I rate Hermès (OTC:OTCPK:HESAY)(OTC:OTCPK:HESAF) a sale at its current price of €1,074. As a long-term investor, I’m generally hesitant to sell stocks as long as the company’s overall growth story remains intact. However, the current valuation of Hermès is not justified and results from a temporary increase in margins. Assuming normalization margins and mean reversion of the P/E and FCF multiples, I see the true value of Hermès around €830 (23% below the current level).
Hermès is a company based in Paris, France, which produces and sells luxury goods in the following categories:
- Leather goods and saddlery: bags, riding equipment and others (45.55% of sales for the 2021 financial year)
- Ready-to-wear and Accessories: Clothing, belts, costume jewellery, gloves, hats and shoes (24.71% of FY2021 sales)
- Silk and Textiles: Scarves, Shawls and Stoles
- Other Hermès sectors: Jewelery and household products
- Perfumery and Beauty: Perfumery, Make-up
Hermès’ total shareholder return over the past ten years is presented in the graph below. Even despite the recent price decline, shareholders have achieved a total return of 287.7% or a CAGR of 14.5% over the past ten years.
Hermès’ main competitors in the luxury goods sector are LVMH (OTC:OTCPK:LVMHF)(OTC:OTCPK:LVMUY), the luxury conglomerate around Louis Vuitton, and Kering SA (OTC:OTCPK:PPRUF)( OTC:OTCPK:PPRUY), the company owning brands like Gucci and Saint Laurent.
Main thesis: temporary raised margins
My thesis is that the margins of Hermès are temporarily raised due to the aftermath of the pandemic. During the 2020 financial year, Hermès’ turnover decreased by 7% to 6,389 million euros (2019 turnover: 6,883 million euros). In fiscal year 2021, revenue increased by 40% to €8,982 million.
I think the revenue lost by Hermès in fiscal year 2020 due to the pandemic has moved into fiscal year 2021 and the start of fiscal year 2022. Hermès’ most valuable items like the Birkin and Kelly Bags often have long waiting lists for interested customers (if anyone is interested, you can read more about that here), so demand will likely never be an issue (and was not an issue in fiscal year 2020). I think Hermès instead faced supply-side challenges in fiscal 2020, causing the 7% drop in revenue mentioned above. With these supply constraints lifted through FY2021, more customers on the waitlist were able to purchase the products they were expecting, resulting in revenue shifting from FY2020 to fiscal 2021 and the start of fiscal 2022, which ultimately led to a temporary margin expansion. Charts 1 and 2 show operating and net margins since 2012.
The operating margin has always been around 32 to 34% while the net margin has fluctuated around 21%. Obviously the current margins of 39% and 27% look like outliers (meanwhile FY2020 margins were quite low, likely due to the supply side challenges I have mentioned earlier). In seeking an explanation from the company for these high margins in fiscal year 2021, I came across only one statement in the commentary to the consolidated financial statements of the annual report for fiscal year 2021:
The gross margin rate stood at 71%, up 2.8 points compared to 2020. This improvement is the result of a leverage effect on fixed production costs, a gradual improvement in productivity and an exceptional stock disposal rate.
Source: Annual report 2021 – page 38
This would explain 280 basis points of the operating margin expansion in fiscal year 2021. Operating margin increased from 31% in fiscal year 2020 to 39.3% in fiscal year 2021. That leaves 650 basis points of operating margin expansion to explain. I assume that part of the margin expansion is the result of moving revenue from fiscal year 2020 to fiscal year 2021. Revenue from goods that were produced in fiscal year 2020 was recognized in the fiscal year 2021, while production costs were accounted for in fiscal year 2020.
I think margins will begin to mean revert in the medium term. Even if the operating margin remains at 35% (200-300 basis points on the average of the last ten years), this would still constitute a significant headwind for the result since the margins would fall by 430 basis points, from 39.3 % in fiscal year 2021 to 35% in fiscal year 2021. future years.
Valuable implications of the thesis
I will first review the current assessment. At the end of fiscal 2021, there were 104,964,401 fully diluted shares outstanding. At the current price of €1,074, this gives a market capitalization of €112.73 billion. After deducting the net cash of 4,894 million euros, the enterprise value amounts to 107.84 billion euros. Net income for the 2021 financial year of 2,445 million euros and free cash flow of 2,873 million euros lead to a current P/E of 44 and an FCF-Yield of 2.66%.
Prior to the pandemic (FY2015-FY2019), Hermès was trading at an average P/E of around 38 and an average FCF yield of 2.80%. It’s fair to say that Hermès has never really been a cheap stock. Comparing the current valuation to FY2015-FY2019 multiples, Hermès appears to be slightly overvalued at the moment.
The average net margin from fiscal year 2015 to fiscal year 2019 was 21.8% and the average FCF margin was 23.5%. I will assume that 200 basis points of margin expansion is not temporary, so I will calculate with a net margin of 23.8% and an FCF margin of 25.5%. TTM’s turnover amounts to 9,663 million euros. Assuming that the normalized margins mentioned above would result in net income TTM of €2,302 million and FCF TTM of €2,462 million.
With a historic P/E of around 38 and a historic FCF-Yield of 2.80%, this would lead to a target price per share of €837 (P/E) and €829 (FCF-Yield) for a potential down about 23% from the current price of €1,074.
Why even invest in Hermès?
To determine how to proceed in the future, we must ask ourselves if we want to invest in Hermès first. The short answer is yes.
Hermès is the absolute leader in the field of luxury goods. This becomes clear after looking at operating margins against the closest peers. The graph below shows the operating margins of Hermès, LVMH and Kering over the past few years.
Hermès’ margins have always been well above those of its peers. The reason for this is the strength of the Hermès brand which allows the company to (a) demand higher prices and (b) save on marketing costs, which results in higher margins.
An example of Hermès’ ability to save on marketing costs since the products speak for themselves is that Hermès does not have to rely on so-called “Brand Ambassadors” to promote the brand.
Kering and LVMH peers regularly appoint these Ambassadors for their brands. Here are two examples:
- LVMH appointed K-Pop boy group BTS as ambassadors for the Luis Vuitton Brand in early 2021
- Kering named Chinese singer and actor Xiao Zhan as the new Gucci Global Brand Ambassador
In the case of Hermès, you won’t find any kind of ambassadors. I think the customers targeted by Hermès just don’t care if a celebrity is promoting a bag, watch or scarf that they want to buy. Hermès knows this and doesn’t even bother to be active in this space (saving millions of dollars in the process since they don’t need to pay anyone to promote their products). This shows the strong moat of the Hermès brand.
The financial parameters are also excellent. For the 2021 financial year, the ROCE of Hermès stands at 55.35%. ROCE has been (except for FY2020) consistently around or above 50% since 2015. This is yet another sign of Hermès’ strong fluke, showing that capital needs to generate high returns are weak. According to S&P Global Capital IQ (Source: TIKR Terminal), at the end of the 2021 financial year, Hermès had 4,894 million euros of net cash on the balance sheet. As for the goodwill, it only amounted to 42 million euros. It’s hard to find such a healthy balance sheet. Hermès’ financial situation is excellent.
What to pay attention to
Hermès will publish the half-year results for the 2022 financial year on 07-29-2022. The most important part of this report will be the margin development. If there are signs that margins are already beginning to compress from record highs in fiscal 2021, it could lead to a further decline in the share price.
My guess is that we’ll only see margins start to compress in the second half of fiscal 2022 results, which are expected to be released around February 2023. I’ll likely write an update post after those results are released.
Risks for the thesis
The main risk of this thesis is that the expansion of the margin in the recent past is not temporary, but rather sustainable in the future. This would be possible if my assumption regarding the transfer of revenues from fiscal year 2020 to fiscal year 2021 and the beginning of fiscal year 2022 is wrong and if the record margins of fiscal year 2021 turn out to be the result of increases from the 2nd half of fiscal 2020 which simply far exceeded cost inflation.
Another risk is that I underestimate the waiting lists for Birkin and Kelly bags that I mentioned earlier. Hermès could just raise prices without worrying about some people dropping out of the waiting list. I have already pointed out that demand is not a concern for Hermès, so it is entirely possible. This would result in a compression of the waiting list and an increase in revenue which could be sustainable in the future.
Basically, Hermes is the absolute leader in the field of luxury goods and has excellent financial measures. Reasonably priced, this is a business I would love to own. A valuation and a premium price for the quality of the company are justified.
However, the current valuation cannot be justified. I think this is a temporary overvaluation due to higher margins which should start to revert to the mean in the medium term. To investors who already own Hermès, I would advise to sell and look for better opportunities elsewhere, while keeping an eye on the evolution of Hermès’ margin. If margin compression occurs, causing prices to fall further, there could be a buying opportunity in the future.
At the current price of €1074, I note Hermès a sale with a target price of around €830.
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