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From Special Report: Luxury Property - May 2012

Luxury comes of age in China

The craze for prime Chinese property is just a single example of a broadening luxury culture in the country

By Arjen Los | Published May 14, 2012 | comments

As demand for luxury property in China reaches historic highs – prices in Hong Kong have surged by more than 50 per cent since early 2009 – so too has the demand for high-end shopping malls and the luxury goods sold within.

Producers of luxury goods have enjoyed many years of impressive growth in demand for their products in the emerging market. However, a number of commentators have been raising the possibility of a ‘hard landing’ for the Chinese economy while Chinese officials tempered economic growth targets.

Therefore, given the changing nature of the Chinese economy, or at least the perception thereof, a re-examination of the prospects for the luxury sector within China seems timely.

On closer examination of likely economic trends and, most importantly, the earnings reports of companies involved in distributing discretionary or non-essential consumer products, the conclusion is that the long-term growth within the sector continues unabated. One is also reassured by the manner in which key producers have adapted their product range to local tastes and market circumstances.

Recently China’s authorities have started to steer opinion makers (and its citizens) towards a lower target for economic growth. During the 11th National Peoples’ Congress, Chinese premier Wen Jiabao revised the nation’s growth target down from 8 per cent to 7.5 per cent. This announcement prompted various forecasters to reduce global growth estimates but, on reflection, the significance of a reduced growth target seems limited: China has a record of consistently exceeding its growth targets.

Also, Chinese officials are explicitly targeting an increase in consumption as a proportion of GDP, aiming to raise it to 45 per cent of GDP by 2015 from today’s level of 35 per cent. Based on 2011 figures from the IMF, this would represent an increase of $2.2trn (£1.4trn) in just four years.

In the context of this “consumption policy”, it is not surprising that lowering taxes on luxury goods is on the political agenda.

Luxury goods taxes vary significantly between products, ranging from 30 per cent for handbags to 20 per cent for apparel and 10 per cent for jewellery.

Policymakers would have noticed that mainland Chinese residents are avoiding luxury taxes by shopping in Hong Kong but also that shopping tourism to Europe and the US has been increasing dramatically.

A reduction of luxury goods taxes will have two effects: purchases will move towards mainland shops, while there could be downwards pressures on prices in line with lower taxation. Nevertheless, on balance, one can expect a boost to the profitability in the sector.

Companies with a comprehensive Chinese distribution base are likely to be disproportionate beneficiaries. This would include BMW, Coach, Estée Lauder, LVMH, PPR (which owns Gucci), Prada, Richemont (which owns Cartier), Swatch and Tiffany.

In the luxury segment, the absence of so-called A1 shopping streets comparable to London’s Bond Street means that expansion is being determined by the pace of shopping mall openings. The location of consumers is gaining in importance as income that can be spent on discretionary purchases is now growing at an accelerating rate in western and central areas of China and at a higher pace than in the more affluent eastern regions.

As a result, the momentum propelling this growth is shifting to so-called tier three and four cities as these cities are now crossing key income thresholds where demand for modern consumer products accelerates.

This represents an important expansion of the available market. Tier one and two cities (Beijing, Shanghai, Guangzhou, Chengdu and provincial capitals) have a combined population of roughly 80m while the tier three and four population (roughly 2,000 regional cities) adds up to 161m. (Tier five, mainly rural villages, has 169m inhabitants).

In the main cities there are signs that markets are maturing. According to Nielsen, facial products are showing high growth but also reflect increasing sophistication among female consumers. Beijing also witnessed the opening of its first outlet mall, Florentia Village, which occupies 60,000 square metres.

Better earnings

Retail sales in China increased by 18 per cent in 2011 and, according to Nielsen, the luxury goods sector grew by roughly a third. This high growth has been reflected in recent corporate results, as companies with established distribution in fast-growing markets have tended to record better earnings than expected.

Dress watches are a top luxury product in China with persistently strong growth. This looks unlikely to change as according to the Swiss watch-making federation, exports to China showed the strongest rise (49 per cent growth) while Hong Kong also showed strong growth (28 per cent growth). This impressive growth has been confirmed by the main Swiss watch producers Richemont, Swatch and LVMH, which continue to report record watch sales in Asia.

Outside classic luxury goods one cannot help but highlight Apple. The company has a unique line-up of products that benefit from increasing discretionary spending. Apple recently surpassed earnings expectations – profits doubled in the most recent quarterly report – for numerous reasons. China was an important factor, as rapid demand for the iPhone saw sales in China reaching almost $8bn (a threefold increase from a year ago) in the quarter up to March.

Worldwide, premium cars are a symbol of affluence within the middle classes. This is no different in China, but the Chinese expect a luxury car to be chauffeur driven. BMW has been an astute adaptor in this market, changing its products (lengthening the Five and Three series) to meet local demand and has been aggressively building production and distribution in the country.

In assessing aspirational goods and discretionary spending in any emerging market one has to factor in locals tastes and cultural backgrounds. Goods that might not be considered luxury items in Europe, for instance, might be aspirational in Asia.

What matters, to companies and investors, is how growing discretionary income is being spent and which companies will benefit, in the form of pricing power, from this consumer behaviour.

The luxury goods sector had another stellar year in 2011 with sales growth, on average, reaching almost 20 per cent. Thanks to operating leverage, profit growth amounted to more than 30 per cent. The earnings reports from companies producing luxury goods and services in high-growth emerging markets – China in particular – have surpassed expectations again so far this year.

Although management of the companies are understandably cautious as far as mature markets are concerned, they consistently remain optimistic with respect to the Chinese market. Urbanisation has barely surpassed the 50 per cent mark, as a proportion of the total population, and income per capita is still significantly below western averages. The structural growth in middle classes and discretionary income still has a long way to go. However, property is not the only beneficiary of the Chinese luxury trend.

Arjen Los is chief investment officer at Dominion Group

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