Description

Long Movado Group (MOV)

High ROIC business in an out of favor industry with large net cash balance

Thesis

The watch is dead. Long live the watch.

Movado is a US-based, family controlled luxury watch company. Shares are down ~36% since early 2014 and ~27% since late last year on a combination of cyclical and secular concerns. The current valuation offers an attractive entry point to purchase a capex light, high teens ROIC business that owns several world class brands, including Movado, Ebel, and Concord. A cash heavy capital structure means that the company screens poorly on equity metrics, helping to create the opportunity, but also leaving room for continued capital returns to shareholders. I believe the impact of current cyclical headwinds (strong USD, customer destocking, broad-based retail weakness) are temporary and structural concerns (growing popularity of iWatch/wearables, slowing luxury sales in China) are overblown with regard to their impact on Movado.

My $36/share price target (implying ~28% upside) assumes a 10% unlevered (EBITDA-capex) yield and implies a partial re-rating to an 8.2x EV/EBITDA multiple. This valuation would mark a slight premium to Fossil Group (FOSL) and a substantial discount to Swatch and other European luxury brands. I see additional upside if the company can continue to grow sales and/or execute on a wearable product. This year, investors will also receive a ~1.6% dividend yield and a ~6.1% buyback yield (based on the remaining repurchase authorization in 2015).

Please see below for important disclosures.

Company & Market Description

Movado designs, sources, markets, and distributes watches. The company owns the Movado, Ebel, and Concord brands and produces watches under license for ESQ, Coach, Tommy Hilfiger, Hugo Boss, Juicy Couture, Lacoste, and Scuderia Ferrari. Originally created in 1947, the Movado Museum watch is one of the centerpiece of the company’s collection (see http://www.movado.com/movado-collections/museum.html). In 2014, 36% of total sales were luxury brands, 50% were licensed brands, and 14% were retail and service. A larger percentage of profits were likely from luxury sales, because these products tend to be higher margin and the company does not have to pay associated licensing fees. In 2014, 55% of total sales were in the US, with 19% in Europe, 11% in Other Americas, only 8% in Asia, and 7% in the Middle East. Unlike many of its peers, the Movado story has to date not been predicated on explosive growth in China.

The company operates primarily in the wholesale market and is fundamentally a branding and design company, not a retailer or manufacturer. As such, Movado outsources manufacturing to suppliers in Switzerland and Asia and does not operate a large store network like other luxury retailers. The company has only 38 outlet stores in the US used to sell factory seconds. In comparison, Michael Kors has 526 stores globally and Fossil has 593. Movado’s wholesale model is a significant differentiator at this point in the cycle. Although it does not have a large retail footprint to benefit from direct-to-consumer margin uplift when times are good, in a challenging market environment the company also does not have a large fixed cost base, including retail leases, with which to grapple.

In general, the watch market can be segmented into several buckets by price. Movado operates in the mid to high end space, with the core Movado product styled as accessible luxury at the $500-$2,500 price point. Concord and Ebel are considered luxury offerings with pricing at $2,000-$10,000, while the licensed brands are mainstream fashion watches with prices from $75-$500. The company does not have any ultra-high end $10,000+ or mass market (sub-$75) products. The Movado brand fits in a niche between more common fashion brands like Michael Kors and Fossil and higher end brands like Omega and Rolex.

Investment Case

Growing, Capex Light, High ROIC Business

As a design and branding focused company with no manufacturing operations and a limited retail footprint, Movado has proven to be a capex light, high ROIC business. This year, capex is expected to total ~2.5% of sales vs. 3.3% at Fossil and 8.4% at Michael Kors. ROIC has been in the mid-to-high teens for the past three years after some post-recession cost cutting. Sales have grown every year since FY2010, averaging a 9.2% five-year CAGR, and are expected to rise by 1.4% this year even after substantial currency headwinds. On a constant currency basis, management expects sales to increase 5.0-6.5% this year. With only ~$600m in annual sales, there is plenty of room to increase market penetration, and the company is gaining market share. For comparison, Swatch Group sales totaled $9.5b in 2014, almost 16x Movado’s sales.

Wearables Are Not an Existential Threat to the Watch

I do not believe that the advent of the iWatch and wearable technology spell the end of the traditional watch. First, there is emerging acknowledgement that wearables around the $500 price point are not directly competing with high end luxury watches that are purchased for conspicuous consumption and/or out of appreciation for craftsmanship. I believe Movado’s Concord and Ebel products, and some but not all of the Movado offering, fall into this category.

Second, I believe that the growing popularity of wearables may actually end up increasing interest in watches. Presumably, watches should have died out starting in the mid-2000s as cell phones became popular, thereby obviating the need for a separate timekeeping device. That watches thrived during this period speaks volumes about how technological change may not have the most obvious effects. Society is now moving back into a paradigm in which wearing something on the wrist is popular again, even in cases when the user also has a cell phone. I can envision a scenario with consumers wearing an iWatch, Fitbit, or similar product during a typical day and donning a fashion or luxury watch at night, for formal events, or to stand out.

Third, the fact that wearable products emphasize form as much as function suggests to me that consumers remain appearance and fashion conscious. For example, the wearable technology product of today looks nothing like a calculator watch, but instead has a much sleeker, designer look. Wearing an iWatch is not just about potentially increasing productivity (in theory), but also about wearing something good looking and making a statement that the wearer embodies the values of the Apple brand. The importance of non-functional elements gives watchmakers room to engage with customers by offering their own aesthetically pleasing products that convey the values of their own brands.

Fourth, the idea that smart watches actually increase productivity or provide functional utility is by no means a given. Given the growing intrusion of technology and advertising into people’s lives, the idea of “silence as a luxury” is being increasingly explored in the press. Traditional watch companies may be able to exploit consumer fatigue with technology.

Movado is Developing a Smart Watch Product

Although I believe that wearable technology is not an existential threat to the traditional watch, it never hurts to hedge. Movado is developing its own smart watch product with an expected launch date in 2H15 in time for the holidays. Details remain scarce, and I view this opportunity as more of an option than a core part of the story.

Slowing China Demand Affects Movado Less

Only 8% of Movado’s sales last year were in Asia, with even less in China, leading to two key conclusions. First, Movado’s growth over the past several years did not stem from a major ramp up in China, making a solid five-year growth rate look even more impressive. Second, as Chinese luxury demand slows, Movado has less exposure than other luxury peers. For comparison, 37% of Swatch’s 2014 sales were in Greater China.

Adjusting Prices in Response to Strong USD and CHF

Much of the volatility in the global retail and luxury goods space is due to recent currency swings, particularly in the Swiss Franc (CHF). A substantial amount of Movado’s product costs are in CHF, although there is a partial offset from CHF-denominated sales. To offset the earnings impact of a stronger USD and CHF, Movado is the midst of implementing selective price increases in the 6-7% range for certain products. The price adjustments started in April, with the impact expected to show up gradually starting with 2Q15 results. Next year will be the first full effective year. On the 1Q15 earnings call at the end of May, management was comfortable with the impact of the new pricing strategy after seeing over a month of execution.

Customer Destocking is Temporary

Customer destocking has been a sales headwind over the past few quarters. Large department store customers are reducing the amount of inventory they hold, meaning sell-through is below sell-in. Retailers in general have been quite focused on managing inventory levels given volatility in the space. However, this inventory headwind is temporary, and once destocking concludes customers will have to increase buying levels.

Cash Heavy Capital Structure Hides Returns

One of the reasons that Movado remains undervalued is that the company’s cash heavy capital structure means the shares screen poorly on equity level valuation metrics. Movado has $186m in cash on hand, equal to 28% of the company’s market cap, and only $25m in gross debt, with net debt of ($161m). In comparison, Fossil has only 7% of its market cap in cash and has net debt to EBITDA of 0.8x. Michael Kors has no gross debt, but its cash pile is only equivalent to 10% of the market cap.

As a result of this large cash balance, I expect a free cash flow to equity yield of ~7.1% this year vs. an unlevered EBITDA-capex yield of 13.6%. However, Movado is working to return some of this cash to shareholders and take advantage of the recent stock price decline via buybacks. The company pays a 1.6% dividend yield and is in the midst of recently expanded repurchase program. Movado has $41m remaining on a $100m buyback program, which equates to a 6.1% buyback yield on the current market cap. Together, total FY2016 (calendar 2015) cash returns total 7.7%.

For illustrative purposes only, I have detailed below the effects of a levered recap on free cash flow to equity yield. A more levered, yet still reasonable capital structure (2.0x net debt to EBITDA in this example) could turn a 7.1% FCFE yield into a 12.1% yield. While I do not expect an increase in leverage of this magnitude, relevering of any kind could be quite impactful.

Downside Protection Given Business Model

If market conditions remain challenging for watchmakers like Movado, the company has options to respond. Movado does not have a large fixed cost base that can be difficult to adjust. For example, the company only operates 38 outlet stores compared to hundreds at Michael Kors and Fossil (see above). Movado also does not operate its own manufacturing facilities. The company is in the midst of a cost cutting initiative, so there will be some one-time associated expenses this year that will yield savings going forward.

Family Control is Both a Risk & a Positive

Movado is led by Chairman and CEO Efraim Grinberg. Although they do not own a majority of total shares, the Grinberg family controls Movado through their supervoting Class A shares (which have 10 votes each compared to 1 vote per common share). As a result, investors are dependent on Grinberg’s leadership and judgment. His controlling stake also means that the company is not an acquisition target despite attractive valuation, unless Grinberg consents. However, I believe having a family sponsor creates a put-like dynamic. If market conditions became more challenging and public scrutiny more distracting, Movado’s cash-rich balance sheet makes a go-private more feasible.

Valuation

I believe Movado is worth $36/share in the near-term (~28% higher than the current share price), with additional upside if sales growth reaccelerates next year. I assume a 10% unlevered (EBITDA-capex) yield, which implies an 8.2x EV/EBITDA multiple and a 1.2x EV/sales multiple. This valuation is a slight premium to Fossil and a substantial discount to Swatch and other European luxury brands.

A premium to Fossil is justified by Movado’s larger mix of higher priced luxury watches compared to lower priced fashion watches (although Fossil also sells other accessories and clothing, providing some diversification). Movado also does not have the burden of fixed operating lease expenses that Fossil faces. The discount to Swatch is validated by Swatch’s higher mix of luxury and ultra-luxury watch products.

Next year (FY2017, calendar 2016) could see a confluence of bullish earnings tailwinds that could drive the next leg higher in the stock. These tailwinds include: The end of customer destocking, a full year of effect for price hikes implemented this year, less currency volatility, and lapping easy comps.

Current Valuations

Risks

1) The iWatch/electronic wearables are a substitute for, not a compliment to, traditional watches

2) Global luxury sales remain depressed for the next several years

3) Increased consumer interest in wearables attracts new watch competitors

4) Controlling shareholders make poor capital allocation decisions

5) Unfavorable licensing contract renewals in the medium to long term

Important Disclaimer

The above text is the view of the author alone and is for informational and educational purposes only. It should not be construed as investment advice or a solicitation to buy or sell securities. The author may hold a position in the securities mentioned and does not have to provide updates for changes to his view or ownership. The author does not warrant his work for correctness or accuracy. Perform your own due diligence before making investment decisions.

Catalyst

1) Earnings releases (next one in late August)

2) Execution on selective price increases

3) Conclusion of customer destocking

4) Wearables product launch by 4Q15

5) Stable to rising headline sales (comps get easier next year)

6) Continued share repurchases