Description
Introduction:
I believe that the Swatch Group represents a compelling opportunity to own a Company with a wide moat trading at an attractive valuation due to a recent sell-off resulting from concerns about the Hong Kong Protests and the introduction of the Apple Watch in 2015. Further, you are investing alongside a group of owner operators with a large stake in the Company and who have allocated capital well in the past.
Business Overview:
Swatch Group (“Swatch”, the “Company”, or “UHR”) is the largest global watch manufacturer with market share of ~18% of the global watch market. Swatch owns an enviable variety of Swiss watch brands, including Omega, Breguet, Tissot, and Swatch. The Company also owns the iconic retailer, Harry Winston. The Company is based in Bern, Switzerland. Many of its brands have been around for over 100 years.
Most of the Company’s income is generate by its prestige & luxury watches, while 85% of its income is generate by high end watches and prestige & luxury watches. High end watches are price around $900, while prestige and luxury watches average almost $4k per watch.
Operating Profit by Watch Category
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Prestige and Luxury Watches
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55%
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High End Watches
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30%
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Middle Range Watches
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12%
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Low Range Watches
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3%
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The Company’s leading brand is Omega, which traces its history back to 1848. It has been worn by JFK, James Bond, and Neil Armstrong wore it on the moon. It is the second largest Swiss watch brand behind Rolex.
Operating Profit by Brand:
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Omega
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44%
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Longines
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23%
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Tissot
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10%
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Rado
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7%
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Breguet
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7%
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Swatch
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3%
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Other
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5%
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The Company sells its products through independent jewelry stores and its own branded stores. Its largest markets are China and Europe.
The Swiss watch industry represents 54% of all watches sold in terms of value, but less than 3% of volume. The Swiss Watch industry has grown at a 6% CAGR since 2000, primarily driven by growth in emerging markets, especially China.
Operating Profit by Geography:
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Switzerland
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13%
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Other Europe
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21%
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China
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38%
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Other Asia
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18%
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America
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8%
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Oceania
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1%
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Africa
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1%
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The Swiss Watch industry is characterized by limited price competition from the following major companies, (i) Swatch (18.3% market share), (ii) Richemont (15.7%), and (iii) Rolex (11.8%). There hasn’t been a major watch brand emerge since the 1980s when Casio and Seiko began taking market share from the Swiss Watch industry with electronic watches. Since that time, the Swiss watch industry has re-focused on the higher end of the market, while Asian competitors focus on the lower end of the market. Swiss watches are not purchased for their functionality, but instead as a status symbol. Consumers typically purchase watches on the basis of brand, quality, and fashion (however, fashion cycles are much longer than in apparel).
One of the reasons the stock has fallen is concern over the introduction of the Apple Watch in 2015. Many worry that the industry will face the same level of disruption that it did when Casio and Seiko caused Swiss watch volumes to decline by over 50%. However, this analysis misses the fact that the Swiss Watch industry of the 1970s is very different than the one of today. Back then, much of the volume decline was caused by functional users switching to cheaper watch alternatives. Today, no one is buying a the Company’s high-end watches to know the time, but instead they are buying them as a fashion / status symbol. In fact the Swiss watch industry has only recovered to 60% of its prior peak in terms of volume, but is thriving due to its focus on luxury. Further, as I will discuss in the valuation section, I believe you are buying at a large discount to intrinsic value of the Company, and even if the Company lost all profits except for its luxury brands, you would be paying approximately fair value for the Company.
Also, the Company has a dominant market position in Swiss movements, or the moving parts that actually make the watch function. The Company is slowly seeking to wind down sales to outside companies, which will impair competitors’ ability to take market share from Swatch, especially given that labeling a product as Swiss Made requires that a certain percentage of costs are incurred in Switzerland.
Management:
In the early 1980s, Nicholas Hayek (a Swiss restructuring consultant) was asked by a group of Swiss bankers to oversee a liquidation of ASUAG and SSIH, two Swiss watch-making firms which were in turmoil due to heavy competition from Japanese watch manufacturers such as Seiko and Citizen Watch. Hayek believed that the Swiss watch manufacturing industry could remain competitive and that ASUAG/SSIH could recover after a restructuring of operations and a repositioning of its brands.
The restructuring of the companies coincided with the invention of the Swatch watch which used far fewer parts than traditional watches thus was cheaper to manufacture. The Swatch watch helped the Swiss watch industry reconquer a large share of the lower end of the watch market which it had lost to Japanese makers.
Having spearheaded the reorganization of ASUAG and SSIH for more than four years, finally bringing about their merger, Hayek, with a group of Swiss investors, took over a majority shareholding in the combined companies in 1985. He became Chairman of the Board of Directors and Chief Executive Officer in 1986. The Company later changed its name to Swatch Group.
In 1995, Hayek's daughter, Nayla Hayek joined the Board of Directors of the Swatch Group and in early 2010, she became co-Vice-Chairman of the Board. In 2003, his son, Nick Hayek, Jr. became the CEO of the Swatch Group. Hayek remained Chairman of the Board of the Swatch Group until his death. On 30 June 2010, two days after his death, the Board elected Nayla to replace him as Chairman.
The Hayek’s own ~25% of the Company valued at ~$5.3bn keeping them very aligned with shareholders. While they draw a salary and there are some related party transactions with the Hayeks’ consulting firm, the fees and salaries are dwarfed by their common equity stake in the Company.
Management has done an excellent job of returning capital to shareholders, returning ~75% of cash flow to shareholders over the past three years and ~70% over the past ten.
Valuation:
Swatch trades at a significant discount to its luxury brand peers despite having higher margins, lower debt, and I believe a wider moat.
|
Company
|
EV / EBIT
|
EBIT Margin
|
Debt / EBITDA
|
|
LVMH Moet Hennessy Louis Vuitton SA (ENXTPA:MC)
|
12.0x
|
19.9%
|
1.3x
|
|
Ralph Lauren Corporation (NYSE:RL)
|
12.3x
|
14.8%
|
0.4x
|
|
Compagnie Financiere Richemont SA (SWX:CFR)
|
13.1x
|
22.7%
|
0.6x
|
|
Hermès International Société en commandite par actions (ENXTPA:RMS)
|
18.6x
|
32.8%
|
0.0x
|
|
Burberry Group plc (LSE:BRBY)
|
13.6x
|
19.1%
|
0.3x
|
|
Ernest Borel Holdings Limited (SEHK:1856)
|
18.0x
|
19.9%
|
1.3x
|
|
|
|
|
|
|
High
|
18.6x
|
32.8%
|
1.3x
|
|
Average
|
14.6x
|
21.5%
|
0.7x
|
|
Low
|
12.0x
|
14.8%
|
0.0x
|
|
|
|
|
|
|
The Swatch Group AG (SWX:UHR)
|
9.3x
|
26.1%
|
0.0x
|
Further it currently trades at a 30% discount to its 10 year average EV/EBIT multiple.
Risks:
1. Apple Watch: As discussed earlier, many analysts believe that the Apple Watch will disrupt Omega. Given its price point ($350 - $1k) and value proposition (functionality versus status), I believe it only has the potential to disrupt the brands outside the luxury / prestige brands. Even if it lost all of profitability from the low end and middle range watch brands, it would trade at 10.9x EBIT compared to peers at 14.6x.
2. Rising Inventory: Inventory has been rising causing many analysts to believe the Company is producing and will need to liquidate inventory at lower prices later. I view this as less of a risk than they do because (i) there is low technological obsolescence risk in the inventory and (ii) when comparing the Company to peers, you need to take into account the Company’s movements business, which is a material amount of the inventory.
3. China Slowdown: A china slowdown is obviously a risk, but the Company doesn’t have much growth priced into the stock, as it trades at 13x EPS.
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
Fears of China slowdown abate
Moat increases