Whether in the Han Dynasty in China, ancient times in the Roman Empire, or modern times in America, people have always craved exclusive jewelry and fashion to maintain a special status in society.
In this context, the term luxury fashion includes not only clothing, but also jewelry, wines, cosmetics and watches.
In today’s world, this seemingly timeless range of luxury items is covered by no group more than Moet Hennessy Louis Vuitton (LVMH).
Founded in 1987, the French company now employs nearly 170,000 people and is the largest luxury company in terms of sales and market capitalization.
If you had invested €1000 in LVMH stock in the year it was founded, the shares would be worth €66,000 today (not counting dividends!).
Since 2009, the average annual performance has been about 20%.
So there’s no denying the sensational success story. But why was LVMH so successful and is it still worth getting involved now?
Business Model
LVMH owns 70 luxury brands in five segments: “Watches & Jewelry,” “Wines & Spirits,” “Perfumes & Cosmetics,” “Fashion & Leather Goods” and “Selective Retailing and other Activities”.
The majority of sales are generated by the apparel segment.
The business model is not simply producing and then selling goods. To understand the business model behind luxury items, you need to know that the only thing that makes an item a luxury item is its exclusivity. Only for exclusive items are certain customers willing to pay exorbitantly high prices. Sometimes customers even buy more products the higher the price. This phenomenon is, of course, diametrically opposed to any conventional market logic and can also only be observed in the luxury market.
So LVMH’s task is not only to invent new products or increase sales, but also to maintain the exclusivity of its products so that its business model works at all.
Thus, LVMH has never offered discounts on its products. After all, discounts would severely damage the image of luxury items. Moreover, customers who bought a product before a discount would be dissatisfied. By not offering discounts, a customer can be sure that the exclusivity of a product will always be preserved and that no one else will be able to buy it at a lower price, so that the prestige of the item will be preserved.
Another LVMH strategy is to destroy its own products. What may seem unbelievable at first glance is a pretty proven strategy for the luxury manufacturer. For example, they always release only a small number of pieces from a new collection to test how the new collection is received by customers. If the products don’t go down well with customers, they destroy a lot of the merchandise to create an artificial shortage. So there are then again more demanders than the supply is large and they even increase the prices of the remaining products. So the main thing here is to have as high a margin as possible and not simply to increase sales.
Target group
A study on the composition of the luxury market from 2019 provides a detailed overview of the target group of luxury companies. The absolute majority of buyers have a household income of at least USD 125,000. Only the minority of buyers are members of the middle class. It is particularly interesting that 60% of the customers have inherited the money. This can be explained by the fact that people who earn their wealth themselves have a different relationship with money. Inheritors tend to spend the money more often. In addition, around two-thirds of luxury shoppers are under 45 years old.
This gives a clear picture of the average LVMH customer: young and affluent (wealth earned primarily through parents). LVMH therefore benefits greatly from the trend that there are both more and more rich people globally and that the rich can increase their wealth much more than the average population. In Asia in particular, the number of rich people continues to increase. In fact, the Asian market is contributing more to sales than the U.S. market.
Motive
For many people (myself included), it may seem absurd that people are willing to pay €4,000 for a bag or backpack that has exactly the same functionality as everyone else.
Consumers’ motives are self-esteem and a sense of belonging. So, on the one hand, they buy the products to satisfy their inner needs for self-esteem. On the other hand, they also do so to convey to society that they belong to a high class and that they have high purchasing power. Thus, luxury corporations do not cover the need for clothing, but the need for self-esteem and social recognition. These two needs are deeply rooted in human nature. This is also the reason why some people have always wanted to set themselves apart from the rest of society with special clothing, jewelry or other items. The luxury industry is therefore one of the oldest industries in human history. This also means that the business model is one of the future-proof ones, as this need satisfaction will always be in demand.
Strategy
As just described, LVMH’s main task is to maintain the exclusivity of its brands. However, since it is very difficult to completely rebuild a brand, as it is usually a very long process until the brands are recognized as exclusive, LVMH has often relied on acquisitions in the past. This has the advantage that LVMH only has to maintain the brands’ reputation, but does not have to go through the long process of establishing a brand. Here is an overview of the acquisitions in recent years:
Another aspect of the corporate philosophy is the independence of the brands. All 70 brands are allowed to operate very independently, which gives them a high degree of flexibility. They benefit from the market research and distribution channels of the parent company, but they are allowed to make independent decisions. This decentralized structure can be compared with Berkshire Hathaway, which also implements this strategy with great success.
Another positive aspect is that LVMH is a family-run company. The family holds 47.5% of the shares and Bernault Arnault heads the company. His children are now already managing individual segments, e.g. Alexandre Arnault is the CEO of Rimova. Thus, the successors are already being introduced to entrepreneurial activities now, so that the company will probably remain a family-run business for a very long time to come. I have described in this article why family businesses are usually very advantageous for the shareholder.
Key figure analysis
As can be seen, LVMH performs worse than its peer group in terms of growth, profitability and financial stability. However, this does not at all mean that LVMH is qualitatively worse than its competitors, but it can rather be attributed to its size. Larger companies can generally afford higher debt levels. Moreover, it is common for the return on assets to be lower, due to the falling marginal utility of capital. This means that LVMH has already made many very profitable investments, but because of its size, it now has to invest in projects that have lower profitability than those they made when they were smaller. The somewhat weaker revenue growth is also natural for large companies. In addition, the period chosen was 2015-2020. This means that the weak sales in the Corona year 2020 are also included. Without this special effect, sales growth would be significantly higher for all four companies.
A look at the size of the companies shows that LVMH is significantly larger than its competitors and therefore the weaker figures are not a cause for concern:
Nevertheless, the key figures must of course be included later in the calculation of the fair value.
One important aspect to highlight here is the development of debt.
Valuation
Historical Valuation
You can see that LVMH is well above its historical 10-year average. This is a concern in this case because they don’t have as much growth potential as they used to. So they should actually be valued lower than their historical average.
Now, of course, it could be that they were simply very undervalued in the past, or that the current environment (e.g. interest rates) has changed, so that the stock is still not overvalued. Therefore, the next cut of the stock will be valued using discounted cash flow analysis.
Discounted Cash-Flow Analysis
In order to be able to give as precise a picture as possible of the intrinsic value and the current deviation from it, the discounted cash flow (DCF) analysis is best suited.
For LVMH, I assume a cost of capital of 8%. Some might note that the business model is so secure that one should assume a cost of capital below the market-standard 8%. That is also true in principle. So I would use a lower cost of capital based on the business model. However, this cost of capital discount is offset again by LVMH’s debt, among other things. Thus, the 8% cost of capital is actually rather low overall and positively designed for the group.
For 2021, free cash flow per share is expected to be around €26. Going forward, I forecast average earnings growth of 6% per year. Due to catch-up effects from the Corona crisis, earnings growth may also be higher in the short term, but I think the averaged value over 10 years is around 6% p.a..
In addition, net debt has to be added to the current value.
This results in a fair value per share of around €485. However, the current market price is €674. Adding the debt results in a current price of €710 and a downside potential of -32% to the intrinsic value.
Conclusion
My calculations are generally more conservative than those of many analysts, but there are stocks that offer a better risk/reward profile than LVMH, even under my assumptions. To be fair, due to low interest rates, LVMH’s good management, and the safety of the group, LVMH has almost always traded at a premium to intrinsic value, so I am by no means insinuating with the difference between current and intrinsic value that I believe the stock will fall 32%. On the contrary, I think that the share will continue to trade at a certain premium to its intrinsic value in the future – but I cannot say how large this premium will be.
In conclusion, those who already own LVMH stock are very fortunate to be shareholders in a superbly managed company with amazing pricing power. Therefore, I would recommend existing shareholders to hold LVMH shares. If you do not yet own shares of LVMH, but are convinced by the company, I recommend waiting for a better entry point.