Tuesday, October 23, 2012

Is Watchmaking a Good Business?

This post is a part of a full analysis of Swatch.

Swatch is in the business of making and selling watches. After determining its investment thesis and valuation, we must dive deeper into understanding its business better.

So is watchmaking a good business?

In the 1980s, most people would argue that mechanical watchmaking sucks. Who needs watches that require winding, maintenance and yet not as accurate as battery operated ones? The story of the demise and revival of the Swiss watchmaking industry is a fascinating one. I suppose you can find a much better version using Google, but for your convenience, let me just briefly summarize here.

About 40-50 years ago, there were no battery operated watches and the Swiss dominated the watchmaking industry. But the Japanese came along, with quartz watches (Seiko and Citizen) and pure battery digital ones (Casio) and virtually wiped out the Swiss watchmakers. Export volume plunged 80% and employment halved. It was a major catastrophe.

In the midst of the crisis, Swatch was born. It started combat with the Japanese from a different angle: cheap watches with bold designs and innovations such as very thin watches and a totally different time concept using decimals instead of hours and minutes. Then as it consolidated its mechanical movement making subsidiaries and acquired more brands, Swatch began reviving the mechanical watch industry by positioning themselves (and other Swiss watchmakers) as luxury items. Its key brand being Omega - the watch that went to the moon which is also wore by the world's most famous spy: 007. Swatch started viral marketing decades before the term viral marketing came about.

Today there are 50-100 brands in the mid to premium luxury mechanical watch segments (price range from USD 500 onwards) and Swatch has 18 of them, of which 3 of them: Omega, Breguet and Blancpain accounts for USD 3 billion out of these market segments which has an estimated global revenue of USD 20 billion . The top 5 players account for the bulk of the revenue as shown below.

Swatch: 6bn
Rolex: 5bn
Richemont: 5bn
LVMH: 2bn
Patek Philippe: 1bn

It is worth noting that Swatch, Richemont, LVMH and PPR (another luxury conglo with brands such as Gucci and Bottega Veneta) owns 45 or more watch brands out of the 50-100 top brands. In reality, counting all the smaller brands, apparently there are 400-500 Swiss watch brands altogether, so the Big 4 have roughly 10% market share in brand names (but it's 80% market share in value). Most luxury watch brands that we see are actually no longer independent such as IWC, Panerai (Richemont) and Tag Heuer (LVMH). New brands also aspire to be bought out by these conglomerates as it represents a windfall for the owners while adding firepower to the buyers. Obviously the two biggest mega watch brands: Rolex and Patek are still independent and privately owned. The other major independent brand is Audemars Piguet.

So how is this business now?

I would say that luxury watches continue to enjoy good secular growth driven by increasing no. of mass affluent households globally with the top few brands continuing to dominate given their high market share (Swatch 20%, top 5 players account for more than 80%) and mind share.

Swatch and the Swiss watchmakers have successfully hypnotize global affluent consumers to accept the inexplicable high values of Swiss watches. This is very similar to De Beer's campaign a century ago, "A diamond is forever". Well, we now know that a diamond is just a rock and definitely not in scarce quantity (it's carbon, one of the most abundant element on Earth) but yet we way overpay for them anyways. The proof of way overpayment: an industrial diamond costs a fraction of the one that sits on your wedding ring.

You see, branding is perhaps the most enduring business moat. Somehow consumers are wired to pay a premium for brands. This phenomenon ought to be studied deeply but I would argue that humans dislike unpredictability and adores familiarity since prehistoric times. A good brand brings about just that: familiarity and a promise that what you pay for is what you expect it to be.

It is said that babies can recognize the Macdonald's golden arches before they recognize other alphabets and even for ourselves, when we are on an overseas trip, in a foreign supermarket, we will buy the brands we know so well right? Why risk using local diapers or generic toothpastes?

Luxury brands obviously have that same appeal: it is a guarantee of a certain quality. On top of that, it is also a status symbol. For better or worse, we buy luxury items to show off. (Yucks but true.) For some, it's as loud as possible. For others, it's subtle and only the like-minded would appreciate. There is no way to justify luxury good purchases using a value philosophy. Value and luxury are opposite poles.

Watches lean towards subtlety. Only people who like watches can tell whether it's really expensive, or really really expensive. Of course there will be Rolexes that are all about flaunting but real watch lovers learn about movements, appreciate the intricacies of grand complication movements such as perpetual calendar (watches that can accurately tell time, day and date adjusting for leap years for the next 100 years) and world time (auto adjust when you are in different cities).

Swatch is the embodiment of all these as the largest player in retail sales and movements. It is in the business of building brands, with key competitive strengths coming from huge economies of scale and its distribution prowess.

See the first post on Swatch's investment thesis.

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