TIVP027: LVMH (MC): Investing in True Luxury w/ Shawn O’Malley & Daniel Mahncke

27:29Buffett is not known for ruthless behavior, but apart from that, you can definitely see the parallels between him and Buffett. He also took over, as you said, a struggling textile business and turned it into something entirely different because he just realized the textile business was too hard to manage. So he was kind of racing against the clock to diversify out of this, you could say, melting ice cube. And now Berkshire is a truly diversified conglomerate that has long relied on Buffett's excellent capital allocation abilities. Well, with LVMH, Arno has done plenty of acquisitions over the years, but always under the same theme, always luxury branding.

28:11The story of how Arno took control of LVMH, I think deserves a little more explanation because there was more going on than I've let on, as you can imagine. The previous head of Louis Vuitton, Henry Racomier, was trying to rally his allies together to help maintain control over the merged LVMH company, as he was worried the Moet and Hennessy side would increasingly drive the conglomerate toward alcohol, especially since there were rumors that Guinness was also going to invest in the company. And so Racamier brought on Arnaud as an outside investor to support him and the Louis Vuitton side of the conglomerate.

28:51But Arnaud ended up switching sides. He got some advice from his investment bank, which was actually the same bank advising the Hennessey and Guinness. So there just might have been a small conflict of interest there. Point being, he realized that Racamier didn't have enough firepower to maintain voting power over the business. or even enough to maintain what's known as a blocking minority of 33 % voting power, according to French law. So Arnaud began putting up the capital to build up a stake in LVMH as planned. But as that position ballooned, Racamier realized he had been betrayed. And even the Moet and Hennessy side was taken aback too, when Arnaud's position hit more than a 40 % stake.

29:37No one really understood what Arnaud wanted. They didn't realize that his ambitions went well beyond the minority investment in LVMH, that in fact, he himself wanted to be the king at the top because his much bigger ambitions to build a luxury giant that could take the independent family owned luxury houses across France and merge them to gain economies of scales. Well, just that had never happened before. No one saw it coming because that playbook didn't exist. There were no other luxury conglomerates. And even LVMH at this point wasn't really a conglomerate in that way, at least in the way it is now.

30:15So the whole idea was unprecedented. And everybody that he was competing against for control of LVMH had no appreciation for what his ultimate aims were. It's just an incredible story. And I wouldn't be surprised at all if in two years from now we see a Netflix documentary just about that story. You almost have to wonder if his time in the US, especially during a period where leveraged buyouts were so popular in North America, but not in Europe, shaped his attitude and also helped him appreciate the chance to even acquire LVMH and build it into this even bigger, huge conglomerate. It's a very astute point, Daniel, and I think you're probably onto something there.

30:56And by 1989, he did become chairman of LVMH. And that sort of marked the turning point where he had fully consolidated, complete power over the company. And this would actually be the first of a handful of examples where Arnaud drove a wedge between business partners and families to gain control. And only rarely has that strategy failed when LVMH tried to launch what ended up being unsuccessful bids to take over both Gucci and Hermes. And in Hermes's case, that takeover was only stopped by court order. So as you said, the wolf in Kashmir is fitting and maybe only the legal system is what can hold him back.

31:36And both are really crazy stories that deserve their whole own episodes. But with Hermes, he basically used all of these shell companies and equity swaps and these other discrete methods over the years to buy up all of the shares that traded publicly for Hermes, which was only like 23 % of the outstanding float. But at one point, Hermes stock almost got delisted because there was no trading in it since Arnaud owned it all. And for a while, nobody realized that it was Arnaud buying up those stakes. And then you can imagine the Hermes family was just absolutely outraged when they realized what Arnaud had been doing very patiently and methodically over several years.

32:20But yeah, ever since taking control of L.E. Mage, he is the person who has unequivocally called the shots and built it into even more of a luxury giant, similar to maybe the Swiss luxury giant Richemont and Kering, who owns Gucci. And as I mentioned, Arnaud almost owned. He actually famously passed up on the chance to buy Kering for a few hundred million after deciding Gucci was worth nothing. So that was a big mistake. And after he tried a hostile takeover later on, some of his rivals combined forces to build Kering into the conglomerate that it is now. The only truly legitimate luxury conglomerate competitor that LVMH has, maybe aside from Richemont.

33:05Going back to LVMH though, through the 90s and 2000s, Arnaud acquired a number of really iconic brands like Celine, Chifan Chi, Christian Lacroix, Sephora, and Todd Hoyer to round out LVMH's business. And in doing so, leverage synergies and supply chains, distribution, and scale and marketing spend to maintain each brand's unique identity. And you can contrast that with Hermes, which never really embraced the conglomerate approach. As we've learned, the synergies that can come with it, if executed well, are really powerful. But Hermes has instead opted to remain as a single brand company for the most part.

33:46Going over that story again, I just couldn't avoid but thinking about what he said regarding his minority stake in Montclair. Because if history has shown one thing, it's that you cannot trust him when he's in the process of building a position in a company. Now, I don't know if it would be a good or a bad thing if LVMH would actually take over Montclair, but for shareholders who want to see Ruffini, who's the current CEO, on top, let's just hope that he's fully aware of Arno's nature and tricks. And maybe you can listen to this podcast to get an idea of his playbook. At least you cannot say that Arno doesn't make much of the brands that he acquires.

34:23As you said, he's an expert in acquiring a range of high-end brands, pool the resources this together and then share their expertise across brands that ultimately makes the whole thing worth more than the sum of the parts would. And that has been a powerful growth act too, where they can acquire smaller brands and then accelerate their growth by just pouring bigger marketing budgets into them and also associating them with more established products, right? And now that the empire expands from leather goods to watches, jewelry, wine, spirits, and cosmetics with Sephora, which I'm sure we'll talk about more since Sephora is the biggest rival of our portfolio company, Ulta.

35:02But the incredible thing, though, is that these products are really all things we could live without, right? The cosmetics and expensive watches are by no means necessities. And yet the storytelling in brand management has been so superb that many women won't blink at dropping$2 ,000 on a Louis Vuitton purse. That's nothing either compared to some of the Tog Hoyer watches that sell for$40 ,000 or$50 ,000. And yeah, this is a company that is still growing revenues at 10 % per year on average over the last five years and over the last decade, which is surprising because there is sort of a paradox here.

35:41In theory, you can only sell so much of one luxury product before you saturate the market and dilute the brand, which I think in part explains why they've branched into so many different areas and brands. Companies like LVMH, just to emphasize it again, are selling aspiration, which by definition means that everyone can't have them or there would be nothing to aspire to. So you might see one beautiful woman walking around with a Louis Vuitton bag and that sophisticated look and elegance is all the marketing you need to dream of one day owning one. Well, probably not for you, Daniel, but for some people.

36:17For you, maybe you have that dream with a Patek Philippe watch from the guys at your gym, and it's the same idea. In this case, it's really about desirability over functionality, ultimately. And Arnaud refers to these star brands as brands that speak to the ages, his words there. Yet these brands also feel intensely modern. And that is kind of the paradox there as well, where you're selling tradition in a way that feels fresh and new still. You're selling the idea that artisans pour countless hours into crafting the perfect product and that quality and the brand's heritage really make your expenditure not a purchase, but almost an investment in your own social status.

36:59And you're buying a part of history for that matter. At least that's how it's supposed to feel. And as Arnaud has put it, profit is a consequence of what they do well, but it should never become the ultimate goal. So that's just such an interesting way to think about it. A very poetic way to put it. I mean, luxury brands, you mentioned this, just have this unique feature that everything you learn in Business 101 just doesn't apply to them anymore. That's why brand billing and history is so important to them. It's what sells their product at prices far above other brands, even when they cannot deliver the same quality or at least much better quality.

37:36This unique strategy cannot really be shown in any spreadsheet. but LVMH in person of Arnaud just proved to be so incredibly good in brand building and storytelling. I know there's caring, but LVMH is on a whole different level. LVMH's free cashflow is about the size of caring's revenues. And if we go through their brand portfolio and you would ask me how many brands will still be around and in demand in 50 years, I just see a dozen more on LVMH's side. Very well said, Daniel. And let me just go ahead and read a quote here from Arnaud to shed some more light on the quality standards they have at LVMH.

38:12He says, a lot of companies talk about quality, but if you want your brand to be timeless, you have to be a fanatic about it. Before we launch a Louis Vuitton suitcase, for example, we put it in a torture machine where it is opened and closed five times per minute for three weeks. And that is not all. It's thrown, shaken, and crushed. And you would laugh if you saw what we do, but that is how you build something that becomes an heirloom. By the way, we put some of our competitors' products with the same tests and they come out like the mush that babies eat. So maybe you find that as an inspiring quote, but then the elephant in the room here is what comes next for the company after Bernard steps down, since he is, after all, almost 80 years old.

39:00It certainly is an inspiring quote. I just ask myself, whenever I buy luxury products, I don't think their quality is so much better. I mean, they seem to test it quite a lot. I've had some products breaking down after two or three weeks, but that's another topic. I was actually just about to ask you, what will happen if Ano is not doing it anymore? When we talk so much about how important he is for this empire and how he built it, then we should also talk about the succession plans, right? I mean, Ano is only 76, and we have just recently seen a 94-year-old Buffett live on stage in Omaha, but I think it would be a bit too optimistic to think that's normal.

39:38So what are the plans? Who will lead LVMH after? When I look at his family, the whole thing kind of reminds me of that HBO show, Succession, where you have the Patriarch's children helping oversee this corporate empire and they're all vying for the chance to then take it over. It's a good comparison. I mean, it was some really crazy drama on that show, which is one of my favorites. But still, I'm sure there's a lot that goes on behind the scenes that we don't see. But yeah, Bernard's five children are all holding relatively senior positions in the company. And you could probably make a case for any of them winning the job.

40:18And it's a real risk for shareholders who wins, as you can imagine. Berkshire was dealing with that same uncertainty of, okay, the person who built this empire is now stepping down. And does it even make sense for this empire to continue to exist in its current configuration than without them? If the brilliant mind behind it all is gone, can anyone inherit that legacy and run it well enough to meet the sort of standards that have been set? And if not, maybe it should just be broken apart with spinoffs for the different units, as we saw with a formerly legendary company, General Electric, just a few years ago.

40:53And his son, Alexander, is actually a VP at Tiffany. while Antoine is the CEO of the holding company that controls much of LVMH. And then there's his daughter, Delphine, who is the CEO of the Dior brand. And then you have Frederic, who is the CEO of LVMH Watches, and Jean, who is the watch director at Louis Vuitton. And all I'll say is that clearly this family is not afraid of a little nepotism. And I don't really want to get into the whole rumors of it all, but really people enjoy speculating on the drama of it. That said, Bernard has stated that maybe it will be someone outside of the family who ends up running LVMH.

41:31So no one really knows for sure at this point. At least with Berkshire, we know Greg Abel is now for certain taking over. To their credit, his children seem very savvy and they grew up around the business at a very early age. So they live and breathe it in a different way, but they know it as well as anyone probably with the exception of their father. And the whole thing just seems outrageously cordial. There's not a ton of drama leaking out about it. He probably taught them for decades how to run their company. So I wouldn't bother too much about these succession plans. That's maybe why we should move on.

42:04And then another important question or just an interesting thing about LVMH is to break down the business by category and by brand. And ultimately, if you want to own dozens of brands, you want the business to benefit from that diversification, right? So from what I've heard right now, it seems that LVMH is still pretty much reliant on the Louis Vuitton brand. And of course, that's a good thing when everything is going well. But we said it before, this is fashion. Things can change fast. So that's why he built this conglomerate. So tell us, how is the business set up? And is it benefiting from this diversification strategy?

42:42Or is it not really showing off in the numbers? so you've got the wine and spirits business which includes all the chandone brands krug dom perian hennessy and i'd say the weaknesses here are twofold there's a lot of exposure to wine champagne and cognac but not really any exposure to gin and tequila which have become very very popular in the last years and then additionally the alcohol business isn't 100 owned by lv mage they have a partnership with diageo actually where diageo owns 34 percent of Moet and Hennessy. So that complicates things a bit. When you look at LVMH's net income, you'll see a pretty substantial minority interest chunk subtracted that comes from deducting the share of Moet and Hennessy profits that belong to Diageo.

43:29This is a decent business, but there's been a lot of reporting around how Gen Z prefers to drink less alcohol generally. So that kind of gives me some concern. And then, of course, there are the fashion and leather goods businesses with Celine, Dior, Fendi, Givenchy, Kinzo, Louboutin, Marc Jacobson, a number of others. And for these brands, there's been a very intentional distribution strategy where, for example, Louboutin will literally destroy excess inventory rather than oversupply the market. So I know it's something we touched on a bit in that Montclair episode. And because of that, these brands almost by definition cannot grow fast.

44:07And then you layer over how cyclical high and fashion spinning can be. And the business just looks shaky to me. Don't get me wrong, it's an incredible unit that generates most of LVMH's operating profits. But we're not talking about a unit that's as stable as Netflix's recurring subscription revenues where it's like there's almost no churn from a year-to-year basis. And it would be unprecedented for a 20 % drop in revenue to occur. That's true. That's something you will definitely never see in fashion and also not with a brand like LVMH. despite being the number one. But what's so special about the leather goods business, and in particular to the Louis Vuitton handbags, is that they are so easy to sell, right?

44:49I mean, they don't have to be fitted at all. They sort of one size fits all. And for the most part, a purse can go with most outfits, which makes it easier to justify one big expense. If a shopper knows they're going to use it frequently, as opposed to, let's say, a dress that they might only wear once, that's why they are the dream of so many people. It's a huge expense, but you can rationalize it. And that's way easier for bags than most other clothes or luxury goods. You're spot on. And it's a little surprised that the company is really anchored around Louis Vuitton. It's the fastest growing and most profitable unit and has been so for a long time for a reason.

45:27But then the third segment of the LVMH empire is perfume and cosmetics. So again, there are Marc Jacobs and Dior, as well as Fenty Beauty by Rihanna and a ton of others, with Sephora being one of the main sales channels for distributing those products. And unlike Ulta, which we've covered in detail before on the show, Sephora focuses primarily on A-list celebrities and driving demand for its products with new innovations, kind of setting the standard at the top of cosmetic beauty as opposed to responding to demand trends, as I'd argue Ulta does more of. And the fourth segment here is watches and jewelry, which we've talked about a bit with Todd Hoyer, but they own a handful of other brands here with really long heritages, but nothing at the highest end of the spectrum like a Rolex or Patek Philippe.

46:17And this is an industry that has generally been in decline to luxury watches just aren't as popular as they used to be. And they've been hit by higher gold and metals prices. so I'd say LVMH's portfolio of brands isn't as strong here as it is in its other segments so I don't get all that excited about this unit. I think LVMH's problem with the watch sector is that they do not own these top tier brands. Tarkoyer is great don't get me wrong but it's more like the Mercedes it's not the Ferrari. They cannot just raise prices as much as they want to to balance out the cost of materials. Rolex, Patek Philippe, or Audemars Piguet don't care about that as much.

46:58I mean, demand may not be as high as in 2020 or 2021, but the wait lists are still full. You cannot just walk into a Rolex store and buy a watch, even if you have the money. That's different for the brands that LVMH owns, but I think watches is not where they see their main jewelry business anyway. I believe Tiffany plays the most important part in that segment, right? Yes, yes. So the jewelry division does now have more going for it. As you alluded to in 2021, they spent$16 billion on Tiffany to become the pillar of their jewelry business. And this will drive the unit more going forward than incremental watch sales, I'd guess.

47:38It's a story for another day. But even though Tiffany was and is a great fit for the LVMH empire, there was a good bit of drama around actually closing that deal since Tiffany's stock fell significantly during COVID. And LVMH wanted to try and pressure them into accepting a lower takeover price to reflect how their valuation had changed in the market. So there's our no being our no again. But anyways, the deal finally closed. And in the US, at least, Tiffany is a real powerhouse for driving jewelry sales and ramping up what would otherwise be LVMH's least inspiring business unit. And as some people say, Tiffany is America's only true luxury brand.

48:17But then on the margins, LVMH has a whole bunch of other stuff it technically owns from these collections of luxury properties to department stores and even media assets, but they don't really move the needle. Just a true conglomerate, right? No kidding. And as I said, a lot of their sales go through department stores, but also duty-free stores in airports. I think we've all seen this, but it makes sense that travelers looking to avoid taxes on high value purchases kind of want to take advantage of that weird loophole and LVMH has made that an important part of their business. To maybe put some numbers around these different segments though, the wine and spirits business is about 8 % of sales, so not that consequential.

49:01The fashion and luxury goods unit is the core unit at about 50 % of sales. Perfume and cosmetics are around 10 % of sales and watches and jewelry are 12 to 13%. And then their retailing business, including Sephora and duty-free stores is a little over 20%. And so this is clearly quite a conglomerate with some brands that are even actually competing with each other. On that point, I just want to read a quote from Arnaud in a CNBC interview a few years ago. He said, quote, in the 90s, I had the idea of a luxury group. And at that time, I was very much criticized for it. I remember people telling me it doesn't make sense to put together so many brands.

49:39And it was a success. And for the last 10 years now, every competitor is trying to imitate, which is very rewarding for us. I think they are not successful, but they try. In other interviews, Arnaud has said that basically the biggest advantage of this model is that it allows you to hire the best people and give them the creative freedom and financial backing they need to succeed. A large part of building the brand image of Louis Vuitton and also similar brands happens through fashion shows as well. That was a big part of Montclair's playbook. And I have to say, it took me a while to understand these kinds of shows.

50:16Many are completely normal, just showcasing the collection for the next season. But you also see these ridiculous outfits that no one would actually wear outside. But to stay with the car comparison that we brought up repeatedly today, they also showcase concept cars that will also never make it to the street. So I think designers are just artists and some fashion shows simply show their creativity and the concept of how the new collection will look like. And even if that's not my world, and I assume you are even further away from that, there's an audience for that. And if you just go to LVMH's website, you can see some of the videos from these and they build hype for the different brands and products.

50:56And it really is something to behold. These are full Hollywood level productions. To use a metaphor that I think you'll appreciate, it's almost like Monday night football in the States. The production value is incredible, and I see what makes people want to go out and just buy more LVMH product. And on the topic of LVMH's brands and business segments, maybe you can just paint some more color around the positioning of the brands and the sales cycle they see. Anything on that vein? So of course, each brand has its own idiosyncrasies, but for LVMH's strongest brands, you might say they have something of a defensive quality to them.

51:34Meaning, for example, when there is a downturn in luxury goods sales, brands like Louis Vuitton will see less of a drop off than others. So a number of LVMH brands gained market share during times of weaker sales generally, which helps minimize the pain they feel, especially relative to competitors. So you have a relatively more stable business in the industry, at least with the top brands. And also these brands are still growing. The fashion and leather goods segment has been growing the most at an average of almost 15 % per year since 2020. While some of the other units have had much more mixed results.

52:11Other units like wine and spirits only grew at 2 % over the same period and have seen pretty dramatic declines in the last two years that have pulled down growth at the segment and company level. And altogether, you've got a mature company that can probably grow organically by maybe five to seven percent on average over the intermediate term. That is coming off a period of sales decline, meaning it might have a bigger short term bounce back at some point in the next 12 to 24 months and longer term with acquisitions to growth could be even higher. That organic growth can come from growing sales volumes.

52:47But in the last few years, much of that has really come from flexing their pricing power, just taking price as much as possible. Louis Vuitton has pretty aggressively hiked prices since 2020 to combat weaker sales volumes, which they've been able to do to an extent that more than makes up for that weakness. And I just don't know how sustainable it is to keep raising prices forever like that, though. It's probably very difficult to estimate where peak pricing would be. I mean, true luxury just shouldn't have peak pricing, right? I mean, the more expensive, the more exclusive and desirable. And then on the other hand, the customer group that can afford that is significantly smaller than LVMH's current customer group.

53:27So I'm pretty sure LVMH itself doesn't really know where exactly you would get the best of both worlds. The good news is that these products are very giftable. Tiffany, Bulgari and Hennessy are all popular gifts or for celebrations, you got the different champagne lines. and with Louis Vuitton as one of the ultimate status communicators, you could say that LVMH runs on what you could call conspicuous consumption. Consumption that's meant to be visible for others. You don't buy a Louis Vuitton to walk around your house with it. It's just for others to see. And same with those gifts or celebratory items.

54:03There's a social element to them. What would be interesting to know is how much of LVMH's sales are the handbags that are owned by atypical Louis Vuitton buyers. And since you said Louis Vuitton tends to drop less in bad times, which we arguably currently have for luxury, it would also be interesting to see whether other brands outperform or at least get closer to Louis Vuitton when times are better for luxury or whether Louis Vuitton just goes up the most in those times as well. I think ideally Louis Vuitton keeps the business running in bad times, but then when good times come, other brands can come and outperform.

54:42What I find really interesting with LV in particular is that while many people view expensive jewelry as quite literally an investment, it hasn't been quite the same with leather goods. They just didn't retain value as well historically, but now you have these secondhand markets for luxury goods growing really substantially. And that has created a lot of extra demand for Louis Vuitton products in particular, kind of helping them keep their value and actually appreciate over time in some cases. And if you think a product can appreciate and also be a status symbol to own, that's just only going to further increase demand.

55:18I've had the discussion about owning luxury products as investments actually quite often. I know people who have tens of thousands of dollars in luxury shoes and clothes. That's just not really my game to play, though. It's a bit different for watches, but even there, it's difficult. Of course, it's unlikely you lose money long-term buying an evergreen Rolex model at list price, but compared to stocks, you probably still underperform, and then you also have the headache and costs of getting them for the listing price, storing them, and then selling them again. So there's just a lot to consider if you think about them as investments.

55:55the only other thing to know here too is that lvmh fully controls its product distribution no one else really sells their products for them and as a true luxury brand that's essential because they need to be in control of supply it's critical to the long-term brand value that we keep talking about that the products remain difficult to acquire and that inventory gluts don't show up in the market and i'll add to that lvmh has a significant economies of scale in its branding efforts and spends around 10 billion euros a year on marketing, which is a small percentage of their sales, but is greater than the total revenue figures than many of their peers generate.

56:32So just to say it again, their marketing budget is bigger than the top line of many of the brands they are going against. And I don't know how you compete with that. It's almost impossible. And that's why LVMH is where they are. I mean, there are even some other economies of scale benefits too. Like the fact that when you have so many brands, it gives you more leeway to promote people across the company. And that also helps attract more of the best creative talent, which are what drive the value of these brands after all. So if you can offer an emerging design star the chance to work on almost any brand they want and promote them across different units, that's a very attractive offer.

57:12And it explains why LVMH has been so successful in continually attracting the best of the best. You've also mentioned the prospects for organic growth, but as we have seen, the main story of LVMH's growth is not organic, right? Acquisitions and mergers are fundamental to the story here, and the bare argument would probably be that they're running out of attractive takeover targets, which caps growth prospects to an extent without paying a significant premium to acquire certain brands. When I looked at Montclair, I also looked at brands they could potentially acquire at some point and it really just showed there's not much of a high quality at least on the market mostly because LVMH already owns everything and since a great brand has a lot of history it's not like in other industries where you could say perhaps in a couple of years there will be new exciting and upcoming players it's just not working like that in luxury and shareholders certainly don't want to see LVMH overpay for acquisitions just to drive top-line growth as well.

58:17So you would really need to go for either lesser quality brands or companies in temporary trouble and then bet on turning them around. It's a fair point and one that I'd maybe have been less concerned about if Arnaud was 20 years younger because I'd trust him to make these acquisitions. And even if deals looked expensive still, you'd have to know that Arnaud has an excellent track record of making brands worth more by being a part of LVMage simply and basically revitalizing them entirely. But we won't have Arnaud around forever and maybe not even that much longer for all I know. And again, the challenge is remind me of Berkshire.

58:55You've got a brilliant allocator at the top, but now due to the law of large numbers, it's just harder and harder to find opportunities that move the needle. And at the same time, the person who built this corporate behemoth isn't going to be around all that much longer. And Arnaud has historically seen the value in brands that others don't see. And that's a gift. And he's been able to spot that emerging value before others too. And not to say that there haven't been mistakes like with its Donna Karan brand or like Kinzo, which is just finally starting to turn around. But overall, the track record is pretty good.

59:26One thing that we haven't yet talked about, and I would like to know how the picture looks there is China. If one has ever looked at any luxury brand, one would know how important that market has become to pretty much every fashion brand out there. The Chinese market is currently estimated to capture roughly a quarter of the global luxury goods market. And according to Vogue, almost one in two shoppers for luxury goods are Chinese. So when the disposable income rises, there's still huge room for more growth left. And when I looked at luxury brands, it's often that the more established a luxury brand is, the higher its market share tends to be in Asia.

1:00:04So I would expect LVMH's share to be significant in China as well. I think often it's 30 % in China, 30 % in the United States, and then 30 % in Europe for these mature brands. And beyond China, being this huge and fast growing market for luxury brands, the story of LVMH just historically ties very closely to China too, going back to the early 1990s. Arnault saw China's rise well before it was obvious, and he had something of a first mover advantage there as a result. As early as 1992, just as China was starting to make market reforms under Deng Xiaoping, Louis Vuitton opened its first store in mainland China in Beijing.

1:00:46At a time when the hotels there didn't even have hot water, Louis Vuitton was selling$1 ,000 purses in the city, and obviously the bet paid off, And now he suggested that he's looking to parts of Africa in that same way. LVMH, in a way, is a business that is ultimately driven by wealth creation around the world. When a country's stock market goes up a lot over a period of time, there's probably a strong correlation with increasing LVMH sales there, too. Morningstar actually, kind of interesting, found a 60 % correlation between S &P 500 returns and growth in the luxury industry. But really, as incomes grow around the world and as quick developing countries produce a growing class of wealthy entrepreneurs and business owners, that increases the number of LVMH can sell its products too.

1:01:41The headwind recently for LVMH, and really ever since the pandemic, has been that China's economy isn't exactly on sound footing. Between harsh lockdowns, skyrocketing youth unemployment, massively indebted municipalities, and a slow motion property crisis. And then now the turmoil with tariffs being imposed on them to their biggest trading partner with the US. There have just been a number of factors that have kind of soured the mood for luxury spending in China. And yet you could argue there's an opportunity for a lot of pent-up demand to be unleashed as we've seen kind of flashes of at different points during this post-pandemic period in China.

1:02:17For a company as old as LVMH, I think they can look past a few quarters of bad growth in China. I think that's not what they are necessarily concerned with. But now there's another topic, and it's once again a bit short-sighted, but we have to mention it. I think you already know what I want to ask you about next, right? We've gone this long without talking about it. Is it tariffs? It is. It seems to be a never-ending story. And although the market currently believes in the so-called taco trade, meaning that terrorists won't hold for long because Trump retreats every time, it would be irresponsible for me not to ask since the impact on businesses is real, even if it's just about planning and terrorists prove to not be long term.

1:03:04Well, I hesitate to say anything specific about terrorists because it feels like it changes every day, which can be hard to keep up with. But as we discussed, much of the luxury goods market doesn't even go through the US, but rather mostly Europe and China in combination. So that helps. And if any industry has the pricing power to shrug off tariffs, it's got to be luxury goods. It definitely doesn't help on the margins, but I don't think it is a concern for the median consumer of LVMH products in the US. Now, if US tariffs kickstart a global recession, that's a slightly different conversation.

1:03:39But still, maybe I'm naive in saying that the rich typically come out of these things somewhat unscathed. And actually, about a third of all global luxury purchases are made by tourists. People love to come home with high-end gifts for themselves or others. And what we can actually see is a higher percentage of Americans making their luxury purchases while traveling abroad instead of buying them at home. But the net effect would really not be much of a difference for LVMH. That's not to say LVMH's business isn't cyclical and that they won't be impacted because it very much is cyclical. and we've been in a bit of a down cycle the last year or so.

1:04:15And tariffs obviously won't help that dynamic at all. That's interesting because it's so much like the playbook that many Chinese citizens also used for years. So shopping for luxury goods outside China to then just avoid higher taxes and also import duties. But I don't know if the effect could be big enough for American shoppers that it could actually just offset all the losses in domestic sales. Let's just hope we don't see much more of these tariff debates. One of the really interesting things I've also heard about LVMH is that there's apparently a way to invest in it at a discount via Dior.

1:04:52Is that actually true? So Dior owns a 40 % stake in LVMH and is overwhelmingly controlled by the Arnaud family. As you say, it's sort of a backdoor way to own LVMH and at an even cheaper valuation. If you can buy LVMH at 19 times earnings, you might get it for a little over 15 times earnings by just buying Dior, since Dior typically trades at a 15 to 20 % discount to the value of its stake in LVMH. And the hang up here is that the listed Dior stock has no operating business. At least it hasn't since 2017 when the Dior brand was formally acquired by LVMH and moved out of the Dior holding company.

1:05:35meaning LVMH completely owns Dior's existing operating businesses. So it's a little complicated, but Dior, the stock, now basically just exists as a holding company with nothing beyond its stake in LVMH. And its reported earnings that it shows are actually just its pro rata claim on LVMH's earnings. So just to clarify, I originally bought Dior through a textile company. and that then became Dior's stock that now trades publicly and while Arnaud controlled Dior he wanted to formally send over its business operations to LVMH which he also owns and then leaving the Dior store as somewhat of a shell company now is that right?

1:06:21because it sounds pretty straightforward pretty much yes Daniel the cross-holdings get confusing but I think you've got the idea Arnaud first built up his ownership of Dior and then used Dior to build up his ownership in LVMH while later transferring Dior's business to LVMH so that now Dior is just a holding company for part of Arnaud's stake in LVMH. And the discount begins to make more sense when you realize that Dior's cost basis is very low. So it would have to pay a 25 % capital gains tax in France and almost the entire value of its LVMH stake. So that would be a massive tax cost. Even if Dior wanted to sell its LVMH stake, it wouldn't even be feasible for them to find anyone to cleanly buy that large of a stake, especially since Dior is controlled by the Arnault family, who has no incentive to relinquish control over LVMH through Dior and pay a bunch of taxes just to close the valuation gap.

1:07:16Arnault controls 97 % of Dior, to be exact. So there's very little free float in the stock anyways. And there's a risk that, due to a wrinkle in French law, Arnault could actually squeeze out the small minority of shareholders at a quote-unquote fair price, which might be the current market price plus a small premium that's still at a discount to the net asset value of Dior's LVMH holdings. The point being, there is really no good way to close the gap between Dior's valuation and the value of its LVMH holding. There's actually a risk that Dior's small basis shareholders, besides Arnaud, could be forced out of Dior without earning the full value of the underlying LVMH holdings.

1:07:55So it's an interesting case study, but the market is probably assuming that the value of Dior's stake in LVMH is what you call trap capital. There's a limited motivation to change the status quo here. There's tax friction, there's legal complexity, and that all sort of explains why this opportunity that looks really good on paper exists and is maybe actually not that attractive. Sounds like it's probably too good to be true to simply have a backdoor way of buying into LVMH that cheap. But maybe with some other luxury giants we can buy into at least the industry at a better price. How does LVMH's valuation and business quality compare with some of the other European luxury giants?

1:08:37If you chart it out, and we're showing the charts on the screen at the moment here for those watching on Spotify or YouTube, but compared to companies like Kering, which owns Gucci, Hermes, Burberry, and Richemont, which owns Cartier and Peter Mellar, Hermes has by far the best numbers. It's had higher sales growth in LVMH, 40 % plus returns on capital on average over the last five years, and a free cash flow margin that is 8 to 18 percentage points higher than these other luxury companies. But at the same time, it trades at more than 60 times free cash flow. So you're paying a massive, massive premium to own this incredibly high quality company.

1:09:15So at that price, I can already tell you, I'm not interested in Hermes. And with LVMH, it's a more diversified conglomerate, meaning it doesn't grow as fast and its returns are lower, both in profit margin terms and returns on capital, probably because they've had to make a number of acquisitions to keep growing outside of their core leather goods business. So in an industry literally defined by quality, LVMH is probably not the highest quality just based on the financial metrics. But in valuation terms, it is right there in line with Caring and Burberry at about 17 times free cash flow, or at least at the time of recording it was.

1:09:52Yet I do think there's a good argument for LVMH being a significantly better business than either of those companies. Caring for Simple hasn't really grown sales at all in the last few years. And its free cash flow margins are half that of LVMH. So I don't think it has any business trading at the same valuation as LVMH. And it's the same story and actually worse at Burberry. So it blows my mind that LVMH is being valued similarly to these clearly inferior businesses. But betting on normalization and multiples isn't something I like to make a habit as a driving factor in my investments. but this relative pricing of LVMH combined with everything else we've covered could get me bullish on LVMH let's just say not to say LVMH should trade at 60 times free cash flow like Hermes but it should probably be somewhere in between those two extremes in my opinion as recently as March 2024 that is exactly where LVMH was valued at at 37 times free cash flow so it's pretty incredible how much the valuation multiple has contracted as sales have kind of flatlined and over the last decade its median price to free cash flow valuation is 25 times so again relative to its own valuation history and to some lower quality peers lvmh does seem too cheap at the moment in relative pricing terms you could probably argue that it's maybe 20 to 30 percent underpriced but again we don't necessarily it's subjective right so we don't want to entirely use that as a driving factor for an investment decision as you know daniel well but you also know me i have a weakness for strong brands that face in my opinion probably short-term headwinds so every major is obviously an interesting opportunity right now and it's not like the business has completely collapsed they did hit some hiccups though sales stagnated last year and margins fell off causing roughly a 20 year-over-year decline in earnings that's quite significant but I struggle to imagine that this reflects lasting damage to the company since it's so diversified and it has so many incredible brands.

1:11:57But you would know better than me. So with that peer valuation backdrop, how about you walk us through your approach to estimating LVMH's intrinsic value? Well, you could do a few approaches. This would be a good candidate for a similar parts valuation, as it's called, where you value each unit individually and then add it up all together to estimate the company's entire value. I didn't exactly do that, but I did try to take a look at each segment's recent track record of sales growth and operating margins just to get an idea for how growth and profitability can fluctuate for the different units.

1:12:30And so because luxury goods can be cyclical, I averaged out the growth rates over the last five years for each segment, and then somewhat conservatively, but also arbitrarily, estimated that they can grow by at least half as fast on average over the next five years as maybe sales bounce back from a down year and operating margins normalize a bit. So from there, I have a simplistic model of operating profits in total over the next five years by summing up the results from each segment. And then on a per share basis, it's easy to estimate what the share count will be in a few years because it pretty much stays completely stagnant.

1:13:04And as I like to typically do, I'm sure you also model this out by different scenarios, right? So let's say a bull case, a bear case, and a base case. Exactly. And in my base case, I try not to make any assumptions that are too optimistic. So even though LVMH's PE is at historically low levels, I didn't want to bet on that multiple increasing significantly over the next few years. Doing so is ultimately speculative. A company can, to some extent, control the earnings it produces, but not the price the market is willing to pay for them. In my bull case model, however, this is where I do give myself a little more space to indulge my optimistic side.

1:13:45And so in my model with adjusted inputs for a bullish outlook, I bet that its valuation can converge toward more historically average levels. And if that proves true, that would, of course, be well, very bullish since it is, after all, the bull scenario. In that bull case, I also anticipate some moderation and sales growth, but it's definitely higher than the base case and anticipates a total revenue cager of over 6 % a year, which doesn't sound crazy but is pretty solid for a company of LVMH's size and in the bull case also model out some more improvement in their operating profit margins for each segment matching more closely to what the average of the past five years has looked like.

1:14:26So again there's a lot of looking at what type of growth is precedented and what normalized profitability looks like where you average out margins over several years and then during a conservative base case with some modest improvement, a bull case with somewhat more aggressive assumptions, and then a bear case where you try to account for just what it would look like if things went wrong. And maybe you have some flat or declining sales at further reduced margins and also maybe a lower valuation multiple, that kind of stuff. I think that all makes a lot of sense. And with some companies we have reviewed, it certainly is easier to just imagine a devastating bear case than with others.

1:15:01On FinShot, I can unfortunately only see the segment revenues and profits starting at 2020. And the pandemic and the years after that are obviously, you know, not the greatest sample size for having an historic average. But to me, your bull case seems to be more or less a return to the old profitability, right? And if I would have to decide whether the bull or bear case is more likely, I think I would certainly go with the bull case. I find it just hard to imagine that these high quality brands just suddenly go out of demand or lose their pricing power. But an important part is what brands are the most vital to LVMH's profits.

1:15:40Not all 75 brands have the same brand strength. And the big ones, Louis Vuitton, Dior, Tiffany, I don't see them getting into long-term trouble anytime soon. But you know, fashion keeps being fashion. Who knows? Taste always changes and there are real headwinds for the business as well. If it becomes less palatable for the global rich to spend on LVMH products like they have, for example. So the current demand picture strikes me as being a bit precarious too. And although I'm cautious with long-term trends, data also shows that younger generations tend to be more experience-driven in their spending.

1:16:18And who knows if that means more travel and less luxury bags at some point in the future. And it's so surprising that last point, and we didn't really have time to cover today, but LVMH has been increasingly leaning into offering luxury experiences from Bulgari hotels, expensive cruises. So I could potentially see an argument for that as a growth driver in a true bull case. It doesn't help though that I'm an outsider looking into the luxury industry, but I agree with the concerns. I think these brands will endure, but I don't feel personally confident enough in arguing that there's no scenario where sales and profitability couldn't continue to decline either, meaning we can't write off the bear case scenario.

1:16:59And so across these three scenarios, you can imagine I get very, very different price targets. In a base case, the stock starts to look attractive at around 400 euros per share, which is something like a 20 to 25 % discount to current levels at the time of recording. But in a bull case, which I should say is not even the most aggressive bull case you'd find out there, the stock looks considerably undervalued, unsurprisingly. And at today's prices, you could probably underwrite an estimated a return of 14 or 15 % a year on paper, again, estimated on paper. We should emphasize though that this is the bull case.

1:17:34So it only takes up a smaller weighting in our overall price target allocation because it's not the most likely outcome. It's an optimistic outcome. And this is meant to reflect a world where everything basically goes right for them. And from there, I tried to calculate a average buy price across all three scenarios by giving a 60 % weighting to the base case since it's most likely to occur and then a 20 % weighting to the bull and bear case scenarios. And when we do that, if you're still following along at home, the blended price target I get is about 412 euros, which is the price that I estimate we'd need to be able to buy at to clear our hurdle rate of 12 % expected returns per year on average over five years.

1:18:21And actually at current prices, since the stock popped on news in May that Chinese tariffs were being reduced, the stock looks priced to deliver, in my opinion, just average returns unless we get a kind of a bull case scenario for the business. Well, you know, as they say, you have to have a varying view of the company and what to expect, different outcomes than the market average. unless we had higher conviction in the bull case scenario, it doesn't surprise me that the stock is about fairly valued. And yet I don't have the necessary conviction for a more bullish scenario. I mean, don't get me wrong.

1:18:59It's not that I can't imagine it. But when I think about the cost of being wrong and the opportunity cost of the other things we can invest in, and just generally that the luxury goods market isn't one that I intuitively understand because I don't buy those kind of products, yeah that's how I get to saying that my outlook probably doesn't dramatically diverge from the market but at least we have a price target where if there is some market panic we know at that level it makes sense to snap up shares of what is objectively a really high quality business like LAMH so I don't see this as the most incredible opportunity to buy LAMH at the moment even if it is seemingly attractively valued on a relative basis and just looking at the stock chart of that it's gone down a decent bit over the last year.

1:19:44It might be attractive given how much the stock is down from its peak, but it doesn't meet my margin of safety threshold. And due to that, I'm not recommending we even initiate a position in it at the moment, and we may not get a chance to do so either. We haven't seen a price quote in the low 400 euros for LVMage since 2020, but that's where it would have to go for me to be really excited about it. And north of 470, 500, 550, I just get a lot less excited. And while I have a chance, I should also mention that because LVMH is listed in Paris, there can be a lot of transaction fees, as I learned for Americans.

1:20:22I'm very spoiled by commission-free trading for U.S.-listed stocks. So when I see the fees to invest in stocks listed elsewhere, it always gives me a little bit of pause. I spoke with the trading team at Charles Schwab, actually, and they said there were basically two options if I did want to buy it personally, which would be to buy the American depository receipt listing, which comes with 0.5 % annual fees and a one-time tax fee to the French government plus a small trading commission fee, or invest in these shares directly in Paris, which would come with something like a flat$100 trading fee, no matter the size of the trade.

1:20:56And if you're making a large trade, maybe more than $10 ,000, those fees are less consequential. But still, this only further kind of dampens my excitement about trying to get into a position in LVMH at current levels, it comes with some friction that I don't get from just buying Alphabet stock, for example. I didn't know about those fees before you told me, and that's definitely bad news for American investors. And if LVMH would be an outstanding opportunity, I think that wouldn't be a problem, but it's not that great, right? When I went through your model, I actually even changed the likelihood of the bull case in the valuation summary to 40 % and I therefore reduced the base case to 40 % as well and to me that's not unreasonable to just get back to historic returns but still the expected return just looks decent it doesn't look great and they're still in the highest single digits and that's with me turning the bull case into somewhat of a base case.

1:21:52LVMH just doesn't scream bye right now and there are probably better opportunities out there. I think we're in agreement than Daniel. And well, this convo has been a ton of fun, but it's that time of the episode then where we look ahead to next week's pitch. So why don't you give us a few hints on what to expect? Well, my next company is somewhat of a luxury company as well. Although when I keep it precise, it's probably more of a premium brand, not luxury. It's in a space where LVMH operates too, and one of our portfolio companies as well. Maybe LVMH would actually look at acquiring it if it weren't for the large stake a single shareholder holds, who will definitely not sell.

1:22:36And I don't want to make these hints too easy. I think it's always hard to judge when you obviously know the company beforehand. Maybe it's too difficult now, but I think I'll just keep it at that. So let me know your guesses in the comments, as always. All right, folks, before we go, let me leave you with this quote from Bernard Arnault. He says, Steve Jobs once asked me for some advice about retail, but I said, I am not sure at all we are in the same business. LVMH is truly in a league of its own, or at least I think so. And just a reminder, folks, if you're interested in securing one of the remaining spots in this cohort of openings for our intrinsic value community for investors to network and share stock ideas, you can join Daniel and I there by applying to the waitlist at theinvestorspodcast.com slash intrinsic value community.

1:23:30That's theinvestorspodcast.com slash intrinsic value community. See you next time.