Description

Investment Summary

Our thesis is that after a decade of poor performance due to a series of macro/exogenous events Swatch Group is entering a period of recovery, sustained growth and significant margin expansion which will drive a rerating in the shares. H1 results published this morning (and the positive share price reaction) offer a glimpse of what’s to come.

Swatch offers exposure to the long-term defensive characteristics of luxury goods businesses at a substantial discount. Due to geographical and distribution channel differences vs peers, Swatch’s sales are about to accelerate materially while peers slow. In addition, as sales rise there is very substantial margin expansion potential that isn’t captured in market expectations.

Brief Background

Swatch Group is a key player in the oligopolistic luxury watch market. The majority of its sales and most of its profits are generated from high-end watch brands such as Omega, Breguet, Blancpain and others. In high-end jewellery, Swatch acquired the ultra-high-end Harry Winston brand several years ago. In addition, Swatch has some unique, differentiated brands in lower/accessible price ranges such Tissot, Longines, Swatch and Flik Flak.

Luxury goods stocks have re-rated over the last 10-15 years as investors have increasingly recognized the power and longevity of brands with a long (sometimes multi-century) legacy and the strong inherent pricing power.  Whilst creating new luxury watch brands isn’t impossible, the barriers to success are extremely high. Conversely, demand continues to grow along with wealth creation around the world and particularly in emerging regions while supply of high-end handmade watches is very constrained. Luxury watches are the key male luxury accessory.

Why Swatch?

• Latent covid recovery: Of the European luxury goods group, Swatch is most exposed to China and Chinese travellers. Last year, greater China sales were still down -20% from the FY19 levels. Chinese customers accounted for 32% of sales last year vs 45% in FY19, implying rest of world customers grew 12% vs FY19. If Chinese customers had performed in line with the rest of the world total group sales would have been 24% higher. With China now reopened and Chinese travellers gradually coming back there is significant upside to consensus sales expectations of +9% this year and +6% next year. There is already evidence for this with Swiss Watch Exports to mainland China +30% YTD and HK +26% YTD and Swatch’s own H1 results showing +18% ex-FX growth
• Least exposed to the US: Of the European luxury goods group, Swatch has the lowest exposure to the US. It is therefore less exposed to the consumption slowdown being experienced almost across the board in the US consumer space.
• Significant margin expansion opportunity: Swatch is a highly operationally geared business. Whilst gross margins have been hovering around the 80% mark, and marketing spend tends to be in the range of 14-16% of sales, the rest of the cost base is essentially fixed. It is comprised primarily of the retail and manufacturing footprint, both of which are highly strategic and inflexible. 10 years ago, Swatch’s operating margin was in the mid-twenties% with CHF8.5bn in sales. In 2014 margins started drifting lower after the slight negative mix effect from the Harry Winston acquisition and the beginning of the gifting/corruption crackdown in China.  By 2016, the operating margin contracted to 11% and earnings dropped 70% from the 2013 level as sales in China and to Chinese travellers in Europe declined >20%. Then, as things started to pick up again and the company initiated a cost base adjustment plan, covid hit and sales dropped >30%, crushing the margin. The sales recovery mentioned above, along with the more aligned cost base, will drive very significant operating leverage over the next couple of years. In the 1^st half of this year, the operating margin expanded 320bps over last year. This is further enhanced by the mix shift to own retail/DTC which in H1 already accounted for 40% of sales. Swatch own stores are far more productive than 3^rd party stores and the marginal contribution is significantly higher.
• Large net cash balance: Cash and financial assets at yr end were over CHF2.5bn or 17% of the current market. Historically, the company has returned excess cash to shareholders through dividends and buybacks and we expect the large increase in cash flow over the next couple of years will again lead to a significant buyback program.  
• Consensus numbers are much too low: current consensus expectations imply H2 operating margin down -85bps over last year despite the 320bps increase shown for H1. This is so ridiculous, management was laughing at it on the call today. Over the next 2 years, consensus expects sales to grow c.5% CAGR and margins to increase 80bps in total. We see a reasonable path to >CHF30 in EPS by 2025, 40% higher than current consensus.
• Massive valuation discount: Even on consensus numbers, Swatch trades at a massive discount to European luxury peers. Richemont, the other large listed luxury watch and jewellery group trades on 19.5x forward P/E while Swatch’s registered (superior voting)  shares trade on just 13x, a 33% discount. Adjusted for net cash balances, the discount is >40%. On more realistic estimates for Swatch growth and margins, the shares are on 8x forward P/E after adjusting for the net cash. LVMH is on 24x.

Common pushbacks:

• “Swatch deserves the discount because its performance has been weaker than peers”:

Actually comparing Swatch’s Watches & Jewellery segment to Richemont’s watch sales shows very similar performance over the past decade. In addition, the margin trajectory of Richemont’s Specialist Watchmakers Maison has also been similar to Swatch’s.

• “Swatch isn’t a pure play luxury group and the lower range brands are exposed to smartwatch competition”:

The vast majority of Swatch’s profits are from its high-end brands. In addition, among its lower priced brands, the most important ones, are far from commoditised products. The Swatch brand for example is a unique iconic brand that has a special place in the watch market that no one has been able to imitate. Tissot is also a highly regarded brand despite its lower range pricing. Smartwatches has been around long enough that any impact has already been absorbed

• “Swatch has always traded at a discount”:

Until the Chinese crackdown and margin compression problems began in 2015, Swatch traded broadly in line with its peers on valuation and in terms of stock price correlation. Since then it has underperformed by a wide margin. Since the start of the pandemic the underperformance was further exacerbated leading to the very large valuation gap discussed above. Our call is that the reversal of the sales and margin underperformance will lead to a reversal of the valuation gap.

Conclusion

Swatch is a high quality luxury goods company temporarily trading like an ex-growth value stock. Over the next 2-3 years we expect Swatch sales growth to accelerate driven by a recovery in sales to Chinese nationals, the effects of mix shift to own retail channels and continued mid-single digit annual price increases. This will drive significant margin expansion back to >20% from 15% last year. The strong operational performance in conjunction with increased shareholder returns through dividends and buybacks will bring a re-rating of the shares to around peer multiples, offering a total return of >100% over the next 2-3 years.

Catalyst

• Results
• Swiss Watch Export Data