The luxury industry, including LVMH, experienced its biggest decline since the pandemic in the third week of August. The Chinese market accounts for more than a third of global luxury spending and continues to be its largest growth engine. Beijing’s push to target the nation’s “wealthy” in order to improve the income distribution structure to tackle social inequality within the country has raised rightful fears about the sector’s near-term growth.
This matters as the Chinese consumers’ enduring love for LV and Dior’s handbags has been the main contributor to LVMH’s outstanding growth over the past 15 months.
We advise utter caution, even if the recent drop looks like an opportunity. Luxury can be the scapegoat of any policy shift in a matter of hours. Such policy shifts have already produced eye-popping results such as the wiping out of the post school tuition business. At 35x current earnings, LVMH cannot afford any disruption to the 30% p.a. growth on the 30% of its sales derived from China.
Fashion & Leather Goods division is the most exposed to the Chinese consumer
Since the pandemic, the F&L division has contributed nearly half of the group’s total sales, of which more than 75% came from Louis Vuitton and Dior, and more than 40% of sales of these two brands came from the Chinese consumer. Excluding the Chinese contribution to cognac and high-end champagne, and ignoring the fact that China is Tiffany’s second largest market, only a slowdown in Chinese demand in the F&L division could end the era of double-digit growth.
LVMH does not disclose its exact sales in China, the above figures are based on AlphaValue’s estimates.
Uncertain consequence of tax reform
The notion of “common prosperity” dates back to the 1950s and Mao Zedong. On 26 August, Beijing clarified that the “common prosperity” mentioned by President Xi does not mean “killing the rich to help the poor”, but mainly refers to improving the tax system, social security and encouraging the wealthy to give back more to society.
As we expected, tax reform is the main focus of the “common prosperity”.
First of all, personal income tax reform may affect the purchasing power of Chinese consumers. Adjusting the personal income tax threshold and balancing labour and capital income taxes can directly reduce the amount of money available for luxury consumption by middle- and high-income consumers.
Secondly, China’s current tax structure is characterised by a low proportion of direct taxes (around 30%), such as income tax, and a high proportion of indirect taxes (around 70%), such as VAT and consumption taxes. VAT is essentially unfair to the poor, whatever the country but even more so in a country where the Gini coefficient of wealth distribution is a disaster. Reducing indirect taxes could improve the income distribution.
Interestingly, luxury perfumes, jewellery and handbags were the main victims of high consumption taxes, which explains why overseas spending accounted for two-thirds of Chinese luxury spending before the pandemic. Counterintuitively, a reduction in consumption tax in general could encourage luxury spending within the country.
Of course, it cannot be ruled out that China can also increase the scope of the consumption tax on luxury goods, luxury cars, private jets, yachts, tobacco and alcohol, in order to regulate the wealth gap and consumption behaviour.
It is important to remind that part of the Luxury sales in China are quasi tax free on a weird concept of would-be travellers exercising a right to buy tax free now, although they are not yet in a positive anticipation to future travelling when the pandemic is over. In other words, this is not exactly a healthy market background as it can be undone overnight by a government not afraid to crash whole industries.
The point is not so much the direction of travel than the timing and brutality of a move with political objectives. Luxury is unlikely to be defended by anyone except Hainan politicians as the island benefited from de facto becoming the new Hong Kong.
The indirect impact will be more painful in the long term
In fact, the possible impact of the above-mentioned tax reform on luxury spending in China will be temporary, in particular, LVMH’s greater diversification across businesses, brands and price ranges could rapidly mitigate the impact. However, we are more concerned about the potential long-term macro-economic consequences.
First, we are concerned that social conflict related to the gap between the rich and the poor could become more widespread during the reform period. Secondly, we are concerned that Beijing’s recent crackdown on technology companies and the curbing of high income will reduce the attractiveness of the Chinese market. Both measures are likely to affect the ability and enthusiasm of Chinese consumers for luxury goods in the long term.
The US demand fireworks
US government hand-outs to households without a need for such benefits has clearly been a driving factor for the demand in luxury consumption (and trucks…). LVMH’s H1 sales in this country went up by 60% (+210% yoy in Q2 21). Actually, the US has been the main driver of top-line growth over Q2. Obviously, this will not last as the free money dries up by September this year.
The high valuation leaves room for a correction
We have repeatedly highlighted our concerns about the group’s dependence on the Chinese market (particularly in the F&L division), which has already been reflected in our below-consensus revenue forecast for FY21 and FY23.
We believe that China’s “Common prosperity” campaign will be released and implemented step by step. The exact size and duration of the direct and indirect impacts on the group’s revenue are certainly difficult to estimate at this time, although we do not expect the consequences of the “Common Prosperity” campaign to be as brutal as the anti-gifting campaign in 2013.
However, after the violent downward corrections of last week, LVMH is still trading at 34.6x its 2021 earnings (32x P/E 2022), which puts the giant market cap into the dubious role of being a ‘short China’ proxy. Incidentally, L’Oréal, just as dependent on China but not as squarely Luxury as LVMH, hardly corrected and still trades at 59x.
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