Degree of difficulty: low.
I am recommending a short position for Hermes International (RMS SBF) with a 40%+ return expectation. Hermes is a €25 billion high quality, growth company that sells luxury goods globally. I am willing to short a quality growth company because there is a very clear reason the shares are overvalued with several natural catalysts for a reversion. And unlike Salesforce.com shareholders, for example, Hermes shareholders probably don't believe the stock can go up by another 50% in the next twelve months. Buyers at the current level are mostly momentum traders riding technical factors based on the low free float. So, the catalysts won't need to change investors' views (a daunting task that can take years) which could accelerate the selling pressure as catalysts unfold.
As of December 31, 2010, the Hermes family owns 63% of the company (74% of the voting rights). The luxury giant LVMH purchased 20% of the remaining shares in the second half of 2010. Currently the shares trade at ~€235, and LVMH bought between ~€100-150. Takeover speculation combined with a decreasing free float has pushed Hermes shares 50% higher than the company's historical valuation (with no major change in the company's fundamental value).
I believe the shares will revert to more a reasonable level as the company's chairman and the Hermes family representatives rule out the possibility of a deal. The chair of the main Hermes family holding company has even called for LVMH to reduce its stake in Hermes. From LVMH's perspective, its stock trades at around 17x 2012 earnings, so buying Hermes above 45x would be massively dilutive to LVMH shareholders. In addition to less takeover speculation pushing down shares, the company's 45x forward 2012 multiple will likely revert back to historical levels as growth slows in the next 4-6 quarters due to tough comps.
Valuation
Hermes is a relatively easy company to value because of its consistent financial performance. The company has 14 product divisions: leather, scarves, ties, men's wear, women's fashion, perfume, watches, stationery, footwear, gloves, enamel, decorative arts, tableware, and jewelry. Many of the company's products are iconic. For example, Queen Elizabeth II wore a Hermes scarf in a portrait for a British postage stamp in 1956. The company now sells over 1 million scarves worldwide. I will not analyze the business model because my thesis does not depend on having a better understanding of Hermes as a business relative to the market.
Due to the company's quality brands, pricing power and growth, the stock historically trades at 25-30x forward earnings. My price target is based on that range, but there are several factors that could drive the company's multiple back closer to 20x. Based on street estimates, the company should be in the €5.0-5.5 EPS range for 2012. Applying the midpoint of the historical multiple range (27.5x) and earnings estimates (€5.25), I get to a per share value of €144 (37% upside for shorts).
I think using a 28x multiple could prove to be conservative for two reasons. First, it is much easier for a €1-5 billion market cap company to justify a 100% valuation premium to the market than a €24 billion company. From a long perspective, your upside with a large cap is much more limited, and the valuation should reflect that fact. For that reason, €20b+ companies trading above 40x are extremely rare (only 2 out of 179 $30b+ in the U.S.). Multiple compression tends to happen quickly to larger companies trading at high valuations. I ran a regression analysis and confirmed that when holding growth constant, larger firms trade at lower multiples in the long run. Based on that analysis alone I would not be surprised to see Hermes trade back towards 20x in the next few years.
Second, the 30% growth Hermes achieved in 2010 will require the company to add capacity for additional growth. And, unlike lower end producers, the expansion will require substantial increases in labor costs. (their products require manual labor) And clearly, less operating leverage forward demands a lower multiple. Furthermore, due to the tough comps, growth is likely to slow considerably in the second half of 2011 and 2012.
Downside / Risks
Shorting growth companies is risky for several reasons. You could end up being wrong (as were early Netflix shorts). At €24 billion with a very well understood business model, I think the odds of being wrong here are low. And, if my analysis is wrong, I think the loss potential is very reasonable given the company's size and already staggeringly high valuation.
The second big problem with shorting growth companies is being right with bad timing and being forced to cover. Hermes stock just rose 50%, which helps reduce the risk of a 50% move. Also, the reason the stock rose is not the market's fervent belief that the company is an undervalued stock. Low free float combined with takeover speculation is the main reason the stock has rallied so much. With a shareholder base that does not necessarily believe in the valuation, the path back towards normal levels could prove to be relatively steady. Contrast this with the huge rally in Salesforce.com. I think the shorts are right eventually about Salesforce.com. However, because the shareholder base is intellectually convinced that the stock is worth so much, the company could end up as a perpetually overvalued stock (like Amazon.com?).
The big risk and downside to this short is the quality nature of the company. It is unlikely that the actual economic value of the company will decrease while holding this short. If, instead, you were shorting an overvalued steel company, you would get a higher return if that company had a bad quarter of or if the world economy fell into a recession. Because the company's value is unlikely to fall, I consider this short less attractive, and I wouldn't be interested if the stock didn't just rally 50% with natural catalysts for a reversion.