The Luxury Flywheel: Part 1

This is Part 1 in a multi-part series on luxury. Luxury is a very attractive industry for long-term investors. Part 2 can be found here. Let's first define luxury.

What is luxury?

There is a huge debate on how to define luxury. For example, in an interview with Bernard Arnault, a student asked if an iPhone was a luxury product (Arnault said no). Others have created luxury sub-categories like premium vs. accessible. Some definitions center around tradition, quality and craftsmanship while others center around status and exclusivity.

I use a simple definition. Luxury is the ability to consistently sell handbags for $3,000+. In fact, I think the sideshow of designing and selling clothes, doing fashion shows, sponsoring art exhibitions, and dressing celebrities at the Met Gala are all ultimately aimed at selling more $3,000+ handbags, which account for anywhere from 40% to 75% of operating profits for megabrands. My definition may be simple, but it's precise and cuts through all the noise. I'm looking at luxury from an investing lens and at the end of the day, $3,000+ handbags are what drive earnings and free cash flow.

My definition will therefore exclude brands like Coach, Kate Spade or Tory Burch that can’t consistently sell $3,000 handbags and will also exclude more fashion orientated brands like Moncler or Brunello Cuccinelli. For this analysis, I'm limiting myself to "soft" luxury which effectively means handbags. I'll leave the discussion on Ferrari's and Rolex's for a later day.

Luxury is a Cornered Resource

Before diving into the luxury flywheel, it is first important to understand that luxury brands are a cornered resource. Just like NBA franchises, there are a fixed number of brands. There have been no new entrants into luxury (remember my definition) over the last 50 years. You can't develop one from scratch and in fact, LVMH has tried but failed. What this means is that if you believe the industry can grow 6% to 8% over the next 10 or 20 years (I do), I believe the pie will be split amongst brands that already exist today, and my industry thesis is that the big will get bigger for structural reasons that have played out over the last 10 years.

The main reason why luxury is a cornered resource is because luxury brands require "heritage", which by definition takes decades to establish. Even if new brands get hot, it takes decades to cultivate those brand, build out distribution, and earn the right to consistently sell $3,000 handbags, which is why the barriers to entry are nearly insurmountable. The only credible new entrant I can think of is Miu Miu (founded 1992) which does €1.3bn in revenue (after growing 100% in 2024) and can claim to consistently sell $3,000 handbags, but they are a unique case where they were a sub-brand of Prada, and grew via the support of a much larger parent brand. This brings me to another industry thesis, which is to the extent a small brand gets large, it will likely be under the ownership of a much larger conglomerate.  

While I use a precise definition of luxury, the real definition is much more subjective, more psychological, and can morph based on the era, country, or demographic but it is important to acknowledge the unsaid, that despite all the talk of artisans, creativity, and quality, luxury in large part is about status and in order to sell status, you need exclusivity and therein lies the paradox. It reminds me of the Woody Allen quote "I would never join a club that would accept me as a member". The former CEO of Hermes put it even better.

Patrick Thomas, former CEO of Hermes

“The luxury industry is built on a paradox: the more desirable the brand becomes, the more it sells but the more it sells, the less desirable it becomes”

The Luxury Flywheel

In my view, there is a universal luxury flywheel. I'm giving credit to Hermes for pioneering it, but it could have its roots in luxury watches. This flywheel has more or less been cloned by every single megabrand including Louis Vuitton, Dior, Chanel, and Gucci with varying levels of success. The flywheel has been mastered by the likes of Rolex, Patek Philippe, and Ferrari. To understand the luxury flywheel, it is worth going over a stylized version. I say stylized because it is never this clean. I'm describing the flywheel from my investment lens. How a "fashion" person describes this will sound different.

1. Start with Heritage. I own a brand that has existed for 100 years that sells a "classic" bag design with a shape or logo that everyone can identify. Maybe Jackie Kennedy carried the bag in a famous photo or maybe it was Princess Diana's go-to. The bag has come to symbolize femininity and artistry, qualities shoppers aspire to.
2. Create a Buzz. I pay Chiara Ferragni to hold that bag on an Instagram post or pay Taylor Swift to wear that bag on a dinner date or send free samples to celebrity publicists to distribute to their clients with the hope that it creates a buzz. In the 1950's, the equivalent of Instagram was LIFE Magazine printing a photo of Grace Kelly clutching her Hermes bag.
3. Create Scarcity. As the buzz creates interest, customers go online to see the bag but it says it's sold out (it's not) so they head to stores only to find that the cute $3,000 black version Taylor Swift had is sold-out but a red version that costs $4,000 is available but with only one in stock (they have more, trust me).
4. Drive Mix. Some customers choose to buy the $4,000 version whilst others message their salesperson incessantly to see if the black version is back in stock. Influencers and VIP customers that spend $100k+ get a special text from their salesperson who offers this $3,000 sold-out black bag to reward them for their loyalty.
5. Elevate Value. You now start seeing celebrities on Instagram carrying the black version of the bag. The VIPs who got the bag start showing off too their jealous friends. Used versions of the bag start popping up in the secondary market at prices higher than $3,000. Customers start saying the bag is an "investment".
6. Drive Price. The following year, there is pent up demand for that bag, but because of inflation and a minor design modification, the bag now costs 30% more. The pent-up demand easily clears through this inventory despite the higher price with enough demand leftover to raise prices again the following year.
7. Rinse and Repeat for 50 years. For context, many "carryover" bags have existed for decades including Hermes' Kelly (1956) and Birken (1984), Louis Vuitton's Keepall (1930), Speedy (1930) and Noe (1932), Chanel's 2.55 Flap (1955), Gucci's Bamboo (1940) and Jackie (1961) and Dior's Lady Dior (1994) and Saddle (1999).

Hermes is the only brand that has achieved this flywheel for a meaningful portion of revenue, albeit, the way they execute on this playbook is far more subtle and nuanced than what I've described. With that said, every megabrand or brand owned by a mega conglomerate (LVMH, Kering) is trying to get on that flywheel with varying levels of success. Once you get on, it is one of the most powerful forces in capitalism. I'm not exaggerating. Hermes' Kelly bags which exploded in popularity from a 1956 photo in LIFE Magazine of Grace Kelly (originally called Sac à Dépêches) spawned a flywheel that has lasted 70 years, creating the largest company in France in the process. Hermes' flywheel is so powerful that they've graduated from having to create any buzz. The buzz they generated from the OG influencer strategy 70 years ago was enough to power this flywheel for decades.

This flywheel also gets to why I narrowly define luxury as $3,000 handbags. Part of the flywheel is dependent on bags being "carryovers" that can be released with the same designs year-in and year-out with minor modifications (color, materials, straps, hardware). The same cannot be done with apparel as fashion styles change too much year-over-year. Another part of the flywheel is the concept of creating scarcity and holding back inventory, but this is simply less applicable to clothing where sizes and seasonal trends come into play. Finally, the flywheel is dependent on the concept of a bag being an "investment", something timeless that holds it value whereas clothes are bought to be worn and their end state is inevitably the donation or garbage bin. As a result, I don't believe the clothing-focused luxury brands like Moncler or Brunello Cucinelli are playing the same game.

The 5Ps of Luxury

Let's think through this playbook in more detail and it is worth thinking about it within the context of the 4P's of marketing: Product, Promotion, Placement, and Price. I add a 5th "P" for Process Power.

Product (Heritage)

Having a high quality product stitched together by artisans in France or Italy is important and the most successful brands have vertically integrated into manufacturing and even to tanneries and crocodile farms to guarantee both actual and perceived quality. However, the most important thing that every luxury brand needs is not a high quality product but rather, its heritage. Heritage is the history and stories that allow brands to communicate quality, value, culture, and status to their end clients. You can't manufacture heritage. You either have a brand with heritage or you acquire one, and even if you acquire one, it takes decades to nurture, which is why family owned conglomerates have a huge advantage as they are the only buyers who can nurture these brands over the long-term.

• Louis Vuitton (1854). Heritage rooted in trunk making
• Hermes (1837). Heritage rooted in saddle making and silk
• Dior (1946). Heritage rooted in Christian Dior's "New Look"
• Gucci (1921). Heritage rooted in luggage
• Chanel (1910). Heritage rooted in Coco Chanel

Promotion (Create a Buzz)

Pre-WW2, luxury was more of a IYKYK product for the wealthy. This evolved post-WW2 where Barney's and Saks, magazines like Vogue, and images of celebrities in newspapers and publications like LIFE drove brand awareness amongst mainstream consumers.

The key is that pre-internet, power was concentrated amongst Barney's buyers and Vogue editors meaning every "fulcrum point" counted that much more. If Anna Wintour loved you as a designer or if Barney's supported you, an up and coming designer could have success. This is what happened to up and comers like Calvin Klein, Michael Kors, Alexander McQueen and Perry Ellis 30 to 40 years ago.

In today's Instagram world, the buyers at Barneys and Anna Wintour have become irrelevant. In fact, Chiara Ferragni and Aimee Song are far more influential to Anna Wintour and buyers at Bergdorf's can't even get an invite to fashion shows. In the Instagram world where there is no clear fulcrum, scale wins as you need to blanket advertise across social media influencers, celebrities, the Met Gala, etc. This has been a structural benefit to the megabrands who have the marketing muscle to buy influence.

The same thing happened with restaurants. In the past, Ruth Reichl, A.A. Gill and the Michelin Guide could make or break a high-end restaurant whilst today, top restaurants have social media managers and the NYT food section is becoming irrelevant. Having Rihanna do an Instagram story on the amazing food is far more impactful to a NYT's review.

Within this context, LV's strategy of hiring Pharrell as mens designer makes sense. Mens clothes are an insignificant part of LV's revenue so whether the clothes themselves are inspired or not, the buzz of having celebrities and rappers attend every one of your fashion shows is priceless. At Pharrell's inaugural show, guests included Tyler the Creator, Offset, Quavo, Meghan Thee Stallion, Jaden and Willow Smith, Kim Kardashian, Naomi Campbell, Lenny Kravitz, Beyonce, Jay-Z, Rihanna and A$AP Rocky.

To give you a sense of the marketing muscle, LVMH has 5x the EBITDA of Nike. Nike's EBITDA is actually in the same ballpark as Kering. It reportedly costs $20m to run a megabrand fashion show (LV will do 8 a year) because LV will fly K-Pop stars and influencers all over the world on first class to fashion shows in cool destinations, pay for their luxury hotel, and throw an amazing party, all to get a couple of Instagram stories (Bernard, if you are reading, please send me an invite). Brands doing <€1bn in revenue run at a low-teens EBIT margin so can't justify this expense vs. 30% to 50% EBIT margins at megabrands. This has raised the barriers to entry in luxury enormously.

While more money = more influence, there are a few nuances which I'll discuss in greater detail in later posts. For example, Hermes is the exception to the rule as they don't throw any fashion shows, they don't sponsor celebrities, and they're barely on Instagram. Gucci on the other hand has been spending heavily on marketing but these efforts have been like pushing on a string given their dismal results, so while promotion spend is critical in the long-run, it is complex and not always correlated to short-term performance. It is just one part of the flywheel.

Placement (Create Exclusivity)

Once a buzz is created, you need to create a false sense of scarcity and in order to do that, you need to own your distribution so you can control your inventory, which is where megabrands have a huge advantage. Megabrands have the scale to sell 100% direct. Louis Vuitton has been 100% direct since the 1970s. Moreover, megabrands have the scale to secure the best real estate in the world. In fact, there is a trend right now of megabrands acquiring trophy real estate outright to secure this cornered resource forever. In China, brands like Hermes are often anchor tenants who get the best location inside the mall at the lowest rent as mall owners know having Hermes in your mall will mean wannabe brands will lease space in that same mall. The benefits of scale and direct distribution are only getting more pronounced as wholesale goes from 72% of revenue in 2010 to 54% in 2020 to likely 25% in the next 10 years.

Louis Vuitton, Hermes, Chanel all sell close to 100% direct (Hermes actually does some concessions) and all do €100k/sqm in sales. For context, Lululemon which is best-in-class does c.€15k. If you are doing €100k/sqm, you not only operate at a 40%+ EBIT margin but you have plenty of cash flow to reinvest into both your own brand and the other brands in your portfolio.

Most small brands are stuck where Ferragamo is or doing even worse, meaning margins are too low to secure better real estate or spend more on marketing. Most therefore end up wholesaling to department stores to try to scale up, which then prevents them from controlling their 5Ps, which in turn means they'll never get on the luxury flywheel. This is why small <$1bn brands reliant on Niemen Marcus cannot drive sustainable price and mix. Yes, Louis Vuitton is sold at Niemen Marcus but LVMH is simply Niemen Marcus' tenant and owns the inventory, hires its own staff, and has full control over customer data.

I believe the only chance smaller brands have on getting onto the luxury flywheel is getting acquired by a larger brand so they can be subsidized. This is exactly the playbook for LVMH (Dior, Celine, Fendi, Loewe), Kering (YSL, Bottega Veneta, Balenciaga, Alexander McQueen, Valentino) and more recently Prada (Miu Miu, Versace).

Process Power (Drive Mix and Elevate)

The whole point of controlling your stores and holding back inventory is to create the perception of scarcity, which in turn creates the perception of exclusivity, which in turn elevates the brand setting the stage for driving mix and price. Mix is particularly powerful as it elevates the brand and raises the accepted price consumers are willing to pay for the entire brand. While this all makes sense long-term, most companies lean into surging demand which is great short-term but creates oversaturation long-term. This type of process power doesn't exist with companies trying to meet quarterly earnings targets. Rather, it is developed over decades under the careful stewardship of European controlling families. This is why I find it difficult to see a legitimate threat to European luxury from an American or Chinese player as the mindset is different. I do see potential for this flywheel to emerge in a country like Japan which may look at brand-building from a multi-decade or even multi-generational lens and whilst some have emerged like Shiseido (cosmetics), Kenzo (owned by LVMH), Mikimoto (pearls) and Issey Miyake (not quite at the $3,000 level), none have really gotten anywhere close to megabrand status.

Price (Drive Price)

With respect to price, there are two key points.

Point 1: Price is the Output, not Input of the Luxury Flywheel. Pricing is misunderstood as the main input in the luxury flywheel. The Veblen Goods argument is that higher prices drive higher demand, so luxury brands should consistently raise price. However, I think the Veblen goods construct is false. Hermes certainly does not believe it. What we've seen time and time again is higher prices but lower demand. If you hit this point, it can take years to recover (Gucci today, Prada in the early 2010's).

I view pricing as the output of the luxury flywheel. When the flywheel is working, demand far exceeds supply allowing brands to improve mix and raise price. Ideally, prices are raised at a rate where demand continues to increase greater than supply. This is where Hermes' strategy is telling. If Hermes viewed their bags as Veblen goods, the logical strategy would be to move prices on Birkins from $15k to the current market clearing price of $30k, then raise prices aggressively thereafter to generate more demand.

Hermes is doing the opposite of this. They are creating excess demand by keeping prices 50% below the market clearing price. This in turn creates a 7 year waitlist which ensures they never get into purgatory. This excess demand then allows Hermes to release some of the pressure every year via price increases. Status comes from exclusivity, not price. In fact, the Birkin is the cheapest bag in luxury as conceptually, the bag costs negative $15k. There is clearly some risk keeping the discount too low (i.e. arbitrageurs as well as annoyed potential customers) but the benefits outweigh the risks (more on this on a later post).

As I'll describe in a new post, COVID was a unique period where luxury brands mistakenly raised pricing too much. Luxury brands have historically raised prices during periods of economic weakness to smooth over revenue growth. Warning customers of an impending price increase also tended to pull-forward demand. Brands mistakenly took the 2020 period as a period of weaker demand so raised price, but 2021/22 ended up being two of the best years for the luxury industry ever, which then forced the brands to raise price again to cool demand, leaving today's prices stretched in the process.

Chanel has been the most aggressive with price in recent years, and they've arguably had the demand to justify their price, but their strategy is price-led rather than demand-led which may pose some problems longer-term. Since 1955, the price of the classic Chanel flap has increased 5.3% CAGR. The chart only goes to 2020 but from 2020-24, Chanel raised prices a cumulative 40% meaning the bag now costs $10,000+.

Hermes' price increases have been relatively tame in comparison.

Point 2: Never Discount. The cardinal rule of luxury is to never discount your product. The luxury flywheel is ultimately a mirage, a ruse, an alternative reality, where a $4,000 bag costs $5,000 the following year and everyone just accepts it. The only thing that keeps this going is that 1) demand far exceeds supply and 2) buying the bag imparts a sense of status and exclusivity. Discounting your product is the antithesis to this. In fact, if you spend your hard-earned bonus on a new $3,000 bag to see a friend buy it on sale for $1,500 at an outlet mall or gasp, at Nordstrom Rack, it demolishes any sense of status or exclusivity. Louis Vuitton has never had a sale and has simply burnt excess inventory. While ESG backlash has put an end to this, the point remains: you cannot discount your products.

However, the inverse problem is equally as bad. Assuming you don't discount, if you raise prices too fast and get to a level where demand does not exceed supply, you enter purgatory where your sales are stagnant. In this situation, you can't discount. Rather, you need to double down on your fashion shows and advertising and pull back on volumes to sustain the perception of scarcity, a very tricky place to be financially. This is where some brands are at today coming out of COVID.

There is also a more nuanced point in the age of the internet, that has led to megabrands having a structural advantage around price and discounting. While "never discounting" is a cardinal rule, the reality is that there are some price differentials between countries. Pre-internet, there was limited price transparency between different geographies and as a result, a brand could position itself as low-end in the US, but be higher-end in Asia or vice versa. For example, Burberry licensed a brand in Japan called Burberry Blue which effectively sold the same products for 30% to 40% cheaper to the main label. Most customers in Europe were none the wiser. However, the internet has made this untenable. There is now full price transparency around the world and hundreds of blogs that talk about the cheapest place to buy a bag. In fact, there is a cottage industry of Chinese arbitrageurs, known as Daigous, who buy in one place for 40% cheaper, then re-sell those goods for 20% cheaper on various platforms capturing part of the spread. The table below from www.theAsianParent.com out of all places has a detailed post on the cost of a 2.55 Chanel bag all around the world. Someone from Thailand could save 15% buying in the UK.

This is a form of discounting, albeit, far less explicit to an actual sale. I have heard arguments that these price differentials exist to account for different cost structures across all the geographies, but the reality is that pre-COVID, 2/3rd of Mainland Chinese luxury spending was done overseas and having a price differential was a way to spur demand.

As a rule of thumb, from the perspective of a buyer in China who doesn't pay sales tax on European purchases but does pay sales tax on Chinese purchases, prices will be 85/100/115 after-tax between France/US/China meaning someone from China saves 26% buying in Europe, too small for professional arbitrageurs but perhaps large enough that you'd ask your cousin to pick up a nice bag for you on her Paris vacation.

Megabrands like Louis Vuitton and Hermes have closed this gap by maintaining consistent global prices and in some cases, prices near parity, eliminating arbitrageurs in the process. Most of these brands dealt with any price anomalies circa 2010 as Chinese outbound travel began surging. For smaller brands, these price gaps still exist today and are often a lot wider at 50/100/150 implying the Chinese consumer is getting a 66% discount buying in Europe, large enough for arbitrageurs and large enough to damage the perception of the brand. These brands have become somewhat reliant on these price gaps to spur demand making them harder to close as raising prices in Paris may demolish demand for several years.

Because megabrands control their distribution and because they have the financial wherewithal to take a hit on volumes from time to time to adjust prices across geographies as FX moves around, they have emerged from the new internet world that much stronger.

What does the economics of the flywheel look like?

If I look at this from a purely financial lens, below is what this looks. In the example below, a brand will have a hot bag that costs $3,000. They will try to throttle growth of that bag to 9% of-which 3% will be volume, 3% will be price, and 3% will be mix. Demand for said bag will far exceed the 3% supply growth, especially if the brand plays their cards right and sustains the perception of scarcity, which in turn will help justify the growth in mix and price. Pricing is 100% drop-through and the cost of goods sold for a $3,000 and $4,000 bag are roughly same so while revenue grows 9%, gross margins are flat and SG&A only grows 3% driving 14% EBIT CAGR. While this is a stylized example, every successful luxury brand has a version of this flywheel running within their portfolio.

Now one of the most important points I want to make is that the megabrands can grow without increasing their store count. In fact, Hermes, Louis Vuitton, Chanel, Gucci, and Dior will probably keep store count flat for the next 10 years or possibly longer. This is highly underappreciated in my view because the luxury industry is currently undergoing a rough cycle, but as it emerges from this cycle, the potential operating leverage on sales growth is very high. Double digit growth but flat store count? How can this be?

• First, megabrands built-out global footprints over the last decade. This ended around the 2015-20 time-frame whereby all of these brands now have 100% global coverage of every street or mall that matters. This is a highly underappreciated view. It is kind of like building a rail network. It is expensive to build at first, but once it's built, it becomes a cornered resource, where lots of sales can flow-through. Hermes has kept stores count flat for 12 years.
• Second, luxury is about price/mix, not volume. As a result, even if revenue grows 10% to 15% for the next 10 years, volumes are only growing 2% to 3%. This 2% to 3% volume growth only requires the odd store expansion and even if stores got too crowded, having lines outside your store only increase the perception of exclusivity.
• Third, e-commerce has been a huge blessing. In the past, teenagers walked into Dior to buy a keychain or silver necklace. The best brands have elevated their mix so that this no longer happens, but to the extent it does, the brands have pushed this to e-commerce which frees up store capacity for higher value clients. The luxury e-commerce playbook is a whole separate post, but the general idea is that megabrands keep high-value items off e-commerce whilst keeping clothes, gifts, and lower value items on.

Conclusion

• The luxury flywheel is one of the most powerful forces in capitalism
• Luxury is a cornered resource. They are not making new brands.
• In order to get on that flywheel, you need to control the 5Ps
• Assuming you can get on the flywheel, the economics are outstanding
• Growth is primarily coming from price/mix. You don't need new stores.

I plan on doing subsequent posts on:

1. An overview of the luxury industry and the key issues facing luxury today
2. LVMH through the lens of the Luxury Flywheel
3. Kering through the lens of the Luxury Flywheel
4. Hermes through the lens of the Luxury Flywheel
5. Side topics like cosmetics, e-commerce, and duty-free