IMPORTANT DISCLAIMER: THE BLOG POST IS NOT INVESTMENT ADVICE. DO YOUR OWN DUE DILIGENCE.

General 

Interest rates have continued to fluctuate this quarter as the market digests inflation reports and adjusts expectations. Government bond yields hover at around 4%.

I continue to use a discount rate of 7-8% to value productive assets, which should provide a good margin of safety if rates, for whatever reason, rise from the current level. I’ve also increased my long-term terminal growth rate assumption to around 2.5% given the higher inflation environment. Reading between the lines, this equates to a short-hand guiding P/E multiple of around 20x.

It’s important to note that we are not trying to predict the movements of interest rates on any frequent periodic basis. That said, we have a sense as to where the long-term rate may be and we just conservatively assume an adequate margin of safety above that level.

Key Portfolio Change – Burberry and Prada

The main update in my portfolio this quarter was the decision to sell my position in Burberry and redeploy that capital into Prada. 

While Burberry may look optically cheap based on reported earnings and management guidance (8x and 12x respectively), I believe the quality of those earnings is weak due to the company’s high exposure to discounted outlet sales. 

An estimated 30-40% of Burberry’s retail revenue comes from outlets like Bicester Village where you can buy core products like the trench coat at 30-50% discounts to full price. This is problematic for a couple reasons:

First, a low percentage of full-price sales (with limited discounting) demonstrates that a brand is not in sync with consumers in terms of price and value proposition. If you cannot sell the majority of goods at your predetermined price, i.e. “full price”, it means you do not have a tight grip over your pricing, which makes revenue forecasting less predictable.

Second, the other leg to a predictable revenue stream is volume. “Do you have a full control over volume?” On this front, Burberry has 15% of its revenue derived from the wholesale channel, which is not massive and the company deserves some credit for cleaning up this channel in the last 3-4 years. However, it still lacks behind other luxury brands due to: 1/ higher use of external third-party manufacturers and 2/ lack of owned-industrial scale operation. Both of which Management provides scant data, but anecdotal evidence points to weaknesses here (e.g. the lack of industrial investments – I don’t believe Management has ever done any sort of major investment plan into industrial capex, other than small acquisitions here and there vertically in the recent years – had it been strong they would have clearly emphasised / advertised or even do plant tours to communicate the strong craftsmanship to consumers!)

Burberry therefore is lacking on both fronts: price control and volume control. 

This creates issues in being able to control the top line and also makes it very difficult to manage brand image. The more consumers see discounted Burberry products out in the market, the more the perceived value of the brand erodes over time. Unauthorized resellers and “gray market” or “parallel market” activity is also harder to control with a more wholesale vs retail driven distribution model and a more external-manufacturer-reliance vs in-house manufacturing model.

Compounding these issues is Burberry management’s incentive structure, with the CEO’s bonus linked to maintaining sales above £3bn annually. This prevents any major change and Burberry needs a major change. To truly elevate Burberry brand image and putting it on a healthy full-price growth trajectory requires a day-1 haircut to revenue of 30%-40%, the equivalence of £750m-£1bn of outlet / discounted revenue. 

Communicating this to the market would be challenging if pursued.

My estimate is that Burberry’s “true” earning power, based solely on full-price sales and assuming some conservative conversion of outlet to full price sales would be approximately £4 billion (20x on 10-12% EBIT margin on £1.8-2bn full-price revenue with net cash and some value from licensing). This is compared to the current market cap of £4.4 billion and therefore the stock is not attractive.

Given the above dynamics, I believe there is limited upside, or even some downside to a Burberry investment case, especially in the absence of a draconian, multi-year effort to eliminate discounting and elevate brand perception. Management may hope to stealthily achieve this by using Daniel Lee’s creative “buzz” to drive full-price demand, but I view this as a low-odd bet as revamped creative effort is not a credible investment thesis (i.e. how can you tell Daniel’s creative versus other designer? Everyone who gets elevated to chief creative officer of any major luxury investment house has in their past demonstrated a strong creative record).

The decision to relocate capital from Burberry to Prada is actually a “negative” process, in that all the bad attributes noted above are absent from Prada!

Prada screens extremely well on the key metrics that matter for a luxury brand:

1. Less than 10% of sales from outlets 
2. 80%+ of manufacturing is owned
3. 90%+ controlled retail distribution
4. 10-year of restructuring to revamp wholesale channel, retail / marketing investments and significant investments to build up vertical integration and industrial capabilities.
5. PRADA is a tightly controlled family business with consistent creative leadership from Miuccia Prada. The incentives are aligned for long-term brand elevation.
6. Strong brand momentum / brand heat with Prada and MiuMiu consistently in the top 5 of the Lyst index

Valuation-wise, Prada trades at 10.6x FY+5 (i.e. 2028) consensus EBIT but only 8x my own estimate. I believe sell side numbers are too conservative on the profitability of this operation – modelling only 25% EBIT margins in 5 years time vs 27-30%+ for other leading luxury houses and compared to already-achieved 22.5% EBIT margin in FY23. 

Large language model risk to current business model

An emerging risk worth monitoring is the potential impact of artificial intelligence on certain business models, particularly Google Search.

With Apple being likely to introduce a search engine choice screen on iOS devices in approximately 2-3 year time, Google could cede meaningful search-query share and ad dollars to emerging players that leverage AI/LLM capabilities at their core to create a compelling consumer search and answer experiences. 

By some investor estimates, losing iOS search equates to roughly $20/share in value for Alphabet and a $30/share haircut to this innovator dilemma in LLM. This translates to a 10% reduction in top line growth over the next few years. 

Is that an extreme level of valuation that market currently believes in, versus the existing data capabilities of Google? I’m still grappling with this very question…but I know for a fact that I will be constantly playing with different AI chatbots. It’s not yet clear what would be the killer application for a consumer facing LLM, perhaps search text, perhaps voice AI… For now, I’m maintaining a 7% portfolio position in Alphabet while continuing to monitor the competitive dynamics closely.

Book Recommendation 

A great book I’ve read recently is Jump: My Secret Journey from the Streets to the Boardroom. It’s an inspiring story of perseverance, redemption, and the power of believing in oneself to overcome even the most challenging circumstances (going to jail as an example!).