Watches of Switzerland Group Trading At An Attractive Valuation (OTCMKTS:WOSGF)

Investment summary

My recommendation for Watches of Switzerland Group (OTCPK:WOSGF) is a buy rating. Two major driving factors have caused the share price to fall by 70% since the recent peak, and I believe the equity value has been over-punished. I don’t believe WOSGF’s position in the distribution chain has been disrupted at all, and the market should eventually realize this. While demand in the UK is weak, it is likely due to the strong growth in previous years and the weak macroeconomic conditions. Luxury watch demand is still strong, as can be seen in the US market.

Business Overview

WOSGF is an authorized dealer of luxury watches, luxury jewelry, and other fashion products. As of 9M24, the revenue split is 85%, 6.2%, and 8.7%, respectively, making luxury watches the most important segment of the business. The business serves only two regions: the US (43% of the total) and Europe, including the UK (57% of the total). Rolex is the largest revenue-contributing brand for the business (cited at ~60% of group revenue as of FY20, as per the 2FQ22 earnings call). The WOSGF share price has taken a big hit since August last year, down 70% since, and I believe there are two driving factors: the Rolex acquisition of Bucherer and the weak 3Q24 performance. Below, I discuss both reasons and why I think this is an investment opportunity.

Rolex acquisition of Bucherer does not threaten WOSGF position

For background, Rolex announced their acquisition of Bucherer last August, and this has led to many investors believing that Rolex is going into vertical integration (direct distribution), which is a big threat to WOSGF business as Rolex is a big chunk of its business. I think this narrative has very little merit. First of all, if we look at the press release, one paragraph stands out that suggests Rolex has no intention of going into direct distribution. If that is not strong enough evidence, the press release by WSOGY after the deal should convince investors.

“Bucherer will keep its name and continue to independently run its business. The Group’s management team will remain unchanged. Bucherer’s integration into the Rolex group will be effective once the competition authorities have approved the takeover transaction.”

“There will be no operational involvement by Rolex in the Bucherer business. Rolex will appoint non-executive Board members. There will be no change in the Rolex processes of product allocation or distribution developments as a consequence of this acquisition.”

So the question is, why did Rolex acquire Bucherer? Although the headline reason was that Jörg Bucherer was dying and had no succession plan, I believe there is a bigger picture behind the scenes that makes strategic sense to Rolex. If Rolex did not acquire Bucherer, it would provide Rolex’s competitors like Richemont or LVMH the opportunity to acquire it, potentially disrupting Rolex’s sales (Bucherer is the largest luxury watch retailer in the world). Hence, the acquisition was done.

Moreover, Rolex has historically relied on a fragmented network of third-party retailers for distribution. Bucherer, which happens to be one of the major Rolex dealers globally, represents roughly 5% of Rolex’s revenue. Using Rolex’s reported $11.5 billion in sales, this implies ~$650 million in contribution to Rolex. Whereas for WOSGF, the business contributes close to a billion dollars in revenue (~60% of total revenue) to Rolex, mostly in the US and UK. For perspective, the US is the largest spender of luxury watches (outside of China), and WOSGF has a larger presence here. As such, WOSGF still holds a very important positive in Rolex’s distribution chain.

Even if Rolex does have intention for vertical integration, Rolex is not going to be able to do so by just acquiring a distribution channel that carries 5% of its revenue. The notable aspect here is that Rolex relies only on brick-and-mortar retail and does not permit online transactions, which further complicates their ability to internalize distribution. It is unlikely for them to change this model because the customer experience while viewing the watches in the showroom is a crucial part of the luxury watch purchase journey. The present retail locations of WSOGY are occupied by partners with long-term leases, which prevents Rolex from making a significant entry into the market anytime soon. It would take decades and billions of dollars to recreate this retail network, and Rolex would be taking a huge operational risk that could damage its reputation. Even if Rolex does want to vertically integrate, it should be good for WOSGF because Rolex is more likely to just acquire WOSGF than to wait out the leases and bid heavily for those prime locations.

We are the biggest, the oldest retailer in Rolex. We’ve got the greatest visibility in projects that we’ve ever had going forward, so we’ve got a very exciting few years ahead overall with Rolex. 2Q24 earnings call

Demand outlook

In 3Q24, WOSGF reported a 7% constant currency revenue decline in Europe, including the UK, at GBP222 million, and confirmed that they are seeing a challenging trading environment. This caused another major sell-off in the stock. While Europe/UK is weak, remember that the U.S. business continues to support double-digit revenue growth (11.4% underlying growth in 3Q24), and this is the largest luxury watch market in the world. I should further point out that FY23 was a very tough year for WOSGF. The UK business grew 11.4% in FY23 on top of the 29.6% growth in FY22. As such, I believe the industry needs some time to digest all the purchases. Given the macro headwinds in the UK, luxury discretionary spending is unlikely to see a major pick-up for the time being. But I see this as a temporary issue, given that the demand for luxury watches has not been structurally impaired (look at WOSGF’s US growth for proof).

During the most recent Investor Day, management announced their intention to allocate GBP300-$500 million in M&A and new projects to consolidate the US market and expand in Europe. These investments have historically generated very attractive payback periods of 2–3 years (20+% ROI). As WOS continues to expand its footprint, combined with the improving macroeconomic conditions ahead, I believe overall growth can easily pick up to at least mid-single digits, in line with industry expectations.

Valuation

I model WOSGF using a forward PE approach, and using my assumptions, I believe WOSGF is worth $5.63. My assumption is that growth will eventually recover to an industry-like growth rate over the next 2 years, with the belief that macroeconomic conditions will ease by then. FY24 growth is likely to be muted (I annualized from the 9M24 results) given the past 3 years saw extraordinary growth and the industry probably needs time to digest this. I don’t expect margin improvement here, as management is going to continue expanding its presence in the US and Europe, which means costs are going to go up. The biggest upside driver in my model is that PE multiple should trade up to 10x, which is a discount to the level before Rolex announced the acquisition (at 12x forward PE). As I stated above, I don’t think the acquisition should have any valuation impact on WOSG given the reasons stated, but a discount is warranted as growth is much slower today. Between the current 7.5x and the previous 12.5x, I used the midpoint as a reference point.

Risk

If Rolex were to acquire more retailers and decide to go into direct distribution, this would be a major game changer for WOSGF in that the equity value and business position could be permanently impaired.

Conclusion

My view for WOSGF is a buy rating despite its recent share price decline. The bearish sentiment surrounding the Rolex acquisition of Bucherer and weak European performance is overblown. WOSGF remains a critical partner for Rolex, especially in the lucrative US market. The UK slowdown is likely temporary due to past years extraordinary growth and weak macro conditions. Looking ahead, I am positive about WOSGF planned investments, which have historically done well and should easily support industry-like growth ahead.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.