LONDON, United Kingdom — “It is true the US economy has confirmed its recovery, but the Japanese economy continues to be flat and Russia has gone into a strong recession. Growth in China has slowed and the Eurozone has seen deflationary measures. In addition to this, currency fluctuations were especially strong, we saw a total turn around in the second half [of the year].” So said Kering chief executive Francois-Henri Pinault, this week, on the group’s 2014 financial results.
Indeed, the past year has seen a surge of volatility in the currency markets, driven, in part, by a series of geo-political shocks, ranging from hostilities in the Ukraine and the Russian crisis to the civil war in Syria and the spread of ISIS to the pro-democracy protests in Hong Kong.
Yet the biggest shock to the global currency markets came on January 15th, when the Swiss National Bank (SNB) announced it would no longer maintain a fixed exchange rate against the euro, as it had done since 2011. On the day of the announcement, one euro was worth 1.2 Swiss francs. By the 16th, the euro had dropped by as much as 30 percent, down to 0.85 francs, before recovering to close at 1.020 francs. Against a strong US dollar, buoyed by a resurgent American economy, the euro suddenly fell to an eleven-year low.
This kind of volatility has significant consequences for luxury companies, which generate revenue and incur costs in a number of different currencies. Following the unpegging of the Swiss franc, which Swatch chief executive Nick Hayek described as a “tsunami,” the costs incurred by the watch maker in Switzerland increased by 15 percent in relative terms, as the currency rose in value against the euro. As a result, the Swatch group’s shares plunged by 15 percent, while Richemont, which owns Cartier and Montblanc, dropped 14 percent.
But the news isn’t all bad. “A falling euro is obviously good news for us, most of our costs are denominated in euro and we complain a lot when the euro rises. We can only be satisfied when it goes the other way round,” said Jean Jacques Guiony, chief financial officer of LVMH. Indeed, a strong dollar and a weak euro not only drives down the cost of production, but lowers the prices paid by American consumers at home and when travelling abroad, flush with extra cash due to a favourable exchange rate. Companies agile enough to increase productivity in the US, while capturing a good proportion of sales from American tourist flow, are in a position to profit.
“In a still unsettled economic environment, the recent currency fluctuations are likely, at this stage, to have a favourable impact on sales, but could have mixed effects on the [Kering] Group’s results,” stated the company’s 2014 financial report.
As Guiony says, “Not all currencies are strong against the euro: [The] yen, the rouble....” And increased American consumption is not big enough to offset negative impact in other markets.
So how can fashion and luxury brands protect their global businesses and navigate the surge of currency fluctuation?
The most instantaneous line of defence available to fashion brands is currency-hedging. At a cost, companies can fix exchange rates at pre-agreed values with banks, thereby offsetting any negative fallout caused by fluctuations in currency values. “Hedging margin exposure 12 months forward is what most companies do,” said Luca Solca, head of luxury goods at Exane BNP Paribas.
Given recent volatility, the popularity of currency hedging agreements is likely to increase. “I think that a company that didn’t hedge in the past, like Swatch, will decide to use more hedging instruments,” said Mario Ortelli, senior research analyst for European luxury goods at Bernstein.
However, pre-fixing exchange rates in order to avoid the risk of currency fluctuations also comes at the cost of forgoing the benefit of any favourable currency shifts. “Currency hedging may, in the short term, limit the ability for luxury groups to benefit from rising currencies. This is not necessarily the case for LVMH, but I have heard comments here and there,” said Guiony.
“The [location] of your revenue is decided more or less by the market, while you decide the base of your cost,” noted Ortelli. “If you have your marketing department in Milan or Genevaou you could outsource that department wherever. But the two things that you do not want to relocate are the production and the points of sale. ‘Made In’ is a great advantage to these brands; they would be reluctant to relocate from Italy, France and Switzerland for watches.”
This makes outsourcing costs difficult to implement. And in any case, “what is really important is the revenue line, because luxury has high gross margins; only a fraction of the cost is the cost of production,” continued Ortelli. Having greater control of costs cannot possibly offset the negative impact of currency fluctuations on a luxury brand’s all important revenue figures.
Brands can also respond to shifting currency values by shifting prices. Traditionally, fashion brands set prices up to six months before goods hit shop floors, leaving ample time for market conditions to change. However, by responding to currency fluctuations in real-time and adjusting prices accordingly, brands can offset the negative effects caused by currency fluctuations. However, this option is only open to brands with businesses with large direct-to-consumer sales channels.
“When you are a retailer, you can change your prices overnight and tomorrow morning your end customer pays a higher price. If you have got a wholesale channel it is a problem, because for all of the inventory that the wholesaler has in store, the end customer is paying a higher price, but you don’t see the advantage of it,” explained Ortelli.
The approach can also have negative consequences for the lucrative travel retail market. “Touristic clients are very sensitive to relative pricing and may decide not to buy in a rising currency market as they get a better deal elsewhere. Some markets are heavily dependant on touristic flows; even if local prices do not move in absolute terms, they rise in relative terms as the euro weakens. Switzerland is good example: prior to the rise in the Swiss franc, prices were more on less on par with the Eurozone. They are now 15 percent more expensive,” said Guiony.
The best remedy for brands is also the most intangible: brand cachet. Ensuring that a luxury brand is at the pinnacle of desirability gives its products significantly greater price elasticity. Indeed, widespread consumer demand is the best insurance a brand can hope for.
“If you have got a desirable brand and desirable product, your customer can better ingest the price increase [caused by currency fluctuations]. If your brand is not so desirable and your products are a bit dusty and not meeting consumer preferences, it is more difficult to justify price increases,” said Ortelli.