A World Trade Organization (WTO) panel recently ruled that the U.S. can impose tariffs on European exports in retaliation for the EU's violation of WTO rules with its government subsidies for aircraft manufacturer Airbus (OTC:EADSY). Shares of Airbus fell after the ruling, but shares of other European companies that generate significant revenue from the U.S. -- like luxury giant LVMH (OTC:LVMUY) -- also tumbled.
I previously highlighted LVMH as a good defensive stock for the trade war between the U.S. and China, but the threat of new U.S. tariffs against European companies raises some questions about my original thesis. Let's examine this case and see if LVMH investors should be concerned.
How does a ruling against Airbus affect LVMH?
Back in 2006, the U.S. filed a case with the WTO, claiming that Airbus -- the primary rival of American aircraft maker Boeing (NYSE:BA) -- had received $22 billion in illegal subsidies from European governments.
In 2010, the WTO ruled in favor of the U.S. and declared that Airbus had received $18 billion in illegal subsidies, mainly through subsidized loans with favorable interest rates. The ruling was upheld in 2011, and the EU was ordered to cut off those subsidies.
A follow-up WTO review in 2016 found that those subsidies weren't reduced, and that Airbus actually benefited from an additional $5 billion in subsidies for the launch of its A350. The EU appealed the ruling again, but the WTO struck down the appeal last May, allowing the U.S. to impose punitive tariffs on the EU.
The Trump administration has already identified a list of potential EU targets worth about $25 billion a year, which includes European aircraft, aircraft components, and high-end luxury products like leather goods, wines, and spirits. The U.S. could potentially hit those products with tariffs of up to 100%.
Evaluating LVMH's exposure to those potential tariffs
LVMH generated 23% of its total sales from the U.S. in the first half of 2019, making it the company's second largest market after Asia.
Its organic sales in the U.S. (excluding Hawaii) rose 8% annually during that period, compared to 10% growth in Japan, 18% growth in Asia (excluding Japan), and 10% growth in Europe. Therefore, higher tariffs on exports to the U.S. -- its slowest-growing market -- could throttle LVMH's total organic sales, which rose 12% annually.
In its first half report, LVMH cited the U.S. and China as key growth markets for its wines and spirits unit, which posted 6% organic sales growth. It also cited the U.S. as a key expansion market for Sephora, a core growth engine of the selective retailing business which grew its organic sales 8%.
But here's the problem: The wines and spirits unit and the selective retailing unit -- which generated 10% and 28% of LVMH's first half sales, respectively -- were also its two slowest-growing businesses. Hitting those businesses with higher tariffs could cause them to fall even further behind.
The U.S. also remains a major market for LVMH's core leather and fashion goods unit, which posted 18% organic sales growth in the first half and accounted for 42% of its top line. LVMH recently expanded that unit with major partnerships with Rihanna and Stella McCartney, and a flurry of tariffs could derail those plans.
But let's not jump to conclusions
The tariffs could cause headaches for LVMH, but investors shouldn't assume a worst-case scenario. It's highly doubtful that the U.S. will immediately hit wines, spirits, and leather goods with 100% tariffs, since it would spark a fierce retaliation from the EU.
Instead, the tariffs might be in line with the 10%-25% tariffs which the EU, Mexico, China, and other countries imposed on U.S. whiskey exports over the past year in retaliation for the Trump administration's steel tariffs.
LVMH's core consumers -- who buy its Louis Vuitton bags, TAG Heuer watches, and Hennessy cognac -- generally aren't as sensitive to price hikes as less affluent consumers. Therefore, it's likely that LVMH can pass the higher costs onto its consumers without significantly impacting its sales or profits. In fact, higher prices often boost the appeal of LVMH's brands.
Lastly, initial EU estimates indicate that the U.S. might only target up to $7 billion in goods with retaliatory tariffs. Most of those tariffs will likely hit Airbus and its suppliers instead of luxury product makers like LVMH. There also might still be room for negotiations between the EU, the U.S., Airbus, and the WTO before the tariffs are enacted.
I'm not selling my LVMH shares
LVMH remains a "best in breed" play in the recession-resistant luxury market, even as recent headwinds -- like the protests in Hong Kong and the threat of U.S. tariffs -- cast clouds over its near-term growth. However, I believe these issues are merely speed bumps in LVMH's long-term growth story, and investors should accumulate more shares on any tariff-related dips.