our coverage, with the lowest exposure for US-based Tiffany (TIF) and the highest for Swiss watchmakers.

However, luxury industry valuations reached their 10-year peak levels around midsummer, with no cyclical risks priced in. With geopolitical risks mounting, it should not be surprising that the sector is rerating and perhaps there is more to come, as it is still trading at an average 8% premium to our fair value estimates, with most stocks in a three-or-two star category.

Chinese Domestic Demand Strong

According to luxury companies' management teams, Chinese consumers are getting younger and are buying for themselves, rather than purchasing gifts for others, which would attract the attention of a government trying to crack down on corruption. Chinese luxury buyers spend a higher proportion of their income on luxury goods than their Western counterparts, which has likely resulted in more cyclical demand.

We believe this explains why the names that enjoyed strong performance with younger, potentially more price-sensitive clientele, have sold off more than firms like Hermes that cater more to high-net-worth individuals.

Exacerbating China fears have been the rumours of Chinese government cracking down on luxury goods imports. We believe the Chinese government’s actions are aimed at supporting local spending and came following the import duty reductions earlier in July, to which most luxury companies responded by cutting local prices.

In 2017, luxury buying in mainland China outstripped Chinese global buying with 15% growth, according to Bain Capital, supported by decreasing price differentials. We believe that the actual location of Chinese purchases has become less relevant, given the established local retail infrastructure in China. The key variable is the overall demand backdrop. Our forecasts are calling for a more moderate high-single-digit growth rate in Chinese consumer demand.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Jelena Sokolova  is an equity analyst for Morningstar