Hermès International: Why Artisan Craftsmanship Is A Bet On The Dawning Technological Revolution
At the dawn of the AI age, Hermès is still focusing on craftsmanship and scarcity, which could make its luxury products increasingly desirable and valuable, especially in an era of rapid automation and commoditization of goods.
This is the author’s opinion only, not financial advice, and is intended for entertainment purposes only. The author holds a beneficial long position in Hermès International S.A.
On November 8, 2024, I added Hermès International to my Innovation & Freedom Portfolio (external link: Snowball Analytics). Since then, the stock has gained 20%. As promised in the last portfolio update, I would now like to explain this stock pick.
Futurist and AI researcher Ray Kurzweil accurately predicted the AI revolution more than three decades ago in works such as "The Age of Intelligent Machines" (1990). In his 2024 book, "The Singularity is Nearer" Kurzweil writes that:
"With AI rapidly expanding its breadth and capability during the 2020s, this will radically transform areas we do not normally consider to be information technologies, such as food, clothing, housing, and even land use. We are now approaching the steep slope of these exponential curves."
We are therefore at the dawn of a technological revolution in which almost all sectors of our economies will experience an exponential increase in efficiency through automation. We will see the commoditization of many everyday goods, such as staple foods or clothing, as has already happened with information (e.g., text, images, sound). Hermès, on the other hand, will probably never automate its production. On the contrary, traditional craftsmanship is in the French luxury company's DNA. Paradoxically, this is why I believe that Hermès is not only immune to the coming tsunami of technological innovation, but also in a position to benefit from it.
Throughout history, technological revolutions have always led to more wealth. While collectivists have long complained about the growing gap between rich and poor, innovation has undeniably created extreme wealth for a few, but also brought prosperity to the masses. But what to do with all this wealth? People crave individuality and seek goods with emotional value. They do not find this in mass-produced goods. Wealth and the demand for luxury goods have been correlated since ancient times. Several studies suggest that the luxury goods market will continue to grow at an annual rate of ~6-8%, and Hermès has historically grown at an above-average rate.
Thierry Hermès founded his saddlery in Paris in 1837. He himself was born in 1801 in the German city of Krefeld, which was then occupied by Napoleonic France, hence the name of the family office "Krefeld Invest" of Thierry Hermès' descendants, who still control the company in the 6th generation. The three branches of the founding family, which together hold around 67% of the company's shares, take a very different long-term view and do not allow the company to be tempted by short-term profits to act at the expense of the brand's integrity: While some other luxury brands have been tempted in recent years to use the means of mass production for their high-priced goods in order to make a quick profit, Hermès has avoided selling its goods at an inflationary rate and thus diluting its brand value.
In my opinion, one of the most valuable books on business valuation today is "The End of Accounting" by NYU professor Baruch Lev, published in 2016. Lev demonstrates that the value of intangible assets cannot be adequately reflected in traditional GAAP (Generally Accepted Accounting Principles), which are still in use today. To illustrate, let's consider the following hypothetical and oversimplified scenario: Let's say a software company has $100 million in revenue and $50 million left over after expenses. The CEO says to himself, "We're doing well, but the competition is out there, so we're going to invest every penny we have into improving and developing the software we sell to expand our market position". Despite the clear long-term nature of this investment, these costs are now written off as R&D for the year under GAAP, and the software company makes no profit from a GAAP perspective. Let's take a company in the old industries with the same sales and the same costs. If the CEO of that company invests the remaining $50 million in a new factory, for example, he can depreciate that amount over 25 years under GAAP and therefore only has to write off $2 million this year. This means that the industrial company has a GAAP profit of $48 million, while the software company has not earned a dime under GAAP.
What does this have to do with Hermès? At Hermès, such long-term investment is even harder to understand. In my view, Hermès' long-term investment is the potential short-term profit that the company forgoes in order to maintain its brand integrity. Suppose Hermès offered a Birkin bag to every customer who wanted one. Sales and profits would skyrocket over the next few years, but the brand would become increasingly diluted until demand collapsed as the bag lost its mystique. Therefore, I think the seemingly absurdly high valuation with a P/E of around 60 is misleading, as the company is well positioned to continue to outperform the luxury market.
And this company has always been a champion of luxury: since its IPO in 1993, its share price has averaged more than +20% per year and has increased more than 300 times since then, significantly outperforming many technology stocks. So Hermès' bet on craftsmanship has been incredibly successful since 1993 in an era of undeniable automation, so why not continue this trend at the dawn of the AI age?
The non-scalability of this kind of craftsmanship results in the rarity of its products and thus their value. Exponentially increasing automation will devalue many goods. In contrast, in this world of abundant homogeneous goods, the handcrafted, unique luxury goods that Hermès sells will stand out more than ever.
Hermès employs some 7,300 artisans in 52 production facilities across France, and trains them for decades before they are allowed to lay their hands on high-priced flagship products such as a Birkin bag. It is not uncommon for an artisan to spend more than 40 hours making one of these bags. And yes, one artisan makes one bag. This deliberate non-scalability of production ensures that the value of the goods increases steadily. In fact, Hermès bags, such as the legendary Birkin or Kelly bags, often fetch significantly higher prices on the secondary market than when they were first sold exclusively in one of the company's stores, of which Hermès has more than 300 worldwide.
Hermès' mostly wealthy customers are willing to accept annual price increases, and even loyal customers have to wait several years for certain bags, such as the Birkin. With this incredible pricing power, Hermès achieves margins of around 70% - margins that are otherwise almost only seen in the tech industry. A positive side effect of this is the company's resilience: while other fashion brands saw their sales plummet during the financial crisis, Hermès' sales didn't suffer because the waiting lists for its most sought-after products were long enough to ensure steady sales.
One risk is the focus on Asia for further growth. An economic downturn there or a trade war could have a negative impact on Hermès' valuation. At the same time, there are hardly any Hermès stores in India, so there is still a lot of potential here. Another risk is the high dependence on a few core products, such as the Birkin and Kelly bags, where changing consumer preferences could have a negative impact. Another risk could be a negative outcome of a class-action lawsuit filed in California in March 2024, which alleges that Hermès engaged in an "unlawful practice of tying" by requiring customers to purchase other products before even having the chance to purchase one of its most coveted bags.
In summary, in an increasingly automated world, Hermès stands out for its uncompromising craftsmanship and exclusivity. High margins and resilience, even in times of crisis, underline the strength of its business model. Although there are risks, such as the strong focus on Asia and the dependence on a few best-selling products, the growth prospects (e.g. in India) and the unique brand positioning prevail in my opinion. Overall, I think Hermès should continue to benefit from the growing desire for individuality and rare, handcrafted quality.
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