The Watch Series: Swatch (UHR.VX) part 2 – Capital allocation, Management & Valuation

It is time to finish the Swatch case. Let’s start with summarizing the first post on Swatch and the post on smart watches:

– I do believe that luxury watches have “staying power” and will not replaced or significantly impacted by smart watches as the main buyers are Emerging Market consumers and collectors
– If we accept that Swatch is in fact a luxury product company, there would be a clear valuation upside compared to other luxury companies
– However the lower range of their products (Swatch, Tissot, Rado, Hamilton etc.) clearly has problems which could become worse over time as the moat here is small to non-existent

So let’s look at some more aspects of how Swatch is run:

Capital allocation:

The company is run like a “family company”, very conservative and “Swiss” and a big contrast to Fossil. As mentioned in my post about the Hayek book, Hayek senior hated banks and Swatch therefore always kept a big cash buffer.

Last year for instance they bought a big piece of real estate in Zurich which might have cost them around 400-500 mn CHF.

A company which would be mostly interested in short-term gains in the stock price would never do that as this will be a very low ROIC investment as yields for prime real estate in Zurich is maybe 2-3% and the purchase is financed purely by equity. As a shareholder I would want them to invest in the business and not in landmark buildings, unless i get comparable returns which here is obviously not the case.

In 2013 they bough US jeweler Harry Winston. strategically that made sense but the price of around 1 bn USD was ~ 30x EV/EBITDA and looked very expensive. In my opinion, the old Hayek would never had paid so much for an M&A transaction.

Another deal which surprised my was the 200 mn USD 6 year sponsorship of Tissot, the “entry-level” brand of Swatch for the NBA. In my opinion this is a quite risky investment as this is exactly the segment where the competition is the hardest and the Apple Watch will have an impact.

Swatch used to repurchase shares in the past, but this was mostly driven by Hayek senior who wanted to increase his share in the votes.

Without big Due Dilligence I would assume that there are many hidden assets in Swatch Balance sheet, mostly in real estate, but overall capital allocation is only OK, not great. Yes, they think long term but some reason decisions look at least not so great at first sight.

Management

If you watch Nick Hayek in an interview it becomes clear pretty soon that besides looking more and more like his father, he is also behaving like his father. One of the best examples is Hayek smoking a cigar in a Swiss TV interview. Although I have to concede that what he actually says makes a lot of sense.

Like his father, he tries to do other stuff as well. At the moment, he is promoting a venture to build batteries for Electric cars. It remains to be seen if this will be succesful, but it is good to remember that his father failed with most of his non-watch activities like the Twin Phone or the Smart Car.

Personally I would think that he should spend more energy and time on smart watches and wearables than batteries. Those developments might eat into his core business and his only answer seem to be a Swatch with a payment function. I think this is a petty, as the Swatch would be the perfect brand to try out something new and do a “real” smart watch or fitness tracking device but Hayek seems to think that Smart Watches are going nowhere.

Here are several statements from Hayek: Part 1, part 2, part 3. MAybe he turns out right in the end, but if he is wrong, he will have big problems to catch up.

Another thing that I didn’t like that much is the fact that he pays himself a very big salary, 7,5 mn CHF in 2014. His sister gets ~5 mn CHF. I think for a family company this is uite a lot and somehow distorts the alignment of interests between shareholders and management to a certain extent. On the other hand, The Fossil CEO who doesn’t take a salary didn’t really add a lot of value for his shareholders either.

All in all, I would judge the management of Swatch as “OK” but not great.

Valuation exercise:

As one commenter in the David EInhorn post accused me of using “useless university knowledge”, I try to keep this one as simple as possible. I want to look at the valuation of Swatch from 3 perspectives:

1. Mean reversion
2. Relative Valuation
3. Required return

1. Mean reversion

A business like swatch which, in my opinion at least for the luxury segment is here to stay, can be always assessed against long term averages to see if current valuations and profitability levels are in line with historical ranges. What I often do is the following:

I calculate the 10 year average profit margin, multiply it with current sales and multiply it with the 10 year average P/E to see if a company is trading below, at or above averages. This of course doesn’t factor in any growth but is a good starting point. Those are the figures fro Swatch:

 

“mean reversion, no growth, 10 year horizon”

Avg. NI Margin 15,66
Avg PE 16,97
Normalized price 306,41
Up/Down -16,5%

 

So no big upside here. The reason is quite simple if we look at the margins from the last 10 years:

NI margin Sales per share
1998 11,2%  
1999 12,5% 48,5
2000 13,2% 56,4
2001 12,5% 69,5
2002 12,6% 67,9
2003 12,9% 117,5
2004 12,9% 114,4
2005 14,3% 119,9
2006 17,2% 130,9
2007 17,9% 150,7
2008 14,7% 179,3
2009 14,8% 185,5
2010 17,6% 98,1
2011 18,8% 115,3
2012 20,5% 125,2
2013 22,7% 144,4
2013 15,9% 155,9
2014 16,9% 160,4

Especially 2011-2013 were exceptional years. If we would go further back, the average would be even lower. So from that perspective, around 300 CHF per share would be a “fair” price unless one expects a lot of growth.

2. Relative valuation

In the first post I had a comparison with the other luxury companies which shows that Swatch looks cheaper on a relative basis. But there is one caveat: Swatch is not a pure luxury play with Swatch and the cheap brands. If we look at Richemont, those guys are “pure luxury” with a real moat and less risk of market entrants like Daniel Wellington and Apple. So effectively Swatch is rather a combination of a “low-end watch company” and a luxury company.
If we model Swatch as a combination of Richemont and Fossil with an 80/20 share, a “fair” multiple for Swatch would look like the following:

EV/EBITDA Swatch: 9,3
EV/EBITDA Richemont: 11,1
EV/EBITDA Fossil: 4,6

(0,2*4,6)+(11,1*0,8)= 9,8

So this would mean that Swatch is maybe slightly undervalued but not by much if we take into account that maybe 20% of the profits do not come from luxury brands with real moats. A fair price would be around (9,8/9,3)*360= 380 CHF.

3. Required return

For a stock like Swatch, I would require between 10-15% return in order to justify the risk. The major risk in my opinion is China and technological change, on the plus side is a rock solid balance sheet, good moat for the luxury brands and a lot of “substance”.

With a very “non University” like calculation I would start the following way:

At a current P/E of 16, my current earnings yield is 6,25%. In order to reach my 10% goal, I would need to assume that 3,75% EPS growth p.a. will happen if no multiple expansion takes place. That could be justified, but then the stock is fairly valued.

If I would want to earn 15% p.a. and give them credit for let’s say 5% growth, I can calculate the level at where I would buy the following way:

2015 2016 2017 2018 2019 2020
EPS 22,8 23,94 25,137 26,39385 27,7135425 29,09921963
P/E 16 16 16 16 16 16
Target price 364,80 383,04 402,19 422,30 443,42 465,59
             
3 year 15% 277,67          
5 year 15% 231,48          
             
3 year 12,5% 292,68          
5 year 12,5% 252,70        

So those would be levels clearly below the current market price. Even if I lower my requirement to 12,5% (still with an implicit assumption of 5% p.a. growth) I would be significantly below current prices.

All of the three versions tell the same story: Swatch is not a bargain. The current price seems to imply either a lt of growth or future multiple expansions which I find pretty hard to justify. I think I would be interested at 300 CHF per share as there would be a clear upside from that level, but I don’t see it at the current level.

Summary:

All in all I would summarize Swatch as follows:
+ Very good and partially great business (luxury watches)
+/- OK management, capital allocation. Long term focus but maybe missing out on innovation
– valuation currently not too attractive compared to the potential risk (China, technical innovation)

I think the key issue for me is that for the moment, there are clear risks to parts of the business which in my opinion are not fully reflected in the price of the shares. If the shares become cheaper, maybe because of a bad 2015 Christmas season, then of course it could become more interesting. Other than Fossil, I don’t think that Swatch has an existential problem as I believe that expensive Swiss watches are here to stay.

For me, the stock would be interesting at a level of 300 CHF, roughly 20% lower where it is today.

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