Richemont is one of the world’s top luxury goods companies. It sells watches, jewellery, pens, clothes, and even guns. Its most well-known brand is Cartier. Jacques Plaut discusses luxury watches, brands, the luxury cycle, and the economics of Richemont.
“The best things in life are free. The second best are very expensive.”
– Coco Chanel
The mechanical watch industry is one of life’s great mysteries. At this very moment, thousands of craftsmen are busy assembling a product that became obsolete 35 years ago. Esteemed Swiss watchmakers are dreaming up innovations like the co-axial escapement and the anti-magnetic watch, but really they might as well be building sundials and water clocks. A standard quartz watch is a hundred times more accurate than the best mechanical watch.
For a while, in the early 1980s, it looked like quartz would replace mechanical just as surely as the wristwatch had replaced the pocket watch 70 years previously. During this period, known as the quartz crisis, production moved from Switzerland to Asia and the number of Swiss watchmakers fell by 66%. Yet the mechanical watch survived, and by 1989 there were waiting lists to buy them. Today only 7% of watches are made in Switzerland – almost all mechanical – but they account for 65% of global revenues. People are willing to pay a very large premium for a technically inferior product, because it is handmade in Switzerland. In a move that seems to be pushing the bounds of irony, Swatch unveiled a low-cost, robotically produced mechanical watch in 2013. This reminds me of modern art produced in factories.
Richemont makes half its revenue from watches, and the rest mostly from jewellery. Measured in US dollars, its share price is down nearly 40% from the 2014 peak. Does this make it an attractive opportunity for our clients?
When evaluating the business, we take into account the following factors, amongst others:
Richemont owns some very valuable brands, and faces little risk of technical obsolescence (as the quartz crisis demonstrated). Like Coke and Colgate, companies that sell branded goods often earn attractive returns on equity, and Richemont is no exception.
But luxury brands are not immune to competition, and are not guaranteed immortality. Browsing through back issues of The Economist, I recognise only four out of the thirteen watch companies that advertised in 1952. As recently as 1985, Watches of Switzerland ran an advert saying: “We are one of the largest stockists of all the leading watch names, including Cartier, Ebel, Omega, and Rolex.” Hands up if you have heard of Ebel. Or consider Aquascutum, a luxury clothing brand established in 1841, that had a royal warrant, opened a store on 5th Avenue in 1984, was mentioned alongside Burberry in 1996, and filed for Bankruptcy in 2012.
The problem with looking at the brands that exist today is ‘survivorship bias’: you don’t see all the brands that have disappeared over the years. What’s more, Cartier might be 160 years old, but for the vast majority of that history it was run as a medium-sized family business. Its history as a global mega-brand covers only about 30 years. The same is true for most luxury brands. The perfume industry in the 1990s is a classic example of competition in luxury: a proliferation of brands saw prices fall and incumbents’ market share reduced. The same could happen in watches. Richard Mille is a watchmaker founded in 1999 that now makes about 4 000 watches per year and generates US$147m of revenue – no doubt some of this revenue would have gone to Cartier.
Since they meet similar needs like status and indulgence, different luxury categories compete with each other for spending. There is a risk that watches become less fashionable and the rich simply spend their luxury dollars on something else. After all, 100 years ago elaborate dance cards were luxury items. Spending on Chinese ceramics and calligraphy, stamps, art, wine, and classic cars are all growing rapidly as these categories compete for luxury spend. Not to mention smart watches, which are currently growing much faster than luxury watches.
The luxury cycle
“The Swiss watch-making industry suffers from constant crises.”
The Economist, 17 April 1948.
Some businesses, such as British American Tobacco or SABMiller, have very stable revenue and margins. Luxury is not like that: it is cyclical. Cartier’s margins have fluctuated over a wide range since the 1980s. It is easy to forget this and extrapolate the recent past into the future. But falling into this trap typically leads to overpaying at the top of the cycle, or selling the share too cheaply at the bottom of the cycle. At the moment, the cycle seems to be turning from strong to weak. Swiss watch exports fell by 8% in January, the weakest number since 2009. Exports to Hong Kong, one of Richemont’s most important markets, were growing at a rate of 50% in 2010 but fell by 33% in January 2016. Retailers in China, like Emperor Watch & Jewellery, are rapidly building up inventory as they struggle to move stock. Luxury brands in watches, jewellery, and leather have gone for two quarters without a price increase in any region.
None of this has yet translated into a weaker profit margin in Richemont’s reported results. When we calculate the normal earnings power of Richemont, we use a margin closer to what the company has been able to achieve through the cycle, not the latest, higher-than-normal reported number.
At first glance, selling US$1 000 handbags and US$20 000 watches seems like the ideal business. But despite making high gross margins, Richemont has some characteristics which are not so attractive to shareholders:
- Poor cash flow: On average, Richemont has produced only 50c of free cash flow for every R1 of earnings the company reports. This is because it carries a large amount of very expensive inventory, which tends to be a drain on cash as volumes grow.
- Poor capital allocation: Richemont has been better than its luxury peers in allocating capital, and there haven’t been any major disasters, but nevertheless the company has continued to support loss-making clothing and leather brands for more than a decade, sits on a very large pile of cash, and has large overhead costs.
- A control structure: Johann Rupert has a 9% economic interest in Richemont, but a 50% voting interest. This means management is effectively accountable to a single minority shareholder. If it should become necessary, it would be very difficult for other shareholders to bring about change at the company despite contributing 91% of the equity interest.
When we evaluate the quality of the business, we weigh these negative factors against the high margins and the low risk of technical obsolescence mentioned before.
Can you expect to see Richemont in the portfolio?
I may be a cynic about mechanical watches, but liking the product is not a requirement for owning the share: British American Tobacco, one of our clients’ largest holdings, is a case in point. We have owned Richemont in the past, when we thought the price was justified by the prospects and quality of the business. If the share continues to fall, it might present us with an attractive buying opportunity.