Kering: It’s Gucci - [Business Breakdowns, EP.199]

0:03This is Business Breakdowns. Business Breakdowns is a series of conversations with investors and operators diving deep into a single business. For each business, we explore its history, its business model, its competitive advantages, and what makes it tick. We believe every business has lessons and secrets that investors and operators can learn from. and we are here to bring them to you. To find more episodes of Breakdowns, check out joincolossus .com. All opinions expressed by hosts and podcast guests are solely their own opinions. Hosts, podcast guests, their employers or affiliates may maintain positions in the securities discussed in this podcast.

0:45This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Matt Russell, and today we are breaking down the global luxury group, Caring. You know Kering from their brands. Gucci, YSL, Bottega Veneta, Balenciaga, and the list keeps going. It's a luxury house with similarities to what you know from LVMH. But LVMH over the past five years is up over 40 % and Kering is down over 60%. To break down Kering, I was joined by Jonathan Eng, Portfolio Manager at Causeway. John has spent over 30 years in the investment space, and he has seen his fair share of cycles for a company like Kering, which made this a fun and timely breakdown.

1:31We covered the Pino family, the owners and operators of Kering. We got into wholesale distribution versus retail distribution and the margin profile of brands and the various levers that you can pull. But Kering's core brand, Gucci, is different than a lot of what you see in luxury. And we spent a significant amount of time diving in there. What makes Gucci more cyclical than understated luxury? Where do we stand with Gucci today? And how does John think about all of this as an investor, tapping into his historical context in the space? It was a very fun conversation. It's a very timely conversation.

2:08So please enjoy this breakdown of Caring. All right, John, I am excited to have you here to talk about Caring. And it's one of these names where I think LVMH gets all of the attention in terms of the mainstream luxury houses that the market has studied and known so well. And this one kind of sits in the shadows a little bit. So maybe we could just start with an outline of the brands that sit underneath this umbrella and a little bit about the umbrella today. Well, thanks, Matt. It's a real pleasure to talk about Caring today. Like you said, it has been in the shadows and there's been a bit of a quiet rivalry going on for a long time.

2:48Kering is a luxury goods company. It's got a number of brands, 15 or 16 brands now. The biggest one is Gucci. A position was started by Kering in 1999 and it steadily bought that up to a full position in 2001. And they've got some other brands like YSL, Yves Saint Laurent. They've got Bottega Veneta, Balenciaga. and they've gone through some advertising challenges. They've got eyewear, they've got Alexander McQueen and now they've just started a beauty business. When you've got a number of brands like that, you could add beauty to a number of these brands. And I think that's a real opportunity for them in the next five to 10 years.

3:28You mentioned Gucci there. I know it is the name that's most associated with the business. Does it represent a large percentage of, whether it's revenues, profits, however you wanna measure it, Is it really the dominating brand within the portfolio? It is right now. It's almost 50 % of revenues and it's over 50 % of profits. When I compare it to LV, it's got a bit more fashion to it. So LV has a lot more leather. It's a little more stable as a business. And if I look at Gucci, its popularity comes in and out depending on how well its fashion does. It's about half leather and the other half is ready to wear and shoes.

4:06So when someone like Alexander McKellie comes in and he does really well, then you see Gucci do very well. The multiple goes up and people start to talk about it kind of in line with the LVs of the world. You see it today where it's struggling a bit. They've changed designers. They want the design to be a little more quiet. You talk about this discreet luxury. It's been a very popular theme in luxury. Keringa's hired for Gucci, Sabato De Sarno. He's the new designer, and he came from Valentino, and they are now updating all of their designs, bags, shoes. We'll see what he does, but it's been a challenging time for them, so it's a good time to talk about it.

4:49You were tapping into some of the things that stood out to me just in terms of thinking about Gucci relative to some of those LVMH brands. Before we get too far into the business today, I don't want to overlook the past. There's the family associated with LVMH. What is the backstory with Caring in terms of whether family, operation, what other dynamics would you point to just in terms of the history? If I look at Caring, it was an eclectic set of businesses. Back in the 80s and 90s, they were in the timber business. They were in some distribution businesses. Very regional, very European. I think maybe 40 % to 50 % of their business overall, they had $22 billion in revenues, was European related.

5:29When the father gave control to Francois Henry, I think he looked at the portfolio and said, we've maxed out on what we can do in some of these distribution businesses. They had electronic retailing, furniture retailing. They had construction goods retailing. So a lot of these businesses, given they were more local, they couldn't benefit from the expansion globally in international markets. And so there was a takeover attempt by LV in 1999 to take over Gucci. Needing a white knight, the CEO and the Gucci family came to Caring and they took a stake. And over the next two years, they won out and took over Gucci.

6:10So that was their first foray. And over time, they bought some other brands, Votego Panetta, Balenciaga, YSL, probably in a pretty quick period of time, three to five years. And they disposed of many businesses. They got rid of Comforama, Rexel, some of the electronic retailing in France, and then finally Puma. That was the final disposal. Since then, they've done a great job of scaling up a lot of these businesses. That's a challenge in itself in luxury. With the Gucci acquisition, it was one that, as I read a bit about it, was particularly fascinating. But the idea of them being a white knight relative to LV at the time, would you say that they have a different approach or more brand friendly?

6:57LVMH certainly has some stereotypes that can be associated with it in terms of what they do when they take over brands. Would you say there's a large contrast in terms of what Caring is known for? I think for Caring, they've done a really good job scaling the business. Caring is a bit bigger, but if I look at businesses like Bottega Veneta when they took over, a lot of it is wholesale. It's a business, let's say, with 50 to 100 million. Putting that business into a company like a caring with different brands is a big advantage because you start out when you're smaller like that, more wholesale, and then you can transition as you get bigger to more retail.

7:36You might start out 70%, 80 % wholesale. And then by the time you get bigger to the size, or say with Gucci or even Bottega these days, you're 70%, 80 % retail. And developing that is a lot tougher as your own company. Having the expertise of a multi -brand strategy really helps something like caring. They can help you out with what type of store, what size store, how many pieces you need, all the backend stuff, all the logistics, all the IT, helping you get a CEO, putting that someone in place, CEO and creator, being on the same page strategically, developing the brand. It's a real challenge, getting a luxury brand to a certain level and then taking it to the next level.

8:21That's what caring is really good at. LV is really good too, by the way, and they've done it with many different areas. So I'm not going to dismiss anything that LV's done. If I look at caring and what they've done with Gucci, Yves Saint Laurent, on Bottega Veneta, that's their strength is really being able to scale up businesses and develop them over time. Bottega Veneta was 56 million. It's now 1 .7 billion. And that's happened in 25 years. It's pretty good. Impressive. Do you think there are any sharp contrast between the two approaches of LV and Caring? I think LV, they've got Sephora, They've got luggage, a business now.

9:03They even have hotel brand. And they've got champagnes and wine. So it's slightly different. If I look at Kering, it's got more ready -to -wear, a little less leather. LV, it's got a lot more leather to it. They've done a phenomenal job with Dior. And they've got a little challenge going forward, given the pricing's gone up for them. But really, the difference between the two is the different areas that LV is in. that's outside the LV and Dior brands. When you look at carrying, you mentioned there's been some divestitures. You referenced some of the brands. When you think about what's left, you describe the brands.

9:40I associate them all with luxury brands and basically a shift away from Puma. I wouldn't put it in that category. Is that a fair way to think about it as luxury is a term that can be argued in terms of what qualifies and it could be viewed as a very, very, very small percentage, but it certainly seems that has been the direction that they moved. Is that a fair classification? Absolutely. It's been going on for a number of years now, and Puma was the final divestiture. Puma was a 10 % margin business. Gucci, over the last 20 years, it's been a 30 % to 40 % margin business. It's a big difference from Puma, which is a 10 % margin business.

10:16Luxury overall, it's a 70 % gross margin business. On average, it's about a 30 % operating margin. LV, it's probably a bit higher. And Hermes is a bit higher too. Thinking about revenue fluctuations at a higher level, I think you referenced one of the things that I was most curious about, which is Gucci, I certainly associate with fashion to a larger extent. And I think you helped answer some of it with reference to leather being maybe less pure fashion forward. But Kering's portfolio and its tie to macro dynamics. What would you say? Is it something that is cyclical with macro environments? They show defensiveness through periods where there still is this demand from the top 1%.

10:58What has that looked like over time? They are cyclical businesses because if I look at global wealth, it's a cyclical situation. If I look at the year 2003 when there's a recession, 2009 is the big one with the big downturn. During those periods of time, luxury goods stocks, derated. I remember buying back in 2003, 2009, Richemont, which we're not talking about today, but they own Cartier and Van Cleef. During that period of time, it went to one times book. That was a great buying opportunity. And as an investor, sometimes we'll use book values, PE multiples, price earnings multiples to figure out how to value these companies.

11:36When global growth is doing really well, when asset prices are going up, the top 1 % are doing well. These are great businesses. They grow 9 % organically, price and volume. There's operating leverage on top of that. It's a great business. But when you have the downturns, like in COVID 2009, they're difficult investments to have. They're great for about 8 out of 10 years and 2 out of 10, they're pretty tough. But last year was a difficult year. Actually, this year in 24 is a difficult year. This is the sixth worst year in luxury out of the last 20. Certainly coming off a high, high, just in terms of what was happening, maybe a reset to some extent.

12:18On the price and the volume points, whether you want to use the 9 % as organic growth as a reference, or just how you would frame that equation, is there a general framework that you think about for year to year, what price improvement drives in terms of revenue? And then, obviously, volume is going to fluctuate, but those two components together and how you think about them? I usually think about 3%, 4 % price and maybe 3 % to 4 % volume. There's some mix in there as well. So sometimes you will discontinue some areas or when you introduce, you'll come in at a higher price. That leads to higher revenues as well.

12:54So there's a mix of all three of those that are helping revenues grow. And would you say that's fairly standard across the industry? Are there certain players that are way more aggressive on price relative to others? I think they've all been pretty consistent. During COVID was very unusual. There were much bigger price increases during COVID, more like 10%, 15%, 20 % a year. And that's starting to catch up with the industry a bit, particularly in the soft leather area where there's a lot more competition. We've seen the likes of Chanel, Dior, they've raised prices 50 % over the last three, four years.

13:28It's a lot. And consumers are starting to notice. You want to have that balance where you don't want to have too much volume growth. You don't want to make your product so available. So you want to make it something where people connect with, but they understand that price going up is a store of value. hey, if I don't buy it this year, it's going to be more expensive next year. It doesn't come down. It's not like I go to wherever and I can buy something 50 % off. This is not going to be 50 % off. It's training the consumer a certain mindset. I don't know if Chanel had a PR campaign that drove all those Bloomberg articles referencing the price of those bags and how it has been a successful investment over the years.

14:13It sure was an effective one, I think, historically, just in terms of creating that mindset that next year, it's only going to be costlier. Definitely true. On the margin side, you talked a bit about the differences that you would see versus a Puma and a Gucci. Can you talk about some of the moving parts? I can understand if you have a store footprint, there's going to be some operating leverage associated there. But what are some of the key cost drivers or key cost levers that are involved in this business? It's making the product. And that's probably 30 % of the cost there. And you can see the gross margins are near 70%.

14:49So it's a very profitable business by itself, but there's a lot of support there. Obviously, you mentioned the store network. There's a bit of a wholesale network and sales people to deal with, and that's a big part of the cost base. The other part is advertising and promotion. A lot of times you'll see it in the magazines that you see, the billboards, you'll see the name and they will get you as a consumer on your mind at the right points in time. You're out on wherever, on vacation and leisure, you're playing golf, you'll see these sort of things. You'll see the names. And people's the other one.

15:25There's a lot of people, there's a lot of creativity. And with creativity comes a lot of costs. So those are the three real buckets. When you see operating leverage in the business, thinking about these costs as a percentage of revenue, the store footprint, the real estate cost, that's going to be largely flat. So you're going to see operating leverage there. But with the others, do you see operating leverage on top of the advertising or are they just pumping that back into the business? We've seen some brands do that where they get to a certain level in operating margin and they've said to us, you're not going to see any more operating leverage.

15:58We're going to reinvest it back in the business. We might open new stores. We might advertise some more. Some managements take a longer term view and they say, no, we're going to reinvest that back into the business. So there is a limit to how far that will go. Now that they've divested Puma, which sounds like it was the lowest margin business within the portfolio, how much variability is there in the margin profiles of the various brands? And maybe just focus on obviously Gucci being the largest, you shared some of the dynamics there, but relative to some of the other bigger brands, is there drastic differences in terms of margin profile?

16:34With size comes better scale. So Gucci had higher margins, They have more fashion as well. So if I looked under Alessandro McKellie, when Gucci got to a 10 billion revenue business, operating margins hit 40%. That was one year. When they were in that range, eight to 10 billion, they were operating in that 35 to 40 % margin area. Today, they're a seven and a half billion business. Obviously, that's why we're talking about it. It's so interesting where it is. And it's just over 20 % margin. To answer your question, there's a lot of variability in their business. That's why historically they've sold at a discount to LV because investors have looked at them and said, oh, I think there's more variability in your business.

17:17The last couple of years is a good indication of that because revenues have declined as there's been a design change and luxury has been tougher. So you've seen consumers say, you know what, I'm going to pull back a bit. I'm going to buy a little bit less, But I'm only going to buy the really, really top brands or the brands that I really, really love. Gucci has more aspirational as well. Those consumers were having a tougher time too this year and last year due to higher interest rates, and they've pulled back. And so you've seen operational gearing in reverse, basically. So you kept the cost base.

17:52You've reinvested back in the brand. Maybe you've cut some wholesale back. But when revenue has declined 25%, profits are down 50%. And that's basically what's happened at Gucci. But that's why it's so interesting. With the creative director, you've had these icons, Tom Ford in the 90s, some of the names you've mentioned recently, and they feel so important. Most investors think about you see a management team change, you might see the CEO or a CFO. This feels like one of the most relevant roles within a corporation that's not the CEO title. How do you just approach that as an investor? And when you see change, how do you get comfortable around what the new person is going to bring in?

18:31A lot of times when we have a CEO change at a company, a normal company, we'll do a lot of background work on what have they done in the past. It's a good thing to look at someone's resume. Same thing as with a designer as well. Sabato was at Valentino. Taking a look at what he has designed, his vision, asking yourself as an investor, is the customer base willing to change and go in that direction? I think that's a really important point because so far the answer has been not yet. To be fair, though, his designs are just coming out in the last three months. So a lot of leather bags are coming out in September.

19:06But as an investor, you're doing a lot of work around what did he do at Valentino? What did those sales look like? What did those margins look like? Was that a successful company? Can that be transferred over to Gucci, which is a little more fashion -oriented in the past when it did well under Tom Ford and McKellie? Can that happen this time? That's really what we ask ourselves. When it comes to something like this, I think you've referenced the difference versus traditional leather, something that's more timeless in design versus something that's fashion oriented. What does get you comfortable in terms of the direction and confidence that there is going to be a hook?

19:43And this can span into the brand's impact on shaping fashion culture. So actually being the leader and telling people what they want to wear and how they want to dress. The easy way out would be, let's pick something timeless. There's going to be less variance in there, but I'm sure that's not the answer. We do a lot of work on Instagram following the strength of the brand on certain surveys like List in the US and how certain brands are doing. I think it's important to look at those indicators. You want to understand, okay, how is it going? Is it being well -received? Sometimes we'll talk to the stores.

20:20Obviously, we look at the Instagram following. We'll look at the likes. We'll try to understand how that brand is developing. It's always dark at the bottom. You never have complete confidence. When it's at the top, everything is clear. There's never been a more bullish picture than when things are at the top. But at the bottom, things are pretty dark. It's like picking up a newspaper in the crash of 1929 and trying to find good news. That's what you're trying to do when you're looking at caring right now is, hmm, it's pretty dark. People are telling me it's bad. Is it really that bad? Let me try to find some good news.

20:54That's what our analysts are trying to do. When we talk to the company, we talk to competitors, when we're looking for doing our researches, try to find that good news that gives you confidence to make this a big position and invest for two, three, four years. That's what we've done with names in the past. And it certainly helps when a brand or brands have the history that these brands do. It is not something that is a pure flash in the pan from that sense. So there's something certainly to stick to with that IP. And I'm sure that drives a lot of confidence. You mentioned some of the things that you're monitoring, which 10, 20 years ago, not monitoring Instagram likes.

21:32So just how much has that changed in terms of having a feel or grasp on this market in your day to day as there has been a shift in terms of what's driving culture, technology, all these different dynamics? Has it drastically changed the investment process or maybe just the analytical process from that sense? I think it's changed the analytical process. Decisions are still decisions. But today, there's a lot more data available. You have credit card data. We have Instagram likes. We have all this different information available to us as investors, all public knowledge. Why not use it to your advantage?

22:08The world has become more global, too. 20 years ago, the Japanese were the big buyers of luxury. Obviously, the Europeans were too. The Chinese were very small. I mean, the last 10 years, they've become a much bigger part of the industry. They were probably almost 50 % of growth. The last 10 or 15 years, now it's down, the last few years, it's only down to 10 % of growth. The Americans now have become a much bigger part of the luxury industry or luxury buying group. They are a third of wealth, but they buy 20, 25 % of luxury products. So they underspend, actually. Pretty interesting. The Chinese actually overspend.

22:42They're probably in the 25 % of wealth. Their wealth's come down the last few years, but they spend 35%. That's why there has been so much focus on China, what's happening there. Investors are using this sort of data that we talked about. Do you have a preference in terms of those demographics, liking to see more exposure to certain regions? I'm sure that some type of diversity in spend would ultimately be the best, but if we were to put the North American customer relative to the Chinese customer, Would you have a preference to see more growth from one specific subset? Revenue is revenue at the end of the day.

23:18Obviously, you'd like to have it balanced because you have a store base that you need to support. So you wouldn't want to have it 90 -10. But as long as it's balanced is the answer. Thinking about the supply chain and the manufacturing process, more of the upstream inputs in terms of logistics, is there anything unique to what they're doing? You hear about the history of these brands and how it originally started. But over the years, thinking about that, is there anything that stands out about the process at Caring? Well, I know at Caring, it could be this way at other luxury companies, but they've got development centers in Europe where they have a development center on leather.

23:55They have a development center on ready -to -wear. And so if a particular brand says, hey, I've got this idea in ready -to -wear, they can have it developed at their development center in Europe. This one, I believe, is in Italy. The development center will help them design, source the materials, and where to distribute it. It's a big advantage to be part of something like caring. You can take a design concept and make it a reality a lot faster and a lot easier with these development centers. It sounds like there is some centralized infrastructure that is available to these brands. is most of the actual decision -making on product and what's released still decentralized at the brand level?

24:41It is. I think what you want to have is the CEO of a brand and the designer to be in concert with one another strategically. And you want the CEO to figure out and to implement that strategy, but you want the designer to design. You want them to do what they're really good at. I think that will always be local. I think it will always be decentralized. lost. And then on the downstream supply chain, logistics, distribution, really, you mentioned wholesale versus retail exposure. What does the difference look like just in terms of wholesale margin versus a mature retail operation? How drastic of a cut are you getting when it comes to wholesale?

25:22And what would the other factors be? It sounds like a balance is okay to have, but I sense that there's more opportunity when it comes to operating your own retail locations. Well, you have more control over pricing and more control over product, and you have more control over the inventory. So you know when something is sold and you can replenish it or maybe not replenish it. Whereas in wholesale, you're selling and you don't have that visibility. The margins are good. I don't think there's a huge difference. There might be some, but you don't have control over pricing. So when things are not selling well, there will be some degradation in the margin.