Activist Targets Swatch!

This post first appeared on 8percentpa.substack.com

Today, we would like to discuss Swatch. We have looked at Swatch for donkey years and wrote a tonne of materials about it. See below:

https://8percentpa.blogspot.com/search/label/Swatch

Since then, share price underperformed big time. To us, there is no surprise that an activist came in and now trying to shake things up. It might be interesting to do more research now and perhaps add this to the portfolio.

This post will not be a full analysis. More like a preamble. We will keep this short and sweet for now. Provide a brief background, tell the activist’s story and how the founding family reacted and set the stage for the bigger analysis.

Here we go!

1. Background

Swatch Group (Market Cap USD8.9bn, EV/EBITDA 8.8x), while being known for its plastic, colourful, quartz wristwatches for kids and youngsters, is actually a watchmaking conglomerate. Swatch owns Omega, with all the heritage - worn to the moon and all, which could have become a premium luxury watch brand like Rolex, but that did not happen. It also owns both mass-tige and high end watch brands like Longines and Breguet amongst others.

Swatch x Omega, the solar system collection

In 2013, Swatch bought jewellery brand Harry Winston as one of the early steps to compete against LVMH, the world’s largest luxury player and also its arch-nemesis, Richemont. While it created much hype back then, management did not follow through. Supposed synergies and growth did not come and Swatch’s growth stagnated and free cashflow generation also collapsed.

Meanwhile, LVMH became Europe’s largest company by market cap (only recently overtaken by Novo Nordisk) and Richemont double its market cap to almost CHF100bn, which is 10x bigger than Swatch over the 10-15 years.

 

Swatch’s overview, thanks to Finchat.io.

In the same time period, Swatch’s market cap more than halved. Its financial ratios became pretty dismal, as we can see above. Both ROE and Operating Margin are at 4+%. Price-to-Book is at 0.6x. The founding family, with two generations of family members running the business and owning majority of the company, are burying their heads in the sand, resisting advice.

Under its founder Nicholas Hayek, Swatch used to be a FCF generating machine. But after he passed, mis-management has caused FCF to turn negative. This was the result of declining margins, ballooning of its inventory (unsold watches) and increasing capex.

FCF from macrotrends.net showed that Swatch’s 2023 FCF was negative…

Swatch also has CHF1.4bn in net cash, which together with its inventory of CHF7bn, amounts to more than its market cap. In fact, Swatch recently met Ben Graham’s Net Net (Current Asset - Total Liability > Market Cap) criteria. Which is somewhat unthinkable for a luxury company.

2. Activist’s Side of the Story

As such, activists found this name. Steven Wood of Greenwood Capital, owning 0.5% of Swatch, called out Swatch’s management. He would like to see the company engaging shareholders and asked for seat on the board. As expected, Swatch’s management poo-pooed him and voted down his request for a board seat.

However, it seemed unlikely that this is the end of the story. For the share price to collapsed so much to become a net-net, it seemed difficult to justify Swatch has done a lot of things right. There is definitely room to improve margins, ROEs and to think about the six point plan (below) that Mr Wood has raised.

1. Breguet: Improve the retail experience, add personalization programs at scale, reduce the wholesale channel variety and improve residual values. We believe these steps can make Breguet once again king of the Swiss watch industry.

2. Harry Winston: Emphasize the brand’s core design elements through annual collections that both reinforce the icons and the exceptionally rare jewels that the group is known for. With annual collections taking the opposite approach as Van Cleef and Arpels, the goal is to replicate Hermès Birkin playbook for unoccupied ultra-high-end jewelry industry.

3. Omega: Increase collaborations to expand the collection, and target audience. A key priority is to add new collaborations, staying true to the brand’s core DNA but aimed to make the brand more relevant with Gen Z. Utilize what’s working and “hot” in the vintage market to inform new design trends and take a few more risks with selected exclusive editions.

4. Capital Markets: Strengthen perception and credibility of the company in the capital markets and media by creating an offensive narrative, as opposed to letting others define the company’s story. Continue to increase transparency and add an entrepreneurial Investor Relations officer to help management stay focused on the business. By regaining a more rational valuation, this will improve stakeholder perceptions of organizational culture, lead to higher employee satisfaction, higher productivity, ultimately benefitting all stakeholders.

5. Brand Marketing: Increase marketing spend, funded by removing overhead burden, to double-down on storytelling for the incredible historic brands and ongoing innovation within the group. Remove layers in between founding family, executives and the company’s core employees of doers, sellers and inventors.

6. Technology Innovation: Expand the group’s innovations across the portfolio brands by layering in technology into replaceable and upgradeable bands.

Courtesy of https://www.watchpro.com/activist-investors-six-point-plan-to-strengthen-swatch-group/

2. Founding Family Strikes Back!

Alas, the founding family is not interested. They believe they know their business best. They would say it was because of China. Once China recovers, all will be good. They believe analysts and investors know shit and so, while they own >50% of the company, it is difficult to see how things could change.

The rest of the post is on 8percentpa.substack.com

Swatch’s Everything (including Serina Wee)

The first Swatch post started in Sep 2012. After 15 months and 8 posts, I am still not done! It’s a marathon competition against the City Harvest trial to see who can last longer. But City Harvest would win the popular vote I guess, with Serina Wee, Singapore's prettiest accused criminal. All Singapore straight guys are just jumping around and can’t wait to see her strut down Supreme Court again in January. But, this blogger would not go down without a fight to win the popularity contest.

Here’s a pic of Serina Wee.

Ah! My eyes… No… Sorry, paisei, sala pic. You can see Serina at the end of the post :)

Anyways, 15 months! That’s too long a time to do a trial, sorry I meant an analysis. So, this is the post that shall end it all. It must be stressed that a good analysis need not take 15 months. Warren Buffett does his in two days. For the rest of us mere mortals, I would say we might be able to do it in a week or two if we put our minds to it? Anyways, sometimes you don’t really need to know 100% or even 90% of the company. Just know the few key drivers.

For Swatch it would be their retail expansion/distribution strategy, the reform of Harry Winston and in the longer run, succession planning. I have discussed these in the previous Swatch posts and Harry Winston would be discussed below.

Do take a look at my work on 3M and Colgate as well to get a feel.

Today we shall cover the rest of the stuff with Swatch. The key remaining components are: Industry and Geography Exposure, Harry Winston (a new topic), Risk and Mitigators and the final questions.

First stop: Industry and Geography. These are no.s that an investor would like to look at. For Swatch I have decorated them into the nice pie charts below. Take that! Serina!

On the left chart, you can see that China and Asia are the key sources of earnings for Swatch. It is worth pointing out that a big part of the sales in Europe is also driven by Chinese and Asian tourists. On the right chart, needless to say, watches and jewellery would be the main contribution. But what is more useful could be the further splits into watches vs jewellery and the split between manufacturing vs retail.

Another important split is by its brands. It should be highlighted that Omega is by far the most important brand for Swatch generating 35% of sales and 40% of EBIT. EBIT is short form for Earnings Before Interest and Tax, also known as Operating Profit. It is the most important line in the P&L statement.

Some of these no.s would not be easy to come by. It would take a lot of reading (of annual reports and analyst reports) to figure them out. Sometimes it’s best to be able to ask someone, like an analyst or the investor relations of the company. But that is not usually an option for retail investors. So for really serious investors, we might want to think about setting up a company if only to gain access to more information.

Next topic: Harry Winston.

Swatch bought over Harry Winston in 2013 with USD 1bn to further its reach. As luxury watches are a very men thing, Swatch is deemed as not capturing the women’s market. With Harry Winston, a niche jewellery brand, Swatch can further increase its expertise both in retail and in nurturing the women’s segment and can also perhaps carve out some synergies with its existing businesses in the future. Harry Winston made sales of US 400m or so with 5% operating margin before its integration with Swatch. Compared to Swatch’s own margin at 20%, there is some room for Harry Winston to improve. Nayla Hayek, the Chairwoman for Swatch will become the CEO of Harry Winston. Hopefully she can put some of her magic to transform and synergize Harry Winston.

Every investment has its risk and we need to be able to identify the 1 or 2 key risk factors and hope to be able to mitigate them. For Swatch, the biggest risk is the anti-corruption clamp down in China. This risk turned out to be a far greater threat than was previously thought as 2013 panned out. It impacted everything from flowers to hard liquor to even mooncakes! And right in the middle of it was luxury spending on watches. You see in order to do business in China, a lot of time and effort is spent taking officials and important counterparties to places, buying gifts and stuff for them. When Xi Jin Ping took over, he wanted to clean up this corruption issue in a big way. So a lot of these gifting was stopped, elaborated parties were cut down. Fresh flowers were not needed at banquets anymore. Mooncakes as gifts for officials were banned too. Swiss luxury watches bore the brunt of the blow. In the past, gifting someone a Swiss watch was one of the best ways to open doors. But now that it was banned, sales plummeted.

The Omega Speedmaster, also known as the Moon Watch.
It was first worn on the moon by Buzz Aldrin on the Apollo 11 mission.

Well, actually, this risk is now almost behind us. What was the mitigating factor? It's the rising middle income class. Swiss watches are part of the aspiration package as the number of middle income families increases globally. The family needs a nice car, which over time gets upgraded to a luxury German one. The mother starts buying high end fashion and jewellery. The father buys a luxury watch and in time buys more for his kids or passes down the old ones and buy new ones. It is a rite of passage for many modern countries, including Singapore. Well for some, it goes further, like launching a music career for the wife while siphoning money from a church, in the meantime engaging a beautiful accountant to do the dirty work. (yes yes piccoming... at the end of the post.)

So, since we will see the rise of the middle income not just in China but globally in the next few decades, the story for Swatch should remain intact after the Chinese government harvested all the bad seeds from this anti-corruption saga. (No City Harvest pun intended :)

The final questions refer to the last few that was listed on the Stocks Page ie "Is there a Second Level Thinking angle here?" or "Can I sleep well at night?" These are part of a sanity check that investors should always bear in mind. Usually there won't be easy answers. Esp for Second Level Thinking. Swatch is a luxury brand and will continue to be one. The angle could well be what's been described above: instead of worrying about anti-corruption, we should be seeing the rise of the middle income class.

As for sleeping well at night. I would say that if you bought the stock and it's been too volatile and you are not sleeping well because of that, then please sell it. Life is too short to brood over a stock. But if you are not sleeping well because you are too excited that you can see Serina in a few weeks on Straits Times, sorry I have no advice for you. Maybe go join City Harvest? Haha... just joking.

As promised, we have come to the end of our analysis of Swatch, so here's her "melancholy look" pic snapped from Google. Stop drooling please.

Do also take a look at my first post on Swatch.

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.
 

Singapore's hottest accused criminal

Swatch's Management

Swatch Group came about via a series of mergers around the time of the near death experience of the Swiss watch industry in the early 1980s and was finally helmed by this legendary guy called Nicolas Hayek, a Lebanese who later became a Swiss. His kids, Nick Junior and Nayla Hayek - a brother and sister tag-team, run the Swatch Group today. Nick Senior passed away in 2010 but he created a lasting legacy by rescuing and reinventing the whole Swiss watch industry.

Nick started his own management consulting firm called Hayek Engineering in the early 1960s and became very successful in consulting and helping to turn around ailing companies all over Europe. Hayek Engineering corporate philosophy embodies Nick’s belief that an entrepreneur is essentially an artist. This is not different with investing which is also an art. Also, an investor should also manage his portfolio with an almost artistic creativity to make outsized returns.

In Nick's own words,

An entrepreneur is first of all an artist, full of fantasy and inventions. He or she needs to be able to communicate, be open to new ideas and able to question everything. – Not only our society but also oneself. An entrepreneur ought to be captured by the beauty of and sensitive to the outcome of our planet. This attitude does not only allow him or her to create new products and more jobs, it also allows for the creation of true values and riches for all people. It is also necessary if one wants to overcome all obstacles using courage and fantasy…

This is how Nicolas Hayek approached entrepreneurship and by 1979, Hayek Engineering had 300 clients in 30 countries and Nick was well regarded as a true entrepreneur and on top of that, a teacher to other entrepreneurs. Today the company still exists as a niche consulting firm headed by Nayla Hayek, Nick’s daughter.

So that was all before Nick got involved in Swatch. Then, in the early 1980s, the onslaught of the cheap Japanese quartz watches drove the mechanical Swiss watch industry to the brink of bankruptcy. A lot of watchmakers and their movement companies were going bankrupt. At age 52, Nick was roped in to oversee the liquidation of two of these companies: ASUAG and SSIH but he thought and decided there could be a way out for the Swiss watch industry.

At the same time, Swatch was created by a group of entrepreneurs led by another guy called Ernst Thomke who was also trying to rescue ETA, a very important Swiss watch movement company. Nick then joined hands with Ernst and a group of investors to form a Swiss watch giant called SMH, which later changed its name to Swatch Group.

Swatch Group today is an integrated watchmaker producing 50% of the world's high end mechanical watch movements and owns a slew of brands including Breguet, Harry Winston, Blancpain, Glashütte Original, Jaquet Droz, Léon Hatot, Omega, Tiffany & Co. (watches), Longines, Rado, Union Glashütte, Tissot, Calvin Klein watches and jewellery, Balmain, Certina, Mido, Hamilton and needless to say, Swatch.

On its website, Swatch also lists all its production companies. Some of which are critical to the development of the human race. Like Nivarox-FAR, one of Swatch Group companies that produced the world's smallest springs and gears for impeccably accurate time-keeping in mechanical watches.

Swatch Group production companies
ETA, Nivarox-FAR, François Golay, Comadur, Rubattel et Weyermann, MOM Le Prélet, Universo, Manufacture Ruedin, Simon Et Membrez, Lascor, Novi, Swatch Group Assembly, DYB, EM Microelectronic, Renata, Micro Crystal, Oscilloquartz and Swiss Timing.

We already know the turnaround story. Swatch was driven by innovation: funky, fashion styled cheap watches that managed to beat the Japanese in their own game. Nick’s masterstroke came with the re-positioning mechanical watches as luxury products. The Swiss mechanical watch became a symbol of art, a reflection of the owner’s appreciation of craftsmanship, a mark of personal achievement, a family heirloom and everything else (including a status symbol, a wealth flaunt and a bragging right). It worked. Swiss watches became the luxury item of choice for successful men and now women as well. A multi-billion dollar industry was born.

Today Nick Jr is the CEO and Nayla is the Chairwoman of Swatch Group. While lacking the larger-than-life charisma of their father, both brother and sister are respectable business people in their own right and have created value for shareholders. Nick Jr seemed to be very interested in movies and his profile says nothing about his achievement in the company. But as CEO of the Group, he holds his own ground and his views on the watch industry and the Chinese consumer are highly sought after. Nayla appears to be the more serious and capable of the two and she recently took on an additional role as the CEO of Harry Winston, the newly acquired diamond ring and jewellery specialist.

The following is a picture of the Chairwoman of Swatch Group and CEO of Harry Winston.

After she became the CEO of Harry Winston, she decided to help a Singapore church pastor and his tone-deaf wife launch a Hollywood music career by siphoning some money from the church fund. Since she was an accomplished accountant, this was child's play to her. She successfully did so for seven years until the whole scheme was found out by the authorities. This picture was taken as she attended court hearings.

Ok just kidding. For the un-initiated, that's Singapore's hottest criminal-in-question Serina Wee who is currently involved in the City Harvest saga. Apparently, she is so hot she singled-handled converted the courtroom to Christianity.

So much for jokes. Let's get back to Swatch. The following is a real picture of Nayla Hayek.

Nayla Hayek, Chairwoman of Swatch Group

Well, she would have rivalled Serina in her younger days. At 62 today, she and her brother are diligently continuing their father's legacy. They have managed to surround themselves with very capable people: PhDs, lawyers, engineers and MBAs to help them run the Swatch Group. It suffices to note that they have not done anything drastically detrimental to shareholders and should continue to help us grow the company in the foreseeable future. Together the Hayek family still owns 20% of Swatch and their interests are aligned with the minority shareholders.

Swatch's distribution

Well we should get back to Swatch after a few digression. So this is a continuation on the full fledge analysis on Swatch. Today we look at the distribution prowess of the company.

Swatch has 900 point of sales from its directly operated stores but these stores generate only 20-30% of sales for its watch division. The remaining 70-80% comes from its distributors and other 3rd party sellers. This is much lower than Richemont or LVMH, its key competitors at 50% or more sales coming from their own stores.

Here is a quick breakdown of the 900 stores:

Mono-brand stores
Swatch 600
Omega 260
Blancpain 30
Breguet 22
Jaquet Droz 6
Glashutte Original 5

Multi-brand stores
Tech Airport 40
Tourbillon 21

Most of Swatch's retail operations are actually in Europe, some airports and major retail outlets while others are in major global cities such as New York, Hong Kong, Singapore etc. Control over distribution has grown in importance in the last decade and Swatch has lagged in this aspect since it had strong history as a watch manufacturer with its watch movements business, not a retailer. Also, it did not have enough key brands to muster a formidable retail strategy, unlike its peers. That was partly why it wanted to buy over Harry Winston, a high end jeweller.

However, Swatch has now emphasized the need to expand directly operated stores so as to be able to get closer to the end customers, understand their preferences better and also have a better grasp on inventory. Not to mention, posh retail outlets are one of the best ways to market luxury brands, which is why we see megabrands like Louis Vuitton and Tiffany go all out to create the grandious stores in major shopping malls all over the world. To that end, Swatch has committed USD 400-600m (CHF 300-500m) in capex for the retail expansion annually. (Note: these no.s are before the acquisition of Harry Winston)

As a result of its smaller retail operations hitherto, Swatch has relied more on distributors to sell its watches. These are the Sincere Watch and Hour Glass that we see in Singapore. But more importantly for Swatch are its distributors in China: Hengdeli and Emperor Watch. Hengdeli has close to 1,000 stores in China while Emperor has a few hundred stores.

These distributors have allowed Swatch to expand rapidly into China at the expense of Swatch giving up the distribution margin. More importantly it has also allowed Swatch to hold less inventory and hence free up its working capital for investment into its movement and other businesses. Insofar, it looks like the strategy paid off with Swatch commanding a higher market share in China while its competitors Richemont and LVMH tries to play catch-up and are still building retail operations.

The next battle for Swatch is for the firm to claw back part of its distributor margin (est to be around 15-25% judging from Hengdeli's and other distributors' gross margins). However this will require time and capex but ultimately it should pay off with the benefits listed earlier (better inventory management and better customer understanding).

Having said that, distributors will still exist side by side as Swatch and other watch makers would still need them for nurturing new brands (the up and coming Omegas and Tag Heuers) and also their presence in inner cities and regional airports etc. With 20% of the global luxury watch market, the distributors cannot afford to ignore Swatch even if the firm decides it should distribute its megabrands (Omega, Breguet) by themselves.

This dual distribution model is one of Swatch's most enduring business moats as new players find it hard to engage distributors like Sincere or Hengdeli with a value proposition that Swatch cannot offer. On the other hand, the new players are also incapable of building up huge retail operations like LVMH and Richemont. So new entrants are almost a non issue.

How does Swatch compares with other branded competitors then?

As alluded to before, Swatch is playing catch-up by building up the retail stores as it sees the value of engaging customers at the last mile. One key difference is that Richemont and LVMH are both conglomerates with businesses that stretches far beyond watches. LVMH has bags and champagne while Richemont has jewellery and pens. Swatch has always been the watch company and by focusing on its strength, it should be able to compete on an even scale in the world of watches. Although this is changing with Harry Winston coming into the picture. Also Swatch always have leverage over these players via its movements business since Swatch provides the movements to these competitors. In an earlier post, we have also talked about how Swatch wanted to prioritize in-house movement to the detriment of its competitors.

As for Rolex, Patek Philippe and a few other remaining independent watch brands, Swatch's edge is again, both scale and again movements. Swatch, with its multiple high end watch brands, sells a much larger volume than Rolex. In terms of value, Swatch is also one notch ahead. Coupled with the fact that Swatch supply some key movements even to Rolex and Patek, we can say that Swatch is not in an inferior position vs these guys.

To conclude, Swatch's dual distribution via its own retail network and outside distributors, together with its dominance, allow it to create a strong business moat that rival the best competitors and should help Swatch maintain a sustainable advantage in the watch business.

And Patek

After Rolex, we have to talk about the world's most coveted watch brand: Patek Philippe. Or just PP or Patek in short. Meanwhile for those who are here for the first time, this is actually part of a bigger analysis on Swatch. Do read from the first post.

Patek Philippe belongs to the few exquisite Swiss watch brands in the world of high horology, which is a chim (difficult) word for timekeeping. To borrow an avid watch lover blogger's words (again): some of these brands in the uppermost echelon of the watch world are spoken with hushed reverence. In my interpretation, it probably means they exist solely to perfect the art of watchmaking and nothing else.

This is a ranking of the top super luxury brands that I found randomly using Google:

1. Patek Philippe
2. Blancpain
3. Vacheron Constantin
4. Breguet
5. Audemars Piguet
6. A.Lange & Sohne

What is meant by perfecting the art of watchmaking? Well, some of these watches are designed with multiple grand complications (very difficult movements) such as the perpetual calendar (a watch that can tell the date, day accurately for 100 years, taking into account of leap years), the minute repeater (a watch that can tell you the exact time by chimes) and the chronograph (a mechanical stop watch, which doesn't really meet the grand complication hurdle but never mind), just to name a few.

The more complications, the more difficult it is to design a mechanical watch. Brands like Patek Philippe, Vacheron Constantin (VC) or Audemars Piguet (AP) take pride in their ability to design and integrate complications into their watches. Whereas Rolex appeal to the masses and the mass affluent with stories of human triumph, simple and useful innovation and popular conspicuous designs, these super luxury brands impress with their wilfulness in achieving perfection.

For most Earthlings, it doesn't really matter if a watch can keep a perfect calendar for the next century taking into account leap years or chime 11:59 PM soothingly but for these top echelon brands, this is their pursue of excellence. It's not about usefulness or utility, it's about creating impeccable masterpieces. Obviously there are people who do appreciate and are willing to pay for such works of art, mostly UHNWIs or Ultra High Net Worth SIngaporeans who also happen to like to buy overpriced shoebox apartments.

As with other artform, there are a few attributes that are common amongst these brands such as a long history (Vacheron Constantin was established a quarter millenium ago), rarity - every model is produced in very limited quantities, usually only a few hundred, and originality - most of these brands do not import any movements or components but take pride in producing almost every component in-house. As such, some of these upper echelon brands have actually been "downgraded" as they now belong to bigger groups (Blancpain and Breguet are owned by Swatch Group) and hence are deemed to have lost that original touch. Although this doesn't seem to apply to the said Vacheron Constantin, which is now owned by Richemont.

But why does Patek stands out above the rest? Shouldn't those that are still independent (basically PP, AP) be as good? I would attribute Patek's success to three reasons:

a. Marketing
b. Ingenuity
c. Luck

Without a doubt, Patek is one of the most powerful marketing machine mankind has ever seen. With taglines such as, "Begin your own tradition" and "You never actually owned a Patek Philippe, you merely look after it for the next generation" etc, you have to give it to them. Like we discussed in a previous post on property, how do you put a price to a family heirloom? It's supposed to be priceless!

Building on this, Patek goes out to hire famous fathers and sons to appear in their commercials, further enhancing the marketing effect. Not to mention, the controlling Stern family own father and son are true to life examples of its own marketing belief. Hence all the more people buy their stories and their watches!

But, Patek's marketing is more ingenious than that. It is believed that the firm intricately strategizes its launches and production of models such that their rare watches will do well in auctions. They make only 200+ models and 50,000 watches every year ie on average, some models can have only 250 pieces in existence! Although most popular models should go into thousands of pieces. PP is also known for its sudden announcement of production cuts for popular models such that these models will then subsequently fetch exorbitant prices in auctions.

Furthermore it has its own museum which participates in auctions to re-acquire their old watches, brush up their stories and re-market to the world, again enhancing the inspiring tales of their traditions. Its own museum had also successfully created some record prices in the past.

No other brands come close to what Patek has done with its marketing and its auction strategies. Of course, this has invited speculators as well as the criticism of honest watch lovers, some of whom then tend to favour others that remained true to just making really, really good watches.

That is not to say Patek is inferior in technology. Amongst the trinity as it is known in the watch world (Patek Philippe, Vacheron Constantin and Audemars Piguet - PP, VC and AP), Patek is still the one that has best history of innovation (though far less than Rolex, a lower ranking brand in this aspect). The most important being the perpetual calendar, which PP invented. Its minute repeater is also perhaps the most intriguing and produces the nicest chimes which contributed to its popularity.

Success = Luck + Perseverance

Patek has persevered in its marketing and ingenuity since 1851, capable employees in the firm making things happen, esp so in the last 30 years. The last piece of the puzzle I believe is simply Lady Luck smiling. With the Queen of England publicly expressing fondness for Patek and the Popes of the past owning Patek's timepieces and the famous story of Henry Graves winning the bet on making the world's most complicated watch which was commissioned to PP, luck has undoubtedly also played a role in Patek Philippe's ascent to the No.1 coveted brand in Swiss watches.

Of Rolex

I supposed a full analysis of Swatch and the Swiss watch industry would never be complete without talking about the two most prestigious brands: Rolex and Patek Philippe. Hence this post and the next are here to fill the gap. Interested readers can start from the first post on Swatch.

Rolex is undoubtedly the most renowned brand in world of watches. In fact it's so popular that most youngsters today would eschew Rolex, believing that it's over exposed, too loud or simply too common. Some would even think that it has degraded to an "Uncle Brand". Only uncles who want to show off would buy that gold Rolex watch that is easily recognizable and the perfect way to brag about the wealth that they actually do not possess.

The Rolex logo and the model Uncles like

I read at another blog where an avid watch lover blogger aptly wrote that when people see his Rolex, there would be almost as many who would go, "Eeee, another Rolex, this guy is all about showing off." versus "Wow, cool, it's a Rolex GMT Master II!".

To understand the story of Rolex, we need to study its history (trust me, it's fascinating) and its founder. Btw, the Rolex wiki also has a good short writeup for those who want the full story.

It is worth noting that major Rolex innovations and events stopped some 50 years ago but what has transpired before that is so profound that it lasted half a century and hence till this day, Rolex is still the No.1 watch brand selling almost a million pieces per year (to be exact, experts estimate 800,000) and Rolex has a revenue of USD 6 billion, an almost 20% market share in the luxury watch market. On average, each Rolex sells for USD 7,000+.

Rolex today remains unlisted and is owned by a foundation with part of its profits going to charity. Its financials are not public and much of what the company does remains illusive to analysis. What we do know is its illustrious history.

Rolex SA was founded by Hans Wilsdorf in 1905, with a dream to make the best reliable watches for people and for those in important and noble but sometimes dangerous professions. As a result of his passion, ingenuity and a lot of business mind, Rolex has a good list of world's firsts, including the world's first waterproof watch, first automatically changing date (apparently in the past, you have to change the date yourself, every day!), first watch to show 2 time zone (GMT) and first to show both day and date. All movements were practical and yet with displays of ingenuity. Needless to say though, they were also made in-house, a trait that serious watchmakers took serious pride in having. Sadly, its innovations ended when Hans died in 1960.

But what's more fascinating about Rolex is its participation in significant events of human triumph. Such as being the watch that was wore on the first conquest of Mt Everest or the watch that went to the deepest dive in Mariana Trench some 10,000 metres deep. Still working, of course at the extremes of our beloved planet. (Well... Omega went to the moon, hence this blogger recommends Swatch which owns Omega :) It was also the preferred watch for soldiers and pilots during the WWII which were, unfortunately, confiscated by the Nazis.

Its enduring effort to help others with innovation and pure simple generosity is another hallmark of its legacy. For the POWs who lost their watches to the Nazis, Hans made sure that the soldiers received a free watch as long as they wrote a letter to Rolex. Then in the 1950s, when pilots needed to fly transcontinental, Rolex developed the GMT watch for PanAm so as to help the pilots and crew cope with jet lag and communications back home.

For workers working in environments that caused interference with mechanical watches (engineers in power plants, doctors using MRI etc), Rolex developed the Milgauss that is anti-magnetic. As for sea-farers, mountain climbers, racers, trekkers and explorers, Rolex have dedicated models to them and some of these are also the best selling and are the best retainers of value.

The Rolex Milgauss

It is hard for us to fathom today, but during those times some 50 years ago, an accurate watch was very important not just for professionals but also for normal folks. There were stories of train crashes because the operator's watch wasn't working well. Hans understood this need for accurate timekeeping for everyone, especially for some who cannot afford Rolex. So he created a second line called Tudor, which uses ETA/Swatch movements so that others can afford them. Today Tudor is seen as 2nd class and hence almost fading into oblivion, but I see the decision back then as a noble one of empowering the working class. One that is close to the heart of Hans and Rolex's legacy.

With all these strong powerful emotive stories behind Rolex, is it a wonder it grew to become the most well-loved watch brand globally? Of course, most aunties and uncles probably don't know the stories of trials and tribulations behind the Rolex brand. They just buy to show off, or they buy it as a store of value, knowing that it will be worth at least 70-80% of their purchase price should they need to pawn it some day. Actually most Rolex watches if held long enough (like more than 10 years) sells for more than its purchase price.

For aspiring watch lovers who bothered and researched about the world of watchmaking, they would usually go full circle with this love-hate Rolex relationship, just like many others before them. We hate it for its conspicuous ubiquitousity but grow to love it for what it stands for and what it is worth.

That's the story of Rolex.

Movements

As mentioned, one of Swatch's biggest advantages is its dominance in the business of making mechanical watch movements.

Start from the first post on Swatch.

When the Japanese started making watches in the 1970s, it decimated the Swiss watch industry. Production in Swiss movements declined from 40 million units per year to 4 million units (90% Crash!). Most Swiss movement manufacturers bankrupted and Swatch was formed initially as a merger of a few movement companies. The most important two being ETA SA and Nivarox FAR. This resulted in Swatch having dominant market share in various parts from 50% to almost 100% for some key components.

Today, movement unit sales have risen to about 6-7 million shipments (up from 4 million 30 years ago) and Swatch produces 3 million movements via its ETA subsidiary, roughly half of which is being used for its own brands. The bulk of the remaining movement makers are Rolex, Patek, Audemars Piguet and Jaeger-LeCoultre (Richemont) that produces movements for their own usage only. Two independent players Selitta and Soprod makes a few hundred thousand movement each. As you can see, this industry is a closed oligopoly. New entrants have a hard time since they have no way to produce or source enough movements to make an impact.

It is estimated that a mechanical watch has approximately 130 parts and the movement which forms to core of the watch sells for roughly USD 200 (Swatch's estimated average selling price). As history has it, Swatch/ETA produces movements to supply other players such as Richemont and LVMH for years, in fact since its inception from the aftermath of the Japanese onslaught. It was a neat arrangement for the industry to counter the Japanese. But today, these other brands will take these movements at USD 200, put on their own outer design and branding and sell for USD 5,000 to the end consumer.

Hence Swatch decided to prioritize in-house use a few years ago, announcing that they would like to reduce supply to external buyers, earning the wrath of its clients. This issue went all the way to the Swiss Competition Commission for arbitration which ended in favour of Swatch. Swatch/ETA will reduce its supply to external parties by a few percentage over a few years, forcing the other players to find alternative sources of movement or invest in new capacity on their own.

So that's the story of ETA but what's more powerful is Nivarox FAR (or Nivarox in short). Nivarox produces nano mechanical components such as escapement and balancing mechanism and hairsprings needed for "automatic" mechanical watches. This innovation basically allows mechanical watches to self-wind whenever the wearer moves and also increases the no. of hours without winding (the reserve). It is estimated that Nivarox has 80-90% market share here with the rest of the players basically producing a portion for their own in-house use.

As a example, Rolex both produces such escapement and balancing movements in-house but also procures from Nivarox because it does not have enough capacity to supply all its watches. So if one day, Nivarox says, "Rolex, we are sorry, we won't supply you anymore.", Rolex will be in a tight spot. But this is also the story for every Swiss watchmaker as Nivarox basically supplies to all the big brands including Rolex, Patek and most of Richemont's brands (IWC, Panerai etc). As a result, Nivarox is actually one of the most critical company in the mechanical watch industry. Swatch owns Nivarox.

Despite Swatch's recent change of heart, the Swiss watching making industry has come a long way since its near death experience. The industry is very closely knitted and it is unlikely for Swatch to turn very hostile towards its peers/competitors. To add, Nivarox does not necessarily sees it the way Swatch does. The company will dutifully produce its nano components be it Rolex or Patek or Tag Heuer since they are all Swiss watches and have gone through a lot together. Besides, Swatch has 150 production centres in Switzerland with employees with friends and relatives all over the industry. It is not as easy as to just cut supply outside Swatch Group tomorrow.

Also, Swatch earns 20+% operating margin in its movement business, quite a good margin as a result of its dominance. The difference in operating margin is about 3-5% between its movement and brand business (brand being higher). So while there is some product mix improvement by producing more movements for in-house brands, it is not game-changing for Swatch. Swatch would most likely continue both businesses while shifting marginally to increase its brand business over time.

To be continued...

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.

Swatch Group

As promised (more company analysis and stock ideas), in the next couple of posts, we will discuss a new stock idea: Swatch Group. To most people, Swatch represents the trendy Swiss watch brand with colourful and bold designs. The evergreen outlet at Raffles City might be most Singaporeans' key contact point. And some of us remember its "Skin" line which was THE coveted watch for teenagers in the 90s. Something like the iPhone 5 today. Well... those were the days.

The Swatch Group, besides the Swatch brand, is also the world's largest supplier of watch movements for mid to high end watches and owns a portfolio of brands from basic, to mid, high, luxury and prestige brands including Swatch, Rado, Tissot, Longine, Omega, Blancpain and Breguet. Don't play pray right?

Ok it doesn't have Rolex and Patek lah. Which are both privately held and we probably won't see them become listed entities any time soon.

Here's the Investment Thesis.

The Swatch Group is the the world's largest vertically integrated manufacturer of watches, components and movements with an estimated 50% market share in watch movements and 20% in mid to luxury/prestige brand segments. Its huge portfolio of basic to mid, high, luxury and prestige brands enables it to have distribution clout while its luxury and prestige brands such as Omega and Blancpain also help capture significant mind share of both general and affluent consumers. With 50% of its sales comes from Asia, which is also the fastest growing segment, Swatch is posed for sustainable long term growth with formidable business moats including brand, distribution and scale.

Well as you might have guess, I am going through the questions on the "Stocks" page where I try to answer all the questions. So next is Valuation.

Swatch trades at 15x earnings this year, but 13.5x one year forward and 12x two year forward (based on my estimates) which is not exactly expensive for such a strong franchise. Obviously the reason why it is not trading at 18x is bcos everyone is afraid of China. 1st level thinkers are saying China continues to stumble with GDP growth slowing further. The escalating tension over some remote islands and Bo Xilai coup de'tat remains to be huge risks near term. So Swatch which is so exposed to Asia and China should be avoided.

Well, good franchises seldom give you the chance to buy at low teens PE. Anyways we will discuss this issues again when we reach the "Risks" part.

Dividend is not great, 1.5-2% based on my estimates but that's to be expected for such a strong franchise. The caveat is that dividend should grow over time.

On other measures, which we will discuss in detail when we get to the Financials segment, Swatch looks reasonable too. EV/EBITDA is roughly 8x and Free Cash Flow Yield is 5%. Again, these are fair valuations and not screamingly cheap. But for a global franchise, it's probably as cheap as you can get. If it gets cheaper, gotta sell your mother and buy liow! Ok just kidding. Investments can always go wrong. Exercise risk controls.

So there you have it, a great Swiss franchise with great brands, exposure to growing markets and at a fair valuation. What more can a value investor ask for?

Next post, we discuss in deeper details the Business and other stuff!

Disclaimer: this blogger owns Swatch.