Hermès: High Flyer

by The U.K. Income Investor

Hermès (RMS) does not get nearly as much attention as it deserves. A significant portion of readers probably recognise the French fashion giant’s name, but finding investment coverage is not that easy. This is odd for a couple of reasons. Firstly, it is a huge company. The €80B market-cap currently makes it one of the largest in Europe. Secondly, the track record in terms of wealth creation here is second to none.

Since not everyone will be familiar with the company, it’s probably worth presenting a brief overview of its business. Hermès probably represents the summit of the luxury goods sector. Its signature Birkin bag, for instance, will set customers back a minimum of €10,000. It is actually pretty hard to get one, as Hermès suppresses supply for brand management purposes.

Absent COVID-19, the firm probably does around €7B in annual sales. Half of those come via its Leather Goods and Saddlery métier. This is basically handbags, satchels, luggage and so on. Most of the rest comes from ready-to-wear items and scarves, while the company also sells jewellery, perfumes, watches and so on. Hermès does all of this through a global retail network spanning around three-hundred stores, most of which are operated directly by the company. It also sells some of its products via third party outlets, and also online, though not its signature items.

Much To Like

Truth be told, there is a lot to like here. Let’s start with that wealth creation I alluded to above. Suffice to say, the stock has been a high flyer for years now. Its share price has appreciated roughly 14-fold over the past two decades – equivalent to annual returns of circa 14%. It has also returned its starting value by way of cash dividends in that time. It has made a lot of folks very wealthy indeed.

What else can we say about this one? Well, its business of selling ludicrously expensive gear is an absolute profit machine. For instance, the company generated €28.5B in revenue between FY15 and FY19. Around €6.2B of that ended up as post-tax net profit, with €3B earmarked for shareholder dividends (including €1B worth of special dividends paid out in that time). More impressive is that Hermès achieved this on the back of a tangible asset base worth around €3.5B. The company owns some major branding power.

Management also runs a pretty conservative ship, which is common in firms with a large family holding. Members of the Hermès family group own two-thirds of the shares here. Anyway, the balance sheet is in excellent condition – more on that below – while the company typically retains plenty of profit to support further growth. Speaking of which, it won’t surprise you to hear that growth has been plentiful here. Much of that has come from Asia ex-Japan. Ten years ago, the region generated just €630M in annual sales for the firm. That number had risen to €2.59B as of last year, and I don’t see why it can’t continue to grow for years to come.

COVID-19

As you’d expect for a physical retail outfit, COVID-19 has posed some serious issues this year. The pandemic closed many of its stores for obvious reasons, while its meagre online presence has never been important to the business strategy. Revenue in the first half of the year amounted to €2.49B, down 25% on the previous year at constant exchange rates. Sales were down across all geographies and product segments. Net profit for the period dipped to €335M, or €3.20 on a per-share basis. Just by way of comparison, the company earned just over €750M (circa €7.20 per share) over the same period last year.

The good news is that this is pretty much the extent of the bad news, at least operationally. There are absolutely zero debt worries here, since the balance sheet is a model of strength. The company reported a circa €3.75B net cash position at the end of June, with that figure only falling to around €2.25B if you include the €1.5B worth of lease liabilities sitting on its balance sheet. Financial debt is basically non-existent here, and it is seriously refreshing to see a large-cap firm sport a conservative net cash position.

Anyway, and looking slightly further ahead, analysts expect the firm to report net income of around €1.15B for FY20 as a whole. I make that equivalent to just over €11 per share based on 105M shares outstanding. Obviously that implies a much stronger second half of the year as the global physical retail sector gradually opens up again. It is a testament to recent strong historical profit growth that COVID-19 will only take earnings down to FY16 levels.

Valuation

One thing I do worry about is the extent of valuation multiple expansion here. Right now, Hermès stock trades for around €738 on the Paris Bourse. It is actually up around 10% year-to-date despite the hit to operations due to COVID-19. Granted, analysts expect profit to recover beyond pre-pandemic levels next year to €15 per share. But even so, that still implies a current valuation of nearly 50x forward earnings.

Now, I don’t doubt that Hermès fully deserves to trade at some kind of premium. It is one of the best businesses in the world and has a great track record of profit growth. Interest rates in the Eurozone also remain at rock bottom levels. It is hard to say something negative about a stock with a 2% earnings yield when French 10-year debt offers an interest rate of negative 0.19%. That said, the medium-term implications of the current valuation need bearing in mind. To add some colour to that statement let’s work through some numbers here. Let’s assume that Hermès stock will trade at 30x forward earnings a decade from now. Let’s also assume that you want a 10% annual return from holding the stock.

In order to offset the above valuation contraction, I have required earnings and dividend growth at around 15% per annum over the next decade. Long-term, I actually think it could justify this price tag, kind of like the best of the Nifty Fifty names did in the 1970s. That said, it definitely wouldn’t surprise me to see a period of stagnation here at some point in the coming years.

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