SIMON BROWN: I’m chatting now with Peter Little, investment analyst at Anchor Capital. Peter, I appreciate the early morning. You put out a note last week on luxury and China. Right up top there’s a chart (see below) that absolutely blew me away. I knew China was important, but if you look at the different companies – [from] Swatch with 50% of sales in China, down to LVMH at the bottom end still with 31%, the average is 35%. Richemont is 40%. Luxury is hugely dependent on the Chinese economy for future growth.
Source: Anchor, UBS Estimates, company data
PETER LITTLE: Yeah, absolutely, Simon. Thanks for having me this morning. That’s why the market’s reacted so badly to [Chinese president] Xi Jinping’s comments sort of mid-August, when they were starting to roll out arguments on ‘common prosperity’ goals, that there was a need to potentially reasonably regulate excessively high incomes – and all of these stocks came off some 15% because people worried that Chinese luxury-goods buyers would be disappearing. Clearly it’s a significant region for them and likely to become increasingly more significant.
SIMON BROWN: Yeah. I want to touch on that ‘more significant’. Certainly the longer-term view or the medium- to long-term view is positive. In the short term, you mentioned concerns around ‘conspicuous consumption’– don’t be flashing your Gucci bag and the like – and potentially taxes coming. There may be some headwinds in China over the next couple of years which will create some challenges for these luxury stocks.
PETER LITTLE: Yeah, absolutely. I think certainly there’s a kind of regulation coming. I think China needs to reform its tax model, which has very low personal income tax. Proportionally I think about 5% of China’s taxes are from income tax, so they need to reform that.
Their consumption taxes are heavily skewed towards import duties and duties on manufacturing, as opposed to the VAT tax style that you see in the rest of the world. So there are lots of these things coming.
But obviously tax is a sensitive matter and the Chinese communist party needs to ensure that it [does not] alienate itself from the population. So I think these tax reforms will be rolled out slowly. But they’re certainly more likely to impact the very high end of the spectrum in China going forward.
SIMON BROWN: And then the bigger story, perhaps – and this is the story of China to a degree – [is that] one of the things they’re looking to do is double the middle-income group over the next decade. That implies a growth of around 7% a year, and that’s the group that’s going to be out there in the future doing the shopping. So once we’re through perhaps the changes to the tax regimes and the like, there is actually a very bullish medium- to longer-term story in luxury and in China in particular.
PETER LITTLE: Exactly. So their goal is to create an olive-shaped income distribution, which is kind of thick in the middle and skinny at the top and bottom, as opposed to the pyramid-shaped one they have now. At the moment they have more than 50% of their population in that lower-income group, and just over 10% in the high-income group.
So the idea is for them to create this olive-shaped thing, just to shrink or to move that low-income group into the middle-income areas. It’s not so much about eradicating the high-income group.
They’re happy for that to exist; it just can’t get disproportionately big.
But in the process of shifting these low-income earners into the middle income – that’s obviously, as you say, a huge boon for the middle-income group which should double over the next 10 years with, as you say, about a 7% growth rate. The surveys done by Morgan Stanley’s AlphaWise suggest that about 70% of the middle-income cohort have made luxury goods purchases over the course of the last 24 months; if you look at the higher-income groups, that number is sort of in the teens.
This says luxury-goods purchases are much more prevalent in that middle-income group, and so growing that middle-income group in China’s is sort of a pretty powerful structural tailwind for luxury-good purchases.
SIMON BROWN: Yeah, 70% is a staggering number.
Last point. You also suggest that perhaps a trend of more the soft luxury – that’s leather goods, that’s fashion – is perhaps growing a little faster than sort of watches and jewellery. That’s a trend that we’ve seen and you think will potentially continue. That plays into LVMH, Hermès and the like.
PETER LITTLE: Exactly. Certainly the whole category has been going pretty fast.
The sector that has probably struggled the most is luxury watches and Richemont is pretty exposed to that. Swatch has obviously that as pretty much all of their income.
Certainly the corruption crackdown in China – it was about 2015 – that sector has come under huge pressure. Even within Richemont, you’ve seen their operating margins of 15% to 20% are right down to kind of 5% now because the volumes just aren’t there. So that’s the one sector that has struggled quite a lot.
Richemont’s latest results show that jewellery may sound like it’s doing pretty well. So that part of hard luxury is doing okay. Watches not so much. But certainly the higher margins and the higher growth have been coming from that soft-luxury portion.
SIMON BROWN: We’ll leave it there. That’s Peter Little, investment analyst at Anchor Capital. As I said, a really, really great note he put out last week. You’ll find it on their website.