Professor Sonia MarcianoSpring 2011

LUXURY

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Value Creation by Luxury Firms Has Distinct Features…

Price:Quantity does increases as price decreases – but can diminish WTP

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Drivers of WTP:Quality & styleVariety & availability of complementary itemsPerhaps most critical are many unquantifiable features such as exclusivity, “affiliation”, authenticity, how “classic”, how “trendy”

Cost:Net efficiency gains are valuable but are challenged by:

- Increased monitoring costs- Preference for the “western made” moniker

• Risk to WTP if increase volume

Buyer Surplus

Producer Surplus

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Luxury is Distinct from Other Markets:

• Customer relies on signals rather than direct observation• Short term gains often create longer term

liabilities • Efficiency gains are difficult. Also,

“negative network effects” make these gains less valuable.

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Objective of the Luxury Brand is “Endogenous” Demand

• Endogenous vs. Exogenous Demand

• Revenues without discounting

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Airlines Don’t Populate Lists of “Best Brands”

• The travel “vertical” includes the:– Ride to the airport– Airport location– Airport operations

• Airlines responded to low profitability by:– Outsourcing call centers– Outsourcing maintenance– Outsourcing food and other services

• Consequently, airlines typically do not control much of what affects a flier’s experience.

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The Airline Story is Analogous to a Luxury Maker Dependent on Retail Channels Run By Others

• The misalignment between luxury brands and retail was made clear by Saks’ “nuclear” discounting in the fall of 2008– Saks did not anticipate that sales would soften by the

summer of 2008– Saks went with 70% off rather than risk inventory

accumulation– Some smaller luxury brands were left with negative

returns– Luxury brands with their own retail operations were

in an additional pickle as their own stores had to match Saks’ prices.

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Some Retail Figures• Recent returns (rough net income/sales):– Saks: 1-2%– Nordstrom: 5-6%– Walmart: 5-6%– Gap: 12-14%– Lulu Lemon: 17-19%

• Gross margins are in the 40% range, but net of fixed operating costs (rent, labor, warehouses, transportation, etc.), most returns are in the single digits.

• Turnover (roughly):– Saks: 2.5– Macy’s: 3.0– Nordstrom: 6.0– Walmart: 8.9

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Retail Economics• Retailers are the re-real estate business --“rents”

are driven by:– Margins– Turnover

• Relatively more of their costs are fixed:– During “good” times, retailers can hold out for

margins and so are aligned with luxury brands– During “bad” times, retailers may drive turnover

through discounting

• Demand for retail services is relatively exogenous:– Generally, less customer intimacy with retailers– Discounting is “quick fix” 8

Key Insights• Retailers often generate negative externalities on luxury brands

– Saks– Nordstrom

• How might some brands respond?– Do their own forecasting! Brands should not be complicit with

retailers being their own (and the brand’s) worst enemy.– Determine HOW each potential retail “partner” drives turnover --

ways to drive turnover including discounting, product mix, location, operations, forecasting, sales service, etc. Some ways hurt luxury brands more than others – some may actually be good luxury brands.

– Don’t think of a “store within a store” as an easy fix:• Fees are correlated with the “rent” the retailer is earning on its

shelf space • Retailers see these deals as a “twin edged sword” as this set up

doesn’t leverage their talent, confuses shoppers and reduces the retailers operating flexibility.

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Integration into Retail Appears Effective for Larger Players

• LVMH controls around 60 brands• Operates 2,400 stores• Arnault family controls 63% of LVMH’s voting

rights• LVMH uses its reach and concentrated

control to impose discipline on LVMH’s operations.

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China is Currently LV’s Biggest Market Where…

• 26 cities have populations in excess of 8 million.

• 93 cities have populations in excess of 5 million.

• 177 cities have populations in excess of 3 million.

In contrast, 35 cities in Europe have populations in excess of 1 million.

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LV Doesn’t Economize on Rent or Use the Brand to Secure a Discount on a Lesser Location

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No and No!

LV Chooses the Developer and the Mall Operator Very Carefully

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LV wants to control the look, feel, smell, etc. of the environment of their stores. Avoids “short term” wins that could diminish the brand.

LV generates Endogenous Demand by Reinforcing Their Background and Heritage and by Building a

Relationship with Customers

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LV sticks with classic rather than trendy merchandise—next best thing to predicting demand.

LV Doesn’t Have a Sense of Humor About Infringement

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Preserving WTP in China …• Harder than in ROW due to – Culture of bargaining and value seeking– Government restrictions on luxury advertising– Challenge in finding brand appropriate, detail oriented

salespeople – 1/1000 make the LV cut.• LVMH is dominating China (40% share) through its

highly vertically integrated structure.– Design (France)– Production(France/US)– Retail (Ubiquitous)

• LVMH is aggressive about preventing and litigating IP and copyright infringement

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Notable for their considered choices.

In Sum• Like airlines, luxury brands risk WTP through outsourcing

activities and JVs– The value of luxury brands is impacted by the actions of

other players in their ecosystem.– Luxury brands need to manage to the externalities.

• It is difficult to amortize the cost of vertical integration over a few brands, hence, the industry may further consolidate.– Interesting that LVMH has taken about a 30% stake in

Hermes (Hermes is resisting).– LVMH has relatively efficient assets and capabilities with

global reach that would provide leverage for Hermes. – Hermes, of course, employs highly skilled talent and

craftspeople, has a few hundred retail stores and is a very exclusive brand with some iconic items. It either cannot drive more sales on its own or it knows better!

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