Hermès: Capitalizing On Heritage
Performance is important, but resilience is of paramount importance.
Axel Dumas, Hermes’ CEO
Hi reader and welcome to yet another Best Anchor Stocks deep dive,
If you have not read the prior deep dives, I just want to let you know that they are accessible through the “Deep Dives” tab in bestanchorstocks.com, but I’ll leave them below too:
Deere: Cultivating Technology (this deep dive is free to read)
In this deep dive I’ll profile Hermes, one of the highest-quality companies I have ever come across. I think Hermès is, by a pretty wide margin, the best publicly traded luxury company and probably the best luxury company in the world even if we include privately owned businesses. I would only consider Brunello Cucinelli and Ferrari as publicly traded peers that come close in terms of brand equity. I don’t think these three companies are comparable to any other company in the luxury space (I have some doubts about Brunello, but not about Ferrari). The market also sees it this way, ascribing a significantly higher valuation multiple to the “Big Three” (any tennis fans here?)
Why does the market grant a significantly higher valuation to these companies? Most likely, this has to do with their terminal value. This is a term that I’ll use quite a bit in this deep dive because it’s critical to understanding the thesis and Hermès’ valuation. In short: Hermès is a terminal value play.
Something critical to understand about any luxury company is its history because it plays an outsized role in its terminal value. Contrary to what many people think, luxury is not a synonym for high prices; it’s a synonym for trust and exclusivity, which can only be built through time. Many companies have tried to disrupt the true luxury companies by offering high-quality products at very high prices but have failed miserably (I’ll later share one example). It’s basically impossible for a company to become true luxury in 5 or 10 years because it takes many generations to build this trust. I like how this former Hermes employee frames it:
Luxury is going to remain. The big players have credibility. It’s hard to build credibility, especially in luxury. What luxury is known for is quality and status. It is hard to build luxury without any type of history or base.
The luxury industry deserves a deep dive in its own right, primarily because it defies economic logic. I participated in a podcast with my friends Ryan and Brett from Chit Chat Stocks and Sleepwell Capital where we discussed the luxury industry. I think this podcast should serve as a good starting point if you are not familiar with the industry so feel free to give it a try.
The “funny” thing about this story is that I conducted my initial research on Hermès when the stock was hovering around €900 - €1,000, but I decided to pass because I had yet to finish some parts of my research. With the stock now hovering around €2,000, it’s pretty obvious I made a mistake by not starting a position then, although I eventually took advantage of an opportunity to add it to my portfolio. As you’ll see later on, Hermes is not a company that gives lots of opportunities to investors and the first thing that might come to your mind is…
Isn’t this insanely expensive?
While I do feel that Hermes is a special company that should trade at a special multiple, we should never disregard valuation. This is a topic that I’ll go over in the final part of this deep dive, which will be divided as follows:
Section 1: History and What the company does
Section 2: The Financials and Growth Drivers
Section 3: Competition, the Moat, and Risks
Section 4: Management & Incentives, and Capital Allocation
Section 5: How the company complies with the Best Anchor Stock traits
Section 6: Current status and valuation
Section 7: Concluding remarks
Before jumping directly to the company’s story and what it does, let me share a snapshot:
The first section of this deep dive will be free to read, with the remaining (together with the PDF) only being available for paid subscribers. You can sign up to Best Anchor Stocks using the link below:
If you are a subscriber and want to read this deep dive on PDF format, go to Section 2 directly.
Section 1: Hermes’ long story and what it does
Luxury can be traced back to ancient Egypt when a select few started amassing exclusive goods and experiences:
This was some 5,000 years ago, meaning that luxury has existed for quite some time. It was not until ancient Greece that luxury started gaining some negative connotations (some of which remain today); some people saw it as virtue; others saw it as vice. Despite these negative connotations, luxury will always be intrinsically linked to human nature. Humans have craved social status since (not coincidentally) Ancient Egypt, meaning that luxury and social status have gone hand in hand for thousands of years. With the rise of social media, there are reasons to believe that the impact of social status on our lives has increased, not diminished.
If we think about it, luxury makes no economic sense. We are taught that, in most products, the quantity decreases when the price increases. However, in luxury, these variables go hand in hand, giving rise to what we know as Veblen goods:
Wikipedia defines Veblen Goods as…
…a type of luxury good for which the demand increases as the price increases, in apparent contradiction of the law of demand.
Luxury has survived humanity's most challenging problems and is still highly sought after today; it’s the perfect example of Lindy (I wrote an article on this concept which you can read here). Lindy characteristics are great because history becomes a competitive advantage for companies exhibiting them. This means that competitive advantages get stronger simply with the passage of time (something that also defies economic rationality and the forces of capitalism):
The Lindy effect proposes the longer a period something has survived to exist or be used in the present, the longer its remaining life expectancy.
Although Hermès is famous for being a French luxury house, its roots can be traced back to Germany, more specifically to the city of Krefeld. It was in this small city in West Germany where Thierry Hermès was born in 1801.
The city was French at that time, as it was under the control of Napoleon Bonaparte. What has never changed is the city’s denomination: “the city of velvet and silk.” Hermès would be later known for its silk scarfs, worn by the Elite Society. It’s a product that Queen Elizabeth wore throughout her entire lifetime:
In 1821, Thierry Hermès started working for the Pleumer family manufacturing saddles, expertise that would later come in handy in his new venture. After several years, in 1837, he decided to move to Paris to start his own equestrian supply business, which would eventually become the luxury powerhouse it is today; Hermès had just been born. This makes Hermès the oldest company in my portfolio at 187 years (together with Deere):
But, why did Thierry Hermès start his venture manufacturing saddles? Context is important here. Horses were the main mode of transportation back then, so an equestrian supply business could ultimately be seen as the picks and shovels for the transportation industry:
The world eventually transitioned to petrol cars in the 1920s, but Hermes never discontinued its saddle business to remain true to its heritage. While this segment might be irrelevant today in terms of revenue, it remains key in terms of brand image. In the words of a former employee:
Equestrian is not big in the revenue, but it is big for the image. It’s making them more legitimate compared to a Louis Vuitton, for instance, who doesn’t have this kind of background to be legitimate with leather.
Despite the company continuing its saddle operations, there was no denying that the segment was facing a terminal decline as cars quickly replaced horses. This surfaced the need for a quick pivot into other categories.
This pivot was possible thanks to Emile Hermès. Thierry Hermès, Hermès’ founder, died in 1878 at the age of 77 and left the business to his sons: Emile and Adolphe. Both followed a similar strategy at first: they continued to evolve Hermès, increased production without compromising quality, and filed for the patent of zips, known as “Hermès Fastener” (yes, the zip was invented by Hermès!).
However, everything started to fall apart with the end of the First World War. Adolphe did not want to pivot despite horses becoming irrelevant as a transportation mode, but Emile remained committed to diversifying the business.
The brothers did not reach an agreement, so eventually (and luckily for Hermès), Emile decided to buy Adolphe out and started the diversification journey. Emile wanted leather to be at the core of Hermès, so he took advantage of the versatility of this material. Under his leadership, the company diversified into handbags in 1922, pets in 1927, clothes in 1929, and watches at the end of that same decade (this segment remained small until the company established swiss making operations 50 years later). Emile died in 1951, the same year when Hermès launched perfumes.
After strong growth, Hermès started to stagnate in the 1970s, so a change was needed. In 1978, Jean-Louis Dumas became CEO (fourth generation), putting Hermès back on its upward trajectory.
He made a choice that would set Hermès apart from peers by setting the foundations of the company’s artisanal production model. During his tenure, he was advised several times to outsource production because workshops were not operating at full capacity. He declined to do it, arguing that it would negatively impact quality. Today, more than 80% of the company’s products are hand-made in France by the company’s artisans, although the problem today is one of undersupply, not oversupply.
Jean-Louis Dumas was also the protagonist of another key moment in Hermès’ history: the birth of the Birkin. Dumas met Jane Birkin (an actress) on a plane in 1984. She complained about the design of her bag, so Dumas offered to design one for her, giving birth to the Birkin, probably the now most iconic handbag in the world. It’s Hermès’ most exclusive product, and resale values are typically 2 or 3 times higher than retail values:
To even get a chance to purchase this bag, customers must spend around 3 times its worth on other Hermès products. This is probably the main reason why the resale value is so high as one doesn’t need to spend this money when buying a Birkin in the secondary market. Only after this upfront “cost” will Hermès take these customers to the back of the store so they can choose one of its famous bags.
Some people will argue that Hermès’ management is artificially reducing the supply of handbags to retain exclusivity, and while this is definitely a believable claim, Hermès’ management argues that supply takes time to come online due to the artisanal model but that it’s not artificially suppressed:
We're not trying to limit production. We're not artificially creating selectivity. We're trying to produce as many as we can.
Source: Axel Dumas, Hermès’ CEO, during the 2022 earnings call
Jean-Louis Dumas was not only a key person in Hermès history due to his focus on the artisanal model and the launch of the Birkin, he was also an excellent operator. Under his leadership, sales rose from $82 million in 1982 to $446 million in 1989 (27% CAGR). There’s more to his tenure, though. He IPOed the company in 1993, only making 19% of the float available to the public; the reason? So that the family could retain a majority ownership.
Being a public company turned out to be more of a challenge than previously anticipated. Bernard Arnault, LVMH’s CEO and arguably one of the greatest CEOs of all time, tried to build a stake in Hermès using derivatives to avoid disclosure requirements. Eventually, the Hermès family found out and took Bernard Arnault to trial. In 2014, he agreed to dispose of his shares and abandoned his quest to take over the company. The Hermès family currently owns around 68% of the company through a company called H51 (which stands for the 51 Heirs of Thierry Hermes).
Jean-Louis Dumas retired in 2006 and left his position to the first non-family CEO in the company’s history: Patrick Thomas. However, his son, Pierre-Alexis Dumas, retained the artistic director position, which is arguably more important than the CEO position at Hermès. Pierre-Alexis’ cousin, Axel Dumas, eventually became CEO in 2014, a position he still holds today after starting his career as an intern.
Hermès’ almost 200-year-long history was not without challenges, but the company never pivoted away from its core: an artisanal model to preserve the highest quality standards. This eventually transformed Hermès into a true luxury company positioned to endure for generations.
What Hermès does
I will not spend too much time on this section because I believe that, as a consumer-facing company, Hermès’ business is somewhat straightforward to understand. Hermès is a French independent, family-owned and operated (the highlighted words here are very important) luxury house that operates in more than 45 countries. It’s one of the few luxury houses that still follows a pure artisanal model, with more than 80% of the company’s products hand-made in France across 52 workshops:
The company operates one single brand (something that’s also quite rare) across 16 métiers or product lines, all of which have been built organically. The company will, from time to time, conduct acquisitions across its supply chain to vertically integrate but will not acquire other consumer-facing companies.
The most important metier for the company is leather goods and saddlery, which made up 41% of the company’s revenue in 2023:
This is normal, not only considering the company’s roots but also the fact that handbags are included in this métier and are one of the most popular luxury goods in the world. Let’s not forget that the company’s two most iconic products are handbags (the Kelly and the Birkin) and both are highly sought after.
Just so you get a sense of prices here, the Kelly typically retails for somewhere around €7,000, whereas the Birkin is a bit more expensive at €10,000 (there are stark differences in price according to the type of leather used). An interesting stat here: both handbags have enjoyed a price increase CAGR of +4% over the past 50 years without impacting demand. Oh wait, this is a Veblen good…not only has demand not been impacted for these products: it has grown significantly above supply. Imagine manufacturing a product that…
Has enjoyed a 4% price CAGR over the last 5 decades
Has seen demand grow significantly above supply despite these price increases
Still retains similar pricing power
This is what Hermes has with the Birkin and the Kelly.
Each Birkin bag is made by the same artisan from start to finish, which takes around 15 hours. This artisanal model makes capacity expansions quite challenging, more so considering that management claims it can only train between 260 and 300 artisans a year. Note that an artisan works around 34 hours a week. This means there are around 1,600 hours of work available for each artisan a year, setting the max capacity at around 100 Birkins per year and artisan.
Does management “artificially” cap supply to retain exclusivity? Well, while there might be some truth to this, it’s also true that capacity expansions seem capped by the nature of the company’s business. Could Hermès grow capacity faster by outsourcing production? It sure could, and this is the route many other companies have chosen. However, this would most likely challenge the company’s quality standards and, thus, the terminal value.
We’re in a house where we have a production which is capped by the number of persons and the number of hours worked.
Source: Axel Dumas, Hermès CEO, during the H1 2023 Earnings Call
Management has announced significant capacity expansion investments in the coming years, although this capacity will take time to come online. Due to training and other things, a workshop takes between 1 to 1.5 years to become fully operational.
Hermès sells its products across a wide variety of geographies. Asia is the most important, generating 56% of the company’s sales, followed by Europe and the Americas. I would argue that the exposure to the Asian consumer is even higher, as these consumers tend to purchase luxury goods when they travel to Europe or other countries:
Something interesting that Hermès has and not many other companies do is that store managers are in charge of choosing the inventory for their stores. This allows store managers to give a local feel to their stores, only selling those products they believe will do well. This also has a beneficial impact on the customer experience. A customer going to the Hermès store in Amsterdam can go to a Hermès store in Paris and see a completely different product assortment:
Our policy is based on the talent and boldness of our strategic directors and the freedom of purchase of our sales teams. This means our stores are all unique spaces.
Source: Axel Dumas, Hermès CEO, during the 2022 Annual General Meeting
Hermès’ stores are typically located in the best spots in cities with high purchasing power, and they are…well, special. For example, the Amsterdam store’s facade is covered with crystal handmade bricks:
The company owns around 300 stores, a number which has remained somewhat static over the last years.
We must not forget that the fact that the company’s real estate is located in the best spots limits the store expansion opportunity. Rarely are these spots empty. A small caveat here…Hermes, unlike other luxury companies, is not always located close to its peers and in the “best” spots. Management believes their store serves as an attraction to the customer, meaning that the customer will go wherever they are located. This strategy has played out well and has allowed the company to somewhat leverage flagship store costs.
Hermes has, however, another way to grow its footprint: store remodels and expansions. This is where most of the investment is currently going:
We pursue investments in the multi-local retail networks, with the 2023 over 20 projects for enlargement and renovations.
Source: Axel Dumas, Hermès CEO, during the H1 2023 Earnings Call
Every square meter added to the stores is relevant because store efficiency is outstanding:
So we reckon roughly their sales per square meter will be about €50,000, which I actually can’t imagine off the chart, even Apple in its prime, the Fifth Avenue store, it was nowhere near that.
Source: Business Breakdowns
Assuming that incremental returns diminish as the store gets larger, we could argue that Hermes can add around €300k and €400k in sales per every 10 square meter expansion. These increased sales would arguably come at a good margin considering that expansions and remodels require significantly lower investments than store openings.
The company also sells certain items through wholesale, although these are restricted to certain métiers (jewelry, homeware, perfume…). (True) Luxury companies typically refrain from selling across wholesale because they want to remain in control of the customer experience. This is probably the reason why wholesale distributors of luxury products (like Farfetch) have ended up exposed to the aspirational brands rather than the true luxury brands (yes, you can find a Birkin on Farfetch, but it’s not being sold by Hermes directly, in fact, reselling a Birkin is frown upon in Hermes).
eCommerce is another channel the company uses to sell its products. Management was initially reluctant to use this channel due to the potential uncontrollability of the customer experience, but the pandemic sort of forced this move. They have since become increasingly open to e-commerce, especially since it helps with customer acquisition considering that 78% of the company’s e-commerce customers were new to the brand.