In April, I finally published a post about Oriental Watch. I followed the company since October 2019, but uncertainty remained too high to form an investment case. The bottom line was, I promised to take another look at Oriental Watch when the (preliminary) annual results are available. Final results were released Monday …
This is not investment advice. Please read the disclaimer. I do currently own shares (economic interest) in mentioned companies.
On June 29th, Oriental Watch released its final results for the financial year ending 31st March, 2020. I will not update the complete report but only discuss the FY 2020 at the very end. FYI: I will only post a full DCF valuation as a follow-up.
Idea from where?
I got the initial idea from a blog post from Forager, last year. I just recommend you to read my original April post (and Foragers), to understand my initial thoughts about the company and why I did not buy shares of Oriental Watch back then.
Quick Facts
Oriental Watch Holding Ltd. (Oriental Watch, OW) is a HKD 1bn market cap holding company that is listed in Hong Kong (398 HK) since 1993. It is active as a luxury watch retailer in greater China with stores in Hong Kong, Mainland China, Macau and Taiwan. Some wholesale activitities and property investments are part of the business as well.
The company has a strong balance sheet with cash of about HK$ 1bn on the books. Since net cash constitutes the better portion of its market capitalization, a sum-of-the-parts valuation approach might make sense — especially taking into account other assets. Inventory levels decreased strongly in the recent past.
High dividend payments since 2018. The company payed much higher dividends to shareholders in 2018 (HK$ 0.345) and 2019 (0.33) compared to former years (0.05). This way, shareholders (insiders own shares as well) directly participate in the company assets and profits in a tangible way. The indicated dividend yield (6%) is low though, and is based on the regular dividends (final + interim), not taking into account special dividends. As a German investor, I believe no withholding tax is due.
Company Operations
Oriental Watch operates 61 stores selling luxury watches, as of March 31, 2019. According to the AR 2019 (p4) the majority is located in Mainland China (46) and Hong Kong (11) and the remain in Taiwan (3) and Macau (1). The number of stores in China were significantly reduced from 89 stores in 2013 to 47 in 2017. The behaviour of mainland Chinese shoppers changed. They tended to buy more luxury items abroad.
Financials rest on Hong Kong so far. With a mere fifths of stores, HK generates about three fifths of total revenue and even a higher share of segment profits, based on financial year ended March 2019 (below). This highlights the importance of the Hong Kong segment for overall financial performance. Oriental Watch is an official Rolex specialist retailer in Hong Kong.
The second segments trends are promising. For the twelve months ending March 2019, revenue share for HK was down to 60%. Revenue per store and profit margins are up for the ex-HK segment. Revenue trends for six months ending Sept 2019 look promising but margins took a hit. A sustained trend to higher segment profitability for the ex-HK segment could be in the making. In 2014 to 2017 the segment profit was negative and many stores were closed. FYs 2018, ’19 ans S1 ’20 were positive, with margins lower than in HK though. But growing revenue and higher margins could create much value.
Hong Kong
Hong Kong is a destinct market. I was able to learn so much when spending a few months in this stunning city. Hong Kongs GDP per capita (US$ 62.7k), as a measure of wealth, is equal to the US and about 4 times as high as Chinas, even though many people immigrated from China in recent years (useful points of reference: Germany 54.5, UK 46.9, Singapore 98.8). Many Hong Kongers earn (very) high salaries enabling them to spend money on luxury items and experiences even after paying rent in one of the most expensive cities to live in.
HK people like to show off. I believe in Germany (as in some other countries), many people do not show their wealth, since their is an ongoing public debate about income and wealth distribution and (un)equality. In Hong Kong (and in other parts of Asia) people earning higher incomes want to show what they earn.
Tourists shopping in HK. Tourist, especially from mainland China, tend to spend big in HK on luxury goods, i.e. expensive watches. Recent headwinds were Chinese crackdown on corruption, protests in HK, covid-19 impediments and in general a weaker economy. So far, these uncertainty factors discouraged me from buying OW.
HK is exposed to special risk factors. The general economy is linked to mainland China and visits from oversea tourists. Many Chinese try to invest their money in HK, i.e. driving the property market higher or spend their money in HK, i.e. on luxury items. China poses a special political risk (ongoing and resurfaced protests since more than one year, umbrella movement before, etc.). HK serves as a financial hub and a gate, connecting China with the western world and was thus immensely important for Chinas economic development, but is losing its relative importance. Chinas treatment of meddling with HK could (unintentionally) discount the long term economic outlook for Hong Kong, diminishing economic growth and salaries and highten uncertainty at the same time, depressing consumer safety.
Financial Performance
Declining revenues since 2013 seem to have been margin (and value) accretive for Oriental Watch. They adjusted their store network, mostly closing down some (unprofitable) stores in mainland China. Chinese consumers did change their consumption habits, spending more abroad (tourists shoppers). As written in my former post, I wondered why revenue is down and margin is up and even dropped them an email (so far I did not receive a reply). Somehow, I remember that they reduced wholesale activities, but I do not remember where I got this information from (or if it is even correct). In AR 2014, ‘wholesale’ was mentioned at least three times for the last time. Since then it seems to have lost even more relevance.
Net profit was stable in 2019. Oriental Watch earned about HK$ 138m p.a. for the last two years, before other comprehensive (expenses) income, resulting in profit margins of 5.6% and 4.8% respectively. This margin expansion was achieved despite less units sold and revenues declining (driven by HK segment) by -400m (-15.7% yoy) accordingly, based on impeded consumer sentiment (trade war, stock market corrections). Yet, gross profit was flat with HK$ 603m, with gross margin increasing to 24.7% (up from 21.0%). Oriental Watch was able to command higher gross margins for its products sold.
Shrinking inventory drives elevated free cash flow since FY 2018. This is merely a one time effect since inventory levels cannot shrink forever, in the long term they have to be kept at a reasonable level (going concern). There could even be a case for rebuilding higher inventory levels in the future.
The balance sheet is pretty solid and seems not to be reflected in the share price as indicated by low P/B. That is why the SOTP approach might make sense here. Non-current assets (635m) are mostly made up of PPE (213m) and Right-of-Use or RoU-Assets (288m, read more about IFRS 16 Leases). Current assets (1,879) outweigh non-current assets by far and are mostly made up of inventories (799m), receivables (113m) and Cash (937m). Other valuable assets are deposits (for rent, acquisition of PPE), interests in associates, joint ventures and financial assets.
Current liabiliites (211m) and non-current liabilities (220m) are essentially made up of leasing liabilities (307m) and trade and other payables (87). Net assets and total equity amount to 2,083m, as of March 31, 2020. This compares to a 1,124 mHK$ market cap as of July 1, 2020, implying a P/B of 0.5x.
Assuming a liquidation of the company the sum-of-the-parts or SOTP valuation approach resulting in comparing NAV to market value might make sense. I do not believe in a liquidation taking place anytime soon, though. But, I believe the company will return more cash to shareholders than was the case historically. Based on the strong balance sheet described above, this would yield tangible value to shareholders if cash is payed out as (special) dividends.
as of July 1, 2020
Most of the companys executive directors have many years of experience managing a business and some bring extraordinary experience in the luxury watch industry. Thus, I believe the chances for serious value destruction are very limited. Especially so, since the owner perspective is given, most of all becasue of Dr. Yeung Ming Bius high economic interest (see appendix).
I feel rather confident that currently I would not pay too much buying into Oriental Watch based on the above SOTP. Since I do not expect the company to be liquidated any time soon, the NAV valuation is not tangible. I believe a cashflow based valuation is warranted.
Final Results FY 2020
On June 29th, Oriental Watch released its final results for the financial year ending 31st March, 2020. Total revenue is down -3.5% yoy, profits are down -28% as are earnings per share. The final dividend (HK$ 0.08) is flat and the special dividend (HK$ 0.05) is lowered by 3 cents.
Revenue decreased by 3.5% overall, with strong differences in segment contribution. Since the increased importance of non-HK segments, the company started to report on the basis of four regional segments.
The high revenue growth of 17.5% in the PRC, despite negative covid-19 effects from Jan to March, is attributable to the sale of in-demand products. With the pandemic mostly under controle, sales rebounded since March.
Sales in HK were strongly impacted by the pandemic and related measures (and less so by social unrests), resulting in a decrease of -17.3% yoy.
Segment profitability of the four regions shows even stronger divergences. The two growing segments (PRC and Macau) contribute much higher segment profit vs last year. PRC’s profits were driven by higher margins and supported by a reversal of provisions on inventories. Profit in HK decreased sharply, driven by impairments on RoU-Assets, PPE and allowance on slow-moving inventory. Taiwan looks critically, profits were impacted by icreased allowance for slow moving items.
Other income, including interest income and subsidies in the PRC, declined from HK$ 42m to 28m.
Other gains and losses decreased from -11m to -32m. Mostly driven by impairment losses on (i) deposits for acquisition of property, plant and equipment or PPE of 4.0m, (ii) PPE of 4.1m and (iii) right-of-use or RoU-assets of 12.5m. I wonder what the (i) is about? Did the company place and ‘loose’ a HK$ 4m deposit, which was meant for acquiring PPE? How can that happen?
Expeted credit losses, booked as impairment losses, were very significant shocking with -15.4m. What happened? I hope that oriental Watch still gets paid.
Profit before tax decreased by -20%.
Income tax expense increased to 28.3m resulting in a tax rate of 22.2%, up from 21.9m (13.7%) in FY 2019. This is due to higher taxes in the PRC and should result in a higher effective tax rate going forward.
Comprehensive income includes some more significant negative items.
Reality Check via DCFs
Despite economic uncertainty and social unrests in Hong Kong, sales and profits kept up very well in the first
To model realistic cashflows that the company will probably be able to pay out to shareholders is what I am aiming for with my DCF approach.
Excess cash will probably result in high dividends at current elevated levels of about HK$ 0.33. When cash levels are at more reasonable levels, eventually dividend payments will adjust to sustainable levels. Assuming growth opportunities are missing, earnings will be are hopefully payed out to shareholders as dividends.
Cashflow could deviate substantialy from profits if working capital levels will change dramatically or capex deviates strongly from periodic depreciation and amortization. I do not assume any material deviations.
Income tax rates range from 8.25% to 16.5% in HK and are c. 25% in the PRC, according to AR 2019 (p144). I expect higher profits outside of HK in the future. Thus I will model the tax rate to increase over time (from 16.5% for the near future transitioning to 20%.
Several economic key factors drive sales trends, gross margins and segment profits as well as net profit margins. According to annual reports, besides others, these are general economic conditions in greater China (PRC) and HK affecting consumer behavior, luxury spend levels and the number of tourists (especially from PRC) in Hong Kong as a group of key shoppers. Gross margins also depend on products mix and average selling prices.
Operating costs (other than costs of goods sold or COGS) and especially rent seems to be well managed based on the most recent annual reports.
HK segment sales levels and gross margins are especially important. If sales and margins in HK were not affected in a negative way too much in the near future, the company should continue to generate considerable profits.
I assume that it is almost flat for a few years in my base case. Business in PRC and Macau, Taiwan should improve over the next few years.
Valuation Inputs
What discount rate to use? is a hard question. On the one hand, required equity yields for chinese luxury retail should be high but on the other hand near term dividend payments seem rather safe. I believe using a low discount rate (of 4%) for the first few years covered by cash is sensible. A higher discount rate (of about 10%) afterwards feels about right.
Claims on equity are potentially significant. According to AR 2019, p58 various persons hold 52 mn options in total to buy shares at differnet exercise prices at or above HK$ 3.44. For reference, currently, there are 570m shares outstanding and trade at a price for about HK$ 2 as of July 1.
I demand a margin of safety of 30% to my fair value calculation and I apply additional discounts to the value of dividend payments based on my capital income tax rate. On the one hand, near term dividend payments seem rather safe and contribute the largest part of value. On the other hand, these dividend payments are (likely to be) taxed at the investor level, the long term busines development is pretty unclear to me and may not provide meaningful growth opportunitites. Overall quality is not high.
I struggle to decide on realistic assumptions. The range is probably pretty wide. Revenues could keep up with current levels for the long term in HK, or decline based on political uncertainty, squeezing segment margins. Revenues and profit margins ex-HK could grow strongly in the future, or fall back to former levels.
Assuming high Ebit margins of 6% (S1 2020: 6.2%), a constant number of stores, recovering sales in HK and growing sales per store in PRC, high dividend payouts at current levels are plausible, I believe.
Oriental Watch released a profit warning for FY 2020 on June 16. Net profit could come in at HK$ 130.5m down from 138.1m (-25%). Most of that hit sems to be a result of non-cash impairment charges. Thus I expect cash generation to be less impacted than net profit.
Revenue decreased by 10% yoy for the period Apr+May, affected by covid-19. I think this is not too negative for a physical stores retailer. Before reading this profit warning I build my model with
My DDM or dividend discount model indicates a fair value of HK$ 3.62 per share (or 2,067 m equity value), assuming total annual dividend payments of HK$ 250m until 2024 and 150m thereafter, a discount rate of 10%. The 10% are too high for the first years I believe (high net cash), but the true value is lower if you consider income taxes due.
A DCF gives a wide range of outcomes, based on very wide ranges for key inputs. Since the company started to report on four regional segments I will adjust my model accordingly. My former DCF yielded a fair value per share estimate (prior to results) of more than HK$ 4. I will think about the differnet segments and will probably come up with a follow up regarding a full DCF valuation when I have more visibility on the different segments’ performance.
Sensitivities are rather low with regard to terminal growth rate and discount rate. In general, most of the value is assumed to be realized within the first few years.
Catalysts are not needed here I believe, since the company already started to make use of paying high dividends, using its excess cash pile. A quote from Jim Grant might apply here:
What’s the catalyst? – I don’t need one. Good things tend to happen to cheap assets.
Summary, Decision and Outlook
The risk to overpay for Oriental Watch is very limited for me I believe, derived from the fact that the company has a very strong balance sheet and the believe that significant dividends will be payed to shareholders during the next few years. However, the visibility on future business performance (of various segments) is very low, representing the considerable long-term risk, amplified through Chinese politics.
I would like to buy a starter position at lower prices. I figured out, that I can buy shares only in Berlin (very thinly traded and expensive) or in HK (very expensive fee) via my usual broker. Trade republic does not offer the shares currently.
I am going to monitor the business performance of Oriental Watch and thy to build a detailed DCF model, focusing on sales trends, gross and operating margins for the four regional segments.
I hope you enjoyed this blog post. Do you agree with my assumptions and methods used to value Oriental Watch?
Best, s4v
Appendix
Annual Key Performance Drivers
In FY 2014, revenue, gross margin and net profit declined with a slowing economy in China, leading to (i) consumers’ shift away from luxury consumption affecting sales volume, (ii) a 1% decrease in average selling price, and (iii) rising rental costs in Macau, HK, China.
In FY 2015, revenue, gross margin and net profit declined with a slowing economy in China due to (i) worsening consumer trends in the luxury segment and (ii) even higher competition.
In FY 2016, revenue, gross margin and net profit declined with a slowing economy in China and HK due to (i) worsening consumer trends in the luxury segment and (ii) keen competition and high costs.
In FY 2017, revenue, gross margin and net profit rose during continuing economic uncertainty resulting in less luxury spending. In late 2016 local consumption and tourists arrivals drove higher luxury sales. Key drivers thus were (i) improving watch retail market and a (ii) successful change of product mix and (iii) rental decreases in HK.
In FY 2018, revenue decreased but gross margin expanded based on a (i) success in enhancing product portfolio and (ii) a strong retail market in HK due to better economic conditions and inbound tourism. Full impact of rental reductions supported net profits.
In FY 2019, revenue decreased but gross margin expanded, due to (i) a continued upturn in retail market in HK despite uncertainties about the global economy (US/China) resulting in shoppers spending more prudently and buying less watches, but (ii) being able to command higher margins for chosen products. The company emphasises costs controls and performance reviews for retail stores. The number of visitors to Hong Kong last year rose by 11.4% to more than 65 million, with an increase of mainland tourists by 14.8% to 51 million, mainly propelled by the openings of Guangzhou-Shenzhen-Hong Kong Express Rail Link and Hong Kong Zhuhai Macau Bridge.
Ownership
Some key persons have a strong economic interest in Oriental Watch, sometimes indirectly through other entities, also taking into account their family members.
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