The Investability Podcast episode 16: Deep Dive Deja Vu

John and Michael look back over their weekly company deep dives

On this week’s Investabilty Podcast John and Michael look back over 4 months of company Deep Dives to see how our calls have stood up … Read more

Watches of Switzerland: a luxurious valuation

The luxury watch retailer has had a great pandemic, but abating tailwinds mean the shares now look too expensive

Luxury watch retailer Watches of Switzerland (WOSG) was the deep dive subject of the last Investability podcast, and if you’ve already listened, you’ll know that Michael and I both gave it the thumbs down. As a trader, Michael didn’t like the chart set up. And as an investor I didn’t like the valuation, especially in the context of our preferred quality and growth metrics, or the outlook in the face of a possible slowdown in the global economy triggered (or, as I believe accelerated) by the War in Ukraine.

Since then, the shares have bounced sharply after a statement from WoS stating that it has “negligible exposure to Russian and Ukrainian customers” and that its latest guidance issued at the time of its Q3 trading statement in February remains unchanged. Did Michael and I get our assessment wrong? I don’t think so and here’s why.

What it does

WoS is a retailer focusing on the sale of luxury watches and some luxury jewellery (c.8% of UK sales, 5% of US) mainly through a network of physical shops in the UK (roughly two-thirds of revenue through c.120 stores) and the US (the rest, via c.40 stores).

That store-base is split between multi-brand chains – Watches of Switzerland, Mappin & Webb and Goldsmiths in the UK, and Mayors in the US – and 46 mono-brand boutiques i.e., outlets dedicated to selling just one brand of watch (32 in the UK, 14 in the US). The group has a multi-store presence at Heathrow airport, and is also targeting expansion into Europe, adding six mono-brand boutiques in Sweden, Denmark and Ireland which will open in the first half of the 2023 financial year, its first European stores.

The company doesn’t split out ecommerce sales, but the company does give a sales per store figure - £5.4m across 148 stores in 2021, implying overall store sales of £800m and presumably the remaining £100m via online channels. The channel has been growing quickly, largely the result of stores closures during pandemic lockdowns, although online sales did fall back slightly in Q3.

But shops are unsurprisingly the most important channel – if you’re spending £88k on a Hublot Big Bang MP-11 you probably want to try it on.

Current Trading

Since the trading update on 10th February there doesn’t seem to have been much change to the trajectory of this year’s trading – the company is sticking to its guidance that profit will be at the top end of the upgraded sales and profit guidance from November 2021. According to SharePad, that means sales of over £1.2bn, up 34% on 2021, and EPS of 40.8p, an annual rise of 69%.

Source: SharePad

Christmas trading was solid, with decent growth in both luxury watches (+21%) and the smaller luxury jewellery category (+88.4%), although overall revenue growth of 27.9% in the 13 weeks to the end of January does represent a slowdown from the half year rate of 40.8%. On the basis of current forecasts, year to date revenue growth of 38% over 2021 mean Q4 growth is expected to be slower still.

The big question is whether this leaves room for upgrades – the company does have a good track record of raising guidance as the chart shows, but the latest statement would suggest we shouldn’t expect one for a while. Whether that matters in the context of the long-term growth story is another matter altogether, but the premium valuation certainly demands continued high growth rates.  

Source: SharePad

Bull case

That said, the growth rates on display remain well in excess of what most retailers could hope for, especially in a tough consumer market. That’s unsurprising to an extent, given WoS largely caters for a wealthier audience that’s less likely to be feeling the current squeeze on household finances – as the group puts it, it has “a thriving domestic clientele”.

It’s doubly impressive as the pandemic meant many luxury watch makers were forced to halt production, limiting supply to partners such as WoS, while high street and travel stores were forced to close for many months, the latter still far from fully recovered. There could still be some pent-up demand from this scarcity.

The group has also been adding new partners in both watches and luxury jewellery which broaden its ranges and audiences. Average selling prices of £6000 in the UK and £10,000 in the US suggesting a good mix between higher and lower priced luxury watches (classed as any watch over £1000).

These partnerships are offer a significant barrier to entry, and partners work with WoS on marketing initiatives and, importantly, store fit outs, helping it stretch its capex budgets, which across maintenance and expansionary capex is expected to be around £50m this year.     

And as it gets bigger, profitability metrics improve, suggesting a degree of operational gearing – in other words, sales grow at a higher rate than costs. Gross margins have also been driven higher by increased selling prices, which were up by nearly a fifth in 2021 and offset lower transaction volumes.

Wos Gross and EBIT Margins

That’s helping it generate strong free cash flow growth and simultaneously reduce borrowings, as can be seen here. 2021’s unusually high free cash flow isn’t expected to be repeated this year, but analysts do expect a permanent step-change in free cash flow going forward as the UK estate matures and despite continued expansion in the US – an underdeveloped luxury watch market with a very fragmented retail industry and the big prize for WoS.   

Wos FCF and Net Borrowing

Bear case

I started the bull case talking about the market, and I’m going to start the bear case talking about the same thing, because markets change and especially markets like luxury - not necessarily structurally, but certainly cyclically as the chart from WoS’s own annual report demonstrates.

So, could WoS’s strong performance in 2021 be a cyclical peak? Arguably the luxury market has enjoyed several tailwinds that have more than offset the difficulties posed by the pandemic, not least booming equity and cryptocurrency markets, the profits from which must surely have made their way into the real economy. To put it bluntly, people got lucky and felt rich.

Lockdowns had also brought about a so-called ‘Covid dividend’ for many in work – helicopter money in the US, and money saved as a result of working from home and both markets. Many have been unable to resist the resulting urge to splurge. Weakening markets, spreading economic worries, and a return to previously low savings rates suggest that dividend has been spent.

WoS’s own annual report highlights two key risks that I also think are more than boilerplate. The first is that any further economic disruption could see a repeat of supply constraints – that’s a real risk given the current soaring demand for precious metals as a safe haven, even if the corollary of that is that hard assets included watches and jewellery may see higher demand as a result of concerns about inflation. Adding new watch partners and a ‘pre-owned’ offer goes some way to mitigating this, but risks dilution of the luxury Swiss watch proposition, and brings it into competition with other retailers and, more worryingly, e-tailers.

Indeed, the second risk is that WoS could see business suffer if watch brands decide to sell direct to consumer, as other subsectors of the luxury goods industry are exploring. Luxury purchasing is still ‘experiential’ – in modern retail speak – but traditions change, especially as younger, digitally native shoppers begin to dominate, and any channel shift could eat into WoS’s growth.

And then there’s the boring financial bit, and especially the lower quality metrics compared to manufacturers of luxury goods. WoS might sell a luxury product, but at the end of the day it’s still a retailer, albeit a very good one. But as the tailwinds that have supported massive outperformance against luxury peers abate, it may find it harder to live up to aggressive expectations. 

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