Hermes Stock: The Ultimate Expression Of Luxury (OTCMKTS:HESAY)

Hermes (OTCPK:HESAY) is a French company founded in 1836 by Thierry Hermès and has had a return of 4969% for its shareholders over the last 20 years. The secret of Hermès lies in having ascended to the highest echelon of luxury, thanks to the founding family at the helm, obsessed with preserving the brand and the company’s durability. It has been operated by six generations of the family. The company does not define itself as a luxury company but as a quality goods company. I believe Hermès is one of the most special companies in the world, and in this article, I will show why.

Business Model

The company operates in various business segments, as shown in the image. Within the “Other” segment, I have included the segments of “perfumes and beauty revenue,” “watches,” “other products,” and “other revenues” that do not have a significant impact separately on its accounts, thus simplifying the analysis, also with the reader in mind.

Hermès is a straightforward business to understand, so I will not dwell much on explaining the company. I believe it’s more important to understand the qualitative aspects that make this type of luxury business special. To conclude this section, it’s worth mentioning that Hermès is fully vertically integrated, controlling the entire flow from raw material procurement to sales channels. Most of its products are handmade in France, and it only has 300 stores worldwide. Among them, 222 are what they call “branches,” which are owned and operated by Hermès, and in which the customer experience is sublime, with a decoration that matches local cultures. Additionally, it has “concessionaries,” which are third-party stores to which Hermès grants permission to operate its brand. The number of concessionaires has decreased from 92 in 2017 to 78 in 2022 (we do not have the figure for 2023 yet). This speaks highly of the brand’s desire for exclusivity, as well as its ownership of its stores, which are high-quality real estate protected against inflation and avoid leases that can drive up rental prices. It is a fact that the luxury goods experience begins from the moment of purchase. That is why they also do not face the risk of technological disruption. Neither Amazon (AMZN) nor Farfetch can sell Hermès items. Hermés online channels are exclusive to the brand and are pursuing its development by opening a new platform in Brazil. Moreover, 75% of Hermés products, are manufactured in France, ensuring their quality.

Qualitative Aspects Of The Sector

Unlike most industries in the world, the luxury sector benefits with the passage of time. By referencing its year of foundation, we can infer that strong brand reputations are built over many years and require time to occupy a place in consumers’ minds. It is the history behind a brand or a company that builds an emotional or logical connection with customers. This makes the supply of true luxury goods very scarce, as it depends on the only asset in the world that cannot be bought or recovered: time.

This aspect can also be explained through the “Lindy Effect,” which states that the future life expectancy of any non-perishable object is a direct function of its past survival. So, considering that some of these companies have more than a century of history and that the risk of disruption is very low compared to many other industries, we can infer that there are greater chances for these brands to endure in the decades to come, further extending their Lindy Effect.

In addition to the Lindy Effect, another unique characteristic of luxury goods is that they are Veblen goods, whose demand increases as the price increases, due to their exclusive nature and appeal as status symbols. Unlike normal goods, luxury goods may be the only items in the world for which price increases are perceived as positive, as this enhances their exclusivity and desirability.

The dilemma between growth and exclusivity is one of the most challenging aspects faced by luxury companies, especially new ones. In order to preserve brand value and create a sense of scarcity, companies must control their supply of goods (volumes) so that there is always greater demand than the products offered. We could say that true luxury companies choose the pace at which they will grow because price increases are well received and volumes are limited compared to much higher demand. Looking at the growth pattern for Hermès in recent years, we see that volume growth has been greater than price growth. However, to preserve exclusivity, it is very likely that, at least in terms of volumes, the company will experience a decrease towards healthier growth rates. Furthermore, the management team stated in the Q4 2023 conference call that the prices of their products will increase by 8%-9% in 2024.

Another differentiating aspect of these brands compared to rivals considered “premium” or “aspirational luxury” but not absolute luxury, is advertising expenditure. If we look at the percentage of marketing expenses relative to sales, we see how it is lower at Hermès. It’s also worth noting that L’Oréal has many more mass-market brands, and (OTCPK:LVMHF) has segments that are more marketing-intensive, such as the wine and spirits segment. Certainly, in the “Fashion & Leather Goods” segment, their marketing expenses are likely to be more similar to those of Hermès. These marketing expenses often do not involve television advertisements but rather exclusive events organized by the brands to enhance customer relations and to increase desire for the brand and its exclusivity.

We can also say that the pure luxury sector is very resilient in the face of crises. Below, I show the evolution of sales and profits during the crises of 2008 and 2020. Sales during the 2008 crisis were hardly affected, although marketing and workforce expenses continued, resulting in more significant margin impacts. The declines experienced in 2020 were much more severe, but they were due to travel restrictions and the closure of physical stores. The luxury sector does not have a strong online presence because the in-store shopping experience is much more important. Hence, the more severe declines during the pandemic. Nevertheless, this is a positive point because websites like Amazon or Farfetch have not been able to compete against them in online channels, thus reinforcing the resilience of the sector.

Another aspect I consider for its non-cyclicality is its limited supply compared to much higher demand. Remember that desirability equals value. Could they increase supply and sell much more? Yes, but they would be mortgaging their brand image, and that is what is truly dangerous in this industry. There always has to be a portion of unsatisfied demand. For a management team with a business-oriented focus and aiming to preserve the company for years, a year with weaker sales may not matter much because they are thinking about the company’s existence in year 30.

Premium Is Not Luxury

If throughout the entire article, I have emphasized the importance of being a true player in the luxury industry, it’s because of these kinds of comparisons. The difference between premium and luxury goods lies in the fact that with premium goods, customers aim to strike a balance between price and technical specifications (functionalities, shapes, colors, etc.), whereas with luxury goods, technological specs are not as crucial as the status the good confers, the sense of belonging it evokes, and the superior quality of the product. An example of this could be the Apple Watch, which is a premium good. The consumption of premium goods is more discretionary and tends to suffer more in challenging economic environments. Furthermore, the fact that luxury companies are vertically integrated and can sell their products at such high prices generates these kinds of figures compared to other good brands, like Nike (NKE), which are not luxury. All the advantages mentioned ultimately reflect in the long-term performance of the stock. A 10-year compounded annual growth rate of 11.8% for Nike and a 26.1% CAGR for Hermès attest to this.

Capital Allocation

If we look at Hermès’ capital allocation, we might be surprised by the amount of cash it holds (over 10 billion euros). This might lead us to think that capital allocation could reward shareholders more through share buybacks or increased dividends since Hermès does not seem inclined towards M&A activities; they aim to remain a single-brand firm. This is a legitimate consideration for an investor. However, as I have mentioned before, Hermès’ management is solely focused on the longevity of the company. Although they distributed an extraordinary dividend of €10 per share among their shareholders this year, having such a large cash reserve allows them to weather the storm in the event of a black swan event, such as a pandemic, reducing their risk of bankruptcy to almost the minimum. With this mindset, it is highly probable that Hermès could continue to exist for another 200 years.

This capital allocation is orchestrated by its CEO, Axel Dumas and its CFO, Eric du Halgouët. Hermès is a company with a long tradition and history. It is currently in its sixth generation of family ownership (unlike other companies like LVMH, which have yet to experience a generational transition), further reducing any risks. The family owns 66.7% of the shares. Undoubtedly, its history is crucial for understanding the tradition and corporate culture that prevail within the company. This corporate culture and company profits are also shared with employees: “A bonus of EUR 4,000 was distributed to all employees so as to share fruits of our growth with those who make up Hermès.” Axel Dumas in the 2023 annual conference call.

Financials

The financial statements of Hermès, when you consider it’s a retail company, seem like science fiction. It has shown mid- to high double-digit growth rates across all figures. We see clear operational leverage, with sales growing at a 15.9% CAGR and EPS at a 23.5% CAGR. Hermès’ margins seem reminiscent of a SaaS company (42% EBIT margin and a 27% FCF margin). Returns and reinvestment rates are above 20%. Additionally, it has $10 billion in net cash. The Capex seems somewhat high, but it’s due to its high vertical integration and continuous reinvestment in improving or acquiring new stores and workshops for its craftsmen. This ensures the extreme quality of its products. There are several examples of Capex use in their 2023 Full-Year Results presentation (slides 5,6,7,8)

2023 Financial Results

Hermés has had an amazing 2023 year. Almost all the segments have experienced a double-digit growth and all of their geographies have had above-average growth of 20%. Sales at current exchange rates have grown by 15.7% (7% of price effect) and profits soared by 28%. The EBIT margin has expanded from 40.5% to 42.1%. The dividend has been €15 per share, but a special dividend of €10 per share has been distributed.

Below, I will leave some comments from the 2023 annual conference call that I have found interesting:

“So once we’ve said this, we remain confident on the Chinese market in the medium and long term per quarter, maybe it’s more difficult to judge. And in my troubles, I saw fewer people in some malls with less footfall — Hermès is not the most affected because our customer traffic is qualified. And I haven’t seen any major projects of infrastructure being stopped. So it’s amazing to see the number of projects being developed in Shanghai and in other cities. So we are between 2 things really that are fair, things continue to move and which direction it will go. But I remain confident on the Chinese market. And I must say that the results up until now have shown that there’s an attachment of the Chinese customers to our House to Hermès.” Axel Dumas

About price increases philosophy: “Well, I’m glad you took the floor because these are very interesting questions to me. So yes, the price increase is around 8.9%, pretty much 8%, 9% across the board. It’s not one mid-Tier 1 division that has increased its prices more than another. The prices I’m going to come up with a broad answer and one that is understandable by all. So what is our MO? The price policy was started out by my mother in the 1980s, and we’ve always done the same. We use the production costs. And based on that, we decide what the price will be at the financial times. You probably heard that there is some inflation out there that has been impacting our prices. And then there’s also currency effects.” Axel Dumas

The increase in productivity for every new shop: “Yes. Regarding leather, our increase in capacity remains quite stable year-on-year. It’s roughly, we say, 6% to 7%. So your question is why did you reach 17% last year? The main reason is that compared to the previous year 2022, we had a higher productivity because our production activities we’re penalized by the — still by the COVID in 2022. So I would say we have kind of 2 points, which is exceptional. But we keep the trend. We opened one new workshop each year at least, which gives us roughly a 7% capacity increase.” Unknown Executive.

Valuation

We come to perhaps the most controversial topic with Hermès, its “high valuation.” Hermès’ average multiple over the last 10 years has been 42x, yet it has achieved a return for its shareholders of 914% compared to the S&P500’s 224% over the same period.

To evaluate Hermès, I will use a reverse DCF model with a discount rate of 10% and a Terminal Growth Rate of 5%. Throughout the article, I have emphasized the high terminal value of Hermès and the company’s obsession with survival. I am very confident that Hermès will maintain growth rates exceeding the typical 3% used as the Terminal Growth Rate for many decades. In order to reward this low terminal value risk, I will use a TGR of 5%.

With these assumptions, the market seems to be discounting a Free Cash Flow Compound Annual Growth Rate of 18.5% for the next 10 years. While this may seem demanding, it’s worth noting that this growth has been 20.6% over the past 6 years. It is the task of the investor to determine if they are comfortable investing at these valuations. However, it’s important to consider that due to limited volumes in their products and significant pricing power, Hermès essentially chooses the growth pace it wants to have (at least in sales). For all these reasons, I rate Hermès as a hold, but never as a sell, as I consider it one of the highest quality companies in the whole world.

Risks

Personally, I believe that there are no external risks for luxury companies, beyond very unlikely scenarios, such as the banning of selling items in China (an extremely remote scenario). The greatest risk I see for them is a failure in business execution, eroding exclusivity, and damaging brand image. This would threaten the brand’s future and seriously endanger its terminal value. If this were to happen, I would expect a normal decline in margins and returns, with a corresponding correction in the valuation multiple. However, in the case of Hermès, and thanks to being a family business that has already gone through 6 generations, I believe this risk is lower than in other rival companies.

Conclusion

As we have been able to verify, Hermès is a rather unique company in the world, whose reputation has been built over decades. The sector in which it operates has a series of unique characteristics that competent management like Hermès’ is able to leverage to its advantage. I sincerely believe that Hermès is a super resilient company, and its remaining lifespan is counted in decades. Despite that, the valuation seems too tight to me, which is why I rate Hermes as a hold for the moment.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.