Now that third quarter earnings season is mostly in the books, we’ve seen a few key trends emerge one of which involves the Luxury Sector. Luxury brands like Nordstrom’s demonstrated major underperformance in their latest earnings reports, sending their shares into a downward spiral, while big box retailers like Wal-Mart and Target did a bit better or perhaps simply not as badly. Middle-of-the-road retailers like American Eagle, Aeropostale, and Abercrombie and Fitch also did fairly well during the third quarter.
So clearly consumers are watching their spending and opting for less expensive retailers rather than luxury brands, and as a result, sales in the Luxury Sector are lagging. Analysts at Bank of America Merrill Lynch warn that this trend will likely continue for some time. They’ve cut their price objectives for Luxury Sector retailers.
Luxury Sector to continue struggling
Analyst Ashley Wallace and her team believe that the lagging sales in the Luxury Sector are structural rather than cyclical. They’re projecting only a 4% increase in revenue for the sector in all of next year.
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They report that “white space retail penetration” in Asia has driven the vast majority of revenue in the sector over the last five years. As a result, Luxury revenues now depend on same store sales for growth because their pricing power is now limited.
Of course margin pressure goes hand in hand with limited pricing power, and the BAML team expects that the continued inflation in rent prices in the premium real estate space will result in deleveraging in the retail sectors. They think historic EBIT margins have become “largely irrelevant” because they included “significant over-earning” in Hong Kong, which they don’t believe will return.
Store closures expected
This year has been a huge one for mergers and acquisitions, although the Retail Sector hasn’t dominated in this area. However, the BAML team expects to see luxury stores in Greater China start shutting down because there are simply too many of them in the nation’s Tier 2 and 3 cities. They note that Louis Vuitton, one of the most-penetrated luxury retailers in China, has already begun shutting stores there.
The devaluation of China’s currency is also causing major headwinds for retailers, especially those in the Luxury Sector, and this trend may not reverse any time soon. BAML analysts believe that the value of the RMB versus the U.S. dollar will fall by up to 10% next year, which would cut the Luxury Sector’s EBIT by 7% and have a major impact on sentiment in China and offshore consumption of luxury goods.
The analysts see Burberry and Swatch as being among the luxury retailers being the most affected.
Luxury Sector no longer supported by tourism
The BAML team also noted that support for luxury goods through tourism is fading, especially in Europe. They believe tourism will continue to slow into the fourth quarter and next year with Europe being the area with the “most to lose.”
They think Louis Vuitton is the most at risk here, although they expect Japan to positively benefit from inbound tourism while Hong Kong loses out.
They add that the only two areas where they’re seeing positive growth in the Luxury Sector is in online spending, as the trend at the high end of retail follows the trend at the low end. Consumers are shifting more and more of their spending on luxury goods online.
BAML recommends only a very small number of luxury stocks, including Yoox Net-A-Porter because it is a pure-play digital retail stock, jewelry maker Pandora, and Gucci parent company Kering.
All graphs and charts in this article are courtesy Bank of America Merrill Lynch.