Description
It appears to be the season for spinning off tobacco stocks. Richemont (CVR VX), the owner of a portfolio of luxury brands including Cartier, has decided to spin-off it’s 19.3% stake in British American Tobacco (BAT LN) in q1 2008. The spin-off of BAT will leave a premier luxury goods company trading at a forward PE of 14. As comparative luxury goods companies trade at much higher multiples (e.g. TIF = 17.3) I am recommending buying the luxury goods stub ahead of the spin-off.
(Note: For convenience, UBS and Merrills are making quotes in the stub.)
CATALYST
The catalyst for the trade is obviously the spin-off of BAT in q1 2008. The spin-off is positive because it
1) Removes the holding company discount as the spin-off of BAT leaves a pure play luxury goods company.
2) Removes the negative stigma associated with tobacco companies.
3) Makes the company easier to analyze. (40% of the Net Income was from tobacco and 60% from luxury goods. This meant that the luxury sell side analysts were always deferring half of the call to the tobacco analyst.)
BRIEF OVERVIEW
Richemont is a prestigious luxury goods company listed and based in Switzerland. In addition to it’s luxury goods interest Richemont owns 19.3% of BAT (British American Tobacco) which is listed in London.
The TTM Income Statement is shown below.
(EURO Mil)
Income Statement (Sept 2007)
Sales 5 072
COS (1 806)
GP 3 266
Oper Expenses (2 073)
EBITDA 1 193
Depreciation ( 153)
Oper Profit 1 040
Interest Income 60
PBT 1 100
Tax ( 192)
PAT 908
Income from BAT 600
Net Income 1 508
GP Margin = 64.4%
Oper Margin = 20.5%
Tax Rate = 17.4%
The income statement highlights two important points.
1) The luxury goods company generated Euro908mil Net Income. BAT contributed Euro600mil.
2) The effective tax rate is 17.4%. (The tax rate in Switzerland is 22%)
PE RATIO
Because the tax rate is well below the tax rates paid by other luxury goods companies I feel the PE ratio is the most relevant metric for comparing the valuations of listed luxury goods companies.
The market cap of Richemont is Euro26 500mil. It’s 19.3% stake in BAT is worth Euro10 700mil. This implies a market cap for the luxury stub of Euro15 800mil.
Forecast 12month rolling forward Net Income from the luxury stub is Euro1 110mil which puts Richemont on a forward PE of 14.2. (If one adjusts for the Euro900mil of excess cash the PE falls below 14.)
LUXURY GOODS BUSINESS
Richemont owns 13 luxury brands including Cartier, Montblanc, Jeager-Le Coultre, Paiget, Chloe to name a few.
The luxury operations are segmented by product line and by region. In order to get a good feel for the business model it worth examining both segmental reports.
Product Lines
Looking at the business by product line highlights the powerful portfolio of brands which are desired around the world. While each brand is operated as an independent unit, they all leverage off Richemont’s world wide distribution network
Jewellery TTM Sales = Euro2 543mil TTM EBIT = Euro 706mil
Specialist Watchmakers TTM Sales = Euro1 318mil TTM EBIT = Euro 353mil
Writing Instruments TTM Sales = Euro 623mil TTM EBIT = Euro 113mil
Leather + Accessories TTM Sales = Euro 308mil TTM EBIT = (Euro 8mil)
Other TTM Sales = Euro 396mil TTM EBIT = Euro 16mil
Head Office TTM Sales = (Euro 116mil) TTM EBIT = (Euro 139mil)
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Total TTM Sales = Euro5 072mil TTM EBIT = Euro 1 040mil
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The brands falling under each division are listed below.
Jewellery (Cartier, Van Cleef & Arpels)
Cartier is the flag ship brand and dominates this division.
Specialist Watchmakers (Jeager-LeCoultre, IWC, Panerai, Paiget, Vacheron Constantin, Baume&Mercier, A. Lange&Sohne)
The acquisition of Jeager-LeCoultre, IWC and Lange&Sohne in December 2001 provide some valuable insights. All three brands are Swiss based watch makers that had been around since the mid 1800’s. Richemont bought the companies and moved them on to their broader distribution channel. The broadening of the distribution channel and new markets unlocked value by boosting sales and profits for all three brands.
Writing Instruments (Montblanc)
Leather + Accessories (Alfred Dunhill, Lancel)
Other (Chloe)
Regional
The brands listed above are generally manufactured in Switzerland and then enter the Richemont distribution and retail network to be sold around the world. (Richemont own 695 retail outlets with a further 523 points of sales operated by franchise partners.)
The TTM Sales for the geographic segments are as follows
Europe Euro2 159mil
USA Euro 786mil
Japan Euro 718mil
China+Hong Kong Euro 691mil
Other Asia Euro 492mil
Other Americas Euro 227mil
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Total Euro5 073mil
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In a nutshell, the cost base is in CHF and the majority of the revenue streams are in Euros’, Dollars and Yen. This set-up means that fluctuations in exchange rates have the following effects on the business.
1) Because cost base is in CHF and revenues in Euro, Dollar and Yen local GP margins are sensitive to the performance of the CHF relative to these currencies. For instance, recently the CHF has been weak against the Euro which boosted margins, but, strong against the dollar and yen, which hurt margins. (In the longer term the pricing power of the brands allows management to adjust prices in order to recapture short term losses in margin. It is important to note that these price adjustments are essential in order to prevent the arbitrage of prices between two geographies.)
2) A large portion of European sales are to tourists. A weak Euro tends boost European sales as the weak currency attracts tourists to Europe. A strong Euro is obviously negative for European sales, but, some of this is offset by tourists shopping at home instead.
3) Richemont report in Euros. The exchange rate translations can often distort some of the trading fundamentals in the local currency. For instance, for the 6months ended September 2007 US sales were up 13% in dollar terms, but, only up 3% in Euros because of the weak dollar.
Summarizing, similar to the other luxury goods companies, an investor has the impossible task of predicting short run currency fluctuations when forecasting revenues and income. Offsetting this complication is the tremendous tax advantage Richemont enjoys by basing it’s business in Switzerland. The low Swiss tax rates and the careful setting of transfer prices allows Richemont to enjoy a much lower tax rate compared to it’s peers in the US and EU.
VALUATION
The table below shows that Richemont is trading at a 20% discount to it’s peers. (This discount is even larger if the Euro900mil of cash is taken into account.)
Forward 12months PE’s
Tiffany (TIF US) = 17.3
Swatch (UHR VX) = 16.5
Bulgari(MC FP) = 18.8
LVMH (MC FP) = 16.7
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Average 17.3
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Richemont(CFR VX) = 14.2
RISKS
Because of the quality of the luxury goods portfolio I am confident that the “discount” will be unlocked once BAT is spun-off. Having said this I am worried about a potential slow-down now that the “easy money” is much harder to find.
Analysts of luxury goods companies are the ultimate optimists, especially during the good times. Historically they have trumpeted the growth of High-Net-Worth-Individuals (HNWI) and the fact that these individuals are not affected by recessions. More recently, China has been added to the optimists list to complete the “this time it is different argument.” (China represents 3% of sales which are growing at 50% per annum.)
Before being mesmerized by these arguments the following brief history shows that Richemont’s sales and margins are sensitive to economic activity.
March 2007: Sales = 4 827mil GP Margin = 63.7% Oper Margin = 19.0%
March 2006: Sales = 4 308mil GP Margin = 63.1% Oper Margin = 17.2%
March 2005: Sales = 3 717mil GP Margin = 64.4% Oper Margin = 13.6%
March 2004: Sales = 3 375mil GP Margin = 62.0% Oper Margin = 8.8%
March 2003: Sales = 3 651mil GP Margin = 62.6% Oper Margin = 9.6%
March 2002: Sales = 3 860mil GP Margin = 64.2% Oper Margin = 13.3%
March 2001: Sales = 3 684mil GP Margin = 67.0% Oper Margin = 19.3%
Explaining the 5% drop in sales and depressed margin the March 2003 annual report refers to
To protect against the possibility of a slow down, conservative investors who want to isolate the “unlocking of the discount” can consider shorting one of the listed peers. The table below shows the quarterly changes in price of Richemont and TIF during the last slow down. As you can see, if a similar relationship holds, TIF should be a good candidate for hedging out economic and market risk.
CFR VX TIF
Sep00 19% 26%
Dec00 -17% -20%
Mar01 -16% -14%
Jun01 30% 27%
Sep01 -36% -37%
Dec01 6% 38%
Mar02 23% 18%
Jun02 -17% -2%
Sep02 -32% -38%
CREATING THE STUB
Richemont owns 19.3% of BAT which will be spun-off in q1 2008. To create the stub one should short 688 shares of BAT for every 1000 shares of Richemont.
For convenience, Merrills and UBS have created a stub which can be traded directly. For those interested I will provide contact details in the Q&A.
I am confident the spin-off of BAT should unlock the 20% discount and therefore recommend buying the luxury stub. The 20% return can be geared by shorting out one of the luxury goods companies that are trading at a premium. The latter strategy provides protection against a possible recesssion and market risk.
Catalyst
Spin-off of BAT in q1 2008