Kering: Too Expensive And Too Dependent On Gucci

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About: Kering SA (PPRUY)
by: Vineet Naik, CFA
Summary

Kering's luxury focused strategy has led to great shareholder returns.

Gucci has had an incredible turnaround, yet remains much more trend driven than LV, Chanel, or Hermes.

However, the current multiple more than accounts for these positive developments.

This is the third article in my Luxury Goods series. Please access the first one on LVMH (OTCPK:LVMUY) here and the second one on Richemont (OTCPK:CFRUY) here.

In this article, I provide an overview and analysis of Kering S.A. (OTCPK:PPRUY). I argue that, while the company’s Gucci brand is a strong brand with attractive economics, its lack of diversity (in brands as well as product types) means that it holds a much weaker hand than LVMH or CFR. For better or worse, the fate of Kering is inextricably tied to Gucci. Gucci’s recent turnaround (which I will also discuss) has provided much of the fuel for the performance of Kering’s stock in recent years. However, the same reliance of Gucci means that the future is less predictable for reasons I will describe. While I will cover the background and details of the Company’s brands (in the same way as I did for LVMH and Richemont) and provide occasional updates, I presently do not recommend the shares on account of elevated valuation.

History & Background

In 1963, Francois Pinault established a lumber trading firm. Pinault went on to organically grow and acquire several firms, putting together a small conglomerate over time. The company went through several name changes and, in 1999, acquired a 42% interest in Gucci Group NV, marking its entry into the luxury goods sector. Gucci Group further bought Yves Saint Laurent (YSL), Bottega Veneta, Balenciaga and signed several partnership agreements to transform itself into a multi-brand luxury group. In the meantime Pinault’s firm (which eventually became Kering with a name change in 2013) increased its ownership of Gucci Group to 99.4% by the year 2004. Over the years the group acquired several brands and disposed of its non-luxury divisions. I will address recent M&A/strategy in a later section.

Today, the Group owns the following well-known brands: Gucci, Saint Laurent (YSL), Bottega Veneta, Balenciaga, Alexander McQueen, Brioni, Boucheron, Ulysse Nardin, and others. More Detailed history can be found here.

Segments/Products

While the Company has only one segment, it reports earnings level data by brand (unlike segment level at LVMH and CFR) which is very useful in understanding revenue and profit drivers. Revenue by brand for the last two years were as follows:

Source: Kering filings

Operating income by brand for the last two years were as follows:

Source: Kering filings

It’s obvious from the above that core to any investment analysis of Kering is an assessment of the strength, longevity, and profitability of the Gucci brand. Gucci accounted for almost 80% of brand-level profits of Kering and 90% of the increase in brand-level profits in FY18. Consequently, I will spend more time speaking about Gucci and its performance and less time on the other brands.

Luxury strategy

Since taking complete control of Gucci in 2004, the Company has moved (slowly at first and rapidly in later years) to shed its non-luxury assets (retail, sports & leisure, etc.) to focus on its flagship luxury brands as described in the 2018 annual report. Though it is not discussed much in the financial press, this has been a terrific capital allocation decision, resulting in this peculiar result: Revenues since 2005 are down 23%, from €17.8 billion to €13.7 billion, whereas recurring profits are up 263% from €1.1 billion to €3.9 billion. The following chart captures just how impactful this focused strategy has been from a shareholder value creation perspective:

(Source: Kering Investing Presentation 3Q17)

Further, during 2018, the Company divested (or is in the process of divesting) its stakes in Puma, Volcom, Stella McCartney, Christopher Kane, and Thomas Maier. This strategy of increasing focus on luxury brands should serve to further improve margins and returns on capital. However, it also means the Company will become even more reliant on the Gucci brand for its success.

Gucci Positioning and Turnaround

An analysis of Gucci is central to the analysis of Kering for reasons stated above. It accounted for 80% of the Company’s brand-level profits and almost 90% of its growth in such profits. Gucci occupies an interesting place in the luxury goods pyramid. It’s not quite at the highest ends of luxury where Hermes, Harry Winston, or Patek Philippe might sit exercising their pricing power a little at a time. But it’s also not at the affordable luxury end with Tissot, Coach, and others who have little pricing power or brand differentiation, and compete fiercely with tons of other brands, mostly on price. Gucci occupies a role in the middle where it’s accessible for most but is marketed in a way that can still make it seem (and be priced) like an exclusive luxury good. As a result, the brand has been able to generate decent sales, high margins, and has had more longevity than most fashion labels. However, that also means it is more susceptible to fashion trends and fads than, say, Louis Vuitton or Hermes, which generate a bulk of the sales from ‘flagship’ products created several decades ago. These flagship products provide a sort of financial predictability to the brands, as long as they can keep them at the front of customers’ minds.

Gucci (by desire or necessity) has had to take an approach of constantly releasing new products which form the bulk of its sales. The brand has its fans who always buy the products, but the growth depends on new successful introductions. As a result of this position in the hierarchy, the brand has had several periods of financial (and operational) weakness. Gucci (under prior ownership) came close to bankruptcy in 1993 but was saved by Marc Jacob’s arrival. Its collections were seen as “tired” in the mid-2000s which led to stagnating sales. By 2012, it was growing comparable revenues around 2-3% per year, though margins were pretty high still.

In 2015, a heretofore unknown creative director, Alessandro Michele, took the reins. At the same time, the brand capitalized on the emergence of digital media channels (social media, internet platforms, etc.) and e-commerce to increase its appeal to millennials (where super-premium brands like Louis Vuitton and Hermes are less represented). This strategy of focusing on millennials, heavily using influencers/celebrities to promote the product, as well as Michele’s well-received shows, led to Gucci sales going through the roof. Gucci brand sales were up 13%, 44%, and 37% in FY16, FY17, and FY18 respectively, an almost unheard of pace for a brand that’s almost 100 years old. Margins also inflected up reflecting operating leverage inherent in the business. So far the turnaround has done wonders to Kering’s stock price. However, since Gucci retains its trendy character and caters to shorter-duration trends, the question always is: Will it last? How long can they keep coming up with products that will allow them to keep breaking records? Are they at the whim of the latest fashion influencers, editors, and reviewers?

Valuation

With free cash flow of €3 billion in FY18, EBITDA of €4.4 billion, net debt of €1.7 billion, EPS of €22.36, the valuation metrics (based on trailing twelve months) are: 20x P/FCF, 14x EV/EBITDA, and 22x P/E. On a forward basis, the stock trades at: 17 P/FCF, and 18 P/E (Adj).

Given the concentration of performance in Gucci, the recent supernormal growth at that brand, and its necessarily slowing growth in the future, the price appears a bit too steep given that other equities with more stable businesses, stable growth profiles, less brand/sales concentration, less economic exposure, and less fashion exposure can be owned for the same multiple or less. For e.g. see my articles on Comcast (CMCSA), Ross Stores (ROST), and within the luxury goods businesses, LVMH (OTCPK:LVMUY) linked above.

As a result, while I am as impressed as anybody with the turnaround at Gucci, at present prices, I cannot recommend the purchase of the shares. Should the multiples return to a 15-20% discount seen a few months ago, I would consider starting a position.

Risks

The risks here are similar to the LVMH article linked above with an additional risk of concentration as mentioned above. As Gucci goes, so does Kering. As noted above, the brand has twice in the last twenty years seen its fortunes flag. The fact that it was saved both times speaks to the strength of the brand (as Warren Buffett commented in his 1987 letter to shareholders, “Charlie and I have found that making silk purses out of silk is the best that we can do; with sow's ears, we fail.”). However, it also shows the exposure of fashion trends on the brand, compared to, say Hermes or Louis Vuitton, who do much more of their business in flagship products.

Conclusion

Given the elevated valuation based off seemingly peak turnaround earnings, concentration on a single brand that is much more exposed to fashion trends than its peers, I do not recommend the purchase of Kering shares at their current price. However, the business is a good one as noted by its extremely high returns on capital. Consequently, as noted above, I would consider starting a position at lower valuations.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.