LONDON, United Kingdom — An atmosphere of economic and geopolitical uncertainty combined with currency fluctuations, pockets of social strife and a slowing China present a serious mix of challenges for luxury companies. Here are the top 10 risks facing the luxury industry today.
1. A cyclical downturn
Luxury is a fixed-cost industry — brand communications, flagship stores, staff, sample collections and other essential elements of a luxury brand’s operations are all cost-intensive — with high gross margins. After 10 years of GDP-beating growth on the back of market expansion in China, store saturation in the country does not bode well for future growth prospects. A downturn in sales would result in operating deleverage and margin compression, typically leading to price-to-earnings multiple compression.
2. A reversal of growing income inequality
Luxury products are typically used as public signals of rising private wealth. And as income inequality increases, luxury consumption accelerates. Witness the global trend that has taken hold since the 1970s. Conversely, a slowdown or pause in the widening of the income gap, through higher marginal tax rates, for example, could lower luxury spending.
3. Lower consumer confidence
Being rich is one thing; but feeling richer, whether because of rising salaries, asset appreciation or easier credit, means new desires and new opportunities for discretionary spending. By contrast, austerity with no end in sight (the eurozone) and declining property prices (China) are hardly conducive to increased spending.
4. A slowing China
The Chinese account for about 30 percent of personal luxury goods consumption, up from only 3 percent 10 years ago. However, the local picture in the Chinese market has become very mixed. Certainly the government’s efforts to reduce income inequality and lift millions of citizens out of poverty are creating a burgeoning middle class. But they also imply higher taxes for the wealthy (on property and inheritance, for example). At the same time, the anti-corruption campaign, which has already skimmed the froth off the market, could engender pro-austerity, anti-wealth sentiment.
5. Shifting tax rates
The world is upside down. “Capitalist” countries are pursuing “socialist” policies, while countries that call themselves communist have embraced a wild form of de facto capitalism. To paraphrase one senior luxury market observer, the consequences of rising marginal tax rates in Europe and the USA can be offset by selling more in countries like Russia and China. But in China, mounting social tension could push the government to take a populist turn and increase luxury taxes as well as customs duties on foreign purchases.
6. Currency fluctuations
European luxury companies spend largely in euros, Swiss francs or pounds sterling, whereas they earn in dollars or dollar-related currencies. In 2014, the euro’s strength was a stiff headwind during the first nine months of 2014, while the strengthening dollar gave the sector a boost in the latter months of the year. Similarly, with the Japanese market still accounting for 10 to 15 percent of sales of European luxury brands, the yen’s collapse was a blow. Now, the Swiss franc has rocketed.
7. Global travel scares
Anything that prevents people from travelling — such as health scares and terrorist attacks — is a major drain for the luxury goods market. Given the fixed-cost nature of the industry, this would precipitate operating deleverage with a knock-on effect on company valuations. During the past twenty years, financial investors have had four opportunities to buy luxury at trough prices: 9/11, during the Asian crisis of the late 1990s, SARS in 2003 and the Lehman Brothers collapse in 2008.
8. Disruption at a major luxury hub
Hong Kong is probably the world’s most concentrated luxury market, accounting for 10 percent of global sales for soft luxury brands and about 20 percent for hard luxury brands. The resurgence of last year’s protests would risk disaster for the industry were it to culminate in civil disorder and the closure of Hong Kong to Chinese tourists. Similarly, a high profile terrorist attack in a major luxury hub would be very painful for the industry.
Brands that grow too quickly and expand too widely run the risk of trivialisation through their popularity. They lose their all important exclusive cachet. Such was the fate of Coach. Maintaining brand desirability is particularly important at a time when growth is lower and consumers have wider choice in an increasingly crowded luxury market.
10. Hefty acquisition premiums
Corporate mergers and acquisitions have their place, but they can come at the cost of damaged returns on invested capital through hefty acquisition premiums. Kering is particularly exposed on this front (Puma is a case in point), as LVMH was in the past. The two luxury giants — with ambitions to consolidate the industry — remain the most exposed to this risk.
Luca Solca is the head of luxury goods at BNP Exane Paribas.