This morning it was reported that branded fashion company Michael Kors (KORS) is in the throes of taking control over Italy's high end fashion company, Versace. Now for those wondering, I have a distant relationship with the family behind the company given the ancestral lineage to Calabria, Italy - nothing more, nothing less. And while that may of some interest to some readers, what I find more interesting is the continued strategic move by Michael Kors to reposition its business toward the high end. For those not familiar, this Versace move by Kors follows last year's buy of British stiletto-heel maker Jimmy Choo for $1.2 billion.
When we think of the term "living the life" we tend to think of an existence filled with joy, personal satisfaction and the ability to live life to the fullest, which usually implies the finer things, be they food and drink, travel and hospitality, automobiles, or clothing and other personal goods. The word "luxury" originates from the Latin word "Luxus," which means indulgence of the senses, regardless of cost. Premium to luxury products and services are defined by McKinsey & Co. as ones that have "constantly been able to justify a significantly higher price than the price of products with comparable tangible functions." The Boston Consulting Group (BCG), meanwhile, defines luxury goods as "items, products and services that deliver higher levels of quality, taste and aspiration than conventional ones." Between those two definitions are luxury brands like Louis Vuitton, Tiffany, Hermès, Gucci, Ferrari, Prada, Porsche, Rolex, Versace and Burberry.
According to data published by Deloitte, the luxury market reached annual sales of $1 trillion at the end of 2017, of which more than 80% was comprised of luxury cars, luxury hospitality and personal luxury goods. In 2017, the core of the luxury market remained the personal goods category. Apparel, beauty and handbags still account for the bulk of the market, with shoes, jewelry and handbags ranked as the three fastest-growing product categories for the year.
One of the demonstrative forces that is driving and shaping the luxury market is the increasing wealth of Chinese consumers. From 2008 to 2014, the number of Chinese households purchasing luxury products doubled, fueled by growing incomes and greater access to luxury goods. Since 2015, the primary driver of increases in luxury spending has shifted from consumers making their first purchases of luxury goods to incremental spending from existing luxury consumers. In 2016, it's estimated that 7.6 million Chinese households purchased luxury goods. That number represents less than 2% of total households in China but is more than the total number of households in Malaysia or in the Netherlands. Each of these 7.6 million households spent twice as much as French or Italian households, leaving Chinese luxury consumers to account for almost a third of the global luxury market.
During this past June 2018 earnings season, brands from Kering's Gucci to Britain's Burberry and French luxury handbag-maker Hermes all reported resilient demand from Chinese shoppers during the quarter, even as China-U.S. trade tensions escalated. Digging into June quarter results for luxury brands company LVMH Moët Hennessy Louis Vuitton S.E. (LVMHF) , its sales and profits in the first half of 2018 rose more than 10% year over year before adjusting for currency primarily because it has tapped into China's demand for luxury goods. Over the last few years, LVMH has continued to emphasize its presence in Asia and during the first half of 2018, its Asian store network hit 1,195 locations vs. 991 in 2016. Asia now accounts for 27% of its overall store footprint.
Michael Kors, however, has a long way to go as fewer of its overall sales for the 12 months ending March 2018 were derived from Asia, per its most recent 10-K filing. What we are seeing in this pending acquisition of Versace, one of the few remaining independent luxury brands, is Kors looking to not only swim upstream into the world of high-end luxury goods and red carpet cachet, but to tap into the growth market that is luxury demand in China. If the $2 billion price target is indeed the final one, it will take a toll on the Kors balance sheet, which saw its debt to debt-plus-shareholders'-equity at just below 29% exiting the June quarter. Some rough calculations suggest the pro forma balance sheet could hit a 58% ratio, which means higher interest expenses that would weigh on EPS expectations at least in the near-term. With Versace being private, it remains to be seen how profitable it is relative to the existing Kors business. If the acquisition is dilutive on the margin and EPS front, the question will be how does Kors leverage the Versace brand name to grow its way out of its financial impact.