Description

Watches of Switzerland (WOS) is an authorized dealer of luxury watches (85% of revenue) and fine jewelry (7%). Over 50% of total group revenue comes from selling Rolex and up to 80% when including other luxury watch brands such as Patek, Audemars, Cartier, Omega, and Tudor, among others. We believe the shares represent a tremendous opportunity to acquire a special, misunderstood business at a deep discount to fair value.

Down over 70% from all-time highs, the equity is currently valued at 7x trailing normalized FCF. This depressed valuation is inconsistent with the company’s a) attractive economic returns (30% ROIC), b) conservative capitalization (net cash position), c) strong operating track record of 25% earnings CAGR since FY 2020, and d) recent financial outlook which calls for a more than doubling of revenue and EBIT by FY 2028 (essentially a 3-year outlook).

In our opinion, the news of Rolex’s acquisition of Bucherer, a leading Swiss retailer of luxury watches, is largely responsible for the market’s orphaning of WOS. We believe investors are misinterpreting this news as a signal of Rolex’s intentions to internalize distribution – effectively moving away from a century-long dependence on 100% third-party distribution, or, at the very least, to favor Bucherer in its supply allocations moving forward. We think these concerns, while understandable at first blush, are overblown and fail to withstand objective analysis. As such, we believe the sell-off has created an asymmetric risk-reward opportunity in WOS shares.

As a starting point, Rolex plans to have no involvement in Bucherer. “There will be no operational involvement by Rolex in the Bucherer business. Rolex will appoint non-executive Board members. There will be no change in the Rolex processes of product allocation or distribution developments as a consequence of this acquisition.” This was the statement issued by WOS in concert with Rolex following the deal announcement. This message, nonetheless, did not assuage investor concerns. WOS shares declined by 30% on the day of the announcement. 

Based on our calls with industry personnel, Rolex’s acquisition of Bucherer was defensively motivated. As background, at the time of the deal, Jörg Bucherer, the third-generation head of the retailer (now deceased), was dying and had no succession plan. To prevent the business from being sold to private equity and/or a competitor such as Richemont or LVMH, Rolex stepped in. The acquisition rationale was to avoid disruption at one of its most important distribution partners. The Rolex-Bucherer relationship dates back to 1924.

The notion that Rolex is trying to internalize distribution via Bucherer is unfounded and nonsensical. Up until now, Rolex has fully relied on a vast, fragmented network of third-party retailers for distribution. Bucherer, which happens to be one of the larger Rolex dealers globally, represents roughly 5% of Rolex's revenue.  Not only is Bucherer merely a small fraction of Rolex's distribution, but its retail network is concentrated geographically, particularly in Switzerland. Rolex, however, is a global business. This issue of fragmentation is unmistakable in examining two of Rolex’s most important markets: a) in the UK, the largest luxury watch market on a per capita basis, Bucherer has less than 5% Rolex share while WOS has over 40% share; and b) in the U.S., the largest and fastest-growing luxury watch market on an absolute basis, Bucherer and WOS both have less than 5% share, yet are the two largest players in the market. Rolex could not vertically integrate its distribution by consolidating its supply through a geographically concentrated retail network that accounts for 5% of worldwide sales.

Further complicating its ability to theoretically internalize distribution is the fact that Rolex does not permit online transactions, solely relying on brick-and-mortar retail. However, the company’s current retail locations are secured under long-term leases by its partners, impeding Rolex from entering the market in any meaningful way with haste. Recreating this retail network would take decades and require billions of investments, not to mention would subject the company to elevated levels of operational risk, which could hurt the brand.

Perhaps if Rolex was intent on shrinking its business dramatically such a transition could be possible over time.  When Audemars Piguet began to meaningfully internalize distribution, it was selling roughly 40k units annually. Rolex, however, not only sells over 1.3mm units annually but plans to increase its production capacity by 60% by the end of the decade. This transformational increase in volume increases the importance of its extensive retail network needed to absorb and thoughtfully allocate this supply. When considering these facts, the argument that Rolex is interested in fully vertically integrating its distribution by acquiring Bucherer appears ludicrous.

But what about the notion that Rolex will now favor Bucherer? We think doing so would run counter to its most important consideration: long-term brand preservation. Since retailers control the customer experience, which in turn influences brand perception, it’s in Rolex interest to ensure that its distribution partners feel treated equitably within the network. Culturally, Rolex, which is owned by a charitable trust, is not the type of organization that is motivated by short-term profit maximization. Besides, allocating better and/or more inventory through Bucherer to capture more profit margin would not have a material financial impact. Non-Bucherer doors still account for 20x more revenue than Bucherer does. It simply does not move the needle.

In reality, Rolex has been deepening its dependence on a consolidated set of trusted, well-capitalized retailers, a paradigm that has and will continue to benefit WOS. In the U.S., Rolex had roughly 2,000 points of distribution in 2008. There are less than 300 doors today. We understand that Rolex has intentions to further rationalize the network, which is likely to come at the expense of smaller dealers who do not have the capital to invest in the retail experience to the degree of players like WOS. As such, ongoing agency consolidation should benefit WOS by removing competition and thus funneling more supply through its doors. Based on our channel checks, WOS is viewed as one of Rolex’s most important retail relationships. This can be appreciated by Rolex’s decision to endorse WOS’ entry and consolidation activity in the U.S. Since entering the market in 2017, WOS has been aggressively acquiring incumbents and expanding/upgrading Rolex's presence via de novo developments and renovations. Based on its robust Rolex development pipeline in both the U.S. and the U.K., inclusive of the new European flagship on Bond St. among many other high-profile projects, as well as its launch of Rolex Certified Pre-Owned (CPO), WOS’ relationship with Rolex appears to be strengthening – contrary to investor fears. 

At present valuation, the market is implying WOS’ business model is at serious risk of disintermediation. We think this assessment couldn’t be further from the truth. If one can appreciate that the bear thesis is without merit, it’s easy to see that being a retailer for the likes of Rolex, Patek, and other prestigious watch brands is an exceptional business. These distribution relationships are often the product of multiple generations. WOS has over a 100-year history with Rolex, for example. These heritage relationships cannot be recreated by a would-be competitor seeking to become an authorized dealer for Rolex – no matter what its financial resources.  This intangible asset is the competitive moat around the business. Not only are there no new dealers, but brands have been aggressively consolidating points of distribution, as discussed. Further, the most prestigious brands deliberately restrict production volume to ensure a supply-demand imbalance. The consolidation of retail doors against a backdrop of restricted volumes creates supply scarcity, which translates to highly favorable operating conditions for the likes of WOS.

WOS has essentially earned the privilege of being able to surf the demand wave behind some of the most timeless and coveted luxury watch brands and earn its fair share of economic rent in the process. WOS’ business model has many special characteristics: 100% full-price sales, high revenue visibility due to muti-year customer wait lists, minimal marketing expense, strong inventory turns – 3.0x across all watches and jewelry and over 10x for the top watch brands (i.e., Rolex), negative working capital (60-day payables), and limited capital intensity with no warehouses (goods are shipped directly from the manufacturer to the store where they are vaulted). These attributes result in a highly predictable, very profitable (20% store-level margins), and capital-lite business model that generates attractive returns on invested capital.

While WOS is currently contending with an air pocket in UK demand (60% of revenue) post several years of above-trend growth, the U.S. business (40%) continues to support double-digit revenue growth (40%). More importantly, the medium-term outlook remains promising due to industry and company-specific growth vectors. As an industry, luxury watch sales have proven resilient and healthy, sustaining a high-single-digit CAGR through economic cycles driven disproportionately by price vs volume. Notably, WOS has been able to greatly exceed the rate of industry growth through its brand-supported growth initiatives: a) showroom renovations/expansions that result in more supply allocation; b) de novo developments of mono-brand and multi-brand showrooms; and c) acquisition of authorized dealers and subsequent improvement of business performance.

After having outperformed its FY 2021-2024 Long Range Plan, management recently provided new long-term guidance that projects a more than doubling of revenue and EBIT by FY 2028. At its recent Investor Day, management detailed its multi-year project pipeline with Rolex as well as other brands. This pipeline provides high levels of visibility into future growth at attractive ROIC. Additionally, the company plans to spend $300-$400 million in M&A funded by internally generated cash flows in an effort to consolidate the U.S. market and more meaningfully expand in Continental Europe – dual efforts that have received the blessing of Rolex. We would note that these deals have historically been effectuated at attractive post-synergy multiples (low single digits). As WOS continues to expand its footprint both organically and inorganically in parallel with same-store growth, group operating margins (10% +/-) should expand as store-level economics (low-teens EBIT margin) are leveraged across a largely fixed corporate expense structure.

In aggregate, we estimate that FCF could compound at over 20% annually through FY 2028. With the business being valued at 7x trailing normalized FCF, we think this earnings stream is grossly mispriced given the quality of the business and the opportunity for reinvestment at high rates of return. Conservatively, if we apply a 12x multiple, we think the shares could be worth over $1,000 pence in two years, with significant upside if the multiple re-rates to more appropriately reflect the attractiveness of the business model and durability of the growth outlook.

Catalyst

Removal of Bucherer overhang with continued execution.