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Stock Idea: Hermes International (RMS.PA)
Object of desire
Everyone is aware that Hermes is an expensive stock that is approaching a record high. However, we will explain why Hermes should be a part of your portfolio. This is accomplished by addressing the three most prevalent concerns regarding Hermes.
Is a High Operating Margin Sustainable?
Hermes EBIT margin increases to over 40% in fiscal years 2021 and 2022, well above the range of 30–35% during 2011–2020. People are questioning whether or not this higher margin can be sustained. The margin is the highest it has ever been and the highest among competitors, who average only 15%. During every earnings call , queries about margin are always raised. So far, consensus has taken a conservative view. The estimated EBIT margin for the second half of 2023 is 38%, compared to 43% in the first half and 39% in the second half of 2022.
While the 2H 2023 EBIT margin may be compressed, we can reasonably expect the higher margin to be sustained due to the following factors:
Historically, Hermes' operating investment (money spent on stores, productions, and projects) has always been closely followed by a steady rise in EBIT margin. And management anticipates a nearly doubling of investment in 2023. In the coming years, they will establish three new leather workshops in France and four more.
Since Hermes is an artisanal company whose handbags are created by hand, production leverage should be challenging. Improving the productivity of artisans is difficult. According to a 2015 Bloomberg article, a craftsman requires 18 to 20 hours to complete a single bag. But during the 2022 earnings call, CEO Alex Dumas stated that it takes 15 hours to complete a purse. This is only anecdotal evidence, but it demonstrates how difficult it is to improve craftsmen's productivity. However, over the past decade, Hermes has increased productivity in all divisions, including production, sales, and support.
Sales is the area where Hermes can increase profitability and distinguish itself from its closest peers , such as LVMH (MC.PA). Due to its 'ultra-luxury' status, Hermes incurred fewer marketing expenses than its competitors. It only promotes its scarf and clothing collections, not its iconic Birkin, Kelly, or Constance handbags.
Will China's Struggling Economy Have an Impact on It?
China is always a concern for luxury goods due to the country's sizeable consumer market. For instance, 49% of Burberry's sales originate in Asia. Hermes and LVMH derive 48% and 30%, respectively, of their revenues from Asia.
We are naive to believe this would have any effect on Hermes. Nevertheless, we believe the impact is minimal in comparison to peers. Hermes products fall within the category of ultra-luxury, where their purchasers are less likely to be affected by a sluggish economy. This was evident during the Asian Financial Crisis, the Global Financial Crisis, the COVID, and most recently the high inflation period in the U.S.
Interestingly, Hermes continues to grow in China despite the gloomy economic outlook. Hermes has 28 stores in China, and this year it will renovate its Beijing locations, establish a larger store in Nanjing, and launch a new store in Tianjin. Clearly, Hermes views the impending crisis as an opportunity for expansion.
Why Invest in a Company with a High Valuation?
Hermes P/E is consistently greater than its peers. And the disparity has been widening recently. And it's not just the P/E ratio; even after factoring in Hermes' 10% long-term growth, its PEG remains above the average of its peers.
However, the most crucial question is whether the high valuation of Hermes is sustainable and justifiable. Multiple factors, including a wide moat, long-term management, and acquisition potential, lead us to believe that the price is reasonable and sustainable.
Hermes' wide moat is the result of a careful balance between scarcity (exclusivity) and growth. Due to the labor-intensive nature of bag production, it is inherently challenging to increase output. But this does not prevent Hermes from growing. Hermes has expanded its product inventory to include scarves, silks, watches, and, most recently, cosmetics. And within the handbag segment, there are 'non-quota' purses that can be purchased 'freely', including Lindy, Picotin, Evelyne, and others.
One can expect a company's direction to endure so long as its management remains intact. We anticipate this from Hermes. The current CEO, Axel Dumas, is a family member in his fifties. In 2014, he succeeded retired non-family CEO Patrick Thomas as chief executive. Prior to that, Mr. Axel held a number of positions, including that of Executive Chairman in 2013. Mr. Axel is committed to the artisans value of Hermes, as he repeatedly emphasized during the earnings call. Importantly, he is responsible for the extension of family commitment in the House for another 20 years, which we will discuss shortly. That is, the family has faith in him.
Hermes remains a target for acquisition despite its high valuation. From 2010 to 2016, there was a legal drama revolving around the Hermes family's efforts to prevent a 'hostile takeover' by LVMH. Since 2011, the family has taken preventative measures by 'locking' Hermes shares held by hundreds of family members under one holding company: H51. This 'blocked' stock accounts for 54.3% of ownership. This is evidence that Hermes is an acquisition target, even though LVMH may not attempt to acquire Hermes again until the 'freeze' period expires in 2041.
Lastly, despite the fact that Hermes is in the consumer discretionary sector, it possesses defensive characteristics that could be advantageous to your portfolio's composition. Below is a chart depicting the 1-year rolling beta of Hermes, LVMH, and SPDR Utilities (XLU). Hermes' 1-year beta has been consistently below 1 over the past twenty years. LVMH's beta fluctuates beyond 1, as expected from a consumer discretionary stock. In the meantime, the beta of SPDR Utilities, XLU, which intuitively ought to be more defensive, repeatedly surpassed 1.
Now, if you haven't been convinced to invest in the expensive Hermes stock, at least you may be persuaded to indulge in the luxury of owning a Hermes bag. However, it is important to note that purchasing one may require careful planning and consideration due to limited availability.
This document is for information only, not an advertisement nor is it a solicitation or an offer to buy or sell any financial instruments. There is no representation or warranty in relation to the accuracy, completeness, future performance, reliability of the information contained in this publication, or suitability to an investor’s individual circumstances. Investments involve risks, and investors should exercise prudence and their own judgment in making their investment decisions. Past performance is not a guarantee of future performance.
As of the date of this publication, Christmas Corp and/or our clients have a beneficial long position in the shares of RMS.PA and MC.PA either through stock ownership, options, or other derivatives. We have no business relationship with any company whose stock is mentioned in this article.
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