Can China generate further upside for brilliant Burberry?

Burberry shares aren’t far off a record high, yet still trade at a bigger than usual discount to the sector. Here’s a view ahead of upcoming results season.

The China-led bounce for Burberry (LSE:BRBY) shares is facing a major test as attention turns to the state of US luxury demand and the debut collection of a new creative director.

Shares have been one of this year’s best performers in the FTSE 100 index as the wider European luxury goods sector benefits from China’s reopening to rise 23% overall.

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But the release of first-quarter results from luxury rivals likes of LVMH (EURONEXT:MC) and Hermes (EURONEXT:RMS) prior to Burberry’s annual results on 18 May is set to refocus minds on the fundamentals of the market.

In advance of the earnings season, Swiss bank UBS signalled further upside for Burberry shares by lifting its price target to 2,593p although it kept its “neutral” recommendation.

The bank’s top picks are Compagnie Financiere Richemont (SIX:CFR), Hermes and Moncler (MTA:MONC) as the “most balanced, high-quality plays” on China re-opening and with the benefits of late-cycle pricing.

UBS said: “The beginning of the year, as always, has driven lots of interest in "turnaround" stories and away from proven winners.

“However, we believe Q1 results could bring back the market's focus to high-quality, strong performing brands, and especially those with incremental pricing opportunities.”

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For the first quarter, UBS is more optimistic than the City consensus after forecasting average underlying sales growth of 11%. It believes the sector's current above-par valuation is justified, but adds that the upside risk is limited amid a looming US slowdown and with still little visibility on the return of Chinese tourists to Europe.

UBS notes that Burberry is more vulnerable to a US downturn, given that it has greater exposure to the "aspirational" lower end of the luxury market.

As well as the economic climate, the focus of Burberry’s annual results will be on the wholesale reaction to Daniel Lee’s first collection as creative director.

He presented his debut runway collection at London Fashion Week in February, with the new range set to be in stores by September. Lee, who is the former creative director of Bottega Veneta, took over from Italian designer Riccardo Tisci in October.

UBS said: “Although we consider Burberry to be at big risk from a potential US slowdown, we remain “neutral” as we await the first signs of turnaround under the creative direction of Daniel Lee, which could mitigate any macro-driven uncertainty.”

The bank notes that Burberry trades at a 55% premium to MSCI Europe versus an historical average of 41%. Relative to the sector Burberry trades at a 32% discount, compared with its 21% historical 10-year average discount.