BURBY - Burberry: Inflation And Decoupling From China

Summary

• Burberry is not affected by inflation in the same way as other companies due to the Veblen effect.
• Hence, Burberry is a good addition to your portfolio despite the global cost of living crisis.
• The West and China de-coupling remain a long-term risk for the stock.
• The Burberry share price is in the red this year so it might be a good time to re-assess the stock.

Overview

Burberry Group plc (OTC: BURBY) is a British luxury fashion powerhouse which is headquartered in London. The company generates more than 50% of its revenue from Asia Pacific (primarily China) with the remaining contribution coming from the Americas and EMEA. Burberry is listed on the London Stock Exchange and is a constituent of the FTSE 100 index.

Thesis

Burberry is unaffected by inflation. Luxury goods benefit from the "Veblen effect" and do not follow traditional economic theory which states that price and demand have an inverse relationship. The basic law of demand states that when the price of a good goes down, the demand for the good is expected to increase. However, luxury goods do not follow this basic law of demand and benefit from the Veblen effect which is explained in more details below.

The Veblen Effect

The term Veblen effect was coined by Thorstein Veblen to explain the consumer practice of buying an expensive product to display one's economic power and status rather than out of necessity. Luxury goods qualify as "Veblen" goods as opposed to "Normal" goods which follow the basic law of demand. The graph below shows the contrasting demand for Veblen goods and Normal goods at different price levels.

Above a certain price or "snob value," the demand for Veblen goods goes up. This is because consumers believe that when a good is priced high, it is necessarily better quality and consumers are willing to pay more for a luxury brand due to the associated social prestige. A fall in prices can reduce the demand as its exclusive appeal falls while as the same time it will be too expensive for the average customer.

This Veblen effect allows Tapestry to earn above market average margins purely due to branding and the need for customers to display their social status. The concept of Veblen good is an important piece of economic theory behind luxury goods as it allows companies such as Burberry to maintain profit margins in an inflationary environment as they are able to transfer price increases to wealthy customers more easily. If we look at Burberry's annual report 2021/22, we can observe this trend. Actually, Burberry was able to increase its margins in 2022 despite the inflationary environment.

In a high inflationary environment like now, the Veblen effect can help Burberry improve its revenue and overall profitability as long as it can continue to maintain its profit margins.

Decoupling from China

If we take a step back from analyzing Burberry from a micro perspective, we can observe some strategic challenges with Burberry's current business model. As mentioned earlier, the company derives more than 50% of its revenue from Asia Pacific (primarily from China). The emergence of China as a superpower with the potential to dominate the U.S. economically and militarily due to its larger population has created tensions between the two countries.

More recently, there has been tensions between the U.S and China on Taiwan where there is possibility for conflict escalation. A conflict escalation between the U.S and China would be highly detrimental to Burberry as a large percentage of its customer base comes from China. Although it is a black swan event with potentially devastating consequences for the global economy, it is important to remain aware of the long-term potential risk and of the direction things are moving before investing.

Conclusion

I believe that Burberry can be a great addition to your portfolio in the current inflation environment. The luxury market is inflation proof as it is able to protect its profit margin due to the Veblen effect. However, the decoupling with China remains a long-term risk for Burberry and the overall luxury market with potentially catastrophic consequences. Before investing in Burberry, I would recommend researching the West - China decoupling risks further before considering an investment in the stock.

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