China’s emerging role in the global economy has elevated the country’s importance to the luxury goods sector, both as a fast-growing market for products and production location.

A report from Merrill Lynch & Co. Inc. issued this past September said that Chinese customers in mainland China, Hong Kong, Macao and Taiwan could overtake Americans as the biggest buyers of luxury goods by 2009.

At the same time, many luxury goods firms are opting to outsource production to China and other emerging markets, but in a more controlled manner and with stricter quality controls than is usually the norm, says Christine Decarie, portfolio manager for Montreal-based IG Investment Management (Que.) Ltd.

The Merrill Lynch report stated that LVMH Moët Hennessy Louis Vuitton in Paris, as well as Switzerland-based Cie Financière Richemont SA and The Swatch Group Ltd., are the best way to play the luxury goods surge in China.

In this issue, Investment Executive examines LVMH and New York City-based Coach Inc., the latter of which has set up its factories in China, where it does all of its manufacturing. (For an analysis on Richemont, see the mid-February issue of Investment Executive.)

> Lvmh Moët Hennessy Louis Vuitton. Richard Nield, a Texas-based portfolio manager for AIM Funds Management Inc. , has this company as one of his picks. But, he warns, it’s not a “clean” recommendation. Its core leather and clothing divisions are “very good businesses” and its wine and spirits businesses are “pretty good.” But its perfume and cosmetics businesses have been underperforming, and watches and jewellery are weak, he says.

However, because the company’s products are in the middle niche — between high-end and everyday items — it tends to hold up better in periods of economic weakness. Organic growth has been strong, at 10% a year, and Nield says the company may rationalize some of its brands.

The Merrill Lynch report said that it expects LVMH — along with Richemont and Swatch — to report “ever-stronger growth and higher margins in emerging markets, thanks to their greater market knowledge, superior financial means but also their uncompromising strategy to control the value chain.”

The three companies already have strong positions in China. They do not suffer from local “cost killers” that sell the same products at a fraction of the price, they are more financially disciplined (read: more profitable) and they benefit from a strong infrastructure compared with the medium-sized companies that have rushed into emerging markets hoping to make a “fast buck.”

LVMH has been in China for more than 30 years; it distributes 10 brands in the country and has 100 stores, as well as almost 600 counters, there. Sales in China account for 9% of LVMH’s total sales, according to the Merrill Lynch report.

LVMH is large. It amassed 6.2 billion euros in revenue for the first six months ended June 30, 2005. In comparison, Richemont had revenue of only two billion euros for the six months ended Sept. 30, 2005. Worldwide, LVMH has 50 brands, 56,000 employees and almost 1,700 stores. Its brands include Moët & Chandon, Dom Perignon and Krug in champagne; Hennessy in cognac; Louis Vuitton and Donna Karan in fashion and leathers; Christian Dior and Givenchy in fragrances and cosmetics; and TAG Heuer in watches.

At the beginning of 2005, LVMH bought Britain-based Glenmorangie PLC — which has three brands of malt whisky — through its Moët Hennessy subsidiary. Conversely, LVMH sold three investments during the year: its 49.9% interest in Britain-based Bonhams Brooks PS&N Ltd. and its 100% ownership of both clothier Christian Lacroix and Mount Adam Vineyards in Australia. The sales are part of its strategy to focus on brands with the highest growth potential.

Increasing Sales

Even though LVMH struggled in this century’s early years, sales and earnings are now moving up strongly. In 2005, it had $13.9 billion euros in revenue, which was up 11% from a year earlier. That followed an 8% rise in 2004. Earnings in the first six months of 2005 — full-year net income numbers won’t be available until later this month — were 596 million euros, vs 548 million euros a year earlier. That’s on top of a 40% earnings jump in 2004 vs 2003. Cash flow during the first six months of 2005 was 934 million euros, vs 723 million euros during the same time a year earlier; long-term debt was 4.8 billion euros as of June 30, 2005.

@page_break@There were 489.9 million outstanding shares as of June 30. Groupe Arnault, which is controlled by LVMH chairman and CEO Bernard Arnault, has 63.9% of the voting rights. LVMH shares were trading at around 75 euros in late February on the Premier Marché of Euronext Paris, well above the levels seen a year earlier.

Most of LVMH’s earnings come from fashion, leather goods, wines and spirits, which combined account for 85% of the operating net income from sales in the six months ended June 30 even though they made up just 52% of total sales. The wines and spirits were a little more profitable, though, with a gross operating profit margin of 31.2%, vs 29.8% for fashion and leather goods; however, sales of wines and spirits, which totalled one billion euros, were only about half of those of fashion and leather goods, which amassed 2.2 billion euros.

The company also sold as much in perfume and cosmetics as it did in wines and spirits, but the profit margin for these products was only 4.3%. Watches and jewellery, with 260 million euros in sales, had a similarly low profit margin of 5.4%.

The company’s other main business line is selective retailing. This includes a variety of retail outlets with large sales of 1.7 billion euros the first six months of 2005, but its profit margin of 7.1% is low.

Businesses in this division include DFS Galleria, a network of travel retail shops; Miami Cruiseline Services, an on-board cruise retailer; Sephora, a retail beauty chain offering fragrances, cosmetics, skin-care and beauty products and accessories that also has an online store; Le Bon Marché, a chain that has two department stores as well as a grocery outlet and a bridal boutique in Paris; and La Samaritaine, a department store also based in Paris that has been closed since mid-June 2005 for renovations.

Sales are well diversified geographically, with Europe contributing 35% in 2005, including 15% from France; 27% from the U.S.; 31% from Asia, including 15% from Japan; and 7% from other locations.

> Coach Inc. Like LVMH, this company’s products also fall between high-end and everyday — a niche in which Coach has done “incredibly well” since it went public in October 2000, says Charles Burbeck, head of global equities at HSBC Halbis Partners in London. Prior to that, Coach’s previous owner — Chicago-based Sara Lee Corp. — hadn’t invested in Coach for years. The company didn’t fit into Sara Lee’s core business, which includes a number of mass-market brands in the food, beverages, household- and body-care sectors. Sara Lee bought Coach, which was founded in 1941, in 1985.

Since going out on its own, a new management team has re-engineered the Coach brand to move it upmarket, brought in “great new designers” and reformulated the business model to make it more relevant to the consumer, says Burbeck.

The team also renovated Coach’s stores and began targeting younger consumers. The company has also expanded the number of stores dramatically in the past five years. These have been very successful and profitable.

In terms of production, Coach’s costs are down in this area because of the low wages in China, where it manufactures all its products; Burbeck says the quality of these products is “very good.”

The niche in which Coach operates is a good one, especially at a time when more women are interested in buying small leather accessories, notes Burbeck. With women finding that they can change their look by changing accessories, they now want to own several handbags, for example, he says. Most of Coach’s bags retail for about US$100-US$300 through its online store.

Burbeck also applauds Coach’s decision to expand into Japan and other Asian markets, but not into Europe. The Japanese are interested in buying U.S. brands and are looking for different things. This is also the case in Hong Kong and China. On the other hand, it’s difficult to break into some of the core luxury areas in France and Italy, while the British and Germans won’t usually spend on luxury goods.

However, the Merrill Lynch report stated that Coach — as well as Hermès International SCA and House of Chanel, both based in Paris, and Geneva-based Patek Philippe & Co. — is making a mistake by not opening stores in China.

The report stated that even though Merrill Lynch appreciates “the reluctance of those companies to stretch their resources for an uncertain near-term return,” it is convinced that the best locations are “being snapped up right now.”

Nevertheless, the report had a “buy” on Coach, with a 12-month target of US$40. Its shares were trading at around US$36 in late February on the New York Stock Exchange. The “buy” recommendation was based on “consistent earnings upgrades driven by strong same-store sales growth in both the U.S. and Japan and a compelling valuation on a dynamic basis.”

The shares have split two-for-one three times, resulting in about 380.8 million in outstanding shares in the second quarter of fiscal 2006, which ended Dec. 31, 2005 — up sevenfold on an adjusted basis since October 2000. At the current price, the shares are trading at around 30 times estimated fiscal 2006 earnings (yearend is June 30) and 24 times 2007 earnings, says Burbeck.

Although many analysts agree on the stock price’s target — the median 12-month target from 11 analysts surveyed by Thomson/First Call Research is US$40 — some, like AIM’s Nield, find the stock too expensive at the moment.

Conflicting targets

The company has reported a profit of US$267.8 million for the six months ended Dec. 31, vs US$187.9 million a year earlier. Net sales for the period were US$1.1 billion, vs US$876 million a year earlier; cash flow was US$303.6 million, vs US$242.8 million. There was virtually no long-term debt, which stood at US$3.1 million as of Dec. 31.

Handbags are the biggest part of Coach’s business at US$1.1 billion, or 64%, of the US$1.7 billion in fiscal 2005 sales — the latest period for which sales are broken out by product. Women’s accessories, such as wallets, cosmetic cases and belts, accounted for another 20%. The remaining 16% comprises men’s accessories, business cases, travel bags, gloves, scarfs, hats, footwear, eyeglasses, watches and office furniture. (The last four products are done under licence and in partnership with specialists in each product area.)

Geographically, the U.S. accounted for US$832 million, or more than 75%, of the $1.1 billion in sales in the six months ended Dec. 31, with Japan at US$200 million (18%) and other international locations, primarily those in the Far East, at US$67 million (6%).

Coach initially went into Japan in a 50/50 partnership with Sumitomo Corp., but bought out Sumitomo’s interest in Japan Coach Inc. last July. Coach is now the second-biggest imported handbag and accessory brand in Japan, and it opened 10 new stores in the country during the first six months of this fiscal year. Coach said in an April 2005 press release that it expects to more than double sales in the Japanese market over the next four years.

The company has also made additions to its Japanese executive team. In particular, it welcomed Norita Ebata, who left Starbucks Coffee Japan to become Coach’s executive vice-president for retail and customer service.

In total, Coach’s products are primarily sold through its own branded stores, factory outlets, catalogues and its online store at www.coach.com; combined, these channels accounted for 74.4% of the company’s sales in the first six months of fiscal 2006.

Coach products can also be purchased at authorized department and specialty stores, some duty-free shops and other authorized catalogues. IE