The Future Of Luxury by CNBC

Emerging economies are providing new demand for high-end goods – but traditional luxury markets face uncertainties, writes Boyd Farrow

In mid-January, at its gleaming new 8,000m2 Milanese headquarters – all polished stone floors, glass walkways and decked courtyards – Ermenegildo Zegna unveiled its autumn/winter 2008/09 collection. But while the men’s luxury clothing group talked up the latest, high-tech fabrics that adapt to temperature changes, its chief executive admitted that he expects the current economic chill to continue for some time.

Gildo Zegna said sales would slow this year partly because of US subprime credit fallout, and that his company is relying on emerging markets to take up the slack. “Sales will be up, but I don’t think they will be double-digit,” he predicted. “There is a slowdown in the American economy, Japan is flat, but we still can count on a decent increase in Europe, a stronger increase still in China, South-East Asia and Eastern Europe.” He added: “Thank God for emerging markets”.

Zegna’s hosanna joins a growing chorus from Europe’s luxury giants. At an industry conference in Moscow last November, Bernard Arnault, chairman of LVMH, forecast that sales of luxury products would double in the next five years to €300bn, mainly because of market growth in China, Russia and India, but also in Eastern Europe and Latin America. Arnault also expects more growth in Western Europe, Japan and North America, which he notes still consumes just 16% of luxury goods but accounts for 28% of world GDP. Indeed, it is precisely because parts of the underexploited US market have more in common with emerging luxury economies than developed ones that the Frenchman expresses such a confident long-term outlook.

According to Franck Petitgas, international investment banking chief at Morgan Stanley, despite the US downturn and slower sales growth in Western Europe, luxury companies posted results for the third quarter of 2007 that showed an average growth of 12% to 16%. Emerging markets, he says, played a substantial role.

The significance of China, with its population of 1.3 billion, cannot be understated. This is a luxury market that did not exist 20 years ago but which now boasts more than 300,000 millionaires and a middle class of around 250 million people. Ernst & Young reckons that €4bn was spent on luxury goods in 2006, while Goldman Sachs forecasts that by 2015 China’s consumers will account for 29% of all luxury goods sales – making it second only to Japan.
Also tantalising the luxury giants is Russia, where oil wealth has led to a retail revolution, evidenced by TSUM and GUM, Moscow’s most glamorous department stores, and the packed, boutique-lined streets of Stoleshnikov Pereulok and Tretyakovsky Proyezd.

However, while a breathless Forbes magazine fixates on Moscow being home to 53 billionaires, general incomes – and the size of the middle class – are rising throughout Russia. The 2005 opening of Luxury Village in Rublyovka underscored how upscale retail is growing outside the capital, and TSUM and GUM are both jostling for real estate in St Petersburg and the other nine Russian cities with populations exceeding a million.

Michele Norsa, chief executive of Salvatore Ferragamo, notes that the 15 countries of the former USSR account for 286 million people. “The Ukraine’s average spend in luxury stores in Europe is higher than Russia’s. The wealth in cities like Baku, Kiev and Vilnius is staggering,” he says. “This is why, while we hear of the mature market’s relative slowdown, we believe the growth and underexploited potential of the BRIC (Brazil, Russia, India, China) economies will guarantee the luxury goods industry an even brighter future.”

The brightest beacon is India, whose economy is growing at 8% and, in 2006, had around 1.6 million households earning over €70,000 and spending more than €6,000 on luxury. This, reports analyst Technopak, will grow 14% annually, while several other analysts predict that during the next five to 10 years, India could become luxury’s biggest market. Yves Carcelle, chief executive of Louis Vuitton, notes that a century ago the maharajahs were among the luxury brands’ biggest customers. “This is an important point because there are other countries where there is no luxury tradition,” he says. India’s luxury renaissance only began in 2006, when its government allowed FDI of 51% in single-brand retail operations. It is estimated that India will have 300 new malls by 2010. From this month consumers on New Delhi’s outskirts will be able to visit the Emporio mall, with its luxury annex. More than 70 international labels have signed up and Emporio’s developer DLF plans similar malls in Hyderabad, Chennai and Mumbai.

Nevertheless, some analysts are sceptical that booming sales in emerging markets will offset downturns in the US and European economies in the short term – particularly with a possible recession approaching. Melanie Flouquet, head of luxury research at JPMorgan Securities, notes that the Middle East, Russia, China, Latin America and India may be rapidly developing, but combined they still account for only 18% to 20% of global luxury goods sales. China represents 6% to 7%; the Middle East 5%; Russia 4%; and other emerging markets about 2%, she says.

Flouquet points out that the large luxury goods conglomerates, such as LVMH and PPR, are counting on emerging markets for 15% to 22% of their revenue. She warns that India – which still has poor basic infrastructure – was more a potential than a current source of abundant revenue for luxury firms. “Japan and Europe must grow,” she says, adding that the whole financial community was also watching for signs of whether the decline of the dollar against leading world currencies and the credit crunch would lead to an economic decoupling from the US.

Many doubt that Europe or Japan can escape America’s gravitational pull. Flouquet says Japan is still the leading market for luxury, despite signs that aside from the ultra high end the sector may be losing its pricing power – the ability to offset currency swings by upping prices.

For the past four years, luxury goods companies – many of them based in Europe -have had to contend with a dollar that was weakening against the euro. That meant that US revenues added less to their bottom lines in 2007 than in 2003, even if stateside sales had risen.

On 22 January, after Asian stocks had dropped 5% overnight and the European markets opened in free-fall, Lehmann Bros downgraded the entire luxury sector to ‘negative’. Meanwhile,
according to Luca Solca at Bernstein Research, problems in the general economy are certain to spill over into the luxury sector, especially for companies that have tapped into the aspirational luxury market.

All signs suggest that Mr Zegna may not be the only luxury brand CEO to be sweating into his high-tech fabric as the year chugs on.