Global Brand Companies: Well Positioned to Deploy Incremental Capital at High Rates of Return
Achieving an optimal balance between growth and return on invested capital is critically important to value creation. Many discretionary product companies attain this equilibrium for a short period of time, but fickle and geographically divergent consumer preferences make it challenging to sustain over the long-term. The appeal of brands invariably fades with time, and resurrecting interest or expanding into new products or markets requires extensive resources. These efforts also introduce the risk of over-distribution and profit degradation. Some companies, such as global brand conglomerates V.F. Corporation (VFC) and Louis Vuitton (MC.PA, listed on the Euronext Paris Exchange), are uniquely capable of navigating this dilemma. In fact, we believe these two companies are poised to benefit from the challenges the industry structure presents to most participants.
V.F. Corporation and Louis Vuitton own a broad range of premium brands and rank among the largest and most geographically diverse firms in the consumer discretionary industry. These characteristics provide many avenues for organic growth and also mitigate the impact of market and brand specific shocks. In addition, since the marketing, advertising, and distribution expenses critical to maintaining brand relevance are scalable, both companies are exceptionally well positioned to compete against the myriad of smaller brands that are the product of an industry with low barriers to entry. When smaller brands reach the peak of their product life cycles, they are often left with great creative talent and brand heritage but lack the resources and infrastructure to expand. At this point, they can be very attractive candidates for acquisition. These factors combine to create multiple opportunities to deploy incremental capital at high rates of return.
The Benefits of Diversification: Though international economies grow more interconnected each year, we have witnessed divergent ranges of growth and consumption, even at times of extreme stress. So while exposure to multiple geographies can provide many sources of growth, it can also diffuse the impact of macro volatilities on sales and earnings performance. For example, organic revenues for V.F. Corporation and Louis Vuitton – both of which have meaningful exposure to Asian and Latin American markets – declined less than 5% during 2009 and 2010 when many brands with exposure only to developed economies saw steeper declines. Owning multiple brands provides similar benefits. V.F. Corporation and Louis Vuitton’s largest brands represent between 25%-35% of total revenue and 25%-45% of total profit – far less concentration than most competitors. More often than not, soft revenue trends in one brand are offset by strength in another. For example, in the last two quarters, Louis Vuitton posted decelerating sales growth for its largest brand, yet strong growth in its Specialty Retail segment and other areas of its Fashion and Leather segment enabled the company to post 8% consolidated revenue growth.
Pricing Power:V.F. Corporation and Louis Vuitton are very adept at managing the global distribution of their product and maintaining an attractive equilibrium between tradition and innovation—all factors important to sustaining pricing power over time. First, by developing their own retail presence, V.F. Corporation and Louis Vuitton control a large percentage of distribution for their brands. Louis Vuitton controls 100% of the distribution for its signature leather and accessories brand and a significant percentage of distribution for many other owned brands. As a result, it has much greater visibility over inventory and demand trends. In the past, if demand weakened and management believed there was too much inventory in the channel, the company removed product from stores. Over time, the lost revenue is a better alternative than pricing actions that can impair the perceived exclusivity and high value of the brand. Similarly, V.F. Corporation almost doubled the percentage of product it sells through its own retail base over the last five years. Having more influence over inventory assortment and placement is beneficial during challenging periods. V.F. Corporation and Louis Vuitton realized very little operating margin attrition during the 2009 and 2010 time period relative to other discretionary brand names that have less control over product distribution. These companies are also very skilled at using their brands to refine existing products and launch new products. For example, in one of its core markets in Japan, Louis Vuitton was able to broaden its customer base by introducing its multicolor monogram bags as an alternative to its traditional monogram bags. Developed by the collaborative efforts of in-house designer Marc Jacobs and a local contemporary art personality, Takashi Murakami, this product was designed to appeal to a younger generation of Japanese consumers.1
Few companies have the resources, skills, or structure to establish these capabilities, which take years to develop. Louis Vuitton, for example, has a global network of 3,200 stores, attracts multiple designers to its company each year, and maintains an annual advertising and marketing spend of around €3 BN – 6 times the size of its average acquisition over the last five years.2 Illustrating the degree of complexity required to distribute products on a global scale, V.F. Corporation maintains a base of roughly 60 sourcing, manufacturing, and distribution facilities staffed by 29,000 individuals who collectively speak 15 different languages.3
Acquisition Opportunities: As noted before, V.F. Corporation and Louis Vuitton are two of the largest names in a very fragmented industry where many components of the cost structure are scalable. A study by the Boston Consulting Group found that a retail brand saves around 30% of its commercial costs (advertising, rent, sales staff and so forth) each time it doubles in size.4 As such, the potential to expand revenue and margins by folding smaller brands into a global brand portfolio is very high. In addition, management at both companies espouse a decentralized management structure that provides for creative autonomy at the brand level, so V.F. Corporation and Louis Vuitton can often retain creative talent critical to enhancing existing brands and introducing new brands. While not all acquisitions are successful, both companies have a strong overall track record. Notable examples include V.F. Corporation’s ability to grow the North Face brand to 12 times the revenue base acquired in early 2000 while significantly improving profitability, and Louis Vuitton’s successful turnaround of Christian Dior and Sephora.5 6
While acquisitions have the potential to dilute returns and stress balance sheets, we believe the size and scope of V.F. Corporation and Louis Vuitton, combined with consistently conservative capital structures, mitigate acquisition risk. The largest acquisition completed by either company represented little more than 10% of total market capitalization. Thus it is unlikely that any acquisition by either name will be large enough to have a materially disruptive impact on its capital structure or financial performance. And although the companies are now large enough that one acquisition may not be impactful, the various opportunities in aggregate are large enough to provide meaningful incremental growth. Finally, even larger acquisitions are unlikely to compromise the healthy balance sheets both companies maintain. With significant acquisition activity, V.F. Corporation and Louis Vuitton maintained average net debt/EBITDA ratios below 1.5x and average dividend pay-out ratios around 40% over the last 10 years.
Attractive Investment Opportunities: In summary, we believe the structure of these companies, the premium brands they own, and the industry in which they operate combine to produce sustainable competitive advantages. This framework provides multiple opportunities to deploy incremental capital toward enhancing and growing owned and acquired brands – both of which can be highly profitable sources of growth. We do not believe this potential and the impact it has on long-term earnings power is fully reflected in the current share prices of V.F. Corporation or Louis Vuitton. Thus, we believe both companies present attractive opportunities to invest in long-term global earnings growth at discounts to our estimates of intrinsic value.
The views expressed are those of the analyst as of October 2013, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
1“Takashi Murakami Vs. Louis Vuitton: The 30 Best Fashion Collaborations of all Time,” Jian Deleon
2 Source: LVMH Annual Report
3Source: “China as a Sourcing Destination: Past Vs. Future: A View from One of the World’s Largest Sourcing Companies” JPM Research
4 “The Empire of Desire, What the World’s Largest Luxury Company will do Next?” Economist June 2, 2013
5 Deutsche Bank Research
6“The Empire of Desire, What the World’s Largest Luxury Company will do Next?” Economist June 2, 2013
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© Diamond Hill Capital Management
