Luxury looks East


By Christopher Spink Acquisitions Monthly (Special Reports – 2008 – France 2008)

The major French luxury goods companies are defying gloomy economic forecasts by exploiting fast-growing Eastern markets. Acquisitions are back on the agenda too. Christopher Spink reports.

In times of economic stress, luxury goods makers should be vulnerable. After all, luxury items would surely be some of the first things straitened consumers would forgo. However, the current credit crunch appears to have separated economies that dance to the tune of the US from those that have their own independent financial beat.

The latter are principally based further east, across the Middle East and Asia. Here, notably in India and China, a wave of middle-class consumers are emerging, eager to spend their new-found disposable income on goods branded with such iconic names as Gucci, Louis Vuitton and others.
Makers of such luxury goods can look forward to strong growth from these areas, more than offsetting any weakness in Europe and the US.

The Chinese practice of big four accountant KPMG recently published a report on “China’s Luxury Consumers”. This found that retail sales rose by 17% last year and have doubled over the past six.

And another recent report on the sector by retail consultant Verdict Research predicted that sales in Asia would nearly treble by 2012, allowing the region to overtake the Americas as the second largest market after Europe.

However, taking advantage of that growth is not clear-cut, as the market is already quite crowded. Nick Debnam, partner responsible for consumer markets at KPMG China, notes that Chinese consumers, while still heavily conscious of status, are now becoming increasingly sophisticated and choosing between different brands.

“The challenges facing new entrants to China’s luxury market are intensifying,” he says. “The market has become more crowded, as evidenced by the rising number of luxury brands recognised by consumers in China.” Two years ago, a representative sample of such consumers aged 20 to 44 recognised 52 such brands. This year, 64 were recognised.

Nevertheless, there still remains a strong desire to enter these markets. Larger groups, with their greater marketing and distribution clout, are well placed to snap up smaller family-owned brands, keen to take advantage of this predicted growth by piggy backing on the larger companies.

As such, the prices paid to acquire particular brands across the luxury universe in its widest sense have remained remarkably resilient. Opportunities in Asia were part of the reason for the biggest deal so far this year, the €5.65bn (US$8.87bn) acquisition at the end of March of Vin & Sprit by French drinks maker Pernod Ricard.

That represented more than 20 times the €270m that the Swedish state-owned spirits company made in earnings before interest, tax, depreciation and amortisation (Ebitda) last year. Pernod managing director Pierre Pringuet was comfortable splashing out, since it gave him control of Absolut Vodka, the fourth biggest selling premium spirits brand globally.

At the moment, the Chinese market is very small for Absolut, but it is likely to grow significantly in the next five to 10 years.

Absolut also fits perfectly with Pernod Ricard’s strategy of focusing on “premium” brands, defined as the upper half of the total spirits markets, retailing above US$26 a bottle. Absolut, as the biggest selling premium vodka, means more than 70% of Pernod Ricard’s sales will now come from these higher margin premium brands.

Pernod Ricard says this “premiumisation strategy” of providing “luxury in a bottle” meets the expectations of consumers “who want to drink less, but consume higher quality products”. It also helps accelerate sales growth and increase margins for the overall business.

French panache
With their glorious wines and fabulous cheeses, the French have long known how to enjoy the best things in life. As well as these gourmet creations, France has also given other items of luxury to the world, notably Paris haute couture and other wearable accessories such as bags, watches, perfumes and jewellery.

Not surprisingly, therefore, the country boasts two of the biggest producers of luxury goods in Louis Vuitton Moet Hennessy (LVMH) and Pinault Printemps Redoute – Gucci (PPR). Both have in the past been highly acquisitive. However, in recent years, despite being linked with many iconic brands, Pernod Ricard has led the way in terms of acquisitive growth.
LVMH and PPR both engaged in a flurry of acquisition activity before the turn of the century. Since then, their focus has been on consolidating their positions, reducing borrowings and managing their balance sheets more conservatively. Most deals have been smaller acquisitions to fill gaps in their portfolios.

In the meantime, Pernod Ricard has made several transformational deals to become the second largest spirits group globally after Diageo. This was achieved through the purchase of Seagram of the US in 2001 and Beefeater gin maker Allied Domecq, bought for an enterprise value of US$17.7bn in July 2005.

LVMH, with its unrivalled range of cognacs and champagnes, was rumoured to be considering a bid for Absolut at one stage last year. However, an adviser to LVMH notes that this was never likely, as LVMH did not want to expand its drinks division beyond “the cognac and champagne markets, which it already has stitched up”.

If the luxury goods sector is defined in a very loose way to include upmarket alcoholic drinks brands, then the Absolut deal, at €5.65bn (US$8.87bn), looks like being the largest transaction this year by some distance in this area. Pernod Ricard looks satisfied for the moment. After the deal is complete, the company’s debt will stand at six times Ebitda.

Managing director Pierre Pringuet’s prime focus will be to reduce borrowings before bulking up other under represented parts of the Pernod portfolio, such as tequila and wine. LVMH and PPR might be more interested in smaller acquisitions in other more obvious areas of luxury.

Maureen Hinton, analyst at Verdict Research, believes the most likely areas are watches and jewellery, where LVMH in particular is under-represented. She says being part of LVMH is useful for a smaller company.

“For any brand, coming under the LVMH umbrella is very useful because of the scale of such a large company,” she says. “Luxury goods are a lot do with marketing. LVMH does understand the value of a brand and has been seen to be quite good at building up underdeveloped brands. And when you are part of a group, you have the benefit of using the superior buying and supply arrangements.”

In April, LVMH bought Swiss watchmaker Hublot for an estimated SFr300m (US$284m), or 12 times Ebitda. One analyst says LVMH was prepared to pay a relatively high price as it “really wanted” the business. This was chairman Bernard Arnault’s first significant deal for some time.

Some commentators maintain that the current financial conditions are discouraging similarly bold deals from being proposed at present.
Pierre Mallevays, managing partner at Savigny Partners, a boutique that specialises in luxury goods M&A, believes that while the current economic uncertainty may or may not be affecting demand for luxury goods, depending on the particular product and its markets, major French acquirers are certainly being more circumspect.

“The reality is that valuations are lower than six months ago,” he says. “Companies are keen to buy but are not keen to pay the same price as last year.” Vendors have yet to catch up with this though. “Sellers don’t want to sell, if they believe the current uncertainty is temporary and they can ride it out and wait for prices to recover,” Mallevays says.

This means a deal will only be struck if it makes strong strategic sense for the purchaser, he says. Bolder deals are currently on ice and he does not expect a revival until the end of the year.

“If it’s a clear strategic deal it will get done but more opportunistic ones will have to wait. We will get a much clearer idea of future developments during the second half of the year,” Mallevays says.

For these reasons, he does not think that any of the larger possible acquisitions with which LVMH has been periodically linked are likely to come to fruition anytime soon. Rumoured targets include fellow French companies Hermes, the leather goods group, and Clarins, the cosmetics producer, as well as US jeweller Tiffany.

Mallevays says Hermes’ family dominated shareholder base is typical in the luxury goods sector. “Structurally, it is like a pressure cooker. One day it will explode but I have no idea when,” he says.

Hermes is more highly valued than many of its peers, at more than 30 times expected earnings, as many believe the family might be willing to sell their stake to a predator. “A lot of the value in Hermes stock is down to takeover speculation,” says Mallevays.

Tiffany might be more affected by a US slowdown and would not necessarily fit with LVMH’s strategic goals either, he says.

Other analysts have pointed out that Tiffany focuses on more middle range goods than LVMH. However, activist investor Nelson Peltz, through his Trian fund, owns 8.4% of Tiffany and could provoke further action.

In terms of cosmetics, earlier this year PPR sold YSL Beaute to L’Oreal for €1.15bn (US$1.75bn). Many thought the business would go to Clarins. While this makes the latter company a more likely target for a third party, again nothing is foreseen in the immediate future.

Allegra Perry, an analyst at Lehman Brothers, agrees that the perennial speculation has become somewhat stale for one obvious reason. “There aren’t that many large deals left in the industry,” Perry says. “Most standalone luxury goods brands of a certain size have already been acquired or are not for sale.”

Italian deals
One area where rival broker Merrill Lynch expects activity is in Italy, where a lot of family owned businesses are facing succession issues. Prada and smaller fashion business Ferragamo are both planning to float in Milan, depending on demand, by the end of the year.

JPMorgan, Mediobanca and UBS are advising Ferragamo, with Banca IMI, Goldman Sachs and UniCredit acting for Prada. A sale to one of the major French trade players could be an alternative exit route.

LVMH again has been linked with Bulgari, which is already partly listed but remains majority controlled by the family, and other smaller brands. Versace’s fate has hung in the balance for most of this decade as well.

Bulgari, which has a strong presence in watches and jewellery, set up alongside others a €300m private equity fund called Opera to take part in the expected consolidation of smaller Italian luxury goods makers.
One striking development last year saw Permira buy Valentino Fashion Group for €2.6bn (US$4bn), beating stiff competition from Carlyle. Opinion is divided about whether this was a one-off deal or that it might herald further activity from financial investors in the luxury goods space.

Certainly, some analysts have subsequently criticised the timing of the deal, which was agreed just before the credit crunch took effect last summer.

Others have pointed out that the main motivation for Permira was the acquisition of German group Hugo Boss, in which Valentino has a 51% stake.

Savigny Partners’ Mallevays says: “There should be huge growth in emerging markets for Hugo Boss.”

Permira itself is keen to use Valentino as a platform from which to make further investments in the fragmented fashion sector. The firm reckons Valentino and Hugo Boss combined make it the fourth largest luxury goods company globally after LVMH, PPR and Polo Ralph Lauren.

“Valentino is already one of the largest groups in the luxury space. We are ready to implement an add-on strategy for the group,” says Gianluca Andena, joint chief executive of Permira in Italy. “Given the large size of the business, we think we are like a natural magnet that can attract other companies with the idea of further expanding the group.”

Permira has experience of executing such a buy-and-build strategy in this area, having built up yacht maker Ferretti by this method. “Group building is in line with our way of looking at private equity, where we act with an industrial approach,” says Andena.

“Accordingly, notwithstanding the current focus, which is more on Valentino and Hugo Boss, we remain interested in both large deals, which could add to the group another important brand, and in smaller transactions, which could complement and further strengthen our product offering of the existing brands,” he adds.

However, he warns that “with the deterioration of the credit environment experienced since the first half of 2007, large transactions like Valentino are not yet possible”.

What are possible in these conditions are deals to restructure the portfolios of existing luxury goods companies. Permira’s Andena says: “Uncertainty may also create unstable situations, triggering sales processes or revisions of portfolios, creating interesting M&A opportunities for the most entrepreneurial players.”

Of the major French groups, PPR is most likely to be involved in such manoeuvres. The group increased its stake in Puma to 64.4% last year, valuing the German sportswear brand at €5.3bn (US$8.2bn). At the time, Merrill Lynch said this meant PPR had “the most stretched balance sheet of all its luxury goods competitors”.

Since then, the company has sold YSL Beaute to L’Oreal for €1.15bn (US$1.68bn), helping efforts to shore up its finances. Other possible candidates for sale include books and music retailer FNAC. One analyst said such a retail restructuring was “highly probable”. The group also has mail order interests, which seem to be non-core.

Luxury goods currently account for just over half of PPR’s revenues. But with its main brand Gucci reporting slower growth than its peers, an acquisition of “a second super- luxury brand to the portfolio is very tempting from a strategic standpoint”, says Merrill Lynch.

Savigny’s Mallevays expects PPR to expand its sporting interests following the Puma deal, saying: “PPR can’t catch up LVMH in luxury goods as the gap is too great. Therefore, it needs a different angle and has bought Puma.”

Overall, the outlook for luxury goods providers remains optimistic. As one adviser says: “This sector is proving to be more inelastic than traditionally thought; when good times are good, consumers want to indulge in luxury goods and when good times go bad, consumers are tending to seek comfort in luxury goods.”