Big discounts ahead for China luxury shoppers

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A sharply weaker euro is giving European luxury goods makers a headache: as the price gap for their products in Europe and China widens they may have to rebalance prices globally, which could hit earnings, analysts say.

European luxury goods have always been priced 30-40 percent more in mainland China compared to Europe, partly to cope with high import duties and consumption tax, said RBC Capital Markets analyst Rogerio Fujimori in a March 31 note. But due to the falling euro, to maintain margins in China, the price differential is now 60-80 percent.

"An adverse scenario for brands would be the need to reduce prices in China (to moderate the price gap) without being able to increase prices in Europe (in order not to cut off domestic consumers)," said Exane BNP Paribas analyst Luca Solca.

Either way, rebalancing prices could be painful.

Earnings before interest and taxes (EBIT) could take a 5 percent hit if luxury goods makers cut prices by 15 percent in China and raise them by 7 percent in Europe, according to RBC's Fujimori.

"[Price cuts] would reduce the FX benefit that luxury players should receive from a weaker euro," Exane BNP Paribas' Lucas added.

Taking action

As price gaps widen some brands are taking action.

Chanel, for instance, cut prices on its iconic handbags by over 20 percent in China and raised them by the same margin in the euro zone in March, according to Reuters.

"If [other] luxury brands directionally follow Chanel's price cuts in Greater China, we see downside risks… because a potential volume pick-up would not be enough to offset negative pricing and this should lead to material margin declines in Greater China," said RBC's Fujimori.

Why China still holds the key to luxury space
Why China still holds the key to luxury space

And that seems likely as an increasingly prosperous and mobile Chinese middle class can go to Europe and compare prices for themselves.

China's middle class is on course to reach 1 billion in 2030, up from 157 million in 2009, according to data from the Organization for Economic Co-operation and Development.

"[The] Chinese now represent close to a third of luxury sales, more than two thirds [of which are] happening abroad. Tourists all in all represent about 44 percent of luxury sales (with Chinese accounting for half)," according to a HSBC note published on April 9.

"Blogs, forums, word-of-mouth and travel are spreading knowledge of brands and what consumers should pay for them…and will likely force brand managers out of what has been a somewhat complacent by-default thought process of thinking Asian consumers could be charged more for the same product," HSBC said.

Concerns overblown?

While many analysts expect luxury brands to follow Chanel's lead, concerns may be overblown.

The weaker euro should compensate for a global price rebalancing, according to HSBC.

At the current euro-dollar exchange rate of 1.08, "the positive FX impact on earnings before interest and taxes will be around 30 percent," it said.

That should offset price cuts by 2016.

"In terms of EBIT margin as a percentage of sales, the impact should be dilutive in 2015, before becoming significantly positive in 2016," HSBC said.