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Stock Strategist

Swatch's Time Has Come

Poised to focus more resources on its own brands and further invest in production technologies, Swatch Group should see margins continuing to expand.

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 Swatch Group (SWGAY) is a unique company with a suite of brands and a dominant market position in watch components, but it is often misunderstood as just a plastic watch brand. As a rare undervalued wide-moat company, we believe the market is concerned that sales will stagnate, that margins have peaked, and that disruptive technologies loom. We believe the firm has developed a number of new technologies that should reinvigorate demand, and its broad portfolio of brands can grow under multiple scenarios. Now that it has approval from government authorities to focus more of its production resources on its own brands, and as it makes further investments in production technologies, we believe margins can continue to expand. While consumer acceptance of these new products remains to be proved, we believe Swatch brands are already gaining momentum. Contrary to some investors’ concerns over smart-watch technologies, we believe mechanical watch sales will continue to grow.

We believe investors may be overly concerned with a slowdown in high-end gift giving in China and a subsequent cooling of emerging markets as the Chinese macroeconomy slows. However, we think Swatch’s diversity of brands and price points, as well as its lower retail penetration in Asia compared with peers, affords it more flexibility and more numerous avenues to continue growing. In addition, we believe the Swatch-branded Sistem51 is launching at a time when European accessory sales should do well as the region emerges from its long financial crisis. Finally, concerns that wristwatches might someday be obsolete because of wearable computing is not supported by data showing growth in mechanical watches over the past decade; it has been the electronic watch segment that has stagnated. We believe true Swiss mechanical watches are fashion accessories, and serve a very different consumer need than just keeping time.

Engineering and Manufacturing Bolster Competitive Advantage
Swatch has created a vertically integrated structure, controlling each aspect of the design, procurement, manufacture, and assembly of its products. Fashion and engineering drive the firm's culture in equal parts, and its continued innovation creates a unique advantage that permeates the entire portfolio of 20 watch brands. We believe that the equity in the brands of Swatch Group is one of its key competitive advantages, with all the aspects of the production and distribution contributing to these powerful intangible assets but also to cost advantages in watch production. These advantages generate positive economic returns and support our view that the firm has a wide economic moat, signifying our confidence that the firm's high returns on capital should continue over the long term.

Despite consumer focus on its brands and fashion, we believe Swatch owns considerable strength in its manufacturing, where it supplies components and innovative watch parts to an estimated 60% of the European watch industry. Swatch's engineering and manufacturing of precision components are unmatched, and some key parts are difficult for anyone to manufacture to the same quality and precision at the same price.

Today, Swatch brands are found at more than 16,000 points of sale worldwide, ranging from Swatch-branded stores to third-party distributors and wholesalers. We believe owned retail can be attractive for Swatch's brands, where supply is limited and the strategy is to control all aspects of the brand, but we also note that operating retail stores tends to increase leverage. Asia should be one of the company's primary growth drivers, though this market is not without risks, as there is always the fear of a slowdown from the region's growth engine, China. Yet Swatch has significantly lower owned retail penetration than some competitors, and even moving retail to 35% from 25% of revenue should increase sales low-single digits before considering same-store increases and wholesale.

Our Fair Value Estimate Is $39 per ADR
Our fair value estimate for the U.S. ADR SWGAY is $39. Twenty ADRs equal 1 bearer share, and we converted the ADR assuming an exchange rate of 0.89 Swiss francs per dollar and a market price of CHF 550 for bearer shares as of March 28.

Swatch continues to gain in its watches and jewelry segment, particularly in Asia, and we believe the firm could post another year of low-double-digit top-line growth and modest operating margin expansion in 2014, but our current assumption of 8% growth assumes that by year-end roughly 4%, or CHF 350 million, is lost because of exchange rates. We believe economic improvement in Europe could be a relief for the upward pressure on the franc, in addition to boosting Swatch's more modestly priced watch sales. Our 10-year financial model includes modest operating leverage over time to an operating margin high-water mark of 25.5% as retail penetration increases, owned-components sales are leveraged internally, and new technologies have an impact on gross margins, before falling to a level of 25.0% by the end of our forecast.

Swatch has both registered and bearer shares. After calculating an equity value for the entire firm, we divide this value between the registered and bearer shares, commensurate with their proportion of the equity structure. We estimate that about 56% of the firm's equity value belongs to the bearer shares.

Brands and Technologies Earn Swatch a Wide Moat
We believe that Swatch's wide economic moat is based on its timeless and prestigious portfolio of Swiss watch brands, its Swatch brand, which is uniquely positioned in the world, and its vertical integration, global distribution, and other intangible assets, including patents and designs that competitors are not able to copy. While sales in developed markets such as Europe and the United States have remained relatively flat over the past decade, the firm has leveraged its diversified brand base to pursue profitable growth by penetration of product categories with new proprietary technologies and designs, and by further penetration of emerging geographies. We believe the combination of Swatch's international multichannel presence and operational prowess will drive returns on invested capital well ahead of our cost of capital assumptions, for many years.

We assign a stable economic moat trend to Swatch. We believe the company will continue to expand internationally through its retail channel as well as incremental license and partnership opportunities. Despite the firm's sterling reputation in the timepiece industry (as well as market share of more than 35%), we believe it is unlikely that its intangible assets become more dominant due to its already-large size. There are also the risks associated with a growth strategy for emerging markets, and we believe that as the company grows, its relative competitive position will not significantly change. There's optimism from the standpoint that the firm is doing even more to control its manufacturing, making its designs even more unique and exclusive, and ramping up its retail locations, which should serve to drive margins higher over the course of the cycle. But we believe these advantages are already represented in the firm's wide moat, and not necessarily a further strengthening of those advantages.

Management Protects Shareholders' Interests
Overall, we view the Swatch Group's stewardship of capital as Standard. Nayla Hayek became chairwoman of the board of directors in June 2011, succeeding her late father, Nicolas Hayek, who had been the guiding force behind Swatch since its creation via the merger of ASUAG and SSIH in 1983. Nayla Hayek has been a member of the board of directors since 1995 and ran the operational leadership of the Tiffany watch business, before that license was terminated. While we have few insights regarding this appointment, Hayek was a logical choice, given her extended relationship with the firm and her father's vision and prominent role in Swatch's success, and she has done well to guide the firm to date. Nick Hayek, Nicolas Hayek's son, is CEO, and also a board member (since 2010). The Hayek family has a vested interest in the success of the firm; overall, it owns about 46% of all registered shares. Assessing the quality of corporate governance can be difficult, given the company's relatively limited level of disclosure, but this isn't a major concern. We believe the family leadership pays attention to return on investment and wishes to create value over the long term. Judging by the company's returns over the years, we believe the board of directors does a good job overall of protecting shareholders' interests.

Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.