Will the Chinese growth story persist post the crisis?

Welcome to Magellan Minutes, a new investment insights initiative in which senior members of our investment team dissect the markets and take a deeper look into the sectors and stocks in our global portfolios. This series is designed to provide you with concise, relevant and digestible talking points on global markets, each in around 10 minutes.

In this episode, we sit down with our Head of Research, Vihari Ross to look at two luxury goods companies, LVMH and Estée Lauder, and discuss the outlook for these businesses and whether the China growth story still exists.

Vihari, the Magellan Global Fund includes two luxury companies which are LVMH from France and Estee Lauder from the U.S. It’s a very interesting time for luxury. How have these stocks fared?

It’s been an interesting and quite an unprecedented time for investors in terms of not only the lockdown, but the recession that we’ll find ourselves in when we eventually come out of our houses. The prospects for Estee and LVMH have been very much linked to the China story, and so their share prices actually started to turn in mid January when murmurs of the virus first hit the newsreels and we had much less inkling about how bad COVID-19 would turn out to be. And so the companies, compared to the rest of the market, actually started turning down a month prior. From the middle of January to the middle of March, which was the most recent bottom, both Estee Lauder and LVMH fell by 34%. Since then, we’ve had about a 20% rally in both, but they’re both down about 23% today.

What has been baked into that do you think?

What it really reflects is that Chinese consumer being so important, but also the importance of travel to the industry. 40% of luxury spend actually takes place when people are traveling overseas and 10-15% of that happens in the airports themselves. So for Estee Lauder, 23% of their global sales happen within an airport. Then you’ve got limitations in manufacturing with Italy being closed. You’ve got the reduced wealth effect, the feel good factor from share market’s falling and things like that are impacting the sector. So we’ve had this 'sugar hit' rally thanks to the monetary and fiscal stimulus that’s been thrown at the problem, but the reality is that the impacts of both the shutdown, the impact on travel and the recession that will follow really does have an outsize impact on these businesses.

We’re assuming a significant change in consumer behavior post COVID-19, what do you expect the recovery to look like for these businesses?

This is a really interesting question, and I think it’s important to separate out the impact of the lockdown versus the impact of the inevitable recession that’s going to follow. Currently our view is that the recovery in developed markets won’t be a V, it’ll take longer than that. How long it’s going to take is really uncertain, and no one really knows yet what it’s going to look like. But when we do think about the recovery, there’s a few important things to think about and note.

The first is that the Chinese growth story still exists, given what the government can do, mandatory tracing apps, mandatory lockdowns, etc. The recovery there is likely going to be sooner and stronger, in our view, than rest of the world, and that is important for Estee Lauder and LVMH, because one third of everything they sell is to the Chinese consumer, and that is set to grow to being more than half of their sales in the coming years. That tailwind of urbanization, that tailwind of the growing affluent class and rising disposable incomes will still be there following the pandemic.

The second thing is that this pandemic is really accelerating a lot of the trends that were already in place around the world before this virus started. I’m talking about the increasing portion of sales coming from the Chinese consumer, the Chinese spending more of their money at home rather than abroad, the rise of digital sales, all becoming increasingly important. Businesses like Sephora, which is owned by LVMH as well as Estee Lauder’s substantial business that they have on Alibaba Tmall platform, actually, has put them in very good stead in this crisis. And in the same breath, there’s this demise of the department store, the wholesale channel for luxury is really accelerating. That’s 45% of Estee Lauders business in the U.S. so that decline is accelerating as well. It makes sense for a brand that has closed all of its stores around the world to rethink which ones they actually want to reopen again. And that’s especially in the context of the online business increasing, in some cases at triple digit rates. The other trends that might accelerate are things like casualisation, which means wearing athletic wear and sneakers. The self-care trend, so people are buying more skincare while they’re in quarantine and also sustainability, so more eco-conscious consumption. And in that vein the resale market, in luxury, is actually seeing a lot of interest at the moment as well. So you might expect brands to try and reclaim control of that sector for themselves in future. 

And the third thing, to think about in terms of a recovery, and what we’re looking out for, is is the desire still going to be there? This is something that people want, not need. These are brands that have lasted the test of time and it’s human nature to desire these products. 

What you’ve seen in the past downturns is that the best brands tend to win in that environment because people want to buy things that will truly last the test of time, rather than something that’s more fashion-oriented or edgy in its environment.

What signs have you actually seen in terms of consumer demand?

The thing that’s missing at the moment is the occasion, no one is able to go out anyway. Despite that, what you’ve seen for example is quite substantial demand percolating in parts of the world. There were news reports that when the Hermès store reopened in Shenzhen recently, that it made $3 million worth of sales on that first day. That’s almost 20% of their typical stores annual takings, in one day. We’ve seen companies like Vestiaire Collective, which is a community of second-hand buyers and sellers of luxury, see 20 to 30% growth year over year despite the existence of COVID-19, and those anecdotes along with other data that we look at gives me a lot of comfort because you can see that the consumer demand, underlying all of this uncertainty in the short-term is still there. That’s a key factor in really working out what the recovery does actually look like for these companies. But the thing to remember is despite these examples and the fact that people we will ultimately come back to some form of spending on luxury, you do need to temper that a bit because you don’t necessarily make up the sales that you lost today. By that I mean just because you don’t buy a new dress or lipstick this year that doesn’t necessarily mean that you will go and buy two of them the following year. The sales that would’ve happened this year are simply lost to those companies.

Both companies have now reported. Can you give us some color on the valuation and price?

The results over the last quarter were largely as we expected given how economically sensitive they are, but the worst is yet to come, which is this April, May, June period where most of the world was locked down. January was really strong, which was pre the virus hitting. February was hurt by China because that’s when they were hit by the virus. And then we had severe declines outside of China in March, with stores closed, travel stopping etc. So we ended up with sales decline of 9% for Estee Lauder and 17% for LVMH in that first quarter. But even Coca-Cola had a 25% volume decline over that period, so it really has been quite indiscriminate in terms of the impact. 

It’s still negative overall because people aren’t traveling. LVMH said that it’s sales within China for its largest brands were up 50% in April, year over year, so there’s that pent up demand story again. And E-commerce is really showing itself to be a big driver of that acceleration. There’s plenty of bad news still to come, with the costs of getting supplies out there and fulfilling online orders going up. There’s an incredible short term uncertainty to contend with and questions around how long this is all going to take to recover,  but we remain confident in the quality of these businesses. And beyond that their management capability, the demand for their products and the importance of China to that growth story as well, so pulling all of that together, despite the obvious short term risks, we do see value in these stocks today

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Magellan was formed in 2006 by Hamish Douglass and Chris Mackay, two of Australia’s leading investment professionals. The company specialises in global equity and listed infrastructure assets.

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