Swatch Group is the world's biggest watchmaker. The group is involved in manufacture of finished watches, jewelry, and watch movements. More than half of its sales are generated in Asia, with China alone bringing 38%, followed by Europe with 34%.
Current, 50% upside prediction by HOLT model greatly deviates from the market implied valuation. Let's examine whether this prediction can be backed by evidence presented by HOLT Lens and further analysis.
During the last 20 years, Swatch Group has been able to consistently create shareholder value with positive spread between its CFROI and cost of capital. Since 2005, Swatch Group was steadily increasing its Economic Return and since 2009, its cost of capital has been constantly decreasing. At the same time, it has been heavily investing in its assets
Now, let's look at the three primary CFROI drivers to determine emerging trends. Excluding 2009, sales and margins were consistently growing since 2004, with asset turns staying relatively steady. As a result, CFROI was increasing during that period.
Swatch HOLT Score falls just below the median of its peers, mainly due to its rather low Momentum Score caused by negative CFROI revisions and price decrease since the beginning of the year. Compared to Richemont and LVMH, Swatch shows somewhat similar performance in Sales, Margins and Asset Turns. According to HOLT, both Richemont and LVMH are close to their fair values. While HOLT default model CFROI forecasts for all of them have the same slowly fading trend, only Swatch has remarkably low market implied future CFROI levels. Industry analysis might give us possible explanation for this discrepancy.
Swatch is primarily operating in the luxury goods industry. Since 2008 and until 2011 the whole industry experienced unprecedented double-digit growth in China. During that time key industry players, including Swatch used this opportunity to grow their businesses in China. However, since 2012 sales growth in China was decreasing and is projected to be only around 3% in 2014. Moreover, what partly explains market pessimism about Swatch compared to its peers is that in China watches segment sales were decreasing in the last two years, while other segments experienced moderate growth. Nonetheless, watches and jewelry are expected to be among leading segments in the industry in the coming years worldwide.
With that being said, we proceed to Flex Valuation. Using 3 Driver Model, which relies on sales, EBITDA margins and asset turns, we will find company's fair value. This is my forecast for Swatch sales growth by region. Analysis is based on the data and forecasts from industry reports. Since potential emerging markets are believed to replicate China's growth to some extent, they are included into calculation but only after their economies overcome current problems. Most of the growth in developed countries is brought by shopping tourists. Market in China becomes more complicated and as a result decreasing returns are expected to slightly reduce margins. With China's low sales growth and lower project returns, as well as more asset investments required by emerging markets, asset turns are predicted to continue its slow decline. After calculation, we get 24% upside warranted price.
Based on this analysis, I believe that Swatch Group will outperform market expectations. This conclusion can be strengthen by the fact that more than half of the polled investment analysts covering Swatch believe that it will outperform the market.
Thank you for your attention and for opportunity to participate in the HOLT Valuation Challenge!
The Swatch Group, FT
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"2013 China Luxury Market Study", Bain & Company
"2013 Luxury Goods Worldwide Market Study", Bain & Company