The Company
Hermès International designs, produces, and distributes personal luxury accessories and apparel. It operates a chain of boutiques that sells items such as leather, scarves, men's clothes, ties, women's fashions and jewelry. At the end of 2013, Hermès employed 11,037 people worldwide and had 315 exclusive stores, 203 of which were operated directly.
Recommendation
We recommend investors buy Hermès International (HESAY:OTCPK) with a 10/10/2014 base case price target of $43 per ADR. This represents a ~30% upside from its current price. Our investment thesis rests on three (3) main points:
1. Hermès should continue to see high topline growth as Europe and Japan high-end consumer spending rebounds from cyclical lows.
2. Management has continued to focus on organic growth generating high returns on invested capital and significant free cash flow.
3. Hermès' management team is focused on maintaining a fortress-like balance sheet. The company has little to no interest in taking on high levels of debt for strategic acquisitions which might dilute the Hermès brand and put the company at financial risk.
Business Description
Hermès has 14 product divisions encompassing leather, scarves, ties, men's wear, women's fashion, perfume, watches, stationery, footwear, gloves, enamel, decorative arts, tableware, and jewelry. Hermès sales are composed of 44% leather goods, 22% clothes (Ready To Wear), 12% silks and textiles, and 22% other wares. The company licenses no products and keeps rigid control over the design and manufacture of its inventory.
Hermès goods are almost entirely made in France by hand in middle-sized workshops ("Ateliers Hermès") with an emphasis on quality manufacturing. The company cites nearly 75% of all items are fabricated from beginning to end by one person.
In 2012, Hermes retail outlets changed its policy regarding returns and exchanges of products. Consumers may only exchange items within ten days of purchase, and only for another color variant of the original purchase. No other post-purchase exchanges are permitted and refunds are never offered, regardless of the consumer having a receipt.
We think Hermès is a high-quality business in an attractive industry (high-end specialty retail) with real barriers to entry related to brand equity, specialized manufacturing, and its unique quality management process.
Within the specialty retail market, brand recognition and loyalty make for extremely wide competitive moats. This drives pricing power and extremely high margins. This – combined with low CAPEX requirements – leads to high free cash flow generation and high returns on invested capital. We think Hermès can be a multi-year compounding machine with limited downside and the potential for significant upside over the long term (5+years).
Investment Thesis
- Hermès has generated consistent growth over the past 10 years regardless of economic conditions. In 2013, growth was consistent across the globe with Asia (except Japan) growing at 16%, North America at 14%, Europe at 12% and Japan slightly slower at 7%. Since 2004, the company has grown revenue from $1.75B to $5.3B in 2014 averaging roughly 13.5% annually. Free cash flow has grown at 19% annually during this same period. Looking forward, the company expects growth to normalize in Europe and Japan from their cyclical lows of 12% and 7% in 2014 to 17.5% and 13.5% in 2018 respectively.
- Management has proven they are wise allocators of capital. Roughly 58% of earnings since 2004 have been paid out in the form of dividends. The remaining retained earnings generated return on allocated capital of roughly 29.6% over the 10-year period. Given the high FCF this business generates (roughly $4 billion in the next 4 years), effective capital allocation can drive meaningful upside (either by buybacks or organic growth). We particularly like management’s commitment to stick with its core competencies – organic growth without adulterating the brand’s value.
- The financial position of the company remains outstanding. The company currently has no short or long-term debt with roughly $1.3B cash on the balance sheet and FCF of nearly $1B in 2014. Since 2004, the company has grown net margins from 16.4% to 23.3% and free cash flow per share from $0.21/share to $1.03/share. Return on equity has increased from 18.2% in 2004 to 30.6% in 2014.
Key Risks
The investment in Hermès is not without risks, but we believe these are well mitigated. The risk of downturn in Europe and Asia should be limited as these markets are currently at a cyclical low in terms of growth. Recent numbers – particularly in Japan – have seen a small uptick even after the country imposed an increase in their VAT. A greater risk is a worldwide economic turndown similar to the one of 2008-2009. In the recent Great Recession, Hermès continued to grow (increasing sales from $2.4B in 2007 to $2.73B in 2009) both in terms of revenue and free cash flow. While China may not provide the key growth driver as it did in 2008, we believe Hermès’ financial position positions the company well in case of another financial crisis.
Another risk would be a large acquisition that places the aforementioned financial position as well as brand equity as risk. We feel this risk is mitigated in two ways – first, management has publicly stated it has no interest in a large acquisition and second, we don't believe an acquisition would work in regards to fitting the new company’s operations into the existing Hermès manufacturing and business model.
Finally, there is the risk of competition in the existing specialty retail sector. We believe Coach (COH, Financial) and Michael Kors (KORS, Financial) represent a good comparison here. While Coach no doubt has taken a hit recently, we believe Michael Kors has not been able to deliver a knock out punch and remove Coach from its throne. Both Coach and Hermès have an extraordinary history of brand loyalty. We believe this provides Hermès with a very wide competitive moat unlikely to be overcome in the near future.
Valuation
Our $43 price target is based on an 18.5X forward multiple of 2018E EPS of $2.27 (this assumes no M&A and no reduction in share count). We think Hermès deserves a premium to a market multiple over the cycle for its business quality and earnings growth potential. In addition, we would note that if management more aggressively deployed FCF, we think it could buy back over 20% of its market cap (assuming current prices) and our $43 target would then represent only 14.4x our adjusted 2018 EPS estimate under that scenario.
Over our 10-year explicit forecast period, we model operating margins first averaging 29.5% for the first five years going from under 28% in fiscal 2015 to over 30% in year five, and remaining between 30% and 31% after that. This is somewhat more conservative than the company's plans to get to 32% operating margins by fiscal 2019. Top-line growth to reach our cash flow-based valuation averages just over 18%, increasing from 15% in 2015 to 20% in 2023.
Conclusions
Overall, we believe Hermès represents an outstanding investment opportunity. It is a company with exceptional brand loyalty with a management team that conservatively focuses on its core competencies and achieving shareholder value. The company’s financial situation is exemplary – no debt, significant cash on the balance sheet, and high free cash flow. Additionally, the company sells at a significant discount to calculated fair value and provides a generous margin of safety in the situation of our assumption being inaccurate. We believe the company represents a great long-term investment that meets the criteria as a compounding machine.
Disclosure: Nintai is currently long HESAY
