Description

Kering owns one of the world´s most valuable brands, Gucci. A decline in share price over the last couple of years have left it trading at 17x earnings, which seems modest for a company with these assets and a history of enviable financial performance. There are some reasons for pause, including a slowing growth and change in the creative director position at Gucci. For those that can stomach the recent challenges, I believe this is an opportunity to invest in a great business at a price that might seem cheap in a few years.

Kering is a French company, controlled by the Pinault family. Kering owns Gucci, Yves Saint Laurent, Bottega Veneta, Balenciaga, Brioni, Alexander Mcqueen, Maui Jim and more. These are some of the most valuable luxury brands in the world. Over the past few decades, the family has slowly turned its conglomerate, from a basket of diverse mediocre businesses in difficult industries, into a concentrated luxury portfolio.

The company was founded in the 1960s by the father of current CEO, Francois Pinault. It was originally a timber trading company and grew via acquisitions into a diversified conglomerate owning disparate businesses in industries such as retail, distribution, manufacturing and others.

The story began to change in 1999, when the group bought a 40% stake in Gucci. At the time, Gucci was publicly traded and LVMH´S Arnault had accumulated a +30% ownership by buying shares in the open market. The Pinault´s were brought in as a type of “white knight”, and bought their participation through a dilutive transaction. Few years later, Kering bought the rest of Gucci and became a 100% owner of the company.

In 2003, Pinault Sr. handed the reign to his son, who is the current CEO. Francois-Henri has followed the strategy of disposing the retail businesses and concentrating the company in luxury. He also tried to get into the sports business by investing in Puma and Cobra Golf but these ventures did not prosper and they ended up exiting these businesses.

Francois-Henri has commented how at the time of the original Gucci investment, he knew close to nothing about luxury, but through his board participation got to know the business and the positive qualities. Kering shareholders have benefited enormously from the move into higher quality businesses.

It is important to note this move of reducing complexity and focusing on a smaller operation of higher quality businesses is not usual. Most families might try to expand their empire and grow by all means. The Pinault´s have significantly shrunk their asset base by disposing tough businesses and focusing on the best. While this is subjective, it seems like management is highly underrated.

The family has a vision of investing for the long term in order to nurture and drive the strength of their brands. Kering has proven to be a great home for these brands as they have benefited from being under the company’s umbrella.

For example, a decade ago Yves Saint Laurent was a marginal business with $400mm in sales and roughly break-even. After years of nourishing the house, with a long term vision and good management, it is now at +$3bn in sales with 30% margins. Same with Bottega Venetta, when the company was acquired in 2001 it was a $60mm revenue business relying mostly on third party distributors. Now the company does $1.7bn in revenue and +20% margins, while controlling most of its distribution. Over the last few years, Kering has taken the tough decision of reducing reliance on wholesale (department and specialty stores). They have invested in their store base and plan is to do 85% of the company´s business directly, they are close to this objective. While this decision has probably hurt short term, it should help over time in driving the strength of the brands as they can control the environment, improve customer experience, react faster to changing trends, etc.

There is significant evidence that Kering has been a good owner. This has been backed by financial results. Over the last 10 years, EPS has 3x from $10 to $30, net debt has remained very low at $2bn, company has returned more than $10bn to shareholders, share count has gone down from 127mm to 122mm. Share price has 4x and TSR has been +17%/year.

Luxury: a good place to fish

Brands such as Gucci are quite scarce assets, which can be incredibly profitable and durable if taken good care of. Brand exclusivity and customer desire is earned over decades of consumer reinforcement. It takes time for a brand to earn a position at the top, and true luxury brands rarely pop out of nowhere. Brands such as Gucci, Chanel, LV & Hermes have for the most part remained at the top for decades. There is some component of fashion and the possibility of mismanagement, but the point is true luxury logos are rare and durable. People want to express their class and even wealth by showing they can wear the same shoes, leather bags or jackets as the wealthy and famous have done for their whole life.  

Another positive aspect for investors is that brands have the ability to raise prices, and by doing so, in some weird aspect, they might drive exclusivity. It is an enviable position where you have a durable brand that might get stronger if you charge more for it over time.

The luxury markets have tailwinds such as society’s growing wealth and a global middle class that wants to wear and show their success.

Finally, these brands have scale benefits in terms of research, advertising, real estate, etc. On top of years of accumulated advertisement and brand building.

The market generally recognizes these attributes. Kering´s peers trade at premium multiples. For example, on earnings they trade: LVMH 25x, Hermes 50x, Moncler 27x, Richemont 22x, Cucinneli 53x, etc. These are high margin businesses with relatively low capital requirements and high ROEs. True luxury brands are quite scarce.

Financials back these claims. Gucci is a $10bn brand with +35% operating margins that has grown sales at 11%/year for the last decade. LVMH is one of the best performing large cap stocks in the last decade. The list goes on.

Why this opportunity exists?

1. Problems at Gucci: Over last few quarters, growth at Gucci has slowed. On top of that, the house decided to change creative director and this creates some instability. It is an important job as this person is responsible for the new collections. While it can´t be brush aside, think the brand has significant legacy and power to navigate this episode. The logo has a loyal clientele that should remain customers over time. Also, the team at Kering has gone through 2 similar episodes in the last 2 decades.
2. Balenciaga: The controversial ad campaign caused immense repudiation and upheaval. This definitely hurt the brand and it was an unfortunate error. While Balenciaga will feel the pain of this episode for a long time and it was a terrible mistake, the business is not highly significant for Kering. They can survive this, and it might proof to be a lesson in terms of controls over time.
3. Recession: Past few weeks, there has been some data coming out that the US consumer has slowed down consumption in the luxury sector. There might be some pain over the short term but my guess is the US consumer will eventually recover and thrive over time. There are some tailwinds coming from China as reopening and travel gains some steam, that might counterbalance a slowdown in other markets.
4. Fashion Risk: In the end, these brands depend on consumer preferences and these might change suddenly. This is a real risk that is difficult to quantify. There have been some indications that Gucci´s desirability has taken a hit as of late, especially in China. This will continue to happen in cycles over time. Kering is trying to push their brands to focus on lasting classy products in order to minimize fashion risk, they call is sustainable elevation. My bet here is that Gucci is a special brand that is strong enough to remain aspirational for the consumer over decades. I am also comfortable with this team, in terms of them being incentivized and having the capacity to invest for the long term. Gucci is probably more dependent on fashion as its products are a bit flashier or less traditional compared to LV & Hermes. Having said that, think valuation discounts that and more. Over its 100 year history, Gucci has survived periods of serious mismanagement, including a family feud in the late 80s/early 90s. Also, changes in directive directors with the feud and exit of Tom Ford. In 2015, Kering changed the CEO & creative director. This ended up being quite a successful change as the brand was reinvigorated and results were quite good over the following years. While no guarantee of success, think it says a lot of a brand that can survive difficult periods.
5. China: Roughly 1/3 of Gucci sales come from China. With all the geopolitical uncertainty and lack of clarity, investors must take this into account. It is impossible to diversify away from such a market.
6. Pinault/Conglomerate discount: Mr. Market dislikes family-controlled conglomerates, and values them as such. My guess is investors might be scared of how the business is managed and capital allocated. Francois-Henri has proven to be a capable executive over the last 2 decades with solid financial results while focusing on the right things. He has executed the strategy of focusing on the luxury sector and disposing the rest of the assets. He has also pushed the company into a global enterprise and away from its dependence on the French consumer market. Pinault is not an empire builder with a huge appetite for large acquisitions, he has been measured and strategic. For example, over the last decade Kering has only spent net $2bn in acquisitions, they have not increased debt levels or issued shares. Few random facts, he studied computer science and co-founded a CRM business with fellow students. He is married to Salma Hayek.

Valuation

In 2023, Kering should earn close to $3.7bn or $30 EPS. Kering trades at 17x earnings or 6% earnings yield.

Over the last decade, revenues and earnings have grown at 12% and 14% respectively. This while returning most of the cash flow in the form of dividends and as of late some buybacks.

At current prices, we are paying very little for the optionality of the future resembling something close to the recent past. While I don´t expect these results to continue, my guess is if the brands remain strong and sales/earnings grow mid-single digits, we should do very well going forward.

Think in 3 years, the company should be doing something close to $40 in EPS. My guess is at that point, the market might assign a multiple that reflects the quality of the business and something closer to its recent past, say 22x, that would yield a $880 share price. This corresponds to a +70% return or 20%/year.

This 22x multiple is not aspirational as Kering traded at these levels prior to COVID and even traded between 25-28x during most of 2021.

In a bullish scenario, where they reach something close to the medium term guidance for the brands, shares might +2x over a similar period. Last year, company indicated that in the medium term Gucci should do $6.1bn revenue and 41% margin, YSL $5bn revenue and 33% margin, Eyewear $2bn revenue and 15% margin.

These are many numbers, but my guess is if they reach something close to those figures, Kering should be doing +$50 in EPS. That would only happen if brands are doing quite well and a multiple closer to LVMH might be appropriate (understanding Gucci has higher fashion risk and less durability than LV). At 25x, stock price might reach $1,250 in an upside scenario.

All mentioned figures are in Euro, not USD.

Appendix

Catalyst

-New creative director should show some of his work in September, that might help remove uncertainty.

-Economic recovery, especially in China

-Continued performance and growth at YSL