With exchange rates reversing again as the U.S. dollar strengthens, and as politics in Hong Kong leads to large shifts in Swiss watch exports by country, we are maintaining our fair value estimates of CHF 85 for Richemont (CFR) and CHF 565 for Swatch Group (UHR). We also remain confident in our wide moat ratings, signalling our belief that high returns on capital are sustainable due to both firms’ inimitable brands.
The Apple watch seems to have had little effect
We also maintain our stance that at present, Richemont is fairly valued and Swatch is undervalued. Historically, Richemont has usually traded at a premium to Swatch, as its ultra-high-end brands are assumed to have the greatest pricing power. At current levels, we believe Swatch will outperform in the long run due to new products and technologies, its retail channel development, and its components business.
How Currencies Matter
Since the Swiss National Bank relinquished its euro exchange peg in January of this year, Richemont has both raised and lowered prices more quickly and more frequently, while Swatch has only raised prices in euro 5% to 10%. Richemont has roughly half its business in watches and nearly 30% of all sales in euro. Swatch is nearly a pure play on watches and components and has most of its production in Switzerland, but euro sales account for only 18% of revenue.
Given the April Swiss watch export figures, Richemont’s comments about a negative sales trends in April and troubles in Hong Kong should not be too surprising. Sales to Hong Kong – the largest importer, with nearly double the U.S. imports in 2014 – were down nearly 30%. Japan, the number-four importer by value, was down nearly 6%, and the growth rate in the U.S. slowed to 3%.
Yet the number-three region, China, which has been driving global tourist growth, jumped upward with a 48% gain. In our view, China macro rebalancing and gift-giving laws have been a much bigger concern than the Apple Watch or the Russian and Japanese currency devaluations.
China Sales Lead the Way
We are particularly surprised by the jump in China given that some analysts believe consumers there would have a greater affinity for the Apple Watch, and due to negative comments about Macau coming from multiple luxury companies such as Burberry and Prada, and jewellery sellers such as Richemont and Tiffany.
Year to date, even after a weak March result from China, the country is up 13%, comparing favourably with the solid 9% four-month growth performance of the United States. Even though the two-year stacked comparison for China’s April sales is up only 25%, the notion that Swiss mechanical watches would fall out of favour, or that gift-giving laws would continue to create downward pressure on industry sales, appears more remote as the market at minimum seems stable.
Swatch Group has suggested that mid-priced watch brands such as Longines and Tissot are even performing in Macau as more middle-class families are frequenting the destination. We believe Swatch Group has a lower exposure to Hong Kong than the industry average, and Richemont has a greater percentage of owned retail (52%) than Swatch (roughly 28%).
We also believe the export figures support Richemont’s comments that wholesale buyers are waiting due to price volatility at retail given the swings in exchange rates. Many high-end brands, including the privately owned luxury brands Chanel, Rolex, and Patek Philippe, have adjusted prices internationally to reflect exchange rates. Swatch Group, on the other hand, has been reluctant to raise prices as quickly, and has refused to lower prices as it becomes a problem with both end consumers and wholesale and retail customers who might have just purchased only to see their product devalued. For a similar reason, Tiffany does not lower prices.
Yet Richemont, with its Cartier brand, has said that it will even adjust prices daily on its most expensive items to avert inter-country price arbitrage. With swings in both directions of the Swiss franc and dollar-related currencies, this has meant price cuts, as well as price increases in euro, yen, and ruble countries. In the April Swiss Watch Federation numbers, big increases running through the U.K. (up 48% in March – or plus 10% adjusting for a timing according to the FH) and the U.S. (up 22%) appeared to shift back to continental European tourist destinations, and of course back to China. Singapore, the eighth-largest market, went from 28% growth in March to just 3% in April. Overall, March exports grew 6.3% in franc terms, while April saw a 0.8% decline.
Swiss Franc Fall Shaves Sales
An examination of the Swiss franc to U.S. dollar exchange rate (USD per CHF 1) shows that the franc depreciated from $1.08 to below $0.99 from early February to mid-March. Export figures represent shipments, not sales. From mid-March to the first days of May the franc reversed, appreciating to a high of over $1.09/CHF. As May comes to a close, the U.S. dollar has again strengthened roughly 5%. Swatch Group management stated that the 1.17 USD/CHF levels experienced on the franc’s strongest day in January could have shaved CHF 750 million off global sales.
Yet somewhat ironically, the average exchange rate for January 2015, despite the franc shock around January 19, was only 1.06 USD/franc, which was actually below the $1.09 average of 2014. So at current levels the average year to date (not sales weighted) of roughly $1.07 should be roughly neutral to the 66% of Swatch’s sales geographies that are dollar-related; euro, yen, and ruble countries are still negative but should trim only a few percentage points off sales, we estimate in the CHF 100 million-200 million range at current levels.
Although price increases were taken at the higher end in Europe (about 18% of total sales), the lower-price-point products were not increased, or were increased by a smaller amount, given that they are more frequently consumed by local customers and not luxury tourists who can chose the least expensive country to buy an expensive piece if the prices are not continuously adjusted.
While this analysis does suggest that Swatch has less pricing power on lower-price-point items than Richemont in general, we reiterate that the shifts and swings in sales patterns appear in part to be responses to exchange rates. We also point out that the unit volumes of the Swiss exports in lower-price-point bucket of 0-200 francs (dominated by the Swatch brand) and other materials (also majority Swatch) are rising faster than the total sales growth in francs, likely due to growing shipments of the new Sistem51.
Taken together, the interest in Swiss mechanical watches appears to be solid, but sales are shifting month to month. Pressure from gift-giving laws may finally have bottomed, even as the predicted storm from the Apple watch seems to have had little effect. If consumers and retailers have in fact delayed purchases due to exchange rate swings, we believe that underlines the enduring value of the brands. As rates and political issues subside, we believe many of those sales will still be made, normalising sales growth over the long run.
