A Play On Emerging Markets: Jewelry & Luxury Goods From Richemont

| About: Compagnie Financiere (CFRUY)

As many investors nowadays, I am looking to have good exposure to the Asian emerging market consumer in my portfolio. One of my preferred methods to do this is to focus on stable and well known Western companies which are expanding rapidly in Asian markets.

As a value investor, I am on the lookout for strong companies that are currently in my opinion under-priced in the market, but at the same time exhibit good long-term business prospects and minimum downside risk. By focusing on companies which are growing in emerging markets but at the same time have strong competitive moats and stable businesses back home, this I believe is a good way to avoid the downside risk.

In this article I will outline why I feel that Richemont (OTCPK:CFRUY) is a perfect global company that fits my strategy, and why I believe it is a good long term buy and hold candidate.

For those who don't know the company, Richemont owns several of the world's leading luxury brands with particular strengths in jewelry, luxury watches and writing instruments.

If you happen to have read some of my previous focus articles, you may know that I use a 10 point system to evaluate companies. Richemont I have scored an 8 out of 10 in my system. I advocate to buy any company which scores an 8 or higher.

Unless otherwise noted, all financial figures quoted in the article are taken from the Richemont FY 2012 annual report and investor presentation.

Note: For more information on my investing philosophy please check out my profile or website linked above. Of the criteria I'll evaluate below, the most important under my system is "circle of competence". This has a point value between 0 and 2. The other criteria discussed in the article are all equally weighted with a value between 0 and 1.

Circle of Competence

I believe it's important that before diving into the details of assessing any business, you first need to take a step back and honestly evaluate how competent you are to make these judgments. I determine whether a particular business is inside my "circle of competence" by giving this a point value between 0 and 2, using the following methodology:

  • First I go to one of the popular finance websites and I read the Profile description of the company. After reading it one or two times, if I still have no clue what the company does or industry is about, then I would score this a 0. In 99% of cases, this lack of understanding that I have of how the business/industry works would cause me to stop looking further into the company.
  • If however the profile description is simple and easy to understand from my perspective, I will score this criteria already at a 1 out of 2.
  • I'll give a 1.5 if I feel I have some relevant practical experience to have sufficiently developed my own detailed perspective on it.
  • A top score of 2 I'll only give if I really have a deep understanding of the company through personal experience with it directly.

In the case of Richemont, I have given this a full score of 2. I have owned and used Montblanc and Cartier products. I also feel the business is understandable from my perspective as an investor, as they have clearly defined business segments (jewelry, watches, Montblanc, other) which make sense to me and I understand their objectives and core strategy. There is nothing high tech or overly complex about the business, which is another reason that I like it.

Score: 100% - (2 out of 2pts)

Business Prospects

The company's Maisons™ (subsidiaries) encompass several of the most prestigious names in the luxury industry including Cartier, Van Cleef & Arpels, Piaget, Vacheron Constantin, Jaeger-LeCoultre, IWC, Panerai and Montblanc. (Source: Company Website).

I first came across Richemont in an article from Kiplinger in early 2011, where it was labeled as one of the The World's 10 Best Stocks. I was intrigued with the company at the time, because it was quite clear to me that the future prospects are very bright. When you mix Asia's rapidly spreading affluence with the region's cultural affinity for brand-name luxury goods, you really have an easy case for owning Richemont. I know from personal experience, that Asian cultures really value status in society, and one way to show this status is to own luxury brands of jewelry and clothing.

I can also add a note here on my personal experiences with Asian culture. I am American, and my wife is Indonesian coming from Chinese ancestry. I noticed right away in the many times I have been to Indonesia, just like other countries in that region including China, the affluent population really values things such as gold, diamonds, and other jewelry. They often give these items as gifts, not just for fashion but actually as a replacement to giving monetary gifts at events such as weddings. This is because historically many of these economies were unstable, with fluctuating currencies, and people found it safer to own precious metals to store away for times of need.

This kind of mentality does not go away easily as it has become ingrained in the culture. As China and other asian nations such as Indonesia continue to grow GDP at high rates, more and more people are able to afford these luxuries. Indeed, if you look at the Sales graph below, Richemont is already no longer a Swiss company - more than 40% of sales already come from Asia:

Click to enlarge

Sales are very distributed across the different regions of the world, which is a big plus to avoiding downside risk, in case certain economies are not doing well. Also impressive, is that margins, sales and profits have been increasing across all regions, and not just in Asia. The following table shows the breakdown of each major business unit, and the increases in sales & operating profit from FY11 to FY12.

Business Division

(Maison)

Percentage of

Group Sales in FY12

Sales Growth

from FY11 to FY12

Operating Profit Growth

from FY11 to FY12

Jewelry

52%

32%

42%

Watches

26%

31%

42%

Montblanc

8%

7.5%

9%

Other (includes clothing and leather goods)

14%

27%

-3%

Click to enlarge

Jewelry & Watches makes up 78% of Sales, showed huge growth of 30% in 2011, and also very impressive profit growth of 42%. Margins improved across the board. The only weak spot for the company is in the Other category, where some restructuring cost in a couple of underperforming units has caused the operating margin difficulties there. The company is however taking further steps to improve this, and expects a gradual margin improvement. In any case this is not a major part of the business overall, and their flagship brands continue to do extremely well.

This past year was perhaps a bit of an exceptional one, as slowdowns in the global economy from 2008 and 2009 caused many people to delay purchases of luxury goods. 2010 and 2011 therefore saw impressive growth again for the company. I expect the prospects for the coming 10 years will continue to be excellent, with Sales and earnings per share to continue their upward march of at least 10% per year.

I am confident to score this criteria a full 100%, or 1 point, as the long term prospects are very bright for this well run company.

Score: 100% - (1 out of 1pts)

Shareholder Friendly

The company has been paying a consistent dividend. The yield is modest at around 1%, but the payout ratio is only 24%, and dividends have been increasing over time. This year the dividend rose a healthy 22%. Having followed several conference calls, I'm also of the opinion that management is quite open and forthcoming. The Chairman and CEO, John Rupert is a charismatic South African billionaire. Unlike a lot of typical politically correct American CEOs I've seen, Rupert is what I would classify as a straight shooter who isn't afraid to say what he thinks in public. On one conference call I watched, an analyst asked a question in regards to raising the dividend and paying out more to shareholders sooner. Rupert took the question and gave the analyst quite a lecture, really showed me some compelling leadership qualities and integrity in the way he answer the question. His response basically was that they will do it prudently and conservatively. But the tone the message was delivered in was a key element for me in deciding to invest in the company. You can watch recent investor presenters here. I feel quite confident the company has shareholder's best interests in mind, and I have scored this a full 1 point.

Score: 100% - (1 out of 1pts)

Moat

Besides the obvious growth prospects for the company, probably the most compelling reason to own it is the strong business moat that exists around so many of their well known luxury brands. Cartier has existed for 160 years. Several of the Swiss and German watch brands are also from the 1800s. It doesn't really get better than that in terms of proven quality and durability of the competitive advantage.

The moat is also very evident in the pricing power and margins. The company has a 5 year average Gross Margin over 60%, compared to the Industry average of only 30%. Net Profit is consistently above 15%, compared to the industry average of only 4.6%.

Looking at these clear advantages I don't need to go any further to determine I can clearly score this a full 1 point in my system.

Score: 100% - (1 out of 1pts)

Conservatively Financed

With this criteria, I look at whether there are any risks to the financial health of the company. With a current ratio over 3, and long term debt/equity only 0.09, the company is in excellent financial health. I've scored this therefore a full 1 point.

Score: 100% - (1 out of 1pts)

Predictable Earnings

With this criteria I look at how predictable and dependable a company's earnings have been in the past. Generally I do not like to invest in wildly cyclical businesses where in my opinion it is notoriously difficult to time when a good entry point might be.

Being a luxury goods business, during hard economic times the business does suffer somewhat. However the company clearly showed during the great recession that it is quite resilient, due to the strong prominent brand names it owns. EPS growth rate has been positive the past 5 years. This criteria also receives a full score in my opinion, because there are no major weaknesses in the business that could cause a drastic drop in earnings.

Score: 100% - (1 out of 1pts)

Margin of Safety

To calculate whether the current price constitutes a sufficient margin of safety against what I feel is the intrinsic value of the company, I have performed a simple DCF, using one my favorite DCF calculators. I compare the potential return of an investment to that of US treasuries, the ultimate "risk free" return. Since long-term treasury rates are at all time lows, (1.65% for the 10 year at time of writing) I use as a minimum a discount rate of 6% in order to be more conservative.

  • Current Earnings: $0.36/share
  • 10 year average growth of Earnings: 10%
  • Growth after 10 years: 0%
  • Discount rate: 6%
  • How confident are we in our earnings estimate? : 75% confident

These inputs give me an intrinsic value of $9.85/share.

With a current market price of only $6.20/share, there would appear to be a sufficient margin of safety in the shares. This is more than a 40% safety margin with an upside potential of 59%. I believe that 10% is quite reasonable growth, looking at the past few years, and the consistent GDP growth expected in many emerging markets where Richemont's products are in high demand. It should be note that the company is not trading ultra cheaply in terms of P/E (17) or in terms of EV/EBITDA (9.94). However as Buffett has taught us, it's often better to own a great business at a good price, than an average business at a great price. I think this is certainly the case with Richemont.

I have scored this criteria a full 1 point.

Score: 100% - (1 out of 1pts)

Total Score: 8pts.

Conclusion: Richemont is a buy.

Overall, I believe Richement has a very strong moat around it's business with well established exclusive brands. The growth prospects in emerging markets are very bright. For these reasons I believe the company is a fine addition to any portfolio.

Final Note: For those keeping score, you might have noticed that Richemont has scored 8/10 points. One criteria missing in this article from my system is the magic formula screening methodology from Joel Greenblatt. I've covered this in previous focus articles - an example here. This criteria however does not work for foreign companies with ADRs on US exchanges, which is why I didn't discuss it here. Note that I still buy company's such as Richemont which don't show up in the magic formula - as I believe if you are confident in the business, its growth prospects, and valuation than it still can be a great investment.

Disclosure: I am long OTCPK:CFRUY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.