Uncovering buried treasure – Swatch
Swatch Group AG manufactures watches, watch components, jewelry, miniature batteries, LCD displays, and scoreboards. The company produces watches under various brand names such as Omega, Breguet, Tissot, Blancpain, Rado, Glasshute, Longines, Jaquet Droz, Swatch / Flik Flak, Harry Winston, Hamilton, etc. Its products are sold globally through Swatch-owned retail boutiques as well as through approved retailers.
Investment case
Swatch has significantly underperformed the market during the past 12 months; the reasons for this include: a) an increase in inventory days (from 318 in 2006 to 484 in 2014), b) Hong Kong based hard luxury sales declined dramatically in 2014, and c) Exports to mainland China have stagnated since April 2012. We believe that Swatch’s management is addressing these issues, as it has in the past, with corrective actions which should show up in the 2015 operating figures.
Additionally, the company is leading the competition in terms of its a) brand diversification, b) growth resilience during periods of economic slowdown, c) category lead and defensive moat, d) growth headroom potential (through various IOT opportunities), e) mid-class potential, and f) digital downstream potential (IOT).
Smartwatch: In contrast with Apple, Swatch is not yet ready to commercialize a digital application which offers functions such as payments, heartbeat counting, and other activity based analyses. We anticipate that rather than market a gadget-based watch, Swatch will develop a device with high added value (after all 86% of its watch sales have some jewelry-like characteristic). Its current absence from this market segment is therefore not necessarily negative in the longer term. Evidence also suggests that the use of fitness bracelets and other gadget equipped watches fades fast, i.e. about half of consumers who owned a digital equipped article stopped using the application after 12 months.
CHF strength: The decision taken by the SNB will have a dramatic impact on Swatch Group which generates more than 88% of its outside Switzerland. Only a few components are produced in low wage countries, the majority of its sales are manufactured in Switzerland. Most of Its brands (ex Tissot and Swatch) are in the high-end market where Swiss watch producers have a certain pricing power. The EUR region accounts for 20% of sales, but the weaker USD will also have an impact as Asia/Americas have a share of >50%. As in the past, we believe Swatch Group will react with cost reduction measures and cautious price increases, but it will obviously not be possible to escape the FX impact in the short -term.
Swatch Group will be hit by the FX shock and it will take some time to go back the previously established margin levels, some of which will be set-off by the price increase. We believe that most adjustments are largely priced-in at present and that longer-term, the company will be able to overcome the situation. Yet, a further appreciation of the CHF, will impact negatively the company development. The company has a highly attractive risk-adjusted investment profile; the stock currently has a P/E for 2015 of 14.4.
Revenue/business triggers
- More than 32% of Swatch’s sales occur in the price segments above CHF 5,000. Consumers in these segments are highly resilient to economic downturns,
- Swatch has one the cheapest valuations in the sector,
- Adjusted to the sector average valuation, there is upside potential of over 30%,
- The announcement of a smartwatch product and the use of some disruptive technologies could provide the share price with upside potential of over 60%.