Richemont: Capital Allocation And Value Creation Par Excellence

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About: Compagnie Financiere Richemont AG ADR (CFRUY), Includes: CFRHF
by: The Profit Hunter

Summary

Richemont is a luxury goods maker run by an exceptional industrialist whose stewardship of the family business has been exemplary for over 30 years.

The business exhibits high returns on capital employed driven by brands with true provenance that behave counter-cyclically.

Founder and Chairman Johann Rupert has positioned the company as a purveyor of ultra high-end watches and jewellery to the rich and famous.

Many of Richemont’s core brands have been developed organically over time. As such, in comparison with peers, goodwill is miniscule at about 1.2% of assets.

Aside from the iconic nature of the brands, a commitment to manufacturing excellence and distribution reach, Richemont stands out as a capital allocator par excellence.

Richemont (OTCPK:CFRUY) (OTCPK:CFRHF) is a Swiss luxury goods maker and owner of the iconic Cartier brand. The business was founded by Johann Rupert, an exceptional industrialist, whose stewardship of the family business has been exemplary for over 30 years.

Cartier is the Jewel in the Crown

The company’s flagship brand is Cartier, which accounts for approximately 66% of Group profits. The brand was established in 1847 by Louis-Francois Cartier who originally opened a jewellery store in Paris and in the following year began selling watches.

In 1902 Cartier opened a store in London, its first outside of France. Expansion followed into the United States and Russia. Until 1964 the company remained under family ownership, at which point it was broken up and in 1974 and 1976 Cartier London and Cartier New York were acquired by a group of investors including Rembrandt. In the early 1980s Rembrandt bought out the interests of the minority shareholders to assume full control of the business. In 1988 Cartier acquired a controlling interest in Piaget and Beaume & Mercier. The Rupert family consolidated its brands under the Vendome Luxury Group in 1993 with Cartier accounting for around half of its sales. In 1998 Richemont bought out a minority interest in Vendome Groupe.

Testament to Cartier’s enduring appeal is its younger audience – 43% of sales globally were derived from customers under the age of 35 – a portion in Asia which is now over one-half. According to a report by MVI, Cartier was rated the second most preferred jewellery brand in the United States among millennials, after Tiffany.

Cartier is one of few luxury brands to embrace a direct-to-consumer (DTC) distribution model focused on retail and online sales. The cartier.com site was launched in the United States in 2010 and a virtual WeChat store front was recently set-up to tap the Chinese market. Not only does the direct model help protect the brand’s identity but should facilitate 1) a higher mark-up; 2) superior inventory management which reduces the risk of product obsolescence and lowers capital requirements; 3) direct access to customer data which can be used to improve marketing, service and product development.

A Collection of Iconic Brands

Richemont owns a portfolio of iconic luxury brands positioned at the high end of the affordability spectrum. These brands include Cartier, A. Lange & Sohne, Piaget and Van Cleef & Arpels. The company has exhibited a history of impressive organic sales growth, which has expanded by around 10% per annum since 2006. Book value has compounded by 8% since 2006, yet is understated by the divestment of tobacco company British American Tobacco (BAT). Shareholder returns have compounded at 15% since flotation in 1998 inclusive of the distribution of BAT. The company has a strong balance sheet with net cash of €5.7bn, equivalent to 16% of the market capitalisation.

The structure of the firm is split between three main entities: Jewellery Maisons, Specialist Watchmakers and Other Businesses. Jewellery Maisons generally comprises two key brands; Cartier and Van Cleef & Arpels. Cartier is the jewel in the crown and accounts for over 50% of revenue though a higher percentage of profit due to loss-making other divisions, such as Monet Blanc and Dunhill. Cutting these losses (which equated to €4m in 2017) and improving operating margins from represents a key opportunity to enhance profits. The Specialist Watchmakers comprise nine different brands, among the most well known are IWC, Jaeger-LeCoultre and Vacheron Constantin. Other business is made up of fashion and leather goods brands (such as Chloe, Lancel, Azzedine Alaia and Dunhill) and writing instrument maker Montblanc. In addition, the Group owns a 95% stake in Yoox Net-a-Porter, holds a 50% JV with Ralph Lauren Watches & Jewellery, a 7.5% interest in leading duty free group Dufry and a 30% holding in Kering Eyewear.

Key Brands by Division

Division

Key Brands

% of Sales

Jewellery Maisons

Cartier, Van Cleef & Arpels, Gianpiero Bodino

57%

Specialist Watchmakers

A Lange & Sohne, Baume & Mercier, IWC Schaffhausen, Jaeger LeCoultre, Officine Panerai, Piaget, Roger Dubuis, Vacheron Constantin

26%

Other Businesses

Alaia, Alfred Dunhill, Chloe, Lancel, Montblanc, Peter Millar, Purdey

17%

Source: Company Reports

In terms of regional split, Asia Pacific accounted for 39% of group sales as of 30 September 2017 with China being the largest market in the region. Europe and the Americas accounted for 29% and 16% of sales overall. The balance is accounted for by Japan and the Middle East.

Sales Break-Down (2017)

Region

Sales %

China, HK & Macau

26%

Other Europe, Middle East & Africa

18%

USA

13%

Other Asia

13%

Japan

9%

Germany, Italy, Spain

8%

France

6%

Switzerland

4%

Other Americas

3%

Source: Company Reports

Over time Richemont has evolved to place heavy emphasis on the direct-to-consumer model leading the retail channel to increase from 41% of sales in 2004 to 60% in 2017. The jewellery category, which represents 56% of group sales, in particular, was driven by growth in Richemont’s franchised stores and direct online channels. Currently, the Group has 1,117 internal stores world-wide.

The headwinds faced by specialist watchmakers in recent years are reflected in operating profit evolution with operating earnings halving between 2013 and 2017. Within Cartier watches used to account for 55% of sales in 2008 and have since declined to 32%. Nonetheless, Cartier remains the number three seller of timepieces after Rolex and Omega.

Richemont’s Watchmakers have experienced compound revenue growth of 10.5% since 1999 but the category is not without its cyclicality. During the Great Financial Crisis sales declined 8% in the full year to March 2009. The company was hit harder with declines of 15% in the two years to March 2016 as a result of the Chinese anti-grafting campaign. In the latter case this resulted in a decline in EBIT margin from a peak of 27% in March 2013 to 10.4% in March 2017.

Jewellery Maisons have maintained a steady stream of operating profit since 2012 at roughly €1.9 billion per year since 2013 but has recorded a 16-year CAGR of 8% since 2001. Sales in the division have expanded from €1.0bn in 1999 to €5.9b in 2017. The EBIT margin for Jewellery Maisons stands at 31% versus 19% for specialist watchmakers and the former has been more stable - gradually trending upward since 1999 – albeit slightly declining from 2014-17 before recovering in the first half of FY2018.

In terms of brands, Cartier accounted for c. 44% of sales and 66% of Richemont’s underlying operating profit (pre-central costs), while Van Cleef’s contribution was c. 12% and c. 20% respectively.

Breakdown of Sales and Operating Profit by Brand (2017)

% of Sales

% of EBIT

Cartier

44%

66%

Van Cleef & Arpels

12%

20%

Montblanc

8%

2%

IWC

7%

4%

Jaeger-LeCoultre

5%

2%

Piaget

4%

N/A

Chloe

4%

N/A

V Constantin

4%

2%

Panerai

4%

3%

Others

8%

1%

Cartier’s Brand has been Re-positioned

Under CEO Vigneron, appointed in January 2016, Cartier has refocused its watch offering away from high end complications into elegant, more feminine watches. Watches are part of Cartier’s DNA – it has been selling watches since 1848 a year after Louis-Francois Cartier opened its store in Paris. Yet, under Vigenron significant buyback programs were undertaken to clear excessive inventory resulting from the gifting policy in China, which curbed demand for men’s time-pieces. It has rationalised the assortment of some lines, improved price coherence and re-launched some iconic models (Panthere, Tank americaine, Santos). Changes in jewellery have been more limited thus far but extending iconic lines (eg. Free Love bracelet launched in 2016), among other initiatives, has added value.

Cartier is one of few brands to show strong authenticity in both jewellery and watches. Alongside Rolex and Patek Philippe, Cartier is the timepiece maker with the highest number of iconic watches. Cartier owns three of the world’s most recognisable jewellery lines – Love, Trinity and Juste un Clou, which is key to generating pricing power (and thus higher margins).

Leather goods account for a small part of Cartier’s sales today (c.3%) and Cartier appears to be targeting the category as a potential growth avenue (mainly women’s handbags). More generally, one might expect Cartier to move more aggressively to expand in the accessories category. At 30.9% Cartier’s operating margin is the highest in the jewellery sector globally. Cartier is set to drive 48% of Richemont’s consolidated sales in FY2018 and 68% of profits.

Preferred Gifting Brands for Chinese High Net Worth Individuals

Rank

Men

Women

Jewellery Brand

Watch Brand

1

Apple

Bulgari

Cartier

Patek Philippe

2

Louis Vuitton

Apple

Bulgari

Rolex

3

Chanel

Chanel

Tiffany

Vacheron Constantin

4

Cartier

Louis Vuitton

Van Cleef & Arpels

Cartier

5

Moutai

Hermes

Chaumet

Van Cleef & Arpels

6

Hermes

Gucci

Chanel

Bulgari

7

Gucci

Dior

Boucheron

Piaget

8

Dior

Tiffany

Chopard

Blancpain

9

Bulgari

La Mer

Harry Winston

Jaeger-LeCoutre

10

Rolex

Cartier

Graff

Omega

Source: Statista

Non-Core Brands

Other businesses comprise brands whose main product categories is neither watches, nor jewellery. Ranked by estimated sales these brands comprise Montblanc, Chloe, Lancel, Dunhill, Peter Milar, Azzedine Alaia and Purdey. Whilst revenues of other businesses equate to circa €2bn, the division has been effectively loss-making for 15 years owing chiefly to the Dunhill and Lancel brands.

Equity Stakes

Yoox Net-a-Porter (95%) – in April 2017 Richemont partnered with Net-a-Porter to exclusively launch its latest Panthere watch from Cartier on the high-en e-commerce platform and in select Cartier stores. By January 2018 six of Richemont’s brands were present on Net-a-Porter: Cartier, IWC, Piaget, Chloe, Jaeger LeCoulture and Alaia. Assuming full control of YNAP will enable Richemont to better compete in an expanding online market for luxury goods. Richemont has already signed a number of deals to exclusively list their watch and jewellery brands on the platform. By January 2018 six of Richemont’s brands were available on Net-a-Porter: Cartier, IWC, Piaget, Chloe, Jaeger LeCoultre and Alaia.

Dufry (7.5%) – In May 2017 Richemont took a 5% stake in leading duty free retailer Dufry (Dufry has a 25% share in the global duty free channel market). In November 2017 the stake was raised to 7.5%.

Kering Eyewear (30%) - In March 2017 Richemont assumed a 30% stake in Kering Eyewear (with Kering retaining a 70% stake). Created in 2014 Kering Eyewear handles design and distribution for Kering Group brands including Gucci, Bottega, Veneta, Saint Laurent and Alexander McQueen, as well as the development, manufacturing and distribution of Cartier eyewear. Sales stood at around €340 million in 2017. It is conceivable that Chloe and Dunhill, whose eyewear licenses are currently fulfilled by Marchon and De Rigo vision respectively, could also look to license their brands to Kering eyewear.

Fortress Balance Sheet

Since 2005 Richemont has held a net cash position (at face value) that has steadily increased to €5.7 billion as of FY2018. In terms of pension liabilities, Richemont has transferred its defined benefit scheme to an insurance company which has reduced the risk to the group of future contributions almost entirely. In Switzerland, Richemont operates a retirement foundation with assets held separately from the group. The foundation covers the majority of employees in Switzerland and provides benefits on a defined contribution basis. However, under accounting rules it is categorised as a defined benefit plan due to underlying benefit guarantees and therefore accounted on that basis. As of March 2017, net liabilities were relatively immaterial at €25m.

Attractive Industry with Branded Jewellery Gaining Share

As a category, jewellery is growing faster than most other luxury goods. According to Bain, the category grew by around 10% in 2017 to reach $300bn. Since 2007 jewellery sales have grown at 8.1% per annum versus 4.4% for the overall personal luxury goods market. Growth is being driven by rising purchasing power among women, a function of rising labour force participation. According to JWT, women’s earnings are expected to surpass that of men within the household by 2025. Currently, around 25% of women in China and the United States are the highest earner. Women are increasingly buying jewellery for themselves with the trend towards self-purchases expected to continue to rise.

According to Euromonitor only 25% of jewellery sales worldwide were branded – an increase from 15% in 2007. This contrasts to 51% for watches and 38% for handbags. Market fragmentation and localisation is gradually ceding to the branded players such as Cartier, Bulgari, Van Cleef & Arpels and Tiffany, which have collectively been gaining share continuously over the last two decades. Brands convey authenticity and heritage, which non-branded jewellery lack. Moreover, many of Cartier’s lines – such as Tank, Panthere and Love - have become highly recognisable – enabling the jeweller to demonstrate status, thereby providing pricing power and high gross margins.

Market Share in Branded Jewellery (2017)

Brand

Share

Cartier

8.1%

Tiffany

7.8%

Van Cleef & Arpels

3.2%

Bulgari

1.4%

Graff

1.0%

Chopard

0.7%

Pommelato

0.7%

Bouhceron

0.7%

Piaget

0.7%

Chaumet

0.6%

Others

75.1%

Source: Euromonitor

Valuation Discounts Zero Long-Term Growth

Richemont is forecast to generate NOPAT of €1.5bn in FY2019 (note FY year-end is March 31). Depreciation and amortization is expected to be around €560m with capital expenditure of €504. Given forecast net positive working capital of €221m, normalised cash earnings would equate to €1.7bn. Assuming a low discount rate of 5.6% to reflect Richemont’s cheap cost of debt finance (0.7% interest rate) and enduring brand portfolio.

Richemont Earnings Power Value (Firm) = Normalized Cash Earnings / r

Where r = cost of capital

= 1700 / 0.0566

= €30.0bn

Richemont Earnings Power Value (Equity) = EPV (Firm) – debt + cash / investments

= 30.0 – 8.4 + 15.4

= €37.0bn

Given Richemont’s current market cap equates to €35.4bn, the company trades at a discount to current earnings power value. This implies the market is effectively discounting zero long-term growth.

Risk Factors

The majority of votes in Richemont are owned by Johann Rupert, and family-ownership is a characteristic of Richemont's operation. Compagnie Financière Rupert, a Swiss partnership limited by shares, holds 522 million 'B' registered shares representing 9.1% of the equity of the Company. However, by virtue of the corporate governance structure, Rupert effectively controls 50% of the Company's voting rights. Whilst Rupert has acted with integrity and great stewardship throughout his tenure as Chairman, shareholders’ are effectively entrusting their power in his hands.

Conclusion: A Well-Managed Enduring Brand Portfolio

Richemont has a leading position in luxury branded jewellery, a market experiencing healthy demand for classic designs, quality craftsmanship and creative collections. Cartier, Van Cleef & Arpels and Piaget are well positioned to capitalise on this growth potential. Over the past decade the luxury jewellery market has grown at an annualised compound rate of 8.4% (according to Bain). Moreover, the industry is highly fragmented with branded jewellery market share at only around 25% today and the combined share of the top ten jewellers below 12%. Yet, the top ten jewellers today account for a disproportionate share of the growth. Allied with the increasing number of high net worth individuals (particularly in Asia) and female economic empowerment, Richemont’s array of brands with distinctive heritage are well positioned to expand and grow profitability. Accordingly, the shares are recommended for purchase.

Disclosure: I am/we are long CFRHF.

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.

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