Tuesday, September 24, 2013

Swatch's Financials

Now, in this post, we get into the really nitty gritty details of investing: financials and revenue and margins and numbers and ratios. This is really the bread and butter of stock analysis which is also perhaps the most difficult part for most laypeople. As alluded to in the previous posts, I would usually like to pick up a few important numbers and ratios out of the financial statements. Most of the time, it would give a really good sense of how the company is doing. I have posted in details what all these numbers meant like a million years ago. You can find the old descriptions in the labels: Financial Statement Analysis and Financial Ratios. For your convenience, I have also added hyperlinks at the relevant paragraphs below. But for Swatch today, I would just do a quick commentary on what’s interesting.

Here’s an updated version of the cheat sheet that I would normally use. As you might be able to tell, I have added some colours and made it look prettier in order to compete with Serina Wee. I hope our beloved media will take some pics here too!

Swatch's Cheatsheet

First, let’s explain the structure. I have divided this table into a few parts, the titles for these parts are in red and underlined. The pure financials are PL, BS, CF. If you do not know what they stand for, I suggest you message Serina Wee on Facebook for a crash course, she would be able to help since she is a certified accountant and a devoted Christian. Of course, you should also make known to her that you will be joining City Harvest tomorrow and pledge 50% of your household income to support her wardrobe.

Well, short of pledging 50% of your income to support Serina Wee’s wardrobe, which isn’t really a bad thing since you will be doing a big favour to all Singaporean guys watching her strut down Supreme Court, you can read the posts I wrote a million years ago under the in the labels: Financial Statement Analysis and Financial Ratios. I just need a Like for my Facebook page on the right of this post.

You are most welcome :) Ok, jokes aside. So the financials are PL, BS and CF. The other segments are:

Stock related: which relates to stock information and the numbers used to calculate its valuation and the all important target price (TP) or intrinsic value.
Stakeholders: who are the big owners and managers of this company.
Comps: how does it compare with industry peers in terms of valuation.

So we see a bunch of no.s all over. I guess it would be easiest to focus on those numbers in blue. Basically these are derived numbers ie they are formulas in Excel rather than hard coded. What does it mean? Take dividend yield which is at 1.4%. It is simply DPS or dividend per share of CHF (Swiss Franc) 8 divided by its share price of CHF 587, ie no.s in blue are derived from other no.s in the spreadsheet.

So as you can see, Swatch is pretty much a top notch business. GPM or gross margin at 80% and OPM or operating margin of over 20%, these are some of the highest margins in any industry. Essentially, when you pay $10,000 for an Omega watch, the cost to produce it in the Swiss watch factory would only be $2,000. *Gasp!* That’s why the gross margin is 80%. Well, since OPM is 20%, it then means that the cost to do marketing like getting James Bond to wear it, putting it in a fancy retail store on Orchard Road and finally packaging it nicely in a wooden oak box, these add up to another $6,000, which is the difference between the gross profit and the operating profit. So Swatch only makes $2,000 at the operating level for every $10,000 Omega watch that it sells.

Then there’s the ROE or Return on Equity, which measures the growth rate of the business. For Swatch it’s 21%, another world-class number. How’s your salary increment this year? If I read the published stats, it’s about 5%? For every year that passes, the capital base in Swatch grows 4x faster than our salaries. So if your savings pool is large enough, you have to think really hard if you should work or you should just put all your money in Swatch. Well, that’s another topic. But even when compared to peers like Tiffany (ROE 16%) and Richemont (20%), Swatch’s ROE is still superior.

The other measure I like to look at is the FCF yield which stands for free cash flow yield. This is basically cash the business churns out after it has re-invested back in the business, divided by the market cap. So it means that if you buy Swatch now, it churns out 3% cash for you, in theory. In reality, it pays out 1.4% as dividends to shareholders. This two no.s then compares whether the dividend is sustainable. If you see a dividend yield higher than the FCF yield, it means dividend cut akan datang (or coming soon).

FCF yield of 3% is actually considered low in most circumstances which means that the stock is expensive. Cheap stocks give close to 10% FCF yield, like Microsoft or Apple, the maker of iPhone 5S, which stands for Same and 5C for which stands for Cheap. Even Singaporeans’ infatuation with the 5C dream would not save Apple. Tim Cook probably needs to seek divine help from Serina Wee.

So Apple 10% FCF yield vs Swatch 3% FCF yield? Shouldn’t we buy Apple? Things are cheap for a reason. Just comparing the plain FCF yields ignores the growth angle. Swatch has a sustainable ROE of 21% while Microsoft or Apple would probably see its ROE decline over time. This means that whatever cash Swatch’s business can churn out, that amount should grow at 21% per annum. For Microsoft or Apple, the cash churned out would decline over time. Hence it’s not really an apples-to-apples comparison (no pun intended :).

Now growing at 21% is powerful. Remember compound interest is the Eighth Wonder. This means that in 2 to 3 years, Swatch’s FCF yield based on today’s price is then 6%. And in 4 to 6 years, it would be 9%. That is not far from the 10% for the 2 loser techland dinosaurs described above. And Swatch's free cash flow will continue to grow after six years, into perpetuity as long as people don't stop buying luxury watches and diamonds.

Finally, we should talk about how we get to Swatch’s target price or intrinsic value of CHF 650. There’s no rocket science here. I simply used the EPS or earnings per share of CHF 36 multiplied by 18x. Why 18x? This is actually at the high end of what I would pay for. (I have advocated paying not more than 18x PE) But 18x should be justifiable for such a great franchise with strong growth, brand recognition and all the business moats we have discussed.

Now do take note that intrinsic value is just a number. The most important point about investing is the margin of safety. At CHF 587, the margin of safety is a mere 10%. Ben Graham, the father of value investing, would want 30%, so this is definitely not enough for him. But Warren Buffett also did say that if the business is great, not just good but great, then it’s ok to buy even with no margin of safety.

Investing is an art and I would leave it to you and your artistic talent to determine what is a good entry price for Swatch. For me, although I started the analysis and bought it way cheaper, I believe Swatch still offers upside at today’s price. I would advocate buying a toehold for now and if it falls, it’s a chance to load the truck! Hopefully we would make enough to fund Serina’s wardrobe in time!

PS: For those who have no idea who’s Serina Wee, where have you been dude? Here’s her pic below.
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