Luxury-goods makers are racing into China

September 2011 – The Hong Kong Institute of Certified Accountant has published a relevant article on Chinese Luxury Business. This article is for a broader audience of professionals; especially for valuers and investors looking to assign a number to a luxury brand’s name.  Sacha Orloff is quoted in the following article, and would like to add other significant points, which we believe to be relevant below:

By Alexandra Orloff

The Chinese purchasers of luxury brands differs from those elsewhere

The Chinese purchaser differs from any other consumers due to its history of luxury consumption in China. This factor remains profoundly rooted into China’s cultural and sociological landscape. If one goes back few decades ago, during the Cultural Revolution there was a void in the luxury culture, however the same generation would purchase products, nevertheless their taste would be less than subtle and would be a mimic of the western signs of richness and power.

Now that social classes have reappeared, the strong desire of the Chinese constumer is to pursue his dreams of certain grandeur through the embedded tastes of their western counterpart; these principles influence strongly their purchases, thinking that their value system can be
leveled to the Western one. However, these scaled values have to compromise between their own traditional Chinese values, the socialist values and the western values regarded as the trend to follow in order to be seen as modern achievers, successful in their own society and worldly travelled. They still have to find peace and equilibrium between their own society and their personal display of wealth and status recognition inside China.

There are particular difficulties in measuring the value of luxury brands in China , after all, brands that do not command a premium in the West, such as Marks & Spencer, Wrangler and Buick, are considered chic in China

It has been demonstrated that 13 million households in China’s upper middle class offer the biggest new growth opportunity, thus accounting for approximately 12 percent of the market. For the western luxury brands, this new customer segmentation has a higher quality of life. The upper middle class population is capable to acquire luxury products.  It might be a mistake on luxury brands to try mould and refined the Chinese customer to their own standard of taste; a great effort should be put in understanding the Chinese mentality to gain their loyalty. One important point also, is that the Chinese consumer is relatively young compare on average of their counterpart in Europe, Japan and other old economies.

All depends of the perception of luxury; in my views, the Chinese consumer enjoys the thought of buying and acquiring luxury brand products, they are prepared and willing to show off their purchasing power, but they lack the know-how to leverage brands to create a sophisticates lifestyle. Now in the Chinese luxury market, with its rapidly increasing incomes, and a great access to internet, there is a wide display, choice and information on available luxury products.  I believe than a larger number of Chinese consumers feel comfortable buying all sorts of products which in their eyes are consider as being luxury. A certain refinement has to be acquired by this new upper middle class; only time will tell if the West should not drastically change their own perception to be lined up for the Chinese market.

There is something  unusual about the way Chinese consumers approach brands, compared with the West

With a high number of luxury stores, fashion magazines, websites and other use of social media, the Chinese consumer is extensively familiar with a larger number of brands and becomes more aware of the world of luxury goods and brands. In this process of time vs. awareness, the Chinese consumer becomes savvier about the relationship between quality and price. It is a matter of time before their knowledge of refinement will be intensified to the same level of their counterparts in the old Europe.





George W. Russell reports

Luxury-goods makers are racing into China, but the intangible nature of brands – especially on the mainland – spells trouble for valuers and investors looking to assign a number to a name

When Italian luxury-goods company Prada made its initial public offering in Hong Kong in June, it was an unabashed bid to court Asian, and especially Chinese, investors. “An IPO’s location represents the market where we’re heading,” Prada’s chief executive, Patrizio Bertelli, said before the listing.

Although the company failed to raise the US$2.6 billion it had hoped for in the IPO – it managed US$2.14 billion – its decision to list here was an obvious one, according to financial analysts, given the lacklustre economic performance of Europe and the United States. “By being listed in Hong Kong, companies can boast higher price to earnings multiples,” says Simone Ragazzi, a luxury-goods analyst at Centrobanca in Milan, Prada’s hometown.

Prada is the first Italian company to list on the Hong Kong stock exchange and it follows listings by French cosmetics maker L’Occitane and U.S. luggage-manufacturer Samsonite. U.S. handbag maker Coach and British clothier Burberry are thinking of following suit, as is Italian couturier Giorgio Armani.

Chinese consumers’ enthusiasm for top-end brands is forcing a rebalancing of the global market. China will become the world’s largest luxury-goods market by 2015, according to research by the McKinsey consultancy. Even during the recession in 2009, luxury-goods sales on the mainland rose by 16 percent, compared with flat or negative growth in Europe and the United States.

Doing the brand maths

This growth in the luxury-goods market has given the practice of brand valuation greater urgency in China, where the concept is nascent. “We don’t even have a brand valuation practice in China,” notes Herman Cheng, a consultant with PwC in Beijing.

The modern brand valuation profession was born in the United Kingdom in the late 1980s, prompted by New Zealand food company Goodman Fielder Wattie’s hostile takeover bid for Rank Hovis McDougall. With the help of Interbrand, a brand consultancy, Rank Hovis McDougall showed that the value of its brands on its balance sheet proved that Goodman’s bid had undervalued the company.

At that time, intangible assets such as brands were not usually counted on the balance sheet as part of a company’s assets. Brand accounting was controversial because procedures for calculation had not yet been standardized.

Today, intangibles account for about three-quarters of corporate value in major markets worldwide, according to Ernst & Young data. The major brand valuation methods are:

• The relief-from-royalty method, which measures a property’s value by what its owner would pay in royalties if it had to license the property from a third party.

• The excess earnings method, which tries to assess the increase in profit or cash flow attributable to the brand. The sum of these cash flows plus the residual value of the brand gives the brand value.

• The brand communication investment method, which computes from total advertising budgets, less a discount for risk used to compute the net present value.

• The awareness and franchise valuation method, which uses equations that convert a given advertising budget into awareness value, consumer franchise and consumption volume.

Relief from royalty is the prevailing method. “It is the approach recognized by technical authorities worldwide and favoured by accounting, tax and legal users. It ties back to the commercial reality of brands,” says Rupert Purser, a Hong Kong Institute of CPAs member who is China chairman at Hong Kong-based valuation consultancy Brand Finance.

“The approach is based on the observation that a company can license out its brand and receive royalty fees rather than operating the business itself,” says Simon Mak, chief executive of Ascent Partners, a transaction advisory and asset management company. “The basic mathematics is royalty rate [multiplied by] net present value of the licensee business.”

Mak, an Institute member, adds that it is the preferred method in Hong Kong too: “The accounting treatment of brand value is ascertained mainly from two accounting standards: International Financial Reporting Standard [adopted as Hong Kong Financial Reporting Standard] 3 Business Combinations and [Hong Kong Accounting Standard] 38 Intangible Assets.”

IFRS 3, first introduced in 2004, has changed brand valuation radically, according to Mak. “Before the standard was put in place, brands could be recognized as balance sheet items in only a few countries, such as the U.K., France and Australia,” he recalls. “Even in those countries, auditors were very cautious. After the adoption of IFRS 3, brand name recognition became a standard practice rather than creative accounting. “Valuing a brand is not without subjectivity,” Mak adds. “Although valuation approaches such as the relief-from-royalty method or the excess earnings method are standard practice, it is more an estimation compared with the prudent approach that auditors have long treasured.”

Branding experts (who aren’t accountants) have long criticized IFRS. “The IASB and International Valuation Standards Council have all made efforts to impose brand valuation regulations and guidelines, but they’ve had limited impact,” wrote Nik Stucky, head of global brand valuations at Interbrand, in a recent assessment. “This is because the methods focus on financial transactions and reporting alone, and omit a brand’s equity and emotional strength.”

Stucky welcomes the introduction in October 2010 of the International Organization for Standardization’s brand valuation standard, ISO 10668, which also takes into account behavioural, legal and other financial aspects. He adds that ISO 10668 is in line with IFRS, but the IASB has not adopted an official stance on the ISO standard.

Besides, accountants disagree IFRS 3 is insufficient. “From the accounting practice standpoint, brand name recognition and the valuation approach have been standardized,” argues Mak. “The core focus of IFRS is financial reporting needs,” he says. “Emotional value should not be quantified in dollars and cents”. Purser, for his part, says the standards have caught up with the branding profession. “The international
accounting bodies have been introducing new standards and guidelines to help accountants identify more classes of intellectual property,” he says. “IFRS 3 and ISO 10668 are the result of this initiative.”

Valuation companies stress the importance of having a valuable brand for transactional purposes. Jean-Baptiste Roy, a manager at the Hong Kong valuing company Censere, gives the example that, while a reduction in revenue results in a corresponding decline in the value of intangibles, residual brand value can be enough to save a company in dire straits. He cites the example of ailing U.S. electronics retailer RadioShack, which ran so short of cash in 2010 that it was expected to be sold to a rival. But the company survived after raising enough operating
capital to keep trading – solely on the strength of its brand name.

“That wouldn’t happen in China or even Hong Kong,” Roy says. A company in similar difficulties would be allowed to die, he says, because of the lack of a sophisti­cated infrastructure for intangible assets. “A bank will not lend on the basis of intangibles such as intellectual capital as collateral and there are no IP brokerages.”

In China there is no strict standardized brand valu­ation method. “We usually adopt the relief-from-royalty method in China,” says Vincent Pang, who is managing director of financial services group Avista Valuation Advi­sory, which is based in Hong Kong.

Pang, an Institute member, explains that there are several complications: China has an immature licensing market, which makes the calculation of brand premiums less straightforward; most Chinese brands are attached to a particular product or service and rarely
licensed out; Chinese companies have only just begun to build brands; and weak intellectual property protection can outweigh the high marketing costs of building a brand.

“With the fierce competitive environment and safety, quality and trust scandals, the brand is becoming more important than price and other factors.”

Despite all this, brand-savvy international companies are convincing Chinese consumers to choose their brands. Consumers themselves are seeking good quality, espe­cially as an alternative to other, perhaps more dangerous choices. “With the fierce competitive environment and safety, quality and trust scandals, the brand is becoming more important than price and other factors,” says Xu Feifei, director of brand strategy at the Labbrand consul­tancy in Shanghai. “While most makers of consumer goods need to set affordable prices in the developing world, luxury goods typically sell at a significant premium on western prices, given the wealthy customer base,” says Rahul Sharma, founder of Neev Capital, an investment house in London that looks at emerging-market consumer goods. “In their quest for exclusivity, the wealthy gravitate towards iconic brands.”

Analysts say Chinese consumers are becoming more loyal to premium brands. “They are no longer choosing products based only on price,” reports Irene Yu, an analyst at China Market Research Group in Shanghai. “The brand is one of the top criteria that people will look into. A high-value brand means that it’s a product that they can trust, that’s not toxic and that it has good before- and after-sales service.”

Furthermore, Chinese investors constitute a great deal of the world’s demand for stock market listings and investor enthusiasm is good for brands. “IPO and M&A activity show how the perceptions people have of a product, service or corporation can price a company at several times its tangible assets,” says Anthony Pettifer, founder and managing partner at Hong Kong consultancy Brandstorm Asia.

Branding experts warn of several quirks in China. Shaun Rein, founder of CMR Group, thinks Chinese consumers gauge international brands differently from western buyers. Many Chinese consumers consider fast-food brands such as McDonald’s and Dunkin’ Donuts healthy, for instance. “They know that a healthy diet should not have too much oil and sugar, but they also trust that foreign brands won’t cut corners in the production process,” he explains.

Similarly, while Prada and Gucci are universally regarded as luxury brands, the placement of other international brands is more nuanced in China. Some decidedly mid-ranking brands in the west – American clothing brands Lee and Wrangler, British retailer Marks & Spencer and U.S. carmaker Buick to name but a few command premium positions in the mainland.

Branding experts say luxury-goods manufacturers shouldn’t try to change attitudes in China. “It might be a mistake on their part to try to mould the Chinese customer to their own standard of taste,” says Alexandra de Kerros Boudkov Orloff, CEO of Sacha Orloff, a London consultancy that helps brands enter new markets. “I believe a large number of Chinese consumers feel comfortable buying all sorts of products that, in their eyes, are luxury goods.”

George W. Russell is the Editor at large, A Plus – the magazine of the Hong Kong Institute of Certified Public Accountants at M&L Asia

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