Sunday, October 28, 2012


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...

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.