Richemont - Luxurious downturn

Management did not prepare itself enough for changing economic conditions

Andrew McNulty,SA Financial Times,13 June 2003

At the Richemont AGM in September 2001, chairman Johann Rupert quoted some supply-side analysts who had named him "Rupert the Bear".

He reminded investors that he had regularly expressed caution about the market for luxury goods in a weakening world economy, accompanied by adverse movements in exchange rates and geopolitical shock.

"I expressed concerns about the sustainability of the unprecedented growth in worldwide equity markets from 1992 to 2000, which led to large increases in consumers' propensity to spend on luxury products."

The group's results for the year to March 2003 vindicate his caution. Sales were down 5% to euro 3,65bn and operating profit slumped by 46%, slightly worse than was foreshadowed in a trading statement in February.

Investors can hardly be surprised that luxury-goods markets are tough. What they may find more striking, however, is just how vulnerable Richemont's profits have proved to be in the downturn, given Rupert's stated conservatism.

Its operating margin (before restructuring and impairment charges) has fallen from last year's 13,3% to 9,6%. A few years ago it was about 16%. Also notable is that analysts are comparing its sales performance unfavourably with those of rivals in the luxury-goods sector, such as Bulgari and Tiffany.

What perhaps contrasts most sharply with Rupert's stated conservatism in earlier years is the sharp rise in group operating costs, capital expenditure and working capital in the downturn.

This followed an aggressive expansion of the group's distribution network, as well as acquisitions made near the top of the cycle - notably the SwFr3bn purchase, in 2000, of three leading watch-making companies, Jaeger-LeCoultre, IWC and A Lange & Söhne.

In short, the severity of the profit slide can be blamed partly on management, not only on markets. Rupert, who became executive chairman last year, acknowledges this. He ends his 2003 chairman's comments with a mea culpa.

"It is disingenuous to blame all our woes on external factors and I will not do so," he says. "The good years' led to contentment and, when contentment sets in, progress ceases.

"To my embarrassment, Richemont was not as prepared as it should have been for these changed circumstances. We were too slow."

Now management is taking action. The Cartier watch-making capacity in Switzerland will be rationalised, with the loss of 200 jobs. Some stores will be closed to shrink the cost structure.

Improved disclosure in the latest accounts, which now provide a detailed breakdown of profits in the various business sectors, reveals hefty losses in the division called "textiles, leather and other businesses".

Last year these activities - consisting mainly of Alfred Dunhill and Lancel - lost euro 67m; this year, the loss has risen to euro 71m. Rupert says Lancel's troubles go back about two to three years. In Dunhill's case, it's at least four.

Expansion in the face of weak markets was part of the cause. However, Rupert says Dunhill's problems were worsened by changes in strategy and philosophy. An analyst contends this business may have confused consumers by quickly expanding its product range. Rupert adds that Dunhill continues to do well where it retained its traditional business model, and emphasises management's confidence in the long term.

Steps now being taken to lift Dunhill's profits include moving its distribution activities from retail to wholesaling in the US, where all Dunhill outlets, except a new flagship store in New York, are being closed. Lancel has closed 16 stores, mainly in the US and Belgium.

The rationalisation carries big costs, which have worsened the group operating result. Provisions for store closures and other such measures at Dunhill and Lancel totalled about euro 52m. In the manufacturing operations, there are restructuring and impairment provisions of about euro 39m.

In other areas, the news is more positive. Between 1999 and 2002, group capital spending ballooned from euro 75m to euro 308m. Working capital also soared, rising by euro 270m in 2001 and by euro 375m last year. Rupert says both have now been pared back sharply, resulting in a euro 500m positive movement in free cash flow. If this can be maintained, he says, in a year the group could have eliminated its net borrowings ( euro 1,18bn at March 31).

"That would put us in a very strong position," he told the FM this week. "We would be unique in our sector." But there is little assurance that the rationalisation costs are over. Indeed, analysts are expecting more provisions next year. As Rupert puts it, management has started with the low-hanging fruit. The group continues to examine other steps to be taken if markets and profitability fail to recover.

It seems clear management is in a phase of extensive re-evaluation and introspection. That includes the management team and structure. Alain Perrin is to retire as group CE in October. The slimming down extends to central and regional structures, and Rupert cites a need to reduce bureaucracy.

In one sense, investors might consider the group is taking a big bath in its latest accounts. Aside from the poor operating result and provisions, goodwill of euro 3,4bn in the luxury goods activities has been written off against unitholders' funds. This reduces the restated unit holders' equity at the 2002 year-end by almost 40% to euro 4,9bn.

This reflects recognition of an impairment of value, but some write-down was probably inevitable. Much of the goodwill was acquired through Richemont's expensive purchases of luxury-watch companies three years ago. It paid a substantial price for assets it considered to be strategic.

"I've said publicly before that we overpaid," says Rupert. "But if it came up again, I would do it again, though we would not overpay by as much."

However, the key questions for Richemont - and for its share - are about its ability to achieve turnarounds in activities that are struggling and to lift group sales. The latter requires more than just coping with the general malaise in the world economy and weak consumer confidence.

Sales of luxury goods depend heavily on travel and tourism. Of Richemont's total sales, 43% are to Europe and 38% are to Asia, with Japan the largest single market; only 19% are to the Americas. Rupert says there are signs that the Sars illness may be passing in Asia, but a recovery in tourism in areas such as Hong Kong would be off a low base.

Exchange rates are also critical. The jewellery maisons, Cartier and Van Cleef & Arpels, contribute most of the group's profits, yet their sales slipped in 2003 by 8%. Sales by Cartier, Richemont's largest business, were dragged down by the weakness of the dollar and yen against the euro. Even some European markets have been grim. In Germany, sales slumped by 16%.

In part, a sales recovery will depend on management's own efforts. On average, Richemont spends about 10%-12% of its sales on advertising and promotion. However, Rupert concedes the group has been weak at creativity and new product launches.

This group's margins and profits should be highly geared to any sustained recovery in sales. But the signs so far are hardly encouraging. Probably the most negative aspect of the results announcement was the news that sales in constant currency were down 19% in the first two months of the current year.

Analysts remain confident in the long-term value of Richemont's leading brands, such as Cartier. For now, though, they tend to view the counter as a hold until the recovery is seen to be working. Johann Rupert - Time to take action Profit broken down Price trend Richemont results table.