A "crypto derivative" value play with Watches of Switzerland (WOSG)?

“Even a broken clock is right twice a day”..

It’s been a while since I’ve shared an investment idea - the last few articles have worked out quite well, i.e. Future Fuel (FF) announced a $2.50 special dividend, ~40% of the market cap from when I first wrote about it; I also questioned the takeover of Samsonite, questioning the valuation multiples financial buyers would be willing to pony up - true enough, private equity firms did feel that Samsonite’s valuation was a little too heady.

This next idea is not a cash box, of which I would prefer; there’s an element of business analysis here which seems to have been well covered (probably better) in the public domain (I’ve spoken to a couple of buyside analysts on this and most reiterate similar points) but nevertheless I think I might have an interesting take on why it might be worth a bet.

Firstly, for those who aren’t too familiar, WOS is an authorized dealer/retailer of luxury watches and jewelry, with stores spanning the UK, US and Europe. Most of revenues is from luxury watches and around 6-8% is from jewelry so our main focus will be on the discussion of watches.

Examining the price action over the last year, there are two “dive points” in the chart below which captures the overhang on WOS stock.

• The first - disintermediation risk - was on 24 Aug, when Rolex announced the acquisition of a comparable peer, Bucherer, stoking fears of Rolex (a big boy), disintermediating authorized retailers like WOS and going DTC themselves.

• The second - earnings risk - was on 18 Jan, when WOS revised guidance due to poor operational performance during the Christmas period - guiding both revenues and margins down.

Concern 1 - Disintermediation Risk

Addressing concern 1 - the acquisition of a comparable peer, Bucherer, stoking fear that Rolex would go DTC themselves (sort of like the purging NKE has done in recent years).

Rolex makes up ~60% of total revenues with ~75% of revenues coming from the top 7 watch brands i.e. 15% comes from PP, AP, Cartier etc. so the main focus of this discussion would be on Rolex.

To sum up the key rebuttal points against disintermediation risk:

• The background of the takeout is important. Jorg Bucherer had no successor, was trying to sell the company for over a year; he wanted to maintain the integrity of the brand and hence, reluctant to sell out to the likes of LVMH or other potential suitors, except without alternatives. Fortunately, Rolex stepped into the fore and paid quite a sum for it - estimates ranging from 3b CHF to 5b CHF.

• Rolex themselves have passively asserted that they won’t be meddling with retail.

• Strategically, there are limitations as well.

  • Location

    • 

    • WOS’ has ~2x Bucherer’s total store base, featuring a much larger footprint in the UK than Bucherer and ~2x Bucherer’s store-count in the US. Bucherer, however, is more dominant in Europe.

    • Moreover, the US market is notably underdeveloped (ref sales per capita vs the UK) and fragmented; replacing WOS’ store footprint cannot be replicated overnight, which is especially important given Rolex is completely reliant on brick and mortar as it doesn’t do e-commerce.

      

    • London is also the most important city outside of Europe and so the anchor WOS has, prevents brands from screwing them over.

  • Bucherer only accounts for ~5% of Rolex’s global sales. Rolex will produce ~1.3m watches this year, is poised to do ~2m watches by 2030 and simply cannot sell-through said quantity through Bucherer.

  • Rolex is onboarding new projects - Rolex Certified Pre-Owned (CPO) - and conducting boutique expansions with WOS - a store expansion was done in Millenia Orland in November last year and Rolex is consolidating four stores into one big boutique in Bond Street London.

    • So while there is some disintermediation in the sense of rationalization of footprint, what seems to be happening is attrition/consolidation towards trusted/well-run operators - such as WOS - further supported by the multitude of projects i.e. strengthening relationship as described above.

  • Some point to AP (Audemar) going DTC as a canary in the coalmine but AP only produces a fraction of what Rolex does per year, i.e. ~40k watches annually and fwiw, still has one mono-brand boutique with WOS which really lends credence to WOS as an operator.

  • PP (Patek) is capping watches at 70k annually and has refined their strategy - in that they are limiting the number of locations that retail their watches and focusing on mono-boutiques in the best locations - but not necessarily running retail entirely themselves. As mentioned, whilst undisclosed, they likely do not comprise a huge % of WOS sales.

  • Retail is a tough business - and if the authorized distributors with their long, tenured experience (WOS has been a partner with Rolex for over a century) are able to maintain brand equity on behalf of the brands, whilst taking on the capital costs, much consideration is required before brands (especially the large production ones) do it on their own. The only gain would be to eke out a few more margin points but that would not be worth given the brands themselves are already extant cash printers.

    • This point is especially salient for Rolex given Rolex is a charitable trust and thus, a not-for-profit foundation, with purposes that don’t include improving EBITDA margins for better shareholder returns.

Concern 2 - Earnings Risk

Management guided down fy24 forecasts and especially on the margin side - 2023 EBIT margins were ~10.7% and so that’s a 2pt guide down.

On the backdrop, there are a few negative headwinds to take note of:

• The UK (which makes up ~60% of revenues) has entered a technical recession and so that has affected discretionary spending, impeding y-o-y comps.

  • This is offset by the growth of the US market (which is still growing low double digits).

  • Growth has been so astounding in the US such that in fy19, the US made up a mere 24% of sales compared to the current 43% of sales.

• ASPs have come down as Rolex is producing more lower priced steel watches though adhering to the original mandated supply.

  • Watch prices in aggregate have increased to offset input cost inflations which feeds into why, despite demand outstripping supply, most of the demand is circling lower ASP watches, taking down sales and margins with it.

• Management has assured that guidance has already baked in continued negative trends.

Of course, the investment public would be afraid that the first guidance revision is merely… the first of many to come… which is entirely possible but stress testing valuation (in the next section), still lends us to a very cheap stonk.

Valuation

With the current guidance, we’re purchasing WOS at ~6x EBIT and assuming normalized margins wilt and degrade to pre pandemic levels ~7%, we’re getting this business around ~7-8x EBIT - perhaps a normalized situation whereby lower ASP watches are holding sales flat as operating costs inflate further.

On a FCF basis, the company is guiding to 50% OCF conversion this year so maybe ~90m of OCF, assuming 180m of EBITDA (EBIT + D&A 3% of sales) and against maintenance capex of ~5m, gets us to ~85m of FCFE which is ~9.5x P/FCF, slightly north of a 10% FCFE yield.

Prior to COVID, WOS traded at a high teens EBIT multiple - in fact the stock is trading below pre-pandemic highs; I would argue the business is much stronger in many ways today - more geographically diversified, better balance sheet (net cash vs net debt previously).

But this is all vanilla valuation and whilst not a pure comp, Bucherer with half the store base was taken out for numbers multiples of where WOS is trading currently; assuming a mean sum of ~3-4b CHF and with sales of ~2.2b CHF, Rolex paid around ~1.3 - 1.8x sales. WOS currently trades at ~0.5x sales.

A possible valuation detractor might be using Hour Glass (AGS) as a comp as AGS trades at quite a low multiple. I’m quite reluctant to use AGS as a good comp for a number of reasons - listed on the SGX, family controlled, illiquid, no earnings calls, no earnings guide.

AGS’ model is also rather different - whilst WOS is in expansion mode (permeating the US for e.g.), AGS capex is de-minimis and apart from maintaining a cash buffer, the company pays out a quarter of net income as dividends.

This also brings to light, for the intrepid soul, the margin differences between WOS and AGS - less expansionary costs weighing on the P&L and I hypothesize more operative leverage due to just fatter spends by Asians, driven culturally at least.

Nevertheless, AGS does provide a good case study on the resilience of the watch retailing model - peek 2008/2009 (GFC) and 2016-2018 (Fed tapering, Chinese equities sell-off, Brexit), sales and EBIT remained rather resilient; even during the GFC, sales fell slightly less than ~10% and EBIT a mere ~7.6%,

The resiliency of the luxury watch industry is further outlined in the chart below - notice the stability in Swiss Watch Exports through the years, it’s not a rapid growth industry and is macro-sensitive but things tend to bounce back well.

The crypto angle

Most of what I’ve written above has been elucidated publicly already but what really brought me to this idea was this Bloomberg article - highlighting a "correlation” between crypto and timepieces. The more erudite readers would probably scoff at this portion, but hear me out; I see it more as a creative “optionality” on the base of what I believe to be a fundamentally cheap stonk.

The S&P 500 is pretty close to all time highs and BTC has done even better since the chart above; secondary watch prices on the other hand have remained rather unaffected. And whilst management has reiterated that secondary watch prices don’t matter to WOS, the truth is they do matter to the extent that people do care about the value of their watches and climbing secondary watch prices would incentivize racking up a solid spending history to obtain better allocations.

On the other hand, whilst the indices in both tradfi and crypto have been rather resilient, the economy is in pain. Interest rates are higher due to rabid inflation and in the labor market at least, we are seeing retrenchment, a cut in bonuses, just massive pains for the consumer.

But crypto…. with BTC halving just a couple days ago, even if that doesn’t cause BTC to shoot (i.e. smaller halving against a much larger market cap), if it could help stabilize the price up here for quite awhile, perhaps this may prove to be +ve for watch prices.

I’ve thought about this a fair bit, even going so far to name it as a “crypto derivative”. I think this is stretching the narrative a little bit, but it’s something worth pondering about perhaps.

Final Points and Risks

• Terminal value problem

The contention of whether WOS is a good business may affect the multiple the business may garner. That’s why it’s difficult for me to say, oh this should trade at 20x EBIT though I do think the starting base here provides a solid margin of safety. The way I’m envisioning this risk is sort of like traditional ICE automobiles → you could quibble the timeline for when EVs or FSDs will dominate the roads but even if this “point of singularity” occurs way out in the future, as long as the uncertainty remains, the market will always be skittish about the terminal value of the disrupted.

In terms of business quality, in many respects, WOS features:

• Strong P&L visibility (conceptually, despite irony of earnings revision) due to i) great visibility with Rolex on project development and mandated watch supply, ii) customer waiting list and iii) limited discounting.

• Cash printer: net working capital changes are but a small portion of OCF and maintenance capital expenditure is de-minimis, creating a very solid CROIC model.

  • See ROCE prior to COVID

    

The terminal value debate would be whether WOS reliance on Rolex is a good or bad thing especially as Rolex pushes WOS to open more mono-brand boutiques potentially contributing to a larger portion of total revenues.

The bull argument would be that being an authorized dealer for Rolex is a scarce, valuable and lasting relationship and that the in-store economics for Rolex mono-brand boutiques are much more lucrative than multi-watch stores - better margins, faster inventory turns - fortifying and further building of the relationship, a good thing and a cash printing license.

The bear argument would be, well, reliance on Rolex - and the potential for them to rug-pull some point in the future, regardless of when.

Another example I could think of whereby terminal value seems to be punished is JD Sports in the UK. Whilst NKE has preserved their relationship with JD given how stellar of a retailer they are, the market doesn’t give much of a valuation premium for the retailer, in spite of the mouthwatering ROCEs posted annually - valuation multiples have fallen from low teens to mid single digits over the last few years.

• Takeout

A takeout might be difficult due to selective distribution agreement specifying for all brands having the right to review change of control. Theoretically, I would think that given the lion’s share Rolex has, she would be the only real natural acquirer should WOS be taken out.

• CEO ownership

Brian Duffy is incentivized for value creation as he owns ~3.2% of the company, a stake valued at ~25m GBP. His base salary is 500k GBP and his bonuses and LTIPs are tied to mainly to earnings - EBIT, cumulative EPS with a minority portion tied to the average 3 year ROCE performance.

Anyway, these are all my key thoughts on WOS, open to discussion.

Disc: Long WOSG