[00:03:01] Clay Finck: Every once in a while. I come across a company that just for lack of a better phrase, I think is just cut from a different cloth, whether it be the business model or especially the management team in many cases and how they manage the business. And this year I started to dig into Hermes. And I felt that this was just another case where I really wanted to understand the business better.

[00:03:21] Clay Finck: And I think there’s some lessons that can be learned from studying such a company. I really hope the audience understands where Shree and I are coming from here and seeking to learn more about a company from an investor’s point of view, because in some ways, I think it can be a bit awkward to talk about a luxury company like Hermes, because generally our audience is full of value investors, many of which are hardwired to look for bargains, whether it be in the stock market or when they’re shopping or whatever they’re purchasing.

[00:03:48] Clay Finck: So if you aren’t familiar with this company, you might go to their website and see that they’re selling very expensive watches, thousand dollar belts, 10, 000 bags. So I wanted to bring Shree on the show to help shed more light on the company for our investing audience.

[00:04:03] Shree Viswanathan: Yeah, no, thank you for thinking about me as it related to Hermes.

[00:04:08] Shree Viswanathan: Yeah, it is one of my portfolio companies. I’ve owned it for a few years and it’s just as you mentioned, it’s a fabulous, it’s a true definition of a quality business. We’ll get into the details of how I define quality and why Hermes is still an interesting proposition for your followers and other investors, but yeah, nicely put cut from a different cloth.

[00:04:33] Shree Viswanathan: I would just add cut from a different leather.

[00:04:36] Clay Finck: That’s right. Cut from a different leather. So how about we just start with a general overview of the company?

[00:04:42] Shree Viswanathan: Winston Churchill said, the farther back you can look, the farther forward you’re likely to see. Fortunately, Hermes gives us more than 187 years to look back, although we have a much shorter history of only 30 plus years to look back since it went public in 1993.

[00:05:03] Shree Viswanathan: In the past, Clay, when I’ve talked to you, I’ve seen this book, 100 Bagger, by my friend, Chris Mayer, right behind you. That’s a fabulous book. In that book, he says that on average, it takes about 25 years for a company to become 100 Bagger. He was right on the button. Hermes took 25 years since going public in 1993 to become a hundred bagger in 2018.

[00:05:29] Shree Viswanathan: It’s gone up more than four x in the last six years since 2018, for a total return of more than 400 times. Since IPO I’m sure we’ll get into some of the quantitative features of the business later. Let me get to the qualitative overview that you just asked. Hermès Paris is a prestigious luxury brand renowned for its exceptional craftsmanship and rich heritage.

[00:05:56] Shree Viswanathan: As I just mentioned, the name is Hermès Paris, not just Hermès, although outside of France and many of the stores, it just goes by Hermès, you know, the great Emerson in his essay titled The Self Reliance. It says an institution is the lengthened shadow of one man. Hermes is a very long shadow of Thierry Hermes, who founded it in 1837 as a harness workshop.

[00:06:24] Shree Viswanathan: The company was selling high quality saddles and other leather goods to Europeans and ended up being European nobility over time. Over the years, the company has evolved into what we now know as a global luxury powerhouse. Maintaining its reputation for exclusivity and quality. It’s celebrated for its meticulous attention to detail and the artistry involved in its products.

[00:06:50] Shree Viswanathan: The brand emphasizes artisanal skills with many items handcrafted. The commitment to quality has positioned Hermes as one of the most valuable luxury brands globally, consistently ranking high in brand valuation studies. Hermes. You know, a few weeks back or months back, maybe you talked to my friend, Christian Billinger about the LVMH and Kapferer’s book, The Luxury Strategy, and I’m sure we’ll get into those as well.

[00:07:20] Shree Viswanathan: But luxury, this is probably a good time to kind of also define luxury as I’m defining the qualitative features of Hermes. Luxury has always been morally condemned. And in ancient Greece, it was the philosophers and today it’s more the moralists and politicians, be that as it may, luxury is here to stay.

[00:07:43] Shree Viswanathan: You know, we have a very large and rapidly growing sector with both public and private companies. But given this moral condemnation, it also is appropriate to highlight that luxury as a concept has been around in the old continent, in Europe and to a certain extent in Asia. It’s actually relatively new in the U.S. So what’s luxury? And there are many, many definitions of this word luxury. But one that I really liked was from Bernard Arnault, the CEO of LVMH, said it’s the ordinary of extraordinary people, and the extraordinary of ordinary people, essentially gets to the heart of luxury strategy. Let me come back to providing this qualitative overview.

[00:08:30] Shree Viswanathan: You know, Hermes as a company has 16 métiers. It’s a French word, it’s essentially a specialized métier, it’s a specialized craft or area of expertise within the company. Each métier represents a distinct domain of craftsmanship and creativity. We’ll come back to that in details as to various different components of this.

[00:08:52] Shree Viswanathan: But the products that Hermes now produces falls into four buckets, essentially. Leather goods, which is the largest within the company, accounts for about 50 percent of sales, features the iconic brand names like the Birkin bag and the Kelly bags. Number two is the ready to wear. That’s about 23 percent of sales.

[00:09:13] Shree Viswanathan: And that includes clothing and accessories for both men and women. Number three is silk and textiles. That makes approximately 10 percent of sales. In the olden days, it was known for its luxurious scarves and ties and other silk products. But as leather has kind of become big within the company, within luxury in general, silk and textiles has come down to about 10%.

[00:09:40] Shree Viswanathan: And then the final category, which is sort of all encompassing is, what’s defined as watches, jewelry, and other home goods. And now that’s the business end of it. What started off as a French company selling to the French more than 187 years ago has now ended up as a French company that exports almost 90 percent of its products.

[00:10:01] Shree Viswanathan: They still keep about 75 percent of the production within the country. And that’s not by accident. That’s a big part of the bigger strategy. Currently, they have 54 production sites across the country with 11 regions, 23, 000 employees, 7, 000 of them are artisans, and they sell it through their controlled the distribution mechanism, about 300 stores around 45 countries.

[00:10:28] Clay Finck: Shree, as I’ve been involved in the podcasting space for coming up on three years, I’ve recognized this importance of the short term versus long-term trade off and trying to find the right balance between the two. And that balance is going to look different for each company. For the podcast, for example, we know that listeners do not like hearing ads.

[00:10:46] Clay Finck: They’re going to hear ads during this episode and they’ll likely continue to hear ads, but without ads, we wouldn’t be able to have this conversation. So inevitably it’s sort of a sacrifice we’re simply willing to make in order to provide this content for free. Now, in the case of a luxury company, they might see a lot of a demand for a product like a Birkin or a Kelly bag, and many management teams are going to be tempted to try and increase the level of production the most, as much as they can to try and boost the earnings.

[00:11:14] Clay Finck: But this can be harmful to a luxury brand if it ends up decreasing the perceived value of the brand. And I think Hermes sort of epitomizes what it means to think long term and not really make these shorter term sacrifices to boost short term earnings. So I was curious if you could speak more to this.

[00:11:33] Shree Viswanathan: That’s a wonderful question about long term. Anytime this phrase long term pops up, it piques my interest. Not to digress too much, I’m sure you’ve heard of Stuart Brand, the founder of Whole Earth Catalog. He created something called the Long Now Foundation, which is essentially seminars on long term thinking.

[00:11:53] Shree Viswanathan: It’s a wonderful platform to follow. You may already know this, and some of your followers may be interested. Back to your question, while there is no perfect count, back in 2008, bank of Korea found out that there were about 5,500 companies around the world that were more than 150 years old at more than 187 years.

[00:12:17] Shree Viswanathan: Hermes is already a part of a select group. Long-term is in its DNA for Hermes. As you know, long-term thinking is core, part of its business philosophy and strategy. To support that long term thinking, there are many factors that go into supporting that. Let me just highlight a couple of them and maybe we can address a few more as we go along.

[00:12:38] Shree Viswanathan: Quality is absolutely paramount to Hermes’. One of the important features of this long term thinking is the quality of the products. And again, allow me to digress a little bit. Walter Isaacson, in the biography of Steve Jobs, he writes about how Steve Jobs was passionate about quality of the computers.

[00:12:59] Shree Viswanathan: Steve and his father were working in building a fence around their house in California. When his father said, you know, you got to make the back of the fence that nobody will see just as good looking as the front of the fence, even though nobody will see it, you will know it. And that will show that you are dedicated to making something perfect.

[00:13:20] Shree Viswanathan: This idea stuck with Jobs. And when he made the Macintosh, he had the engineer’s names engraved inside each one of those computers. And he said real artists signed their work. No one would ever see them, but the members of the team knew that their signatures were inside. Why do I bring that Steve Jobs episode here?

[00:13:42] Shree Viswanathan: Because I sometimes wonder if this quality obsession of Hermes had an influence on Steve and how he thought about quality. While there is no direct evidence, similarities are striking, I think. When many of Hermes competitors began using sewing machines, Hermes refined the 400 year old saddle stitch so that connoisseurs could distinguish between their inevitable craftwork and mechanical sewing.

[00:14:12] Shree Viswanathan: A saddle’s underside rivals its upside. Its inside outclasses its outside. That’s the classic stamp of a quality product. You know, therein lies that nobility. Hermes products are made to last. a long time. Axel Dumas, the current CEO he says, we want our products to look even more beautiful 10 years later.

[00:14:38] Shree Viswanathan: In these types of products, there is no planned obsolescence or forcing the customer to buy a new collection because the previous ones no longer make sense. So that’s the type of commitment. That’s the type of quality that Hermes brings to its products. Another trade that lends to this long term thinking is craftsmanship.

[00:14:59] Shree Viswanathan: Now, Hermes invests heavily in training its artisans and preserving traditional craftsmanship techniques. They take a patient approach to production, focusing on quality over speed. Let me tell you something about this lady, Christine Nagel. She’s the head of the perfume division of Hermes. and is termed as the nose of Hermes within the company.

[00:15:24] Shree Viswanathan: Perfumes make up just a few percent of the total business, but I think what, in a recent interview that I read, what she said about her work, her career, and Hermes’s, her employer, is very appropriate in terms of defining this craftsmanship. She created this perfume called H24. This is the first perfume for men in the last 15 plus years.

[00:15:46] Shree Viswanathan: Christine is the first female perfumer for Hermes. She has the gift of what’s called a synesthesia. It’s the merging of certain senses. She says, odors have a color for me. She has the unique ability to smell and taste color. Hermes she says is a playground for me and I’m happy to work for a house with a lot of stories and roots. My day to day life here inspires me because I don’t have the limitation of time or price. And choosing a perfume is not a question of marketing, but if we like the perfume or not. I’m exercising the real job of a real perfumer, we like to go where no one else has or will go.

[00:16:31] Shree Viswanathan: What’s remarkable about Hermes is the constant faith placed in creation and the creator and that’s a very very important phrase to remember all through this. Hermes commitment to the creation and the creator. I’ll come back to that in a few other places later. She says if I was chosen by the house, it was for this signature.

[00:16:52] Shree Viswanathan: This recognition is a source of delight every day because I’m living my dream of creating fragrances that uphold and embody all the values of this house. My only aim, therefore, is to create exceptional fragrances. That’s a little bit about the craftsmanship that I mentioned. This is an integral part of how the company has put together this long term success story.

[00:17:17] Clay Finck: I think there’s so many examples within the company we can think of where they truly think long term. And one that certainly comes to mind that I’d like to mention is during the 1970s, they were going through some issues as a company. And I believe they were speaking with some consultants, these wise consultants were like, Hey, you need to start doing what all these other luxury names are doing, you know, take production elsewhere, minimize costs, increase efficiencies, cut corners on product quality and such.

[00:17:48] Clay Finck: Thankfully, they didn’t go that route. And I believe they even adopted a corporate philosophy of no consultants. They just operate in a much different manner.

[00:17:58] Shree Viswanathan: Yep, absolutely. As you correctly pointed out, this is a unique business and a unique management team in many regards. That’s one of them. I told you that they have this commitment to the creation and the creator.

[00:18:12] Shree Viswanathan: There are many examples in that sense. For example, there was this leather artisan from France who moved to Japan. Primarily, his responsibility in Japan was repair related work, and one day Hermes got a request from the Empress of Japan saying that she wanted one of the bags that she carried that had some sort of strip, a leather strip, she wanted that to be removed, and this gentleman this artisan took a look at the bag and he suggested that they not remove it.

[00:18:45] Shree Viswanathan: If it was removed, it would change the complexion, the quality, and the true value of the bag. So, he did the unthinkable, which is stand up to the impress of Japan. Obviously, this became a big issue, and the current CEO, Axel Dumas father, Jean Louis Dumas was the CEO at that time. It got to him, he intervened, he listened to both sides, and he agreed with the artisan that cutting that strip out would essentially change the nature of the bag.

[00:19:15] Shree Viswanathan: And so he actually had a new bag, without the strips, sent back to the Empress, of course. But it tells you a little bit about how the management team and the culture within the organization is all for the artisan and the creation.

[00:19:29] Clay Finck: So Hermes is well known for being a family owned and family controlled business.

[00:19:35] Clay Finck: They opened up shop in 1837. And as you mentioned, they’ve been operating in that manner for 187 years. I look at Hermes and it just reminds me of one of those companies that doesn’t seem like it should be public, just because it operates much differently than your typical public company. So talk about the family ties and what even led them to being a public company.

[00:19:59] Shree Viswanathan: I mean, in answering your previous question, I listed just a couple of the features, quality and the craftsmanship. But the other important feature is this. A family ownership. This might be, in fact, slightly more important than many other features. Now, it’s a classic family business company. As you said, it’s more than 187 years old.

[00:20:20] Shree Viswanathan: There’s a lot of history and some monumental decision points along the way. Axel Dumas, he’s currently the sixth generation family member, who’s the head of the organization. And from the Dumas family branch is his cousin, Pierre, who is essentially signing off on every product that comes out of the company.

[00:20:41] Shree Viswanathan: So the top two spots are held within the Dumas branch of the family. I’ll come back to that in a second. While there isn’t a precise count of sixth generation family run companies around the world, data suggests that such businesses are quite rare. Now, the odds of a sixth generation family business is 500 to 1.

[00:21:03] Shree Viswanathan: Only 3 percent of the family businesses operate at the fourth generation. 30 percent of businesses get to the second, and only 12 percent get to the third. So, Hermes is currently in ratified air, I would say. But why is that important? You know, there’s a wonderful book called The Founder’s Mentality by Chris Zook and James Allen.

[00:21:26] Shree Viswanathan: I’d say that the founder’s mentality constitutes a key source of competitive advantage, and it consists of three main traits. An insurgent’s mission, owner’s mindset, and an obsession with a front line. They go on to show that the returns to the shareholders from these types of companies is three times higher than in other companies.

[00:21:48] Shree Viswanathan: Back to Hermes, it’s actually controlled by three branches of the founding family. The Dumas family, which I mentioned Axel Dumas is part of that branch. There is the Guérin family, pardon my French actually. As you can tell, I’m originally from India, spent all my life here in the U. S. I have an accent that’s neither European nor American, and so I may be mispronouncing some of these French names.

[00:22:14] Shree Viswanathan: But the second family is the Guerin family, and the third one is the Pouecq family. These three branches are descendants of Émile Maurice Hermès. He was the grandson of the founder of Thierry. Together, these three branches of the family, they currently control 67 percent of Hermes. And this combined ownership is currently worth about 155 billion, making it the world’s third wealthiest family.

[00:22:42] Shree Viswanathan: Al Nahyan family, the family that controls Abu Dhabi, and Walton family from the Walmart wealth, those are the only two that are ahead of this family group. At Hermes, the family itself is one of the secrets and principal assets of the brand’s success. They’re the keepers of the heritage and know how to make it evolve without a revolution.

[00:23:06] Shree Viswanathan: Created in 1837, the company has always been independent. And has been passed down from son to son as it expanded over time from harnesses to saddles to everything that they sell today. Thierry was the founder and his son Charles, he took over the business in 1880. And here’s an interesting stat, he’s the one who moved the company to 24 Faubourg, which is the headquarters even today, more than 150 years later, that is still the headquarters of the company.

[00:23:38] Shree Viswanathan: After Charles Emile, he retired, you know, his two sons Adolph and Emile Morris. They took over, and watching the decline in sales of horse harnesses and saddles, Adolf, he left the business in 1919, letting Emile Morris be the sole owner. That was the glorious period when he introduced many products that are popular even today.

[00:24:00] Shree Viswanathan: For example, Sac de Peche, which is essentially the Kelly bag that we know today. Silk scarves, leather jacket with a zipper. These were all introduced during that period. In the twenties and thirties, he had three daughters, and so Emel Morris is groomed his sons-in-law in the business in 1951, Robert Dumas, he took the helm.

[00:24:25] Shree Viswanathan: He was one of the sons in law. Of course. He’s credited with the success of the Kelly bags, even though they were founded a couple of decades earlier. In 1978, his son, Jean Louis Dumas, he took the helm, and he’s credited with making the Birkin bag, which is even more expensive today. In 2003, for the first time, and the only time, Patrick Thomas, who is not a family member, he took over as the CEO.

[00:24:53] Shree Viswanathan: He ran the company, and he’s the one who successfully defended this hostile takeover attempt from Bernard Arnault of LVMH. And then he handed over the reins to Axel Dumas, who is currently the CEO. As to why Hermes remains public today, Jean Louis Dumas, who was the CEO in the early 90s, when he took the company public, he had a few reasons, apart from providing capital to strengthen its financial position, going public, you know, allowed some of the family members to liquidate their holdings.

[00:25:27] Shree Viswanathan: And Jean Louis said, you know, it helped lessen the family tensions by allowing members to sell some shares without disputes over valuation among themselves. Today, in addition to the family itself owning such a huge percentage, about 80 percent of the employees own some shares of Hermes. So it’s also turned out to be a good compensation tool for the company as artisanship and culture within the organization is all important for the company.

[00:25:57] Shree Viswanathan: So that’s a little bit about the history and why they went public and why they remain public.

[00:26:03] Clay Finck: A hundred fifty five billion in shares owned by the family is amazing to say the least and it’s quite fitting with the show name, We Study Billionaires.

[00:26:13] Shree Viswanathan: Yes, that is perfect.

[00:26:16] Clay Finck: I think it’s a good point to also mention another extremely wealthy billionaire who you just mentioned, Bernard Arnault.

[00:26:22] Clay Finck: Christian Billinger and I chatted about him and LVMH back on episode 645 for listeners that want to learn about that company. You mentioned the attempted takeover. With this being a family business and very high ownership within the family. That really didn’t stop Bernard from that attempt to take over, which ended up being unsuccessful.

[00:26:43] Clay Finck: So I was curious if you could just tell this story because it’s just so fascinating. Just points to sort of Bernard’s character and who Hermes is in that, you know, their family company and they’re not going to let a corporate raider come in and take it away from them.

[00:26:57] Shree Viswanathan: Yeah, this was a momentous episode in the long history of Hermes.

[00:27:01] Shree Viswanathan: You know, just a couple of hours before the world would find out, on October 23rd, 2010, Patrick Thomas, as I mentioned, he was the CEO, he was the person, the only non family member who was the CEO. He was cycling through rural France when he got a call from Bernard Arnault. He took the call standing on the side of the road.

[00:27:23] Shree Viswanathan: Arnault wanted him to know, you know, he was just alerting him that LVMH would be announcing that it had acquired 14. 2 percent stake in Hermes. Hearing this, Patrick, who is enraged, had an immediate and colorful response. Unfortunately, I can’t repeat it here since it’s not appropriate for a family friendly show like this, but your listeners can go Google and find out what exactly was his response.

[00:27:53] Shree Viswanathan: And as the family’s anger and protestation were gathering steam, within less than a week, LVMH announced that it had raised its stake to 17. 1%. The big question in the minds of family and Patrick and everybody was, how did he build such a big stake? Thank you Here’s what we were able to find out between 2001 and 2002.

[00:28:14] Shree Viswanathan: LVMH acquired 4.9% stake through a handful of subsidiaries. French law requires the acquirer to disclose the identity if you go past 5% and if it reaches 10%, the acquirer has to disclose his or her intentions. That’s the reason why LVMH stopped at 4. 9 to hide its identity. LVMH had banks in Luxembourg and Panama purchase shares in Hermes on its behalf.

[00:28:45] Shree Viswanathan: LVMH then paid these banks in cash. In order to avoid any sort of a discovery, nothing happened for about five years. Then the action started again in 2007, when LVMH engaged in a string of complex cash settled equity swaps through financial intermediaries and subsidiaries. However, in 2010, LVMH’s stock swaps with its own subsidiaries.

[00:29:11] Shree Viswanathan: LVMH brought its stake in Hermes to an accumulated 14. 2%, which is what triggered that call. In spite of strong protests from PUAG and Guaran and, you know, Dumas families, LVMH maintained its stake and flatly denied that it was entertaining ambitions to slowly gain control and take over Hermes.

[00:29:34] Shree Viswanathan: While the French regulatory authorities started an investigation into LVMH’s investment, Patrick Thomas said, I’m not a fan of conflict, but I can fight from time to time if necessary. He quietly helped the family set up H51, a private holding company with more than 50 family members who agreed to pool all their shares and to keep them in it for at least 20 years.

[00:30:00] Shree Viswanathan: H51 was designed to have the first right of refusal should a family member decide to sell. LVMH, of course, didn’t back down in spite of this investigation and all those responses from the family. In fact, in May 2011, it announced that its stake had gone up to 21%. And this elicited further response from the family and Patrick.

[00:30:24] Shree Viswanathan: Patrick said this whole affair is ungentlemanly. Hermes culture is fundamentally incompatible with that of a conglomerate such as LVMH. Bertrand Pouet, the head of that Pouet branch of the family, chaHermesn of the company, said, you know, we are the target of incessant attacks of the kind we have never seen in 174 years, even though LVMH says its approach to us is friendly.

[00:30:49] Shree Viswanathan: I don’t agree. With friends like this, who needs enemies? Every time Hermes responded verbally, LVMH upped its stake. By the end of 2011, its stake had gone up to 22. 6%. You know, as you would have suspected by now, there were suits, counted suits, back and forth. And the regulatory authorities were concluding their investigation, and when they did, they ordered LVMH to pay 10.

[00:31:15] Shree Viswanathan: 4 million dollars for serious and successive breaches of public disclosure requirements. LVMH said it would appeal the ruling, and you guessed it, increased its stake further, now to 23. 1%. The two parties were unable to resolve their differences, and court cases continued on for a number of years, for a few years after that.

[00:31:37] Shree Viswanathan: And finally, in 2013, Bernard and LBMH announced that they’ll distribute the stake in Hermes to its shareholders and institutional investors. Even though he had been building up a stake for about nine years, he talked about Hermes for the first time in an earnings call in 2011. Now, Bernard said something very interesting.

[00:31:57] Shree Viswanathan: He said, I understand that they were a bit surprised that we came in, but we ourselves, we didn’t expect to become shareholders of Hermes, and the circumstances meant that starting from a financial investment standpoint, for technical reasons, it was more or less imposed upon us. In the same call, Bernard acknowledged the question about the difference in culture between the two organizations.

[00:32:21] Shree Viswanathan: He said, I’m often told that Hermes culture is different from that of Louis Vuitton. Well, that’s true, but do you prefer Hermes or do you prefer Louis Vuitton? Do you prefer Proust or Stendhal and the two great writers? I think we can prefer one or the other, but we are bound to recognize that both are great talents.

[00:32:42] Shree Viswanathan: I said Christian Dior’s culture is different from that of Chanel’s, which is different from that of Hermes, and that’s different from that of Louis Vuitton’s. I find it rather pointless to oppose cultures. What I believe is that LVMH, in today’s world, is best placed to preserve the crucially important cultures for the future of these companies, and now that we are a significant shareholder of Hermes, we can guarantee the preservation of their culture in the long term.

[00:33:11] Shree Viswanathan: So that’s all about how Bernard and LVMH came at this. But, remembering this event and how they went through, the family finally put another fine touch on this ownership. In 2022, they took a further step to unify this family ownership by bringing eight families together under an investment vehicle called Krefeld Invest.

[00:33:35] Shree Viswanathan: Krefeld is where the founder, Thierry Hermes, was born. So, this will be a family ownership business for a long, long time. Thank you. You’re welcome. This was as I said up front, a very colorful and a momentous episode in the long history of Hermes.

[00:33:50] Clay Finck: What a wonderful story. Just to put some perspective on where shares were when Bernard started buying in around 2001.

[00:33:59] Clay Finck: Shares of Hermes were trading around 50 euros then, and today shares are trading north of 2100, so that’s a over 40 times increase, and of course he doesn’t own that stake anymore today, but yeah, he saw the tremendous value in Hermes, certainly. I want to transition here to talk about their moat. I think it might sound ridiculous to some in the audience to think that a company that sells handbags has a strong moat.

[00:34:26] Clay Finck: I had asked Christian Bellinger, what is it that makes a luxury product different than say, a premium product or a high quality product? And he mentioned the importance of singularity. So the product and the brand are really in a category of their own, and they simply can’t be compared to other products in the minds of consumers.

[00:34:46] Clay Finck: And in preparation for this episode, my friend Leandro, who writes the blog best anchor stocks, he did this wonderful five part writeup on Hermes that I found to be quite helpful, which I’ll be sure to get linked in the show notes. So when looking at Hermes’s competition, one could argue that Hermes and some of the other luxury players are competing for a set amount of luxury dollars, let’s call it.

[00:35:10] Clay Finck: And the way Leandro puts it is that the typical luxury customer rarely has to choose between the product of one company versus another. So if you’re an Hermes customer and you see something that you like at a Brunello Cucinelli, for example, then you likely aren’t going to delay the purchase of a Birkin bag to make that other purchase.

[00:35:31] Clay Finck: And since Hermes is sort of at the top of the luxury industry. This dynamic, I think, plays more into their favor maybe than some of the other players, presumably because they are appealing to the higher end customers. So let’s cover the moat and what gives you confidence in the long term sustainability of the moat.

[00:35:51] Shree Viswanathan: Clay, before I forget, with respect to this Bernard Arnault question. I just want to make one more comment or maybe a couple of more comments. One is Hermes was not the first one that he missed. He tried doing something similar with Gucci before it ended up in what is now known as Kering. And the second comment I want to make is there is a similar effort going on at Richemont today.

[00:36:15] Shree Viswanathan: LVMH has a deep interest in Richemont as well, and there’s likely some change of management team coming up within that company, and he finds Many of those brands are very attractive. I just wanted to mention that before I forgot. Back to your question about the mode of Hermes. Yeah, it’s a wonderful question.

[00:36:34] Shree Viswanathan: Before talking about the mode, I think it’s appropriate to again bring up Kapferer’s book, The Luxury Strategy. I know you discussed that with Christian. Three very important takeaways from that book. One is the 24 anti loss of marketing, which you discussed. Second is that dream equation. Now he explains it very beautifully.

[00:36:56] Shree Viswanathan: He says a basic product corresponds to a need. If you’re thirsty or you need to go to a hospital, the role of the basic product is to do this at the lowest cost. A branded product corresponds to a desire, a wish. Now we are thirsty and we desire a high quality beer, preferably on tap. A luxury product, on the other hand, corresponds to a dream.

[00:37:20] Shree Viswanathan: They do not need to be satisfied. Sometimes their existence alone makes us happy. Luxury brands must be, you know, sensitive to the difference between their level of awareness and their penetration. And he says, in this difference lies the dream. The product is known by all, but bought by a few. So I think that dream equation is another major takeaway from that book.

[00:37:45] Shree Viswanathan: The third one is art and luxury share several characteristics. For example, art value grows over time. How can art achieve this fee? It does so by being totally independent of function. Just as art has done, luxury must decorrelate price and function, according to Kafferer. So those are, I think key takeaways and are worth keeping in mind as we talk about the moat of quality business like Hermès.

[00:38:16] Shree Viswanathan: And I’m sure you’ve heard of this gentleman, François Rochon, who runs Giverny Capital out of Montreal, Canada. He wrote a fabulous newspaper article in 2014 titled, Finding Durability Value is Tough, but it’s Worth the Effort. He says you have to look for three important things in a prospective company.

[00:38:36] Shree Viswanathan: Competitive edge, durability, and culture. I don’t think he had Hermes in mind when he wrote this, but all three are present in plentiful within Hermes. Competitive advantage can be a brand name, reputation for excellence, or a monopoly position. Hermes brand name has not just survived, but thrived over the last 180 plus years.

[00:39:00] Shree Viswanathan: And as for the Lindy effect, it’s likely to last that long. Quality of a product, which I talked about earlier, lends to that reputation. And while companies like LVMH and Chanel offer some similar products, Hermes doesn’t look too much at the competition the case. They fear they might be influenced.

[00:39:20] Shree Viswanathan: Durability, at Hermes, the products are made to last for a really long time. Patrick Thomas, the former CEO, in a recent interview, he talked about an incident where, when he was the CEO of the company, he talked about an incident when a famous actress, he didn’t name her, happened to be a friend, you know, who had a saddle in possession.

[00:39:41] Shree Viswanathan: And she had some issues with the saddle, so when she came in to meet him, brought the saddle and told him about some of the issues that she was facing. He took her to the saddle shop nearby, and the guy, the artisan at the saddle shop, took a look and asked her, you know, when and where did she buy this?

[00:40:01] Shree Viswanathan: And this is a very interesting side note. At their mass, they maintain a log of all the purchases made, essentially a big book of all the purchases made, details of the purchaser, the amount, the item purchased, and if it was repaired, when, where, things like that. So this guy was able to go to the log and see if he could find this actress’s name and the details.

[00:40:25] Shree Viswanathan: He couldn’t find it. And she remembered, no, I got it from my mom. So I said, okay, let’s go look for your mom’s name. And they went and looked for, they couldn’t find it. And she thought, okay, maybe she got it from her mom. And bingo, it was the grandmother who had purchased the saddle more than 70 years, you know, before she came into the office and had never been repaired.

[00:40:47] Shree Viswanathan: Now, that’s durability at its best. So that’s the second feature that Francois Rochon, for example, writes about in that article. And the culture. You can appreciate the culture within the organization, not just from the family standpoint, but from the 23, 000 employees as well, particularly the artisans.

[00:41:04] Shree Viswanathan: As I mentioned, the commitment to the creator and the creation has developed a very unique culture within the organization. I already mentioned this diplomatic quandary that they found themselves in when this gentleman, Francis Norbert, From France, he went to Japan and stood up to the Empress. And all three factors are sustainable over a really long term.

[00:41:28] Shree Viswanathan: And these are the sort of features that combine to form what is called as the moat within the organization.

[00:41:36] Clay Finck: There’s a couple points I’d like to hit on there. So I pulled a quote from Axel Dumas from the 2022 AGM that ties in well with your comments. He said that performance is important, but resilience is of paramount importance.

[00:41:51] Clay Finck: I wanted to also mention the Birkin and Kelly bags because the high desirability of these products are extremely important and getting these bags is not easy. You and I just can’t walk in and just pick one up off the shelves. It’s a process and I’ll give you the opportunity to share a bit about that if you’d like.

[00:42:09] Clay Finck: So to give the audience a sense of the prices of these bags and sort of their history, the Kelly typically retails for somewhere around 7, 000 and then the Birkin bag, it’s a bit more expensive at 10, 000. And one thing I found just extremely fascinating with this is you’re talking about the durability and the resilience of the brand.

[00:42:30] Clay Finck: These two bags have had a compounded annual growth rate of 4 percent in their price over the past 50 years. What’s also very interesting and pointing to the desirability of these bags Is that oftentimes customers can buy these from Hermes and they can sell them tomorrow in the off market for more than what they bought it for.

[00:42:51] Clay Finck: Just like it goes completely counter to what we learned about business and it just points to, there’s a lot of untapped pricing power with these bags and that’s likely to be sustained for a very long period of time. Who knows how long it seems quite durable.

[00:43:09] Shree Viswanathan: Absolutely, absolutely. Yeah, those prices that you mentioned, you know, there are actually 17 different bags, at least that I am aware of, that the company makes.

[00:43:20] Shree Viswanathan: Birkin and Kelly are the two famous ones. Close to those two are the third brand, which is Constance. There are many other brands of bags that they manufacture. The 10,000 for a Birkin is at the lowest end. The price of the bag depends upon the complexity involved, the skin type, the quality of the leather.

[00:43:41] Shree Viswanathan: For example, the crocodile skin is one of the most expensive, and they have something called the Himalayan crocodile skin color. Himalayan is not necessarily to do with the mountain, but it’s more the color white with a blend of gray in it. For when you see it in picture, you’ll see what I’m talking about.

[00:44:01] Shree Viswanathan: But those things go for hundreds of thousands of dollars. That’s just retail, and you are right. These bags are not necessarily available for us to walk into a store and buy it on the spot. Typically, this is again, part of the culture within the organization. Part of managing the brand, managing the supply, and everything associated with making sure they put out the best quality product that lasts for a long time.

[00:44:30] Shree Viswanathan: And so to begin with, these bags, which are made by these artisans. It takes a long time. So, for example, an average mass market automobile can be put together within somewhere between 18 to 35 hours. It takes about 40 hours to make just one bag, one Birkin bag. It takes about 20 plus hours for Kelly, which is apparently a little less complicated.

[00:45:00] Shree Viswanathan: But still, it gives you some context. And the other interesting and an important feature here is, Hermes has a requirement that the artisan who makes the first cut on the leather gets to essentially complete the bag. So it’s one artisan working on one bag. That’s the reason why it takes about 40 hours.

[00:45:20] Shree Viswanathan: And by the time the artisan gets to make the first cut of this very expensive leather, the artisan has gone through some serious training. The company hires about 200 artisans a year, and they go through mandatory schooling for about a couple of years. And even after that, it takes about six years for them to work with a veteran and another couple of years after that before they can graduate to making the first cut for a Birkin or Kelly.

[00:45:51] Shree Viswanathan: So it takes a really long time. In the meantime, as I described, the veteran who is well trained is also not necessarily focused on making The product every day, because he or she is now having to spend time with these novices who are growing within the organization. So the culture and the commitment to quality comes from a variety of different angles.

[00:46:15] Shree Viswanathan: And so the margins on these products are immense. While they don’t necessarily disclose what the cost is on a per bag basis, if you look at the gross margin of this business, you may think that it’s more like a software company at 70 percent consistently over time. It’s partly because of the pricing that they’re able to obtain on these really high quality products.

[00:46:41] Shree Viswanathan: Back to your point about pricing and the ability to walk into a store and buy these things. Yeah, that’s not possible because there is significant demand for these products. And at the same time, they have serious constraint in how many bags they can actually put out. Unofficially, I’ve seen numbers, something like 12, 000 Birkin bags a year.

[00:47:01] Shree Viswanathan: For a company that’s about 240 billion in euros in market cap. 12,000 bags a year, and each bag taking about 40 hours. That’s partly self constrained, and at the same time, that commitment. So that all translates into a really healthy margin, and net margin, in fact, has continued to go up. Post COVID, net margin has also gone up quite significantly.

[00:47:24] Shree Viswanathan: These bags are not readily available, even though the company has in fact, the fastest growing segment within the company is online. You can buy many products within, you know, from the online stores, but you can’t buy these two bags or a few other bags that they manufacture through the online option.

[00:47:43] Shree Viswanathan: As a result, you know, the company maintains sort of a wait list. It’s an unofficial wait list. You are not required to put a deposit down. You’re required to put your name and contact info down as and when that particular salesman or the representative at the store finds it available and interesting enough, picks up the phone and calls you and if you are ready, you go by.

[00:48:07] Shree Viswanathan: If not, they go to the next guy on the wait list and these wait lists go from anywhere from one year to six years. It moves around a little bit and that, again, lends to the stable top line over time. In fact, both Hermes and LVMH were the two companies that had positive revenue numbers even during the financial crisis.

[00:48:29] Shree Viswanathan: Now, the numbers did go down. They were down about 7 plus percent in Hermes during COVID, partly because most of the stores around the world were shut down. But the fact that even during the great financial crisis. The company was able to put out positive revenue numbers, tells you a little bit about how this wait list helps them remain committed to quality and continue to put out strong top line.

[00:48:54] Clay Finck: One comment I have in relation to the Birkin and Kelly bags, they almost require customers to spend something like three times the amount in the store on other items before they get the call and say, hey, we have a Birkin or Kelly ready for you. And they don’t even get to pick the color of the bag.

[00:49:10] Clay Finck: They’re going to get something about it almost doesn’t feel right. And it makes me think of the luxury strategy, the anti law of marketing that mentioned to dominate the client. I mean, that’s what dominating the client looks like. That brings a question of why aren’t some of these customers just going out and purchasing the exact bag they want from just somebody else and not going directly to the store?

[00:49:31] Clay Finck: I’m curious your thoughts on that.

[00:49:33] Shree Viswanathan: Yeah, I think that’s a wonderful question. In fact, there is actually a case going on, a couple of purchasers from California filed a suit alleging that there is something called this tying, which is you get to buy the bag only if you buy a few other items. I’m not sure how this is going to settle, but it is a live case that you bring up at this point.

[00:49:55] Shree Viswanathan: It’s tied to this question about why aren’t customers willing to go buy other products. Well, that tells you a lot about the quality of something like a Birkin or a Kelly. There are no alternatives. There are really no alternatives for something like a Birkin or a Kelly. If it was available, yes. Many of these buyers would gladly go buy you know, those alternatives.

[00:50:19] Shree Viswanathan: Yeah, Chanel puts out good quality bags, but it’s not a Birkin. Louis Vuitton puts out good quality bags, but it’s not a Birkin. So, there is something about a qualitative feature of this name Birkin or the name Kelly that brings credibility to these bags that is absent in many of them. With some of the buyers, it may not matter.

[00:50:40] Shree Viswanathan: But many actually crave, would actually wait for a few years to get their hands on these types of bags. Peter Bernstein in 1956, he wrote a very interesting article on Harvard Business Review. He talked about growth companies, provided essentially a checklist of growth companies, and he listed a number of items.

[00:51:03] Shree Viswanathan: A few of them are relevant to this point that you are raising. One of them is the ability to create its own market is the strategic, dominating, and the single most distinguishing characteristic of a true growth company. The company’s products have above average profit margins. The products have little to no price competition.

[00:51:24] Shree Viswanathan: The company is constantly improving products, developing new products, or creating new markets for existing products, which help insulate it from economic trends. It’s a non conformist and economic society. It adapts the outside world to itself by creating something or a demand for something which did not exist before, instead of adapting itself to the changes in the outside world.

[00:51:48] Shree Viswanathan: So he lists a number of these things, and I’m sure he did not have Hermes or luxury for that matter in mind when he wrote this, but this was 1956, and he answers your exact same question.

[00:52:01] Clay Finck: So given that the moat is just so strong and that the family is so incredibly protective of the brand, they really have a lot of control on how fast they can grow to a large extent because they set their own prices.

[00:52:14] Clay Finck: And it’s also worth mentioning that like Axel Dumas mentioned that they’re producing as many of these bags as they can, and they’re not purposely limiting supply like a lot of people would think with a lot of these luxury names, just artificially suppressing it. So I’m curious about their future growth.

[00:52:30] Clay Finck: Obviously they’re a very large company today. Their market capitalization is 222 billion euros. So a very big company already today. I’m curious your thoughts on what you’re looking at for growth for say the next three or five years. And I think another important point of this company is Just that untapped pricing power we discussed and that pricing power is going to be used and implemented for many, many years down the line that’s going to impact your terminal value when looking at this company, which, you know, it’s a much different terminal value for a company like this than I think for a lot of other companies.

[00:53:08] Clay Finck: So that’s also an essential part. So maybe you could speak to that terminal value in the longer term growth.

[00:53:13] Shree Viswanathan: Altagama is an Italian trade association that includes mostly Italian and some European brands. Altagama and Bain Capital, Bain Consulting rather, they released a report on the luxury market in I think it was 2022.

[00:53:29] Shree Viswanathan: And a couple of years prior to that, Deloitte had also released a similar study and Sanford Bernstein’s analyst Luca has released some studies on this luxury market. All of them point to a market that’s about personal luxury product market is about 350 billion and is growing at a high single digit percentage.

[00:53:50] Shree Viswanathan: Luxury market consumer base is expected to grow from 400 million in 2022 to 500 million by 2030, just about eight years. Already crossed a couple of years into that. The size of the market is expected to go from 350 billion euros to somewhere between 540 to 580 billion. That’s about a 50 percent growth.

[00:54:13] Shree Viswanathan: Among these rising stars, one of the countries that they highlight is India. You know, India stands out. Its luxury market is currently approximately 50 billion euros, is expected to hit 200 billion by 2030. You know, more than three times where it is today. If you look specifically at Hermes, as you would suspect, sales has grown at a much better rate than what the market has done so far.

[00:54:40] Shree Viswanathan: As I said, revenues did go down a little bit during COVID, but revenue growth over the last five years has been approximately 19%. More than offsets the small decline in 2020. Revenue growth over the last 10 and 20 years being 14 and 13%. Now it’s a remarkably resilient business. And as I mentioned earlier, this is one of the few businesses that actually had revenue go up about eight and a half percent in 2008 during the crisis, during the financial crisis.

[00:55:10] Shree Viswanathan: As for the next few years, I expect a similar low 10 percent revenue growth. Your question, you mentioned that the company has the ability to control its growth. I think that’s a very unique feature in this retail business. In some manufacturing businesses, for example, you know, the customer puts down a deposit while placing an order, which then leads to a negative working capital situation, which is wonderful.

[00:55:36] Shree Viswanathan: But here, it’s a retail business where the customer is scrambling to get on a wait list that runs anywhere from one to six years. Apart from being able to control its growth, another aspect to take into account is the considerable operating leverage. Now, given the business. Where the company controls it’s vertically integrated in a business model, it’s fixed costs are high, at least relative to many other players in the ecosystem.

[00:56:04] Shree Viswanathan: In 2024, for example, you know, they instituted an 8 to 9 percent price increase. That’s at the company level, individual geographies. We’ll have had different percentages, for example, Japan, whose currency has been depreciating at a rapid clip, notwithstanding what happened in early August, is expected to see a double digit price increase.

[00:56:28] Shree Viswanathan: So that 8 to 9 percent for 2024 is at the company level. That is essentially remaining true to covering its production costs. Production costs have increased at approximately 6%. The price increase that the Institute also goes towards pointing out the commitment to the employees. Axel Dumas, he said, we wanted to cover the currency impact.

[00:56:52] Shree Viswanathan: That’s quite negative. And that’s an extra cost of about 300 million euros. This is in 2024. So the price increase that the Institute takes into account, the increase in raw material cost. Labor costs and this foreign exchange in certain situations like Japan, all that is taken into account and they push through somewhere in the 5 to 10 percent consistently, but more recently they’ve done 8 to 9 percent.

[00:57:20] Shree Viswanathan: Typically when you push through that sort of a price increase regularly, you may feel pushback from your customers. It’s the exact opposite in a company like Hermes and many luxury companies as well, but particularly in Hermes. And that’s likely to continue. That’s likely to continue for a variety of reasons.

[00:57:39] Shree Viswanathan: The brand strength, the increasing demand from not just the existing marketplaces, but also countries like India and Southeastern Asia, African countries. And so in my estimation, I still expect a low team percent revenue growth after taking into account these types of price increases.

[00:58:01] Clay Finck: Do you have any thoughts on terminal value since that seems to just be such an important aspect of Hermes, say 10 years down the line, you would expect the growth to be higher than say the GDP growth rate, for example.

[00:58:15] Shree Viswanathan: Absolutely. Yeah. Again, luxury as a business is one where it’s grown at almost two times. The GDP growth rate beginning in the mid 90s, of course, a big reason is the growth in China over the last 15 20 years, but the business has continued to grow at a much better rate than GDP. As for your question about terminal value, yeah, that is absolutely key.

[00:58:40] Shree Viswanathan: You know, if you extend it, say, over the next five years, your cash flow model based on, let’s say, the next five years, irrespective of whatever timeline you use. Anywhere from 85 to 90 some percent of the eventual value lies in this terminal value. That is based on the kind of margins, the kind of cash flow that the business generates, and the quality aspects that we have discussed all through the call today.

[00:59:06] Shree Viswanathan: So, I’ve run a variety of scenarios in my analysis. Every single time, I arrive at a terminal value that’s well north of mid 80%. You know, that tells you a lot about the definition quality as it relates to Hermes.

[00:59:22] Clay Finck: Yeah. And just to make sure I’m understanding it correctly. So north of 80 percent lies in the terminal value.

[00:59:29] Clay Finck: And that’s relative to what you determine as your intrinsic value. So I also want to discuss capital allocation and valuation. So Christian Billinger actually chatted with our TIP mastermind community. He talked through the financial statements and all these metrics on Hermes and LVMH. And one of the things he mentioned that just really blew my mind is he mentioned that Hermes is return on incremental invested capital is north of 100%.

[00:59:58] Clay Finck: It’s just an amazing metric and it helps further illustrate just the quality of this business. So when they’re renovating their stores or maybe building a new store or investing in R and D and such, they’re getting a high, high return on that investment. But the problem is they can’t reinvest a hundred percent of their cash flows. So it’s just a portion of it. So talk about how they approach capital allocation.

[01:00:22] Shree Viswanathan: You know, when you look at any business, when you go from the top of the income statement down, as you hit the gross margin line item, you can tell by looking at the gross margin, the consistency of the gross margin line item, you can tell what the quality of the business is.

[01:00:39] Shree Viswanathan: To understand the quality of the management team, you can go from the bottom of the income statement up. And in both cases, in the case of Zermes, you can tell the quality of the business, you know, 70 plus percent gross margin, the healthy net margin tells you a lot about the quality of the management team as well.

[01:00:58] Shree Viswanathan: That all leads to this prodigious cash machine that we’re discussing today, which is Zermes. On a free cash flow basis, on a per share basis, free cash flow per share in, for example, 2023 was about 34 euros per share. Which is almost five times what it was 10 years ago. So that free cash flow is a number that continues to grow at a very healthy double digit rate.

[01:01:24] Shree Viswanathan: And I expect, as I mentioned a few minutes ago, I expect that to continue to perform at a high level. What does the management team do with the prodigious cash? In fact, Axel Dumas addressed this in 2018. In his prepared remarks, he said, we keep one third of the cash for dividends. This is for the following year.

[01:01:45] Shree Viswanathan: And that includes special dividend, for example, in 2023, they just announced a special dividend of 10 euros per share on top of the regular, one third for capex for the following year, and another third for the future. And that I think he was referring to as capex for the future. Unlike LVMH, Hermes doesn’t do any acquisitions.

[01:02:08] Shree Viswanathan: They’ve done a few, very few in the past, but that’s not the mojo here. It’s organic growth and reinvestment through what are called ateliers, these workshops. They’ve got 54 of them in France today. Along with the year end earnings announcement, they said they want to open up four more early years over the next four years, one each year.

[01:02:32] Shree Viswanathan: And so these things take up a lot of capital. And as I mentioned, Chicago’s store, for example, was refurbished a couple of years ago. I haven’t been to the new store. So that sort of a refurbishment is an ongoing exercise across the world. They did one in Vegas. They’ve done one in Beijing, for example. And so that refurbishment, and of course, they open up new stores.

[01:02:54] Shree Viswanathan: So all these things take up capital over a long stretch of time. They also have a small buyback program in place. I think 10 percent is something that they can buy back. They have done a little bit of buyback, but that’s not their primary capital return. As we discussed earlier, this is essentially a family run business.

[01:03:14] Shree Viswanathan: Almost 70%, 67 percent is in the hands of those family members, 50 plus family members are a part of this. As a part of keeping the group together without a revolution, it’s part of their strategy to pay a healthy dividend. So unlike LVMH or maybe a few other, even non-luxury businesses, where we may see very efficient capital management, you can probably point out a few inefficiencies.

[01:03:42] Shree Viswanathan: Of course, the management team wouldn’t accept them as inefficiencies. It’s part of the strategy. It’s part of their culture, keeping their artisans together. In fact, they also have a free share compensation program to the artisans. In addition to these things, as a part of the culture of keeping the artisans happy, they get more than 12 paychecks per year.

[01:04:05] Shree Viswanathan: Depending upon the year, there is one extra paycheck for seniority, a few other paychecks for the company doing well over a stretch of time. So, those all come into play as a part of what we may define as inefficient capital management. But that’s part of the culture. Bringing it back, yeah, they currently sit on what appear to be a hefty cash balance, approximately nine and a half or close to 10 billion net cash on the balance sheet.

[01:04:33] Shree Viswanathan: But that’s by design again. They want to remain independent, be able to fund their growth internally through their own funds. Keep the family unit, the group together without a revolution. And so that’s how they’ve thought about capital management. It prioritizes the capital allocation strategy, prioritizes long term value creation and brand strengthening over short term profitability or aggressive expansion.

[01:05:03] Clay Finck: So, Howard Marks and Morgan Housel recently recorded a podcast together. They discussed the impact of debt and the podcast was just phenomenal. One of the points that Howard made is when you go back and you look at bankruptcies during these various financial crises, excessive debt is involved in every single one.

[01:05:24] Clay Finck: debt works well until the unimaginable happens. And when you’re focused on maximizing the terminal value, it’s not just critical to be able to withstand the average crisis. It’s critical to withstand every crisis. So I think your typical investor would look at 10 billion euros on the balance sheet. I mean, that’s just insane, but it’s not insane if you’re Hermes, because you’re maximizing for the terminal value and you care about that durability.

[01:05:52] Clay Finck: And that terminal value. So add a note here that conventional wisdom tells us that a lot of this cash should be distributed through dividends or through share buybacks, but air messes, anything but a conventional company. All right. So I’m sure a lot of people when they clicked play on this episode, they know Hermes is an amazing company, but it’s probably too expensive in their eyes.

[01:06:15] Clay Finck: So the PE multiple today sits around 50 and we’re recording here on August 29th, 2024. And the share price on the ticker RMS on the Paris stock exchange is around 2160 euros. So I’ll just throw it back over to you to talk about valuation.

[01:06:33] Shree Viswanathan: Ah, yes, the premium valuation of Hermes relative to the market or even to the luxury landscape.

[01:06:40] Shree Viswanathan: At the outset, you know, one explanation for this valuation is the markets expect Hermes to continue to maintain its healthy profitability while growing at this fast pace. That’s been the case for a long time. If you actually go back to 1990, mid 90s, if you look at the P multiple, average has been somewhere close to where it’s trading today.

[01:07:02] Shree Viswanathan: Maybe slightly less, but not a whole lot different from where it’s trading today. While that may not be satisfying for the valuation minded investor, let me offer a couple of thought leaders. Who have helped me think about quality and long term, you know, one that I would bring to this point is one, Mr. Bharat Shah is the head of research at a firm called ASK funds in India. He wrote a fabulous book long time back called off long term value and wealth creation. As you know, I started investing in India, I was in India recently and met with him. He talks about quality and valuation associated with quality very elegantly.

[01:07:44] Shree Viswanathan: He didn’t talk about Hermes, but I’m just highlighting his perspective on quality and how I view Hermes’s valuation today. Typically, returns on stocks reflect the underlying business’s earnings growth. Right? When earnings have compounded at X percent, returns on the stock are generally around X. When the stock returns X plus Y percent, that Y is the result of quality.

[01:08:10] Shree Viswanathan: Obviously, this should be evaluated over a long stretch of time. Now, in the case of Hermes, earnings have gone up around five times over the last ten years. The stock has gone up about seven times over that ten year period. Over the last 20 years, earnings have gone up 21 times, and the stock has gone up almost 50 times.

[01:08:31] Shree Viswanathan: Back to Bharat, you know, he says quality is more real than the numbers like growth or whatever else that we can compute. Because it can be computed, it sounds mathematical. What is mathematical sounds precise and what is precise sounds true. While all of that may have some merit, quality simply because it’s not so easy to compute or to define very pinpointed manner, it doesn’t mean that it doesn’t exist.

[01:09:02] Shree Viswanathan: It’s just that we need to learn to better appreciate the market mechanism and valuation mechanism really works in the market. That’s essentially the essence of what Bharat has taught me or what I have learned from him through his view of quality. And that’s what I would bring to bear in the case of Vermes evaluation today.

[01:09:22] Shree Viswanathan: Of course, we can’t run around assigning, you know, super high multiple to all businesses and claim that they’re quality. And that’s where I would bring in, for example, Peter Bernstein’s. 1956 article in HBR to bear when you bring all that to account, you know, you’ve got a business that is almost that doesn’t have any competition.

[01:09:45] Shree Viswanathan: Has complete control over its growth as control over its pricing power. has a strong brand loyalty. When you bring all that together and you bring Bharat’s view of quality and how it translates into valuation, current valuation, I would say is fair. It’s probably not cheap, but I don’t think it is supremely rich.

[01:10:09] Shree Viswanathan: It’s just fair, and the historical performance tells you a lot about why one should at least take a view at what Bharat is saying and what Peter Bernstein has written about. That’s how I view valuation today, and that’s why it’s part of my portfolio.

[01:10:27] Clay Finck: Oftentimes the toughest part of some of these quality companies is figuring out the right valuation.

[01:10:33] Clay Finck: I looked back over the past five years and there’s been three scenarios where the market sold off this stock by 20 percent or more. I think that’s one other thing about the company is the drawdowns. I think the volatility relative to the market tends to be lower based on what I’ve seen. I think the pricing power is also worth revisiting.

[01:10:53] Clay Finck: You mentioned the recent price hikes that were above average, but I think over time their price increases have actually been pretty modest. So do you know what price increases look like say over the next three to five years? Or does management give a sense on what that might look like?

[01:11:12] Shree Viswanathan: They don’t talk about the future in those terms, but you can absolutely look back and see what they have done and why they have incorporated those price increases.

[01:11:22] Shree Viswanathan: That’s how I arrive at this. It’s somewhere in the high single digit percentages price increase. Of course, in the case of 2024, Axel Dumas in the earnings call did say they were instituting eight to nine percent price increase, but it’s generally in the high single digit percent at the company level, and different geographies may have different price increases.

[01:11:45] Shree Viswanathan: That’s been a consistent theme. In fact, going back to the book about luxury by Kapferer, one of the things he talks about is a luxury company must institute price increase irrespective of what the underlying economy does. And in fact, do not have a price based or a discount based sale program. If you walk into a store and you end up buying, eventually buying, say 30, 000 worth of Birkin bag, and for that exact same bag, I go in and buy a 20, 000, how would you feel if I told you that?

[01:12:20] Shree Viswanathan: So, in luxury, discount to pricing is never The right strategy. Most of them do not do it. But instituting this price increase is somewhere in the, I would say, high single digit percent and that’s been consistent. It’s essentially, Axel Dumas, he talked about this. It was his mom in the 1980s who came up with a strategy of having this price increase at a percent higher than the cost.

[01:12:45] Shree Viswanathan: In this case, cost increase was around 6 percent and they’re pushing through a few percent more than the cost. That’s how they end up in this high single digit percent. So that’s been consistent for a long time. I expect them to continue to do that in the next three, five years and far into the future.

[01:13:05] Clay Finck: Yeah, and some other points on valuation I think are also worth noting is that the market tends to put a premium on certainty. So if there’s a high level of certainty that free cash flows are going to continue to grow and revenues are going to continue to grow and it’s a good inflation hedge, they can increase their prices in line, at least with inflation.

[01:13:23] Clay Finck: And I believe you mentioned earlier that it was LVMH and Hermes that have been growing in China. And I think on our previous call, you mentioned to me that Hermes is going to be able to grow in essentially any economic environment. One, due to the quality, but two, just due to the luxury market overall, the growth being quite strong globally.

[01:13:43] Clay Finck: Yeah, so maybe there’s more to add on China, because China’s around half of Hermes’s business. And I think it’s really amazing to hear that Hermes is still growing in China and in Asia, despite these economic issues they’re currently going through.

[01:13:59] Shree Viswanathan: Absolutely. Absolutely. Before I forget, we brought up a very interesting point about inflation.

[01:14:05] Shree Viswanathan: I don’t know who ran this study, but somebody did, and they actually compared the price of gold, the price of S&P 500, the index, and the price of Birkin bag. As you may guess, over a long stretch, I think about 25 years or so, S&P, of course, beat out gold, hands down, but the price of Birkin actually beat out S&P itself.

[01:14:28] Clay Finck: It’s honestly unbelievable.

[01:14:30] Shree Viswanathan: Yeah, and so this person was essentially pointing out how Birkin could be a better inflation hedge than many things that we generally consider as inflation hedge. That’s for you to chew on later, but back to your question about China. Many luxury brands have benefited from this, enormously benefited from this growth of China.

[01:14:53] Shree Viswanathan: I mentioned luxury as a sector has grown at two times the global GDP since the mid 90s. Much of it is due to the growth of China. And today, both LVMH and Hermes, for example, have a little less than 50 percent of their business coming from Asia X Japan, which is essentially China. Japan, by the way, is another big market, has been a big market for luxury for a long time.

[01:15:20] Shree Viswanathan: And as I mentioned, that gentleman, Francois, he moved to Japan because the Japanese market was growing back in the 70s. The other interesting aspect, this is not just China. The other interesting aspect about Hermes is when they operate these stores. What they maintain in each store is essentially catering to the local clientele.

[01:15:43] Shree Viswanathan: There are many luxury companies that cater to the tourist community. Chinese are known to spend enormously on their when they travel. And so many luxury brands and premium and super premium brands have geared up their businesses to cater to that touring Chinese community. But for example, in the case of Hermes.

[01:16:03] Shree Viswanathan: What you may find in a Hermes Beverly Hills store would be different from what you would see in Boston. And that’s because the store manager, the director, is buying products from the company that cater to the local community. And that’s another distinct feature I want to highlight here. Twice a year, every six months, The store director, approximately 300 stores, 295 to be precise, but 300 stores, all these directors go to Paris twice a year, and they buy products that they think, or they essentially get products from the headquarters that they think will sell well in their store.

[01:16:45] Shree Viswanathan: And that’s the reason why products in different stores may look different. Of course, there are going to be similarities like some of these handbags and a few other products that they sell, but the scarves, for example, that you find in Beijing may be different from what you find in Bombay or Mumbai. So, that’s another distinct feature.

[01:17:04] Shree Viswanathan: Catering to the local community as opposed to the tourist community. Is an important feature that has helped the company come through different cycles. And today in the most recent quarter, also announced that along with many other luxury brands that their sales in China was a little soft. Chinese buyers have historically this was actually who mentioned this.

[01:17:27] Shree Viswanathan: He said, chinese buyers have historically relied on their local real estate and their stock market, which has been the support for their wealth to be able to spend on luxury products. As you very well know, both asset classes have been hurt badly in China. And that’s one of the reasons why the luxury market has had this.

[01:17:48] Shree Viswanathan: soft patch. Be that as it may, they still have a very robust presence in China, 30 some stores, the second highest number of stores around the world, you know, 40 something in the U.S., 30 something in China, and I think 22 or 23 in France. They still have a big presence there and they expect the Chinese buyer to be able to come back and, you know, buy our best products over time.

[01:18:12] Shree Viswanathan: But in the meantime, they’re not necessarily just waiting for the Chinese buyer to come back. Within Asia, for example, as I mentioned earlier, India is a big market for them. The Indian luxury market itself is expected to grow three times. In my most recent trip, for example, I was in Mumbai. I was going through, going in an Uber to one of my meetings, going through the largest slum in the world.

[01:18:38] Shree Viswanathan: This is the slum where part of the movie Slumdog Millionaire was shot. Going in the opposite direction to me was a Rolls Royce. This is a very common scene in India. This is a country with contradictions galore. I come from a city down south, a city called Chennai, used to be called as Madras.

[01:18:58] Shree Viswanathan: Madras. Supposedly a conservative city. Right close to the airport is a Rolls Royce dealership. I was very surprised. This is to just highlight the fact that India as a luxury market maybe is at a very incipient stage, but is absolutely bound to grow. That’s just one of the markets. Africa is growing through similar growth pattern.

[01:19:22] Shree Viswanathan: Much of Indonesia, Vietnam, a few other Southeast Asian countries are also growing at a reasonably good clip. And that’s partly why I keep saying I have a growth expectation that’s slightly better than inconsistent numbers relative to what they’ve done in the past. Definitely better than many other luxury markets.

[01:19:43] Shree Viswanathan: So yeah, China is a big market as is going through a relatively soft patch company and a few of its competitors do expect. The Chinese market to come back may take a little longer than expected, but we’ll come back. In the meantime, many other peripheral markets are opening up at a healthy pace.

[01:20:03] Clay Finck: One more question on China and India, so 295 stores today globally, do you have an idea of what the store counts look like in India and China and if they’ll be pursuing opening new stores in those markets in the coming years?

[01:20:21] Shree Viswanathan: Absolutely. So they currently have 36 stores, I think, in China, but only three in India, only three. The third one was just opened recently, but in both markets, they expect the number of stores to go up. I mentioned anecdotally from my own experience as to where I see luxury in India. And I left the country a long time ago, and it was an absolutely poor, it still is poor, but it was an absolutely poor and socialist country, has come a long way, is positioned exceptionally well, is evident in many of the market dynamics that we are seeing today.

[01:20:58] Shree Viswanathan: That’s just India. China, over the last 30 plus years, has had a phenomenal growth. No time in history have we seen so many hundreds of millions of people get upgraded from penury and poverty to middle income and upper class. As I mentioned, they just expect this soft market to play out over the next few years.

[01:21:17] Shree Viswanathan: They’re still growing their store base within the country. I’m not sure what the plans are in terms of specific numbers for both countries. And that’s something that they don’t disclose publicly. What they have disclosed is the ateliers, the workshops, and they are talking about just four workshops over the next four years.

[01:21:36] Shree Viswanathan: But the number of stores in both countries are expected to grow. I suspect the number of stores in India will be growing. The number of new stores in India will be more than number of new stores in China. I think that’s a reasonable conclusion to make.

[01:21:51] Clay Finck: Wonderful. It’s really fun to talk about all the good things in a company like Hermes, but I think I can come up with plenty of reasons why things might go wrong or things might not go as planned.

[01:22:04] Clay Finck: Just to mention a couple here, let’s say younger generations aren’t as interested in high end luxury. Or maybe the growth in India doesn’t go as planned, or the Chinese economy continue on its downward trajectory, or maybe it takes a while to recover. Yeah, I’m interested in hearing what you think are some of the biggest risks that you’d be monitoring as an investor in this company.

[01:22:28] Shree Viswanathan: So, in a company that is more than 180 years old, you would suspect that it’s gone through some existential questions. And of course it has. As I mentioned, Adolf, one of the brothers of Emile Morris, left the business in 1919 because there was a significant slowdown in the sales of horse harnesses and saddles because automobiles were sprouting up all over the country, all over the world.

[01:22:55] Shree Viswanathan: Of course, Emile Morris started supplying to both the automobile market and some of the nobility that existed at that time. That’s just one example of how the company had an existential question raised, and it has come through very successfully. It’s also had the factor of luck work in its favor. For example, even though the bag itself was released to the market in the 1920s, Kelly, as a bag, did not become as popular until Grace Kelly, the Princess of Monaco, a Hollywood actress, was essentially hid her pregnant belly using the bag. And Birkin bag itself was also an accident that turned out to be a big success. Jean Louis Dumas, he was sitting right next to this actress Jane Birkin, and she spilled a whole bunch of things from her bag and complained about not having a good bag to keep all her things, including her kids things, in a big enough bag.

[01:23:54] Shree Viswanathan: And that’s how the Birkin was founded. So while the company has had existential questions raised, it’s had some lucky breaks, it came through this Bernard Arnault assault successfully, and I’m sure it’ll go through some existential question in the future. I’m absolutely not discounting it. However, I am confident that having come through these tough situations, it has the experience, the expertise, the management team, and the financial wherewithal to withstand any kind of assault.

[01:24:30] Shree Viswanathan: One of the quirky things about this company is, there are many quirky things, but one of the quirky things about this company is they put out an annual report that runs to almost 600 pages. 2023 annual report is about 592 or 93 pages. European companies generally cover many things ESG related and all that, which makes the annual report even longer than American ones, but this is one of the longest that I have come across.

[01:24:59] Shree Viswanathan: It is so long that they actually have a sort of bibliography or a sort of a cross reference table in the end. Where you can search by words or phrases and go to the actual page number. But in any case, in the middle of the annual report, about 380 or 384 page number, they have a nice table about risk factors, certain risk factors that they view, and the severity of the risk factors on one axis, and the variety of risk factors on the other.

[01:25:29] Shree Viswanathan: As you very nicely said, listening to Howard Marks podcast, debt is a killer in many businesses. We don’t have that problem here, right? It’s a net cash balance sheet, has been a net cash balance sheet for a long time. Ownership interest, it’s held within this family and now they have this other investment vehicle called Krefeld Invest, which makes it even more difficult to pry open the family ownership.

[01:25:56] Shree Viswanathan: Those things are not going to be a problem, but if you go back to this table, one factor that they list, and which I agree with, is the reputational risk. Just a few years ago, 2020 or 21, there was a video circulated which showed in a crocodile farm in Australia, the treatment meted out to these crocodiles.

[01:26:19] Shree Viswanathan: It was very inhuman. It was very unfriendly. People immediately concluded that it was Hermes controlled crocodile form. Hermes, by the way, it controls its suppliers. Crocodile skin being an important quality feature on a working bag. They do control crocodile farms in Australia. But it was a video that was distributed and got wide attention.

[01:26:44] Shree Viswanathan: In fact, Jane Birkin, before she passed away, she actually announced that she may actually dissociate her name from the company because she was so perturbed by this mistreatment. Later on, they found out that this whole footage was from a farm that somebody else had. It was not a Hermes form, but the damage was done.

[01:27:06] Shree Viswanathan: That sort of a reputational risk is what I worry about the most. By the way, to address this leather and various different skins, One of the areas where the company is spending capital on is something called mycelium. Mycelium is essentially the roots of a mushroom. Apparently when you put a whole bunch of roots of the mushroom together, it gets into a material that is close enough to leather.

[01:27:33] Shree Viswanathan: And so they’re working on making their products even more eco friendly. I’m not sure when they will come out with mushroom leather, but to avoid these types of reputational risks. I don’t think they’ll be able to avoid completely, but to at least address the need for these types of animal skins and other types of leather, they are working on certain alternatives.

[01:27:56] Shree Viswanathan: In fact, Patrick Thomas, the CEO who defended the company against Bernard, He’s now on the board of a company in California, which focuses on mycelium. So bringing it back to your question, I think that sort of a reputational risk is what I worry about the most. I’ll keep my fingers crossed as to when the next existential question arises.

[01:28:20] Clay Finck: Yeah, that makes sense. It’s pretty easy to tell you’re very knowledgeable about this business. So before I give you the final handoff, I’m not sure if there’s anything else that you’d like to cover just to give you the opportunity to share anything we might’ve missed during this discussion.

[01:28:36] Shree Viswanathan: No, your questions were very well thought out, detailed, given that the company has such a long history, we could pick any one of those topics and go into just one question or maybe a couple of questions and make that a podcast by itself.

[01:28:51] Shree Viswanathan: But thank you for giving me the opportunity to talk about a very high quality business. Whether I own it or not, you know, the business is, business talks quality and highlights its own strengths and establishes its presence in a very dynamic industry. So thanks for giving me the opportunity to talk about a wonderful business today.

[01:29:13] Clay Finck: Well, Shree, this was definitely a very fun conversation, and I’m really happy we could put this one together to learn more about just this amazing business. So please let the audience know how they can learn more about you to get in touch with you if they’d like to.

[01:29:28] Shree Viswanathan: Sure. I am, I run a fund called SVN Capital Fund LP.

[01:29:35] Shree Viswanathan: I’m on svncapital.com. That’s the website to my fund. And I’m also on Twitter, handle is at SVN Capital. I would love to hear from some of your listeners if they’re interested in learning more about Hermes or just my fund.

[01:29:50] Clay Finck: Well, Shree, again, thank you so much. This was absolutely wonderful and I’m excited to deliver it to the audience.

[01:29:58] Shree Viswanathan: Thank you again. Appreciate this.

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