For some people, appearance is everything, and this business is making a fortune supplying that demand. Analyst Edmond Jackson explains why he likes these shares.
Do strong annual results from mid-cap company Watches of Switzerland (LSE:WOSG) mean this leading retailer has reached a positive inflection point after a 60% de-rating?
The stock has fallen from a 1,518p high in December 2021 to 613p only last week. The shares are currently 720p to buy. This puts it back to mid-2021 levels having originally floated in May 2019 at 270p.
Peak-cycle performance or resilient demand for watches?
During this time, I have been quite wary as the stock went to a big rating in anticipation of earnings growth from a low base. The table shows this kicked in from the year to April 2021. As stock analysis goes, that is not really an established earnings record, and there is the added question of whether this rather bumper period of performance reflected “peak economy” of ultra-low interest rates and people looking for amusement – sat at home during lockdowns, flush with cash.
On the other hand, might a social trend of narcissism have created a permanent shift in demand for status symbols, where a luxury watch is plenty more affordable than a car? This I believe may be the crux question for demand.
Strong US weighting may mitigate decline in the UK
Group revenue is up 19% to £1,543 million, with the US up 35% at constant currency versus the UK/Europe up 10%, these regions constituting 42% and 58% of group total respectively.
If as this week’s US inflation data is starting to suggest, higher interest rates there are already containing inflation without much damage to consumer demand, possibly its economy has a silver lining – versus dark clouds over here.
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Net profit of £122 million appears shy of £126 million consensus forecasts. Likewise, diluted earnings per share (EPS) of 51p is marginally behind the 52.3p targeted. Yet management already asserts the April 2024 year is set to be “significantly ahead of our long-run forecasts” and this autumn will present its growth ambitions out to April 2028.
Luxury watch sales – 87% of group revenue – are up 28%, benefiting from higher prices as well as volume growth. Luxury jewellery rose 10% for similar reasons. The company has spent £28 million on new showrooms (taking the total to 193) and acquisitions, plus £25 million on inventory to support sales growth.
A consequent 18.3% return on capital (including leases) may justify retaining earnings than paying out dividends.
Mean reversion of the PE multiple from 35 times to 13
Management re-affirms guidance issued in May for April 2024 revenue growth of 8% to 11% Consensus for EPS of 54.3p in the April 2024 year, implying a price/earnings (PE) multiple of 13 times at the current stock price of 720p. It marks a substantial mean-reversion from 35 times the April 2022 outcome when the stock traded at an end-2021 price of 1,518p.
In respect of the latest year, a 21% EPS advance meets the test of a “growth company”. Moreover, there has been 30% growth in free cash flow. Yet recent consensus has been only for a few per cent growth in EPS this current year and management has not raised guidance. That may, however, be shrewd at this stage, rather than having to reign back later.
I suspect the market’s chief concern has been discretionary consumer spending to be impacted at some point by higher interest rates; this coinciding with the group nowadays being a £1.5 billion company rather than £700 million pre-Covid. EPS growth is arithmetically more challenging.
Are latent increases in mortgage payments really the crux?
The Bank of England estimates that nearly one million households will see their monthly mortgage bills rise by more than £500 by the end of 2026. For around 250,000 people the rise will be as much as £1,000.
Wealth manager Quilter goes further. It estimates £500 extra per month could be equivalent to a pay cut of £10,345 a year for higher-rate taxpayers or £8,824 for basic-rate taxpayers. Finding an extra £1,000 per month is equivalent to a £20,690 pay cut for higher-rate taxpayers, and a £17,647 cut for those at the basic rate.
This counts in the reality of income tax and National Insurance contributions. A further squeeze to discretionary spending would come where affluent people have other financial obligations such as school fees.
The stock market has therefore been justified in de-rating this stock, but it’s unclear quite whether the drop from 1,000p to 700p in five months is justified by UK interest rate rises when Watches of Switzerland is an international business?
For example, a flagship Rolex boutique is due to open in Old Bond Street next summer. Surely, this is geared to wealthy travellers.
As for the real effect of mortgage increases: only 38% of UK homeowners actually have a mortgage. I respect that renters are also seeing increased demands, but the segment of population likely to spend on luxury watches is very small and may yet prove resilient.
Watches of Switzerland Group - financial summary
Year-end 30 April
|Turnover (£ million)||509||631||774||811||905||1,238||1,543|
|Operating margin (%)||4.5||5.9||5.9||2.4||9.0||11.5||11.6|
|Operating profit (£m)||22.6||37.4||45.3||19.8||81.9||142||179|
|Net profit (£m)||5.3||0.4||-1.8||0.5||50.6||101||122|
|EPS - reported (p)||0.9||0.1||5.8||0.2||21.1||42.0||50.9|
|EPS - normalised (p)||2.7||0.9||8.1||28.0||26.3||43.1||51.2|
|Operating cashflow/share (p)||19.5||19.8||26.9||40.7||71.7||70.8||88.4|
|Capital expenditure/share (p)||7.4||6.2||15.1||12.3||10.9||18.3||39.9|
|Free cashflow/share (p)||12.1||13.6||11.8||28.5||60.9||52.5||48.5|
|Dividends per share (p)||0.0||0.0||0.0||0.0||0.0||0.0||0.0|
|Return on total capital (%)||12.5||10.3||13.2||3.4||12.8||18.2||18.3|
|Net debt (£m)||105||247||240||441||353||367||394|
|Net assets (£m)||51.0||85.1||76.6||200||250||361||469|
|Net assets per share (p)||21.3||35.5||32.0||83.3||105||151||196|
Source: historic company REFS and company accounts
Narcissism, hence demand for status symbols, is increasing
However unpleasant the narcissistic character can be, the booming number of psychology articles on how to cope on the receiving end of such behaviour, testifies to its advance.
For such people, appearance is all, and watches fulfil a vital role as status symbols.
This social trend is I believe a key reason why management here says “luxury watch demand remains strong and continues to outpace supply, with our client registration lists extending and average selling prices growing”.
The international network of showrooms has continued to expand by a total of 28 across the UK, US and Europe, while also upgrading a further 13 including the roll-out of Goldsmiths luxury format.
Yes, it does concern me that 15 of those 28 have been in the UK where there could be comparatively most softening of demand.
In the possibly more resilient US, however, two new showrooms have recently opened in New Jersey and Florida, with another in New York due in early 2024. A Dallas one is being re-located and expanded.
Slight rise in operating margin despite inflation
Operating margin edging up from 11.5% to 11.6% implies higher costs are being amply absorbed by price rises. The income statement shows administrative costs as a percentage of revenue actually falling from 3.0% to 2.6%.
Net finance costs, however, took 13% of operating profit against 11% the previous year, as interest rates rose on otherwise quite similar £530 million financial liabilities. Leases comprise the 77% majority.
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End-April cash still rose 28% to £136 million, aided by a 25% advance in net cash generated from operations to £212 million.
Investment comprised £96 million and there was also an £85 million net cash outflow – mainly paying for leases, plus share buybacks (albeit for employee benefits than EPS-enhancing cancellation).
On dividend capability, I conjure that if we add back the £21 million spent on buybacks, with the £31 million net increase in cash, the resulting £52 million could finance a 22p dividend equivalent to a circa 3% yield.
A dilemma with introducing a dividend, however, would be tacit confirmation the stock is going “ex-growth”.
Still a candidate to consider averaging into
At some risk of repetition, I think this remains an appropriate stance both with selective fallen growth stocks and quality cyclicals.
Broad experience is that economies/consumers do muddle through rather than experience worst-case scenarios. It is therefore being wise to explore buying when fears run high.
As a starter position: Buy.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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