Lap of Luxury V - Emerging Markets

GLOBAL
2 September 2005
Lap of Luxury
Enter the Dragon
Luxury Goods Global Team
Global Coordinator Antoine Colonna>> Research Analyst, Merrill Lynch (France) (33) 1 5365 5815 Flavio Cereda>> Research Analyst, MLPF&S (UK) (44) 207 996 1455 Mark Friedman Research Analyst, MLPF&S (1) 212 4449 1540 Virginia Genereux/Michelle Graham Research Analysts, MLPF&S (1) 212 449 5100/6862 Mohamed Mayet>> Research Analyst, Merrill Lynch (South Africa) (27) 11 305-5160 Rodolphe Ozun>> Research Analyst, Merrill Lynch (France) (33) 1 5365 5892 Aymeric Poulain>> Research Analyst, MLPF&S (UK) (44) 207 995 5547 Marni Shapiro/Jaime Sheinheit Research Analysts, MLPF&S (1) 212 449 0232/1991 Stacy Turnof Research Analyst, MLPF&S (1) 212 449 8262 Specialist Sales Emma Whybrow (44) 207 996 1544
Highlights of this Issue

Focus Topic: the Chinese Market
Emerging markets and China, in particular, are becoming increasingly relevant for the luxury goods sector. In this report, we examine the medium-term issues we believe will be crucial to determining which companies will successfully capture that growth. Lap of Luxury is the fifth in our series of reports analysing trends in global luxury goods, in which we provide comparisons and recommendations across the sector. The fortunes of the stocks in our coverage are still inextricably linked to European, American and Japanese consumers (each generating about 25% of sector revenues). However, Chinese customers are increasingly driving sector growth and are set to be the heavyweights of luxury goods buying in years to come. Looking at traditional regional performance, therefore, is increasingly irrelevant to forecasting future revenues. What now matters is who is doing the buying, not where it is done.
Travel Flows to Boost Spending by Emerging-Market Customers

With economic growth and favourable demographic trends, the acceleration of travel flows should boost revenue growth. Offshore spending by emerging-market buyers is two to three times greater than onshore spending. The World Travel Organisation estimates that the number of Chinese outbound travellers will grow at a CAGR of +22% in 2004-2008. We believe the Chinese could become the No. 1 customers for luxury goods as early as 2009, generating 24% of sector sales, up from 11% today.
Tomorrows Winners
Of the stocks we cover, we expect LVMH, Richemont and the Swatch Group to report ever stronger growth and higher margins in emerging markets, thanks to their greater market knowledge, superior financial means but also their uncompromising strategy to control the value chain. We show in the report that the balance of power is already similar in Greater China versus the rest of the world. This suggests that the companies that are not faring well in Europe, Japan and the US are unlikely to do much better in China and emerging markets in general in the medium term.
Our Key Stock Picks

LVMH (Buy, B-1-7) and Richemont (Buy, B-1-7) have, in our opinion, the greatest upside potential of the big caps in our sector. LVMHs valuation is still well away from normalised peak levels, especially if Louis Vuitton beats expectations this year; transitional 1H earnings are being increasingly pre-empted by the market and the theme of portfolio restructuring is, in our opinion, still actionable. We believe Richemont could significantly beat market expectations this year. Our price objective of CHF55 corresponds to a 12-month exit P/E of 21.6x for the core business, reasonable by historical standards. Value is emerging at the Swatch Group (Neutral, B-2-7), but for the time being, we remain Neutral for valuation reasons. We also like Burberry (Buy, C-1-7), a three-pronged growth story (sales momentum, Atlas project, buybacks) and TODs Group (Buy, C-1-9). In the US, we continue to recommend Coach (Buy, C-1-9) for its consistent earnings upgrades on strong same-store sales growth in the US and Japan and a compelling valuation on a dynamic basis.
>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under NYSE/NASD rules. Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Customers of Merrill Lynch in the US can receive independent, third-party research on companies covered in this report, at no cost to them, if such research is available. Customers can access this independent research at http://www.ml.com/independentresearch or can call 1-800-637-7455 to request a copy of this research. Refer to important disclosures on pages 109 to 110. Analyst Certification on page 108.
Global Securities Research & Economics Group
RC#60224502
Global Fundamental Equity Research Department
Lap of Luxury 2 September 2005
Executive Summary
In this issue of Lap of Luxury, we investigate how the Chinese are becoming the worlds heavyweight luxury goods buyers. Those companies likely to benefit most from the Chinese snowball effect LVMH, Swatch and Richemont are also the most investable and liquid stocks in our coverage universe.
How important is China?

In this report, we present a detailed snapshot of the Mainland Chinese market. Only 5-10 million Chinese can today afford to buy luxury goods as we define them, for instance, a Made in Europe luxury handbag. These five million inhabitants (or 0.3% of the population) have an annual income of more than USD30,000. Because the price of goods and services in China is lower than in the US, these consumers can live the lifestyle of someone with about USD140,000 in the US. Remember there are about 2.5m Americans with a comparable income, so this is a substantial number of new customers in any market. In addition, as the number of HNWIs stalls in the US (+2.6% CAGR 2000-2004) and falls in Europe (-1.5%), China is catching up quickly (+6.4%). If the number of HNWIs grows at 10% a year in China and 2% in Europe, we estimate it will only take about 20 years for China to have half as many millionaires as the whole of Europe.
A New Approach
As globalisation increases, analysis of the performance of individual countries or regions becomes increasingly inadequate. In trying to understand market dynamics, therefore, what matters is not so much where spending occurs, but rather who is doing the spending. The split of sector sales by nationality is set to change dramatically over the next 10 years. We estimate that last year, Chinese customers (Mainland Chinese, Hong Kong, Macau and Taiwan) already accounted for 11% of sector revenues (less than 1% in Mainland China itself), or about half the contribution of US, European or Japanese customers. However, revenues from Chinese buyers could overtake US customers as early as 2009. By 2014, these customers could become No. 1 nation in the world for luxury goods, accounting for as much as 24% of sector revenues.
Chart 1: Sector Sales by Nationality, 2014E (EUR160bn)
Korean 2% Indian 2% American 22% Russian 7% Japanese 20%
Supportive Growth Drivers

Demographic trends, economic growth forecasts and wealth creation support expectations of higher-thanaverage future growth from China and other emerging markets, such as Russia and India. Purchasing-power parity (PPP) calculations suggest that the real middleclass purchasing power in these countries is considerably higher than most people think, especially if we look at the average savings trends compared to G7 countries. We also believe that offshore spending will remain a key driver of emerging-market luxury goods spending in the coming decade. A further significant reevaluation of the Chinese Renminbi our foreign exchange experts expect further appreciation of 12% by end-2006 would trigger a similar appreciation of the purchasing power of the Chinese consumer base. This would no doubt prove a fantastic accelerator for the offshore constituent of Chinese consumption (2.5 to 3 times more significant than domestic, onshore luxury spending). In practice, 15% to 20% of sector revenues may stem from Chinese tourists in 10 years time, up from about 10% today.
Chart 3:Outbound Travel-Flow by Nationality 2001A-2008E
50 49
MiddleEast 5% Other European 18% Chinese 23%
Other 1%
Source: Merrill Lynch Luxury Goods Team
Chart 2: Luxury Goods Sector Revenues CAGR % for Selected Nationalities (2004-2014E)
+16% +14% +12% +10% +8% +6% +4% +2% +0% Chinese Indian MiddleEast Russian Total Market American Korean Other Japanese European Other +8.8% +14.8% +14.0%
40
Koreans Chinese Japanese Russian
IN 2010, 50mn OUTBOUND CHINESE IN 2020, 100mn ACCORDING TO WTO
33 32 29
BY 2008, CHINESE TOURISTS=2.5X JAPANESE
30
+7.6% +6.3% +4.8% +4.2% +3.8% +3.4%

10 20 18 16 12 5 0 2001 2002 2003 2004E 2005E
BY 2008, RUSSIAN TOURISTS=1.5X JAPANESE
20 18
+1.1%
8 7 2006E 2007E 2008E
KOREAN TOURISTS 5mn IN 2003, 6mn IN 2004
Source: World Travel Organisation; *in millions of departures already includes 1m Chinese visitors to Europe in 2004; Note that this chart was last updated in 2004.
Refer to important disclosures on pages 109 to 110.
Exposure of Selected Players to non-Japan Asia in Pictures

On the face of it, the lower contribution of non-Japan Asia and Greater China, in particular, to LVMHs revenues masks an incredible snowball effect - underlying revenue growth is similar to the sector average.
Chart 4: Multi-Brand Companies Clearly Dominate the Scene
Sales Ranking of Selected Luxury Goods Companies (YoY underlying % Chg)
Tomorrows Winners & Losers

We demonstrate in our report that the balance of purchasing power in Greater China is already similar to that of the rest of the world. In Greater China, LVMH leads the pack in terms of accessories, primarily with Vuitton, with about a third of the market, by our estimates, but also in cognac, with Hennessy (also about a third of the premium spirits market versus 20% ten years ago). Swatch Group rules luxury watch sales (also with about a third of the market). Richemont dominates jewellery. Zegna and Hugo Boss top the polls on apparel. Beyond their superior and historical exposure to the market, there are three reasons why, from an investment standpoint, LVMH, Richemont and Swatch the most liquid stocks are the best vehicles for playing the theme: 1. They already have strong positions in China and are likely to take advantage of increasingly homogeneous global demand trends. 2. Their brands do not suffer from local cost killers. We examine the limits of the argument for certain product categories, price points or brand origins. 3. They are more financially disciplined (more profitable) and benefit from a strong infrastructure, not to mention group synergies, as opposed to many medium-sized players, which have rushed into emerging markets hoping to make a fast buck. In the long-run, we identify three types of loser: 1. European brands that have tapped into male demand without securing strong positions elsewhere (ie, Cardin, Montagut, possibly Dunhill and Givenchy); 2. Made in Europe labels that are suffering from Asian competition, eg, fashion watches (ie, Gucci cK) 3.
5% 1% 1% Hugo Boss
2000 1800 1600 1400 1200 1000 800 600 400 200 0 LVMH 631 1010
+28%
Revenues in EURm in 2004
Rest of Asia Hong Kong Mainland China

+26% +25% +27% +22%
260 214 446 193 143 Swatch Group 234 110 14 Gucci Group
+11%
+25%
+25%
252
74 Richemont
173 33 7 Herms
66 75 8 Bulgari
56 22 10 Burberry
58 12 Hugo Boss
Sources: Company Data & Merrill Lynch Luxury Goods Team fiscal 2004 Data
With 27% of group revenues in non-Japan Asia and 18% in Greater China alone, Swatch Group has by far the highest exposure to the Chinese market in the sector.
Chart 5: Swatch Has the Highest Exposure By Far to Asia
Exposure of Selected Luxury Goods Companies to non-Japan Asia
30% 25% 20% 15% 10% 5% 0% Swatch Group 10% 12% 7% 2% Richemont 5% 2% Burberry 9% 1% Bulgari 3% 1% Herms 12% 11% 7% 8% 13% 8% 9% 5% 2% LVMH 4% 1% Gucci Group
% of Group Revenues
Local brands (ie, Ports) fighting against multi-brand conglomerates with deeper financial pockets and labels with stronger brand awareness.
Sources: Company Data & Merrill Lynch Luxury Goods Team fiscal 2004 data
Low-cost Sourcing & Producing

The sector has historically ignored the concept of cost advantage, as the cost of sourcing and manufacturing goods has often remained a marginal issue in the generation of profit. However, we believe that companies that do not adapt to the emergence of competitive production know-how in low-cost regions will find it increasingly difficult to survive. This can already be seen in the ready-to-wear category and, to some extent, in the areas of small accessories, jewellery and tableware. In the 1990s, most firms tried to maximise their distribution margin by extending their retail network. In the coming decade, we believe sector peers will start to focus more on their production margin. We therefore view low-cost regions primarily as a threat to those companies unable to adapt their business model and as an incredible opportunity for other, more flexible producers.
The dominance of Vuitton, Cartier, Omega, Hennessy and Gucci is already established in Greater China.
Chart 6: Star Brands Stand Out
Relative Importance of Key Luxury Goods Brands for Selected Players in Greater China (EURm) 1000 900 800 700 600 500 400 300 200 100 0 LVMH Richemont Swatch Group
Vuitton Cartier Omega Other (incl. DFS) Watches & Jewelry Brands Hennessy Other Fashion Brands Cosmetics & Fragrances Other Piaget Dunhill Montblanc
Other Tissot Rado Longines Other Brands (incl. YSL) Gucci
Gucci Group
Bulgari
Herms
Burberry
Hugo Boss
Sources: Company Data & Merrill Lynch (fiscal 2004A estimated revenues in EURm)
The Counterfeiting Issue

Counterfeiting remains one of the major threats to the industry, especially as the vast majority of faked products are made in China. We believe the best way to deal with the knockoff problem is to refresh designs quickly, so that counterfeiters can't keep up. With the expansion of luxury operators in China, however, some companies are a lot more lenient than others and seem to tolerate this major problem. Consequently, we believe that economic expansion and the ensuing wealth creation will create a discrepancy over time between those brands that control the value chain and those that do not or cannot.
Top Picks
Richemont and LVMH (Buy B-1-7) are our top European picks among the big caps (Burberry also if one considers the companys free float will treble to EUR3bn after the GUS de-merger in December): LVMHs valuation is still far from normalised peak levels, especially if Vuitton beats expectations this year; transitional H1 earnings are increasingly pre-empted by the market and the theme of portfolio restructuring is, in our opinion, still actionable. Our multi-criteria price objective of EUR74 corresponds to an exit 2005E P/E of 22.4x vs. a normative peak multiple of 25x. The risk is a significant or/and sudden depreciation of the USD. We believe Richemont will significantly beat market expectations this year. Our price objective of CHF55 corresponds to a 12-month exit P/E of 21.6x for the core business. Assuming that the BAT share price does not underperform and there are no other significant terrorist attacks that would hamper the tangible but fragile return of the feel-good factor, the risk is a sudden and/or substantial depreciation of the USD or/and the JPY. We recommend Burberry (Buy C-1-7) on the back of its sales momentum, the benefits related to the Atlas project and the ongoing share buybacks, which together could lead to 45% increase in EPS over 2005E-2008E. Our price objective of 475p suggests the progressive suppression of the residual discount to the sector. This corresponds to an exit March 2006E P/E of 21.1x, broadly in line with the sector average. The risk remains the ability of management to execute the growth strategy. Our favourite mid-cap stock remains TODs Group (Buy C-1-9), the fastest-growing stock in Europe in the sector, with a strong margin recovery ahead. Our price objective of EUR55 assumes that TODs could trade at par with the sector on an EV/EBITDA basis. The risk lies, in our view, managements ability to execute the retail strategy.
7/7/2005 London A ttacks
Still Overweight the Sector

We remain overweight on the luxury goods sector, because we believe valuations remain reasonable and we think most sector players can beat market expectations in H2. In particular, assuming average exchange rates remain stable until year-end, we believe the price increases passed on in H1 and the strong product innovation of many companies should result in additional upgrades.
Chart 7: Re-rating Continues, but a Selective Approach Needed
50x
Luxury Goods Sector PER- Simple Core Average (*) Long TermAverage
45x
Peak of OECD Leading Indicator Enron Affair
40x
USD W eakness
35x
M illenium Bubble Krach
June 2002 W orldcom Affair
30x
25x
9/11/2001 Terrorist A ttacks in the US
20x
A sian Crisis (YEN/USDFloor: 147)
O ECDLI B ottom ed
3/11/2004 M adrid Attacks
15x
January 1991 Gulf W ar SA + Iraq RS W ar Trough of the OECDLI
Normalised Trading Range
10x
January 2005 Kobe Earthquake
Russian D Crisis ebt
5x 1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Sources: Merrill Lynch Luxury Goods Team & Datastream
Finally, in the US, we continue to recommend Coach (Buy C-1-9) for its consistent earnings upgrades driven by strong same-store sales growth both in the US and Japan and a compelling valuation on a dynamic basis. Our price objective of USD40 per share assumes a 12-month exit P/E of 29x. The risk is a poor response to new products or a slowdown in the accessories segment.
Table 1: Importance of Chinese Customers to LVMH, Richemont, Swatch

COMPANIES LVMH RICHEMONT SWATCH GROUP Years Present Over 30 years (1) Over 30 years Over 100 years (6) Brands Distributed 10 12 (3) 11 % of Group Revenues 9 (2) 15 (4) 18 (7) Points of Sale 100 stores and nearly 600 counters 108 boutiques & about 576 corners (5) 120 corners for Longines, 74 for Omega
Sources: Company data, Merrill Lynch estimates; (1) Hennessy brought its cognac to China in the 19th century. It withdrew when the Communists took over in 1949, but returned in 1972; (2) of 2004E sales, incl. Mainland China over 1%, Hong Kong about 4% and Taiwan about 1%; (3) Chloe, Van Cleef & Arpels and A. Lange & Shne in 2005-06; (4) of FY2005 sales of which Mainland China is about 2%; (5) incl. Macau - Swatch Group; (6) Omega, Tissot and Longines since about 1880; (7) of 2004E finished watch sales (Mainland China accounts for about 13% of watch sales)
CONTENTS
Section Executive Summary A New Approach to Luxury 1. Spending Emerging Market Growth 2. Drivers At a Glance 3. Success Factors 4. Ten Most Frequent Mistakes 5. The Counterfeit Issue 6. Sourcing/Producing in Emerging 7. Markets Investment Thesis & Global 8. Comps Company Profiles 9. Look at Who is Spending, Not Where Spending Occurs Page 2 6
Economy, Demography, Travel Flows
12
A Snapshot of the Chinese Market Identifying the Winners, and the Losers Reservations to the Methods of Expansion Pursued in Those Markets Blown out of Proportions or a Major Threat? Is Designing/Sourcing/Manufacturing in These Markets an Alternative?
33 35 42 49 53
Why we remain Overweight on the Sector
58
Including summarised P&Ls, Cash Flow Statements and Balance Sheets, but also Investment Charts and Key Performance Metrics A Snapshot of Key Emerging Markets Calendar of Events
65
Appendices
89 105
China is like a sleeping giant. Let her lie and sleep, for when she awakens, she will astonish the world Napoleon Bonaparte, 1803
It is time to prosper. China has been poor a thousand years...to get rich is glorious Deng Xiaoping, 1982
1. A New Approach to Luxury Spending

The fortunes of most luxury goods companies are still inextricably linked to the US and Japanese markets, even if emerging markets and China, in particular, are becoming increasingly relevant for the sector. Just like post-war Japan, China is a fantastic opportunity for luxury goods companies. For the domestic Chinese market to match the size of Japan or even the US, however, will take several decades. Investors should not just look at the split of sector revenues by country or region, but rather by nationality: what matters is not so much where the luxury spending is taking place, but rather who is buying. We estimate that Chinese customers could overtake Americans as early as in 2009 as the No. 1 purchasers of luxury goods, accounting for about 22% of total sector sales. Including offshore spending, China could account for as much as 24% of luxury goods revenues in 10 years time.
Background Sector Revenues by Region: the Traditional Approach

The US and Japan remain by far the largest markets for luxury goods, even taking into account the fact that their contribution to total sector revenues has been diminished over the past two years by the appreciation of the euro.
Chart 8: Luxury Goods Sector Sales by Region, 2004A
Rest of World US 24% 4%
Japan 18%
Rest of Asia 14% 40% Europe 40%
The Chinese market is very young, but we see the same potential we noted in Japan 20 years ago
P. Bertelli, Chief Executive Prada Group
We estimate that the emerging markets of Mainland China, Russia and India currently account for less than 4% of overall sector revenues combined. The US, therefore, with a 24% share, should remain the largest market for luxury goods for at least the next 15 years. Looking at both onshore and offshore spending, however, emerging-market customers account for a heftier portion of the global market. In other words, it is becoming increasingly irrelevant where luxury spending takes place. What matters is who is spending.
A New Approach to Luxury Spending We should increasingly be asking ourselves who is doing the spending, not where
The analysis of the performance of individual countries or regions becomes increasingly inadequate with increased globalisation, in our opinion. In trying to understand market dynamics, therefore, what matters is not so much where spending occurs, but rather who is doing the spending.
2004-2014 Projections by Nationality

The split of sector sales by nationality is set to change dramatically over the next 10 years. We estimate that last year, Chinese customers (Mainland Chinese, Hong Kong, Macau and Taiwan) already accounted for 11% of sector revenues, or about half the contribution of US, European or Japanese customers. We estimate that revenues from Chinese buyers could overtake US customers as early as 2009. By 2014, this clientele could become the largest nationality in the world for luxury goods, accounting for as much as 24% of sector revenues.
Chart 9: Sector Sales by Nationality, 2004A (EUR86bn)
Middle-East 4% Other European 23%
Other 1%
Korean 3%
Indian 1% American 25%
Chinese 11%
Japanese 26%
Russian 6%
Chinese customers set to rival American shoppers by 2009 and Japanese customers by 2011
Chart 10: Sector Sales by Nationality, 2014E (EUR160bn)
Other European 18%
Middle-East 5%
Other 1%
Korean 2%
Indian 2% American 22%
Chinese 23%
Russian 7% Japanese 20%
Source: Merrill Lynch Luxury Goods Team; Chinese simplistically includes Mainland Chinese, Hong Kong Chinese, Taiwanese, Singapore Chinese and Macau clienteles while Americans includes Latin Americans. Merrill Lynch Luxury Goods sector includes the following product categories: accessories (including shoes), apparel, champagne, cognac, cosmetics & perfumes (only prestige), eyewear, home decoration, jewellery, lighters, tableware, watches, writing instruments and yachts detailed assumptions available upon request.
Chart 11: Luxury Goods Revenues CAGR % for Selected Nationalities (2004-2014E)
+16% +14% +12% +10% +8% +6% +4% +2% +0% Chinese Indian MiddleEast Russian Total Market American Korean Other Japanese European Other +8.8% +7.6% +6.3% +4.8% +4.2% +3.8% +3.4% +1.1% +14.8%
+14.0%
Onshore Versus Offshore Spending

Analysing the luxury goods market by nationality rather than by country or region requires calculating the split between onshore (domestic) and offshore revenues. In deciding when and how to enter into new markets, therefore, companies should balance the relative weight of the local market with the revenues they already capture from that customer base abroad:
Looking at onshore + offshore luxury spending allows companies to measure the full potential of emerging customers, notably the Chinese
Even when we were in the process of entering India, we realised there were already a great number of Hugo Boss customers in the country. In our London stores, for instance, 20% of the customers are Indian. Bruno Salzer, Chairman and CEO of Hugo Boss The contribution of Mainland China to total sector revenues is minimal for most brands at this time. The Mainland accounts for between 1% and 3%, while Greater China, a more mature market, averages about 10%, or, indeed, more if one includes the Taiwan, Macao and Singapore Chinese. Chinese customers already contribute almost 100% more revenues than the French, for instance (the fourth largest client group), and are already the third most important customer base for luxury goods after the Americans and the Japanese. As an illustration, we provide a detailed breakdown of Vuitton brand revenues globally to Chinese consumers. Chinese consumers worldwide account for c. 13% of Vuitton sales, according to the company:
3
Mainland Chinese generates about 7% of sales (only about 2% onshore at this point in time, but 2.5 times that offshore). Hong Kong Chinese account for around 4% of sales (2% at home and 2% abroad the assumption here is that the multiplication factor between onshore and offshore consumption is about 1x due to the strong retail network already in place in Hong Kong, the relatively low number of Hong Kong Chinese who travel compared to Mainland Chinese and the still lower price differential versus Mainland China with Europe, in particular) Taiwan and Macau Chinese account for about 2% of sales (they do not travel a lot, so the multiplication factor is nil here, with Macau probably a lot larger going forward, with the arrival of the Vegas casino chains)
Is China the Next Japan?

Our forecasts are broadly consistent with predictions made two years ago by Domenico De Sole, former CEO of the Gucci Group: Within 10 years, non-Japan Asia could account for 30% of Gucci Division revenues against 18 % today." Domenico De Sole, former CEO of Gucci Group La Tribune - 3 December 2003 Note that some industry experts are even more optimistic than we are, at least after adding onshore and offshore spending: Today, three to five million Chinese can purchase our (Richemont) watches (average price EUR5,000) and Mainland China only represents 2% of group revenues Within the next 10 years, Chinese consumers could account for 20% of sector sales and 40% if one includes offshore spending. Franco Cologni, Senior Executive Director and Board Member of Richemont Le Temps - 27 September 2004
Chinese customers should increasingly replace the Japanese as the worlds most fanatical luxury goods shoppers
China, as a domestic luxury goods market, will not be the next Japan for several decades
Whether the Chinese customer base will account for as much as 40% of sector revenues by 2014 is debatable, in our opinion. If anything, the actual definition of the sector remains highly subjective. By 2010, the Chinese consumer will have USD500bn to spend on luxury goods. China may even overtake the US as a luxury goods market by 2020. Patrizio Bertelli, Chairman and CEO of Prada Group Financial Times Business of Luxury Summit - 18 May 2005 It is critical, in our view, to highlight the difference between the domestic mainland Chinese market and the market including sales made by Chinese consumers outside China. The former will take at least 20 to 25 years to match the size of the US market, by our estimates. The latter is relatively more important. In other words, sector growth will be primarily driven in the coming years by the sales made to Chinese consumers when they are abroad, not at home. "China is a fantastic opportunity, but it is still the beginning. For the Chinese market to match that of the US - today, 25% of LVMH sales - will take at least 20 to 25 years. Yves Carcelle, President of LVMH Fashion & Leather Goods Group International Herald Tribune Conference - 20 November 2004
If China continues at the present rate, in a generation, our operations in China can be as successful as our operations today in Japan. It will take some time, but it leaves considerable potential. Bernard Arnault, Chairman and CEO of LVMH Analyst Presentation for FY2004 Earnings 9 March 2005
LVMH, Richemont and the Swatch Group Lead the Pack

Customers from Mainland China make up about 2% of worldwide sector revenues, but along with buyers from Hong Kong (another 2-3%), Singapore, Taiwan and Macao, as well as offshore spending, we estimate that Chinese consumers now account for more than 10% of sector revenues. Table 2 below highlights the relative importance of Mainland China for selected luxury goods groups, notably relative to total non-Japan Asian revenues. Swatch Group, Richemont and LVMH are the listed companies we cover (should Zegna consider a listing, it would probably be the ultimate China play) that have been the prime beneficiaries of the recent surge in sales from this promising customer base.
Table 2: Mainland Chinese Contribution to Total Sales of Selected Luxury Brands and Groups
Brand Bang & Olufsen Bentley Bulgari Burberry Ermenegildo Zegna Giorgio Armani Gucci Group Gucci Herms Prada Group LVMH Christian Dior Parfums Hennessy Louis Vuitton Richemont Cartier Dunhill Montblanc Swatch Group Longines Omega Rado Tissot Rolls Royce Valentino Fashion Group Hugo Boss Valentino
(1)
% of Sales in nonJapan Asia 5 30 18 18 30 (3) 12 13 18 16 11 15 10 29 20 21 (1) 19 45 28 27 40 27 25 15 35 8 (4) 5 8 (4)
% of Sales in Mainland China 0 15 1 2 22 1 1 1 1 1 1 5 10 3 2 2 20 3 7 17 18 15 3 15 2 2 3

(2)
Comments 8 to 10 shops planned for China by 2007, operated by three regional partners Bentley sold 70 cars in China for USD240,000 on average in 2003, or a third of its global production Targeting 14 Chinese cities by 2010 (Hong Kong 9% of group revenues) Six stores in 2004-05 and a service organisation Greater China accounts for 6% of group revenues First company to have entered the market after 1974 20 to 30 openings by the end of 2008 Group expects 30 to 40% CAGR revenue growth in China over 2004-2007 Company breaking even at end 2004 in Mainland China Greater China only accounts for about 3% of group revenues vs. 7.4% for South-East Asia and 6% for Taiwan/South Korea Greater China 7% of group revenues (incl. 5% in Hong Kong) Already the sixth-largest market for the brand Second-largest market after the US; Greater China accounted for an estimated 15% of Hennessy sales and Taiwan another 10% in 2004 Objective is to double the distribution network over 2003-2006 from 13 to 26 directly operated stores Second exposure to Greater China in sector (14% of sales) First brand to obtain an import license on gold jewellery until 2003; Nine boutiques in Mainland China and 35 corners as of end-March 2005; the company expects 10% of sales to come from China by 2012-2015 27 boutiques in Mainland China and 34 corners as of end-March 2005 China to become biggest global market by 2010 Largest exposure to Greater China among listed peers (18% of revenues) China topped the list in terms of value and volume in 2004 for the second year running (2) Omega expects China to become its largest market worldwide within a few years; the brand currently has about a 20% market share in China and is thought to be market leader already One of the leading brands in China with high brand awareness and a more selective distribution Best-selling Swiss watch brand in the mid-range price segment in the Chinese provinces Companys largest market; more important than Hong Kong and even Japan Greater China sales rose 32% to EUR22m in 2004 (Mainland China is twothirds of Greater China revenues)
Sources: Company data, Merrill Lynch estimates; Asia-Pacific as of end-March 2005; According to Longines CEO M. Von Knel Longines - LAgefi 5 April 2005 - not even including Hong Kong, Macao and Taiwan (3) Australasia as of end-2004 (+34% YoY); (4) includes Japan
10
Multi-Brand Conglomerates Lead the Pack in China

Table 3: Luxury Players Opening Stores Faster than you can say Charge it Please in Mainland China
Brand Bulgari Burberry Chanel Christian Dior Coach Dickson Concept Dolce & Gabbana Number of Mono-Brand Boutiques at end-2004 Two franchised stores: Beijing opened in 2003 and Shanghai (Plaza 66) 35 stores/concessions* in 23 cities, half of which approximately as corners Nine stores that stock fashion and jewellery/watches + 18 for cosmetics Seven boutiques, including a Dior Homme store in Shanghai Two stores in Beijing and Shanghai 140 stores out of 390 throughout the world 1750m2 directly operated store in Hangzhou (first Italian company to obtain a retail licence to operate in China without local partners) 52 stores in 29 cities before the opening of a 1,945m2 flagship in Shanghai Ermenegildo Zegna Six points of sale Escada Ferragamo 38 points of sale Frederique Constant 25 points of sale One flagship store of 11,000m2 in Shanghai + 1 460m2 store in Hangzhou Giorgio Armani Gucci Group (Gucci brand) 8 franchised stores Herms Five franchised stores (7 in Hong Kong) including two openings in 2004 120 boutiques in Greater China including 80 in Mainland China LVMH Cline Four stores and two corners in department stores Dior Parfums About 60 doors Nine stores and six corners Kenzo Loewe Two stores in Shangha and Beijing and one corner Louis Vuitton 13 directly-operated stores (7 in Hong Kong) including 4 openings in 2004 76 retail outlets Tag Heuer Movado 25 corners and about 100 points of sale PPR 5 franchised stores including a 880 sqm flagship in Shanghai Gucci Prada Group (Prada) 15 stores Richemont 63 boutiques* and 330 corners (a third of them assimilated as boutiques) 25 points of sale Baume & Mercier Cartier 9 franchised boutiques (8 in Hong Kong) and 44 points of sale in 18 cities Chlo First shop in July 2005 in Beijing 61 points of sale in 35 cities (incl. 27 boutiques) Dunhill IWC 13 points of sale in 9 cities Jaeger-LeCoultre 35 points of sale in 20 cities (incl. 3 boutiques) 38 points of sale in 22 cities (incl. 8 boutiques) Lancel Montblanc 104 corners in 40 cities and 4 boutiques at end March 2005 Montegrappa One boutique and four corners 3 points of sale (incl. one boutique) Officine Panerai Piaget 27 points of sale in 18 cities (incl. four boutiques) Shanghai Tang Three boutiques (2 in Shanghai, 1 in Beijing) 26 points of sale in 15 cities (incl. three boutiques) Vacheron Constantin Swatch Group** Including about 305 boutiques and about 850 points of sale Blancpain 10 points of sale including 3 single-brand boutiques 6 retailers including 2 shop-in-shops in Shenyang and Dalian Brguet Glashtte Original 5 shops including a single-brand boutique in Ningbo Longines 235 points of sale including about 120 corners 200+ points of sale incl. 40 outlets and 16 mono-brand shops (4 in H.K) Omega Rado More than 200 retailers Tissot About 150 points of sale including 5 single-brand shops Two (Peninsula Palace Hotel in Beijing and City Plaza in Shanghai) Tiffany Tods Four franchised stores (Shanghai, Beijing, Huangzhou, Shenyang)*** Valentino Fashion Group 60 points of sale in 30 cities Three menswear stores and 57 franchised shops in 30 cities (7 in H.K) Hugo Boss Valentino None Versace Group Three stores in Shanghai, Beijing and Shenzhen Planned Number of Store Openings when Available 5-6 stores by 2006 and an extended wholesale presence About 10 store openings by 2008 (net of relocations) 30 openings by the end of 2009 50 new stores Two stores in Shanghai and Beijing in 2006 Five stores in 2005 35 points of sale before the end of 2008
20 to 30 openings by the end of 2008 60% of 2004-2007 Gucci Group openings planned in Asia 1-2 franchised stores per annum going forward
13 additional directly-operated stores by the end of 2007 3-4 franchised stores in 2005 and 25 additional outlets
30 stores by 2008 including 15 openings in 2005 12 brands distributed and 15 by the end of 2005 100 points of sale 20 franchised boutiques by 2006-2007 Shanghai in Sept 2005 + more boutiques within two years Will double the distribution network in two years
200 boutiques by 2010
Brand more than doubled its sales in China in 2004 Brguet entered the Chinese market last year Glashtte Original entered the Chinese market last year Third largest watch brand in Mainland China 50 to 100 outlets/counters, 20% of which in Shanghai Distribution shifted to direct sales since 2004 na 20 franchised stores by 2007-2008 1 womens wear store in 2006 and 100 shops medium-term First womens wear and accessory store in Shanghai in 2005 12 openings boutiques in H.K, Macao and China this year
Sources: Company Data, Merrill Lynch estimates* as of 31 March 2005; ** Rado declined to provide us with a list of its authorised dealers; ***As at 31 July 2005
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2.
Emerging Market Growth Drivers

In this section, we examine the major growth drivers behind the development of emerging-market client bases in the luxury goods sector. Demographic trends, economic growth forecasts and wealth creation clearly support expectations of higher-than-average future growth from China and other emerging markets, such as Russia and India. Moreover, purchasing-power parity (PPP) calculations suggest that the real middleclass purchasing power in these countries is considerably higher than most people think, especially if we look at the average savings trends compared to G7 countries. We believe that offshore spending will remain the main driver of emerging-market luxury goods spending in the coming decade.
"China has excellent growth potential for the luxury goods sector. The growth of the economy, the formation of a new management class, the money-saving mentality of Chinese consumers, and especially the great attention to high quality, made in Italy products, make it an emerging market, yet to be fully developed. Domenico De Sole, former CEO of Gucci Group Womens Wear Daily - 20 February 2003
The Economies GDP Growth Strong growth relays in emerging markets

Merrill Lynch is reasonably optimistic as to the growth prospects for the global economy in the coming two years. Our economists expect a slower pace of growth in the Eurozone than in the US and see the main seeds of economic expansion in China, Russia and India. China is already the sixth-largest economy in the world, flirting with French and UK GDP levels, and has already outpaced Italys GDP. According to the World Bank, China will be the third largest economy on GDP behind the US and Japan as early as in 2020, having overtaken France and the UK by 2010. On the following pages, we present a number of long-term statistics highlighting the increasing economic relevance of China, in particular, to the global economy.
Chart 12: GDP Growth (2003, 2004) by Country (%)

9.3 9.5 8.4 7.3 7.1 5.2 4.4 3.0 2.2 3.1 2.0 2.8 2.5 2.6 0.6 2.3 0.1 Germ any 6.8
10 9 8 7 6 5 4 3 2 1 0
2003 2004
1.6 0.4
1.0
0.5
United States
United Kingdom
Canada
Japan
France
Italy
Brazil
Russia
India
China
G7 Nations
Source: Economist Intelligence Unit, Merrill Lynch World Wealth Report
BRIC Nations
12
Chart 13: GDP per Capita in USD 2000-2050

90000
80000
70000
60000
50000
40000
30000
RUSSIA AND CHINDIA INCREASINGLY RELEVANT
20000
10000
0 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050
US
Source: Merrill Lynch estimates in USD
China
Japan
Russia
India
Chart 14: GDP per Head at Purchasing Power Parity (PPP) (USD)
5000
4000
THOUGH BOTH HAVE DONE WELL, CHINA HAS DONE FAR BETTER OVER THE LAST 55 YEARS
3000
2000
1000
0 1950 1960 1970 1980 1990 1995 2000 2004
China
India
Source: Financial Times, A Maddison 'The World Economy: Historical Statistics' (OECD 2003); A Virmani ICRIER Working Paper 2004; IMF; WTO; World Bank
13
Chart 15: Catch-up in Asia

90%
G D P p e r h e a d a t P P P , a s a % o f U .S le v e ls ( s e m i- lo g s c a le )
80%
70%
60%
50%
40%
" C H IN D IA " IN C R EA S IN G L Y R EL EV A N T
30%
20%
10 %
0% 5 10 15 20
Y e a r s S in c e T a k e o f f
25
30
35
40
45
50
55
C h in a 1 9 7 8 - 2 0 0 4
In d ia 1 9 8 0 - 2 0 0 4
Ja p a n 1 9 5 0 - 2 0 0 4
Ta w a n 1 9 5 8 - 2 0 0 4
Chart 16: Major countries share of world GDP
80% 70% 60% 50% 40% 30% 20% 10% 0% 1820 1870 1913
China India
% of global GDP at Purchasing Power Parity
1950
Japan US
1973
2001
2015
2025
UK, France, Germany, Italy
14
Purchasing Power Parity (PPP) PPP analysis highlights the increasing relevance of Greater China, in particular
On a PPP basis, i.e, taking the variation in prices of the same goods in different countries into account, Greater China already ranks as the second-largest economy in the world, admittedly far behind the US (and with Mainland China far behind Hong Kong). Unlike comparisons at market exchange rates, PPP reflects the real purchasing power of each countrys residents. In PPP terms, Greater Chinas output per person is about 80% of Americas. In other words, local low prices mean the real purchasing power of the middle class in Greater China is considerably higher than simple exchange-rate calculations suggest. As a comparison, Russias output per person is around 20% of Americas. Indias output per person in PPP terms is USD2,800, which is about 7% of Americas output and around half of Mainland Chinas.
Chart 17: Selected Countries, PPP $000s, 2004 Forecast
0 United States Japan Hong Kong Singapore Taiwan Israel Czech Republic Hungary 5 10 15 20 25 30 35 40
Hong Kong and Mainland China PPP already secondhighest in the world after that of the US
Saudi Arabia Poland Argentina Chile South Africa Malaysia Russia Mexico Brazil Thailand Turkey Colombia China Peru Venezuela Philippines Egypt Indonesia India Pakistan
Source: IMF
Although the analogy has its limits, there is a growth parallel between modern China and Japan in the 1960s, in our view
Although Japanese and Chinese societies are very different, what is happening in China reminds us to some extent of what happened in Japan in the 1960s. Most middle-class Chinese spend very little on clothing during the week. They often share a common roof with their parents even after they get married and often use public transportation rather than a car. Therefore - all other things being equal they may be tempted to spend more on discretionary items, especially on holiday, than their Western counterparts.
15
Savings A picture of decline in most rich countries, but a substantial rise in savings in Greater China
Household savings rates in most OECD countries have fallen sharply in recent years. In contrast, they are not just higher, but also steadier in Greater China. The longer-terms implications of the growing discrepancy between the purchasing power of Greater China and the G7 countries when it comes to discretionary consumption are not clear. However, it is obvious that the sharp fall in household savings rates in most OECD countries and in the US, in particular, could in the long run jeopardise sector sales growth. In contrast, our economists are convinced that higher wages, more employment, rising inflation, continued urbanisation and the growing middle class in China should help boost consumption in the years ahead. Merrill Lynch estimates that urban average incomes, which have doubled since 1995, could soar 45% through 2015. In short, luxury-goods consumption is likely to intensify as the younger age groups replace the conservative pre-1978 generation who saved more.
Chart 18: Net National Savings Rates as % of GDP
As % of GDP
35
30
25
20
... B U T C L E A R L Y N O T T H E C A S E IN G R E A T E R C H IN A
15
D O W N W A R D T R E N D IN G 7 C O U N T R IE S
10
0 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
H ong K ong
C h in a
Japan
U n ite d S ta te s
F ra n c e
G re a t B rita in
Sources: PricewaterhouseCoopers, OECD, Merrill Lynch Asia Pacific Economics Team
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Further Chinese Revaluation Could Spark Luxury Takeoff Renminbi revaluation more to come?
On 21 July, China revalued its currency by 2.1% to 8.11/USD (from 8.28). At the same time, the authorities adopted a more flexible currency regime, switching the Renminbis peg from the dollar to a basket of currencies and a trading band of 0.3%. Whether this move is an indication of more to come is a tough call, but if it is, then clearly, other Asian currencies are likely to follow suit, as emphasised recently by Johann Rupert, Chairman of Richemont: The key issue for us is when, not if, when the Chinese decide to revalue the Yuan whether Asia will follow or no. I have a gut feeling that we may be surprised that South East Asian countries, and maybe even Japan, may decide that they're going to follow. Now, that changes the whole ball game for everybody. Johann Rupert, Executive Chairman of Richemont Analyst Presentation for FY2004/05 Results in Geneva - 9 June 2005 The offshore luxury-goods business conducted with Mainland Chinese tourists is 2.5 to 3 times more significant than domestic, onshore luxury spending. And when luxury consumers travel, they tend to spend more than at home. As operating margins are similar everywhere in the world, an acceleration of travel flows would clearly result in an overall positive impact, especially for the listed companies with the highest exposure to Mainland China (LVMH, Richemont and Swatch Group). Additionally, what a significant revaluation of the Chinese Renminbi would mean for the luxury sector in the medium term is difficult to assess, but, clearly, it would be very positive, as Chinese consumers could buy more goods for their money. Simplistically, a 12% reevaluation of the Renminbi as forecast by our foreignexchange experts by end-2006 would trigger a similar appreciation of the purchasing power of the Chinese consumer base. This would no doubt prove a fantastic accelerator for the offshore constituent of Chinese consumption. In practice, 15% to 20% of sector revenues may stem from Chinese tourists in 10 years time, up from 10% today.
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Wealth Creation Although wealthy individuals account for a tiny portion of the population in emerging markets, their numbers are growing fast
One of the key drivers for the industry is the absolute level of wealth in the world. Every year, Merrill Lynch and Cap Gemini publish a key study on the worlds HNWI. The latest report published in June 2005 shows that HNWI wealth creation has varied from country to country in the past, reflecting domestic economic conditions. Along with the US and Spain, once again, China and India are notable high performers. Merrill Lynch estimates the number of Mainland Chinese HNWI (defined as people holding more than USD1m in financial asset wealth) at 300,000. There are also 88,000 HNWI in Russia and 70,000 in India. Remember that China was in 2004, for the second year running among the worst performing stock markets in the world with share prices falling by 15%. So imagine what the trend would be otherwise...
Chart 19: HNWI* Population Growth by Country (2001-2004)
HNWI growth most prevalent in Singapore, South Africa, Greater China, Australia and India
25%
22%
22% 19% 15% 15% 12% 11% 10% 9% 9% 4.3% 4.2%
20%
15%
10%
5%
0% Singapore South Africa Hong Kong Australia India United Arab Emirates 49 37 67 134 70 53 71 2,498 418 141 300 88 South Korea United States United Kingdom Spain China Russia
300,000 Chinese individuals with more than USD1m of financial wealth
HNWI Population (in thousands)
Source: Merrill Lynch & Cap Gemini World Wealth Report 2005; *HNWI: High Net Worth Individuals defined as people holding more than USD1m in financial asset wealth
Merrill Lynch expects high net worth individual (HNWI) financial wealth to grow 6.5% per annum and to exceed USD42tn by 2009. Our economists remain confident as to Asias strong prospects and expect the Asia-Pacific region (excluding Japan) to report GDP growth of +7% this year and +6.8% next year.
Chart 20: HNWI* Financial Wealth by Region (2001-2009E) (USDtn)
Merrill Lynch expects a 6.5% CAGR in HNWI wealth in 20042009, driven mostly by North America and Asia-Pacific
$42.2 45 40 35 30 25 20 15 10 5 0 2001 2002 2003 2004 ~ 2009E 7.6 8.2 7.4 8.4 $26.0 0.6 3.5 5.3 0.8 $26.7 0.6 3.6 5.9 0.8 $30.8 $28.5 0.7 0.6 3.4 6.6 8.5 8.6 0.8 3.7 7.2 13.9 9.3 At 6.5% Growth 8.9 10.7 1.0 10.1 5.0 0.9 1.5
Annual Grow th Rate 2004-2009E
Worldw ide Africa Middle East Latin America Asia-Pacific North America Europe
6.5% 5.6% 9.1% 6.4% 6.9% 8.4% 3.8%
Source: Merrill Lynch & Cap Gemini - World Wealth Report 2005; *HNWI: High Net Worth Individuals defined as people holding more than USD1mn in financial asset wealth.
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Demography & Wealth Creation We estimate there are about 15 million consumers in China, Russia and India who can afford luxury goods
We estimate there are about 15 million consumers in China, Russia and India who can afford to purchase luxury products, comprising 5-10 million in China, 3-5 million in Russia and 3-5 million in India. The common factor between those consumers is their rapidly rising income, which is fuelling strong sales growth.
Chart 21: How Many Consumers are there for Luxury Goods in China, Russia and India?
China
1.5% of households have a net income of USD30,000, equal to 5 million consumers A middle-class of 150 million individuals and a well-off class of 30 million people are emerging Those consumers are urban, well educated and young (2540 years old) They purchase foreignbranded goods and their consumption patterns are rapidly changing
Russia
Thirty-six Russian billionaires possess financial wealth of USD110bn, or 25% of national GDP (Source: Forbes) Super-rich nouveaux riches account for 2% of the population (
India
Still a niche market, i.e, comprising 3-5 million individuals, primarily in urban areas across India The portion of Indian luxury consumers is growing by 15% per annum The biggest gold jewellery market in the world
3mn) in a
country with huge economic inequalities The share of earnings of the richest quintile is 67% A growing middle-class but with grey definitions (6% to 10% of population)
Sources: Merrill Lynch, World Bank, IPSOS, Komkon
This report focuses on Chinese consumers, who we believe will be critical to the luxury goods market going forward
Chinas fascination with luxury consumables is understandable, in our opinion, it being a country of 1.3bn people - almost a fifth of the planet's total population which for the past half-century has been closed to the outside world by its Communist regime. Now, as China starts to relax its trading laws, it promises to be a considerable new market for Western brands. In this report, we focus on the Chinese customer base which we believe will be critical to the luxury goods market going forward. We also present a snapshot of the Russian and Indian markets for luxury goods in the Appendices to this report.
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What the Chinese Pyramid of Ages Means There are ten times as many 20-34 year olds in China than in Japan
In China, the spoilt single-child generation and the new middle class who have no experience of hard-line Communism will, in coming years, replace the pre1978 reform generation and be able to consume with no constraints. Yves Carcelle, President of LVMH, said as much earlier in September:
"Ten years ago, we were all thinking about Japanese consumers. More than 700 million Chinese are under the age of 35. And if you look at the population between the ages of 20 and 34, which in Asia is, of course, the most targeted group, they are by far the highest spending consumers. There are 320 million Chinese between the ages of 20 and 34, versus 27 million Japanese in that age group. Yves Carcelle, President of LVMH Fashion & Leather Goods Group Analyst Presentation, Paris - 15 September 2004
Chart 22: China Demographics (million inhabitants)
80+ 70-74 60-64

SINGLE-CHILD GENERATION & GROWING MIDDLE CLASS LIKELY TO CONSUME WITH NO CONSTRAINT
50-54 40-44 30-34 20-24 10-14 0-4
PRE-1978 REFORM URBAN GENERATION >40 YEARS OLD: 35% TODAY, 15% by 2015E
YOUNG POPULATION VS AGEING POPULATION OF THE WORLD (EXCL. INDIA)
80
60
40
20
20
40
60
80
Source: US Department of Census - Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat, World Population Prospects: The 2002 Revision and World Urbanization Prospects: The 2001 Revision - http://esa.un.org/unpp
20
Chart 23: Breakdown of Chinese Urban Population by Age Group

100% 80% 60% 40% 20% 0% China Population, 2004 S-Generagion (Single Chinese generation) China Population, 2015 China's Opening New Middle Class (born after 1978) China Pre-reform population 35% ~135mn aged >40 26% ~100mn aged 29-39 39% ~151mn aged <24 55% ~230mn 15% ~162 mn 30% ~124mn
Source: World Population Prospects: The 2002 Revision and World Urbanization Prospects: The 2001 Revision & LVMH - http://esa.un.org/unpp
The main driver is the appetite for consumption of the urban population under 40
In the coming ten years, this single-child generation will replace the pre-1978 generation, which still believes that money should be saved systematically to ward off uncertainty. Today, there are 500 million Chinese under the age of 24, corresponding to 38% of the total population, and by 2015, there will still be 455 million under the age of 24, or 33% of the population. In other words, in 25 years time, the one-child policy may have created a generation of little emperors who will want to spoil themselves as they grow older.
Chart 24: The Chinese Population Remains Young vs. the Ageing Population of the Rest of the World (excl. India)
65% of Chinese born after 1978 reforms today, 85% by 2015 +7mn of Men 132 125 +1mn of Men 96 97
+18mn of Men 250 200 150 100 50 0 0-19 211 193
+12mn of Men 226 214
20-39 Male Female
40-54
>54
Source: World Population Prospects: The 2002 Revision and World Urbanization Prospects: The 2001 Revision & LVMH - http://esa.un.org/unpp
Promising Age Mix in China

Luxury goods brands are finding that the demographics of big spenders in China are largely to their advantage. Many surveys have shown that the majority of Chinese consumers of luxury products are aged between 30 and 40, considerably younger than those in the US and Europe, who are aged between 40 and 70.
21
There are enough wealthy people around to make China one of the largest markets for high-end products
The tastes of Chinese 20 year olds are generally conservative and more homogeneous than in the Western World, partly because of more slowly adapting social attitudes and traditional tastes, and partly because the vast majority of young professionals work in manufacturing and state-owned enterprises in provincial cities. As college-educated, professional, middle and upper-class Chinese enter their 30s, their place in society changes, as do their consumption habits. Either promoted to management or founding their own businesses, their incomes rise substantially. As they marry and move out of their parents' home, they enjoy double income, but often also face significantly higher expenditures, such as the purchase and furnishing of a home. Yet, as we observe in Japan, they often splurge on imported products for the home, as well as fashion items. Similar to other countries, Chinese professionals in their 30s and 40s have less leisure time to spend shopping or thinking about fashion. However, for some, this, combined with rising incomes and a growing need for status, pushes them towards luxury brands and brand loyalty. People aged 40 to 50 generally do not spend much on clothing and are more concerned about saving for their children. A recent study by Horizon Research Group found that 31% of Shanghainese reported school fees for their children as their biggest expenditure increase in 2004. In that sense, this age group in major Chinese cities is not much different to that in Western Europe or the US. Last, but not least, well off children are an important and oftenoverlooked consumer target in China. For many experts, the 10-20 age group is one of the most promising targets for luxury goods brands. Chinese families often spend significantly more on luxuries for their children than for themselves.
The Downside to Chinas Demographics Unlike Europe, Japan or Korea, China risks becoming old before becoming rich
Over the next 25 years, the number of 60-plus year olds in China is going to double. While this age class accounts for 11% of the total population today, that will grow to 24% of the total population by 2030 (Source: United Nations). Remember that in the 1960s, the average age in China was 20 years old. It is now close to 33 years old and will reach 44 years old by 2040. At that time, Chinas age pyramid will look like Japans today, albeit with a much lower average income per capita. Whether these 400 million senior citizens will have any discretionary purchasing power when they retire remains debatable.
The Chinese Middle Class: Tomorrows Target for Luxury Goods? Only a portion of the Mainland Chinese middle class (100-140 million individuals) can be considered a medium-term target for luxury goods
According to Lane Crawford, there are 250 million Chinese households with an annual income of USD1,875 to USD7,125 (RMB15,000 to RMB57,000). In addition, there are between 100 million and 140 million Chinese (or about 25-35% of the urban population of 400 million) with an annual income of USD6, 000, or about RMB48, 000. This is the target of most fast-moving consumer-goods multinationals. This middle class of, say, 120 million people is growing by about 15% per annum, according to McKinsey research, especially in coastal cities like Shanghai, where young, well-educated, high-income people tend to live.
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"Today, we are targeting 110 million urban women between the ages of 20 and 40 years old as our potential market. The purchasing power of these people is increasing, so every day there is a new potential consumer for our brands. It depends on many things, not least on how China is able to control its economic growth and allow it to trickle down from the top to the bottom. Just in 2002, we spoke of about 95 million as our potential market. Paolo Gasparrini, President and Managing Director of LOral China International Cosmetics News - Dec. 2004 These data are broadly consistent with a recent survey by Chinas National Bureau of Statistics, which indicates that the middle class, defined as households with a combined annual income in excess of 200,000 RMB (USD24, 096) make up 5% of the population (22% of the urban population), about 65 million people. Chinas new wealth, which showed itself first in the consumption of TVs, motorcycles and air-conditioners, then in cars and new apartments, is today apparent in the demand for credit cards. Visa estimates that the number of Chinese with an annual income of at least USD3, 600 will rise at a CAGR of 22% to 200 million by 2010. MasterCard estimates that by 2010, there will be 120-160 million middle-class Chinese, with an annual per capita income of at least USD5, 000. "In 10 to 15 years time, there will be about 100 million moderately affluent Chinese consumers. This is what the race into China is all about. This is why companies are coming now. Its all about a land grab." Edward Bell, Ogilvy & Mather (quoted by Betsy Lowther in WWD) Today, most Chinese consumers are far from able to afford foreign fashion. Even mid-range Hong Kong brands, like Baleno and Giordano, are often beyond their means. Mainstream Chinese rarely spend more than USD5 on an item of apparel and will splurge on items costing USD15-30 only once or twice a year. Their preferences run towards low-end local brands and knock-offs of foreign brands. Still, the China Brand Strategy Association claims that some 175 million Chinese, or 13.5% of the population can today afford to purchase a variety of luxury brands (cosmetics, watches, wallets, clothes and jewellery). It defines this group as the number of people with a monthly salary of RMB20,000 (USD2,400) to RMB50,000 (USD6,000). According to this association, quoted by European Union Trade Commissioner Peter Mandelson, many earn as much as RMB240,000 (USD30,000) a year and have between RMB300,000 and RMB500,000 in savings. By 2010 the number of people earning this kind of money is expected to increase to 250 million. "There are reliable estimates that up to 250 million Chinese people will be able to afford luxury products in five to seven years time. Peter Mandelson, European Union Trade Commissioner WWD 7 June 2005
Table 4: Emerging Markets Increasingly Crucial to Hennessy

Market Ranking 1. 2. 3. 4. 5. Country US Mainland China Taiwan Japan Russia
Source: Hennessy Top 5 countries for Hennessy by revenue as of end-2004
How Many Luxury Customers are there in Mainland China? The expansion of Chinas middle class is primarily driven by a rise in purchase power
Many reports from government agencies, banks, marketing experts and economic think tanks amply reflect the growing interest by foreign companies in tapping this slice of the Chinese market. Their studies have shown that not only is the number of wealthy people growing rapidly, but also their ability to spend on big-ticket items. Going forward, our calculations suggest that the expansion of the middle class is actually driven almost exclusively by an increase in purchasing power, not by changes in demographics (The number of 20 to 50 year olds in China is expected to grow at a CAGR of +0.65% over 2004-2010, from 635 million today to 660 million by 2010).
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Today, the bulk of Chinas wealth is concentrated in the East Coast, as highlighted below. In the cities with more than 5 million inhabitants, GDP typically grows by 15% a year, almost twice the pace of Chinas nationwide GDP growth. Within this core population target of 300 million people, about 10% have the ideal profile for luxury brands, according to LVMH. However, only 5-10 million can today afford to buy luxury goods as we define them, for instance, a Made in Europe luxury handbag.
The expansion of Chinas middle class is primarily driven by a rise in purchase power
These 5 million inhabitants (or 0.3% of the population) - a substantial number in any market - have an income of more than USD30,000 (China's national average per capita income is USD1,100, but in Shanghai/Guangzhou, it is USD6, 000 and in Beijing it is USD4,000). Because the price of goods and services in China is lower than in the US, an individual with an annual income of USD30,000 in China can live a lifestyle of someone earning about USD140,000 in the US (the IMF's PPP conversion factor is 4.64). In other words, although the overall level of income is still low in USD terms, these consumers have more income for luxury goods than someone with USD30,000 in the US, because basic necessities cost less in China. Compared to the 5 million or so Mainland Chinese who can afford to buy luxury goods, there are about 2.5m Americans with a similar income, adjusted for the cost of living.
Chart 25: Luxury Goods Consumer Targets in Mainland China (Source: EIU)
300 Million 30 Million 5-10 Million
Heilongjiang
Nei Mongolia AR. Xinjiang Uygur AR. Gansu Ningxia Hui AR.
Jilin
Liaoning Hebei Beijing Tianjin 13 Million Hebet Shanxi Shandong
Qinghai Tibet AR.
Jiangsu Henan Shaanxi Shanghai Anhui Hubei 30 Million Sichuan Jiangxi Zhejiang Hunan Fujian Guizhou Yunnan Taiwan Guangxi Guangdong Zhuang AR. Hong Kong Macau Hainan
Urban with Disposal Income Core age group: 25-35 years old Skilled white collar
Population from Beijing, Shanghai, Guangzhou, Dalian, Shenzhen . . . Age group: 25-44 years old Well educated With income over US$500 per month
23 Million
Urban coastal area population with higher incomes
According to the Merrill Lynch World Wealth Report, there were 8.7 times more high-net-worth individuals in Europe (2.6 million) than in China (0.3 million) in 2004 and 8.3 times more in the US (2.5 million) than in China. This ranks China just below Latin America, the Middle East and the UK (c. 300,000 each). As the number of HNWIs stalls in the US (+2.6% CAGR over 2000-2004) and falls in Europe (-1.5%), China is catching up quickly (+6.4%)! If the number of HNWIs grows at 10% a year in China and 2% in Europe, it will only take about 20 years for China to have half as many millionaires as the whole of Europe.
Fast-Rising Incomes in Cities

The emergence of a middle class in China is underpinned by the strong development of academic and professional skills across the country. Remember that until the mid-1990s, private car ownership was rare. Consequently, the surge in car purchases made by individuals reflects fast-rising incomes in Chinese cities. Today, about 70% of women in Shenzhen - a city that manufactures 70% of the worlds toys and photocopiers - have a cell phone. However, the emergence of a middle class with significant purchasing power is not limited to one or two cities: there are already 200m cell phone and 70m internet users in China. The main risk to this scenario is a significant economic slowdown in the region.
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Lap of Luxury 2 September 2005 Fast-rising incomes in cities

Chart 26: People (million) with Third-Level or College Education
90 80 70 60 50 40 30 20 10 0 1988 1998 2008E
Chart 27: Skilled White-Collar Workers (million inhabitant)

140 120 100 80 60 40 20 0 1998 2008E
Source: Economist Intelligence Unit
Chart 28: New Passenger Car Registrations (million)

New passenger car registration 2,000 1,500 +51% 1,000 500 0 1998 1999 2000 +20% +7% +6% 2001 2002 2003 +40% +20% +0% YoY variation % +64% +80% +60%
+10%
"The luxury goods market in China has entered a period of stabilised growth and I expect it will grow at a speed of about 20% annually in the coming five years." Yang Qingshan, General Secretary of Chinese Brand Association
Wide Geographical Spread of Wealth across the Country Luxury market spreading from Shanghai and Beijing to the South and East coastal areas
China boasts 34 cities with a population of 1 million or more inhabitants, including 11 with a population over 2 million. There are 78 cities with a population of at least 500,000 and 159 second tier cities with a population of between 200,000 and 500,000. Luxury goods players tend to initially set up stores in the two largest cities, Shanghai (16.7 million) and Beijing (13.8 million). Along with their superior economic wealth and growth, the population of Southern and Eastern coastal regions are also becoming key regions for new stores, notably, the Pearl River (Shenzhen to Guangzhou - 70 million inhabitants) and the Yangtze River Delta region (Shanghai, Suzhou, Hangzhou, Ningbo - 79 million). On the other hand, the West of the country, with the exception of Chengdu (10 million) and Chongqing (31 million), remains largely unexploited and is less of a priority for most companies. LVMHs Chinese fashion and cosmetics distribution network can be seen in the chart below and highlights this clearly:
25
Chart 29: Market Skewed Toward Wealthy Areas (ie, LVMH Distribution Network)
Boutiques & Corners Louis Vuitton Celine Fendi Loewe Christian Dior Beijing
TY Tienjin Qingdao Jinan Xian Nanjoig Wuham Nanchang Chongqing Kunming Wenzhou Changsha Xiamen Harbin Changchun Shenyang
Dalian
Counters Parfums Christian Dior Guerlain Givenchy Kenzo Parfums Chengdu
Shanghai
Hangzhou Fuzhou
Shenzhen Guangzhou
Source: LVMH (September 2004)
Most brands today still have a limited presence in China, at least compared to more mature markets like Japan. There are only 270 luxury goods stores in China, opening at a rate of about 50 new shops per annum.
Chart 30: Store Network in Japan and Other Key Emerging Markets for Selected Luxury Brands
A P M S P O T H S T A R T F R O M E N S W E A R E C I A L I S T S E R B R A N D S I L L H A V E A L I M I T E D P R E S E N C E I N E M E R G I N G M A R K E T S
J a p a n C h in a R u s s ia In d ia
6 0 5 0 4 0 3 0 2 0 1 0 0
C.Dior
Zegna
Hermes
Cartier
Loewe
Celine
Tod's
Fendi
Armani
Source: Company Data & Merrill Lynch 2003 Data
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Louis Vuitton
Montblanc
Bulgari
Dunhill
Tiffany
Gucci
Chart 31: Chinas Population: 34 Cities with more than 1 Million People
China 1.3 Billion

Heilongjiang
Nei Mongolia AR. Xinjiang Uygur AR. Gansu Ningxia Hui AR.
Jilin
Liaoning Hebei Beijing Tianjin 13 Million Hebet Shanxi Shandong
Qinghai Tibet AR.
Jiangsu Henan Shaanxi Shanghai Anhui Hubei 30 Million Sichuan Jiangxi Zhejiang Hunan Fujian Guizhou Taiwan Guangxi Guangdong Yunnan Zhuang AR. Hong Kong Macau 23 Million Hainan
Sources: LVMH, Abc-luxe.com
Shanghai is generally considered the top tier of Chinese consumerism and has emerged as the entry point for most foreign brands making their way into the country. It is the most fashion-forward place in Mainland China and also attracts a lot of shoppers from other cities who might not have the same selection at home. Beijing is the country's second-biggest market and has been bolstering its retail position with massive development plans, including more luxury malls. Last fall for instance saw the opening of the Golden Resources Mall in the city's university district - a 5.9m square-foot monolith of more than 500 stores, restaurants and attractions. Remember that a brand like Hennessy still records less than 10% of its China revenues in the North of the country (more than half is still recorded in the South) and as a result of the potential in coming years in a city like Beijing. Outside of Beijing and Shanghai, other cities are developing as retail malls for foreign brands. Luxury brands are opening stores in provincial capitals and second-tier cities such as Harbin, in the Far North of China, and Shenzhen, in the South just outside Hong Kong. One of the major secondary markets to emerge is Hangzhou, the capital of the Zhejiang province about 180 km West of Shanghai in the Yangtze River delta region. A long-time vacation destination for many Chinese, the city has welcomed dozens of luxury stores looking to capitalise on the region's growing wealth and the city's proven tourism appeal. Last fall, Vuitton joined Cartier and Ferragamo in the city's Hangzhou Tower mall, down the street from a Lane Crawford department store that sells labels such as Prada and Burberry and Armani and Dolce & Gabbana on the lakefront walkway.
Shanghai and Beijing are top targets, of course...
but so are Shenzhen, Hangzhou and many other second tier cities
Table 5: The Two Louis In China: The Cartier and Vuitton Store Networks Vie for Business
Cartier Beijing x 6*, Changchun x 2, Chengdu, Chongqing, Dalian x 3, Guangzhou x 3, Hangzhou, Harbin, Kunming, Ningbo, Qingdao, Shanghai x 6*, Shenyang x 3, Shenzhen x 4, Wuhan, Wuxi, Xian Vuitton Beijing x 2, Chengdu, Dalian, Guangzhou x 2, Hangzhou, Qingdao, Shanghai, Shenzhen x 2, Xiamen, Xian
Source: Company Data - * Two of the six stores in Beijing are Cartier Boutiques. One of the 6 stores in Shanghai is a Cartier Boutique. The other sales points are authorised retailers.
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Travel Flows
Unlike most consumer goods categories, luxury goods sales are not only driven by domestic demand, but also foreign or tourism-related consumption. This offshore share of demand is critical to the sector. One reason why emerging-market customers primarily buy products abroad rather than at home is that non-domestic prices are lower. Five-year travel-flow projections are therefore crucial in assessing which nationalities are likely to drive sector growth.
The Meteoric Rise of the Chinese Traveller

The World Travel Organisation estimates that: The number of Chinese tourists abroad will be 2.5 times the number of Japanese foreign tourists by 2008; it already matches the number of Russian foreign tourists; The number of Russian tourists abroad should also be 1.5 times the number of Japanese tourists in three years time; Indian travellers (4.5 million last year, 5.5 million in 2005) are acquisitive and brand conscious, so could also contribute significantly to sector sales growth. By 2020, there will be 100 million Chinese tourists, or 4 times the current number.
Chinese tourism will be the new driving force of luxury goods spending in the next three years
Chart 32: Outbound Travel-Flow Projections by Nationality 2001-2008E*

50 49
40
Koreans Chinese Japanese Russian
IN 2010, 50mn OUTBOUND CHINESE IN 2020, 100mn ACCORDING TO WTO
33 32 29
BY 2008, CHINESE TOURISTS=2.5X JAPANESE
30
BY 2008, RUSSIAN TOURISTS=1.5X JAPANESE
20
18 16 18
20
10
12 5 7 2002 2003 2004E 2005E 2006E 2007E
KOREAN TOURISTS 5mn IN 2003, 6mn IN 2004
0 2001 2008E
Source: World Travel Organisation; *in millions of departures already includes 1 million Chinese visitors to Europe in 2004; Note that this chart was last updated in 2004.
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China is both a market for international tourists and for Chinese outbound tourists. However, outbound tourism will, according to CNTA, post the strongest growth or the two by far in coming years.
Chart 33: 1995-2020E CAGR Tourists by Nationality (%)
Canada United States Germany Netherlands Italy United Kingdom France Russia Japan China 0% 2% 4% 6% 8% 10% 12% 14%
CHINESE OUTBOUND FLOWS ALREADY 9% OF WORLD TOURISM
Chart 34: China: Inbound Versus Outbound Tourists (mn)
60 50 40 30 20 10 0 2003 20 33
+7% on average x 1.5
54 49
x 2.5 +20% on average
2004 2005E 2006E 2007E 2008E Chinese outbound tourists
International arrivals in China

Source: CNTA, 2004
Source: World Travel Organization
Chinese Travellers Already Outnumber Japanese Its not an evolution, sir, its a revolution
The number of outbound Chinese tourists already exceeds the number of Japanese, according to the World Travel Organisation. Bernard Fornas, CEO of Cartier, told the Financial Times on 18 May 2005 that he expects there to be more Chinese travellers abroad than Japanese within the next 10 years, possibly to Europe. Given that there were already 900,000 Chinese visitors to Europe in 2004, compared to about 2 million Japanese, it is clear why the opening up of the Chinese market is so revolutionary for the luxury goods companies.
Chart 35: Already More Chinese than Japanese Travellers (000s)
30,000 C hinese O utbound Travel M arket 25,000 20,000 15,000 10,000 5,000 0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Japanese O utbound Travel Flow s
Source: Datastream & Merrill Lynch Luxury Goods team estimates for 2004
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Coming Soon to a Luxury Goods Store Near You . . .

Europe has seen a sharp rise in the number of Chinese tourists and this growth is likely to continue as travel constraints are loosened: An agreement signed last year between the British and Chinese governments allowed a near doubling of the number of flights between the two countries to 31 a week. British Airways now flies to Shanghai as well as Beijing and is considering starting services to several other Chinese cities. Chinese tourists started flocking to Paris about two years ago and this has picked up significantly since the Chinese government lifted visa restrictions on travelling to France late last year. Galeries Lafayette and Printemps set up special services for Chinese visitors (200,000 in 2004 and 280,000 expected in 2005, according to the Paris Convention & Visitors Bureau) at a dedicated tour-group entrance and Cartier has begun hosting private soires.
Paris has see a sharp increase in Chinese tourists
The USD/EUR exchange rate has punished business, but thankfully this has been largely offset by other foreign tourists, mainly Chinese customers. Chinese tourists have climbed from 20th position 10 years ago to the No. 1 spot in terms of visitors to our Galeries Lafayette store today, overtaking the Japanese, British, Russians and, in fifth place, the Americans. Jean-Michel Hallez, General Manager, Galeries Lafayette flagship store Reuters 22 December 2004
Shopping Beyond Hong Kong and Macau Hong Kong and Macau have attracted Mainland bargain hunters
"Those who say that Hong Kong is losing its allure as the gateway to the mainland are dreaming. The Chinese government will continue to need and respect Hong Kong because it is special. China is unpredictable, while Hong Kong is stable." Christian Blanckaert, Executive Vice-President of Herms South China Morning Post - 8 January 2005 Hong Kongs role in stimulating demand for luxury goods in Asia will remain critical, in our opinion. However, as Chinese mainlanders are allowed to travel more and more, the weight of Hong Kong as a destination will progressively diminish, especially as the price differential to Mainland China will decline further and the selection of products available locally in China will increase. In our view, the recent construction of Las Vegas-style resorts in Macau, Singapore and Thailand is likely to boost sales to Chinese tourists in those regions.
Chart 36: Three-Quarters of Chinese Tourists Still Travel to Hong Kong and Macau
Japan 3% Malaysia 3% Australia 3% New Zealand 1% Hong Kong 42%
Source: DFS; Note, 35pp of visitors to Hong Kong are transit travellers and the majority of travellers to Macau are on day trips from Guangdong Province
Singapore 3% Korea 3%
Thailand 3%
Other 7% Macau 32%
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First anniversary of lifting of passport restrictions in September this year
The loosening of passport restrictions is a key reason for the strong growth of Chinese outbound tourism. An additional 37 destinations (including Canada, the UK and the US this year) have been approved for group travel by the government over the course of 2004 and 2005 (total number of destinations is now 65) and should account for a significant portion of outbound tourism in coming years.
Where are the Chinese Tourists Going?

Hong Kong, Macau, Korea, Japan, Thailand, Singapore, Malaysia, Philippines, Australia, New Zealand, Vietnam, Cambodia, Laos, Myanmar, Indonesia, Brunei, Nepal, South Africa, Egypt, India, Russia, Turkey, Malta, Cuba, EU countries
Spending Profile of Chinese Tourists Luxury goods industry keeping a close eye on Chinese offshore spending trends
Chinese tourists spend a lot on luxury goods when they travel, even though most of them are still travelling on business rather than holiday. This is reminiscent of the behaviour of Japanese consumers in the 1980s. For every US dollar spent at home on luxury goods, the Chinese spend two to three when they travel abroad. At this time, there are few reliable statistics on this area, but those that do exist point to an extremely promising outlook for the luxury goods industry: According to a recent study by ACNielsen and the Tax Free World association, total spending by Chinese tourists on overseas tours is still lower than that by Japanese tourists. However, Chinese tourists spend more than 30% of their tour expenses on shopping, notably on cosmetics and clothing (USD987 on average, but USD1,781 in Europe). Alpitour, an Italian travel specialist has also begun researching Chinese travel habits in the hope of tapping into this customer base in the coming years. So far, it has observed that most Chinese tour groups that have visited Italy had spent only a day or two in its major cities (a trend confirmed by LVMH) before moving on to other countries. It has proved difficult, therefore, to come up with the right itinerary and accommodate those tourists generally. However, Alpitour was positively surprised at the amounts of money the Chinese allocated to shopping, in particular for luxury goods. Those Chinese travellers surveyed brought an average of EUR1,000 each and spent most of it on luxury goods. The French Tourism Bureau claims that total spending by Chinese tourists in France, though still lower than that of Japanese tourists, is already superior to that of tourists from Europe and the US. These findings are consistent with a claim by Galeries Lafayette that although Chinese tourists spend less than Middle Eastern, Japanese, Russian and US tourists, their sheer number makes their total spending higher. Whether this is primarily a reflection of the strong proportion of businessmen in the mix and whether, as a result, those numbers come down with the development of group travel, remains to be seen.
The Chinese spend less than the Japanese overall when they travel, but they spend more on shopping
The Chinese go to Paris, stay at two- star hotels, eat cheap Chinese food and spend all their time shopping. Christopher Zanardi-Landi, General Manager, Louis Vuitton China The Economist - 17 June 2004
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Profile of Chinese Outbound Tourists

According to LVMH, average spending on shopping typically close to USD1,000/stay or about 25% more than Japanese tourists. Though the Japanese spend more overall while on holiday (hotels, restaurants, etc), the Chinese spend more in the shops. They spend less overall, but apparently allocate a much smaller portion of their budget to hotel bills. 85% of Chinese tourists still travel in a group, with 15% making individual arrangements - a mix similar to that of Japanese travellers in the 1980s. Some 56% of travellers are men on business trips, down from 75% in 1998. About 80% of Chinese travellers got to Asia, specifically Hong Kong and Macau (32% CAGR 1997-2003), South Korea (23% CAGR 1997-2003), Japan (10% CAGR 1997-2003) and Thailand. On average, overseas tours last 10-15 days with numerous destinations (8-15 countries). Package tours to Europe cost on average EUR2,000 per person. 50% of passengers are aged between 25 and 45 years old.
Chart 37: The Chinese Travel and Shop

1200 1000 800 600 400 200 0 US Japan China USD Shopping and Div erse Ex penditure in Haw aii (*)
Source: Hawaii Tourism Authority; *Travel expenditures excluding transportation, activities, accommodation, visit to neighbouring islands, food and drinks.
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3. A Snapshot of the Chinese Market

In this section, we present a snapshot of the major and most promising emerging-market for luxury goods: Mainland China.
The move towards luxury buying in China may start changing the way some companies approach the market
Within five to seven years, China will be our second Asian market after Japan." Francesco Trapani, CEO of Bulgari La Tribune 3 December 2003
Characteristics of the Chinese Luxury Consumer

We present below what we believe to be the key features of local consumption: Status, status, status What one wears says much about the social class to which one belongs: - Ive got power: Old-money customers attempt to differentiate themselves from the nouveaux riches, while both endeavour to differentiate themselves from the emerging middle class. - Ive got money: Very affluent customers look for elite products, the middle class for identifiable, ostentatious and logo-ridden products. - The importance of corporate gift giving is reminiscent of Japan in the 1980s. Because Im worth it Buying for pleasure, reward and the expression of a certain individuality, selfishness, notably by women (but not only). Combining the traditional & the modern (few Chinese brand names), collective and individual values. Consumers are brand-driven in China, so brands dont sell in the mid-price range, because of the perception of poor quality. There is a sizeable gap in the mid-market, with no equivalent of, say, Gap or Old Navy. Brand awareness is developed for most luxury brands among the middle classes in cities like Shenzhen, Guangzhou and Shanghai. Fashion preferences among Chinese shoppers vary greatly by city. Generally speaking, young white-collar Chinese in the so-called "first tier" cities of Beijing, Shanghai, Guangzhou and Shenzhen enjoy higher salaries and exhibit a more sophisticated approach to fashion. They are highly brand aware. This sophistication, however, means that they are not easily impressed and do not exhibit as much blind enthusiasm for famous brands as many of their country cousins. Rather, they will pick and choose to establish their own personal style and image. In particular, young Shanghainese are willing to support emerging local designers and have embraced rebellious styles like hip-hop and grunge.
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Main Differences to the Japanese Consumer

Luxury goods companies often refer to the similarities between Chinese consumers today with Japanese consumers in the 1980s. Though there may be similarities, there are also a number of key differences, in our opinion: The Chinese have lower purchasing power than the Japanese, but travel and shop in higher numbers. The market is less crowded in certain product categories (eg. Cognac). Conversion rates of Chinese consumers are higher, but brand loyalty is lower. Chinese consumption is driven more by the individual than in Japan. Customer education as regards brands is less established than it was in Japan in the 1980s and in the mid-tier cities, is likely to remain so for some time.
Is Mainland China Still a Male-Dominated Market?

Mainland China has always been considered a male market. According to a study on luxury brands in emerging markets by the Centre for Fashion Enterprise, men currently account for 70% of purchases there. Ferragamo says that seven in 10 of Mainland customers in its Hong Kong stores are men. "Brionis core customer in China: the tycoon, the new rich, the establishment and government officials. Eventually he will get more sophisticated and appreciate well-made suits and customisation. In China, there is actually an advantage over Russia, in that they understand the culture of custom tailoring. There is a huge group of aspirational clients who will buy just one piece. This is different from Russia, where it is just the rich. They do not have the same spending attitude..." Umberto Angeloni, CEO of Brioni Womens Wear Daily - 15 June 2005
Long gone are the days when any form of ostentation was frowned upon in China
The market has been dominated by mens brands
There are 12 million more men (226 million versus 214 million) than women between the ages of 20 and 39 in China today. It is also important to note that there are 18m more 0-19 year old males than females (211m versus 193m). Though the market may appear somewhat man-heavy, recent trends suggest that, as in more mature countries, women are actually becoming the more dominant market force. In the early 1990s, men may have accounted for about 90% of Chinese luxury goods sales. Now, though, for instance, Vuitton claims that more than half of all of its transactions and sales in China are made by women.
We believe branded jewellery will take off in China
Some analysts have argued that branded jewellery was unlikely to see any great degree of success in China, as male consumers are dominant and branded jewellery is less identifiable as an item. We disagree with this assessment. Chinese customers purchased more than USD1.2bn of diamond jewellery in 2003, making the country the worlds fifth-largest market. With nearly four-fifths of new brides in major Chinese cities buying diamond rings and the likely removal in our opinion of a portion if not all of 70% import tariffs on diamond jewellery, we believe that the market for imported labels will surge in coming years. In other words, we see no reason why leading jewellery brands that have just entered the market can not do well in China in coming years. We will have 10 stores in China this year. Thats the best proof of our confidence (in the branded jewellery market). (...) There is still a price barrier, but it should be gone when the Chinese market becomes more mature. Nigel Luk, Managing Director, Cartier Greater China Financial Times - 12 January 2005
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4. Identifying the Winners and the Losers

Multi-brand conglomerates own the brands with the highest growth potential in emerging markets
In the section below, we show that the balance of power is already similar in Greater China and in the rest of the world. What this suggests is that the companies that are not faring well in Europe, Japan and the US are unlikely to do much better in China in the medium term. Apart from their long-term, superior exposure to the Chinese market, there are three main reasons, in our view, why LVMH, Richemont and the Swatch Group the most liquid stocks in our sector are the best investment vehicles for playing this theme in the medium term: (1) Their leading brands in China already have strong positions on a global basis. They should therefore benefit from the strong increase in travel flows, but also from increasingly homogeneous global demand trends, notably because they have deeper financial pockets than most players. (2) These brands do not suffer from local cost killers who can sell the same product at a fraction of the price. Arguably, this is one of the major differences between leading luxury brands and consumer goods brands. (3) These brands are more financially disciplined than the medium-sized players, which have often compromised on their original business model to survive and have therefore rushed into emerging markets hoping to make a fast buck. Ultimately, we expect the LVMH, Richemont and Swatch Group star brands to post similar profitability in China and emerging markets as the rest of the world, unlike most players, who are already and will likely remain loss-making there in the medium term. The industrys challenge is to balance the gold-rush mentality towards developing new markets with a careful emphasis on quality standards. Bernard Arnault, Chairman and CEO of LVMH International Herald Tribune Conference - 20 November 2004
Tomorrows Winners
Chart 38: Luxury Goods Market Share Data on Hong Kong Accessories Market
Prada Gucci Fendi Dior Herms 5% 4% 2% 2% 6% Ferragamo 8% YSL 12%
In Greater China, LVMH already leads the pack in terms of accessories notably with Louis Vuitton with about a third of the market in our estimates but also in cognac with Hennessy (also about a third of the premium spirits market versus 20% ten years ago). Swatch Group rules luxury watch sales (also with about a third of the market). Richemont dominates jewellery. And Zegna and to a lesser extent Hugo Boss top the polls on apparel. The balance of power may already prove largely established in those markets. We're by far the No. 1 in China. For the next 20 years, we have a trajectory for Vuitton more or less comparable to the one we saw in Japan in the past 20 years. Bernard Arnault, Chairman and CEO of LVMH Analyst Presentation for 1H 2004 Earnings 15 September 2004 On the following page, we highlight the relative performance of selected sector peers and show how LVMH, the Swatch Group and Richemont have already built a competitive advantage over most of their peers, at least as far as their star brands are concerned (Vuitton and Hennessy for LVMH, Omega and, to a lesser extent, Longines for the Swatch Group, Cartier and, to a lesser extent, Montblanc for Richemont).
Louis Vuitton 47%
Chanel 14%
Source: LVMH and Merrill Lynch estimates 2003 Data
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Chart 39: Multi-Brand Conglomerates Clearly Dominate the Scene

Sales Ranking of Selected Luxury Goods Companies (YoY underlying % Chg)
2000 1800 1600 1400 1200 1010
+28%
Revenues in EURm in 2004

+26% +25% +27% +22%
The low contribution of nonJapan Asia and Greater China, in particular, to LVMH revenues masks an incredible snowball effect, as underlying revenue growth is similar to the sector average
1000 800 600 400 200 0 LVMH 446 252 74 Richemont 631 260 214 193 143 Swatch Group
+11%
+25%
+25%
234 110 14 Gucci Group 173 33 7 Herms 66 75 8 Bulgari 56 22 10 Burberry 58 12 Hugo Boss
Chart 40: The Swatch Group Has the Highest Exposure By Far to Non-Japan Asia
Exposure of Selected Luxury Goods Companies to non-Japan Asia
30% 25% 20% 11% 7% 15% 10% 5% 0% Swatch Group 10% 12% 7% 2% Richemont 5% 2% Burberry 9% 1% Bulgari 3% 1% Herms 12% 8% 13% 8% 9% 5% 2% LVMH 4% 1% Gucci Group 5% 1% 1% Hugo Boss
% of Group Revenues
With an estimated 27% of group revenues in non-Japan Asia and 18% in Greater China alone, Swatch Group has by far the greatest exposure to the Chinese market in the sector
kdlslfsdlmf
Chart 41: Star Brands Stand Out

Relative Importance of Key Luxury Goods Brands for Selected Players in Greater China (EURm) 1000 900 800
Other (incl. DFS) Watches & Jewelry Brands Hennessy Other Fashion Brands Cosmetics & Fragrances Other Piaget Dunhill Montblanc Other Tissot Rado Longines Other Brands (incl. YSL) Omega Gucci
The dominance of Vuitton, Cartier, Omega, Hennessy and Gucci is already established in Greater China
700 600 500 400 300 200 100 0
Vuitton
Cartier
LVMH
Richemont
Swatch Group Gucci Group
Bulgari
Herms
Burberry
Hugo Boss
Sources: Company Data & Merrill Lynch Luxury Goods Team (fiscal 2004A estimated revenues in EURm)
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Potential Losers
Long term, we identify three types of brand that may lose out in the Chinese market in the medium-term: 1. European brands that have strong positions in Mainland China (ie, Cardin and Montagut, but also maybe to a lesser extent Givenchy (LVMH), Dunhill (Richemont) in the apparel category and Rado (Swatch Group) in the watch category), which have tapped into the historical importance of male demand without securing first a strong competitive position in Europe, Japan or America. In that sense, we agree with Herms Christian Blanckaert that within the context of an increasingly global industry, where travellers compare what they have seen at home to what is available abroad, those brands have a low probability of succeeding in the medium term in China.
Chinese tourists visiting foreign countries will see which companies are strongholds of legitimacy in the world of luxury. Entering into the Chinese market involves being legitimate worldwide." Christian Blanckaert, Managing Director of Herms International South China Morning Post - 8 January 2005 2. Brands that are currently produced in Europe but suffering increasing competition from Asian manufacturers, notably fashion watch brands (Gucci and cK Watches, in particular). Indeed, we estimate that one in every three Swiss made watch contains at least Chinese components. Local brands (ie, Ports) that are fighting against multi-brand conglomerates with deeper financial pockets and labels with strong brand awareness. Whether these companies will manage hold out against the industry leaders for any length of time is very uncertain, in our view.
3.
Our choice to focus on China does not mean that we will be less successful. With 298 stores and 7.5% market share of the Chinese luxury fashion market, we think its better to be a leading player in one market and we are number one in China. Alfred Chan, CEO of Ports Financial Times- 12 January 2005
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Three Keys to Success

Apart from the need to adapt product, pricing and, generally speaking, marketing for each brand to each local market, we believe there are three main keys to success in emerging markets and China, in particular: (1) early entry and/or coverage of customers in China and the largest cities worldwide, (2) financial discipline and (3) for multi-brand companies, a strong back-end infrastructure.
First-Mover Advantage Early entry is clearly a plus when it comes to succeeding in emerging markets
Background: WTO Agreement Accelerates Brand Commitment in China Lately, sector growth has been given a boost by the progressive reduction of tariffs on imported luxury goods in accordance with China's commitments to the World Trade Organisation (WTO). The move was bolstered by recent decisions to lower import duties and also to loosen passport restrictions and to lift last December the restrictions on business ownership and direct investment by foreign companies.
For example, the prohibitive tariffs that were historically levied on imported watches until 2001 have been progressively slashed, as highlighted below. Similarly, import duties on cosmetics have decreased from 25% to around 15% today. In the medium-term, we believe these tariffs could be cut further, narrowing the price gap versus Hong-Kong.
Chart 42: China Import Duties on Watches
25%
20%
SENSE OF HISTORY IS EVEN LOWER IMPORT DUTIES

15%
10%
5%
0% 2001A 2002A 2003A 2004A 2005E
Sources: Company Data & Merrill Lynch estimates
Some companies, especially in the cosmetics sector, are taking this as an opportunity to lower their selling prices. However, most industry players are opting to leave prices unchanged and to reinvest the margin differential in higher advertising budgets to raise brand awareness.
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Early Entry is Clearly a Plus While first-mover advantage doesnt guarantee a company success in the future, being in there early certainly helps.
Ten years ago, only a handful of luxury brands were present in China. On the vendor front, Ermenegildo Zegna was the first to enter the market, followed by LVMH and Ferragamo, while on the hard player front, Swatch Group and, to a lesser extent, Richemont have been in the market longer than anyone else. This did not necessarily give these companies a competitive advantage per se, especially if one remembers that industry brand managers, over the past 30 years, have been dealing with 30 million or so Chinese citizens outside of their home countries. However, we believe that those companies that entered the Chinese market first have gained precious time and have acquired a superior knowledge of the local market during this the period.
Chart 43: As GDP Growth Accelerates, Brands Line up to Open a Retail Store Network in Mainland China
BUT STRONG INVESTMENTS ARE NEEDED TO BUILD BRAND IMAGE
China - GDP Per Capita (US$ at Purchasing Power Parity)
7000 6000 5000 4000 3000
FIVE YEARS AGO 20 TO 30 BRANDS IN CHINA TODAY EVERYBODY'S Baume & Mercier THERE Dunhill Hugo Boss
Ferragamo Montblanc Hennessy Piaget Parfums Dior Louis Vuitton Pierre Cardin Zegna
Vacheron Constantin Lancel Guerlain Gucci Herms Cline Armani Dior Jaeger LeCoultre
Herms Bulgari Tiffany IWC Baccarat Omega Loewe Tag Heuer Fendi
Cartier
2000 1000 0 1990 1991
Isetan
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Sources: Company Data & Merrill Lynch - Omega, Tissot and Longines since about 1880, Rado since 1974
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Financial Discipline Balancing speed with a careful emphasis on quality standards

Along with an optimal presence in China, we are convinced that one of the main factors of success in this market is financial discipline. Today, within our peer group, apart from Burberry, LVMH, Richemont, and the Swatch Group, we dont think many luxury brands or companies are making a profit in China. In our opinion, and beyond the strong revenue growth which is currently boosted by the rollout of store networks in China, how the current rush of many luxury brands into the market translates into profits remains unclear in the long term: Most companies are losing money in China, either because the traffic they can generate in their store network is insufficient and/or because they often do not adjust their prices to compensate for higher import duties or distribution costs. Others are apparently reporting healthy margins, but it remains to be seen whether their business models are sustainable in the medium term. Take Montagut, for example, the French high-end sweater and polo brand, which generates 85% of its revenues (EUR31mn) from Chinese customers. The company sells its products at 3,400 points of sale in China (notably 600,000 polo lumire to 10 million clients) and posts a solid net margin of 9.6% (EUR3mn in 2004A). However, more than 100% of these profits come from licenses (ie, luggage, suits, shirts) signed with Chinese suppliers. This means that Montagut is in the red excluding royalties. If the company delocalises its production it risks losing its technology very quickly and if it does not then its profits will continue to come exclusively from licences with the underlying risk of brand dilution in the medium-term. "Of course, we could today manufacture our clothing in China for a third of the cost in Europe. However, we would make it easier for our competitors: by training local staff there, we would make our technology commonly available. Pierre Gros, CEO of Bonneterie cvenole (Montagut) Le Point - 16 June 2005 In the medium term, we do not believe that many luxury players will be able to report similar margins to Europe, at least for those where the cost of production remains primarily Europe-based. The main reason is average transactions should remain low compared to local operating costs. But another is the likely reinvestment of lower import duties into higher communication expenditures, which will make it more and more difficult for medium-sized companies to compete against the leading players.
(Ex-royalty) margins - the key to assessing success in emerging markets?
China's luxury car producers are virtually all in the red now
An Illustration of a More Mature Segment: Luxury Car Producers in China In China, we analyse with great interest the profitability of European companies from other sectors than our own. In the car sector, for instance, most companies that sell luxury vehicles initially recorded high profits in China. Today, they are all virtually in the red. We do not believe it will be easier for our companies to do much better, at least those that are not already profitable in Japan or in the US. The main difference, in our opinion, between the luxury car market and the product categories we follow is the only way the European car industry can be profitable in emerging markets is to align its production costs with those of its local competitors. Unfortunately, production costs per car account for a much higher proportion of total costs than for handbags.
In China, we defended our market leadership, but we did not keep pace with market growth. We are currently working within the framework of the market, which is that the Chinese Government on macro-economic dumps quite rightly decided to calm down the car economy a little bit. Dr. Bernd Pischetsrieder, CEO Volkswagen AG Q4 Earnings Conference Call 9 March 2005
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Strong Infrastructure & Group Synergies

We are convinced that multi-brand conglomerates will establish a competitive advantage in emerging markets, not least because of their deep pockets and commitment to those regions, but also because of the logistics and supply-chain synergies they can generate there. Swatch Group, LVMH and, to a lesser extent, Richemont are, for the time being, the most advanced companies in this field, in our opinion. They are the only groups that are well advanced in setting up a state-of-the-art regional infrastructure: For instance, in order to sustain its growth on the Chinese market, in 2003, the Swatch Group opened a 22,500m2 factory in Zhuhai. LVMH also opened a unique regional platform in Singapore for selected brands last year. And in December 2003, Richemont was one of the first companies to set up a fully owned distribution subsidiary in Russia, allowing it to avoid going through agents in this complex market. Similarly the group plans to set up an import and distribution subsidiary which will deliver directly points of sale as of 1Q 2006 in China rather than use sales agents, initially only for Cartier and then progressively for other brands within the group. Montblanc will similarly import and distribute directly in China as of September this year, beyond the current project to buy back franchised stores.
If group synergies are critical to success, then the advantage of multi-brand conglomerates is twofold: Those companies can open several stores at the same time in a given location. By creating retail hubs, they negotiate lower rents from local landlords, but also are adjacent to one another for the right branding environment.
It's all the easier to forge synergies that we are in inter-penetration. I mean because when a new hotel or a new shopping centre opens, we can negotiate for several brands. We shall open several brands in Hangzhou in December. Bernard Arnault, Chairman and CEO of LVMH Analyst Presentation for H1 2004 Earnings 15 September 2004 Unlike small to medium-sized firms, multi-brand companies can, in many cases, implement group synergies by using the same back-office resources (distribution platforms, assembling capacities, R&D, marketing functions, human resources, cost controls, etc.) for several brands. The alternative is once again to sub-contract all of these functions and risk losing control over the value chain.
The power of brands acting collectively will create a luxury destination. Ian Hawkesworth, Hong Kong Land LTD International Herald Tribune Conference - 20 November 2004
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5. Ten Mistakes to Avoid in Emerging Markets

Some of the reservations we have as to the methods of expansion pursued by many companies in emerging markets may appear overly candid, extreme or simplistic. However, they do demonstrate the reality of everyday business constraints in emerging markets. We list below the ten mistakes luxury goods players should avoid, in our opinion, when operating in these markets.
1. Not Investing Appropriately in Brand Awareness

In emerging markets, there are companies investing too much too quickly and others investing too little to succeed:
Late entry in emerging markets could be an issue for many brands
One strategy is pursued by Herms, Chanel, Coach and Patek Philippe, to name a few. These companies could open many stores each year in China due to their excess net cash position. However, they prefer to see themselves as tortoises rather than hares. They consider the market insufficiently large to justify more local investment, especially as they are already capturing a significant portion of the Chinese offshore business. We appreciate the reluctance of those companies to stretch their resources for an uncertain near-term return. However, we are also convinced that the best locations are being snapped up right now. You build a huge shop and the next day they tell you it will be an underground car park. China today can be a mirage. The horse is our soul, our guard and our angel and we enter new markets with our horse, on a horse, as a horse. Horses like us do not like to jump any given obstacle, we prefer to jump step by step and not to fall." Christian Blanckaert, Executive Vice-President of Herms South China Morning Post - 8 January 2005 In our opinion, these companies run the risk of structurally delivering belowaverage momentum from the luxury goods boom if they are not in the right locations should prices fall due to lower import duties and when the purchasing power of those new customers is more substantial. Now is the time to position brands on the map in China. Diego Della Valle, President and Chief Executive of Tods Group Reuters - 2 December 2004
Chi va piano va sano e va lontano (proceed in haste, repent at leisure)
On the opposite, rather than taking their time, many firms are rolling out a dense network of stores in China without checking that they can make money with them first. In our opinion, this could be punished mercilessly in the end. Both LVMH and Swatch Group CEO M. Arnault and Hayek have stressed that in emerging markets Chi va piano va sano e va lontano (proceed in haste, repent at leisure). Ultimately, in these markets, brand success proves a trade-off between their ability to capture the onshore vs. offshore, but also the local vs. national business. One reason we havent entered the (Chinese) market earlier is we were able to catch the big spenders as they travelled outside China. Giovanni Di Salvo, Asia-Pacific Chief Executive of Marzotto Reuters 20 May 2005 The market is actually getting smaller, because they (luxury brands) are opening stores in second-tier cities like Dalian and Shenyang, so the rich people who used to fly to Shanghai to buy these products now have them as much there as here. Paul French, Director of Business Consultancy Access Asia Womens Wear Daily - 11 January 2005
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2. Poor Franchising, Licensing or JV Partners Franchising, licensing or joint ventures take off faster, but do not win in the long run
Although we should not generalise, we have always been sceptical of the virtues of luxury goods players entering into franchising, licensing or joint-venture agreements on a large scale in the long term. Until the end of 2004, the Chinese government did not allow retail stores but this is over. In our opinion, the temptation to sign loose agreements with local partners usually backfires on luxury brands in the long run for the following reasons: If the brand takes off, a significant portion of the brand goodwill and profitability is lost to the local partner. Foreign companies then wonder whether they would not have been successful by themselves, while the local partner wonders if it should have given a significant portion of its capital and its expensive loyalty to a contract it may eventually lose. If the brand does not take off or stumbles, then the local company blames the label and the foreign company the ability of the local partner to bring something to the party, so the relationship eventually collapses.
"Weve taken our time to open our first store in Russia because we were looking for the ideal location and the market was not open enough in our criteria. Vuitton always prefers to adopt an exclusive distribution strategy. Were the first company to open a store near Red Square in Moscow without using a local distributor. Yves Carcelle, President of LVMH Fashion & Leather Goods Group Le Figaro - 17 April 2003 It is impossible, in our view, to devise a wholly owned business model in China or India without significant human-resource or capital investment. But the main reason why most companies choose a local franchisee is it allows them to save precious time when they set up a local distribution network. For this reason, contract clauses with local partners need to be extremely strict. We believe that most of the firms in our sector will want to buy back their franchised distribution as the business gains in importance and their ability to control all the aspects of the value chain is affirmed. This is already the case of Montblanc in China.
Two Main Issues with Loose Franchising Contracts

Somehow, the current system of franchises of varying quality in emerging markets is reminiscent of what happened in Japan in the mid-1970s. At the time, liberalisation of capital was just happening, but there was a limit to the number of stores a company could open in the country. As a result, most European brands thought that progress in legal liberalisation was not enough to break into the local market, especially given the difficulty to secure qualified personnel.
Just like in Japan in the 70s, luxury players generally use local partners in China
Consequently, foreign direct investments in Japan were minimal. Gucci signed a contract with a specialty retailer. Herms used the Seibu department store chain as its agent. Loewe established a joint venture with a wholesaler and another department store chain. Even Vuitton, which was selling in the US under a licence agreement with Saks Fifth Avenue, took a while to find a modus operandi in the country (Louis Vuitton Japan: The Building of Luxury by Kyojiro Hata). Today again, franchisees often choose where they want to locate stores on the basis of the real estate they own rather than where brands can sell best. Moreover, franchisors do not always monitor what is sold in their corners. Their products are sometimes heavily discounted or even mixed with counterfeits in certain stores. "I just went into a store in Shanghai and found in the store products made in Poland, Mexico and Slovakia along with the usual France and Italy. James McArthur, Former CEO of Gucci Division The Financial Times Business of Luxury Summit - May 2005
For how long?
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3. Recycling Unsold Products from Other Countries Not respecting product integrity can prove disastrous
Another common mistake is to use emerging markets as a major factory outlet (to use, say, Mainland China as a dumping ground for goods not sold in Hong Kong) or to develop simultaneously in a country a duty-paid and a duty-free outlet. One of the key differences between customers in China with those say, in Japan, is that the former primarily gain their initial exposure to luxury brands when they travel abroad. As a result, they can easily see if they are being offered an inferior product at home and do not buy those brands again. This is why the majority of the offering from the most successful brands is the same on a global basis. "Our approach in emerging markets is to start small. But we offer the same assortment we have in Paris, or Milan or Marrakech. Sidney Toledano, CEO of Christian Dior Couture Financial Times 18 May 2005 That said, the personalisation of the product offering to local consumers is required in certain cases. To take two extremes, wines and spirits are the same on a global basis, but perfumes and cosmetics differ significantly with the mix skewed to skin care in Asia, overwhelmingly anti-ageing products (as of 20 years old...) and whitening products. Companies must be careful, therefore, even if adapting products to local markets, that their offering remains similar on a global basis, so that customers do not believe they are being treated differently.
4. Not Adapting to Local Markets

Most companies tend to push accessories in emerging markets primarily because of their higher margin, but also because they offer more attractive entry-prices than many other product categories. In many cases, however, local demand is stronger in other product categories. For instance, Russia is the third-largest market in Europe for Louis Vuitton ready-to-wear. If the level of product renewal is insufficient and the local customer is not getting any incentive to shop at home (ie, products exclusive to the store), then sales do not follow. "Our experience, built over many decades, is that investment over time is critical. If we go too fast, it will be a disaster Bernard Arnault, Chairman of LVMH The Wall Street Journal - 1 December 2004
A PR approach is needed
Luxury goods companies spend little on advertising in emerging-market mass media (the typical fashion-magazine in China sells only 100,000-200,000 copies) and target potential buyers through product promotions and public-relations events. For instance, Vogue Magazine is only now launching a Chinese edition, because the market has not been considered mature enough. Similarly, communicating to the right target market is an issue in countries like China and India. Tag Heuer has just signed a marketing agreement with the Chinese Americas Cup team, but the returns of such an initiative remain difficult to predict.
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5. Losing Financial Discipline A slow, steady approach is preferable

Even after the removal of restrictions on business ownership and direct investment, we predict that most companies will continue to operate in China through franchised stores or independent retailers in future. The paradox is that although there is no room in China for brands that expect or need a quick payback, the barriers to entry will remain relatively low because the bulk of the initial costs are still supported by local partners. That leaves many companies engaged in marketing efforts that will hopefully pay off over the long term, when and if more of the population can afford their products. We are looking at Greater China in a more serious way, even though we think the opportunity, meaningful opportunity is post 2010. Lew Frankfort, Chairman and CEO of Coach, Inc. Q4 2005 Earnings Conference Call - 2 August 2005 The other reason why market leaders are generally more cautious when they invest in emerging markets and China, in particular, is that they often have no visibility on the returns from their investments. In contrast, medium and small players get immediate returns that are positive initially, but also potentially mediocre in the long run. Speed is not everything, clearly. We think the potential of the Chinese market is large, but we're not quite sure when that is. We opened in Japan in 1972, and to be honest with you for 11 years - in the first 11 years it grew to USD3m. And now it's a third of our business. That really happened after that initial 10 or 11 year period. So I think China is a sound investment but we will probably see returns on that investment, though, more toward the long-term horizon, maybe 7 to 10 years from now. James Fernandez, Senior Vice President - Finance, CFO of Tiffany & Co Wells Fargo Securities Consumer Conference - 25 September 2003 This is also visible in the store opening policy of sector peers. Just like Japan in the early 1980s, some companies pay exorbitant rents for locations that sometimes make little sense from an economic standpoint. In many cases, new store openings end up in our opinion being a mere exercise in raising brand awareness. The paradox is depending on whether a brand opens, the economics of its store can sometimes prove very attractive but obviously only a steady approach and good local connections are needed to avoid making serious mistakes. (About the Bund in Shanghai) There are no customers (for the time being) either way; its all about the rents, which are phenomenally more than they should be. These rents are much more than comparable places in London and New York. Paul French, Director of Business Consultancy Access Asia Womens Wear Daily 11 January 2005 (About Nanjing West Road malls) At Plaza 66, the stores arent paying anything, just a service charge, because they want the luxury brands in there at the street level. Its cheaper than a billboard those you have to queue for; just stick in some purses and some girls. Its good for the brands, free advertising plus a Shanghai store, they dont care if anyone ever goes into them. Paul French, Director of Business Consultancy Access Asia Womens Wear Daily 11 January 2005
Flagship stores in emerging markets: necessary showpieces or profitless volume?
Mistakes will be punished mercilessly, just as they are in more mature markets
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6. Not Monitoring Local Demand Patterns

"Today, across Greater China, the new luxury consumer is vastly more sophisticated. They are much better informed, much more widely travelled and far more exposed to global fashion trends than their counterparts of some years ago." Adrienne Ma, MD of Joyce Boutique Holdings International Herald Tribune Conference - 20 November 2004
Taste levels are already more sophisticated than many believe in emerging markets
Much of todays spending power in emerging markets remains in the hands of government officials, both national and local, and their children. It is these consumers that luxury goods companies are currently chasing. However, some vendors are finding that taste levels are already far advanced when it comes to luxury goods. In China, for example, Ogilvy & Mather noted recently that the segmentation of the market is more sophisticated than anticipated: The vast majority of Chinese luxury consumers use their newfound money to buy the showiest, biggest, most expensive brands they can. Today, some of these consumers also buy knockoffs of foreign brands. Local managers must adapt their product offering to this specific logodriven clientele, without giving it the feeling that it is a second-class clientele compared to more mature countries. There are also status customers who buy luxury products that give them a certain social standing and distinguish them from others. There is a final segment of the market much smaller for the time being which consists of highly sophisticated consumers who have lived abroad, have had a significant amount of exposure to luxury brands and purchase brands for their symbolic value. These consumers are looking for details in their purchases. They want to know the history, the background and the relevance of brands. And whether they buy a made in China label remains highly debatable at this point.
A differentiated approach is increasingly needed
I am looking forward to discovering the performance of the companies that source in China and think they're going to sell also in China. I've been there. My colleagues have been there. They're not creating real wealth studying, working to buy luxury goods made in China, unless they do it inadvertently and they're buying fakes. But by choice, they will not do it. So, you've got the constant play. And in the end you rely upon pricing power, in the very end, the desirability. Johann Rupert, Executive Chairman of Richemont Analyst Presentation for FY2004-05 Results in Geneva - 9 June 2005
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7. Stinting on World-Class Merchandising

Most companies are now upgrading their operations in emerging markets, notably on the merchandising front, where they need to adapt to demand specifics: "In order to succeed abroad, luxury goods companies need to already have a solid base in their domestic market. Otherwise, the implementation of risks can make their business model implode." Isabelle Allen, KPMG La Tribune 15 November 2004
"Our stores are operated in China through a wholesale partner, but what we've done as a house, we've established a service organisation to better manage the buying, merchandising and operations in these stores, with particular emphasis on improving the assortments, the visual presentation and our sales capabilities." Brian Blake, President & COO of Burberry Group Presentation to Financial Analysts - 16 November 2004 Luxury manufacturers are realising that last year's product is uninspiring for increasingly discerning emerging-market customers with a voracious appetite for newness, premium and aspirational products: "We knew there was a market for us in India, but even we were overwhelmed by the response. The critical factor behind our success has been the simultaneous launch of products and services in our flagship stores in Paris and India. This earned us the trust of the Indian consumers." Prasanna Bhaskar, Retail Manager, Louis Vuitton India Indu Business Line - 16 December 2004
Beware of the performance gap between companies with customised regional hubs and those with an overly centralised or decentralised organisation
8. Operating with a Poor Supply Chain and Logistics

With the need to customise their product offering to suit the specific needs of their growing emerging-market customers, luxury goods companies are likely, in our view, to progressively transfer resources from Europe to Asia and offer more local value-added services. This could include 24-hour seamless distribution and labelling and assembling capacities from a logistic standpoint, but also research and development, laboratories and marketing centres. Companies with insufficient scale run the risk of either having an overly centralised structure and missing growth opportunities or losing a portion of the value chain to local partners. We are rolling out a stronger infrastructure in China and Russia, (markets) that are very considerable growth drivers for TAG Heuer Antonio Belloni, Managing Director of LVMH Presentation to Financial Analysts - 9 March 2005
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9. Not Investing in a Strong Local Leadership Team

Here, the major difficulty for luxury goods companies, in our opinion, is retaining educated and loyal local partners, as well as managers who understand the specific issues of brand management. "We have a very strong merchant based in Hong Kong who understands the differences, the merchandising expertise needed between merchandising in Northern China stores versus that of the Southern." Brian Blake, President & COO of Burberry Group Presentation to Financial Analysts - 16 November 2004 There arent many people here who know how to develop and nurture brands Marvin Traub, Murjani Traub India Ltd Hindustan Times 26 February 2005
If you want one year of prosperity, grow a grain. If you want ten years of prosperity, grow a tree. If you want one hundred years of prosperity, grow people.
Chinese proverb, The Economist
Of course, small and medium-sized companies find it more difficult to achieve this because their ability to attract talent is less evident. They often pay less than multinationals, which invest in local teams for the medium term. Also multi-brand companies often offer more interesting long-term career prospects than smaller companies, which, as a result, often suffer from a high level of staff turnover. "It is not easy to maintain staff turnover at a low level in China. All of our employees want to prove themselves. Everybody, literally, is taking courses in the evening. For instance, even our former main switchboard hostess has just set up her own printing company. Pierre Gros, CEO of Bonneterie cvenole (Montagut) Le Point - 16 June 2005 Companies with limited management resources are tempted to use expatriates to manage their local operations. These managers often do not grasp the specifics of emerging markets or are unable to deal with the local administration. Over the coming decade, we believe that it will be those companies capable of investing in an optimal mix of informed and influential local managers, complemented by experienced expatriates, which will win in emerging markets. Often, Italian companies are family owned: who in the family will go and live in Guangzhou, for example? Or they are too small to hire managers who will. You need presence and continuity to build your business abroad. Guido Corbetta, Co-Director of the Masters Degree in Fashion, Experience and Design Management at Bocconi University Womens Wear Daily - 20 February 2003 Entry into emerging markets shows up, therefore, the differences between multinationals that are sufficiently organised to succeed and small, independent companies lacking management and financial resources. In our opinion, this will become more and more obvious as the market develops in the coming years.
10. Not Implementing Synergies between Units Big is not beautiful, but small is increasingly vulnerable when creating a local infrastructure
Most companies in the sector unfortunately enter into emerging markets without thinking that they need a solid infrastructure. They quickly realise that those markets and China, in particular are so big that without cost-effective and efficient back-office functions, they can quickly face insurmountable logistics and commercial difficulties. In other words, big is not necessarily beautiful in emerging markets, but small is clearly vulnerable.
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6. The Counterfeiting Issue

Counterfeiting remains one of the major threats to the industry, especially as the vast majority of faked products are made in China. The best way to deal with the knockoff problem is to refresh designs quickly, so that counterfeiters can't keep up. With the expansion of luxury goods operators in China, however, some companies are a lot more lenient than others and seem to tolerate this major problem. Consequently, we believe that economic expansion and the ensuing wealth creation will create a discrepancy over time between those brands that control the value chain and those that do not or cannot.
A Guide to Counterfeiting There are many forms of counterfeiting

Counterfeiting has arisen as a result of the incredible success of luxury goods houses in the past few decades and is not a recent issue. About ten years ago already, sales recorded by counterfeiters of the Louis Vuitton label were in excess of EUR1bn, almost the equivalent of what the brand itself recorded at the time. There are three main forms of counterfeiting, according to Christian Blanckaert Executive Vice-President of Herms and author of Les Chemins du Luxe. The most common form of counterfeiting consists of copying an original product to various levels of quality. Counterfeiters set up their production units in China, Thailand, Korea, Italy, Turkey, Morocco and in numerous other countries, but sell their products on a global basis. The second form of counterfeiting is the registration of labels with names similar to existing luxury brands. Korea has famously registered Channel, Chanelle, Chanele, Vouiton, Vuiton and Vuitone. The Indonesian Suharto family, for example, was once famous for its P.T Permona company, which registered more than 100 brand names similar to famous labels. More recently, in Shanghai department stores, we have seen several UbinoBoss and Georgi Amoni stores. Lobbying of European authorities on intellectual property rights has been less effective than in the US. Only with stronger cooperation among EU member countries will France and Italy be able to eradicate this issue, particularly in the context of the potential entry of Turkey into the European Union. The third form of counterfeiting is more recent and involves using the name of an existing luxury label on products that the brand in question has never created. Many companies in our peer group have mentioned to us in recent months that they have seen unknown objects in Chinese hotels, restaurants and stores bearing their brand name. Tableware specialist Christofle once discovered watches being sold under its name, when the company was not producing any and had not granted any licences in this product category. Vuitton even also discovered false Vuitton boutiques in Dempasar airport in Bali, where knockoffs and real products were mixed and sold together, a handy solution for passing police checks. This is an example which dates back more than a decade, but such scenarios are common for many brands in emerging markets today. It is easy to imagine the damage caused to luxury brands if the level of local corruption is such that local customers are buying fake goods in real stores.
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Blown out of all Proportion or a Major Threat? The ultimate form of flattery?
After buying a fake Armani watch in Shanghai: "It was an identical copy of an Emporio Armani watch. (...) As for the fakes, they can cause confusion among consumers. But on the other hand, it's flattering to be copied. If you are copied, you are doing the right thing.
"I saw some stores using our name (Giorgio Armani, Armani Fiori, Emporio Armani) but selling totally different things inside. I now know I have some stores in China - that have nothing to do with me.
"Piracy is the issue in China. I may have to move some of our production lines, such as watches, away from China. Giorgio Armani CEO of Giorgio Armani Group Associated Press Newswires - 19 April 2004 Counterfeit luxury goods should give most brand owners nightmares, not just because of the fake products on offer, but also the fake stores and production units. As highlighted below, it can be argued that opening stores gives consumers the chance to buy legitimate products, but whether this happens in reality is debatable. Also, we are not convinced that economic expansion has a positive effect on demand for the genuine article. If it did, the incredible growth of the US economy in recent years should have resulted in lower demand for knock-offs, whereas the opposite happened. This is why we see counterfeiting as more of a threat than ever to the industry. China has now emerged as the global epicentre of piracy and counterfeiting: 60% of the 92 million faked products seized last year by Europen customs came from this country. However, industry experts say the theft of intellectual property is also rampant in Korea, Taiwan, Malaysia and Vietnam. Some of the organised corporations now have distribution centres in Hong Kong, Milan, Shanghai, New York or Buenos Aires. "Counterfeiting greatly damages the brand image - there is a whole problematic about the desirability of the brand, and the desirability of a brand is its true asset. Counterfeiting finances terrorist and Mafia networks and has become a very lucrative way to buy arms or launder drug money. We shouldn't forget that the Chinese population, some of whom already and others in future will buy Cartier, should not be bathed in an atmosphere of counterfeits that can only penalise the image of our brand and, at the end of the day, our business." Bernard Fornas, Chairman of Cartier Reuters 6 November 2003
Or flattery of the worst kind?
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Fakes do not Build Brands

One of the issues in emerging markets is it is still unclear whether the increasing mass of newly rich consumers is willing to spend on real labels instead of a nearidentical copy for a fraction of the price.
We are not convinced that people will upgrade when they can afford it . . .
Also more worryingly, there is a growing contingent of affluent consumers around the world who are purchasing luxury fakes and mixing them with genuine products. This demonstrates that the idea of respect for intellectual property is a notion foreign to many. As if to prove the point, the wife of former Australian Prime Minister William McMahon was photographed carrying a fake Herms Birkin bag, while former Italian Foreign Minister Franco Frattini* (now EU Justice Commissioner!) was snapped buying a fake Rolex watch. * "What's just about the worst thing an Italian minister could do while in China to sign an agreement on trade piracy on behalf of the European Union?" La Repubblica October 2003 Should they ever take their fake purchases to France, whose intellectual property laws are rigorously enforced under the Longuet Act, however, they could find themselves detained at the airport, taken to the police station and fined twice the retail price of a genuine product sold in France. Indeed, in France, counterfeiting is an offence punishable by criminal law, with a two-year prison term and a 150,000 fine, as well as the removal of the right of election and ineligibility for commercial courts, permanently or temporarily. Unfortunately, none of these provisions are widely applied. And unless strict European legislation is adopted, the situation is unlikely to change near term.
Little evidence that counterfeiting can be brought under control in coming years
How to Spot the Winners from the Losers

Certainly, for companies that control the entire value chain and, in particular, sell their products only through directly operated stores, there is less of a possibility of duping a customer into believing he/she is buying the real product when it is a fake. In that sense, shopping at designer boutiques in Europe is giving Chinese tourists a guarantee that the goods they buy are not counterfeit, something they cannot be sure of when shopping in some malls in Hong Kong or on the Mainland. The best answer to this issue, however, is constant innovation, more sophisticated designs/materials/styles and a zero tolerance policy, especially in the case the brands that use the wholesale channel. Chinas self-esteem and self-confidence is increasing every day, as is its ability to compete with foreign products, to imitate them or why not just say it to counterfeit them. The real answer to counterfeiting is constant innovation and manufacturing quicker than the counterfeiter. Christian Blanckaert, Executive Vice-President of Herms South China Morning Post - 8 January 2005
. . . if luxury brands do not have a zero tolerance policy when it comes to counterfeiting
"Innovation is our only chance for survival. A new model can be approximately imitated in only four months. We must therefore constantly innovate. Pierre Gros, CEO of Bonneterie cvenole (Montagut) Le Point - 16 June 2005
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Alternative Solutions The Carrot or the Stick

The International Intellectual Property Alliance (IIPA) recently stated that the only viable means of effectively reducing piracy levels is to "use its criminal laws to prosecute pirates. Though correct to a certain extent, such an approach may only reap limited rewards in terms of reducing piracy levels. The unusually high piracy level in emerging markets is more than a legal problem. It is a social problem. Despite recent efforts to protect trademarks and intellectual property with companies setting up special task forces, hiring undercover agents and stepping up their cooperation with local governments we fear that the market for counterfeit goods could remain out of control if this is the only strategy used in emerging markets. Criminal prosecutions are rare in those markets, as counterfeiters are increasingly sophisticated and organised. The legal strategy of luxury goods companies in developed markets often involves taking out injunctions against the owners of stores selling counterfeit products. Unfortunately, this is still largely ineffective in emerging markets. Although local governments have pledged to crack down on piracy especially at the border with Hong Kong - factories sometimes make genuine goods by day and fake goods by night. The closures of Silk Alley in Beijing and the Xiang Yang Fashion and Gift Market in Shanghai by local authorities are mostly symbolic, as vendors have simply transferred their activities to nearby locations (including the Xiangyang market) in the city. " We noticed that although I had been with President Chirac to China and I had secured the destruction of a shop that sold counterfeit products, at the same time, the local government authorised the building of a mall where these retailers of counterfeits could sell their wares. Bernard Arnault, Chairman and CEO of LVMH Annual General Meeting 12 May 2005 For many individuals in emerging markets (and China, in particular), especially those from the rural areas, the decision to become a "pirate" is one of survival. With high unemployment rates and a scarcity of jobs that can provide a liveable wage for individuals with limited or no education, it is not surprising why some individuals commit piracy.
The threat of legal action will not be sufficient to eradicate counterfeiting
The problem is further exacerbated by the fact that local officials see such activities as a major source of employment and as a pillar of the local economy, so national political agreements to crack down on piracy are often undermined on the local level. Increasing fines and prison terms is an insufficient deterrent in such situations. Fixing the laws will only scratch the surface of the piracy problem. The obvious key to stamping out piracy is to provide stable jobs with reasonable wages and economic opportunities. In the absence of such a solution, however, one approach could be to use anti-piracy campaigns at the grassroots level - in universities, commercial centres and entertainment venues. Piracy is commonly not viewed as an offence.
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7. Sourcing & Producing in Emerging Markets

The luxury goods sector has historically ignored the concept of cost advantage, as the cost of sourcing and manufacturing goods has often remained a marginal issue in the generation of profit. However, in those product categories where labour and raw-material savings are a more significant issue, we believe that companies that do not adapt to the emergence of competitive production know-how in lowcost regions will find it increasingly difficult to survive. This can already be seen in the ready-to-wear category and, to some extent, in the areas of small accessories, jewellery and tableware. In the 1990s, most firms tried to maximise their distribution margin by extending their retail network. In the coming decade, we believe these companies will start to focus more on their production margin. We therefore view low-cost regions primarily as a threat to those companies unable to adapt their business model and as an incredible opportunity for other, more flexible producers.
A Starting Point: the Absence of Chinese Local Luxury Brands It will take a whole generation to exorcise the legacy of Mao
Why do Chinese customers buy western brands and not local labels? Well, for one thing, there aren't many Chinese luxury brands. We believe Chinese entrepreneurs do understand the concept of branding and its long-term implications. However, the Chinese are a nation of traders - they often look to the short term. They're also not always willing to invest the kind of money or time and effort that it takes to build a brand. Consequently, they often want a quick return.
There arent many Chinese luxury brands

The Financial Times illustrated this well on 16 October 2004, when the journalist was hard pressed to name Chinese luxury brands apart from its first home-grown brand, Shanghai Tang, and The Mandarin Oriental hotel group. (Incidentally, Jardine Matheson, a company of Scottish origin that began trading in Asia in the 1830s, owns the latter while Richemont has owned the former since 1994.) More importantly, though, is the fact many Chinese still associate all things local with the low-quality items available under Communism. At the Vuitton flagship store opening in Shanghai in September last year, we were surprised to see no Chinese wearing ethnic clothing, but mostly European dress (including Gucci). To make an impact abroad Chinese designers need a clear ethnic look, like the Japanese designers of the 1980s, and yet at home this will not sell. If anything, if they want to be a success here, they have to present a contemporary Western look. It is almost as though they have to go overseas, make their name and then come back. This is what has happened to Shanghai Tang. China has lost its cultural heritage over the past 50 years. After the communists took over, we have not had much to shout about in the way of Chinese culture. Young Chinese designers need to take some time to re-learn what has been lost. Eddy Koh, Publisher of Mens Folio and Wow magazine The Financial Times - 16 October 2004
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If you Cant Beat em, Join em

Many emerging-market entrepreneurs have local distribution reach, not to mention the ability to produce a portion of the product mix locally, directly or indirectly. As a result, we believe they are likely to acquire several European luxury brands in the coming years.
Table 6: Recent Acquisitions of Luxury Brands by Chinese Firms
Company Asprey Bertolucci Guy Laroche Lanvin Pringle Seller Brunei Investment Agency M. Remo Bertolucci Leman Capital LOral Dawson International Acquirer Silas Chou Dickson Concept (Dickson Poon) YGM Trading Wang Xiao Lan Fang Brothers Knitting Date of Transaction July 2000 December 2004 August 2004 September 2001 2000 Comments Chinese by origin only 10,000 watches per annum, sales of EUR15m Hong Kong manufacturer looking to expand its luxury impact purchased for USD17mn Fang Brothers are regular suppliers to Marks & Spencer and The Gap - Pringle bought for 10m Founded in 1971 by former CEO Roger Saul and his mother; now 53% controlled by Christina Ong & Ong Beng Seng
Mulberry
Roger Saul
Christina Ong & Ong Beng Seng
Nov 2002
Sources: Le Temps, Les Echos, Le Point, WWD
As mentioned above, it takes decades to build venerable brands, so in the absence of local Chinese luxury brands, the fastest way to enter the market for these investors is probably to acquire some directly in Europe and/or in the US: "What these companies are looking for is to build up capabilities. This (acquisitions) is a shortcut. They dont have billions of dollars to invest in the growth. But here in one fell swoop, youre acquiring a venerable brand name. Oded Shenkar, Author of The Chinese Century New York Times - 29 June 2005
We believe emerging-market entrepreneurs will acquire luxury brands and know-how in the years ahead
Of course, and in the more general context of the consolidation of the luxury goods industry, this reasoning is not valid just for Chinese entrepreneurs, but also, to some extent, Middle-East investors looking at a diversification of their investments or to leverage their existing investments in the retail and hotel business in the region. For the moment, the link between Middle East investors and luxury goods companies only takes the form of hotel joint-ventures (Versace with Emirates International Holdings, Giorgio Armani with EMAAR Properties). However, if they are invest in five-star hotels in Europe, then Middle-East investors could well eventually invest in luxury goods brands. "People in Dubai are the ones with cash and they don't know what to do with it. They live in great palaces in an ultra-modern country and they want to conquer the world. They could buy Armani. To them, buying Armani would be like putting on a beautiful hat." Giorgio Armani, Chairman and CEO of Armani Group The Sunday Times - January, 23 2005
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Made in Europe or Designed in Europe?

Most of the companies in our peer group claim that relocating design or manufacture of their luxury labels to low-cost regions does not make any sense. "Louis Vuitton has no plans to shift manufacturing to low-cost China. Chinese factories lack the craftsmanship and experience to make luxury goods. For those who see China as a cheap source of labour, there is a short-term benefit in production, but no long-term gain. European designs and makers will still dominate the business of luxury goods for the foreseeable future (...) It is still British, German and Italian cars that are the stuff of dreams. Bernard Arnault, Chairman and CEO of LVMH Wall Street Journal - 1 December 2004
"Made in Italy an essential part of the personality of the Gucci brand. Made in Italy and Gucci brand is one and cannot be separated; there will not be a Gucci brand made in China. Robert Polet, President and CEO of Gucci Group Presentation to Financial Analysts - 14 December 2004 Admittedly, European players are finding it hard to shift production and expertise to other countries, as opposed to US companies, which have always predominantly produced their goods abroad. Certain product categories and segments shifted their production to Asia several decades ago (ie, clothing, sporting goods), but more recently, US brands like Coach and Kate Spade have gone as far as delocalising outside of their home country all production of accessories, a category historically produced in developed economies. And European companies are probably shifting more production to low cost regions than they admit: "Come on! All Italians produce in China (in our field). Marco Palmieri, President of Piquadro Finanza & Mercati 18 May 2005
The seed of decentralised outsourcing has already been sown, in our opinion
In a recent interview, Prada Group CEO Patrizio Bertelli said it made perfect sense to manufacture high-volume luxury goods outside Italy, either in a lowercost Mediterranean country or further afield. He added that this would not necessarily hamper the quality or perceived quality of luxury brands. He predicted that over the next 10 years, Italy would simply not have enough labour to manufacture everything that the market requires and outlined a potential system whereby a made by Prada declaration would suffice on a garment made outside Italy. The question is, therefore, whether this is an extreme thesis and to examine under which conditions a company is likely to delocalise the production of a portion of its products without endangering its brand image and ultimately its profitability. Its paradoxical to raise import barriers, a Great Wall to keep China out. China should be seen as an opportunity for the world and for Italy, not a threat. Patrizio Bertelli, Chairman and CEO of Prada Group Financial Times Business of Luxury Summit - 18 May 2005
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A Starting Point: the Risks Inherent in Offshoring Production

Manufacturing in low-cost regions raises several issues:
Obvious risks to bear in mind
The risk of violation of intellectual property rights Coach is tackling this issue well, but it may prove more difficult for other companies, especially if their distribution is not sufficiently controlled in the Chinese market. Ultimately, investors will know whether Coach has managed to overcome this difficulty when it starts distributing its products in China in the coming years, because right now, it is impossible to know whether the current production model means the brand is more copied than if it did not produce in China. The potentially lower manufacturing integrity of Made in China labels We believe that some product categories will continue to be produced in Europe, but that others will see their production increasingly offshored. For instance, in the accessory and luggage business, the production of small leather goods and basic luggage cases is increasingly delocalised, but less so in the case of precious materials or more expensive items. Offshoring to low-cost regions raises expectations of lower prices, which could become an issue for many brands.
The Delocalisation Alternative

We present below the factors which we believe essential to any decision to relocate design or manufacture to low-cost regions.
Table 7: Deciding Whether to Offshore Luxury Goods Sourcing, Design or Production to Low-cost Regions
Delocalisation of Design/Production Possible Higher volume items Lower margin products Low cost of labour in added value of final product When quality is selling Lower cost of production and/or distribution Multi-segment brand Made by products Fashion products Brand extensions (second lines) Products for which origin is Irrelevant or/and production process is simple and easy to replicate Selected product categories (ready-to-wear, footwear, small accessories, tableware) Product categories or brands Fashion watches & jewellery (cK Watches, Diesel, Follie- Folli, Giorgio Armani) Ready-to-wear (Emporio Armani, Hugo Boss, Ralph Lauren) Luggage & small accessories (Coach, Lancel) Tableware & crystal ware (Waterford Wedgwood)
Delocalisation of Design/Production Not Possible Low volume items Higher margin products High cost of labour in added value of final product When the brand name is selling High cost of production & distribution Mono-segment brand Made in products Timeless products Core brand not amortised through volume lines Products with a strong-rooted origin and/or where production process is complex and difficult to replicate Selected product categories
Product categories or brands High jewellery & watches (ie, Cartier, Omega, Rolex) Premium and super-premium leather goods producers (Bottega Veneta, Louis Vuitton, Herms) Cognac & Champagne brands Puiforcat, Limoges porcelain brands
China is a threat for fools and heaven for those that will be capable of exploiting the opportunity. Patrizio Bertelli, Chairman and CEO of Prada Group Financial Times Business of Luxury Summit - 18 May 2005
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Beyond the potential for incremental revenues, we see opportunities on the sourcing and manufacturing front for many European and American brands:
Companies are just starting to explore sourcing and manufacturing opportunities in low cost regions
On the sourcing front and apart from a few early exceptions (Zegna as a buyer of cashmere in the mid-1980s in China), initiatives are still at an early stage (mass brands like Benetton have been sourcing from India since 1991). Tiffany is exploring the possibility of setting up a processing unit for diamonds in India, the largest cutting and polishing centre in the world (Source: Asia Pulse 5 May 2005). Bulgari is also working at developing its diamond jewellery business by further integrating its production process via the creation of a joint venture with the Leviev Group. On the manufacturing front, there are many discussions underway. Since 2001, before Chinas WTO concessions came into effect, made in China imports into Europe have more than doubled. According to Finanza & Mercati, Prada Group CEO Patrizio Bertelli recently met with management of Focus Mate, a company based in the Guangdong area or China, to discuss the potential production of bags there. But many other European groups are showing an interest for Chinas producers, including Armani (well beyond the jeans produced by its subsidiary Simint for many years in the Far East), Paul Smith, and Ferragamo to name a few. Even Hugo Boss, which already is already producing in Turkey, recently confirmed that it was testing out the production of mens suits in China (source: Handelsblatt, 1 April 2005). The train is clearly in motion and we do not believe it can be stopped now.
China is a threat for fools and heaven for those that will be capable of exploiting the opportunity, Patrizio Bertelli Prada Group CEO
We would bear the following in mind when deciding whether to outsource production to low-cost locations: When the gross margin is in excess of 50% and retail prices are high, it may prove undesirable to produce in low cost regions. Here, it makes no sense to cheapen a brand from a marketing standpoint and reduce selling prices accordingly if a reduction of the cost of goods sold is achieved. This is the case for Cartier, Chanel, Gucci, Herms and Vuitton, for instance. If selling prices are lower or the cost of labour is much more significant in the added value, then the temptation to produce in low-cost regions may make it worthwhile. The mention of made in China may not necessarily be an issue, other things being equal, as long as consumers are aware of it and they get value for their money. A good example is the Coach business model which offsets lower-than-average selling prices with a 100% delocalised production model. Coach ends up with some of the best margins in the sector, but with a different business model. This is probably what Tods Group CEO Diego Della Valle is hinting at below. And this goes well beyond the sphere of luxury brands at a time when many shoe and apparel manufacturers are struggling in Italy. Remember, the competition is also domestic with mass market brands that are aggressive from a commercial standpoint because they do not produce a single product in Italy and as a result have much lower manufacturing costs.
The seed of decentralised outsourcing has already been sown, in our opinion
Now is the time to reaffirm what are the most important things Made in Italy can do. Thats why its necessary to appeal to these entrepreneurs who are most visible. They have to stop confusing the issues and state clearly whose side theyre on. If theyre Italian and want to produce in China, they should write that on their labels. We need to create a powerful operation in patriotic production. Diego Della Valle, President and Chief Executive of Tods Group Corriere Economia - 21 February 2005
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8. Investment Thesis & Global Comps

We remain overweight on the luxury goods sector, because we believe valuations remain reasonable and we think most sector players can beat market expectations in H2. There are risks, however, most notably a lack of visibility on currency fluctuations. Assuming average rates remain stable until year-end, though, we believe the price increases passed on in H1 and the strong product innovation of many companies should result in additional upgrades. We believe that the current buying opportunity more than outweighs any lack of visibility and certain company-specific concerns.
Why We Remain Overweight on the Sector More Supportive Growth Expectations

Luxury-goods sector performance has historically been strongly correlated to the OECD leading indicator, which usually gives a good six-month lead on the industrial cycle. We do not expect the indicator to correspond with the actual economic performance of the companies in our universe, but indicator upturns have tended to signal a period of stronger performance for our sample. In other words, the indicator leads the economy, not stock prices. A key issue for investors is whether the expansion of sector multiples in recent months has already pre-empted the economic recovery of OECD member countries. Our economists view is consistent with a reacceleration of growth, especially in Europe, and the latest data are supportive of this view. They believe that the global economy is still growing above trend, even if it is highly desynchronised at present. The US consumer remains robust, the Fed is continuing to raise rates and the housing market is steaming ahead. Japan, with falling unemployment, could be characterised as being in recovery and recent business trends in the sector have been encouraging. In contrast, the Eurozone has had a rather flat cycle, with growth slightly below trend, despite tentative signs that growth prospects may improve in the next few quarters.
Chart 44: Luxury Sector Recovery YTD Suggests Market Is Pre-empting a Significant Recovery of OECD Growth Expectations
ML Luxury Goods Core Index (6 Months % Chg, L.H.S) 90.0% 70.0% 50.0% 3% 30.0% 1% 10.0% -10.0% 1996 -30.0% -50.0% 1997 1998 1999 2000 2001 2002 2003 2004 2005 -1% OECD Leading Indicator (6 Months % Chg, R.H.S) 7%
5%
-3%
-5%
Sources: Merrill Lynch Luxury Goods Team & Datastream - The OECD indicator is a composite of 190 fundamental, economic and financial indicators, and, in our view, is one of the best measures for the alignment of the forces that signal the beginning of a cyclical upswing. Each country-leading indicator is composed of distinct variables (production orders, unemployment claims, price indices, credit, money supply, interest rates, stock prices etc.) to make the most accurate indicator for that country. The country specific indicators are then weighted according to GDP. The indicator is released with a five-to-six week lag. To account for the release delay, when drawing conclusions from this data, the measured leading indicator should ideally be lagged by one month when compared with investment multiples - Core Average includes Bulgari, Herms, LVMH, Richemont and TOD's Group
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Mid-Cycle Valuation
For the luxury goods sector, this sense of optimism overall is somewhat tempered by the fact that the sector is now trading with one-year forward P/E multiples closer to what we would see as a normalised peak, ie, about 25x earnings. Although the increasing exposure of sector to the retail channel may result in shorter and more-volatile-than-ever cycles, there is indeed little reason to believe, in our opinion, that the group can reach the stellar multiples of the millennium, when the euro was a lot weaker. However, just like in H1 2002 and H1 1999, the leading indicator trend is likely to improve significantly in coming months. And as a result, potential earnings upgrades are likely to delay a return to peak multiples. This leads us to conclude that although macro sector drivers are now more supportive, EPS upgrades are essential to trigger additional performance. We believe that the selective opportunities (see our Stock-Picking Rationale) the sector can yield in the coming months must all offer significant upgrade potential.
Chart 45: Luxury Goods Sector Re-rating not Over, but a Selective Approach is now Needed
50x
Luxury Goods Sector PER - Simple Core Average (*) Long TermAverage
45x
Peak of OECD Leading Indicator Enron Affair
40x
USD Weakness
35x
Millenium Bubble Krach
June 2002 Worldcom Affair
30x
25x
9/11/2001 Terrorist Attacks in the US
20x
Asian Crisis (YEN/USD Floor: 147)
OECD LI Bottom ed
3/11/2004 Madrid Attacks
15x
January 1991 Gulf War SARS + Iraq War Trough of the OECD LI
Normalised Trading Range
10x
January 2005 Kobe Earthquake
Russian Debt Crisis
7/7/2005 London Attacks
5x 1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Sources: Merrill Lynch Luxury Goods Team & Datastream
59
Our Stock-Picking Rationale We take a selective view and generally prefer the big caps in the sector which would benefit most from a stabilisation of currencies in coming months
Richemont (Buy, B-1-7): Compelling valuation, strong consensus upgrade potential and positive news flow near term. Our price objective of CHF55 corresponds to a 12-month exit P/E of 21.6x for the core business (16.4x today). Assuming BATs share price does not underperform significantly and there are no other significant terrorist attacks which would hamper the tangible but fragile return of the feel-good factor, the risk to our price objective is a sudden and/or substantial depreciation of both the USD and/or the JPY. LVMH (Buy, B-1-7): Valuation far from normalized peak levels despite recent rally, especially if Vuitton beats expectations this year; transitional interims increasingly pre-empted by the market and the theme of portfolio restructuring is in our opinion still actionable. Our multi-criteria valuation indicates a price objective of EUR74/share. This price objective corresponds to an exit 2005E PER of 22.4x vs. a normative mid-cycle range of 15x to 25x in our view. The risk to our valuation is a significant or/and sudden depreciation of the USD. Coach (Buy, C-1-9): Consistent earnings upgrades with comps continuing at a brisk pace both in the US and Japan and a compelling valuation on a dynamic basis. Our price objective of USD40 assumes a 12-month exit PER of 29x. The risk to the valuation is a poor response to new product or a slowdown in the accessories segment impacting our earnings estimates. Burberry (Buy, C-1-7): Earnings momentum, Atlas project and buy backs to drive 50% jump in EPS over 2005-2008. Our multi-criteria valuation indicates a price objective of 475p and suggests a progressive suppression of the residual discount to the sector. This price objective corresponds to an exit March 2006 PER of 21.1x, broadly in line with sector average. The risk to our price objective remains the ability of management to execute the growth strategy. TODs (Buy, B-1-7): Fastest growing stock in Europe in the sector with strong margin recovery ahead. Our price objective of EUR55 assumes that TODs could trade at par with the sector on an EV/EBITDA basis. The risk to our price objective is in our view the ability of management to execute the retail strategy. Bulgari (Buy, B-1-7): Strong operating leverage with cautious margin assumptions. Using a WACC of 7.9% and a 10-year free cash flow CAGR of +13%, our DCF indicates a price objective of EUR10.7. This corresponds to an exit 2005 PER of 25.4x, below the groups historical average of 29.7x. The risk to our valuation is terrorism and a substantial depreciation of the USD. Herms (Neutral, A-2-7): Valuation no longer compelling near-term in the absence of upgrades before 4Q at least. Swatch Group (Neutral, B-2-7): Superior momentum in emerging markets in particular and with high and middle range brands largely reflected in the share price. PPR (Sell B-3-7): Short-term expectations still too high and new management will write off 2005 to bounce back later.
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Stock Universe/Global Comparatives

Table 8: Global Forecasts
Ticker BULIF BBRYF COH HESAF LVMHF RL PPTOF CFRUF SWGAF TIF TODGF Reco. Buy Buy Buy Neutral Buy Neutral Neutral Buy Neutral Neutral Buy Rating B-1-7 B-1-7 C-1-9 A-2-7 B-1-7 C-2-7 B-2-7 B-1-7 B-2-7 B-2-7 B-1-7 Currency EUR GBP USD EUR EUR USD EUR EUR CHF USD EUR Price (*) 9,3 423,5 32,5 171,5 65,5 49,3 86,9 47,6 174,0 33,3 46,8 Adj. EPS 2005E 2006E 0,42 0,48 0,23 0,27 1,00 1,26 6,78 7,94 3,30 3,58 3,00 3,31 4,52 5,22 1,92 2,12 10,75 11,62 1,65 1,85 1,77 2,18 3Yr EPS Growth (%) 13,9 8,9 36,1 14,1 14,3 17,3 1,9 17,2 11,5 15,8 28,4 Sales (mn) 2005E 2006E 900 990 762 808 1 710 2 101 1 422 1 550 13 566 14 618 3 436 3 754 17 792 18 873 4 090 4 327 4 441 4 824 2 428 2 652 497 555 EBITA EBITDA (mn) 2005E 2006E Margin (%) 194 217 16,3% 186 208 22,5% 677 847 33,6% 416 476 26,5% 3 063 3 600 19,0% 645 701 12,8% 1 553 1 698 6,4% 818 900 13,6% 958 1 044 16,0% 497 560 15,2% 113 134 15,1%
62
Bulgari Burberry Coach Herms LVMH Polo Ralph Lauren PPR Richemont (**) Swatch Group Tiffany & Co. TOD`S Group
Source: Merrill Lynch estimates, (*) Prices as of 31st August 2005 (**) Share price in CHF, accounts in EUR.
Table 9: Global Multiples

Rating B-1-7 B-1-7 C-1-9 A-2-7 B-1-7 C-2-7 B-2-7 B-1-7 B-2-7 B-2-7 B-1-7 Currency EUR GBP USD EUR EUR USD EUR CHF CHF USD EUR Price (*) 9,3 423,5 32,5 171,5 65,5 49,3 86,9 47,6 174,0 33,3 46,8 Price Objective EUR10.7 GBp475 USD40 EUR74 Local Mkt Cap (mn) 2 760 2 040 12 696 6 274 32 091 4 851 10 466 26 381 10 195 4 845 1 415 EV (mn) 2363 1782 12265 5264 33474 3582 14987 6999 4378 5098 863 P/E 2005E 22,1 18,8 32,6 25,3 19,9 16,4 19,2 17,6 16,2 20,2 26,4 21,3 22,3 2006E 19,5 15,8 25,8 21,6 18,3 14,9 16,7 15,7 15,0 18,0 21,5 18,4 19,3 PEG (1) 2005E 1,59 2,10 0,90 1,80 1,39 0,95 9,91 1,02 1,41 1,28 0,93 2,1 1,35 EV/EtBITDA 2005E 2006E 14,2 12,6 10,9 9,6 18,2 14,1 13,5 11,6 12,0 10,0 7,2 6,3 9,5 8,5 11,8 10,5 9,1 8,0 10,4 9,1 11,9 10,0 11,7 10,0 12,7 10,9 EEG (2) 2005E 1,19 1,82 0,82 1,42 0,82 0,43 ns 0,57 0,95 0,84 0,51 0,94 0,90
Bulgari Burberry Coach Herms LVMH Polo Ralph Lauren PPR Richemont (**) Swatch Group Tiffany & Co. TOD`S Group Average Core Average (3)
CHF55
EUR55
Source: Merrill Lynch estimates, (*) Prices as of 31st August 2005 (**) Share price in CHF, accounts in EUR (1) 2005E P/E multiples adjusted for growth (2004A-2006E) (2) 2005E EV/EBITDA multiples adjusted for growth (2004A-2006E) (3) Core Average includes Bulgari, Herms, LVMH, Richemont and TOD's Group.
Chart 46: How Long Will Equity Markets Continue to Support the Sector?
50x Luxury Goods Sector Weighted 1-Y Forward PER (LH-axis) Nasdaq Price Index (RH-axis) 45x 5000 4500 40x 4000 35x 5500
Chart 47: Luxury Goods Rating Highly Dependent on Consumer Confidence in Europe
50x Luxury Goods Sector Weighted 1-Y Forward PE (LH-axis) 45x EU Consumer Confidence 4
40x
35x
3500
-4
30x
30x 3000 2500 2000 20x 1500 15x 1000 500 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Consumer Confidence in Europe: A Long Way to Go
-8
25x -12 20x -16
25x
Yen/EUR rate
EV/EBITDA
15x
10x May-05 Aug-02 Aug-03 May-95 May-96 Aug-04 Apr-02 Apr-03 Nov-99 Nov-00 Nov-01 Apr-04 Sep-95 Sep-96 Jun-97 Feb-98 Jun-98 Feb-99 Jun-99 Dec-02 Dec-03 Mar-00 Mar-01 Jan-05 Jan-95 Jan-96 Jan-97 Jul-00 Oct-97 Oct-98 Jul-01
-20
10x 1995
* Nasdaq proxy to Wealth Effect
Chart 48: Recent USD/EUR Suggests a Much Better 2H 2005 for the Sector
50x 0.80
Chart 49: Long Term, Relative Strength of the JPY And Other Asian Currencies (incl. RMB) Critical from a Translational/Transactional Standpoint
25x
Luxury Goods Sector Weighted 1-Y Forward PER (LH-axis) USD/EUR Exchange Rate
Luxury Goods Sector Weighted 1 Year Forward EV/EBITDA (LH-axis) JPY/EUR Exchange Rate"
85
45x 0.90 40x 1.00 35x
23x
95
20x
105
18x
115
30x
1.10
15x
125
25x 1.20 20x 1.30 15x
13x
135
10x
145
8x
155
10x
1.40
5x
165
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
63
Sources: Datastream, Merrill Lynch Luxury Goods Team
64
Company Profiles
Bulgari Burberry Coach Herms LVMH Polo Ralph Lauren PPR Richemont Swatch Group Tiffany TODs Group 66 68 70 72 74 76 78 80 82 84 86
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Bulgari
Managements objective of 10%-12% underlying sales growth in 2005 is already within reach, with low singledigit growth in watches and high single-digit growth in jewelry, as long as accessories (as targeted by management) account for 10% of group revenues by year end
Simplified P&L (EUR mn) Net Revenues % Chg Gross Profit Gross Margin (%) EBITDA Operating Profit Before Goodwill % Chg Goodwill Amortisation Operating Profit EBIT Margin (%) % Chg Net Financial Charges / (Profits) Interest Cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Current Net Profit % Chg Minority Interests Attributable Net Profit Net Margin (%) % Chg Restated Net Profit Adjusted EPS % chg Published EPS % Chg Dividend Per Share (EUR) Pay Out Ratio
2002A 774 +1.0% 478 -4% 148 109 +5.4% (1) 108 13.9% +5.4% 15 6 91 11.8% 14 15.4% 77 +7.5% (1) 76 9.8% +11.6% 82 0.28 +6.6% 0.26 +11.6% 0.07 29% 2003A 759 -1.9% 474 -1% 157 118 +8.4% (1) 117 15.4% +8.6% 9 10 109 14.4% 17 15.4% 92 +19.1% (0) 92 12.1% +20.7% 92 0.31 +11.9% 0.31 +20.7% 0.11 35%
Buy (B-1-7)
2004A 828 +9.0% 528 11% 173 135 +14.7% (1) 134 16.2% +14.8% 13 ns 121 14.6% 13 10.6% 108 +17.4% 0 108 13.1% +17.9% 109 0.37 +18.2% 0.37 +17.9% 0.22 60% 2005E 917 +10.8% 603 14% 196 154 +14.2% 0.0 154 16.8% +14.9% 1 ns 153 16.7% 25 16.0% 129 +18.8% (3) 126 13.7% +16.1% 126 0.43 +15.2% 0.43 +16.1% 0.25 59% 2006E 1,009 +10.0% 667 11% 218 176 +13.9% 0.0 176 17.4% +13.9% 0 ns 176 17.4% 28 16.0% 148 +14.7% (4) 144 14.2% +14.2% 144 0.49 +14.2% 0.49 +14.2% 0.29 59%
This suggests that the companys target of another 70pm of EBIT margin improvement this year (130bp before the first-time 100% consolidation of Crova and the hotel in Milan) is a minimum
Simplified Cash Flow Statement Cash Flow CFPS (EUR) Capital Expenditures Change in Working Capital Requirements Free Cash Flow Dividends & Others Financial Investments & Rights Issue Increase / (Decrease) in Net Debt Net Debt / (Cash)
2002A
2003A
2004A
2005E
2006E
116 0.39 (33) 56 145 0 (0) (145) 140

2002A
131 0.44 (23) 47 150 (58) 0 (91) 48

2003A
147 0.50 (50) (19) 78 (61) 18 (35) 13

2004A
167 0.57 (50) (37) 80 (72) 0 (8) 5

2005E
186 0.63 (40) (47) 99 (99) (1) 1 6

2006E
Working-capital management remains essential in Bulgaris core business, at least compared to apparel & accessory players
Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%) Capital Employed % Chg
62% 70% 25% 710 -12.3%
57% 64% 8% 663 -6.6%
55% 61% 2% 728 +9.7%
54% 59% 1% 772 +6.1%
53% 58% 1% 828 +7.2%
Source: Company Data & Merrill Lynch Estimates (IFRS as of 2005)
66
Chart 50: Bulgari Product Sales Breakdown
Chart 51: Bulgari Geographical Sales Breakdown
Watches 31%
Royalties & Other Accessories 2% 8% Perfume 19%
Far East (*) 18%
Rest of the World 6%
Italy 13%
Japan (*) 25% Jewellery 40% US 15%
Europe 23%
Source: Company Data
Chart 52: Back to a More Normalised Valuation vs. the Group

100% Bulgari 1YF PER - Premium / (Discount) to Sector Average
Chart 53: Share Price Only Back to 2002 Level, Much Lower EV
35x Bulgari EV/EBITDA 1 Year Forward (LH-axis) Bulgari Share Price EUR/share (RH-axis) 15
80%
30x 12
60%
25x EV/EBITDA
40%
Long Term Average
20x
20%
6 15x
0%
-20%
10x
-40% 1995
1996
1997
1998
1999
2000
2001
2001
2002
2003
2004
2005
5x 1995
0 1996 1997 1998 1999 2000 2001 2001 2002 2003 2004 2005
Source: Merrill Lynch estimates and Datastream
Chart 54: Bulgari Return on Equity

31% 26% 21% 16% 11% 6% 1996A 1998A 2000A 2002A 2004A 2006E
Chart 55: Bulgari Return on Capital Employed

31% 26% 21% 16% 11% 6% 1996A 1998A 2000A 2002A 2004A 2006E
Source: Merrill Lynch estimates (IFRS as of 2005)
Source: Merrill Lynch estimates (IFRS as of 2005)
67
EUR/share
Burberry
Simplified P&L (Year to March, GBP mn) Net Revenues % chg Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % chg Net Financial Income / (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Net Income % chg Goodwill Amortisation & Except. Income Net Adjusted Profit Net Margin (%) % chge Adjusted EPS % chge Published EPS % chge Net Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow CFPS (pence) Capital Expenditures Changes in Working Capital Requirements Free Cash Flow Dividends Disposals / (Acquisitions) Other Increase / (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%) Capital Employed % chg 2004A 676 +13.8% 392 58.0% 172 134 19.9% +7.0% 2 ns 139 20.5% -47 34.1% 92 +75.3% -5 97 14.3% +30.9% 0.192 +30.9% 0.181 +75.4% 22.77 23% 2004A 122 24.18 -29 14 -17 108 -3 -6 -76 -121 2004A 13% 27% -28% 490 +9% 2005A 716 +5.9% 424 59.3% 185 161 22.5% +20.0% 6 0.0x 167 23.3% -54 32.1% 113 +23.9% 0 114 14.2% -0.8% 0.226 +17.7% 0.224 +23.6% 32.84 29% 2005A 138 27.31 -34 -19 -25 84 0 39 -33 -153 2005A 14% 29% -34% 501 +2%
Buy (B-1-7)
2006E 762 +6.5% 454 59.5% 187 157 20.6% -8.8% 3 40.4x 160 20.9% -51 32.0% 108 -4.3% 0 108 14.2% -4.8% 0.225 -0.3% 0.225 +0.6% 33.76 31% 2006E 138 30.07 -37 -21 -37 81 -22 2 165 12 2006E 15% 30% 3% 414 -17% 2007E 808 +6.0% 489 60.6% 207 179 22.1% +7.4% 2 51.8x 180 22.3% -58 32.0% 123 +13.0% 0 123 15.2% +13.0% 0.267 +18.5% 0.267 +18.5% 36.80 30% 2007E 151 32.93 -40 -24 -46 88 -10 -4 -37 -26 2007E 16% 32% -5% 510 +23%
Our estimates assume midsingle-digit sales growth for the coming three years and obviously could trigger significant upgrades if this is exceeded, particularly with licences, but also in the retail channel
Our forecasts assume 45% EPS growth over 2005A2008E, but are probably more back-end loaded than the companys budget, especially this year, when our EBIT forecast is at the bottom of consensus expectations
Even after the completion of the current 250m sharebuyback programme, Burberry will report a quasi neutral net debt position
Source: Company Data & Merrill Lynch estimates (IFRS as of March 2005 fiscal)
68
Chart 56: Burberry Product Sales Breakdown
Chart 57: Burberry Geographical Sales Breakdown
Licenses 11% Accessories 26%
Other 2%
Menswear 27%
Rest of Asia 18% Japan 8%
Europe 50% North America 23%
Womenswear 34%
Chart 58: Removal of GUS Hangover Risk Has Helped the Stock Lately (Market Less Worried About De-merger from GUS)
27x
Chart 59: Slowly but Surely, Burberry's Valuation Gap to the Sector Is Narrowing
27x Historical Discount to Sector Peers Stabilising Between -10% and -30% 0%
25x
25x -10%
23x
23x
21x
21x
-20%
19x
19x -30%
17x
IPO: 40% Discount to Luxury Peers GUS Placement: Valuation Peak (7% Discount) to Sector
17x
15x
Announcement of GUS demerger in December 2005
15x Burberry 1YF PER (Left Axis) Discount to Luxury Goods Sector Simple Average (Right Axis)
-40%
13x
13x
Burberry 1YF PER LVMH 1YF PER Sector 1YF PER - Simple Average
-50%
11x
11x
9x
2002
2003
2003
2004
2005
9x 2002
-60% 2003 2003 2004 2005
Chart 60: Burberry Return on Equity

31% 26% 21% 16% 11% 6% 2000A 2001A 2002A 2003A 2004A 2005A 2006E 2007E 2008E
Source: Merrill Lynch estimates
Chart 61: Burberry Return on Capital Employed

31% 26% 21% 16% 11% 6% 2000A 2001A 2002A 2003A 2004A 2005A 2006E 2007E 2008E
69
Coach
Our fiscal 2006 assumptions include 23% top-line growth driven by a 12% comp gain and new stores. Near term, we believe Coach can continue to deliver double-digit comps in the US and MSD comps in Japan, as the brand remains the dominant player in the affordable luxury segment for handbags and accessories.
Simplified P&L (Year to June, USD mn) Net Revenues % Chg Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % Chg Net Financial Income (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Net Adjusted Profit Net Margin (%) Average Fully Diluted Shares Outstanding (mn) Adjusted EPS (USD) % Chg Net Dividend Simplified Cash Flow Statement Cash Flow From Operations CFPS (USD) Capital Expenditures Changes in Working Capital Dividends Free Cash Flow Disposals / (Acquisitions) Other Increase / (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%)
Buy (C-1-9)
2004A 1321 +38,6% 990 74,9% 487 444 33,6% +82,1% 3 n.a 447 33,8% (168) 37,6% 262 19,8% 386 0,68 +74,0% 0 2004A 449 1,16 (68) 4 0 381 0 (323) (58) (431) 2004A 12% 40% -52% 2005A 1710 +29,4% 1311 76,7% 677 621 36,4% +39,9% 16 n.a 637 37,3% (235) 36,9% 389 22,7% 390 1,00 +47,0% 0 2005A 557 1,43 (95) 29 0 462 0 (470) 8 (380) 2005A 12% 29% -37% 2006E 2101 +22,9% 1616 76,9% 847 784 37,3% +26,2% 20 n.a 804 38,3% (305) 37,9% 500 23,8% 395 1,26 +26,3% 0 2006E 544 1,38 (119) (19) 0 425 0 (200) (225) (737) 2006E 12% 24% -59% 2007E 2520 +19,9% 1943 77,1% 1 023 947 37,6% +20,8% 24 n.a 971 38,5% (369) 38,0% 603 23,9% 398 1,51 +19,8% 0 2007E 669 1,68 (139) (14) 0 530 0 (200) (330) (1067) 2007E 12% 21% -64%
We estimate that the operating margin will increase reflecting SG&A leverage. More modest expansion versus recent years reflects an already impressive operating margin of 36.4% in FY2005.
The company has a strong cash position and recently launched a new share repurchase program of $250 million. We would expect the company to remain aggressive in its buyback when appropriate.
70
Chart 62: Coach Sales Split by Channel
Chart 63: Coach Same-Store Sales Growth

20.0% 15.0% 10.0% 5.0%
Direct to Consumer, 55%
Indirect , 45%
0.0% 2003 2004 2005 2006E 2007E
Chart 64: Coach, S&P PER

50 45 40 35 30 25 20 15
8/ 8/ 2 10 00 /8 2 /2 12 00 /8 2 /2 0 2/ 02 8/ 20 4/ 03 8/ 20 6/ 03 8/ 20 8/ 03 8/ 20 10 0 /8 3 /2 12 00 /8 3 /2 0 2/ 03 8/ 20 4/ 04 8/ 20 6/ 04 8/ 20 8/ 04 8/ 2 10 00 /8 4 /2 12 00 /8 4 /2 0 2/ 04 8/ 20 4/ 05 8/ 20 6/ 05 8/ 20 8/ 05 8/ 20 05
U:COH(PE) S&PCOMP(PE)
Chart 65: Coach Relative PER Against S&P 500

2,0 1,8 1,6 1,4 1,2 1,0 0,8 0,6 0,4 0,2 0,0
02 /2 0 8/8 10 /8 / 20 2/8 02 /2 0 4/8 0 3 /2 0 6/8 0 3 /2 0 8/8 0 3 /2 0 10 0 3 /8 / 2 12 0 03 /8 / 20 2/8 03 /2 0 4/8 0 4 /2 0 6/8 0 4 /2 0 8/8 0 4 /2 10 004 /8 / 2 12 0 04 /8 / 20 2/8 04 /2 0 4/8 0 5 /2 0 6/8 0 5 /2 0 8/8 0 5 /2 0 05 20 02
Source: Datastream
Source: Datastream
Chart 66: Coach Return on Equity

50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2003 2004 2005 2006E 2007E
Chart 67: Coach Return on Capital Employed

50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 2003 2004 2005 2006E 2007E
12
/8 /
71
Herms
Simplified Income Statement (Eur mn) Net Revenues % Chg Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % Chg Net Financial Charges Interest Cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Net Income % Chg Minority Interests Net Attributable Profit % Chg Goodwill Amortisation Net Adjusted Profit Net Margin (%) % Chg Adjusted EPS % chge Published EPS % Chg Net Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow CFPS (EUR) Capital Expenditures Changes in Working Capital Requirements Free Cash Flow Dividends Financial Investments & Buy-Backs Disposals / (Acquisitions) Other Increase / (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%) Capital Employed % Chg
2002A 1,242 +1.3% 805 64.8% 372 320 25.8% +4.3% 8 61.6x 328 26.4% 108 32.8% 220 +5.9% 5 216 +6.8% 4 219 17.6% +5.6% 5.98 +5.5% 5.88 +6.8% 1.65 28% 2002A 273 7.46 -95 -22 157 -58 -7 -3 0 -89 -370 2002A 2003A 1,230 -1.0% 803 65.3% 372 333 27.1% +3.9% 7 79.2x 339 27.6% 119 35.0% 221 +0.1% 4 217 +0.6% 3 220 17.9% +0.3% 6.01 +0.3% 5.92 +0.6% 1.70 28% 2003A 259 7.06 -85 -21 152 -63 -9 6 -8 -79 -449 2003A
Neutral (A-2-7)
2004A 1,332 +8.3% 869 65.3% 397 337 25.3% +1.2% 5 105.2x 342 25.7% 127 37.2% 215 -2.7% 5 210 -3.1% 10 223 16.8% +1.5% 6.11 +1.7% 5.74 -3.0% 2.02 33% 2004A 292 7.99 -93 -14 186 -65 -25 -16 1 -81 -530 2004A 2005E 1,422 +6.8% 927 65.2% 416 372 26.1% +10.4% 11 137.7x 383 26.9% 132 34.5% 251 +16.9% 7 244 +16.3% 4 248 17.4% +11.0% 6.78 +11.0% 6.68 +16.3% 2.24 33% 2005E 312 8.54 -130 -16 167 -82 0 0 32 -117 -646 2005E 2006E 1,550 +9.0% 1,014 65.4% 476 427 27.5% +14.8% 23 170.7x 449 29.0% 155 34.5% 294 +17.3% 8 287 +17.3% 4 291 18.7% +17.2% 7.94 +17.2% 7.84 +17.3% 2.62 33% 2006E 359 9.80 -130 -22 206 -96 0 0 14 -125 -771 2006E
Company is now saying that 8% underlying sales growth this year is unlikely to be significantly exceeded
Herms operational gearing is less obvious now thanks to the absolute high level of margins, especially if one bears in mind the highly negative impact of currencies in recent years
How long will family shareholders be happy with such an under-leveraged balance sheet?
22% 16% -43% 1 245 +9.9%
23% 18% -43% 1 322 +6.2%
22% 18% -44% 1 445 +9.3%
22% 18% -44% 1 574 +8.9%
22% 18% -46% 1 777 +12.9%
Source: Company Data & Merrill Lynch estimates (all numbers are French GAAP at this time)
72
Chart 68: Herms Product Sales Breakdown
Chart 69: Herms Geographical Sales Breakdown

Pacific (excl. Japan) 16% Americas 15%
Watches Other Activities (1) 10% 8% Tableware 3% Perfumes 5%
Other (2) 4%
Silk 11%
Rest of the World 3% Japan 30%
RTW 20%
Leather Goods 39%
Rest of Europe 17%
France 19%
Source: Company Data (1) Art of living,Diaries/Stationery, Bracelets in enamel, Jewellery, Gloves, Hats and Shoes. (2) John Lobb Shoes + Outlook activities made for brands outside group.
Chart 70: Similar Share-Price Volatility than its Peers, Despite Superior Earnings Resilience
25x
Herms One-Year Forward EV/EBITDA (LH-axis) Herms Share Price in EUR (RH-axis)
Chart 71: Back to Historical Average Multiples since IPO : Upgrades now Needed to Trigger Additional Outperformance
55x 50x 45x 40x 35x Herms 1YF PER Long Term Average
190 170 150 130 110 EUR/share
20x
15x 90 70
30x 25x 20x
10x
50 30
15x 10x 5x 1993
5x 1994
10 1995 1996 1997 1998 1999 2000 2002 2003 2004 2005
1994
1995
1996
1997
1998
1998
1999
2000
2001
2002
2003
2004
2005
Chart 72: Herms Return on Equity

24% 22% 20% 18% 16% 14% 12% 10% 8% 6% 1997A 1999A 2001A 2003A 2005E 2007E
Chart 73: Herms Return on Capital Employed

22% 20% 18% 16% 14% 12% 10% 8% 6% 1997A 1999A 2001A 2003A 2005E 2007E
73
LVMH
Simplified Income Statement (Eur mn) Net Revenues % chg Gross Profit Gross Margin (%) EBITDA EBITA EBITA Margin (%) % chg Net Financial Income / (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Current Net Profit % chg Equity Associates Minority Interests Net Profit Before Goodwill % chg Goodwill Amortisation Net Adjusted Profit Net Margin (%) % chge Exceptional Profit / (Losses) Attributable Net Profit Adjusted EPS % chge Published EPS % chge Net Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow CFPS (EUR) Capital Expenditures Changes in Working Capital Free Cash Flow Dividends Financial Investments & Buy-Backs Disposals Other Increase (Decrease) in Net Debt Net Debt
2002A 12693 +3.8% 8130 64.1% 2910 2,008 15.8% +28.7% 1651 13.0% 691 4.3x 1,317 10.4% 350 26.6% 967 +103.6% -18 131 818 +144.9% -262 556 4.4% +234.9% 0 556 2.28 +89.4% 1.67 +144.5% 2002A 1 518 3.11 -559 436 1 395 -372 82 190 92 -1 790 6 482 2003A 11962 -5.8% 7791 65.1% 2818 2,182 18.2% +8.7% 1752 14.7% 564 7.8x 1,618 13.5% 488 30.2% 1130 +16.9% 1 108 1,023 +25.1% -300 723 6.0% +30.0% 0 723 2.59 +13.6% 2.09 +25.1% 2003A 1 949 3.99 -578 -107 1 264 -448 -72 152 13 -1 055 5 427
Buy (B-1-7)
2004A 12623 +5.5% 8130 64.4% 2790.774 2,420 19.2% +10.9% 2022 16.0% 307 12.1x 2,113 16.7% 603 28.5% 1506 +33.6% -14 202 1,294 +26.5% -284 1,010 8.0% +39.7% 0 1,010 2.83 +9.3% 2.65 +26.5% 2004A 2 137 4.37 -628 -174 1 335 -521 -621 67 94 -353 5 074 2004A 28% 26% 55% 17 388 +3% 2005E 13566 +8.7% 8,923 65.8% 3,063 2,734 19.0% +15.3% 2734 20.2% 146 16.8x 2,588 19.1% 729 28.2% 1,860 +29.9% -15 234 1,611 +34.9% 0 1,611 11.9% +24.1% 0 1,611 3.30 +20.3% 3.30 +20.3% 2005E 2 237 4.58 -650 -193 1 394 -464 -125 0 185 -936 4 138 2005E 29% 26% 40% 17 706 ns 2006E 14618 +7.8% 10,487 71.7% 3,600 3,036 20.2% +11.0% 3036 20.8% 207 13.5x 2,828 19.3% 820 29.0% 2,008 +8.0% -15 244 1,749 +8.6% 0 1,749 12.0% +8.6% 0 1,749 3.58 +8.6% 3.58 +8.6% 2006E 2 621 5.36 -700 -277 1 644 -627 -52 0 -154 -771 3 367 2006E 29% 26% 29% 19 278 +9%
Underlying sales growth (+11% - already published) and MLe of +13% for EBIT in 1H
Is 15% EBIT growth tangible enough? (consensus between +10% and +15% at this time for FY2005)
Although net gearing is a lot lower than three years ago, we do not believe that the theme of portfolio restructuring is obsolete at LVMH
Balance Sheet Key Data 2002A 2003A 27% 29% Inventories as % of Sales 26% 26% Working Capital as % of Sales 73% 62% Net Debt / Equity (%) 17 567 16 899 Capital Employed -11% -4% % chg Source: Company Data & Merrill Lynch estimates (IFRS as of 2005)
74
Chart 74: LVMH Product Sales Breakdown

Watches & Jewellery 4% Champagne & Wines 11% Cognac & Spirits 7%
Chart 75: LVMH Geographical Sales Breakdown

Rest of Asia 15%
Selective Retailing 27%
France 17%
Japan 15%
Perfume & Cosmetics 17%
Leather Goods & Fashion 34%
US 25%
Rest of Europe 20%
Chart 76: Valuation Still Compelling Against the Sector...

70% 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% 1996 LVMH PER Premium / (Discount) to Sector Peers (*)
Chart 77: ...and Against the French Market

3.5x 3.0x LVMH Rel. PER vs French Market Average Average except 'Bubble' (Jan 2000 - Sept 2001)
Long Term Average Discount to Sector Peers = -6% (excl. millennium bubble)
2.5x 2.0x 1.5x 1.0x
-13% on 2005E
0.5x
(*) Peer group includes Bulgari, Herms, LVMH, Richemont and TOD's Group
1997
1998
1999
2000
2001
2002
2003
2004
2005
0.0x 1991
1992
1993
1994
1995 1996
1997 1998
1999
2000
2001
2002
2003 2004
2005
Chart 78: LVMH Return on Equity

25%
Chart 79: LVMH Return on Capital Employed

14% 12% 10%
20%
15%
8% 6% 4%
10%
5%
2% 0%
0% 1997 1999 2001A 2003A 2005E 2007E
1997
1999
2001A
2003A
2005E
2007E
75
Polo Ralph Lauren

RL is one of few names in our US branded apparel group with real drivers of longerterm growth and margin expansion (including Rugby stores, Chaps womens and kids, and Lauren footwear). This makes target multiples less restrictive, in our view.
Simplified P&L (Year to March, USD mn) Net Revenues % Chg Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % Chg Net Financial Income (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Net Adjusted Profit Net Margin (%) Adjusted EPS (USD) % Chg Net Dividend Simplified Cash Flow Statement Cash Flow From Operations CFPS (USD) Capital Expenditures Changes in Working Capital Requirements Dividends Free Cash Flow Disposals / (Acquisitions) Other Increase / (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%)
Neutral (C-2-7)
2004A 2381 +8,8% 1323 55,6% 373 289 12,1% -4,6% (10) 28,9x 279 11,7% (101) 36,2% 183 7,7% 1,83 -1,1% 15 2004A 236 2,34 (123) (50) (15) 113 0 14 (127) (66) 2004A 16% 33% -5% 2005A 3061 +28,6% 1685 55,0% 516 406 13,3% +40,5% (6) 63,6x 400 13,1% (148) 37,0% 250 8,2% 2,40 +31,4% 20 2005A 444 4,27 (165) 34 (20) 279 0 (225) (54) (60) 2005A 14% 25% -4% 2006E 3436 +12,3% 1966 57,2% 645 515 15,0% +26,8% 0 1388,4x 515 15,0% (192) 37,3% 320 9,3% 3,00 +24,8% 21 2006E 321 3,00 (162) (130) (21) 159 0 (131) (28) (239) 2006E 14% 26% -12% 2007E 3754 +9,3% 2170 57,8% 701 565 15,1% +9,7% 8 n.a 573 15,3% (212) 37,0% 357 9,5% 3,31 +10,2% 23 2007E 448 4,15 (167) (45) (23) 281 0 (102) (179) (418) 2007E 14% 25% -19%
Full-year 2006E EPS will see more Lauren footwear dilution, a higher tax rate, higher share count and unfavourable foreignexchange rates in the back half. The FD-MAY merger is only expected to result in about a 1% revenue contraction at wholesale.
76
Chart 80: Ralph Lauren Sales Breakdown by Channel
Chart 81: Ralph Lauren Geographical Sales Breakdown
Licensing, 7%
Japan, 10% Europe, 16%
Pac Rim / Korea, 3%
Other, 2%
Retail, 42%
Wholesale, 52%
US, 69%
Chart 82: Ralph Lauren, S&P PER

50 45 40 35 30 25 20 15 10 5 0
U:RL(PE) S&PCOMP(PE)
Chart 83: Ralph Lauren Relative PER Against S&P 500

1,6 1,4 1,2 1,0 0,8 0,6 0,4 0,2 0,0
8/6 / 12 1 99 /6 / 8 1 4/6 9 98 /1 8/6 99 9 / 12 1 99 /6 / 9 1 4/6 9 99 /2 0 8/6 0 0 / 12 2 00 /6 / 0 2 4/6 0 00 /2 8/6 00 1 / 12 2 00 /6 / 1 2 4/6 0 01 /2 8/6 00 2 / 12 2 00 /6 / 2 2 4/ 0 02 6/2 8/6 00 3 / 12 2 00 /6 / 3 2 4/6 0 03 /2 0 8/6 0 4 / 12 2 00 /6 / 4 2 4/6 0 04 /2 8/ 00 5 6/2 00 5
Source: Datastream
8/ 6/ 19 98 2/ 6/ 19 99 8/ 6/ 19 99 2/ 6/ 20 00 8/ 6/ 20 00 2/ 6/ 20 01 8/ 6/ 20 01 2/ 6/ 20 02 8/ 6/ 20 02 2/ 6/ 20 03 8/ 6/ 20 03 2/ 6/ 20 04 8/ 6/ 20 04 2/ 6/ 20 05 8/ 6/ 20 05
Source: Datastream
Chart 84: Ralph Lauren Return on Equity

20.0%
Chart 85: Ralph Lauren Return on Capital Employed

20.0% 15.0% 10.0% 5.0% 0.0%
15.0%
10.0%
5.0%
0.0% 2002 2003 2004 2005E 2006E
2002
2003
2004
2005E
2006E
77
PPR
Simplified P&L (Year to Dec, EUR mn) Net Revenues % Chg Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % Chg Net Financial Charges Interest Cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Net Income Goodwill Amortisation & Exceptional Income Net Adjusted Profit Net Margin (%) Adjusted EPS % Chg Published EPS Net Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow CFPS (EUR) Capital Expenditures Changes in Working Capital Requirements Dividends Free Cash Flow Disposals / (Acquisitions) Increase / (Decrease) in Net Debt Net Debt / (Net Cash) Balance Sheet Key Data Inventories as % of Sales Net Debt / Equity (%) Capital Employed % Chg
Source: Merrill Lynch Estimates
Neutral (B-2-7)
2002A 27,877 +0.3% 10,590 38.0% 2,282 1,827 6.6% -8% -415 3.6x 1,412 5.1% -706 50.0% 1,589 1,044 633 2.3% 5.12 -30.0% 13.05 2.30 45% 2002A 1,287 10.57 -868 97 -378 -761 2,712 -2,326 3,092 2002A 13% 48% 14,753 -6.4% 2003A 24,361 -12.6% 9,281 38.1% 1,753 1,297 5.3% -29% -314 3.3x 983 4.0% -143 14.5% 645 -150 608 2.5% 4.54 -11.2% 5.34 2.40 53% 2003A 1,148 9.51 -707 -132 -267 -829 374 1,940 5,032 2003A 14% 73% 13,663 -7.4% 2004A 24,213 -0.6% 9,431 38.9% 1,940 1,467 6.1% +13% -349 4.1x 1,118 4.6% -415 37.1% 941 312 666 2.7% 5.02 +10.5% 7.74 2.52 50% 2004A 1,258 0.00 -462 -183 -279 -645 93 -498 4,534 2004A 11% 59% 12,398 -9.3% 2005E 17,643 -27.1% 7,587 43.0% 1,554 1,135 6.4% -23% -300 2.9x 835 4.7% -218 26.1% 565 -29 565 3.2% 4.54 -9.5% 4.69 2.50 55% 2005E 1,071 8.89 -450 -1 -293 -442 90 -153 4,380 2005E 15% 57% 12,884 +3.9% 2006E 18,712 +6.1% 8,046 43.0% 1,700 1,250 6.7% +10% -285 3.4x 965 5.2% -252 26.1% 656 -31 656 3.5% 5.21 +14.8% 5.45 2.60 50% 2006E 1,168 9.69 -490 -72 -322 -552 0 -284 4,097 2006E 15% 51% 12,920 +0.3%
Including IFRS adjustment of 30mn for convertibles 272mn underlying interest is based on 3.9% average borrowing costs on average net debt of EUR6bn
Capex Retail: EUR300mn, Capex Luxury: EUR150mn
78
Chart 86: PPR Sales Breakdown by Channel
Chart 87: PPR EBITA Breakdown
Luxury Goods 16% Printemps 6%
Redcats 25% CFAO 15%
Fnac 14%
Printemps 3%
Luxury Goods 26%
CFAO 11% Conforama 18% Fnac 24% Redcats 21% Conforama 21%
Chart 88: PPR Share Price (EUR) & 12-month forward Contour Line
300 250 200 150 100 50 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06
Source: Company Data & Merrill Lynch estimates
Chart 89: : PPR Share Price Has Displayed a 81% Correlation With French Consumer Confidence Indicators
500 400 300 French Consumer Confidence PP 300 250 200 150 100 50
22x
19x
200 100 0 -100 -200
16x 13x 7x
0 -300 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Source: Datastream
Chart 90: PPR Return on Equity

10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 2003A 2004A 2005E 2006E 2007E
Chart 91: PPR Return on Capital Employed

7% 6% 5% 4% 3% 2% 1% 0% 2003A 2004A 2005E 2006E 2007E
79
Richemont
Simplified P&L (Year to March, EUR mn) Net Revenues % chge Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % chge Net Financial Income / (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Luxury Goods Net Income % chge Minority Interests Associates Group Net Profit Before Goodwill Net Margin (%) % chge Goodwill Amortisation Exceptionals Reported Profit % chge Adjusted EPS % chge Published EPS % chge Net Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow CFPS (EUR) Capital Expenditures Changes in Working Capital Requirements Dividends & Other Free Cash Flow Financial Investments & Buy-Backs Disposals / (Acquisitions) Other Increase / (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories (% of Sales) Working Capital as % of Sales Net Debt / Equity (%) Capital Employed % chg
2003A 3,651 -5.4% 2,284 62.6% 487 259 7.1% -46% -56 ns 203 5.6% 50 24.6% 156 -53% 3 486 642 17.6% -22% -186 272 728 +20% 1.15 -21% 1.15 -22% 0.32 28% 2003A 556 1.00 -180 69 96 541 0 -89 -84 -368 1,177 2003A 44% 49% 24% 4,998 +2% 2004A 3,375 -7.6% 2,092 62.0% 447 296 8.8% +14% 6 ns 302 8.9% 64 21.2% 238 +53% 0 422 660 19.6% +3% -196 -144 320 -56% 1.19 +3% 1.20 +4% 0.40 33% 2004A 561 1.02 -118 114 158 715 0 30 -147 -598 794 2004A 42% 50% 16% 4,972 -1%
Buy (B-1-7)
2005A 3,717 +10.1% 2,392 64.4% 618 505 13.6% +71% 2 ns 507 13.6% 92 18.1% 413 +74% -2 468 881 23.7% +33% -222 326 985 +208% 1.59 +33% 1.61 +34% 0.50 31% 2005A 481 0.88 -127 -137 193 410 0 1,002 -190 -1,222 -617 2005A 41% 49% -10% 5,958 +20% 2006E 4,090 +10.0% 2,712 66.3% 818 699 17.1% +38% 28 ns 727 17.8% 124 17.0% 604 +46% 0 460 1,064 26.0% +21% -222 0 842 -15% 1.92 +21% 1.94 +21% 1.00 52% 2006E 635 1.16 -135 -183 151 469 0 0 -275 -194 -993 2006E 41% 49% -15% 6,524 +10% 2007E 4,327 +5.8% 2,882 66.6% 900 779 18.0% +11% 39 ns 818 18.9% 139 17.0% 679 +12% 0 497 1,176 27.2% +11% -222 0 954 +13% 2.12 +11% 2.15 +11% 0.65 30% 2007E 784 1.43 -140 -116 166 694 0 0 -563 -132 -1,241 2007E 41% 49% -18% 6,915 +6%
We believe that Richemont could report 10% underlying sales growth in 2005-2006 with high single to low doubledigit sales growth across all regions for Cartier
Our EBIT forecast of EUR700mn assumes that the group could report higher operating income of say EUR750m under IFRS but that the difference of about EUR50m will be neutralised by the implementation of IFRS Today the consensus is around EUR650mn for 2005-2006
Source: Company Data & Merrill Lynch estimates (all numbers are Swiss GAAP at this time)
80
Chart 92: Richemont Product Sales Breakdown

Writing Instruments 11% Leather Goods 7%
Chart 93: Richemont Geographical Sales Breakdown

Far East (excl. Japan) 17%
Clothing & Other 5%
Americas 19%
Watches 24%
Europe & Other 21% Jewellery 53% Japan 43%
Chart 94: Discount of Richemonts Core Luxury Business to Peer Group now Excessive
50%
Chart 95: No Reason Why Richemont Should Trade at Such a Discount to LVMH Given Its Long-term Growth Prospects
26x Richemont vs. LVMH on a One-Year Forward PER basis*
Richemont PER Premium / (Discount) to Sector Peers (*)
30%
24x
22x
10%
20x
-10%
LONG TERM AVERAGE DISCOUNT TO SECTOR PEERS = -6% (excl. millennium bubble)
RICHEMONT'S DISCOUNT TO LVMH SHOULD IN OUR OPINIO NARROW IN COMING MONTHS
18x
-30%
16x
LVMH One-Year Forward PER Richemont One Year Forward PER
-27% for 2005E -50%
14x
(*) Peer group includes Bulgari, Herms, LVMH, Richemont and TOD's Group
-70% 1996
12x 2003 2004 2005
1997
1998
1998
1999
2000
2001
2002
2003
2004
Sources: Merrill Lynch estimates and Datastream
Chart 96: Richemont Return on Equity

19% 18% 17% 16% 15% 14% 13% 12% 11% 10% 1997A 1999A 2001A 2003A 2005A 2007E 2009E
Chart 97: Richemont Return on Capital Employed

10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 1997A 1999A 2001A 2003A 2005A 2007E 2009E
Source: Merrill Lynch Estimates
Source: Company Data & Merrill Lynch estimates (all numbers are Swiss GAAP at this time For comparative purposes we have included the goodwill of the core businesses on the balance sheet in our calculations, hence the difference with the official returns now that Richemont has eliminated all the goodwill within fixed assets ahead of its transition to IFRS
81
Swatch Group
Simplified P&L (EURm unless otherwise stated) 2002A 3,933 -2.8% 3,210 77.1% 842 632 15.6% -1.9% -22 ns 610 15.5% 110 18.0% 500 -2.0% -6 494 -2.0% 12.6% 9.16 +1.1% 8.47 +0.1% 2002A 717 12.28 -258 -119 340 -58 90 -161 -126 -632 2002A 37% 53% -18% 3,824 +4% 2003A 3,845 -2.2% 3,134 79.5% 810 594 14.9% -6.0% -1 ns 593 15.4% 96 16.2% 497 -0.6% -5 492 -0.4% 12.8% 8.60 -6.2% 8.40 -0.9% 2003A 693 11.83 -199 -40 454 -64 84 420 -359 -991 2003A 39% 55% -25% 4,693 +23%
Neutral (B-2-7)
2004A 3,981 +3.5% 3,361 78.5% 869 651 15.7% +9.6% -26 ns 625 15.7% 107 17.1% 518 +4.2% -6 513 +4.2% 12.9% 9.35 +8.7% 8.84 +5.3% 2004A 737 12.71 -300 -71 366 -85 -162 24 -161 -1 152 2004A 41% 55% -27% 4,992 +6% 2005E 4,174 +4.8% 3,466 77.2% 932 704 16.2% +8.1% 4 ns 708 17.0% 124 17.5% 584 +12.8% -6 578 +12.8% 13.9% 10.39 +11.1% 10.17 +15.0% 2005E 814 14.31 -400 157 570 -99 -168 0 -303 -1 454 2005E 37% 49% -31% 5,492 +10% 2006E 4,520 +8.3% 3,754 77.2% 1,021 757 16.1% +7.5% 11 ns 768 17.0% 134 17.5% 633 +8.4% -7 627 +8.4% 13.9% 11.24 +8.2% 11.02 +8.4% 2006E 899 15.81 -282 -140 477 -108 0 0 -368 -1 823 2006E 37% 48% -35% 6,032 +10%
Top-line growth less penalized in FY2005E by unfavorable currency fluctuations, especially now that luxury brands account for more than 80% of watch sales. However, microelectronics and movements lower group sales growth in finished watches, not to mention the Swatch brand nearterm
Rebound in earnings essentially dependent upon economic environment, given limited operating and financial leverage
Net Revenues % chge Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % chge Net Financial Income / (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Current Net Profit % chge Minority Interests Attributable Net Profit % chge Net Margin (%) Adjusted EPS % chge Published EPS % chge Simplified Cash Flow Statement Cash Flow CFPS (CHF) Capital Expenditures Changes in Working Requirements Free Cash Flow Dividends Financial Investments & Buy-Backs Other Increase (Decrease) in Net Debt (Net Cash) / Net Debt
How long before the next shareholder-friendly initiative?
Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%) Capital Employed % Chg
Source: Company Data & Merrill Lynch estimates (IFRS as of 2005)
82
Chart 98: Swatch Group Product Sales Breakdown
Chart 99: Swatch Group Geographical Sales Breakdown

America 11%
Electronic Systems 11% Horological Production 26%
General Services 0%
Oceania 2%
Europe 51% Asia 36% Finished Watches 63%
Chart 100: Swatch One-Year Forward EV/EBITDA (1993-2005)

17x
Chart 101: Swatch Group One-Year Forward P/E Relative to Luxury Goods Sector (1993-2005)
1.3
Swatch PE Relative To Luxury Goods Sector PE

1.2
1.1
One-Year Forward EV/EBITDA
Discount to the Sector at a 7 Year Low in terms of PER
13x
Now Closer to Normalised Peak Multiples
1.0
0.9
0.8
9x
0.7
0.6
0.5
5x 1993
0.4
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Chart 102: Swatch Group Return on Equity

20% 18% 16% 14% 12% 10% 8% 6% 2000A 2001A 2002A 2003A 2004A 2005E 2006E
Chart 103: Swatch Group Return on Capital Employed

18% 16% 14% 12% 10% 8% 6% 2000A 2001A 2002A 2003A 2004A 2005E 2006E
83
Tiffany
For the full year 2005, we estimate total revenues will increase 10%. This reflects a 7% comp increase in the US and a flat comp in Japan. The US continues to be driven by strength in higher priced product, while Japan is seeing signs of a recovery and reported its first positive comp in the second quarter since Q2 2003.
Simplified Income Statement (Year to January USDm unless otherwise stated) Net Revenues % Chg Gross Profit Gross Margin (%) EBITDA Operating Profit EBIT Margin (%) % Chg Net Financial Income (Charges) Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Net Income % Chg Net Adjusted Profit Net Margin (%) Average Fully Diluted Shares Outstanding (mn) Adjusted EPS (USD) % Chg Net Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow From Operations CFPS (USD) Capital Expenditures Changes in Working Capital Requirements Dividends Free Cash Flow Disposals / (Acquisitions) Other Increase / (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%)
Neutral (B-2-7)
2004A 2000 +17,2% 1157 57,9% 445 356 17,8% +11,5% (13) 27,7x 343 17,2% (127) 37,0% 216 +13,7% 216 10,8% 149 1,45 +19,4% 28,00 13% 2004A 281 1,89 (273) (56) (28) 8 0 (9) (1) 238 2004A 44% 60% 16% 2005A 2205 +10,3% 1231 55,8% 443 335 15,2% -5,9% (16) 20,9x 319 14,5% (122) 38,2% 197 -8,8% 204 9,3% 148 1,38 -4,9% 34,00 17% 2005A 201 1,36 (142) (116) (34) 59 0 7 66 253 2005A 48% 60% 15% 2006E 2428 +10,1% 1345 55,4% 497 392 16,1% +17,0% (18) 21,8x 374 15,4% (134) 35,8% 240 +21,8% 240 9,9% 145 1,65 +19,7% 35,00 15% 2006E 255 1,76 (170) (97) (35) 85 0 (35) 50 324 2006E 48% 59% 17% 2007E 2652 +9,2% 1481 55,8% 560 447 16,9% +14,0% (20) 22,3x 427 16,1% (163) 38,2% 264 +10,0% 263 9,9% 143 1,85 +12,1% 37,00 14% 2007E 295 2,06 (186) (85) (37) 109 0 (81) 28 276 2007E 48% 57% 17%
We look for gross margin to decrease modestly in FY2005, due to the decline in the first quarter. The back half should benefit from price increases Tiffany has taken on diamond and platinum product, a stronger sterling silver business and improvements in Japan.
84
Chart 104: Tiffany Product Sales Breakdown
Chart 105: Tiffany Sales by Channel
Tableware, Timepieces and Other, 17%
Direct Marketing, 9%
Other, 4% ,
Jewelry, 83%
International, 39%
US Retail, 48%
Chart 106: Tiffany, S&P 500 PER since1994

60
Chart 107: Tiffany Relative PER Against S&P 500

1,8 1,6 1,4 1,2 1,0
50
40
30
0,8 0,6 0,4

U:TIF(PE) S&PCOMP(PE)
20
10
0,2 0,0
11 /3 /1 99 4 11 /3 /1 99 5 11 /3 /1 99 6 11 /3 /1 99 7 11 /3 /1 99 8 11 /3 /1 99 9 11 /3 /2 00 0 11 /3 /2 00 1 11 /3 /2 00 2 11 /3 /2 00 3 11 /3 /2 00 4
Source: Datastream
Source: Datastream
Chart 108: Tiffany Return on Equity

20.0%
Chart 109: Tiffany Return on Capital Employed

15.0%
15.0%
10.0%
5.0%
0.0% 2002 2003 2004 2005E 2006E
/3 / 1 5/3 9 94 / 1 1 19 9 /3 / 5 1 5/3 9 95 / 1 1 19 9 /3 / 6 1 5/3 9 96 / 1 1 19 9 /3 / 7 1 5/3 9 97 / 1 1 19 9 /3 / 8 1 5/3 9 98 / 1 1 19 9 /3 / 9 1 5/3 9 99 / 1 1 20 0 /3 / 0 2 5/3 0 00 / 1 1 20 0 /3 / 1 2 5/3 0 01 / 1 1 20 0 /3 / 2 2 5/ 0 02 3/ 1 1 20 0 /3 / 3 2 5/ 0 03 3/ 1 1 20 0 /3 / 4 2 5/ 0 04 3/2 00 5
11
10.0%
5.0%
0.0% 2002 2003 2004 2005E 2006E
85
TODs Group
Simplified Income Statement (Eur mn) Sales % chge Gross Profit Gross Margin (%) EBITDA % chg EBIT % chg Operating Margin (%) Net Financial Chages Interest cover (x) Income Before Tax Pre-Tax Margin (%) Income Tax Expense Tax Rate (%) Current Net Profit % chge Minority Interests Attributable Net Profit % chg Net Margin (%) Reported EPS Adjusted EPS % chge Published EPS % chg Gross Dividend Pay Out Ratio Simplified Cash Flow Statement Cash Flow CFPS (EUR) Capital Expenditures Changes in Working Capiatl Requirements Free Cash Flow Dividends Financial Investments & Rights Issue Disposals / (Acquisitions) Other Increase (Decrease) in Net Debt Net Debt / (Cash) Balance Sheet Key Data Inventories as % of Sales Working Capital as % of Sales Net Debt / Equity (%) Capital Employed % chge
Buy (B-1-7)
2002A 358 +12.5% 222 61.9% 92 +14% 63 +13% 17.7% 1 na 63 17.7% 27 42.6% 36 -3% 0 36 -2% 10.0% 1.19 1.40 -5% 1.19 -3% 0.35 29% 2002A 65 2.16 -8 -12 45 -11 0 0 -6 5 -85 2002A 26% 27% na 422 +13% 2003A 371 +3.7% 225 60.6% 76 -17% 44 -31% 11.8% 3 na 46 12.5% 20 43.7% 26 -28% 0 26 -28% 6.9% 0.85 1.11 -21% 0.85 -28% 0.42 49% 2003A 58 1.91 -8 -14 36 -11 0 0 -2 15 -70 2003A 28% 31% na 447 +6% 2004A 421 +13.3% 248 59.0% 88 +16% 54 +24% 12.9% 0 na 55 13.0% 24 43.6% 31 +19% 0 31 +19% 7.3% 1.01 1.32 +19% 1.01 +19% 0.61 60% 2004A 66 2.17 -9 -5 52 -8 0 0 -5 -26 -96 2004A 31% 28% na 474 +6% 2005E 497 +18.2% 309 62.1% 113 +28% 76 +40% 15.2% 0 na 76 15.2% 32 42.4% 44 +41% -1 43 +40% 8.6% 1.41 1.76 +33% 1.41 +40% 0.73 52% 2005E 82 2.71 -9 -53 19 -18 0 0 -10 19 -77 2005E 30% 35% na 492 +4% 2006E 565 +13.7% 352 62.3% 137 +21% 97 +28% 17.2% 0 na 98 17.3% 41 42.0% 57 +30% -1 56 +30% 9.8% 1.84 2.22 +26% 1.84 +30% 0.80 44% 2006E 98 3.25 -9 -20 69 -34 0 0 -15 0 -77 2006E 30% 34% na 508 +3%
Sub-optimal profitability, at least compared to its peers
Still one of the fastest-growing companies in the sector in Europe and a strong recovery in margins underway
86
Chart 110: TODs Group Product Sales Breakdown
Chart 111: TODs Group Geographical Sales Breakdown
Leather 20%
Other 0%
North America 12%
Apparel 16%
Europe 28% Shoes 64% Italy 48%
Chart 112: Back to the Future as the IPO Strategy Drivers Progressively Materialise?
40x Tod's Group PER Long-Term Average
Chart 113: Superior Earnings Growth Prospects Progressively Preempted by the Market
30%
35x
20%
Tod's Premium / (Discount) to Sector Averager Long-Term Average
30x
10%
25x
0%
-10%
20x
-20%
15x
-30%
10x 2000
-40% 2000
2001
2002
2002
2003
2004
2005
2001
2002
2002
2003
2004
2005
2005
Sources: Datastream & ML estimates
Sources: Datastream & ML estimates
Chart 114: TODs Group Return On Equity

35% 30% 25% 20% 15% 10% 5% 0% 1997A 1999A 2001A 2003A 2005E
Chart 115: TODs Group Return On Capital Employed

14% 12% 10% 8% 6% 4% 2% 0% 1997A 1999A 2001A 2003A 2005E
87
88
Appendices
A Snapshot of Key Emerging Markets Russia India Other Emerging Markets Economic Snapshots of China, Russia and India China Russia India 102 103 104 90 93 100
89
Russia
What the Russian Pyramid of Ages Means
In Russia, the main demographic issues for the luxury goods vendors are the dramatic contraction in the birth rate and the level of mortality in men over 60 years old. On the positive side, however, the proportion of wealthy women between the ages of 25 and 50 is growing rapidly, as is their luxury spending.
Chart 116: Russian Demographics (million inhabitants)
80+ 70-74 60-64 50-54 40-44 30-34 20-24 10-14 0-4 8

Source: US Department of Census
PROPORTION OF WOMEN BETWEEN 25 AND 50 IS GROWING RAPIDLY
DESPITE A DRAMATIC DROP IN BIRTH RATES
Market Size
Russia's national statistics agency, Goskomstat, says that an average 13% of Russian household spending (USD10-12bn annually) goes on clothing and footwear. This compares to 6% in the UK and 5% in Japan. The market for luxury apparel, accessories, jewellery and beauty products in Russia is estimated at EUR4.5bn, including about EUR2bn for fashion (Source: Altagamma, Pambianco, Bain & Co) and is forecast to grow by about 6-8% in 2005-2008. "In two years, the Russians have changed greatly. They are more educated and want not just brands. The luxury goods market in Moscow is now worth more than USD2bn, larger than New York's. Claudia DArpizio Bain & Company South China Morning Post - 21 May 2005 The Russian population is about eight times smaller than that of India, but in absolute terms, we estimate that the number of Russian consumers who can afford to purchase European luxury goods is similar (3-5 million people). While this reflects, to a large extent, the early stage of development of the Indian market, it also highlights the substantial appetite of the Russian elite for luxury goods.
90
Key Characteristics of the Russian Luxury Consumer We are not rich enough to buy cheap stuff Russian Proverb
In the Russian market, luxury consumption is more ostentatious, hedonistic and logo driven and the act of spending has strong symbolic and social value. To spend a lot, is to be socially recognized: consumer spending sustains Russian economic growth. The act of spending has a higher symbolic value than it does in the rest of Europe. Russia has a low median purchasing power and a significant portion of total spending on luxury goods is undertaken offshore. This is particularly visible in the areas of womens apparel in countries such as Italy, where Russians are already the seventh-largest customer group by nationality. For the first time, in Q1 2005, the Russians became the second-largest purchasers of luxury goods in Europe after the Japanese and before the Americans. Nouveaux riches searching for wealth-distinctive signs; students versus mass consumption. Bulimia consumption and obsession with brands, prominent logos and constant newness Hedonistic approach to buying as a result of economic conditions and for cultural reasons.
Chart 117: If your income increased by 10%, what would you do? Spend, invest or save? Below the percentage of respondents who would spend.
Europe 22%
Russia is a country of culture and history. They know what a watch is and they know what fine jewellery is. The potential is not only in the domestic market, but also elsewhere, for the Russians spend money on luxury goods when travelling." Bernard Fornas CEO of Cartier International Womens Wear Daily - 30 September 2004
Russia 0% 10% 20% 30%
41% 40% 50%
Source: IPSOS
"It's a very fashion-driven clientele. They love colour, print, patterns and have a more bold approach to buying. There's really an enthusiasm for fashion and luxury with Russian customers." Rose Marie Bravo Chief Executive of Burberry Womens Wear Daily - 30 September 2004
Russians like to spend; they like to have fun, go out and to party, and they like fashion. Also, men like to buy gifts for the women in their lives. Sidney Toledano CEO of Christian Dior Couture Womens Wear Daily - 30 September 2004
I believe the Russian customer is becoming increasingly sophisticated and therefore more open to all kinds of fashion. We sell more beaded evening gowns in Moscow than in many other principal cities in the world Giorgio Armani CEO of Giorgio Armani Group The Sunday Times - 18 April 2004
Is the Local Market Becoming Saturated?

In contrast to China, a recent survey by Pambianco showed 98 Italian brands present in Russia alone, operating 326 stores, along with 23 French brands, operating 40 stores, compared to just a handful in the 1980s. Just like in India or China, wealthy Russians are likely to buy luxury items when they travel (see below). For this reason, whether the potential for additional store openings is still substantial in Russia is debatable, in our opinion. We are not convinced that the recent explosion of store openings by certain brands in the country can remain profitable in the long run.
Too many stores in Moscow?
91
More and More Russian Travellers From Russia with Money

More than 6.5 million Russians holidayed abroad last year, with about half of them travelling to Turkey, China and Egypt - by no means luxury-goods destinations (if anything, more centres for designer knock-offs). Italy and Britain, the two most popular tourist destinations for Russians in Western Europe, only accounted for 4% of outbound Russian tourists (about 200,000) in 2004. We believe it should become easier for Russians to get visas for the European countries bound by the Schengen accord now that the European Union has been enlarged, especially if the Russian government follows in the footsteps of Ukraine, which has recently decided to do away with visa formalities for European Union citizens.
Consumption is More Polarised than Ever

Moscow has the largest concentration of billionaires in the world, according to Forbes Magazines most recent annual survey. Together, these 36 men and women are worth more than USD110bn, or about a quarter of national GDP. The number of Russian millionaires rose 4.2% in 2004, according to the Merrill Lynch 2005 World Wealth Report. That gave Russia 88,000 millionaires in 2004, the eighthbiggest group after the US, Germany, the UK, China, Canada, Australia and Brazil. It is, therefore, not surprising that Russian clients have, for many years, been the main purchasers of the most expensive Swiss watches. Industry experts estimate that 60-70% of watches sold for more than CHF70,000 in Moscow, Geneva or New York end up on a Russian wrist. Russian connoisseurs are particularly keen on complication watches, one of the reasons for the recent explosion of this segment (there are approximately 110 brands offering tourbillons today compared to about 10 in 1990). I am very much aware of the fact that London is very international. For instance, the Arabs and the Russians are two of the largest clients of Cartier UK and it is very important to target these people too." Arnaud Bamberger, Managing Director Cartier UK Magazine Info - July/August 2005 Most industry experts believe that the potential of the market is more limited outside of capital city Moscow and, to a lesser extent, St. Petersburg. The consensus today is that the big money is in Moscow () We might even open a third store in Moscow before going into St. Petersburg. Outside of Moscow, the potential is limited. Yves Carcelle, President of LVMH Fashion & Leather Goods Group Womens Wear Daily - 30 September 2004 The extreme polarisation of the Russian market is illustrated by the absence of better brands, at least for the time being. What we are concerned about is the development of a middle class in Russia if this stalls, then the market will too. The great question is how the middle market will develop. That's where the biggest gap exists right now, and I think if H&M were to set up in Moscow, they would become billionaires. We need stores like Gap, Marks & Spencer, H&M." Aliona Doletskaya, Editor in chief of Vogue Russia WWD - 30 September 2004
Russian luxury consumption is offshore-driven
92
India
What the Indian Pyramid of Ages Means India shows the most promising demographics, with half of all Indians under the age of 25
In India, the demographics are extremely promising and should prove a key growth engine for luxury consumption in the coming decades. India has the worlds youngest population, with 65% below the age of 35 and half under the age of 25. As soon as China's market started to grow, everyone began looking at India's population and demographics and realised that they needed to include us in their global plan as well. S. Motwane, Editor in Chief of LOfficiel and Seventeen Magazine in India WWD - 5 May 2005
93
Chart 118: India Demographics (million inhabitants)
94
A A A A
95
Source: US Department of Census
India has a huge middle class. Now it has to translate that into disposable income. Maybe itll take 15 years instead of eight, but theyll do it. Johann Rupert, Executive Chairman of Richemont National Post - 2 August 2004
Do Indians have the capability to spend on such super-premium brands? () We hope to reach one million lifestyle consumers in India." Prasanna Bhaskar, Retail Manager, Louis Vuitton India Indu Business Line- 16 December 2004
Market Size
Indias retail industry is estimated at around USD10bn for 2005 versus about USD3.5bn in 2000. According to PWC, it should grow at an accelerated pace in coming years. It is difficult to make reliable forecasts for the local luxury goods market, but we estimate that it is today worth only about EUR300m. This explains why many companies are still reluctant to invest any money in India. India is not yet on our radar screen. I don't think it will be for a long time. Wealth is very broadly distributed geographically. That is, the affluence is not concentrated in small enough areas that can support, we believe, any meaningful business for Coach, at least not now. Lew Frankfort, Chairman and CEO of Coach, Inc. At Piper Jaffray Consumer Conference 2005 - Final 7 June 2005
India is potentially interesting for us, not now, but in the long term. You need to look 50 or 100 years into the future. Patrizio Bertelli, Chairman and CEO of Prada Group International Herald Tribune Conference - 20 November 2004
Case in Point: The Indian Luxury Watch Market

The Indian market is estimated at RS1,500 crore (USD350mn). The the premium watch segment is estimated at RS600-800 crore (USD138-183mn) and the balance of power is already visible: LVMH and the Swatch Group together own about a third of the premium segment (about 20% for the former with Tag Heuer and to a lesser extent Christian Dior and about 10% for the latter with Rado in particular). LVMH aims to position India among TAG Heuers top three markets by 2009 and operates in the country through a joint customer-service centre with Titan the largest watch producer in India. By 2006, Tag Heuer plans to sell 100,000 units at an average price of Rs70,000 (USD1,600). The Swatch Group now also distributes Omega, Longines, Swatch, Tissot and Brguet in India.
Key Characteristics of the Indian Luxury Consumer

Luxury has been a characteristic of Indias elite for generations. Unlike China, wealthy Indians never lost their interest in Western design and luxury brands. As in Europe in the nineteenth century, luxury spending in India today takes place within the context of cultural and social traditions, with raw materials (fine silks, heavy embroidery and opulent jewels) a must-have for their intrinsic value. We sum up our view of the key features of Indian luxury consumption:
India: the next China?

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Luxury spending takes place within the context of cultural and social traditions: - Social castes support consumption for status and property security - Accumulating ostentation is an integral part of the culture of the rich
Upper-class young Indians are very receptive to luxury brands but brand awareness remain generally low in the middle-class: - Consumers are increasingly sensitive to brand names and service - Within urban areas, Western fashion trends are being imitated
Our company has entered the Indian market four-five years ahead of time. We want to educate the market on luxury and generate awareness that will contribute to a lifestyle-oriented generation within the country. Prasanna Bhaskar, Retail Manager, Louis Vuitton India Indu Business Line- 16 December 2004
Raw materials are highly desirable for their intrinsic value, as well as signs of opulence (gold, precious stones, high-end jewellery) Many customers are top industrialists or senior executives who have bought luxury brands while travelling abroad.
India has a strong potential, especially a tradition and a sensitivity for fashion and luxury that is deeply rooted in the history of this country and its people. Patrizio Bertelli, Chairman and CEO of Prada Group Womens Wear Daily - 20 February 2003
How Many Luxury Goods Customers in India?

Over the past decade, Indias economic growth, the rise in per capita income, the opening up of the economy and a parallel boom in the IT and services sectors have created an entire generation of wealthy Indians, distinct from India's traditional business families. The rich and affluent (able to spend USD21,000 or Rs 9 lakh a year on conspicuous consumption) make up 0.5-0.75% of the population, but with a base of one billion people, that still adds up to 3-5 million customers (about a quarter of credit-card holders), a substantial number in any market. Do Indians have the capability to spend on such super-premium brands? () We hope to reach one million lifestyle consumers in India." Prasanna Bhaskar, Retail Manager, Louis Vuitton India Indu Business Line- 16 December 2004 In 2002, there were 20,000 families in India with annual incomes of more than Rs 1 crore (USD230,000) (Source: NCAER Household Income Survey). That number is expected to jump to 53,000 families this year and to 140,000 by 2010. Some 100,000 boast incomes between Rs 50 lakh (USD 115,000) and Rs 1 crore (USD230,000) and this number could reach 250,000 by 2010. The increase in the number of households headed by salary earners, professionals and business people and the emergence of a thriving consumer finance business
The Indian market is small today, but arguably the most promising longer term
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are expected to prolong the consumerist boom. Average living standards are 70% higher than in 1991, as evidenced by sales of around 1.7 million mobile phone connections monthly and the number of credit cards in issue (expected to double to 14 million by 2007). The diamond acquisition rate is already close to that of the US, the worlds largest market, with more than a 50% global share: India has had an annual growth rate of 20% for a decade and is now one of the top five consumer diamond markets in the world. It's a country with a jewellery culture, with constantly rising numbers of people with disposable income. Gareth Penny, Managing Director-Designate of de Beers Financial Times 28 June 2005
Mass consumption is prompting Indias super-rich to buy luxury goods to maintain their distinction from the mere affluent. The wealthiest families in the country (53,000 with an annual income of more than USD225,000 versus 20,000 in 2000) have developed a liking for labels, which they indulge when travelling to Singapore, Thailand and Hong Kong. They do not just live in Mumbai, Delhi and Bangalore (80% of the market). Nagpur, for instance, recorded nine people with annual income levels above USD230,000 in 1995-1996 and now boasts 425 such people. Also, contrary to popular perception, Delhi has more billionaires than financial capital Mumbai. This is still a drop in the ocean in terms of the luxury goods market, but initial results for selected brands are very encouraging: Vuitton sales since it entered the market in 2003 are double those of the Beijing store that opened in 2002. Management expects double-digit growth for the next six to eight years. Products sell for around 10% more than in Paris, but demand for personal shopping appointments in the stores still outweighs casual walk-in shopping. Ermenegildo Zegna says that sales of its premium made-to-measure suits in India have already exceeded world average levels in volume terms. Audi, Bentley and Porsche have all entered the market in the past two years with cars ranging from USD100,000 to USD200,000 (Rs 44 lakh and Rs 88 lakh). The luxury car market in India has tripled over the past five years and now totals about 2,000 cars annually, despite import duties of about 100%.
India's luxury car market is growing and more people are looking for exclusive cars. Our decision to come to India was based on demand. We are convinced that the market potential of India will grow. Amaury La Fonta, Porsche Marketing Chief for Asia and the Middle East India Today - 22 November 2004
Emerging Indian Tourism

The number of Indian tourists (4.5 million in 2004, 5.5 million in 2005) should reach 8 million globally by 2008, according to the World Travel Organisation, and luxury goods retailers are getting ready for the boom. We are expecting to see a very large number of new customers from India, who could be as numerous as Chinese customers in the next two to three years. India is developing at high speed. We are seeing the same signs as we saw two to three years ago with China. Jean-Michel Hallez, General Manager of the Galeries Lafayette flagship store
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on Boulevard Hausmann Reuters 22 December 2004
Indian Network Reminiscent of China Five Years Ago

Compared to China, India is still largely devoid of foreign luxury brands, at least aside from mass labels and a few shops in hotels and airports. With the recent lifting of an obligation to use local partners, many companies (ie, Gucci, Fendi, Yves Saint Laurent) are fine-tuning their penetration strategy.
Table 10: Luxury Players Starting to Play Catch Up in India

Brand Bulgari Burberry Christian Dior Richemont Cartier Montblanc Piaget Chanel Ermenegildo Zegna PPR Gucci Swatch Group Longines Omega Rado Valentino Fashion Group Hugo Boss Valentino Versace LVMH Louis Vuitton Tag Heuer Number of Points of Sale at end 2004 One store in New Delhi Two shopin-shops (corners) None Retailers only (number not available) Seven pen stores One watch boutique One store opened in April 2005 in New Delhis Imperial Hotel One store in New Delhi None About 40 points of sale Two in Mumbai + two in Chennai and Bangalore by July 2005 116 points of sale Two 140m2 stores in Oberoi hotels in New Delhi and Mumbai One in Mumbai None Two stores (New Delhis Oberoi opened in February 2003 and 170m2 Mumbais Taj Mahal in Sept. 2004) 40 points of sale and eight boutique outlets Planned Number of Store Opening When Available na One store in 2005/2006 in Mumbai One store before years end 3-4 stores by 2007-2008 na na na One this year in Mumbai as directly-operated First opening as of 2007 na 10-12 franchised boutiques by 2010 20 in 2005 (from 44 cities to 54 at the end of 2005) Two stores in 2005 in Mumbai (Grand Hyatt) and Bangalore na Five stores in major cities in 2006 Bangalore store planned 15 outlets by the end of 2006
Sources: Company Data, Italian News Digest, Indian Business Insight , Merrill Lynch Rado expects as much as a third of its revenues to come from India by the end of 2005
Main Obstacles
Despite enthusiasm over the Indian market's potential, there are four main issues hindering the growth of luxury spending there.
Steep import levies remain a serious obstacle to luxury spending
1. Import Duties The main obstacle to the development of a luxury goods market in India is the persistence of import duties, which still remain at 80% for watches and range from 40% to 60%, depending on the different cities for jewellery. Many luxury brands (such as Zegna, Hugo Boss, Dior, Canali and Bulgari) are pricing their products broadly at a par with New York, taking lower margins to offset the high duties in India. However, this is not enough to encourage consumers to buy locally, limiting the potential of the market near term. The sector needs a reduction in import tariffs
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similar to that negotiated by the EU as a condition for backing Chinas entry into the WTO. We believe that such a move may take some time, however.
2. Ownership of retail Another issue is retail stores can only be owned by Indian nationals and many companies prefer to see a change in the legislation before entering the market.
The grandes maisons ought to team up with a local partner or to adopt a franchising agreement when they enter the Indian market. The problem here is that controlling your image is essential for luxury goods brands and that sharing the control is a risky move that some companies are hesitating to take. Rooma Kumar Bussi, Former Commercial Agent for the French Embassy La Tribune in New Delhi - 15 November 2004
The absence of suitable store locations is another hindrance
3. Infrastructure Another basic concern is the lack of suitable locations for store openings, given the early stage of development of the local market. At this time, most luxury brands have little option but to occupy expensive store space in five-star hotels (for more details, see section on Ten Mistakes to Avoid in Emerging Markets).
Infrastructure is probably the biggest challenge in India. There are no roads here that you could easily walk on in Louis Vuitton shoes, and thats an issue. The chance of an Avenue Montaigne developing in India is very low. A Street of highend retailers is definitely a distant dream." Prasanna Bhaskar, Louis Vuitton India Retail Manager Womens Wear Daily - 9 May 2005 The countrys first three shopping centres only opened in 2001, but there are now about 25 malls and 250-300 of them are projected to be built by 2007 so this lack of infrastructure is in our opinion less of an issue in the medium-term.
Historically, wealthy Russians and Indians have been reluctant to spend at home
4. Historical Importance of Offshore Business The third obstacle to the development of a local market in India is the general perception that the prices of imported products are systematically and significantly higher than in Western Europe a perception that is largely incorrect.
It took years for people to start getting used to the idea of shopping for international brands here. Part of the problem was just the mind-set about the currency. They were used to shopping abroad, and a higher-end product that costs 100 in London would be the equivalent of about 80,000 rupees here. It's the same price, but just the thought of spending in the thousands versus in the hundreds. People still felt like they were spending less if they shopped abroad." A. Bredemeyer, Entrack (Montblanc, Canali and Girard-Perregaux stores) Womens Wear Daily - 9 May 2005
Differences between the Indian and Chinese Markets Differences between Indian and Chinese luxury-goods customers
The similarities between the two countries, at least on paper, are undeniable. Both have populations of more than a billion people. Both have quickly growing economies and emerging wealthy classes with an increasing number of business people and entrepreneurs who have lots of cash to spend. And both have been opening their doors to western ideas, companies and lifestyles over the past decade. Still there are, we believe, key differences between consumers: Unlike in China, where many companies have to work on increasing their brand recognition, most Indian consumers are well aware of western labels and the products they're known for.
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In India, unlike China, the interest in Western goods, travel and luxury brands has never disappeared. In India, unlike China, customers are mindful of their own fashion history and continue to wear traditional formal designs (saris, salwar kameez). Indian customers prefer buying pieces that are unique or less mass-produced a trait that theyve carried over from their traditional clothes, which are often custom-made and always colorful and creative. More than wealthy Chinese, wealthy Indians have long travelled abroad primarily to London and Dubai to buy their western wardrobes each season, so convincing them to shop at home is maybe more difficult.
I have been surprised by the needs of our clients, who often ask for the latest innovations or selected editions. Chinese clients want what the other one already have, whereas here (in India), clients are looking for exclusive products. They are more mature in that sense. Prasanna Bhaskar, Louis Vuitton India Retail Manager La Tribune - 15 November 2004
The Indian customer is very individualistic. You will not see 30 people carrying the exact same bag in this market. Unlike a place like Hong Kong, where you do not need to remember what bag you sold to a customers sister-in-law, in India, you do. They do not want to be sold the same design. Prasanna Bhaskar, Louis Vuitton India Retail Manager Womens Wear Daily - 9 May 2005
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Other Emerging Markets

Although this issue of Lap of Luxury is primarily devoted to Chinese, Indian and Russian consumers, we also see very strong growth opportunities in other emerging markets. The nouveau riches of the emerging markets are a relatively new story for luxury brands. These markets all have an emerging consumer class with money to spend, eager for the status that luxury brands provide. South America, Eastern Europe, the Middle East (including Iran and Iraq) and the less developed countries of the Far East should all prove major markets in the medium term.
Eastern Europe
Whether Moscows wealth trickles down to other cities in Russia and to former country members of the Soviet Union remains to be seen. Of course, some of those countries will clearly become natural targets for luxury players as their GDP per capita progresses in coming years. The real question is how much room is there in these markets for aggressive new entrants. Within the next five years, Poland, Hungary, Rumania and the Czech Republic will be important new luxury goods markets for Italy. These markets are already important producers for many Italian companies, such as clothing and textile manufacturing, and are gradually evolving from producers to consumers. Guido Corbetta, Co-Director of the Masters Degree in Fashion, Experience and Design Management at Bocconi University Womens Wear Daily - 20 February 2003
The Middle East Dubai: the Hong Kong of the Middle East?
The Middle East is also becoming an interesting market for luxury goods vendors. Some of the countries in the region have invested heavily in upgrading the local infrastructure, notably Dubai, now a major tourist destination (eg, Armani and Versace luxury resort complexes). In addition, of course, wealth in the region has been boosted significantly by the high price of oil, though this is, admittedly, a more volatile driver of luxury goods sales in the region and in the UAE, in particular.
Latin America Mexico, Brazil and Chile appear to be the most promising Latin American prospects
In Latin America, Mexico and, to a lesser extent, Brazil are the most attractive target countries for the luxury goods industry. MCF Fashion estimates that the Brazilian fashion market, though predominantly wholesale, is worth USD2.2bn annually (75% in Sao Paulo). This market has expanded at a CAGR of +30% over the past decade. There are at least 1 million wealthy Brazilians who regularly buy luxury goods, either at home or abroad.
Other Markets Many smaller countries show potential, notably in Asia

Finally, among the emerging markets, there are still countries that remain largely untapped by luxury goods companies. Some are small and have just opened up (Vietnam, Morocco) and some are potentially larger markets for certain categories (Indonesia for accessories and apparel). We were surprised to learn, for instance, that Indonesians are already among the top 10 purchasers of the Vuitton brand on a global basis.
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Economic Snapshots of China, Russia & India

Chart 119: China Major Cities
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China
With 171 cities with a population of 1 to 2 million inhabitants and 13 of more than 4 million, China is by far the most promising market, especially as the removal of duties under WTO accelerates luxury goods penetration in the country. However, for the moment, we estimate that the market is relatively small, at about EUR1.5bn. The wealth gap in China is considered as one of the highest in the world. There are vast disparities today between urban and provincial areas, with significant spending power still concentrated in the hands of government officials. However, there have been crucial moves recently from the government to placate the middle class. Urban average incomes have doubled since 1995 and, according to our economists, could jump 45% from 2005-2015. According to our economists, bear cases underestimate the consumer. Rising wages, rising employment, rising inflation and a rising middle class should boost consumption and help deliver a soft landing in the years ahead. Sure, there will be headwinds to consumption. The urge to save is strong. The future costs of education and medical care are uncertain and growing. The public sector is almost certainly unable to provide for retirement. Neither is the family, thanks to Chinas one-child policy. But these trends have been in place for some time. Now the business cycle is moving in the right direction. Merrill Lynch estimates suggest that 55 milion urban households (5.5 million rural households) had incomes greater than USD4,000 per annum in 2004. In 2005-2006, we expect 15-20 million new middleincome households to be created each year in urban areas (4-5million in rural areas). Car sales fell sharply in 2004 (to 17% year-on-year from 76% in 2003), due to a decline in auto financing and expectations of further price declines. This dragged down overall consumption growth (we estimate that autos account for 3-3.5% of total consumer expenditure.) We expect car sales to stabilise at about 20% YoY in 2005.
Source: Merrill Lynch Luxury Goods team
Table 11: China Key Data - 2004 Data

Total Population: GDP/ Inhabitant: GDP Growth: Outbound Travellers / annum: Luxury Goods Target Clientele
Source: Merrill Lynch Luxury Goods team estimates & Bloomberg 13mn Chinese earn EUR19,500/annum 39mn Chinese earn EUR5,000 - 7,000
1.3 bn USD1,233 +9.5% 20 m 10-15 m
Chart 120: Major Cities in Russia
Russia
In Russia, the economy is strong, although from a luxury goods perspective, were tempted to ask for how long? As opposed to luxury spending in Western Europe, traditionally dominated by 35 year olds plus, Russia offers a young consumer economy unwilling to save. Helped by high oil prices, Russia GDP grew by 7.0% in 2004 and could rise by 5.8% in 2005E. However the OECD says that growth will slacken unless the economy becomes less reliant on oil production. Reform of the state-dominated natural-gas industry is therefore an urgent priority. Continuing fiscal discipline is vital because public finances are so vulnerable to a fall in oil prices. Greater security of property rights is essential if growth is to be sustained. The government has just implemented a new fiscal regime, which enables it to capture 90% of oil revenues as soon as the price of the barrel is in excess of USD25. Oil production has been stagnating at about 9.4m barrels since last October. One reason is that oil companies now have to look beyond the easy-to-tap oil revenues of Western Siberia for new fields. But another is a loss of confidence after the governments assault on Youkos, but also the Sibneft, BP-TNK and Loukoil to name a few. Russia has run trade and budget surpluses for five years. Still, fear of bureaucratic attacks trigger a spate of company flotations in London, while nave foreign loans still come in the country, a puzzling similarity with the default and devaluation of 1998. While there is nervousness about the market and its stability, fashion and retail firms are heading to Russia in droves, attracted by a vibrant economy, a free-spending elite and what's perceived as pent-up demand for style and status.
Table 12: Russia Key Data 2004 Data

Source: Merrill Lynch Luxury Goods Estimates & Bloomberg
144 mn USD3,971 6.7% 23 m 3 to 5 m
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Chart 121: India Major Cities
India
India is probably where China was five to ten years ago in terms of stage of development for luxury consumption. We expect the development of luxury spending in India to be a lot faster than it has been in China, just as Chinas development has been a lot faster than that of Japan in the 1970s and the 1980s. Like China, it is still difficult to find the right location, but things are changing quickly. Import tax duties are still off-putting, especially on watches, but more changes are expected. Most pressing of all is the countrys fiscal mess: its deficit runs at about 10% of GDP and continues to absorb far too much of the budget.
Table 13: India Key Data - 2004A Data

Source: Merrill Lynch Luxury Goods team estimates & Bloomberg
1.07 bn USD615 6.2% 6m 3 to 5 m
Calendar of Events in 2H
27 Jun 3 Jul 4-10 Jul 11-17 Jul LOral: 1H Sales (12 July) Wolford FY04 Earnings (ar. 16 Jul) Burberry 1Q Trading Update (13 Jul) 18-24 Jul Essilor 1H Sales (21 Jul) Dior 2Q Sales (ar. 24 Jul) Remy Cointreau 1Q Earnings (21 Jul) PPR 1H Sales (28 Jul) Wolford FY04/05 Earnings (21 Jul) 25Jul 31 Jul LVMH 1H Sales (25 Jul) Tods Analyst & Investor Day (27 Jul) Tods 1H Sales (26 Jul) Hugo Boss 1H Earnings (29 Jul) Marzotto 1H (25 Jul) Bulgari 1H Sales (27 July) Luxottica 2Q Earnings (ar. 28 Jul) Clarins 1H Sales (ar. 29 Jul) FHS Quarterly Earnings (ar. 27 Jul) Remy Cointreau AGM (28 Jul) PPR 2Q Sales (28 Jul) Hugo Boss 1H Earnings (28 July) 29 Aug 4 Sep GEOX 1H Earnings (1 Sept) LOreal: 1H Earnings (2 Sept) Tiffany 2Q Earnings (31 Aug)
1-7 Aug Adidas Salomon 1H Earnings (3 Aug) Polo Ralph Lauren 1Q Earnings (ar. 4 Aug) Burberry Final Dividend (3 Aug) Coach FY05 Earnings (2 Aug) 5-11 Sep Remy Cointreau AGM (ar. 7 Sept) Essilor 1H Earnings (8 Sept) Clarins 1H Earnings (ar. 9 Sept) LVMH 1H Earnings (7 Sept after close) PPR 1H Earnings (8 Sept) Benetton IFRS Conference Call (8 Sept)
8-14 Aug Herms 2Q Sales (10 Aug) Rodriguez Group 3Q Earnings (10/15 Aug.) Tiffany 2Q results (ar. 12 Aug) Wolford 1Q05 Sales (ar. 9 Aug)
15-21 Aug 22-28 Aug Bang & Olufsen Annual Accounts (15 Aug) Swatch 1H Earnings (24 Aug) FHS July Results (ar. 24 Aug)
12-18 Sep 19-25 Sep FHS August Statistics (ar. 23 Sept) Bulgari 2Q Earnings (13 Sept) Mariella Burani 2Q Earnings (ar. 13 Sept) Wolford 1Q (22 Sept) Wolford Shareholders Meeting (12 Sept) LOral Field Trip US (19-21 Sept) TODs 1H Earnings (26 Sept) Clarins: 1H Earnings (15 Sept) Benetton 1H Earnings (21 Sept) Clarins: Analyst meeting (16 Sept) Richemont AGM (15 Sept) Herms 1H Earnings (15 Sept morning) Marzotto 1H Earnings (12 Sept) Escada 3Q Earnings (14 Sept) 17-23 Oct Essilor 3Q 05 Sales (20 Oct) Remy Cointreau 2Q Sales (20 Oct) Dior 3Q Sales (ar. 17 Oct) Loreal 3Q sales (19 Oct) 24-30 Oct Luxottica 3Q Earnings (ar. 28 Oct) FHS Sept Statistics (ar. 25 Oct) PPR 3Q Sales (27 Oct) Oriflame 3Q (25 Oct)
26 Sep 2 Oct Bang & Olufsen AGM (28 Sept) Bulgari 1H Earnings (26 Sept)
3-9 Oct Bang & Olufsen 1Q05/06 (7 Oct) LVMH 3Q Sales (ar. 14 Oct) Mariella Burani 1H Earings (7 Oct)
10-16 Oct Burberry 1H Sales (11 Oct) Clarins: 3Q Earnings (13 Oct) LVMH 3Q Sales (ar. 14 Oct)
31 Oct-6 Nov
7-13 Nov adidas Salomon 3Q Earnings (3 Nov) Bulgari 3Q Earnings (14 Nov) Herms 3Q Sales (9 Nov) Hugo Boss 3Q Earnings (3 Nov) Laurent Perrier 2Q Earnings (ar. 12 Nov) Marzotto 3Q Earnings (10 Nov) Rodriguez Group 4Q Earnings (10/15 Nov) Tiffany 3Q Sales (ar. 11 Nov) Tods 3Q Sales (11 Nov) Wolford 1H Sales (8 Nov) Benetton 3Q (11 Nov) GEOX 3Q Earnings (14 Nov)
14-20 Nov Bulgari 3Q Earnings (14 Nov) Burberry 1H Earnings (15 Nov) Richemont 1H Earnings (17 Nov) Mariella Burani 3Q Earnings (16 Nov)
21-27 Nov FHS Oct Statistics (ar. 23 Nov)
28 Nov 4 Dec Laurent Perrier 1H Earnings (ar. 3 Dec)
5-11 Dec 12-18 Dec Remy Cointreau 1H Earnings (8 Dec) Rodriguez Group Finals (10/15 Dec) Wolford 1H Earnings (16 Dec) FHS Nov Statistics (ar. 23 Dec)
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Analyst Certification
We, Antoine Colonna, Aymeric Poulain, Nicole Smith and Mark Friedman, hereby certify that the views each of us has expressed in this research report accurately reflect each of our respective personal views about the subject securities and issuers. We also certify that no part of our respective compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.
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Important Disclosures
Investment Rating Distribution: Consumer Products Group (as of 30 June 2005)
Coverage Universe Count Percent Inv. Banking Relationships* Count Percent
21 40.38% Buy 29 55.77% Neutral 2 3.85% Sell Investment Rating Distribution: Global Group (as of 30 June 2005)
Coverage Universe Count
Buy Neutral Sell

Inv. Banking Relationships*
7 5 0
Count
33.33% 17.24% 0.00%

Percent
Percent
Buy Neutral Sell
1089 1378 195
40.91% 51.77% 7.33%
Buy Neutral Sell
359 404 36
32.97% 29.32% 18.46%
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Other Important Disclosures

The company is a corporate broking client of Merrill Lynch International in the United Kingdom: Burberry. MLPF&S or one of it affiliates has a significant financial interest in the fixed income instruments of the issuer. If this report was issued on or after the 10th day of a month, it reflects a significant financial interest on the last day of the previous month. Reports issued before the 10th day of a month reflect a significant financial interest at the end of the second month preceding the date of the report: Richemont; LVMH; Swatch Group. Copyright, User Agreement and other general information related to this report: Copyright 2005 Merrill Lynch, Pierce, Fenner & Smith Incorporated. All rights reserved. This research report is prepared for the use of Merrill Lynch clients and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of Merrill Lynch. 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Lap of Luxury V - Emerging Markets

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Lap of Luxury V - Emerging Markets

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GLOBAL

Highlights of this Issue

Travel Flows to Boost Spending by Emerging-Market Customers

Our Key Stock Picks

Global Fundamental Equity Research Department

Lap of Luxury 2 September 2005

How important is China?

Supportive Growth Drivers

MiddleEast 5% Other European 18% Chinese 23%

Source: Merrill Lynch Luxury Goods Team

Koreans Chinese Japanese Russian

IN 2010, 50mn OUTBOUND CHINESE IN 2020, 100mn ACCORDING TO WTO

BY 2008, CHINESE TOURISTS=2.5X JAPANESE

+7.6% +6.3% +4.8% +4.2% +3.8% +3.4%

BY 2008, RUSSIAN TOURISTS=1.5X JAPANESE

8 7 2006E 2007E 2008E

KOREAN TOURISTS 5mn IN 2003, 6mn IN 2004

Source: Merrill Lynch Luxury Goods Team

Refer to important disclosures on pages 109 to 110.

Lap of Luxury 2 September 2005

Exposure of Selected Players to non-Japan Asia in Pictures

Tomorrows Winners & Losers

Revenues in EURm in 2004

Rest of Asia Hong Kong Mainland China

Rest of Asia Hong Kong Mainland China

Low-cost Sourcing & Producing

Other Tissot Rado Longines Other Brands (incl. YSL) Gucci

Refer to important disclosures on pages 109 to 110.

Lap of Luxury 2 September 2005

The Counterfeiting Issue

Still Overweight the Sector

Peak of OECD Leading Indicator Enron Affair

June 2002 W orldcom Affair

3/11/2004 M adrid Attacks

Normalised Trading Range

January 2005 Kobe Earthquake

Russian D Crisis ebt

Sources: Merrill Lynch Luxury Goods Team & Datastream

Table 1: Importance of Chinese Customers to LVMH, Richemont, Swatch

Refer to important disclosures on pages 109 to 110.

Lap of Luxury 2 September 2005

Economy, Demography, Travel Flows

Why we remain Overweight on the Sector

Refer to important disclosures on pages 109 to 110.

Lap of Luxury 2 September 2005

1. A New Approach to Luxury Spending

Background Sector Revenues by Region: the Traditional Approach

Rest of World US 24% 4%

Rest of Asia 14% 40% Europe 40%

Source: Merrill Lynch Luxury Goods Team

Refer to important disclosures on pages 109 to 110.

Lap of Luxury 2 September 2005

2004-2014 Projections by Nationality

Middle-East 4% Other European 23%

Indian 1% American 25%

Chart 10: Sector Sales by Nationality, 2014E (EUR160bn)

Other European 18%

Indian 2% American 22%

Russian 7% Japanese 20%

Refer to important disclosures on pages 109 to 110.

Lap of Luxury 2 September 2005

Source: Merrill Lynch Luxury Goods Team