Hermès: The pinnacle of timeless luxury and craftsmanship

The secret sauce – the 7 powers analysis

Helmer’s 7 Powers framework, developed by Hamilton Helmer in his book "7 Powers: The Foundations of Business Strategy", provides a structured approach to evaluating a company's strategic positioning. It can help investors understand why a company has a high ROIC and whether it has endurability. Below we analyse Hermès in each of the seven powers.

1. Scale economies - Large-scale production allows Hermès to spread its fixed costs over a greater number of units, reducing the average cost per unit.  As a global brand, Hermès can leverage its extensive marketing campaigns across multiple regions, maximizing its reach and impact while minimizing the per-unit marketing cost.

2. Network economies - While network effects are more pronounced in tech companies, Hermès experiences a form of network economy through its loyal customer base and brand community. Owning Hermès products often serves as a social status symbol, encouraging more customers to buy its products to be part of an elite group.

3. Counter positioning - Unlike competitors who may pursue broader market segments, Hermès focuses on maintaining high prices and limited availability, which reinforces its luxury image. Hermès emphasizes traditional craftsmanship and high-quality materials, distinguishing itself from brands that may adopt more industrialized production methods.

4. Switching costs - Many Hermès products, such as the Birkin bag, are personalized and have a heritage value, making customers less likely to switch to other brands. Hermès products often retain or even appreciate in value over time, making them attractive investments for customers who are less likely to switch to other brands that do not offer similar value retention.

5. Branding - With a history dating back to 1837, Hermès is synonymous with luxury and exclusivity. Its brand is built on a legacy of quality and craftsmanship. Items like the Birkin and Kelly bags have achieved iconic status, reinforcing the brand's allure and desirability.

6. Cornered resource - The company employs highly skilled artisans whose expertise in leather craftsmanship is a key differentiator. Hermès has access to rare and high-quality materials, such as their specific leather types and silk, which are not easily available to competitors.

7. Process power - Hermès maintains rigorous quality control processes to ensure that every product meets its exacting standards. Unlike many luxury brands, Hermès produces a significant portion of its products in-house, allowing for greater control over the manufacturing process and maintaining high standards of craftsmanship.

It is clear that the company's competitive advantage lies in its strong brand identity, high switching costs, exclusive resources, and control over its production processes. These factors collectively enable Hermès to maintain its position as a leading luxury brand with sustained profitability and market dominance.

Quality characteristics: The power of margin expansion and consistent growth

It is without doubt that Hermès is a high quality company. Not only because of its high quality products, but also the way the company is managed. Revenue has grown from €1.8bn in 2008 to €13.4bn in 2023 translating into 14.5% annualised revenue growth over 15 years. This growth rate is significantly above the average growth rate observed in the equity market and is the first beacon of growth. It all starts with revenue.

The next marker of high quality is not only the high EBITA (earnings before interest tax and amortisations) margin but the expansion over the past 15 years. In 2008, the EBITA margin was 27.5% and whopping 42.9% in 2023. This is simply outstanding. One might wonder why we focus on EBITA and not EBITDA. This is because EBITA gives a more realistic view of a company’s recurring revenue operational profitability and because it includes depreciation it takes into account the costs tied to maintaining long-term operational assets.

The final quality characteristic is the combination of high ROIC (return on invested capital) at around 35% compared to only 10% cost of capital and the growth rate of the invested capital. Sometimes the problem for a ROIC company is that it is difficult to reinvest into the business at high levels, but in the case of Hermès the company has been able to grow the invested capital by 17% annualised while maintaining  a very high ROIC.

It should be clear by now, that Hermès brand is one of its key competitive advantages against the competition. The impressive part is that Hermès has invested around 4.5-5% of revenue into its brand every year since 2008. Even without meaningfully increasing spending on the brand the company has been able to grow revenue at a faster pace and maintaining a solid position.

Key risks: It is all about the brand

Luxury goods are typically very sensitive to the economic cycle but the 2008-2009 cycle showed that Hermès was able to grow through economic stagnation. The business is larger and more diversified, so the sensitivity to a recession might be bigger next time. As Asia-Pacific is the biggest revenue source the economic growth in Asia is the most important driver of Hermès’ future revenue.

The brand's value is closely tied to its reputation. Any scandal, quality issue, or negative publicity can harm the brand's prestige and customer loyalty. This is probably the biggest risk facing investors in Hermès shares.

Hermès' emphasis on artisanal craftsmanship, while a key strength, also poses a risk. Any disruptions in the availability of skilled labour or key materials can impact production capabilities and timelines. The reliance on rare and high-quality materials can lead to supply chain challenges. Any disruption in the supply of these materials can affect production and profitability.

Changes in trade policies, tariffs, and international relations can impact Hermès' ability to operate smoothly across different markets. For example, heightened trade tensions between major economies can affect costs and supply chains. Another risk is shifts in consumer preferences, especially among younger demographics, can affect demand for luxury goods. Trends towards sustainability and ethical consumption may require Hermès to adapt its practices and product offerings.

What defines a quality company?

Quality companies can be defined in many different ways just like value. MSCI, which is world’s largest equity index provider, has defined it using three fundamental variables return on equity, debt to equity, and earnings variability. This definition makes sense because it can be applied to all companies regardless of which sector they are part of. The definition puts emphasis on profitability relative to the deployed equity, leverage ratio (less debt leverage relative to equity is good), and finally the predictability of the business with less variance in earnings being a good thing. In our past equity research we have also found that the lower earnings variability a company has the higher its valuation becomes, so this is a quality marker.

In our equity research note Top quality companies and how to decode their traits we focused on return on invested capital (ROIC) relative to the cost of capital (WACC) as the key measure to identify quality. Next we explained, that around half of those companies with the highest ROIC see their ROIC falling from the top to outside the top over three years due to competition or changing technologies. This is the quality trap that investors need to avoid. It is about finding enduring quality. The “7 Powers” framework is a good approach to analyse whether a company has enduring characteristics or not. Finally, a company can have a stable spread in ROIC minus WACC with a ROIC not in the absolute top and still be a phenomenal stock for shareholders. All it requires is that the business can invest a lot into the business. Historically, Walmart was exactly such a case.

The interesting thing about researching quality companies is that you cannot put it all into a formula. You must apply discretionary thinking about the business, its products, the company’s strategy, the industry drivers, technologies strengthening or weakening the business, because in the end the big returns about changes in expectations for the company.

Previous analyses of quality companies

The list below highlights our previous analyses of quality companies.

• Otis: A one-way lift? (19 June 2024)
• AstraZeneca: From patent cliff to oncology leader (29 may 2024)
• Nvidia: Can it fend off the barbarians at the gate? (22 May 2024)