Swatch Group is suffering from decreased sales and profits while accruing massive inventory levels over the past few years. The company has recently identified non-specific opportunities for growth in 2017 that seem to have little chance of loosening the quickly tightening belt. While Swatch Group’s self-projected sales growth would be nice, growing inventory levels are something that cannot be ignored. This should leave all of us wondering Is Swatch Group being realistic? Here is my op-ed analysis.
Swatch Group recently released its 2016 annual summary of key financial figures which gives a peek into its performance and includes a few comments and general forecasts from the company. The Swatch Group report is very optimistic about 2017 (which is typical for most companies). Despite this optimism, there are reasons for concern from an investor’s standpoint. I will not make buy/sell/hold recommendations as there are already plenty of people who are engaged in doing so. Instead, the purpose of this article is to analyze Swatch Group’s recently released key financial figures and explain why its forecasts for growth are misguided and why growing inventories is the real problem that needs to be addressed in order for Swatch Group to attain long-term sustainability.
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Here are some of the key figures reported by Swatch Group for 2016:
Net Sales: -10.6% compared to 2015 and -13.3% compared to 2014
Net profit margin: 7.9%, an almost 50% smaller profit margin than a year ago
“The months of November, December and January showed, particularly in Mainland China, very good growth in the Watches & Jewelry segment, with a substantial improvement in operating margin.”
“Based on the positive development of the last three months, healthy growth is expected for the year 2017.”
“Healthy Growth” Opportunities in 2017?
Swatch Group wrote in their just-released 2016 report:
Consumer interest and the potential for Swiss watches remains strong. Particularly Asia and the Middle East are showing again increasing sales in recent months, including brands in the luxury segment, so that healthy growth in local currency can again be expected for the year 2017, even more this expectation also applies to the USA and Europe…Based on the positive sales figures in all segments in recent months, including January, Swatch Group anticipates healthy growth in 2017.
While Swatch Group cites specific countries and regions to be optimistic about in 2017, the recent Swiss watch market export data released by the Federation of the Swiss Watch Industry (FH) leaves little room for optimism. Because Asia, the Middle East, Europe, and the United States are critical areas for future watch sales, I wanted to know how realistic it was to count on these regions for growth in 2017?
I cross-referenced these regions against the country-specific results released by FH just a few days ago (Swatch Group has not released country-specific sales figures, so FH’s report is the best data available). The FH is an independent body that represents and reports on the Swiss watch industry. It is important to note that the FH encompasses the whole watch industry, so its statistics do not represent only Swatch Group. However, Swatch Group is the largest global producer of watches by value. Its sales represent about 19% of the total global value of watch sales and about 35% of the Swiss watch industry sales. It is possible that Swatch Group’s sales figures are dramatically different from the rest of the Swiss market. However, given that Swatch Group represents such a significant portion of the Swiss watch market, it is an approximation that the FH statistics are representative of Swatch Group’s figures.
Important terminology note: The FH reports Swiss watch export statistics. Therefore, this metric doesn’t include watches sold in Switzerland, so sales figures could vary depending on how much a brand sells within Switzerland. These sales figures also don’t exactly mirror retail sales. However, since retail sales drive exports and demand, exports are a natural proxy for sales. When I refer to the FH’s statistics, I use the term “sales” for ease of understanding, but they are actually export numbers.
Comparing the FH Watch Export Data
Swatch Group says the following regions have shown growth in sales in the recent months and will offer healthy growth opportunities in 2017. I compared this claim against the FH sales statistics for these regions, including all countries that individually represent 5% or more of Swiss watch exports. Here’s what the FH says OVERALL SWISS watch sales have been in 2016 (compared to their corresponding period in 2015):
Asian Segment (about 40% of all Swiss watch sales): -5% in December and -5% in November. Overall, sales declined by -11% for 2016.
Hong Kong (about 12.3% of all Swiss watch sales): -15% in December, -1% in November, and -21% in October
China (about 6.6% of all Swiss watch sales): +28% in December, +8% in November, and +3% in October
Japan (about 6.5% of all Swiss watch sales): +4 in December, -15% in November, and -14% in October.
Singapore (about 5% of all Swiss watch sales): -10% in December and -5% in November.
Middle East Sub-Segment (about 10% of all Swiss watch sales) — reported as part of the Asian segment: -4% in December and -7% in November. Overall, sales declined by -4% for 2016.
USA (about 11% of all Swiss watch sales): +11% in December, -18% in November, -17% in October. Overall sales declined by -9% for 2016.
European Segment (about 34% of all Swiss watch sales): -9% in December and -4% in November. Overall sales declined by -9% for 2016.
Germany (about 5.5% of all Swiss watch sales): -3% in December and -9% in November.
Italy (about 6% of all Swiss watch sales): -19% in December, -12% in November, and -12% in October.
United Kingdom (about 6% of all Swiss watch sales): -8% in December, +7% in November, and +9% in October.
France (about 5% of all Swiss watch sales): -12% in December and -19% for November.
Of all the regions mentioned (and the major country markets within those regions), the only countries showing ANY signs of recent increasing sales in the last quarter are (in green): the US, Japan, China, and the United Kingdom. How significant are these countries? They represent about 30% of total Swiss watch exports (again, Swatch Group’s sales likely differ somewhat as these are total Swiss watch export figures). These markets represent 1/3 of the Swiss watch exports, meaning that more than 2/3 of markets had declining sales. With only a few major markets showing recent signs of increasing sales, the remaining markets would have to slow their declines significantly to stem losses in 2017, much less achieve positive “healthy growth.” Growth implies non-negative numbers and given current trends, this seems unlikely unless Swatch Group’s sales figures vary widely from the rest of the Swiss watch market.
Is Swatch Being Too Optimistic?
Perhaps these forecasts are in line with previous years? In a recent Bloomberg article covering an interview with Nick Hayek, the Swatch Group CEO, the Bloomberg piece states:
“Revenue will rise 7 percent to 10 percent in local currencies, Hayek said in an interview, adding that growth depends heavily on exchange rates. The CEO’s forecast was off in the past two years: he had predicted increases and then sales declined.”
Although, the article continues to offer optimism in Swatch’s forecasts as well:
“2016 was negative, and people have to consider it as over and done with,” said Patrik Schwendimann, an analyst at Zuercher Kantonalbank. “What’s the deciding factor is whether 2017 trends are indeed turning better, and while Mr. Hayek is usually optimistic at the beginning of the year, there are positive signs that give his optimism some ground.”
With Mr. Hayek reporting a 50% growth in Chinese sales in January, perhaps the winds are truly shifting.
Growing Inventories are the Bigger Problem
Swatch Group had significantly higher“Days of Sales Inventory” than its peer companies at of the end of 2015 (and this grew longer by mid-2016).
The Swatch Group inventories have continued to grow over recent years and this should be a source of concern. Below is a chart that shows Swatch Group’s inventory levels compared to similar companies as of the last published full reporting year (2015). (You can read more about my analysis of this in an article published with aBlogToWatch).
Another important metric to consider is how much of the inventory is in raw materials versus finished or in-progress goods. By the end of 2015, 89% of Swatch Group’s inventory was either in-progress or finished goods. This is important because it is an indicator of how Swatch Group is handling its operations. In the face of declining sales, an obvious response would be “produce at the rate you’re selling”. However, decreasing production becomes difficult for accounting purposes. As a result, inventories have continued to grow over the last few years. Though Swatch Group has claimed the inventory growth is due to forecasted future growth in demand, I propose they likely continue to grow because they have to grow.
Here’s why (using a fictional example):
Variable Costs: a company only incurs a variable cost if they produce a unit. Examples of VC are the metal that goes into the watch, the wear on the machine, the gas to operate the machine, etc.
Fixed Costs: a company incurs fixed costs regardless of whether they produce anything. Examples of FC are the building mortgage, the salary of the CEO, property taxes, insurance, the pension of retired workers, etc.
Let’s pretend Swatch Group stopped producing for a little while and just sold off what it had in its inventory in order to decrease its inventories by 25%. (These numbers are not Swatch Group’s cost structure nor representative. I’m using simple numbers for ease of understanding — skip to the diagram below if you are a picture person like me).
Pretend that Swatch Group has 100 watches in inventory.
It decides to adjust production so it only produces 75 watches next year.
Meanwhile, Swatch Group has $1,000 in fixed costs to run the company (the factory, power bill, salaries, etc).
Before, it used to spread the fixed costs across 100 watches, which works out to $10/watch and resulted in $1 profit on each watch it sells.
Now, it spreads the same fixed costs across 75 watches, which works out to $13.33/watch.
Assuming that Swatch doesn’t raise the cost of its watches, it now will have to take a $2.33 loss on each watch sold.
This is over-simplification of accounting, but the general principles apply.
Applying this scenario to Swatch Group’s actual financials, if Swatch Group decreased its production of inventory by only 10%, it would result in an 11% increase in fixed costs applied to each watch, meaning less profit on each watch. Depending on how much Swatch Group’s variable production costs are, it could drastically reduce profit margins further. With Swatch Group only reporting an 8% profit margin, there is little room to spare. Therefore, continuing to produce inventory allows it to spread fixed costs over more units, increasing profit margins for each watch sale. Meanwhile, the remaining inventory gets logged as an asset on the balance sheet, which is a standard accounting procedure. While Swatch Group sites forecasts for growth in demand, fixed cost factors should also be considered. This large volume production practice is not unique — it is also very common in the auto industry.
How Inventories are Affecting the Balance Sheet
Keeping an eye on inventories is critical because they can make a company’s profitability look good while sales stagnate or decline and inventories pile up in the company’s warehouse. As inventories stack up, the company’s profit margins on watch sales look acceptable, but it is actually pushing itself into a corner that is very difficult to escape. By looking at Swatch Group’s historical reports, we can see that inventory as a % of its total assets has increased from 33% in 2010 to over 47% by mid-2016. As inventories continue to grow, more and more of the company’s assets are tied up in inventories instead of being spent on marketing, sales, or other efforts to increase sales.
Note: Depending on method of calculation, investment banks estimate the Days of Inventory at over 300, meanwhile Morningstar puts them at over 1,000. Regardless of method, Swatch inventories are large and are larger than their peer companies.
In Conclusion: Where are the Growth Opportunities
In light of FH’s relatively pessimistic sales data, Swatch Group should be more specific about where it sees growth opportunities. This latest Swatch Group report is not its only forecast of growth. Swatch’s mid-2016 letter to shareholders reported multiple statements of forecasted growth in 2017, despite sales being down for a second year in a row with little sign of a turnaround:
“Inventories have already been increased accordingly in order to meet future demand for Swiss made products.”
“…as well as by increasing inventories in anticipation of the higher demand for Swiss made as of 2017.”
These optimistic projections are difficult to reconcile with the Federation of the Swiss Watch Industry’s sobering data and Swatch Group’s own recent financial data. Swatch Group owes it to its investors to clarify how it intends to draw down inventories through growth. Clearly, Swatch Group sales figures likely vary to some extent from FH’s export data — yet Swatch Group sales account for about 35% of Swiss watch sales. The FH’s sales data for the USA, Asia, Europe, and the Middle East don’t seem to support Swatch Group’s optimism. There just doesn’t seem to be enough overall growth in Swiss watch sales in these regions to stem the decreasing sales and shrinking profits of Swatch Group. At this point, those growth opportunities remain a question mark (?) and (in my opinion) inventory levels remain the pressing problem. No matter what, 2017 will prove to be a pivotal year for the Swiss watch industry.
Another article on this topic by Zen Love of aBlogToWatch.
Bloomberg article on this topic
Article by Paul Whitfield at TheStreet