Wednesday, January 19

Luxury is highly dependent on the Chinese economy for future growth

SIMON BROWN: I’m chatting with Peter Little, investment analyst at Anchor Capital right now. Peter, I appreciate the early morning. You turned off a note last week about luxury and China. Right at the top is a table (see below) that absolutely blew my mind. I knew China was important, but if you look at the different companies … [from] Swatch with 50% of sales in China, down to LVMH at the low end still with 31%, the average is 35%. Richemont is 40%. Luxury is heavily dependent on the Chinese economy for future growth.

Source: Anchor, UBS estimates, company data

PETER LITTLE: Yes, absolutely, Simon. Thanks for inviting me this morning. That is why the market has reacted so badly to [Chinese president] Xi Jinping’s comments came around mid-August, when they were starting to make arguments about “ common prosperity ” goals, that excessively high incomes needed to be reasonably regulated, and all of these actions were reduced by 15% because people were worried. that Chinese buyers of luxury goods would be disappearing. Clearly, it is an important region to them and it is likely to become increasingly significant.

SIMON BROWN: Yes. I want to touch that ‘more meaningful’. Certainly the longer term vision or the medium and long term vision is positive. In the short term, you mentioned concerns about “conspicuous consumption” (don’t display your Gucci bag and the like) and the possibility of taxes coming in. There may be some headwinds in China over the next several years that will create some challenges for these luxury stocks.

PETER LITTLE: Yes absolutely. I think there is certainly some kind of regulation coming. I think China needs to reform its tax model, which has a very low personal income tax. Proportionally, I think about 5% of China’s taxes come from income tax, so they need to reform that.

Its excise taxes are heavily skewed towards import duties and tariffs on manufacturing, unlike the VAT tax style seen in the rest of the world. So a lot of these things will come.

But obviously, taxes are a delicate matter and the Chinese Communist Party must make sure that [does not] alienate themselves from the population. So I think these tax reforms will be implemented slowly. But they are certainly more likely to hit the higher end of the spectrum in China in the future.

SIMON BROWN: And then the bigger story, perhaps – and this is the story of China to some extent – [is that] one of the things they are looking to do is double the middle income group over the next decade. That implies a growth of around 7% per year, and that is the group that will be there in the future doing the purchases. So once we’ve gotten through perhaps the changes in tax regimes and the like, there is actually a very optimistic medium and long-term story in luxury and China in particular.

PETER LITTLE: Exactly. So your goal is to create an olive-shaped income distribution, which is a bit thick in the middle and thin at the top and bottom, as opposed to the one you have now in the shape of a pyramid. They currently have more than 50% of their population in that lower income group and just over 10% in the high income group.

So the idea is that they create this olive-shaped thing, just to shrink or move that low-income group to the middle-income areas. It’s not so much about eradicating the high-income group.

They are happy that it exists; it just can’t be disproportionately large.

But in the process of shifting these low-income workers to the middle-income ones, obviously, as you say, that’s a huge boon for the middle-income group, which should double in the next 10 years with, as you say, about 7%. growth rate. Surveys conducted by Morgan Stanley’s AlphaWise suggest that about 70% of the middle-income cohort have made luxury goods purchases in the past 24 months; If we look at the highest income groups, that number is in adolescence.

This says that luxury goods purchases are much more prevalent in that middle-income group, and therefore the growth of that middle-income group in China is a kind of quite powerful structural tailwind for item purchases. deluxe.

SIMON BROWN: Yes, 70% is a staggering number.

Last point. It also suggests that perhaps a softer luxury trend, which is leather goods, that’s fashion, maybe growing a little faster than watches and jewelry type. That is a trend that we have seen and believe it will potentially continue. That plays with LVMH, Hermès, and the like.

PETER LITTLE: Exactly. Certainly, the whole category has gone pretty fast.

The sector that has probably had the most problems is luxury watches and Richemont is quite exposed to that. Swatch obviously has that as almost all of its income.

Certainly, the crackdown on corruption in China was around 2015, that sector has been under enormous pressure. Even within Richemont, you’ve seen its 15% to 20% operating margins drop to something of a 5% now because the volumes just aren’t there. So that is the only sector that has had enough problems.

Richemont’s latest results show that jewelry can seem to be doing quite well. So that part of the hard luxury is working well. Watches not so much. But certainly the highest margins and the most growth come from that slice of soft luxury.

SIMON BROWN: We leave it there. That’s Peter Little, an investment analyst at Anchor Capital. Like I said, a really cool note you posted last week. You will find it on their website.

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