HESAF - Hermes: A Superb Company But Too Pricey Right Now

2023-04-22 03:46:51 ET

Summary

• Hermes has rallied over 110% from its 52-week low, fueled by impressive growth and optimism regarding China's reopening.
• The company continues to deliver outstanding results with double-digit sales growth across almost all segments.
• The current valuation is very expensive with multiples meaningfully above peers and its own historical average.
• I rate the company as a hold.

Investment Thesis

Unlike the broader indexes that continue to move sideways, Hermes ( OTCPK:HESAY ) has been rallying in the past few months with shares up over 110% from its 52-week low. The company continues to demonstrate excellent growth in its first quarter update and the reopening of China shoulder further boosts financials in the near term. Many investors are also attracted to the company because of its ability to withstand economic downturns, thanks to its affluent customer demographic. However, valuation is a huge concern as the current multiple is very elevated after the massive rally. I believe this will likely limit the company's upside potential therefore I rate it as a hold.

Upbeat Q1 Update

Hermes released its first-quarter update last week and it continues to see great momentum coming off a strong FY22. The figures are very upbeat despite facing a rapidly weakening economy (It is worth noting that this is just an update not earnings therefore the income statement and balance sheet are not included).

The company reported revenue of €3.38 billion, up 22.3% YoY (year over year) compared to €2.78 billion. The growth was very broad-based, with 5 out of 7 segments reporting double-digit sales growth. Ready To Wear and Accessories was the best-performing segment, with sales increasing 33.7% from €710 million to €950 million, accounting for 28.1% of total sales. The Jewellery and Home Products segment was also very strong, with sales growing 27.7% from €330 million to €421 million, accounting for 12.5% of total sales. The growth is mainly driven by the ~10% price increase implemented earlier this year.

The Others segment (production activities carried out on behalf of non-group brands) was the only segment that reported a decline, with sales dipping 6% from €77 million to €74 million, as non-group brands are being impacted by increasing macro headwinds.

The overall results are outstanding in my opinion, especially when considering the current macro backdrop. The Others segment was quite weak but I am not too concerned as it accounts for less than 3% of total revenue, therefore its impact should be very minimal. The reopening of China should also be a meaningful catalyst in the near term. While the news has been formally announced for a few months, the recovery is still in its early innings. For instance, the company finally reopened its symbolic store in Beijing last week. The ongoing rebound should further boost growth as Asia (excluding Japan) accounts for over 50% of total revenue.

Immune To Downturns

I believe many investors are piling in because of the company's counter-recessionary nature. As the economy continues to deteriorate, investors are actively looking for companies that are able to withstand economic downturns, and Hermes is one of the best options in my opinion.

Hermes is one of, if not the most prestigious, consumer brands in the world, and its target demographic is mostly wealthy individuals with no financial pressure. Therefore an economic downturn is unlikely to impact their financials and spending habits. The company's strong branding also resulted in extremely strong customer loyalty, which further increases its stickiness.

Thanks to its insanely high pricing and exclusive product nature, the company also does not have to rely as much on volume and can keep its SKUs (stock-keeping units) low. This allows them to always maintain high product demand and have great control over inventory levels.

Looking back at history, the company actually managed to grow revenue by at least mid-single digits even during the great recession from 2008 to 2010, as shown in the chart below. Therefore, I believe Hermes should hold up very well in the near term unless we see an unexpectedly strong recession.

Valuation

After the massive rally, Hermes' valuation looks extremely expensive. The company is currently trading at a PE ratio of 65.4x, which is much higher than other luxury brands such as LVMH ( OTCPK:LVMHF ), Ferrari ( RACE ), and L'Oréal ( OTCPK:LRLCY ). As shown in the chart below, its multiple represents a significant premium of 52.8% compared to peers' average PE ratio of 42.8x.

The valuation is elevated on a historical basis as well. The company is trading at a premium of 25.3% compared to its 5-year average PE ratio of 52.2x. I believe Hermes deserves a higher valuation as its revenue growth remains the strongest among peers, but this magnitude of a premium seems a bit too much. The company should continue to report great financials but most optimism should be priced in unless it can vastly exceed expectations.

Investors Takeaway

Hermes is a superb company but I do not think now is a great time to initiate a position. The company's outstanding fundamentals alongside the ongoing recovery of China should continue to drive great results. However, the valuation is a huge problem right now. Even if we factor in its best-in-class growth, the current multiples still look extremely lofty. I believe most optimism should already be priced in unless the company can vastly exceed expectations. This makes the risk-to-reward ratio pretty underwhelming and should likely limit its near-term upside potential. Therefore I rate the company as a hold and will wait for future pullbacks before jumping in.

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