The Luxury Flywheel: Part 3

In Part 1, I went over a stylized Luxury Flywheel and went over the 5Ps of luxury. In Part 2, I went over luxury's emergence from the 1960s to 2000s with a particular emphasis on Japan's boom and subsequent bust. In Part 3, I will go over luxury's performance through the financial crisis and the subsequent rise of China. The key topics I'll go over include:

1. China's Rise (2000-2007)
2. Global Financial Crisis (2007-09)
3. China's Dominance (2007-13)
4. Corruption Crackdown (2013-18)

I'll also go through some of the nuances of the industry including the concept of price differentials and daigous.

In subsequent posts, I will begin doing deep dives on individual companies including Hermes, LVMH, and Kering. I haven't decided yet whether I'll do a dedicated post on the impact of COVID or simply incorporate this analysis into a deep dive.

Overall Context

This graph shows rolling 3YR share price CAGR of the 3 major European luxury groups and is the basis of explaining the luxury industry from 2008 to today. There were 3 critical periods when luxury underperformed. From 2007 to 2009, luxury underperformed as a result of the financial crisis. From 2014-2017, luxury underperformed due to softening demand in China because of the corruption crackdown. Finally, we are currently in a period of luxury underperformance (at least for LVMH and Kering). As a broad generalization, the industry allowed you to earn a 3YR 20%+ CAGR coming out of crisis, so buying around 2008 to 2011 or buying around 2014-17 during the Chinese corruption crackdown would have resulted in a 20%+ CAGR for each of the major European luxury groups. The question is, are we in such a period today? While it is hard to get "China Macro" right, as I argued in Part 1 I believe that the scaled luxury players have greater structural advantages today than any period in history.

China's Rise (2000-2007)

In 2000, China accounted for just 1% of the overall luxury market in contrast to Europe (30%), Japan (27%), and America (25%). However, rising incomes owing to the establishment of a more open economy in the 1990s and China’s entry into the World Trade Organization in 2001 led to exponential growth. By 2010, Chinese accounted for 19% of industry spend and by 2012, Chinese officially overtook Japanese as the largest luxury buyers. Chinese luxury consumption grew 80x from €1.2bn in 2000 to €87bn by 2018.

In the early days of luxury circa 2000’s, gift giving was a major component of demand and bribery was widespread. The most popular luxury categories were watches, jewelry and spirits which were used as gifts or bribes for government officials (mostly men). Per Bain's China luxury report, in 1995, luxury spending in China was 90% men's. It was only relatively recently in the 2010's when luxury demand became driven by personal consumption. 

To the extent luxury was bought for personal consumption, Chinese consumers were first-time luxury buyers with low brand awareness. Even in 2010, Bain estimated 2/3rd of Chinese luxury spend was from first-time luxury customers. The concept of "iconic designs" or "carryovers" was less relevant to first time consumers. The preference was to buy the newest or latest products. The preference was also for conspicuous consumption with monograms and large logos doing well.

Global Financial Crisis (2007-09)

The GFC and subsequent Euro area crisis was by most measures the most severe recession any developed country had faced in decades. Unemployment rates exceeded 8% in the US, 10% in France, and 11% in Italy.

Despite the severity of the recession, the GFC was only a modest headwind to luxury. Industry sales fell -2% in 2008 and -8% in 2009 before exceeding 2007 levels by 2010. As expected, accessories (i.e. handbags) were the most resilient category growing 1% in 2008 and declining just -1% in 2009. My previous post details the resilient performance of handbags during Japan's megabubble.

The emergence of China helped soften some of the declines, but even if you strip out Chinese demand, luxury spending ex-China still did a reasonable -4% in 2008 and -10% in 2009 before bouncing back +11% in 2010.

Within this environment, the biggest brands did better. LVMH's FLG for example saw just 3 quarters of negative -8% to -10% growth in the US before fully recovering, a strong performance considering the circumstances. Gucci was hit harder seeing 8 quarters of negative growth in the US. Inclusive of China, LVMH only saw a single quarter of negative growth while Gucci only saw 2 quarters.

So what accounted for such resilient performance?

1. First, stronger brands with directly operated stores took significant share from weaker brands reliant on wholesale.
2. Second, while demand declined, the strongest brands executed on the Luxury Flywheel by limiting supply and raising price.