Sector focus: Luxury goods firms face up to new Hong Kong reality

Anthea Arff-Pettersen

Analyst, European & UK equities

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Hong Kong used to be the prime shopping destination for Chinese tourists.

The introduction of the Individual Visit Scheme in July 2003 marked the beginning of a decade with unprecedented growth in mainland Chinese visits to Hong Kong.

Before the introduction of the scheme, a little over 7 million mainland Chinese residents visited Hong Kong on an annual basis. Ten years later that number had grown to 44 million, an astounding increase of over 500%.

Hong Kong’s attractions as a shopping destination for mainland Chinese consumers were clear: it was close and easy to access; it was cheaper (with lower taxes on goods plus favourable exchange rates); it offered a wide range of brands and product; and the risk of buying counterfeit goods was low.

What has changed?

Ten years later the situation in Hong Kong is very different.

After a decade of 11% cumulative annual growth in retail sales, 2014 marked the first year of decline, with retail sales down 0.2% year-on-year.

So far there are no signs that growth is picking up again, with retail sales down 3% year-on-year during the eleven months to November 2015.

This development is especially meaningful for luxury goods companies because the Chinese represent a significant portion of their customer base.

The decline in Chinese visits and retail sales is a consequence of a variety of factors, including the Chinese government’s anti-corruption campaign, Hong Kong residents’ hostility towards mainland visitors, currency fluctuations, changes in travel patterns and consumer preferences.

The relaxation of visa requirements coupled with higher discretionary income and a favourable exchange rate spurred exceptional growth in Chinese tourism to continental Europe, Japan and South Korea.

In many cases, these destinations can offer cheaper shopping than Hong Kong as well as more varied cultural experiences and ancient history.

How can the luxury goods sector respond?

As luxury goods companies face up to the new reality in Hong Kong, earnings disappointments might continue.

Management execution will be crucial in tackling imbalances in global pricing structures and potential rationalisation of store networks.

It is becoming increasingly apparent that the sector will have to be more agile in the future in responding to fluctuating currencies, changing travel patterns and rising online penetration.

The relative winners during this transition will be those companies that can be flexible in their inventory management and have the ability to predict the location of consumer demand and shift products accordingly.

A digital offer and omni-channel strategy will also become even more important as consumers are becoming more sophisticated, online penetration is increasing and a brand’s global pricing structure is more transparent than ever.

What are the opportunities for investors?

When facing an uncertain future, investment opportunities will arise.

We believe that identifying those companies that are prepared to tackle pricing imbalances, have the flexibility to respond to changes in the location of end demand, and have a superior digital offering to capture the growing online demand will deliver the greatest investment returns.