Editor’s Notes: We previously covered how we were able to net a 153% gain on Oriental Watch Holdings here. It appears that the HK protests alongside the unsteady world macroeconomics have resulted in a buying opportunity once again. These are Oriental Watch Holdings relevant data as of 7th Nov 19. Note that yields might shift as share prices fluctuate.
Disclosure: I am intending to take position in this when able. Caveat Emptor. DYODD.
This is data from our proprietary screener available only to Dr Wealth graduates of the Intelligent Investor Immersive. I have displayed it here for ease of understanding.
There’s probably no better way to flaunt your wealth than to put on an expensive wristwatch. It’s easily displayed, does not take up a lot of space and provides instant recognition on the amount spent.
As Asia’s middle-income class expands rapidly due to urbanisation and industrialisation, many aspirational watch-owners have thronged watch boutiques, eager to get their hands on a symbol of their social ascension.
I will be exploring a luxury watch retailer that has an interesting twist to it – it’s also a net-net company using Benjamin Graham’s strict value investment rules.
The company is Oriental Watch Holdings Limited (SEHK: 0398), and its principal business is in the retailing of luxury watches.
The group operates around fifty outlets in Hong Kong, China and Macau, and carries over a hundred of the world’s top-class brand name watches, including some of the most renowned Swiss watch brands such Rolex, Breitling and Franck Muller.
A reversal of fortunes
The above table displays the fortunes of the group over the last five fiscal years (note that Oriental has a 31 March year-end).
What’s intriguing to note is that the group reversed its losses in FY 2016 and went on to record a close to ten-fold jump in net profit within two fiscal years.
Revenue itself was fairly stagnant from FY 2015 through to FY 2017 and for FY 2018 and FY 2019, even continued to dip by 8% and 15.7% year-on-year respectively. Oriental’s results, therefore, appear to be a result of stringent cost reduction rather than a case of growing its top-line.
Delving deeper into this, I realise that the group had managed to increase its gross margin from the 16% range in FY 2015-2017 to an impressive 24.7% by FY 2019. The latest annual report does not provide a lot of detail on this phenomena though, only to state that it was due to the “Group’s ability to command higher profit margin for its choice of products”.
This statement implies that it was probably both the product mix as well as Oriental’s negotiating power that resulted in the significant improved gross margins. Another factor mentioned by the group in its annual reports is how rental expenses have managed to reduce over the years.
I have indicated the rental expense figure over the past five years and though the proportion of rental expense as a % of revenue has not fallen significantly over the five years, the absolute rental expense has indeed declined from HKD 224 million to HKD 162 million, a 28% drop.
I will tie this later to the store count figures for Oriental in a later section of this analysis.
A Net-Net Company
Oriental is also a “net-net” company, as defined by the late great value investor Benjamin Graham. By taking the total of its cash, trade receivables and inventories, and netting off all liabilities, I get a value of HKD 1.86 billion.
The group’s market capitalisation is only around HKD 1.03 billion, and it is trading at a significant 45% discount to its net-net value.
This is an anomaly in today’s market, as it seems to imply that the market is pricing Oriental business at a significantly lower value than what its Balance Sheet indicates. This may be due either to misinformation or excessive pessimism.
Free cash flow
In terms of free cash flow (FCF) generation, the group has been very consistent in the last five years. FY 2015 started off on a low base as the net profit was fairly low, but FCF continued to improve even though FY 2016 reported losses, while the later years FY 2017-2019 saw very consistent FCF levels of above HKD 200 million.
This attests to Oriental’s strong operating cash flow generation capabilities, which ties in with its reputation for being one of the leading retailers for luxury watches.
Dividends Dividends Dividends
Oriental has been a certifiable dividend machine, with management hiking dividends by almost tenfold from FY 2016 to FY 2017 as a result of the turnaround in the group’s fortunes.
From FY 2017 to FY 2018, there was another sixfold increase in dividends from HK 3.6 cents to HK 25 cents as net profit saw a huge jump. Though the increase in dividends for FY 2019 was just a “mere” 32% year-on-year, Oriental had begun declaring special dividends alongside both interim and final dividends, for a total of HK 33 cents worth of annual dividends.
The trailing dividend yield for the group is 6.1% if only the ordinary dividends are accounted for. However, if the special dividends are also included, the historical yield is a whopping 18.6%! (editor notes: don’t be drawn in simply by the yields)
Of course, this yield is contingent on whether the group is able to continue to do well and whether management is willing to continue declaring special dividends, but the conclusion, for now, is that Oriental represents a dividend bonanza for investors who had held on to its shares since FY 2015.
Store Count & Falling Rental Expense
The interesting part about Oriental’s business is how the group had managed to rationalise its store count over the last five years by closing down underperforming stores. As can be clearly seen in the table above, total store count has fallen steadily every year from a high of 87 stores in FY 2015 to the current 61 stores.
Though rental expense per store and sales per store have not altered significantly if we compare FY 2015 to FY 2019, it is the gross profit per store that has shown vast improvement, jumping from HKD 6 million per store in FY 2015 to nearly HKD 10 million per store. What investors can deduce here is that Oriental has been retaining better-performing stores and also curating its inventory selection to focus on an optimal mix of watches to achieve better overall gross margins.
Geographic Segment Analysis
Segment highlights for Oriental show that the performance for the “Taiwan, Macau and PRC” segment improved dramatically from FY 2017 to FY 2018, reversing from a loss to a profit of HKD 18.4 million. This is even though the total store count for that segment fell from a high of 74 stores to just 50 stores over the last five years. Revenue from this segment has increased in FY 2019 but I believe it was effective expense control that led to the segment becoming strongly profitable, with a segment margin of 5.1% for FY 2019. Though Hong Kong’s segment profit dipped year-on-year from FY 2018 to FY 2019, it still managed to increase its segment margin from 7.5% to 8.9%.
Catalysts for the business
The case for Oriental seems to be one of effective and stringent cost control rather than aggressive business development efforts to garner more sales. Catalysts will, therefore, include the rationalisation of even more stores so that the group can focus on the strongly profitable ones, as well as negotiating for even better rental rates from landlords.
Another ongoing catalyst would be the continued curation of its inventory to ensure a mix of higher gross margin items, such that the gross margin for the group can continue to remain consistently high and in line with other peers (detailed in the competitor section below).
The Swiss Watch Industry
The Swiss Watch industry has detailed statistics on the exports by country, and the industry has seen several lean years in 2016 and 2017 when watch exports declined or slowed down in various countries.
The above table shows this effect, and we should note that consumer discretionary can be fairly cyclical and tied to economic conditions, so this is not a surprising facet of the industry.
For Hong Kong though, watch exports have been climbing year-on-year since the calendar year 2017, and 2018 saw stronger growth of around 19.1%. This bodes well for Oriental’s future prospects as the industry appears to be rebounding after a period of slower exports. This was probably tied to China’s crackdown on luxury spending back in 2014/2015 that resulted in muted sales of luxury watches and high-end liquor (such as baijiu).
In terms of stress-testing, the business may also see a sharp fall in demand for luxury watches by up to 30% to 40% as evidenced by the 2014-2016 numbers. However, stringent cost control can help to mitigate the impact of such a fall in demand, and not all players will suffer to the same extent, as those with stronger networks and better reputations (such as Oriental) will be able to better weather such cyclical downturns.
“Pre-owned” watches – a growing trend
Interestingly, the number of used watch dealers selling “pre-owned” luxury watches has also been increasing, and a recent news article reported that there are now 50 such watch shops in Singapore alone, more than double the number a decade ago. But this phenomenon has been described by European financial consultant Kepler Cheuvreux as being a global one and is not confined to just Asia alone.
The market for used watches is estimated to be growing at 5% per annum, more than twice the growth rate for new luxury timepieces.
Major Swiss watch brands are now working with these pre-owned watch retailers rather than treating them as competitors, and this symbiotic relationship may enhance the appeal of luxury watches and help the industry to grow further and faster.
There are a few competitors to Oriental, one of which is Hong Kong-listed Emperor Watch & Jewellery Limited (SEHK: 0887). The other two prominent ones are Singapore-listed The Hour Glass Ltd (SGX: AGS) and Cortina Holdings Limited (SGX: C41).
The table above shows a comparison between these four companies. It can be seen that Oriental has the lowest gross margin of the four, suggesting that there may still be room to optimise its gross margin. There is also room for net margin improvement as the Singapore players have better net margins than the Hong Kong ones. In terms of revenue and net profit growth, Oriental seems to be the laggard with declines in both revenue and net profit on a year-on-year basis.
In terms of inventory turnover, Oriental is comparable to the Singapore-listed watch retailers in that it turns its inventory around twice per year on average. Its shares are also way more liquid than those of the other three companies with around US$223,000 traded daily on average. Valuation-wise, Oriental is just slightly cheaper than Hour Glass and Cortina on a price-earnings basis.
Risks to the Business
The main risks to the business is that of an economic and cyclical industry downturn. The former will crimp consumer sentiment and the propensity for spending, resulting in lower demand for discretionary goods such as luxury watches. We have already seen this happening post-crackdown in China a few years ago. An industry cyclical downturn could also hit all players badly and cause Oriental’s profits to plunge sharply due to the effect of operating leverage (i.e. a high layer of fixed rental and staff costs that are not easily reduced). Another key risk that revenue may continue to be impacted by competitions from smaller, cheaper players in the industry. However, I believe the overall pie is still growing and this can mitigate some of the impacts from smaller upstarts that seek to take market share away from Oriental Watch.
Valuation and Conclusion
Oriental is an example of a great business that is trading at extremely cheap valuations. Price-earnings ratio is below 8x and the company is also trading at a 45% discount to its net-net book value. While the group appears to be too cheap to ignore, investors need to be aware that most of the recent business improvement was the result of cost reduction and gross margin expansion, rather than top-line growth.
I have issues with companies that grow their net profit in this manner, as there may be a limit to how much costs can be cut. So, what happens then when expenses are literally cut to the bone?
Growth will still be elusive for Oriental unless it can, somehow, show year-on-year increases in revenue. The good news is that the Swiss Watch industry’s exports are growing, even amidst a protracted US-China trade war.
Along with the boom in the pre-owned watches market, these trends bode well for Oriental, assuming it can capture more business and grow its top-line. Investors can consider owning the company for its stellar dividend yield, but they also need to be aware that this is more of an asset play than a growth play.
Editor’s Investing Thesis: We have highlighted before that our Conservative Net Asset Valuation strategy aims to own businesses with superior assets cheaply and own the business for free. All in, considering the yields and the depressed stock price, I consider this a solid counter to hold for the next 3 years and something I might add to if prices trend lower depending on my own cashflow.
The thesis is simple.
Even within an economic downturn, Oriental Watch’s ability to sell is not restricted to Hong Kong. The company is severely undervalued. Yields are decent. Inside managment also owns shares within the company totalling 28.6%.
Let’s dig abit deeper behind the thinking.
Won’t HK protests affect business?
As noted above, it has 46 stores in China, 3 in Taiwan, 1 in Macau, and 11 more in Hong Kong. What happens if the protests keep going on and becomes untenable? As a business owner, its simple. Shift my goods to other stores and sell them there or liquidate them. Closing 11 stores reduces gross operating costs by a significant chunk (11/61th portion of rentals costs). So the risk of HK protests is actually not really high imo. I also doubt their ability to protest for three years straight. Unlike the markets, my ability to remain in the stock is stronger than their ability to remain protesting for three years. Even if I’m wrong, stock prices trend lower, I average down and wait for the eventual upside.
Won’t China boycott the company?
Another key risk is Chinese Nationalism. Oriental Watch is a HK stock, a country with anti-China sentiments. Nationalism in China is at the point where consumers can openly boycott companies and force them to pack up shop as in the case of South Korea’s Lotte. So what happens if HK becomes untenable and China boycotts it in addition? Management has 2 decisions. Head to Macau/Taiwan and set up shop or close down and liquidate. Either way, balance sheets improves once u close down 46 stores in China and 11 stores in HK since operating costs take a nose dive.
Our conservative valuation also places them even below a 50% discount at a price of $2.75 which is above the $1.81 now. That means even if the company closed up shop and sold everything, I’d still profit.
Can’t the stock price go lower?
Yes. It sure can. If it does, I’ll probably average down over the next 6 months or so and wait. The stock is just that cheap. Anytime you get paid decent yields to sit on an undervalued stock with immense upside, you take it. Like Buffett says, these numbers hit you over the head with a baseball bat. It’s just ludicrously cheap.
What about an economic recession?
This is a question often fielded by people. The simple answer is that if you’re worried about your stock plunging 50%, you shouldn’t even be invested in the first place. I’ve said earlier I intend to average down should that happen. As long as managment continues to own significant inside shares, I don’t think I’ll sell in any base case. What you want to watch out for is if managment stays stubborn and refuses to budge while enduring losses and reducing company value.
Beyond that, remember that recessions don’t last that long historically. 2 maybe 3 years max. If its the great depression, everone get whalloped anyway and we all have to be able to adjust to a new paradigm. The key here is in your investment fundamentals – are you playing too big? Are you investing too much? Did you save for the day you lose your job? If you haven’t don’t invest. Period.
How do you know management won’t screw shareholders?
I don’t. But insiders owns 28.6% of the shares. It’s not as big a piece of the pie as I’d like it to be, but I think its decent enough for them to have siginificant aligned interest in maximising shareholder value. This is seen in stringent cost control and dividends disbursed. When managment owns the business and has skin in the game, they tend to not want to screw themselves over.
Remember, when you own a company that’s priced like its dead, it doesn’t take alot to make money out of it. It just has to show some signs of life. I’ve developed most of my mindset and approach independently, but the basis for being able to value companies quickly came from the Intelligent Investor Immersive. It’s been undeniably valuable. I recommend you check it out if you want to be more serious about investing for your own life.