Prada

3rd largest luxury handbag brand/company in the world.  For fashion and leather, the Prada brand had 2011 sales of 2b Euros, compared to:

• LV's sales of 8.7b (includes all LVMH's fashion and leather brands - Fendi, DKNY, Loewe, Celine and others - majority of sales are probably from Vuitton).
• Gucci's 3.1b (part of PPR).

What do they do?

In 1H12, 62% of their (company wide) sales were leather goods (excluding footwear), so we'll concentrate on that.  In Asia, I would say that all the 'fashion' stuff is really just there to decorate handbag shops.

Prada bags are roughly the same price as LV, in the middle of HSBC's luxury pyramid:

I believe Prada is targeted at women over 30.  Their sister brand, Miu-miu, has bags around 30% cheaper, aimed at younger people.

Prada also owns Church and Car Shoe - they are insignificant so ignored here.

Prada is more fast-moving than LV: they are more design or fashion driven.  As a they were initially a clothing brand, they have collections and fashion shows every year.  As much as 70 percent of its products are renewed every year.  They also hold 'flash sales' of limited edition items available one-time only, and constantly add new collections (e.g.: Valentines day).  Although their signature look is "black leather with a small gold logo", they have a larger variety of bags with different shapes/colors, compared to LV or Gucci:

Although LV's bags have changed (e.g.: neverfull), their colors and logos are the same as from ten years ago.  Even their new designs (e.g.: Athena hobo) are 'logo driven'.  Every bag I see  in an LV shop had an instantly recognizable logo.  Good, because the bags are 'timeless' and instantly recognizable.  Bad, because they are becoming boring and ubiquitous.

Other than that, Prada's business model is similar to Vuitton:

• Building temples:

•  Opening new retail outlets:

          They intend to add 100 outlets in 2012, 60 in 2012 and 60 in 2014.

          From DBS (Mar 12), they still have less than half LV's outlet numbers.

           Still have low penetration in China and the US:

• Reducing sales through franchise stores (down to 25 stores in July 2012):

• Reducing mark down policy: DBS Mar 12: "Since 4Q09, Prada has cut down price reduction rate for certain products from 50% to 30% and some from 20% to 10%".

Interesting that Prada spends a lot less on marketing and advertising than LVMH (5% vs 11.5% of sales in 2011).

Made in China?

Unlike Vuitton, which manufactures its products in-house in Factories in Europe and California , Prada manufactures all over the world.  From the DBS report: "It outsources c.80% of its product manufacturing processes to  c.480 external manufacturers (semi-finished and finished products) while keeping the balance 20% of processes in-house, hence ensuring at least one important phase of the production process is performed internally. Prada has a total of 11 in-house factories (10 in Italy,  1 in England)."

About 20% of Prada's collection (including some bags) are made in China.   "Sooner or later, it will happen to everyone because [Chinese manufacturing] is so good," Prada designer Miuccia Prada said in an interview.  "What do you care where I make my shoes?" says Prada Group NV Chief Executive Patrizio Bertelli. Where local laws permit, Mr. Bertelli says he'd prefer to insert a "Made by Prada" tag in his products.

I think that Prada is doing this because, as they are more design and fashion orientated, they need faster and responsive manufacturing capabilities.  Unlike LV.  I don't know if this will become an issue: Coach and Burberry manufacture in China, but their bags range from several hundred to SGD 1.5K - almost half the price of a Prada or LV.  I believe that, for an Italian luxury brand, people do not expect their bags to be made in China.  And in Prada's price range, people do want to have to search for the hidden label to see where something is made.

Maybe people will accept it, maybe not.  This is possibly a serious threat to the image...the authenticity of the brand.

Management

Company is led by Micciu Prada (63) who handles fashion, and her husband Patrizio Bertelli (66) who handles business.  This article suggests that their children (early 20s) may not be part of the business.

This article mentions a high turnover of execs due to Bertelli's style.

An old 2001 article: Bertelli, some Prada people say, wants to go mass-market by buying brands such as Italian tennis-shoe company Superga and sticking the Prada name on everything from fragrances to jewelry. " 'We don't see ourselves as a luxury company in strict terms,' says Bertelli, who points out that people who buy Rolex watches also buy Swatches. "  Fashion or Luxury?

Could not find Prada's conference call transcripts.

The company is under family control: almost 80% of Prada SPA shares are held by PRADA Holding BV, leaving a ~20% free float.

Profit breakdown

Their largest costs are COGS, which as a proportion of sales has been dropping steadily over the years.; Probably due to the increasing proportion of retail sales:

This has givem both top and bottom line growth for the past few years.

Their expansion over the years comes at a risk of increasing operating leverage (e.g.: fixed costs from store rentals). Their operating costs are given in 2 breakdowns (footnote 35).  The main one is personnel, followed by Admin: Its not really possible to guess which are fixed costs and which are variable:

The largest costs in in the 2 different breakdowns are 'Selling' expenses and 'Staff' costs.  Fixed or variable?  I do not know if Prada sales associates earn a commission or not.  Some brands pay commission (6% given here), some don't (Vuitton).  COGS is probably variable, since most of their production is outsourced.

Liabilities

From the 1H12 results, balance sheet looks clean. Debt has steadily been shrinking since listing in 2010.  Retirement liabilities of 42m are insignificant compared to the 289m half-year's profit.

Only possible issue is the high operating lease commitments: 254m due within 1 year.  And 771m due in the next four years.  A significant fixed cost.

There one contingent liability: The Shareholders’ agreement signed between PRADA spa and Al Tayer Insignia llc for the development of a Prada and Miu Miu network in the Middle East provides that the parties may exercise an option whereby PRADA will buy back up to 20% of PRADA Middle East fzco shares.

Cashflows

CashFlows from operations has been higher than earnings every year since listing.  The difference is mostly depreciation and amortization:

Working capital is usually negative (but very small compared to the depreciation and amortization).  WC was only positive in 2009, as inventories and receivables were drawn down, probably due to recession:

CFI has been less than CFO, generating free cashflows every year:

Conclusion

Seems to be a cash cow, and growing.  In that respect, its like Richemont: a cash cow with high operating leverage, but little or no debt.

The risks are:

1. Its a single brand only, maybe two....Prada and Miu-Miu bags are kind-of similar. More than LV or Gucci, Prada relies on constant updates to get people to buy.
2. The "Made in China" issue.  Long term, it may threaten the desirability of the brand.  Fashion vs luxury?
3. Has not been listed for long enough to see how demand is affected during recession.

See how they sales and profits are affected during a recession first.  If I do buy, I must remind myself to buy less, due to 1. and 2.

Quick notes on Swatch

1) Omega is trying to move upmarket, having:
       - increased prices dramatically (~30 to 50%) in the past few years, with
       - more marketing: Olympics and James Bond, and
       - pulling stock from third party stores while relying on their own boutiques.  Who no longer give the expected 20% off MSRP.

If successful, they will end up like Rolex: widely known to the general public as an expensive watch to buy when you've 'made it'.  Instead of 'the watch for when you cannot afford Rolex'.  I think it will take 5-10 years for the general public's perceptions to change, but Swatch (being family controlled) should be disciplined enough to pull it off.

Those buyers priced out can always buy a cheaper brand instead: its common here to see am Omega boutique next to a Longines or Tissot one.  I love Swatch's long term branding strategy, market segmentation...and their profit/cashflow numbers.  Just wish they would give more transparent: giving breakdowns between their high end and low end segments, make conference calls available, and give a better breakdown in their P&L statement.

2) In late March, HSBC downgraded Richemont to neutral on fears that high-end watch demand may be starting to see a downturn (poorer sales and rising inventory at Hengdeli), partially due to a decline in 'gift giving' due to China's leadership transition.  They were more optomistic on Swatch due to its lower end brands.  HSBC turned out to be a a bit early, but still take note of this to see how accurate their reading of the (Chine) watch market was.

I still like Richemont, and would buy on any serious downturn.

Because you're worth it

L'Oreal is the largest beauty company in the world, selling a variety of different brands.

Also owns a minority stake in Sanofi-Aventis - this is ignored here, all earnings are operational earnings.

 

Sales and Profitability

By sales, the company is the largest in the world, closely followed by the beauty divisions of P&G and Unilever.  The other players, such as Ester Lauder, Avon have less than half their revenue.

Notes on the categories:

• For P&G we are looking at 'Beauty' category: this excludes 'Grooming' (men's personal care)
• For Unilever, it is 'Personal Care': this includes all skin care, hair care,m deodorants and oral care.
  

Looking at profitability:

All operating margins above exclude taxes.  P&G and Unilever numbers are special: their margins exclude additional company-wide 'corporate' costs (so really, their margins should be reduced a little):

• P&G 'corporate' costs are mentioned in the breakdown, but I could not understand the description.
• Unilever's profit numbers also exclude corporate (2011: about 8% of operating profit).  However the profit numbers already include interest costs.

We can see that size matters.  The top 3 (Loreal, P&G, Unilever) consistently have a distinctly higher profit margin.  L'occitaine is still in its early growth phase, hence its high profit margin.

The beauty market is still quite fragmented.   Total size is estimated at 153bn Euros - all the players above together have less than 50% market share.  There must be a 'long tail' of smaller, localized or niche players.

It is a fiercely competitive market; L'Oreal is one of several large players and there are no barriers to entry for smaller players.

Marketing Costs

Since marketing is their largest cost, lets compare:

L'Oreal consistently spends one of the highest percentage of sales on marketing.

In dollar terms, it was the only company to increase marketing spend every year over the period shown.  Tom Russo often talks about a company's capacity to suffer: the ability to spend money for the long term, while ignoring short term drops in EPS.  Publicly listed companies often face pressure to cut costs.  L'Oreal is controlled by the Bettencourt family and Nestle, who each have a 30% stake, it seems to meet this criteria.  (Wonder why Tom Russo has no direct investment in L'Oreal?)

 

Industry Growth

Woldwide growth has been 3-5% in good times and 1% in bad times:

Looking at different regions:

• Developed countries show low single digit growth in good times, offset by the same low single-digit declines in bad times.
• Developing countries (AsiaPac, Eastern Europe and Latin America) show continual high growth (between 5-20%).  Don't know about bad times - was not able to get figures back from the Asian Financial Crisis.

Cyclical

L'Oreal's sales show mid to high digit growth in good years; -ve single digit growth in bad years:





How much of their costs are fixed vs variable?  From the 2009 contraction:







Their main costs are variable, especially A&P.  Low fixed costs (depreciation and R&D), high variable costs (A&P and others - that covers SGA and COGS - cannot break them down due to depreciation).

 

Balance sheet:

Compared to their 2011 earnings of 5bn Euros, the balance sheet looks fine.

Negligible liabilities. Debt, contingent liabilities and operating leases added up are far less than 1bn.

Pension fund is underfunded by 753m.   Conservatively invested: 50% bonds, 35% equities.  Acturial gains/losses are recognized as they occur, it seems that other losses (e.g.: poorer than expected returns) are not.  Their assumptions look reasonable:

History of Debt and acquisitions

The beauty industry is fast changing, and L'Oreal makes constant acquisitions.  How are their acquisitions funded, and what is the effect on their balance sheet?

Long-term debt and spending on acquisitions is below, with operational earnings for comparison:

• LT debt has always been less than 1 years operational earnings, except in briefly in 09.
• Acquisitions are always funded by debt, no new shares issued.
• Sometimes they change their LT debt to ST debt, usually before paying it off.
• They are conservative: Historically, L'Oreal does not carry large amounts of debt, and likes to pay it off within a few years after accumulating it.

Business Model

Low capex, low working capital, high marketing.

In the long term: develop brands so that customers come to retailers for them.  Occasionally acquire some of the new brands that pop up and give them support to expand.

In the short term: its a constant battle to push new ideas, new products, new advertising.  And to keep up with compeditors.

Independent Retailers

A recent trend is the rise of large, independent beauty retailers stocking multiple brands.  LVMH's Sephora is the largest:

Sephora is popular because they offer a large variety of products in a clean, bright environment, allowing customers to try them.  They are a possible threat to beauty brands, as they will try to push their house products first, LVMH brands second, then others third.

Sephora's sales are unknown: LVMH's Selective Retailing group made 6.4bn Euros sales in 2011, but this includes DFS plus a few other businesses...so maybe say 4bn.  Compared to 19bn Euros sales of L'Oreal alone, or a total estimated market of 153bn Euros, Sephora is still a small player.  The beauty product retailing space is still fragmented, but if Sephora keep doubling the number stores every 6 years, they could gain some control over the market in the future, similar to how supermarkets can replace some products with their own brands (e.g.: Kraft cheese) and therefore control pricing.

Another US player is Ulta, supposedly more mass market, but trying to move upmarket.  They had roughly 1.4bn Euros sales in 2011, and 449 stores.

Retailers are not a threat yet, but may be later.

Conclusion:

Like:

• One of the strongest players in a growing industry.  Wide variety of brands from mass market to luxury.
• Recurring income (unlike watches, cars for example).  Low capex.
• Good play on emerging markets, can deploy capital to wherever the growth is.
• As people grow from poor to middle class, they use more beauty products.  And after they get richer, they use more expensive beauty products.

Don't like:

• Fiercely competitive industry, no barriers to entry.  Constant re-invention, pushing of new products (or of marketing passing itself off as re-invention).  Consumer tastes can be fickle.  The phrase "You're only as good as your last ad" comes to mind.
• Possible threat of large retailers gaining control of products placement and pricing: Sephora/Ulta.  LVMH is a formidable competitor. Not a threat yet, but something to watch for.

I'll put L'Oreal on my watchlist to buy

The Beauty Industry

Want to look at beauty products because they are based on branding.  Unlike other supermarket products, such as tissues, cleaning detergent, or breakfast cereal - I've never seen a woman buy a generically branded beauty product.

A quick look at the market, to get a feel for the products sold and the industry.

Breakdown by Category

An estimated breakdown of the total beauty product market, from L'oreal's 2011 Annual Report:
Some of these products, like toiletries, deodorants, nail polish, hair coloring, perform simple, straightforward functions.  For others, like perfume and skincare, its not really clear what they do, and they rely 100% on branding.  Skincare products are the most expensive, as well as the most nebulous in their claims, especially with the latest trend of combining them with 'anti-aging'.

What are you paying for?

Marketing

Even for lower-end products performing a simple, clear function, marketing is still important.  For example, this advertisement pushed sales up by over 50% in three months, and by another 100% in the follow-up online campaign:


The largest expense for beauty companies is marketing:

Company	2011 Revenue spent on Marketing
Loreal	31%
Beiersdorf (Nivea)	30%
Revlon	20%

So the idea here is to bombard people advertisements everywhere: on TV, magazines, cinemas, bus stops, internet... wherever.  With the breakdown in traditional media (do people still watch free-to-air TV, or read paper magazines anymore?), it will be interesting to see how the beauty industry adapts.

A Story

The Body Shop is probably the best example of a brand selling a story.  Even people like me, who know nothing about cosmetics, had some vague idea that they use natural products, love animals and help African tribes.

Brief history, from Branded Beauty by Mark Tungate:

• Anita Roddicks opened first shop in 1976.  Wanted to sell natural beauty products inspired by her travels.  Invited customers to bring back bottles for refills as she barely had enough bottles.  Handwrote the labels.  "Tales of the products and how they were made were displayed alongside photographs of the countries she had visited and the tribes peoples she had met. She was selling the story as much as the product" [*].
• After opening a second branch, set up a franchise model.    Franchises agreed to stick closely to the branding and retail template.  Billed the products as 'cruelty free'.
• Floated on LSE in 84.   Rapidly spread franchises over UK.  First US shop in 88.  Rivals started making 'cruelty free' products.  In the early 90's, 'switched "her stores' focus to 'saving the planet'...just as public awareness of environmental issues began to accelerate.'  [*]
• Established a marketing dept and appointed an advertising agency in 95.  Company still associated with activism, e.g.: save the whales,  WTO protests.
• In 1998 Roddicks started to relinquish control, and in 2002 stepped into a non-executive role.  Continued her activism.In 05, set up the Roddick foundation. 
• Sold Body Shop to L'oreal in 2006.
• Anita Roddicks died in 2007.

 The Body Shop was the first brand to bring 'organic' and 'cruelty free' products into the mainstream.  Since then others have followed.  Later on, it'll be interesting to see how it has fared since being bought over.

Luxury

Some beauty products are luxury items.  The way to build these brands seems similar to other luxury products, such as watches or handbags:

• Control of retail experience: boutiques, beauty salons, spas, kiosks in department stores. Where you manage your own staff and create your own environment.
• Selective placement, or strict control of channels.  In other words: making sure the products is always variable in an appropriately upscale place (e.g.: given only to top range rooms in a hotel or 1st class passengers in an airplane).  And that they never go on sale.
• Crossover of other brands/icons e.g.: Dior, Chanel moving into skincare.

Being Different

Quick example of a new company, also from Branded Beauty.  Aesop skincare as started by a salon owner in Melbourne in 1987; by 2011 had 36 stores worldwide.  Their products are very distinctively and simply packaged.  Their stores are unique to their neighborhood: one in Tokyo has recycled materials from a demolished house nearby, one in London's Mayfair has a Gregorian air with antique green walls.  These stores are marketing tools, often featured in design and architecture magazines.  Their website features artistic stuff like photography and travel guides.  Products are also supplied to selected restaurants/hotels.  "Our customers tend to be urban, worldly, well-traveled, curious and quite demanding".  Founder says that mainstream cosmetics are "passionless products constructed by marketing departments and focus groups, and designed to exploit the vulnerabilities of people to appeal to those who would like to be lighter, slimmer, thinner, whatever...".  Maybe he's right.

Perhaps this company is where The Body Shop was 20 years ago.

Scientific Research

R&D seems to be a part of marketing.  From Branded Beauty again: how a cream is launched:

• Companies watch the market carefully and launch new lines based on their competitors and the latest trends, or because their old lines are getting tired.
• Find a new active ingredient - a story to tell.  Written down, with the aim of creating the advertising copy at the end of the process.
• Discuss with the laboratory.  Refine the story until the research supports it.  An example is Vichy's LiftAvtiv Derm Source, targeting the epidermis to imply that it the source of all skin problems and can be target with a plant extract.
• Laboratory makes samples, and tests that the active ingredients do not react with the common ingredients (water, preservative, fragrance) or with the bottle.  Packaging is decided with marketing team.
• Sample creams are created tested by several people for texture.
• Blind consumer tests carried out with volunteers.  Asked to use the cream for 15 to 30 days to see how it affects their skin.  Small sample groups - as few as 30 - allow companies to claim things like '80% of women tested noted an effect on their skin'.
• Packaging and advertising with agency.  'Dramatize science'.   Translate some scientific terms into something women can understand (epidermis --> 'derm source'), and have a close up picture like a biology textbook.  Maybe add a celebrity.

From conception to launch usually takes 18 months.

Interesting note that the UK Advertising Standards Authority is one of the strictest in the world, and may not even allow normal sounding claims ('younger looking skin') and digital enhancement, even when the advertisements are peppered with disclaimers.  Overseas brands often have to adjust advertising copy for the UK market.

Conclusion

Marketing and packaging is the most important part of a beauty product.  Even for simple, lower end items such as nail polish, lipstick, maybe even shampoo and conditioner.  Skincare products are the highest priced - as their claims are the most nebulous, they can afford to price their products higher and use any possible angle to sell them: creams with new scientific breakthroughs or ancient herbal remedies, gold dust...whatever story you can think of, it can be spun.

As ethical, cruelty-free and organic ingredients have become mainstream, the industry will move on to other things.  Neutriceuticals, neurocosmetics, nanotechnology, whatever.

There are no barriers to entry in this business.  Brands and beauty products pop up like mushrooms.  At the high end of the market, anyone can come up with a new twist, like Aesop above, or Absolution (customizable creams), Caudalie (vinotherapy - wine).  At the mass-market end, there may be some barriers in terms of scale, due the the distribution and marketing required, but even here, new products emerge frequently.

I would guess that women know they are buying hope-in-a-jar, but are happy to do so anyway.  Maybe it is soothing or stress relieving for them.  As long as people keep buying the fantasy, there may be money to be made.

The Swatch Group

Largest watchmaker in the world.  Provides a 'ladder of brands', from low end to high end:

• Swatch and Flick Flak: $30 to $100+
• Hamilton and Tissot: Around $300 to $1500
• Longines: 1.5 to 3.5K per steel watch
• Omega: 3K to 8K: per steel watch
• Breguet, Blancpain, Glashuette Original: starting at 15K

Competes with Citizen/Seiko/Casio and many others at the low end, Rolex and Richemont in the luxury range, Richemont, LVMH and Independents in high end luxury.

Segment breakdown

How much of their sales are from high end watches vs low end?  Swatch gives no breakdown: 70 color pages of rubbish in their Annual Report without a single number!  Have to guess from online snippets.  Out of 2011 revenue of CHF 1.27b, from high end to low:

• Breguet nearly reached 1b (8%).
• Omega is the largest contributor, 2011 estimated revenue will be CHF 3 or 4b, or an estimated 30% of 2010 Swatch Group sales.
• Longines is close to 1b (8%).
• Tissot produces 3-5m watches per year (video from May 12), I'm guessing 1b revenue (wholesale prices), giving (8%).
• Hamilton is now top of Swatch's mid sized brands.  Lets say 1b (8%)
• Swatch has yet to reach 1b (maybe 5%)

Estimated 2010 revenue (from HSBC Research) is:

Revenue accounted for seems to be spread between low, mid and high end.  Based on the above, and the list of Swatch brands, my guess is: 15% high end luxury (Blancpain, Breguet, Glashuette Original), 30% luxury (Omega), 15% high end (Longines, Rado), 25% basic watches (Hamilton, Tissot, Certina), 5% for kids (swatch, flick flak).  Remainder for ETA and electronics.

Swatch Branding

All swatch brands are neatly categorized into a specific price range with certain characteristics.  For example, a Hamilton or Tissot will never release a watch at a Longines price range.  Only Rado will make ceramic watches.  It follows 100% a textbook strategy on price segmentation by branding.

This is a different approach from Richemont, whose brands compete a little, and do sometimes their own thing by releasing watches that are 'out of character'.  For example, up-market JLC released a Navy Seal watch.  Panerai, a sports brand with large luminous dials, made a  torbillion watch.

Hamilton

Has a rich history and tradition. After dying and being resurrected by The Swatch Group, is now a shell of its former self.

Gained fame in the 19th century as a railroad watch.  Official watch of the American Expeditionary Forces in WWI.  In the 20s and 30s, was used by explorers: Commander Richard E. Byrd f;ying over the North Pole in 1926,  Roy Chapman Andrews  in three years' exploration of the Gobi Desert, First Byrd Antarctic Expedition to the South Pole.  Produced a maritime chronometer in WWII: from zero they produced 10,000+ pieces by the end of the war - considered the 'most accurate portable mechanical timepiece ever made'.  Produced the worlds first electric watch in 1957, the Ventura, worn by Elvis Presley in 'Blue Hawaii'.  Went out of business in 1964.

Brand sold to Swatch Group in 1974; production moved to Switzerland in 2003.  Hamilton watches feature in many Hollywood movies.  Still marketed as an 'American' brand, is pigeon-holed at the lower end of the swatch range (U$300 onwards).

Profit breakdown

Personnel costs usually increase steadily (1% down in 03, 4% down in 04, increased all other years).  'Rent, maintenance and Energy' is also probably fixed.  The other costs seem variable, especially Materials, and Marketing/Sales/Admin:

Profit margin (before tax) recently is between 15% in bad years and 23% in good years, similar to Richemont.  But if we look further back:

Richemont is far more cyclical than swatch - Richemont's profit margins are lower in bad times and higher in good times.  As expected, since Swatch also sells lower end products.

Balance Sheet

Quite clean, 1.6bn CHF net cash.

600m contingent liabilities.  700m leases over the next 5 years. 

Comparison to Richemont

Transcripts: In 2011, Swatch tried to sue Bloomberg for secretly recording a conference call with Securities Analysts and selling it to their clients.  Apparently Swatch has never heard of immediate disclosure of public information.  Switzerland is ranked 3 out of 10 in the world bank ranking for investor protection, on par with countries such as Mali, Chad and Iraq.

Richemont has the potential to branch out into other luxury products (leather goods, jewellery).  Swatch will forever sell watches.

Swatch has many competitors in the sub USD 1000 range.   Some of them make excellent watches (e.g.: Seiko), but have not been able to brand their products to successfully move above that range.  Richemont has fewer potential competitors: in the luxury segment (e.g.: Omega/Rolex/Cartier), branding builds most of the product's value, and only large companies can bankroll this.  LVMH is a threat to both companies (Tag Heur competes directly with Omega....I don't think it has the same type of image as Cartier...achievement vs luxury).

Cannot fault the numbers from Swatch, they are profitable in good times and bad, and less cyclical that Richemont.  They are also financially conservative and don't like debt.

But it seems easier to get a feel for how Richemont develops its businesses, and they have greater potential to expand.  Subjectively, I would choose Richemont.

Richemont

Second or third largest luxury goods company in the world, after LVMH and PPR.  Sell mostly watches and jewelery.  Owns Cartier, Van Cleef and Arpels, IWC, Panerai, Jaeger-LeCoultre, A Lange & Sohne, Montblanc, Shanghai Tang and others.

Its a holding company for the South African Rupert family's Luxury goods companies.  The CEO, Johann Rupert, owns 10% of the stock but has majority voting rights.

Some Brand History

Some scattered bits and pieces about their brands....to get a feel for the business they are in.

LMC

In 2000, Richemont sold their media business and bought LMH (Lange & Söhne, Jaeger LeCoultre and IWC), paying 3b Swiss Francs, at the peak of the economic and watchmaking cycle. They were widely considered to have overpaid - LMC sold 91000 watches in 1999 though 15000 retailers, giving a price tag of U$1.2m per retail outlet, none of them exclusive.  Rupert later admitted they overpaid, but said if they could go back, they would do it again, only overpay by less.  It led Richemont to become one of the largest players in the luxury watch industry.

Cartier

The Cartier brand has gone through many transformations, from being 'Jeweller to the Kings' to 'appealing to American secretaries'.  In the 70s and 80s, their 'Les Must de Cartier' line aimed to be affordable to a younger audience, and sold cigarette lighters, perfume, watches, scarves and sunglasses. In 2000, Cartier began to a costly exercise to reposition itself as an exclusive watch and jewelry brand, removing cheaper items in the $1000 to $4000 range, and turning into the brand known today.

Luxury brands may be ephemeral.  It takes a constant effort to build and maintain them, and they can be devalued if they branch into cheaper or inappropriate product lines.  Johan Rupert has said that they do not want to "pick the low hanging fruit".  I think, like what Pierre Cardin did in the 80s and what Armani Exchange is doing now.

Profit Breakdown

Notes:

• Operating Margins below approximate PBT in the period shown, they differ only by (negligible) finance costs.
• Using PBT allows us to ignore BAT associate (divested Nov 08)

The dip in 2010 seems to trail the stock market by one or two years: hard luxury is historically more cyclical than soft luxury.  Operating margins are between 15% (bad times) to 23% (a stellar 2012).

As a percentage of sales:

What costs are fixed and variable?  Looking at the absolute amounts (not percentages):

• Only their Administrative costs seem to be fixed (Only dipped once in the past 7 years, and that was less than 1%).  
• Other costs seem to be variable: Advertising declined 21% in 2010 (its not obvious on the chart) but rose every other year.  
• It takes a fixed investment in staff and equipment to produce and jewelery and watches, but Cartier cut about half their production staff in the last downturn.  Variable....I guess.

 

Balance Sheet

Very clean. Negligible long term debt.  3b Euros cash.

Minimum operating lease less than 600m Euros.  Interesting that about 40% of this is contingent, the real minimum (if they don't sell anything) is under 350m.  They get their landlord to share in their success - first time I have see this in a listed company.

Non-cancellable leases are 900m for the next 5 years.

FCF and Capex

First, looking at CFO and Profits: since COGS is their largest cost. their CFO is most influenced by inventory:  (All charts below exclude BAT)

There is a clear pattern: CFO is usually slightly lower than profits, the difference being mainly inventories and depreciation.  Except for the past two recessions, where they work off inventory (2004 and 2010 were the only 2 years where inventories added to CFO), resulting in CFO being higher than profits.

They have generated free cashflow for the past 10 years (2002 was negative due to high CFI):

Majority of CFI was spent on PPE (mostly) and acquisitions (approximately 1/3rd of it).  Can't determine how much of the PPE was replacement and how much was expansion.

In the 2011 AR, they said they will keep expanding: "Our capital investments are therefore likely to range between 6 % and 8 % of sales in the next two years".

Business Model:

Buy troubled brands on the cheap, then take 5 or 10 years, using cashflow from their existing successful brands, to turn them around.  Examples of troubled brands acquired include Cartier in 1979, Panerai in 1999  - LMC was the exception (...not cheap).  They take time and effort to build their brands.  They mention that their businesses need to reach a critical mass: "it’s a lot harder to get from zero, or from €100 million to €200 million, than it is from €200 million to €600 million. From €500 million to €1 billion is a lot easier than from €100 million to €200 million".  Some of their brands are still loss making (Baume and Mercier) - Richemont did not break down the sales/profits of individual brands.

They are financially conservative.  No debt for the past 10 years.  Cashflow from their successful businesses is used to turnaround the troubled ones, and overall they have been profitable, and generating free cashflow for 10 years.  The CEO has stated that they prefer to build their current brands rather than acquire new ones ("Our job is to create goodwill, and not to pay other people for goodwill").  And that they will not use equity for acquisitions

I think they need to be financially conservative to handle bad times in a highly cyclical industry:

• They prefer, as much as possible, variable costs instead of fixed costs.  e.g.: have a turnover clause when leasing from landlords.
• In 2011, retail sales grew to match wholesale, for the first time.  The CEO previously mentioned that there is no fixed target to increase the percentage of retail.
• CEO previously mentioned that they are one of the fastest in scaling back production when bad times occur. 

Each brand has separate manufacturing facilities: "Our philosophy is based on verticalisation, i.e. each maison has its dedicated manufacturing facilities to guarantee authenticity."  This is important, because serious watch-people care about the components inside their watches.  So they don't try to get 'synergies' or economies-of-scale from combining (the manufacture of) different brands.

The transcripts of the results presentations are very informative. And even entertaining - especially the Q&A sessions.  Really get a feel for how management runs the business.

Conclusion

Like this company: Its long term approach to building brands, clean balance sheet, free cashflows, and financially conservative nature.

And my wife likes their brands.

Risks:

• LVMH. With 3X the revenue and profits of Richemont, and its Bvulgari acquisition - LVMH is moving further into the luxury watch industry.  The barriers to entry are not strong enough to stop a monster like LVMH.
• China.  A downturn would affect everyone else too.  With its cash, the company will survive.

High beta stock, we see it roughly drop and rise 4X from peak to trough (stock price in Swiss Francs):

(Note the chart's y-axis does not start at zero, so looks a little worse than it is).

Dangerous game, playing with highly cyclical stocks.  I don't think I could bear seeing my stock drop 4X....Wait for a recession to buy.