2023-09-29 00:13:33 ET
Summary
- Kering's first half results show slow top-line growth and several organizational changes, but also reinforced M&A.
- The debut of Gucci's new creative director was a promising success, enhancing the brand's prospects.
- The bearish market sentiment combined with current uncertainty makes Kering a compelling investment opportunity.
Kering ( PPRUF ) is a successfully transformed luxury conglomerate that incorporates and enhances several well-known luxury brands through the entrepreneurial spirit of François-Henri Pinault. In my last article in June, I reviewed Kering more in depth, while focusing especially on the current situation for its key brands and the companies' capital allocation. The conclusion was: Although Kering has clearly done a good job of evolving its brands, the current situation is challenging and brings a higher degree of uncertainty in terms of required investments to bring the key brands back on track. Therefore, I argued that the valuation was not really appealing, considering the missing catalyst at that time.
Since then, Kering released several interesting news, including the companies' first half results, operational changes and announcements of M&A. Nevertheless, the market seems to have increased its pessimistic outlook regarding Kering's future, correcting the share price down more than 17% since June.
Now, I want to take another dive into the potential investment case around Kering, which led me to start building a position.
Operating Performance
Let's start by reviewing Kering's results for the first half of 2023. During the first six months of the year, Kering continued its slow top-line growth with sales increasing by 2% YoY to a total of €10.14 billion. Compared to last year, the company especially suffered from a weaker customer in the US, which was offset by the continuous comeback of Asia and stable demand from Europe. Additionally, the company commented on an overall comeback of tourism, especially fueled by the Chinese customer, which is still 40% below its H1/19 level.
Thus, while sales remained somewhat flat, Kering was able to increase its gross margin by 2%p to 76% in H1, a new high for the company. However, we also saw the announcement of increased investments materialize, as the company's operating expenses rose by 9.50%, reducing the EBIT margin to 27% (from 28% in H1/22). During the related earnings call , Deputy CEO, Jean-Marc Duplaix described the situation in terms of profitability as follows:
EBIT margin stood at 27% and we maintained a very high level of profitability, although lower than last year. This reflects the ongoing reinvestment in all our Houses to nurture their desirability through their current trajectory or prepare for the next phase of sustainable growth.
As readers of my last article already know, preparing for the next phase of growth is, of course, in the context of the current reorganization of Gucci. And with that, we move on to a brief recap of Kering's segments.
Gucci
Kering's flagship brand continued its flat sales trend, with reported sales down 1% and operating income down 4%, resulting in a lower EBIT margin of 35.3% (versus 36.5% in H1/22). While Gucci's results still show excellent profitability and underlying customer demand, we can clearly see the lack of extra demand as a result of creative stagnation.
So we were all excited to see the creative void come to an end when Gucci's new creative director, Sabato de Sarno, made his debut at the Spring/Summer 2024 show in Milan. Expectations were high, but as far as I'm concerned, he delivered. In front of a star-studded audience, we got to see an interesting new face of Gucci, which I think has successfully made the transition from the Michele era. A similar picture is painted by fashion and media house Highsnobiety , who summarized the recent event as follows:
De Sarno's collection naturally offered some of that Gucci magic, courtesy of sparkly dresses, glimmering bags, and teeny-tiny shimmery tops that reminded of us of Miu Miu (recall: De Sarno hails from its big sister Prada). [...]
Quiet, sleek, heritage, and luxe. Welcome to De Sarno's Gucci era, folks.
The recall of de Sarno's history with Prada is interesting and underlines the fact that the Neapolitan designer already has a successful vita in the fashion industry, but mostly behind the scenes. It remains to be seen how significantly Gucci's new creative direction will convert into actual sales, however, these changes will not materialize overnight.
Saint Laurent
At Saint Laurent, overall demand was solid, leading to sales growth of 6%, mainly driven by continued growth in ready-to-wear and leather goods. In addition, retailization continued to be successful and now represents 80% of sales. The development of Saint Laurent's profitability represents a promising operating leverage, as operating income grew by 10%, resulting in a higher margin of 30.5% (versus 29.6% in H1/22). The higher margin level was mainly driven by pure price increases and a more favorable product mix.
Overall, the brand continues to reinvest in improved production capabilities and increased communication intensity. The brand is also looking forward to opening a new Flagship Store on the Champs-Elysees in Paris, scheduled to open at the end of the year.
Bottega Veneta
At Bottega Veneta, the ongoing divestment of the wholesale business negated the 6% growth in retail sales in the first half of the year. While the resulting stagnation in total sales is sobering, management sees further opportunities in China, which has now been addressed with the first fashion show in Beijing.
The brand's profitability remained solid, but at a significantly lower level than its two big sisters, with an operating margin of 20.3% (versus 20.1% in H1/22). While Bottega Veneta has undoubtedly made impressive progress over the past decade, its status as an ultra-luxury brand will take some time to consolidate and be reflected in margins.
Other Houses & Eyewear
Finally, we need to talk about the other houses and the eyewear business of Kering. During the first half of 2023, sales growth at Other Houses and Kering Eyewear came in at -5% and +51%, respectively. While the jewelry business continued their strong momentum with double-digit growth, the wholesale business for the remaining brands led were again a victim of continued retailization and a weak US customer.
Overall, the declining sales and remaining challenges at Balenciaga and Alexander McQueen materialized into a negative operating leverage, declining the segments' margin to 12.1% (versus 17.3% in H1/22). It is still hard to achieve further insights for this segment given the consolidated reporting. However, the jewelry brands remain promising, while the reinforcing of Balenciaga needs to be monitored.
At Kering Eyewear, we already discussed Kering's active M&A activity in the first quarter, which is now starting to materialize. In particular, the integration of Maui Jim seems to be progressing smoothly, although further investments will be required, as already indicated by management. Overall profitability also looks strong with an operating margin of 21.4% (versus 19.3% in H1/22), which shows that Kering's efforts in this business were a good call by management.
M&A Announcements
In addition to Kering's existing businesses, we have some interesting news to discuss. First, the company launched Kering Beauté to further develop the beauty category of the Group's houses, an opportunity to increase their brand equity. To this end, Kering also announced the acquisition of Creed, a high-end luxury fragrance house and the largest global independent player in its fast-growing segment. This major acquisition will significantly increase the size of Kering Beauté and provide a platform for future developments. Indeed, Creed is growing at double-digit rates in a very attractive niche (according to industry reports ), is highly profitable and has a solid distribution network that can be leveraged for the Group's other brands.
Second, Kering announced a strategic partnership with Mayhoola to take a 30% stake in the equity of Valentino. The agreement leaves the option for Kering to reach 100% ownership of the Italian luxury house by 2028. Kering expects the deal to close by the end of this year and will then begin working closely with Valentino's current CEO, Jacopo Venturini. Similar to YSL and Bottega Veneta, Valentino is rooted in haute couture, but has expanded its offerings to include ready-to-wear, leather goods and accessories. If we add the brand to Kering's existing revenue contributors, we can conclude that Valentino, with sales of €1.4 billion in 2022, would be directly in 3rd place after Gucci and YSL, also in terms of profitability, posting an operating margin of 25%. However, the 30% stake should initially contribute around €420 million to the Group's turnover, while the future of this deal remains to be seen.
Organizational Changes
After having done a recap on Kering's operating performance, we need to talk about quite impactful organizational changes.
On a group level, Kering announced that Francesca Bellettini will expand her current role as President and CEO of Saint Laurent by becoming Deputy CEO of Kering for Brand Development. In her new role, she will be in charge of preparing the houses for future growth, while being partially relieved of her responsibilities at YSL. Complementary hired as Deputy CEO was Jean-Marc Duplaix, currently the group's CFO, in charge of Operations and Finance. François-Henri Pinault, Kering Chairman and CEO, stated :
I look forward to working with Francesca in her new executive leadership role; while being instrumental in multiplying revenues sixfold since she joined Saint Laurent, she has been a fantastic partner, and all brands as well as the Group will now benefit from her expertise. Jean-Marc has overseen our transformation into an integrated Luxury group, and I count on him to continue infusing discipline and responsibility across the organization and foster the continuing development of best-in-class practices in all our operations.
In addition to these group-level changes, Kering announced further organizational changes at Gucci. Marco Bizzarri, President and CEO of Gucci since 2015, will leave the company and its board. The vacant role is temporarily taken over by Jean-François Palus, currently the Group Managing Director, who is closely related to Pinault. According to the statement, he will be in charge of strengthening Gucci's teams and operations in order to readying its leadership and organization for the future. According to Pinault:
Jean-François has been my right-hand man and a daily sparring partner for several decades, he will now focus his energy on getting our largest asset in top shape, and I couldn’t be more grateful.
Overall, I like a lot of the changes that have been made, but since Palus is only in the position temporarily, the management restructuring at Gucci needs to continue before it can be called complete.
Final Thoughts
While we discussed several challenges that have emerged at Kering in my last article, we now have the opportunity to watch Kering's patron, François-Henri Pinault, address them hands-on over the past 3 months. The current situation of Kering's brands appears to be stable and remains very profitable, even if they undoubtedly underperformed their peers during the year. Thanks to Sabato de Sarno's promising debut at Gucci and the advanced stage of retailization in all the Group's houses, there are several levers that can positively accelerate the company's results in the future. In my view, these far-reaching changes were necessary and will stabilize the Group and its brands going forward. Moreover, the increased organizational and operational strength could then lead the market to value Kering more closely with its peers.
However, all these possible developments are hypothetical as it's too early to assess the success of the changes.
Cash Flows
In order to analyze a company's ability to generate cash from operations, I focus primarily on its free cash flow. Despite the usual calculation (OCF - CapEx = FCF), I adjust the operating cash flow for changes in net working capital, the expenses for stock-based compensation and off-balance sheet financing. Using this approach, I try to get closer to the actual and sustainable cash generation of the business through the perspective of its owners.
For Kering, the updated calculation (based on TTM) looks like this:
in € million | |
Operating Cash Flow | 4,465 |
- Stock-based Compensation | 37 |
- Change in NWC | -845 |
- Lease Liabilities (Repayment + Interest paid) | 984 |
= Adjusted Operating Cash Flow | 4,289 |
- Net CapEx (excl. Acquisition and Disposal of Real Estate) | -1,241 |
= Free Cash Flow (excl. Real Estate transactions) | 3,048 |
- Acquisition and Disposal of Real Estate | -1,242 |
= Free Cash Flow (incl. Real Estate transactions) | 1,806 |
A closer look at the adjustments shows a significant investment in real estate during the quarter. According to Jean-Marc Duplaix :
In the first half, we also acquired prestigious buildings in Paris, securing prime location for our Houses in Place Vendome and on Avenue Montaigne and sold a building in London.
Although I am not really capable of getting more insights out of this little information, I still think this meaningful investment materializes the current "all it takes" mentality regarding reinvestments, populated by the new Deputy CEO. Therefore, one should definitely include these transactions when evaluating Kering's capability to deploy cash. However, in terms of valuation, I will later exclude these investments to maintain comparability based on Kering's historical valuation and its peers.
Regarding the expected free cash flow, I based my calculations on the analysts' EBITDA estimates and a reasonable free cash flow conversion. Since my last article, current analyst estimates have been lowered, which is understandable given the stagnant business for this year. In addition, I have lowered my assumed conversion rate from 47% to 45% given the potential increase in reinvestments.
Based on these assumptions, I arrive at an expected CAGR for Kering's FCF of 7%, which seems fair given the secular growth and strength of Kering's brand portfolio.
Valuation
In order to value Kering, I'll use the free cash flow, as calculated above, in relation to the total enterprise value. My assumption for this approach is that I probably won't be able to calculate a comprehensive DCF model as accurately as Wall Street, therefore I'm following Warren Buffett's approach :
It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
So let's see, what PPRUF has to offer for us at the moment:
As mentioned above, Kering's share price has fallen more than 17% since my last article in June. At a current share price of €429 (or $453), Kering has an enterprise value of approximately €60 billion. Therefore, using the calculated free cash flow of €3.05 billion, we can currently invest at 19.7x FCF. In my last article, I noted that Kering was trading close to the historical average, excluding the outliers in 19/20, of 22x FCF, so we're finally seeing a bit of a discount that looks compelling.
Similarly, I put the current data into an inverse DCF model and found that Kering's current share price implies about 5% growth over the next 10 years, assuming that Kering can at least maintain its expected FCF of €3 billion. Of course, this can't be taken completely seriously, but it's an interesting model to get an idea of the current valuation.
Takeaway
Kering's first half results weren't really appealing regarding the operative stagnation in its key brands and the ongoing transformation of the group. Furthermore, several institutions shrank their expectations for the luxury industry, which led to a general sell-off during the last month.
However, I remain optimistic about the industry and Kering in particular, as secular growth continues and Kering still owns some of the most popular and profitable brands in the industry. I also like the strengthening of M&A, the launch of Kering Beauté and the revival of Gucci through a promising Sabato de Sarno.
From my point of view, Kering is a compelling investment opportunity at the moment, as the pessimistic view on Kering is combined with a general bearish market sentiment, resulting in an attractive risk/reward. Some time ago, I set a limit at around €450, which was eventually triggered, leaving me with an initial position in the company. If the stock continues to fall, I will probably add more.
For further details see:
Kering: Finally, A Compelling Investment Opportunity (Rating Upgrade)