Hermès: Strong Fundamentals And 'One And Only' Status Justify Valuations

Summary

• Hermès is a high-quality franchise with a track record of high profitability, free cash flow generation, and pricing power.
• Its core earnings driver is the Asia market, which showed significant resilience during FY12/2020 as well as being the most profitable, improving the sales mix.
• Headline valuation metrics may be high, but we believe they are justified based on the company's "one and only" status in the competitive premium luxury goods sector.

Photo by Freedoo/iStock Editorial via Getty Images

Investment thesis

Hermès (OTCPK:HESAY) (OTCPK:HESAF) is a high-quality franchise generating shareholder value on a consistent and predictable basis. With its strong pricing power, returns will remain high, and earnings growth will come primarily driven by Asian markets. We are buyers of the shares.

Our objectives

In this piece, we want to assess the following:

• Outlook for demand recovery per geographic markets, assessing whether European weakness will be a major headwind.
• Capital allocation in light of a well-capitalized balance sheet.

We will take each one in turn.

Geographic demand profiles

Hermès has its largest sales weighting in Asian markets, comprising 58% of total FY12/2020 sales. Despite the pandemic, Asia sales grew 8.6% YoY driven by Asia-Pacific excluding Japan (incidentally Japan sales fell only by 3.5% YoY). The marked decline in demand came from Europe where sales fell 24% YoY, followed by the Americas with sales falling 21% YoY. Overall, sales dropped 7% YoY including FX impact.

FY12/2020 sales split per geography

Source: Company, created by author

FY12/2020 sales growth YoY per geography

Source: Company, created by author

Despite the 7% drop in total revenues YoY, overall operating margins remained resilient at 32% from 34% in FY12/2019. What this tells us is that Asia-Pacific and Japan are high margin, allowing Hermès to maintain high profitability via a positive geographic sales mix. However, the overall high margins amply illustrate Hermès' pricing power of its products - even during uncertain times in FY12/2020 the company raised price worldwide by 1%.

Operating margin trend

Source: Company, created by author

Looking at historical data and based on our estimates, we think the operating margins per geographic market looks as follows in FY12/2019 under more normalized conditions and subsequently in FY12/2020. Effectively Asia is the key earnings driver, both from a top-line as well as profitability viewpoint. We estimate Asia ex-Japan operating margins are in excess of 40%.

Operating margin estimates per geography

Source: created by author

For recent trading Hermès saw Q4 FY12/2020 sales recover by 12% YoY, again driven by the Asian market as demand began to normalize. Weaker areas like Europe and Americas began to show a deceleration in declines YoY.

Q4 FY12/2020 sales growth YoY per geography

Source: Company, created by author

We estimate Asia will grow FY12/2021 sales in the high teens YoY, generating operating margins approaching 45% in the region. We believe that even if Europe sales remain flat to down YoY as a result of the current third wave of the pandemic and subdued levels of overseas visitors, the overall outlook for FY12/2021 looks positive. We also expect worldwide price hikes to resume to at least 2%-3% levels YoY. Overall, we see these factors being reflected in consensus sales forecasts for the next three years. We feel that operating margin forecasts look on the conservative side given the strength expected in Asia.

Consensus sales forecasts

Source: Refinitiv, created by author

Consensus operating margin forecasts

Source: Refinitiv, created by author

On the digital front it is interesting to see the company's recent Asia focus. The hermes.com platform is accessible in 28 countries, including Korea in June 2020 and Hong Kong (where tourism has significantly fallen). Thailand and Taiwan are expected to follow in 2021. Hermes' website traffic was said to have doubled YoY in FY12/2020, reflecting lockdown situations and consumer shift to online purchasing - there is potential for margins to increase further from online sales growth.

In terms of its real world distribution network, for FY12/2021, Hermès has a focus on opening or renovating its key stores in Paris, Lyon, Zurich but also Omotesando (Tokyo), Macau and Beijing.

From the above we believe that Asia will remain a key driver for growth, offsetting any weakness in Europe.

Now we take a look at capital allocation.

Capital allocation

The company has a strong track record of free cash flow generation, with its free cash flow conversion averaging 95% for the last 10 years. Its free cash flow margin also stands at a 10-year average of 20%.

When we look at how this generated capital has been allocated over the last 10 years, we see the majority has been spent on dividends. There has been limited spending on M&A mainly on investments into associates and strategic vertical integration. Overall, we can see that not all the capital has been utilized.

Capital allocation of generated free cash flow - last 10 years

Source: Company, created by author

This activity would partly explain the rising cash pile in the business.

Net cash balance trend

Source: Company, created by author

Hermès is not a particularly capital intensive business, spending on average 6% of sales as capex. Recently capex has focused on vertically integrating its workshops and suppliers, resulting in cost reductions improving margins, as well as ESG efforts for lowering machinery energy consumption and tannery waste management. The net cash balance is not a major concern when compared to the market capitalization, making up only 3% of its value. If we speculate how it could be utilized, some cash set aside for M&A looks most plausible, as its peer LVMH (OTCPK:LVMHF) continues to add to its portfolio of brands worldwide. Any deal is likely to be fairly small and bolt-on as opposed to a major acquisition, rather like the current ancillary brands like bootmaker John Lobb and silversmith Puiforcat.

From this we conclude that there is unlikely to be major changes in capital allocation. The company will continue to invest in the business through organic means, and net cash is expected to continue building as there is unlikely to be a policy change for shareholder returns which could provide some upside.

Valuation

With immense intangible value from its brand and market-leading pricing power, Hermès is a high-quality franchise generating high returns and sustainable free cash flow generation. The balance sheet is strong, and return on equity is high at 20% even in FY12/2020.

It is therefore not a huge surprise when we see the valuation metrics demonstrating the company's "one and only" status in the industry. On consensus forecasts the shares are trading on PER FY12/2022 50.4x on a free cash flow yield of 2.0%. Based on a steady dividend payout ratio of around 33%, the prospective dividend yield is a low 0.7%.

Whilst headline multiples and yields do not appear undervalued, when we take a step back and think "how much money would it take to build a business and brand like Hermès?", this is where the intangible value of the company comes in. Effectively conjuring up a replacement value is a moot exercise - but does highlight where the market is placing a significant emphasis on its valuation, and this appears justified given the company's track record.

Risks

The biggest risk in the short term is a major return of the pandemic to Asian geographies during FY12/2021. This may look like an unlikely scenario as of now, but if China and Japan begin to see lockdowns and store closures, this will have a major negative impact on the company's key markets.

Another China-specific issue is a demand backlash for Western brands. Although Hermès has not been affected as of now, brands such as Burberry (OTCPK:BURBY) and H&M (OTCPK:HNNMY) are beginning to be boycotted by Chinese shoppers. Burberry is a member of the Better Cotton Initiative, a cotton sustainability project that last year suspended its links to Xinjiang over alleged Uyghur human rights and labor abuses.

Other more macro factors that would be negative for the company are a major strengthening of the Euro against the Renminbi and Japanese yen. Also, major cost inflation of input materials such as leather, precious metal components and labor. However, we are aware that with Hermès' pricing power, price hikes can be introduced to mitigate some of these ill effects without affecting demand elasticity significantly.

Conclusion

Hermès has the hallmarks of a quality well-run business in the niche premium luxury goods sector. Its market position is strong, there are very high barriers to entry and the company has immense pricing power. Its track record of returns and free cash flow generation is strong and predictable.

Justifying the valuation is less straightforward. Headline metrics do not denote much in terms of undervaluation (quite the reverse in fact). However, with strong fundamentals, its unique market status and giving some thought over replacement cost or even as an acquisition target provides some reasoning as to why the stock should trade at a relative premium.

Hermès' strategy of operating an artisanal model with conservative financial management may be a stark contract to peer LVMH with its M&A strategy, but we believe generates consistent shareholder value. From the viewpoint of investing in a high-quality franchise, we are buyers of the shares.

Analyst’s 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.

Comments

[Adjank]

Another question to ask is if Hermes ever traded at a lower valuation then around 40 to 50 times earnings.

[billbyte]

M8 has HESAY at 1* valuation. Occasionally HESAY price drops because of some major macro event. Then it is time to buy.

[Steven Miller]

I can understand paying a premium for a quality company. I do it often. But I've never been able to bring myself to pay for this one. I keep thinking the stock price going to come down one of these days. I still believe it will, and it may even being showing a top now. It's hard to know.

[Karreta Advisors]

@Steven Miller Thanks for your comments - it is not an easy call with the headline multiples, but the business keeps proving itself time and time again it seems.

[piterectus]

@Steven Miller My friend I can tell you that I have owned thsi stocks for several decades and never, never had a good price "to buy", it as always too expensive. However its price never came dawn, never. Du you know why? Because it is a unique company with Velben products run for a family as good as its product. So is the crown jewerly of the luxury & Velben producs. Buy now and in a few years you will know what I mean

[piterectus]

The track record for the past several decades show that Hermes is unique.
Has The best managed family company in Europe (perhaps the world) with unique VEBLEN goods that, for me, make it the best large company in Europe.

Hermes is so strongly hold and preserve for the long term that not even Louis Vuitton could purchase it.
By the way, LVMH is the second best company in Europe, just behind Hermes

[Christian Louis Boutin]

@piterectus Own both. They are amazing companies and investments.

[Karreta Advisors]

@piterectus Hi and thank you for your comments - I think you may be right, but my preference is LVMH just from a higher FCF yield. Both are amazing businesses, so high quality.

[Karreta Advisors]

@disney4ever You are a great stock picker! Thanks for the comment.