FOSL - The Swatch Group: Is It Time To Buy This Deep-Value Gem?

2023-11-08 13:01:43 ET

Summary

• The Swatch Group is the largest Swiss watch manufacturer with a diverse portfolio of market-leading brands and a real manufacturing cost advantage.
• The company has a conservative fiscal management style, a healthy balance sheet, and minimal debt.
• The recent market selloff has created a deep-value opportunity, with shares potentially undervalued by almost 40%.
• Strong Buy rating issued.

Investment Thesis

The Swatch Group (SWGAY) is the largest Swiss watch manufacturer in the world. Their massive range of market-leading brands is combined with a tangible cost advantage that allows the firm to exceed the returns and margins of its competitors.

A highly conservative fiscal management style has allowed Swatch to become an incredibly robust and well-run business with a healthy balance sheet and overall minimal debt.

The recent YTD market selloff has led to a great deep-value opportunity with shares potentially valued at an almost 40% discount.

Strong Buy rating issued.

Company Background

The Swatch Group is the largest and arguably the most influential Swiss watch manufacturer in the world. The firm has an impressive product portfolio of over 18 unique brands of watches which Swatch uses to target essentially every segment of the watch market environment.

Swatch's most luxurious brands target the high-end watch market with retail prices often ranging north of $10,000 up to over $100,000. The firm also sells many upper-mid range watches as well as a host of so-called "fashion watches" that target the lower-end of the market.

Over the past 30 years, Swatch has successfully curated a significant following and reputable image for the majority of their brands with unique identities characterizing and differentiating each watch brand from both one another and the competition.

While the firm has historically refrained from moving brands upmarket to ensure the overall image and synergy between their banners remains uncompromised, the past ten years have seen Swatch develop the Omega brand from an upper-mid level watch brand to a true luxury banner capable of rivaling competitors such as Rolex and IWC.

Swatch Group's management board boasts a huge array of incredibly talented and influential leaders from within the watch industry including Raynald Aeshlimann, Marc Alexander Hayek, and Nayla Hayek to name a few.

The management structure at Swatch has multiple CEOs with each responsible for either a brand, region, or both. I believe this unique structure enables Swatch to accurately control the image and future of each watch brand.

The overall governance coming from the board of directors is what brings these brands together under the Swatch banner and is integral in ensuring all brands work together synergistically to benefit one another.

Economic Moat: In-Depth Analysis

The Swatch group has managed to build a mid-sized economic moat around their business operations with competitive advantages stemming primarily from manufacturing cost advantages and brand reputation driving this moatiness.

Swatch's portfolio of brands has massive diversity and market coverage with notable banners being Omega, Harry Winston, Blancpain, Rado, Breguet, Longines, Tissot, Certina, Hamilton, and of course Swatch.

This huge set of iconic brands allows the group to target consumers in essentially every single price range of the market. Furthermore, even the more budget-end watches sold by the Swatch group benefit from being Swiss-made which in itself has become an attribute that suggests higher quality and reliability than watches from other nations.

Swatch's luxury brands allow the firm to target the highest-margin segment of the industry with luxury brands Omega, Blancpain and Breguet brands selling some of the firm's most expensive watches. The significant brand reputation and critical acclaim these watch brands have allow the group to extract significant margins from sales thanks to increased markups relative to the cost of production.

Of course, the assembly of high-end luxury watches requires huge amounts of time and labor with most manufacture still being entirely done by hand. In this regard, I do not see Swatch necessarily benefitting from any real cost advantages as the costs of labor mostly even out the playing field across competitors.

Therefore, I see the reputations of Swatch's most luxurious brands generating some moatiness to the firm thanks to the pricing power this image affords the firm.

While maintaining brand reputations can be difficult, I believe the successful development of Omega into a luxury brand along with enduring fanfare around industry classics such as Longines and even Tissot suggest Swatch has an acute understanding of how to maintain popularity among its brands.

While the labor-intensive manufacturing processes associated with the assembly of Swatch's most luxurious watches may not yield any scale or cost advantages (primarily due to the incredibly high wages paid in Switzerland), I believe Swatch's scale and operational structure allows the group to enjoy lower overall COGS among the firm's cheaper brands (relative to peers).

Swatch has an impressive 5Y average gross margin of 76.44%. This figure is already impressive on its own but becomes particularly outstanding when compared to the gross margins of some of Swatch's closest competitors.

Rival Fossil Group (FOSL) (who manufactures primarily "fashion" watches for luxury brands such as Diesel, Michael Kors, Emporio Armani and Kate Spade) only manages a 5Y average gross margin of 50.2% while even Compagnie Financiere Richemont (CFRUY) (who primarily only sell luxury watches under the iconic Cartier, IWC, Jaeger-LeCoultre and Roger Dubuis brands) can only muster a gross margin of 62.3% for the same period.

This fundamentally outstanding gross margin acts as a key indicator of core business efficiency and profitability which supports the hypothesis that both Swatch's luxurious brands and more mainstream "fashion" watches generate moatiness and overall profitability for the firm.

Interestingly however, the swatch group has not set out to directly compete within the increasingly popular smartwatch category unlike some competing watch manufacturers such as LVMH's (LVMHF) Tag Heuer Connected Calibre E4.

While the emergence of smartwatches has undoubtedly resulted in a decrease in the sale of mid- to lower-price watches, I do not believe that the luxury segment faces any real threat from these electronic devices.

To combat erosion within the lower-priced watch segment, Swatch has actually created a line of SwatchPay watches that allow consumers to use their traditional Swatch watches as payment devices much like a contactless credit card.

The firm also has some Tissot " connected watches " that offer consumers limited activity tracking, alarm setting and altimeter functions. However, Swatch stresses that these are not smartwatches or "devices" but high-quality Swiss timepieces with additional digital features.

While such innovations may pale in comparison to what the latest Apple (AAPL) watch or Google (GOOGL) (GOOG) Wear OS-based smartwatches can do, it may be a signal that Swatch is finally exploring this segment of the market too.

If the Swatch Group enters the smartwatch industry fully, I would prefer it to happen through a partnership with already established PED manufacturers such as Apple. A mid-tier watch brand such as Tissot could be used to test the appetite among consumers for a 'Swiss-inspired' smartwatch.

Even if such a product were not to sell as intended, I believe no real damage would be done to the Tissot brand thanks to its middle-of-the-market positioning.

Overall, I believe Swatch has a fundamental understanding both from manufacturing and brand maintenance perspectives. The firm's successful curation of iconic watch brands across the market allows the firm to enjoy substantial pricing power which, when combined with a clear ability to manufacture lower-end products at a lower cost has allowed the firm to generate massive margins on their business.

However, I believe that the continuous erosion of the mid- to low-price segment of the watch market due to the emergence of smartwatches may result in a slight degradation of margins ceteris paribus.

To avoid this, Swatch must either move one of their mid- to high-end brands even further upmarket (Longines would be a logical choice for this) or enter the smartwatch market through a partnership with an established competitor.

The Swatch Group's midsized economic moat should protect the firm's business for at least the next 20 years in my view, given the extensive time required for a competitor to build up a brand reputation akin to the likes of Longines or Omega and the massive capital required for rivals to match Swatch's overall scale of mid- to lower-tier watch manufacturing.

Financial Situation

Swatch has historically been a very profitable business and continues to excel with regard to its fiscal performance.

The firm has 5Y average (as measured from FY18-FY22) gross, operating and net margins of 76.44%, 11.50% and 7.98%. As discussed above, the substantial 76.44% margin illustrates just how much pricing power Swatch has among its brands with the metric acting as an efficient yardstick to quickly gauge the core viability of the firm's business.

Furthermore, these margins even include the difficult FY20 which due to the pandemic saw relatively lackluster one-off results.

Swatch has 5Y ROA, ROE and ROIC of 4.59%, 5.47% and 5.37% respectively. While these returns may not initially seem that impressive, one must remember how capital-intensive high-quality watch manufacturing (both low- and high-end watches) can be.

When compared against the returns of Fossil and Richemont , Swatch leads its rivals by over 3% in each metric. This relative outperformance once again suggests that Swatch has mastered the manufacturing and sales process of Swiss watches.

From these basic operating performance metrics one can already see how impressive The Swatch Group is within the industry. Their massive margins, strong returns, and overall market-leading status support the hypothesis that the firm enjoys a midsized economic moat at the very least.

H1 of FY23 was also positive for Swatch with the firm seeing healthy net sales growth of 18% YoY on a constant currency basis with an 11.3% increase even at current FX rates.

This massive growth was fueled by strong double-digit growth in all of Swatch's watch and jewelry price segments with surprising pricing resilience occurring in the lower-priced category.

The overall popularity of lower-end watches suggests that the adoption of smartwatches may have peaked with maturity being experienced within the segment. As smartwatches are no longer the popular "next-big-thing", consumers appear to be willing to sport both a digital device on their wrist and a high-quality traditional watch too.

Recovery of Swatch's Asian market region thanks to the final lifting of COVID-era travel restrictions helped fuel sales in mainland China, Thailand and Macao.

The massive successes of the MoonSwatch launch accelerated in H1 2023 with the new Omega/Swatch partnership seeing massive popularity among consumers and critics alike.

Swatch also noted Harry Winston, Omega, Longines and Swatch as brands having developed successfully within the half-year period with increased pricing power begin achieved across the board.

The increase in popularity across Swatch's core brands illustrates just how successfully the group is able to manage reputations and brand image among consumers. Furthermore, Swatch has simply hit a home run with regard to recent product launches and has enjoyed the ensuing boost in publicity among its brands.

A decrease from 33.2% to total net sales to 32.1% of total net sales in personnel expenses also highlights how operationally efficient Swatch has managed to be despite the highly inflationary environment overall leading to rising wage prices.

Material purchase costs also decreased 0.5% YoY for the first half-year of 2023 which (when combined with the significant increase in sales) illustrates how well Swatch manages their supply chains to maintain a lean operational model.

Operating profit increased 36.4% YoY to over CHF686M with operating margins expanding a whopping 3.2% from 13.9% to 17.1%.

This was accompanied by a net income increase of 55.6% YoY with net margins also expanding from 8.9% to 12.4% YoY.

Overall, Swatch expects H2 to be equally impressive for FY23 thanks to the release of new and innovative products, particularly across the firm's lower and mid-range segments. The only real concern for Swatch moving forward is the difficult FX environment due to the continuous appreciation of the Swiss franc making the firm's products more expensive abroad.

Seeking Alpha's Quant calculates a " C+ " profitability rating for Swatch which I believe to be an excessively pessimistic view of the firm's fundamental profitability.

The letter grade appears to be heavily affected by the firm's relatively slim 1.29% levered FCF margin and ROCE. I see neither of these figures concerning given the highly successful nature of the firm's business model and resilience in pricing power.

The Swatch Group continues to excel on a capital allocation front with the firm sporting an excellent balance sheet and solid liquidity.

The firm has $11.60B in total current assets while total current liabilities amount to just $1.37B. This huge short-term liquidity leaves the firm with an impressive quick ratio of 2.52x and an outstanding current ratio of 8.46x.

Swatch also has $1.96B in cash and equivalents at its disposal which is great to see and illustrates the traditional, conservative Swiss fiscal management strategy being pursued by management. I am truly delighted by the firm's balance sheet.

Total assets for the firm amount to $15.67B with total liabilities just $2.19B. This leaves the firm with an excellent debt/equity ratio of 0.13x.

Considering The Swatch Group as a whole one can clearly see that we are dealing with an incredibly well-run, lean, and profitable business. Their excellent balance sheet is a testament to the conservative fiscal management style present at the firm and acts as an outstanding example of how a company should be run in my opinion.

Swatch pays shareholders a once-per-year dividend which while not amazing is still quite a good opportunity to benefit from.

With a dividend yield FWD of 2.50%, an annual payout FWD of $0.33 and a negative 5Y growth rate of -2.38%, Swatch's dividend is not particularly exciting.

However, the dividend has grown since 2021 by over 73% with recent outperformance signaling a potentially increased dividend for FY24.

Historically, Swatch has decreased its dividend when returns have been more muted and tends to increase it in times of fiscal outperformance. I believe this strategy (while not conducive to flashy multi-year dividend growth metrics) is sound and once more is simply a byproduct of the conservative fiscal management strategy pursued by management.

Valuation

Seeking Alpha's Quant assigns Swatch with a " B " Valuation grade. I believe this is a mostly accurate if slightly pessimistic evaluation of the relative value present in Swatch shares.

The firm currently trades at a P/E GAAP TTM ratio of 15.96. Swatch's P/CF TTM of 17.36x is relatively elevated but still reasonable. Their FWD EV/EBITDA of 5.64x is quite low in my opinion especially when considering the firm's EV/Sales FWD of just 1.25x.

To put that into perspective, Swatch is trading at just 1.25x of their future 12-month sales.

Considering these basic relative valuation metrics, Swatch begins to appear as potentially slightly undervalued relative to the firm's market peers.

From an absolute perspective, Swatch shares are trading at a relatively pronounced discount compared to previous valuations trading around 30% lower YTD.

When compared to the 57% growth seen in the S&P 500 tracking SPY index over the past five years, Swatch has been soundly outperformed by the U.S. market index as a whole by over 73%.

While the relative valuation provided by simple metrics and ratios along with the absolute comparison allows for a basic understanding of the value present in Swatch shares to be obtained, a quantitative approach to valuing the stock is essential.

By utilizing The Value Corner's specially formulated Intrinsic Valuation Calculation, we can better understand what value exists in the company from a more objective perspective.

Using Swatch's current share price (under the UHR ticker on the Swiss stock exchange) of CHF243, an reasonable 2024 EPS estimate of $17.55, a realistic "r" value of 0.10 (10%) and the current Moody's Seasoned AAA Corporate Bond Yield ratio of 5.61 x, I derive a base-case IV of CHF392.30. This represents a huge 38% undervaluation in shares.

When using a more pessimistic CAGR value for r of 0.06 (6%) to reflect a scenario where a globally spanning recession causes Swatch group sales growth to stagnate, shares are still valued at around CHF282.20 representing a 13% undervaluation in shares.

Considering the valuation metrics, absolute valuation, and intrinsic value calculation, I believe that The Swatch Group is a deep-value bargain.

In the short term (3-12 months), I find it difficult to say exactly what may happen to valuations. The uncertainty regarding the future direction of both the U.S., Swiss, and global markets as a whole means predicting the direction for most stocks from a qualitative side is essentially impossible.

Furthermore, the non-essential nature of watches and luxury jewelry could see Swatch group sales drop sharply if a more acute recessionary environment were to exist.

Tax harvesting could see Swatch Group shares decline further as a less than stellar 2023 may lead some investors to cut the firm from their portfolio as the year winds to a close. However, the recent rally suggests investor sentiment may overall be improving in Swatch.

In the long-term (2-10 years), I see Swatch continuing to be one of the most influential players within the watch industry. Their market prowess both from a brand management and cost-control perspective generates tangible competitive advantages for the firm which makes it difficult for rivals to unseat the firm from their top spot.

Risks Facing Swatch

Swatch faces some tangible economic risks primarily stemming from their exposure to a highly-cyclical market environment along with some threat of new entrants degrading Swatch's market position.

The sale of any luxury products immediately exposes a company to cyclicality in earnings resulting from the transitionary nature of the economic cycle. Boom times lead consumers to spend more on discretionary items while recessionary periods will see limited purchasing power affecting the bottom line of such firms.

Swatch is no different as the majority of their revenues are derived from high-end watches and luxury brands.

While I do believe this premium approach to revenue generation yields Swatch the best long-term earnings, short-term volatility is a natural tradeoff.

However, given Swatch's massive balance sheet reserves and robust capital allocation structure, I do not believe the firm will face any trouble navigating even the roughest of recessionary waters and firmly believe that long-term success will remain unaffected.

The entrance or development of new brands by Swatch's competitors also presents a limited risk to the firm's operations through the potential for market share degradation. Repeated execution successes by competitors may lead to popularity swings among consumers which could come at the expense of Swatch's brands.

While the firm clearly has a great understanding of how to keep brands alive, some inherent unpredictability exists with regard to the choices and preferences of consumers due to the irrational nature of humans.

From an ESG perspective, Swatch faces no real concerns.

I believe the overall lack of material environmental, societal, or governance concerns would make the firm a suitable pick for a more ESG-conscious investor.

Of course, opinions may vary and I implore you to conduct your own ESG and sustainability research before investing in the firm if these matters are of concern to you.

Summary

The Swatch Group is the leading watch producer. Their highly reputable set of brands, high-quality timepieces, and clear manufacturing cost-advantage all act to generate moatiness to the firm which aids the company in earning outsized returns on their invested capital.

A management style focused on conservative growth and smart capital allocation has allowed the firm to become one of the most robust businesses currently in existence in my view. When combined with an acute understanding of what drives sales among consumers, I believe Swatch is well poised for decades of excellent fiscal performance.

A recent selloff primarily led by fears of a recession has resulted in shares potentially becoming almost 40% undervalued relative to the intrinsic value present in Swatch stock.

Therefore, I rate the firm a Strong Buy and have begun building a position worth around 8% of my total portfolio value in the stock.

For further details see:

The Swatch Group: Is It Time To Buy This Deep-Value Gem?