After experiencing a cold winter in the second quarter, will the luxury goods sector rebound in the third quarter? It depends on the digestion period of the industry, operating leverage, as well as the situation of valuation and PE ratio. If the luxury goods industry fails to recover middle-class consumers, the digestion period grows, the increase in operating expenses exceeds the top-line growth, and the industry valuation continues to be adjusted down, then the cold winter may continue.

Luxury goods are not selling well. In the second quarter, luxury goods companies' revenue remained basically flat, with average profitability in the first half of the year declining by 12% year-on-year, and their stock prices have underperformed the market by an average of 5% since May. From the beginning of the year to present, the luxury goods sector has fallen by a cumulative 20%, and last week alone it fell by 8.5%.

Morgan Stanley has also lowered its valuation of LVMH, Richemont, Hermes, and Moncler.

On Thursday, September 12, Morgan Stanley strategy analyst Edouard Aubin and his team released a report analyzing the five key points that investors are currently concerned about in the luxury goods industry.

Will the middle class come back?

Luxury goods prices are becoming increasingly unaffordable, and middle-income earners have already been excluded.

In May of this year, Morgan Stanley stated that the pricing of the luxury goods industry has become excessively high, especially in the leather goods sector. Currently, there are very few luxury brand leather bags priced below 2000 euros in the market. This has led to a significant loss of sales volume and customer base for luxury brands, distancing them from the middle class.

Moreover, over the past two to three decades, the global middle class's extravagant consumption has been a key factor driving the total available market (TAM) of the luxury goods industry.

Furthermore, consumers have become more discerning. In recent months, luxury brands have noticed that consumers are more willing to purchase the iconic products of major brands, and low-priced products have become crucial because they can attract a wider range of consumers.

Due to the iron rule that luxury goods cannot be discounted, each brand may have to add more entry-level products in the coming months to expand sales volume. Therefore, Morgan Stanley believes that this year's price mix of luxury goods will turn negative, and may continue to remain negative next year.

Morgan Stanley also predicts that the prices of luxury goods in 2024 and 2025 will only increase slightly by about 2%, so the decrease in price mix and the increase in product pricing may offset each other.

How is the current situation of luxury goods sales in the USA?

In the first half of 2024, the profitability of luxury goods in the US market is still declining, but some brands like Van Cleef have achieved growth. Optimists believe that luxury goods sales in the USA will turn positive in the second half of the year, and this growth will once again become the industry's engine.

The argument of the optimists is that the performance this year is expected to be better because the base of performance last year was low, and the wealth level of American consumers is currently at a historically high level.

In the first quarter of 2024, the net assets of American households were 5.7 times the GDP, an increase of 3% year-on-year and an increase of 2% quarter-on-quarter, almost reaching the highest ratio since 1950. Moreover, this ratio is expected to increase further in the second and third quarters of 2024.

The pessimists do not agree, and there are three reasons for this:

1. The correlation between household wealth and personal luxury spending disappeared after 2023.

Before the pandemic, there was a strong correlation between the two, and Tiffany's sales were significantly correlated with the S&P 500 index before 2021. But after the pandemic, this correlation basically disappeared.

2. The recovery of luxury consumption in the US market will not show a V-shaped rebound.

Although the net assets of American households are at a historically high level, spending on luxury goods has decreased year-on-year. In recent months, US consumer spending has been slowly improving or, more accurately, deteriorating less. Morgan Stanley believes that this improvement is gradual. For example, in LVMH's fashion and leather goods division, Morgan Stanley expects spending by US consumers to decrease by about 5% year-on-year in the first quarter of 2024, 3% in the second quarter, and an expected decrease of 1% in the third quarter.

3. Wealth in the US is not evenly distributed among different age groups, and the average age of luxury consumers in the US has significantly decreased in the past decade.

According to the Federal Reserve report for the first quarter of 2024, the "Baby Boomer" generation (60 years old and above) and the "Silent Generation" (78 years old and above) together account for 65% of the wealth in the United States, with the "Baby Boomer" generation alone accounting for 52%.

In addition, approximately 53% of the wealth growth in the first quarter of 2024 was acquired by the "Baby Boomer" generation. In contrast, Millennials (28-43 years old) and Gen Z (12-27 years old) have a lower share of wealth created in the United States.

Morgan Stanley states that the age of the primary luxury goods consumers in the United States has decreased from the mid-40s to the late 30s, and Gen Z has become the growth engine of the luxury goods industry in recent years.

Will the luxury goods industry face a period of digestion in the coming years?

From 2019 to 2023, the compound annual growth rate (CAGR) of luxury goods companies' revenue averaged a high 11.5%, nearly double the rate from 1996 to 2019.

Did consumers over-purchase luxury goods after the pandemic?

Morgan Stanley points out that the luxury goods industry has strengthened cyclically after the pandemic. There is a group of cyclical consumers in the luxury goods market who purchase a luxury handbag every 3-5 years. After the pandemic, due to excess savings and pent-up demand, Morgan Stanley believes that many consumers simultaneously bought luxury goods in the short term, making the cyclical nature of the luxury goods industry more pronounced than before.

After this strong growth, will the luxury goods industry enter a digestion phase of 1 or 3 years?

According to Morgan Stanley, most investors tend to believe that the luxury goods industry will undergo a longer digestion period.

Will the slowdown in revenue growth trigger significant operating leverage?

After the epidemic, luxury goods consumption has quickly recovered. The pre-tax profit margin (EBIT) of Hermès and LVMH's Fashion & Leather Goods (F&LG) division significantly expanded from 2019 to 2023, with Hermès increasing from 34% to 42.1%, and LVMH increasing from 33% to 39.9%.

After experiencing the luxury goods industry's winter in the second quarter, investors are starting to question whether luxury goods companies are over-profitable in the short term after the epidemic.

According to Morgan Stanley, most investors believe that the profitability of the luxury goods industry may fall to a lower level.

As a result, the post-epidemic revenue growth and operating expense growth in the luxury goods industry may not match - as companies increase recruitment and continue to invest, coupled with the impact of inflation, if the growth of luxury brand profitability remains stagnant, the growth of operating expenses may exceed the growth of revenue.

For example, in 2021, Hermès' global workforce increased by 6% to 17,595, while its revenue increased by 41%, resulting in a record pre-tax profit margin of 39.3%, creating significant operating leverage. In 2024, Hermès plans to add 2,400 employees, increasing the total number of employees by 11% to 24,439. Assuming a wage inflation rate of 3%, this means that Hermès' total employee costs will increase by about 14%, while its revenue growth in euros is only 12%. This is one of the reasons why Morgan Stanley predicts that Hermès' pre-tax profit margin will decline by 200 basis points to 40.1% in 2024.

Will the valuation of the luxury goods industry continue to be downgraded?

The luxury goods industry mainly relies on brand momentum, that is, organic sales growth (OSG). As shown in the graph below, there is a good correlation between organic sales growth of luxury brands and future P/E ratio. Due to many investors' doubts about the recent growth of the luxury goods industry, believing that the future growth may only maintain a low single-digit rate, they think that the luxury goods industry may further reduce valuation to adapt to long-term growth slowdown and profit margin contraction.

Since March, the valuation of the luxury goods industry has significantly decreased, accompanied by multiple downward revisions of earnings expectations. According to data from Reuters Eikon, LVMH had a forward P/E ratio of 26 times in March this year, while the current market consensus expectation is 19 times.

If the downward adjustment cycle continues, industry valuation may further decrease. However, Morgan Stanley believes that the valuation downgrade has already largely completed.