Anatomy of a Good Company: Hermes
Jamie Ross, Portfolio Manager of Henderson EuroTrust, provides a snapshot of the typical analysis undertaken on every company considered for the portfolio. In this case, he explains the rationale behind the inclusion of one of the most prestigious luxury brands - Hermes.
7 minute read
- Hermes carefully manages the volume of products it manufactures, tightly controls the distribution chain, and ensures that demand growth exceeds supply growth year-after-year. This helps drive brand desirability and pricing power.
- High gross margins enable Hermes to invest heavily behind the brand whilst also generating high levels of profitability. Meanwhile, long-term wealth creation and the growth of aspirational, middle-class consumers in emerging markets continues to drive growth.
- We take a long-term view when judging the merits of a particular company and this aligns with family owners who tend to care about the long-term wealth creation that comes from their stake in the company, rather than being concerned with short term profitability.
There tend to be many features that most good companies have in common, but there are myriad characteristics and features to analyse that will be unique to each and every business. By undertaking a detailed analysis of the 50 or 60 companies we have on our radar (a portfolio of ~40 positions and a watch list of 10-20 names), we try to ascertain whether a business is a good business and if so, whether now is the right time to be invested or not.
In 1984, on a late-night flight from Paris to London, a chance encounter between Jane Birkin, the actress, singer and model, and Jean-Louis Dumas, the CEO of Hermes, resulted in a moment of inspiration that created the Birkin Bag. Nearly 40 years later, The Birkin is well established as Hermes’ most iconic and desirable handbag. Demand for these bags significantly exceeds their carefully managed supply and even second-hand prices can be stratospheric. The Birkin is a wonderful example of the power of human desire for beautifully made, scarce items and it is this longstanding desire that drives powerful, resilient economics for a company like Hermes.
The history and heritage of the brand is a crucial driver of desirability for any branded goods company. The history of Hermes goes back a long time before the iconic Birkin was dreamt up. In 1837, Thierry Hermes opened his first workshop in Paris, specialising in harnesses. Made-to-measure saddles followed, with the establishment of a broader leather goods offering during the interwar period. Today, Hermes has grown into a global company employing nearly 20,000 people and generating revenues of over €11bn.1 The power of the business today stems from the history and heritage of the brand.
You can’t create heritage, you can’t invent a history, but brand desirability is inextricably linked to the past. This gives companies like Hermes a huge competitive advantage and creates a powerful moat around their business. Hermes is a great example of a company with a carefully protected brand heritage – this drives attractive and durable economics for shareholders. We have owned Hermes since 2014 and continue to see attraction in the long-term investment case, the key pillars of which are laid out below.
Desirability, brand heritage, and limited supply drive attractive gross margin dynamics…
Heritage and history are extremely important elements of brand desirability. However, brands can lose their desirability over time. Hermes has consistently invested in its brand and has maintained exceptional manufacturing quality, with every Hermes bag handmade, and hand stitched in an artisanal workshop.
Another risk to a brand comes from the supply side. A desirable, aspirational brand loses its appeal the minute that supply exceeds demand – humans desire things that they can’t have! Hermes carefully manages the volume of products which they manufacture, tightly controls the distribution chain, and ensures that demand growth exceeds supply growth year-after-year. Waiting lists are the norm for their most desirable products. This has helped drive brand desirability and, with it, Hermes’ ability to charge prices significantly ahead of the cost of the raw materials used to make a particular product.
These factors – amongst many others – contribute to high (~70%) gross margins for Hermes.1 These exceptional gross margins are a key element of the overall strong economics delivered by the company.
High gross margins enable Hermes to invest heavily behind the brand whilst also generating high levels of profitability…
High gross margins mean that for every unit of revenue that Hermes receives, they simply generate more profit and cash than a lower gross margin company would. This is extremely important and acts as a significant competitive advantage. It provides Hermes with the firepower they need to consistently invest in the brand and to grow the business. They spend less than you might imagine on Advertising & Promotion (circa. 5% of sales versus some peers at 10% of sales), but that is the beauty of operating such a well-known brand with such a long history behind it.1 The strong presence of flagship stores helps build their brand presence as well as acting as a core sales channel; most of their operating costs are focused on investments behind their retail stores.
With 70% gross margins, Hermes is able to invest around 30% of sales in operating costs (advertising, costs associated with the stores etc) whilst still generating extremely healthy operating margins of around 40%.1
Low capital intensity and working capital needs combine with high margins to drive an attractive return on invested capital…
Though Hermes is a vertically integrated business, it is operating in an industry where capital intensity is not high. This factor combines powerfully with the high margin structure to ensure that Hermes generates a very attractive return on invested capital. In 2022, Hermes generated €4.7bn of operating income, and with a 29% tax rate, this resulted in net operating profit after tax of around €3.3bn.1 From my calculation, its average invested capital for 2022 was around €5.1bn, meaning Hermes is currently generating a return on invested capital of around 65%.2 This is exceptional when compared to the wider market. There are not many companies in Europe that can match this kind of economic performance.
Long term wealth creation and the growth of aspirational, middle-class consumers in emerging markets continues to drive significant growth…
For any potential investment, growth in revenues and earnings are not necessarily attractive or desirable. It all depends on how much capital is required to fund that growth and what return on capital the company is able to generate. As I have shown above, Hermes is able to generate very attractive returns on capital. Therefore, this is a company that we want to grow – we love it when they are able to deploy capital for further growth. Growth is a significant part of the attraction for us with a business like this.
In 2012, Hermes generated €3,484m in sales, by 2022, revenues have expanded to €11,602m.1 Clearly, part of this strong growth (12.8% compound annual growth rate) is related to the strong desirability that Hermes has and their success in expanding to new customer groups in new regions.3 However, an important reason for why we like Hermes simply relates to the industry in which they operate. The luxury goods industry has experienced significant growth over the past 20 years, driven by powerful structural themes, whilst Hermes has managed to consistently outgrow the sector; from 1999-2019, the sector has grown at a 7-8% CAGR, whilst Hermes has grown at an 11% CAGR.4
Global wealth creation is the most powerful sector driver. Over the past 20 years, global wealth has grown by 7% per annum and this is set to continue. The wealthy are getting wealthier, and the growth of the middle classes in China, India and other regions is helping to support global wealth creation. This is a major growth driver for the sector.5
Family ownership and control drives long term behaviour…
A final point worth discussing is the fact that Hermes is a family-controlled company. Different investors view family ownership in different ways. As a general rule, we like to invest alongside families that have been longstanding owners of a business. We take a long-term view when judging the merits of a particular company and this aligns with family owners who tend to care about the long-term wealth creation that comes from their stake in the company, rather than being concerned with short term profitability. Thus, family control allows the management team to think and act in a long-term way without being worried about whether they might be judged on shorter term metrics. This fosters the perfect environment for maintaining the power of a heritage brand; the long-term health of the brand should trump concerns over short-term profitability every time. With Hermes, we truly believe this to be the case and the family ownership plays a significant role in this.
Recently, the family behind Hermes have committed to maintaining their controlling stake in the until 2041 at the earliest. We see this as very good news.6
2Source: Henderson EuroTrust, 2023
4Source: Citi Research – The Power of a 183-year-old icon, 26 June 2020
5Source: Credit Suisse – EMEA Luxury Goods: Entering a new dawn – 50 key questions for luxury investors, 8 November 2022
High gross profit margin – A high gross profit margin indicates that a company is successfully producing profit over and above its costs.
Invested capital – intangible assets + right-of-use assets + property, plant & equipment + inventories + receivables – payables
Return on invested capital (ROIC) – Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency in allocating capital to profitable investments. The ROIC formula involves dividing net operating profit after tax (NOPAT) by invested capital.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
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