Swatch Reports Solid Sales Growth but Currency Headwinds Weigh on Profitability 

Senior Equity Analyst

Jelena Sokolova

The Swatch Group is the biggest vertically integrated Swiss watch manufacturer with 18 brands covering all price ranges, from entry to ultraluxury. Swatch-owned brands account for around 35% of Swiss watch exports, and the company supplies competitors with watch movements. Swatch Group’s luxury brands boast 100- to 200-year histories, iconic collections, and deep cultural heritage. Most of Swatch's brands (at price points below $10,000) benefit from a cost advantage through scale and a higher degree of production automation. Swatch’s diversification in terms of brands and price points helps it to avoid the pitfalls that come with extending brands into categories where they don’t strategically belong, and to potentially capture positive mix as consumers trade up. However, we see a lack of control over distribution (a little less than 60% of sales are wholesale) as a weak spot for the company. Distributors are more likely to engage in discounting to maintain cash flows when demand sours, which we believe can be damaging for brands with long-shelf-life products. We believe that the demand for high-end watches is not structurally impaired (around 50% of revenue), branded jewellery offers attractive upside for growth (around 9% of revenue from Harry Winston brand), while lower-priced watches (less than 20% of sales) are stabilizing and growing from a low base as the smartwatch category matures and innovation provides a boost. The company is increasingly taking action to tackle costs in the low-end brands and limit grey market channels for high-end brands while investments in automation should help achieve higher profitability even with lower volumes. We expect Swatch Group’s sales to grow at a 4% pace over the long term (versus low-single-digit growth over the prior decade) with mid-single-digit growth for its higher-priced watch brands such as Omega, Longines, Breguet, and Blancpain, high-single-digit growth for jewellery brand Harry Winston and low-single-digit growth for low-end watches (Tissot, Swatch, Mido, Hamilton, and so on).

Business Strategy & Outlook

We assign a narrow moat rating to Swatch based on intangible assets and cost advantage. In our view, business characteristics that support brand-based moats in the luxury industry include. We apply our luxury brand power framework to analyze Swatch's competitive strengths through examining its pricing power, the conspicuousness and investment value of its products, control over distribution, and supply discipline.

We believe Swatch scores well on the first and second points; however, it is weak on the last two, resulting in a narrow rather than wide moat rating.

Since the revival of the Swiss watch industry from near bankruptcy in the 1980s (the quartz crisis), “Swiss-made” in itself has become a symbol of luxury brands (Swiss watches account for around 2%-3% of watches sold globally in terms of volume but more than 50% in terms of value). The industry has commanded remarkable pricing power over the years; in fact, the average prices for Omega watches have tripled in the past 15 years. Since the 1980s, there have been cheaper alternatives for telling the time, from quartz watches to electronic watches to mobile phones. Swiss watches have become associated with design, craftsmanship, and prestige. Some unique watch models are sold at auctions at much higher prices and have become collectibles and investment pieces. Iconic watch models boast a unique historical heritage that cannot be replicated. For example, Omega Speedmaster was the first watch worn on the Moon, while Breguet was favored by Napoleon and Winston Churchill and has been mentioned numerous times in classic literature. The Omega brand is further supported by important and long-standing marketing partnerships, namely the James Bond franchise and Olympic Games sponsorship. 

The growth in Swiss watch exports since 2000 has been driven by value (4% per year in Swiss francs with flat volume, as the lower-price segment has shrunk and the higher-end segment has expanded).

Product cycles in watches tend to be longer than in apparel. Iconic collections are periodically reworked, and changes made to collections are often incremental.

We believe that luxury brands Omega, Breguet, Blancpain, Jaquet Droz, and Harry Winston have wider moats than lower-end Tissot and Swatch, and Longines falls somewhere in the middle. The firm’s lower-end brands have faster fashion/product cycles and compete in the same price category as smartwatches. 

Further, we believe that diversification by brand and price point is an advantage for Swatch, helping the firm not only extract some manufacturing efficiencies (all brands served by ETA) but also avoid the pitfalls of extending brands into categories where they do not strategically fit (pushing too much upmarket or downmarket to follow growth, which is detrimental to the brand identity). Omega is the only brand that Swatch has converted from midrange to upmarket, and the firm did this over time and fairly successfully, in our view. 

Swatch Group is one of the few luxury firms that enjoys meaningful cost advantages in its business niche (Swiss-made watches) stemming from vertical integration. It is the biggest vertically integrated Swiss watch manufacturer, with 20 brands covering all price ranges from entry to ultraluxury. Given that Swatch is the largest industry player with over 30% Swiss watch export share, according to our estimates, and a supplier of watch mechanisms to the remainder of Swiss watch industry with around 20% watch movement market share, it can achieve capacity utilization and per-unit cost reductions that smaller competitors cannot match.

In our opinion, a manufacturing cost advantage plays out best for products that have scale and are at price points below $10,000 (most of Swatch's sales fall into this category, according to our estimates). In this category, production has a relatively high level of automation and can be scaled up. It can take up to five years and require investment of up to CHF 10 million to develop an in-house manufactured mechanical watch movement, according to A Blog To Watch (an industry source), and the fixed costs of running watch manufacturing are high (wages in Switzerland are among the highest in the world), which makes it uneconomical for the majority of smaller midpriced peers to invest in their own production capacity. Production of extremely high-end watches (at price points north of $10,000 apiece) yields little scale benefit, as production is small-batch and highly labor-intensive.

From our vantage point, Swatch's cost advantage is represented in its gross margin. Swatch's average channel-adjusted gross margin of 75% over the past eight years has topped that of Richemont (73%), Fossil (70%), and Movado (71%). The firm's ability to best Richemont despite a higher contribution of cheaper brands in the mix (low-priced Swatch and Tissot represent a little less than 20% of sales, whereas Richemont possesses only luxury brands) points to a manufacturing cost advantage. 

Why not a wide moat? The presence of smartwatch substitution threat for the traditional watch industry prevents us from becoming confident that the company will generate excess returns over the next 20 years. We have indication of smartwatches significantly hurting lower priced Swiss watch sales, although we see high-end brands to be more resilient. Additionally, we see the following weak spots for the firm’s moat protection: 

The luxury watch industry relies on wholesale distribution, where it has rather little control after a sale is complete. As luxury watch production has long lead times (it can take up to six months or a year to manufacture a luxury watch, and design-ins can take up to five years if substantial mechanism changes are made), a lot of inventory investments have been made during boom years. This inventory in the distribution channels is being discounted, which can hurt brand image in the long run. It can be especially damaging for products with long shelf lives. 

Environmental, social, and governance factors relevant for Swatch are human rights in the supply chain—notably in the mining of precious stones and increased circularity of the industry (for example second-hand watches and jewellery), which could hurt demand for new products. We already factor in the strong and growing preowned watch segment into our forecasts for Swatch. Further, we believe the preowned watch industry could help consumers trade in watches more frequently (typically it's a rare purchase), which could even boost demand not only for other preowned watches but also new ones. We believe many of Swatch group's products are produced in small quantities and are long-lasting (sometimes family heirlooms), which reduces their environmental impact.

Narrow

Economic Moat

Swatch Group AG/The

The Swatch Group AG engages in the business of designing, manufacturing, and selling finished watches, jewelry, watch movements, and components. It operates through the following segments: Watches and Jewelry, Electronic Systems, and Corporate. The Watches and Jewelry segment is involved in the designing, producing, and commercializing watches and jewelry. The Electronic Systems segment focuses on electronic components and sports timing activities. The company was founded by Nicolas Georges Hayek in 1983 and is headquartered in Biel, Switzerland.

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News for Swatch Group AG/The Stock (SWGAY)