In the luxury goods sector, brand is the name of the game. Any company selling luxury products needs to have a recognizable brand for which consumers are willing pay a premium.

It can take years — and lots of advertising dollars targeted at the right market — to establish a brand. And it then has to be maintained through quality control.

“As investors, we are very interested in seeing how these companies build their brands and how much they spend doing so,” says Ed Loeb, portfolio manager at Chicago-based Harris Associates LP, which manages AGF International Value Fund. “The brands have to be nurtured through advertising and other marketing, as well as other services. This is ultimately what delivers profits.”

The concept of luxury goods goes well beyond extremely expensive jewellery, watches, clothing, furs, accessories, cars, spirits and wines. There are also brands that sell at prices well above the generic versions of such products, but which are within the reach of many consumers. There are sports luxury brands as well, such as Nike, Adidas and Puma, and everyday luxury products such as Starbucks coffee and organic groceries. Services such as hotels, resorts and spas are also part of the luxury sector.

Not surprising, many of the luxury products — particularly at the very high end — are European. This was the first region to brand high-quality goods, so it has many long-established companies in the sector.

However, the big growth in consumption is in Japan and the rest of Asia. Analysts speculate that the reason for Japan’s level of consumption is that living spaces are so small, so consumers look to personal luxury items to show how well they are doing. (Conversely, in North America, people spend a lot of their luxury dollars on big houses and then cram them full of furniture, electronics and art.)

In fact, demand for luxury goods remained strong during Japan’s long, 15-year pause in economic growth. During that time, Japanese incomes remained quite high, says Charles Burbeck, head of global equities at HSBC Halbis Partners in London. Now, the rest of Asia is following Japan’s example. Given the huge populations and very strong economic growth in countries such as China and India, that is very good news for the luxury goods sector.

Sales of luxury goods will probably grow 10%-12% this year, Burbeck says. That assumes 6%-7% nominal (3%-5% real) global economic growth. He notes that severe economic slowdowns or recessions hit the luxury goods sector harder than most sectors because it is an area of spending that people — at least, in North America and Europe — will cut in difficult times.

Demand for luxury goods is growing strongly in emerging economies, including Russia and Brazil, in which income levels have increased sufficiently to permit their purchase. Burbeck notes that the newly rich tend to be ostentatious in their spending. This is such a strong phenomenon that sales of luxury goods might not recede, even if those economies go into a recession. This will provide a positive backdrop for the sector for many years.

The key to a successful luxury goods company, Burbeck says, is “creating a brand franchise that is both relevant to consumers and is something people will aspire to have.” It needs to be unique in terms of design, quality or image. The company also has to invest a lot in producing a superior product and in advertising it.

“If you can create a durable image, you can be profitable for a long period of time,” he says.

Also key to success is controlling growth so that the brand retains its exclusivity. It is almost impossible to turn the fortunes of the company around if this element of exclusivity is lost. An example is the Pierre Cardin brand; it licensed too many products, including suitcases and cheap wallets. In contrast, Paris-based Hermès International SCA limits the number of Kelly bags — which retail for US$3,000-US$4,000 — that it sells each year. Another example is the long-established Cartier brand, owned by Switzerland-based Compagnie Financière Richemont SA. Cartier has a deliberate policy of not expanding. “You have to balance growth with profitability,” Burbeck says.

A deterrent to success is having the wrong type of person buying the brand. This happened to Britain-based Burberry Group PLC, which had a problem when football supporters bought its scarves. This wasn’t the image Burberry wanted. Fortunately for the company, this trend didn’t last.

@page_break@Knock-offs are another challenge with which luxury goods companies have to deal, and there isn’t much they can do about it. This is especially true in emerging economies in which copyright laws aren’t well enforced.

In this issue, Investment Executive examines Richemont and London-based Diageo PLC, the dominant premium spirits company. In following issues, we will examine other luxury goods companies that global money managers recommend.

> Compagnie financière richemont sa. This is Burbeck’s core high-end luxury goods holding. He likes the company’s brands, its control over these brands and the potential in Asia. Sales there now account for 38% of its total — and are growing rapidly. He also finds its stock price attractive; shares were recently trading at around 57 Swiss francs, which is 18 times 2006 earnings.

Richard Nield, a portfolio manager at AIM Capital Management Inc. in Texas, also likes the company. Richemont owns 18.5% of London-based British American Tobacco PLC (BAT), which provides stability to Richemont’s earnings. There is little risk of tobacco litigation in Europe.

As well, its main brand, Cartier, is moving into more accessible, lower-priced items for younger people, he says. It is continuing to develop its accessory business, branded under the name Trinity, which includes small leather goods, fragrances, clocks and cufflinks. It is also accelerating its rollout of a new design of prestige boutiques. It has nine of these in China already.

The Cartier brand accounted for 50% of Richemont’s two billion euros in sales in the first six months ended Sept. 30, 2005, and 75% of the 323 million euros of operating income before non-recurring items, says Nield.

Richemont has 16 other brands of products, including watches, jewellery, accessories and clothing. Many of its brands have products in more than one category. Cartier, for example, makes watches, jewellery and accessories. Van Cleef & Arpels and Piaget both make watches and jewellery. Dunhill produces watches, clothing and accessories. Chloe, Old England, Purdey and Shanghai Tang make accessories and clothing. Mont Blanc produces watches and accessories. Montegrappa and Lancel make accessories. And A. Lange & Söhne, Vacheron, Jaeger-LeCoultre, Panerai and Baume & Mercier produce watches.

Jewellery accounted for 52% of sales and 71% of operating profit from sales in the six-month period; watches accounted for 26% and 29%, respectively; and writing instruments for 10% and 7%, respectively. Leather and accessories totalled 6% of sales and had an operating loss of 26 million euros, while sales of other products came in at 5% and had a loss of two million euros during that same period.

Europe still accounts for the most sales, with 42% in the first six months. Asia-Pacific totalled 21%; the Americas, 21%; and Japan, 17%. Asia-Pacific had the strongest growth in sales from 2001 to 2005 at 7.3%, followed by Europe at 6.6%. Sales were down 11.1% in Japan and down 5.1% in the Americas.

Sales, however, are volatile. Overall sales were down in both 2003 and 2004, but rose 10.1% in 2005. In the first six months of fiscal 2006, sales were up 15.8% from the same period a year earlier. Operating profit is even more volatile. During the six months, it was up 62%, excluding non-recurring items, and net earnings were up 37% to 601 million euros from the first six months of fiscal 2005.

Richemont also has little debt. The contribution from BAT is significant; sometimes, it is even bigger than Richemont’s net income from operations, as was the case in each of the past four fiscal years. But in the first six months of fiscal 2006, contribution from BAT was lower than profit from operations.

The company has 522 million “A bearer” shares, which are widely held and trade on the Swiss Stock Exchange. It also has 52 million registered “B” shares, all controlled by Johann Rupert, the managing director, through Compagnie Financière Rupert; these carry 50% of the voting rights in Richemont.

> Diageo plc. Harris Associates’ Loeb, whose firm manages a number of AGF funds, recommends this dominant player in the global spirits business. “Diageo is much larger than its competitors,” he says. “This allows it to spread its advertising more effectively, because the money is spent over a bigger base to not only maintain but also improve its market positions.”

Loeb also notes that the company is exceptionally well positioned and there is “sensible management of the brands.” In addition, he says, “Management has acted in a very responsible, shareholder-oriented way to improve returns on the stock through dividends and aggressive share repurchasing.”

Diageo’s one problem is — given its control of 25%-30% of the premium spirits market — it can’t easily make really big acquisitions because of anti-trust considerations. On the other hand, Diageo has a dedicated sales force, so when the company adds brands, the sales team can concentrate on selling the products and getting leverage out of the infrastructure.

The company reported income before extraordinary items of £1.5 billion in the fiscal year ended June 30, 2005, almost unchanged from the previous fiscal year on net sales of £6.7 million, also unchanged from the same period a year earlier. However, sales have declined in recent years as Diageo has disposed of a number of businesses. Gross sales, including excise duties, were down 25% in fiscal 2005 from 2001 sales levels. However, operating profit was down just 8% over the same period.

Loeb says the widely held ordinary shares, of which there were 362 million as of Aug. 15, 2005, are attractively priced. An ADR, which represents four ordinary shares, recently traded around US$60, or 15 times this year’s earnings, on the New York Stock Exchange. The ADRs have a 3.5% dividend yield. Four analysts reporting to Thomson/First Call Research have a 12-month median target of US$65 an ADR, with a low of US$54 and a high of US$67.

Diageo vaulted to its dominant position with its acquisition of Seagram Co. Ltd.’s spirits and wine business in 2001. This included Smirnoff vodkas and ready-mixed products — now Diageo’s No. 1 brand, with 25.2 million nine-litre cases sold in fiscal 2005. Smirnoff is the No. 1 premium vodka brand and the No. 2 premium spirit brand in the world.

Diageo has seven other premium brands that it sells worldwide. In fiscal 2005, the company’s brands sold the following in nine-litre cases or the equivalent: Johnnie Walker Scotch whiskies, 12.3 million; Guinness stout, 11.4 million; Bailey’s Original Irish Cream liqueur, 6.7 million; Captain Morgan rum, 6.5 million; J&B whisky, 5.9 million; Jose Cuervo tequila, 4.5 million; and Tanqueray gin, 1.9 million.

The eight global brands combined accounted for 59% of volume and £5.2 billion of the £9 billion of gross sales, including excise duties, in fiscal 2005. This excludes Diageo’s ninth global brand, Bushmills Irish whiskey, which it bought in August 2005 for £200 million from Paris-based Pernod Ricard SA. Loeb expects this purchase to bring very favourable economic benefits.

All nine brands are in the top 20 of premium distilled spirit brands. The company considers these premium brands to have the greatest potential for earnings growth.

Diageo has 12 other spirit brands, six wine brands and five beer brands. About half of the other spirit brands are local brands (22.7 million nine-litre cases, with gross value of £1.9 billion); the others (21.4 million nine-litre cases, with gross value of £1.2 million) are sold in a number of markets. Other beers sold 4.8 million nine-litre cases, with a value of £403 million; the wine sales were 2.3 million nine-litre cases, worth £323 million.

In 2004, the company reorganized into three regional divisions. North America accounted for 29% of sales and 37% of the operating profit before exceptional items and corporate costs; Europe was 43% of sales and 33% of the operating profit; and the international division accounted for 28% of sales and 30% of the operating profit.

Diageo also owns 34% of Möet Hennessy, the spirits subsidiary of LVMH Möet Hennessy-Louis Vuitton SA. IE