As the Market's Appetite for Handbags Cools, Prada Looks to the Future

Both emerging and mature markets are cooling off on their demand for luxury goods. Certain economies, like China for instance, are experiencing a slowdown and citizens have cut back on spending. Europe is also in the midst of a slowdown in their economic cycle.

Prada SpA's full year 2013 results showed lower sales due to weaknesses in certain markets. Markets like China and Italy play an important role in meeting revenue targets for Prada. Unfavorable exchange rates also had a negative impact, especially during the third quarter of fiscal 2013.

Prada shares have been falling steadily throughout 2013. While the company grew 45% in 2012, last year saw flat income growth. The slowdown in China and Europe, its top two markets which bring in about 45% of sales, has had a considerable impact. Prada's fiscal 2013 report suggests that the situation is not improving and that the company will need to bear down and manage the impact of the slowdown in key emerging economies .

The opening of new store locations, expanding its manufacturing capacity, and growing its menswear and Miu Miu brands are all part of Prada's drivers for future company growth. While profit margin is expected to be flat in 2014, sales growth is expected going into 2015. Operating margin should improve as the number of store openings level off as well.

Investor day presentation shows growth with short-term volatility
Research firm Altagamma predicts an annual growth rate for the luxury market between 3% and 5% between 2015 and 2016. If the current slow growth and flat sales continue into the next few quarters, it is likely that Prada's shares could remain expensive; the company's trailing twelve months (TTM) P/E ratio is 43.9. According to Morningstar, the rest of the luxury goods industry carries a TTM P/E ratio of 24.8.

Prada reported $1.57 billion in EBITDA for fiscal 2013, a slight rise from 2012's EBITDA of $1.45 billion. It didn't help that the company's expenses rose much higher during the year than its net sales. Despite the soft sales results, the company continued to pursue its retail store development. Retail capital expenditures for the year more than doubled from the prior period. The state of the luxury market weighed heavily on Prada's results; the approximately 5% growth that took place between 2010 and 2012 slowed considerably in 2013 .

What are Prada's competitors up to?
A close competitor of Prada in the fashion and leather goods business is LVMH Moet Hennessy Louis Vuitton . The group is also involved in other business lines, including wines and spirits, perfumes and cosmetics, and watches and jewelry. The company also runs a selective retailing unit, which includes the popular makeup and beauty products retailer Sephora. LVMH's fashion and leather goods business grew 9% in the first quarter of 2014, a close second to selective retailing's 10% quarterly growth. Overall revenue growth for the quarter was 6%.

A new creative director at Louis Vuitton delivered new models for the brand's Monogram line that were well received. The first quarter also saw the opening of two new stores, and Italian wool and cashmere producer Loro Piana, which LVMH acquired last year, achieved top results . LVMH acknowledged the challenges they are dealing with in the European market and remain focused on developing its brands and keeping costs under control. As Prada's latest results also showed, cost control for these luxury good producers is critical during periods of soft demand.

Another of one of Prada's rivals and a luxury brand that has been on a tear over the last few years is Michael Kors Holdings Ltd . The company has seen total revenue for the third quarter ended Dec. 28, 2013 rise 59% and comp store sales increased 27.8%. The company had strong revenue growth in North America and saw revenue rise 144% in Europe; this was attributed to brand awareness and growing demand across regions . The brand's strong showing in Europe is interesting, especially since its rivals have seen a slowdown in sales coming out of Europe. This could be due to the Kors' brand association with "affordable luxury" and the availability of merchandise at lower price points that keeps customers returning to the brand.

My Foolish conclusion
As Prada navigates what may be short-term volatility in the demand for its luxury goods, it should emulate its rivals on how to manage the current market. LVMH's focus on cost control is important in periods of volatile demand, especially for Prada, which has continued to pursue a fairly aggressive retail store expansion despite the decreased demand for its goods. Michael Kors shows no signs of slowing down, and its lower-priced merchandise is part of the key to the brand's success.

Lower prices could benefit Prada and demand in economies that are experiencing a slowdown could pick up. The company has been investing in its value chain and enhancements in manufacturing could produce products that cost less while maintaining the level of quality the brand is associated with. For now, Prada's shares are overvalued and I would steer clear until the company shows signs that its sales are starting to pick up and its retail store expansion is contributing to the bottom line.

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Eileen Rojas has no position in any stocks mentioned. The Motley Fool recommends Michael Kors Holdings. The Motley Fool owns shares of Michael Kors Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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