Warren Buffet believes that determining whether a company has a competitive advantage and can sustain it is crucial to investing. In the luxury space, competitive advantage hinges on capital intensity. The more capital intense a company is, the harder it is for peers or newcomers to replicate a superior product.
Capital intensity also provides a link between asset use and revenue and growth estimates. A high return on capital base indicates a firm is obtaining capital at a reasonable cost. Societe Generale analysts’ return on capital (ROCE) estimates are still close to 20% for 2014-2016. However, Societe Generale reduced ROCE by 300 basis points relative to last year. On earnings before interest and taxes (EBIT) forecasts for same period, Societe Generale analysts indicated a 100 basis point reduction relative to last year.
Competitive advantage comes with high ROCE
Societe Generale believes that firms with high capital intensity and ROCE have a competitive advantage that is hard to duplicate. Such firms, including Hermes International SCA (EPA:RMS) and Compagnie Financiere Richemont SA (JSE:CFR), have scale and pricing power. They have a large percentage of revenues, between 40% and 80%, over balance sheet assets. Capital spending as a percentage of sales is 6% or more at both firms. Societe Generale analysts opine that Hermes and Richemont will outperform. Both have high ROCE estimates for 2014-2016 (above 28%).
There are firms that have high ROCE but low capital intensity. They can manage their balance sheet effectively and recover swiftly after a recession. Production fixed costs are lower and they create brand differentiation with limited resources. However, it is easier to replicate the firms’ competitive advantage and margins are volatile. Firms in this group include Burberry Group plc (LON:BRBY) (OTCMKTS:BURBY), Hugo Boss AG (FRA:BOSS) (ETR:BOSS) and Salvatore Ferragamo Italia SpA (BIT:SFER) (OTCMKTS:SFRGY). Societe Generale analysts think the three firms will outperform in the next 2 years.
ROCE combined with valuation helps identify opportunities
Societe Generale analysts reconciled high ROCE, competitive advantage and value to determine which luxury firms could appreciate in the next 2 years. They calculated ROCE in industrial terms, using net operating profit after tax (NOPAT) divided by an estimate of current capital base as opposed to the accounting capital base in balance sheet. Then Societe Generale analysts compared market expectations versus their own estimates of NOPAT and brand value to determine which firms were attractive purchases. Only Compagnie Financiere Richemont SA (JSE:CFR) and Kering (EPA:KER) (OTCMKTS:PPRUF) were inexpensive in Societe Generale’s view relative to the overall sector. Societe Generale expect both Richemont and Kering to appreciate over 20% in the next 12 months.