Is Gucci Dead? Think Again (OTCMKTS:PPRUY)

What’s going on with the company?

Kering’s (OTCPK:PPRUF) (OTCPK:PPRUY) shares have been in free-fall lately, as the company is under a double whammy of a cyclical demand pullback among its mainly aspirational consumer base, and the reinvention of its flagship brand. Indeed, Gucci suffered a ~20% top-line drop during the first half of 2024. In contrast, LVMH (the home of Louis Vuitton and Dior) and Richemont (Cartier) had roughly stable results, highlighting the evident underperformance of Kering’s largest house. For context, Hermès remains immune to weakening customer trends, delivering a strong double-digit revenue growth rate in the period. This underscores that while Gucci caters to the top 10% of consumers (indulging in at least one luxury item per year and spending $3,000-$10,000 on fashion annually), Hermès is at the absolute pinnacle of the industry, targeting the <1% highly affluent cohort that is unaffected by economic cycles.

While Gucci’s new creative director is working on revitalizing the brand, this process will likely take years to show results, and the short-term picture will be grim. Kering’s management is not in an enviable position to turn the ship around in such an unfavorable market environment. Declaring the brand dead would be a dire mistake, though, as Gucci has repeatedly proven its resilience in similar situations in the past. Look at the above collection of article headlines from the past few decades. In fact, every 5-10 years, the century-old Gucci brand gets declared dead. We computed the historical growth figures that the luxury house delivered over 30 years: Gucci achieved a more than decent ~9% top-line CAGR over this period, clearly outperforming the overall market of luxury fashion.

Is this time different? Has Gucci permanently lost its glamour compared to its peers? Perhaps, but history suggests that the doom-and-gloom sentiment surrounding the stock is not justified. Moreover, Kering’s second-largest brand, Yves Saint Laurent (YSL), achieved a whopping 16% annualized growth rate over the past 20 years, although it would be a false hope to say that the firm’s future is not overly dependent on the successful turnaround of Gucci. In the meantime, Gucci’s popularity is as strong as ever, underscoring our thesis that despite short-term turbulence, the brand is indestructible and will eventually shine through. The below survey of U.S. consumers places Gucci at the top spot among popular luxury brands, in the same category as Louis Vuitton, Chanel, and Dior.

Before diving into the investment case details, it is crucial to highlight another ace up Kering’s sleeve: substantial insider ownership. Since 2005, the company has been led by François-Henri Pinault, the son of the empire’s founder. Kering has remained a family-controlled holding, with ~40% of the capital and ~60% of the voting rights held by the Pinault family. Nothing aligns shareholder interests with a CEO’s more effectively than having a lot of skin in the game, and we have come to appreciate this business characteristic more and more. Pinault is putting his money where his mouth is. As a vote of confidence, he bought over $65 million worth of shares at the end of April, priced around $36 when translated to the ADR with the ticker symbol PPRUY.

While a concentrated ownership structure could be a double-edged sword in general, we believe it is preferable for luxury companies. It is important to prioritize the sustainable, long-term growth of the fashion houses by curbing supply and avoiding price discounts at any cost. As a counterexample, a short-sighted management team could double sales in a matter of years, causing immense reputational damage. Restoring brand image and pricing power would take much longer (if even possible). To the Pinault family’s credit, they seem to understand the ins and outs of running a successful luxury conglomerate. While we view their company’s earlier forays into the commodity sportswear segment as a clear dead end, the strategic focus on building a pure-play luxury empire is bearing fruit. This picture illustrates how Kering has become the powerhouse it is today:

As investors, it is our primary job to distinguish between short-term operational weakness and the erosion of a company’s long-term value-creating potential. Kering continues to rest on solid fundamentals, making it a firm member of our shortlisted group of exceptional quality-growth businesses, or EVA Monsters, as we like to refer to them. For reference, Economic Value Added, or EVA, measures the company’s economic profit after deducting all costs, including the cost of giving the stock’s investors a full, fair, and competitive return on their investment. Let’s delve into the key characteristics of Kering that support our EVA Monster classification.

How does the company make money?

The overwhelming majority (93%) of Kering’s 2023 sales stemmed from its “Luxury Houses.” Its largest brand, Gucci, is responsible for 50% of the top line, while Saint Laurent accounts for 16%. The third-biggest house is Bottega Veneta, with an 8% contribution. Its smaller brands, such as Alexander McQueen and Balenciaga, share a further 19% top-line contribution. Kering’s Eyewear and Beauty divisions explain the remaining 7% of sales. On a brand level, Gucci is the key value driver, responsible for ~70% of Kering’s overall EVA generation as of today. When we add YSL and Bottega Veneta to the mix, the three biggest brands make up ~90% of economic profits. In terms of geographical distribution, Kering’s top line is well-balanced across its key regions. As of 2023, the Asia-Pacific is the firm’s biggest market, generating 35% of sales, followed by 28% from Western Europe and 23% from North America.

Value Creation: What type of moat rating is warranted?

We tend to prefer companies whose businesses are protected by large and enduring economic moats, as buying their stock at the right price generally leads to outperformance, as outlined in our research article. The existence of a durable competitive advantage is essential to sustaining outstanding profitability, and this is where qualitative, subjective judgment comes into play.

In many ways, the company follows the proven playbook of LVMH’s Bernard Arnault. Its houses possess creative autonomy, while they also have access to the holding’s vast resources and enjoy scale-related cost advantages in centralized expense items such as purchasing and technology investments. Within the personal luxury goods segment, a few traits are required for a brand to carve out lasting pricing power and warrant a price tag often 10x higher than that of comparable items from premium brands, like Tommy Hilfiger or Lacoste. The handful of fashion houses that succeed in doing so possess a respectable heritage, often dating back more than a century. Besides that, it is quintessential to maintain the brand image by controlling the distribution network, while exclusivity must be ensured by a limited supply where price discounts are unthinkable. In our view, Kering’s flagship house, Gucci, ticks all the above boxes, although clear cyclicality marks the brand’s recent past. We think Gucci plays in the same league as (or only just below) Louis Vuitton, Chanel, and Dior in terms of brand perception and pricing power. Kering’s other houses, such as YSL, Bottega Veneta, and Balenciaga, are considered to be in the second tier of the luxury segment, with slightly subpar profitability and a smaller scale.

From a quantitative standpoint, EVA Monsters are characterized by consistently high returns on invested capital and EVA Margin levels. In the EVA framework, the EVA Margin (EVA/Sales) will serve as our ratio to define a company’s moat. It is the percentage of sales that ends up as EVA after all operating expenses, taxes, and capital charges have been paid. This indicator consolidates pricing power, operational efficiency, and the quality of asset management into one overall score that effectively measures business model productivity.

Turning to the quantitative side of the story, the firm’s EVA has been on a steep ascent in the second half of the past decade (aside from the recent bump in profitability). This clearly reflects the strengthened focus on Kering’s luxury houses, and we believe that the double-digit EVA Margin and ROC levels across cycles are sustainable and are telltale signs of a moaty business. For reference, the typical company in the S&P 500 index is capable of delivering an EVA Margin below 5% and a ROC barely above 10%.

Fundamental Return and Valuation

The global luxury goods market is expected to grow at a mid-single-digit rate between 2022 and 2030. The primary catalyst behind this expansion is the seemingly unstoppable trend of the rising number of high-net-worth individuals (HNWIs) globally. The group of people with $1 million or more in liquid financial assets is forecast to increase by ~40% over the next five years, translating to a CAGR of 7%. Although Kering’s brands are best positioned to continue taking market share over the long run, our midpoint scenario calls for a top-line expansion roughly aligned with the expected market growth during our 5-year forecast period, reflecting Gucci’s recent weakness. We also like the fact that there is sufficient headroom left to decrease the ~22% wholesale revenue portion. In the retail industry, selling the same item directly to consumers compared to wholesalers translates to roughly twice as much realized revenue for the manufacturer. This continued transition could add a few percentage points to Kering’s sales trajectory for years to come.

Regarding profitability, after the recent industry backdrop highlighted mounting difficulties in the Gucci brand, we now expect the company to rebuild its EVA Margin levels to 9-12% on a 5-year horizon (note that figures will look ugly in 2024, and possibly in 2025). Once the Gucci turnaround bears fruit and the customer environment normalizes, there may be room for further improvements, but we would regard that as an upside surprise, just to err on the conservative side.

Switching gears to capital allocation, the firm pays a semi-annual dividend, which tends to fluctuate with earnings, rendering the stock a rather hectic income source. That said, the current ~5% yield is over 3x the U.S. market average. In addition, share count reductions began in 2019, although the net impact of stock buybacks has remained in the sub-1% range annually. Overall, we expect shareholder returns to add 4-5 percentage points to the annualized fundamental return going forward. Combined with the profitable growth component, this results in a fundamental return outlook in the 10-12% range (from a normalized profitability baseline).

The second step in computing the prospective total return is estimating the impact of valuation. We use the Future Growth Reliance (FGR) metric, which indicates how much incremental EVA growth is expected as a percentage of the stock’s Market Value (MV). A higher number translates to a higher valuation, while a negative figure means that the market is pricing a decline in true economic profits. See our publication for further details.

When adjusting the currently depressed profitability to reflect a normalized operating environment (translating to an EVA Margin of ~10%), Kering hovers around a -20% FGR. This seems utterly pessimistic, as the market is essentially pricing in a decline of the company’s EVA generation capability from today’s levels, despite the secular growth drivers paving the way for decades of potential EVA growth. Therefore, the valuation component could act as a tangible tailwind to the total return formula from today’s levels, as we assume a 15-30% fair FGR range in our model, justified by Kering’s EVA growth characteristics and historical average multiples.

Putting the pieces together, we build a 5-year EVA-based financial model for each company we cover. Our models employ both an enterprising and a conservative fundamental scenario, reflecting our assumptions for sales growth and the underlying profitability. We also take into account the impact of shareholder distributions (dividends and share buybacks), which add to the fundamental return outlook alongside the annualized EVA growth component.

Regarding the “exit multiple,” we consider an FGR range that seems feasible based on the historical valuation profile and the underlying business growth characteristics. The annualized total return is highly dependent on the length of time it takes for the FGR to reach the level included in our model; this is one of the main reasons why you may see significant differences between the one and 5-year annualized total return percentages in the charts. The lower end of the shaded band represents our conservative scenario, the upper end shows the result of the enterprising calculation, and we also mark the midpoint values.

Here’s what the annualized total return outlook looks like for Kering from today’s levels, based on the inputs outlined above:

Turning our valuation framework upside-down, we also like to compute the market’s expectations baked into the current share price, expressed as the annualized EVA growth rate that would justify the stock’s current valuation. By examining the reverse growth scenario, we considered a normalized 10% EVA Margin as the current baseline. From that point, the market is currently pricing in a halving (!) of Kering’s absolute annual EVA amount in the next decade. This essentially means that assuming a 3% top-line increase over the next 10 years (well below the expected industry growth rate), the market is only giving credit to a ~5% end-point EVA Margin, which seems highly unrealistic. In a nutshell, our reverse discounted EVA valuation model also confirms that the current beaten-down valuation of Kering’s shares doesn’t seem justified.

Final assessment

Historically, Gucci has always been able to come out stronger at the other end of the fashion cycle, even though elevating the brand’s prestige could take longer than a few quarters, especially in today’s market environment. While relying on aspirational customers far more than its peers has taken a toll on Gucci, secular tailwinds behind the growing number of wealthy individuals bode well for luxury demand to recover. Additionally, substantial family ownership guarantees that long-term shareholder value creation is the primary objective, while luxury conglomerates also possess a material financial and human resource advantage versus niche, monobrand companies. We like the analogy that we are sitting on a ski lift tossed by the wind, yet the direction is upward. To conclude, we believe that the market is serving up Kering on a silver platter for investors looking to build a long-term holding in the stock.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.