7.5x PER and 4% dividend yield, but why isn’t the market providing more love to this company by re-rating them higher?
This was the exact question running through my mind when I purchased this company and then divested it thereafter, within a short period of time.
I’ll go through some of my thought process, as well as collating the research I’ve done on this company in this article.
THG has been a well-known luxury retail name for a number of years now.
Founded in 1979 by husband and wife, Chairman Henry Tay and Mrs. Jannie Tay, the first store was opened at Lucky Plaza in some 40 years ago.
Over time, they branded themselves as one of the world’s leading luxury watch retail groups with established presence of 40 boutiques in 11 key cities in the Asia Pac region. THG’s network of multi-brand and standalone boutiques are strategically located in key markets such as Singapore, Kuala Lumpur, Bangkok, Phuket, Ho Chi Minh, Hanoi, Hong Kong, Tokyo, Sydney, Melbourne and Brisbane.
The Group is also one of the key official retailer for luxury brands such as Rolex, Patek Philippe, Audemars Piguet, Hublot, Richard Mille, A. Lange & Sohne, Breguet, Cartier, Jaeger-LeCoultre, IWC, FP Journe, Omega, Tagheuer, Tudor and many more.
Industry Demand For Luxury Goods
In a research report from Bain & Co (Source here) on the rising demand for luxury segments, they mentioned that demand for luxury goods is set to grow at to a market size of €366-390 billion in 2025. This represents a 4-5% growth per annum from the current spending of €276-281 billion worldwide.
The report, in collaboration with the Luxury Goods WorldWide Market Study, focuses principally on personal luxury goods including watches and jewellery, the second top performing segment in value terms after cars.
The reports shed interesting insight on the various demand outlook for luxury goods, in particular from the perspective of China. Currently, China accounts for just 9% of the global luxury spend but is expected to grow by 18% in 2019. The growth for the other regions include “Rest of Asia” at 7%, Japan at 3%, Europe at 1% and Americas at 0%.
The Chinese consumers are and will be the largest contributor to this lion share, as the rising middle income group will tend to drive the growth of this market over time.
Online channeling and exchange rate fluctuations are also one of the factors driving the volume of the global luxury market.
According to Bain & Co, by 2025, e-commerce will go from the current 10% of market value to 25%, increasing by double digit growth year after year.
There will be a segment on e-commerce at the bottom below which I will discuss more about it.
The Group has a pretty substantial portfolio of investment properties in their book which they purchased it for lease and shophouses for rental.
They have been increasing it over the years as a double up for their leases in countries where they operate in.
The value of these investment properties as of 31 March 2019 financial year stands at $55m.
Investment in Associates
The Group accounts for its investment in associate using the equity method and recognized $3.32m as its share of results of associates in 2017, down from $6.5m back in 2016. Specifically, THG Prima Times Co. Ltd, which the Group has a 50% effective stake, reported a 22% drop in revenue and 50% drop in profits in 2017 in what a sign to be a challenge in the Thai market. In 2018, this number dropped further to $2.8m, before rebounding in 2019.
In Mar 2018, the Group incorporated an associate company, THG S&S Indochine Ltd (50% effective interest), in a joint venture collaboration with Hublot to open its first standalone boutique in Hanoi, Vietnam to meet the rising needs of the Vietnamese market. The boutique is housed in the historic Sofitel Legend Metropole Hanoi, a historic Old Quarter icon in its own right.
It is unknown how the Vietnamese market will perform over time but I am guessing since they have a retailing distribution in Ho Chin Min, they have probably worked out the risk reward return using that as a reference to gauge the demand of the Vietnamese market.
Overall profits from the share of associates have increased from $3.3m in 2017 to $2.8m in 2018 to a strong $6.7m in 2019.
When we think of watches as inventory, we don’t usually think of them as raw goods or materials that can go bad and decay very quickly like food if they remain unsold. Plus, there is always a perception that most luxury watches tend to appreciate in value over time, thus there is an intent to build up inventories as much as possible to meet the rising demand.
But this is not entirely true.
Chairman Henry Tay has repeatedly stressed in his Chairman statement on the annual report on the needs for his team to focus on rightsizing the level of inventories turnover to meet the right needs of demand, not too much and not too little. He specifically mentioned the swiftness of market recovery in late 2017 that caught many watchmakers and distributors by surprise, as they ended up with lesser supply and a shortage for most of the desired watch models.
On the other hand, holding too much inventories will not be optimal and good for the company as well.
The Group recognized stocks / inventories sold as an expense in the cost of sales and they charged any movement in stock allowance and write-down in their income statement as part of the requirement to estimate the gross value of the inventories.
Not only will this affect the working capital and cashflow turnover for the Group, but the company will also recognize a “loss” in their income statement should they decide to shelve off aging inventories to the secondary market which will result in a drop in value of the watches.
Auction houses and online marketplaces like Chrono24 and YNAP have frequently been mentioned as the bigger players to serve the secondary market.
The recent FY19 full year results that they announced was a really strong one.
Not only does topline revenue increased by 4%, but they managed to keep their cost of goods expenses very close to last year, which means Gross Margin has increased to 26.98% in FY19, the strongest performance they have exhibited since they were listed.
In fact, if we look across the performance over the past 10 years, the management has done a good job in growing all aspects of the financials.
Revenue grows from $483m back in 2010 to $721m in 2019 while they managed to boost their GP margin from 20.1% in 2010 to 27% in 2019. NP margin has also improved from 6.9% in 2010 to 9.9% in 2019 at the same time.
The profits from the share of associates also increased over the years as they expanded into regional investing in more JV and Associates with some of the luxury watch retailers names. The partnership they have with Hublot in 2018 is the latest JV they’ve partnered.
From a cashflow perspective, the company has also done really well, generating good amount of cashflow over the years.
In FY19, even after setting up the JVs with Hublot for their exhibition in Hanoi, they are still generating almost $48m in free cash flow, with translates into a 9% fcf yield.
Based on the table appended below, you can see that they generate a lot of cashflow in an uneventful years where they do not have to fork out a lot of capex. But the chances of that happening should be low. I think they would want to capture more market share given the rising sentiments of the middle income group across Asia, hence they would be growing.
In some years where their free cash flow tend to dip is when they bought an investment property like the case in 2016 or when they invest in JV or Associates in 2018.
From a balance sheet point of view, it looked really healthy as well.
From a meagre $50m cash back in 2010, the company has grown the cash and cash equivalent to $181m in 2019.
Borrowings have also dropped in 2019 to $14.9m as the company’s generation of free cash flow enable them to repay most of the borrowings in 2019. The borrowings should be paid off likely by next year.
Net cash equivalent is at $166m, the highest since they are listed.
NAV is at 79 cents, which majority consists of the cash, investment properties, inventories and property, plant or equipment, all really good assets type.
Based on 9.99 cents EPS for FY19, this translates to 7.5x PER based on the last closing price of 75 cents.
This definitely looks cheap from a historical perspective but the bigger question remains why isn’t the market re-rating them with higher valuation and with more love.
The reason I suspect is because the company has done a really good job on all fronts in 2019 but we do not know if this will be the new norm. That is to say, we don’t know if the margins will be maintained at 26.98% or better for FY20 or will it drop given the cyclical demand of the luxury goods tied to the economic condition of the market. If the Trade War continues to persist for a longer period of time, will this dampen the demand and hence impact the margins for the company? I believe these are all valid questions that an investor can run through and ask themselves.
Second, the company has not been very generous with the dividend payout despite generating a good amount of cashflow for a number of years now. The management has tried to maintain the payout at 30% based on earnings and you can see why they are paying 3 cents this year. I believe that if the management is willing to payout more than what they’ve been doing, the market will re-rate them higher immediately. I think this is one of the reason for the lack of movement in share price in recent years, despite the share price appreciation by about 10% this year.
The only way for investors to get a decent yield on this company is to wait for the share price to come down, which I think has a higher probability than expecting management to increase the payout.
I tried to play around and angle it from the future cashflow perspective, knowing that this company must be worth much more, given the way they have grown over the years.
First, I took their past 10 years cashflow to see how much they’ve grown and found that they’ve grown by 12.3% per year up till 2019. Since they are now at a much higher base, it is a lot harder to maintain this 12.3% growth over their next 10 years, so I’ve taken a conservative 12.3% divided by 2 to assign 6.2% instead.
As correctly predicted, this company is worth much more when we use future cashflow as a basis to determine their intrinsic value. At an earnings multiple of 8x and a discount rate of 8%, the intrinsic value will be at 98 cents. If the earnings multiple is higher and the market decides to rate them higher, then their value will be even higher.
E-Commerce Digital Future
The E-Commerce online digital distribution channel is definitely one area of growth gaining momentum over the past couple of years due to increasing connectivity with the digital age.
This area of growth is specifically mentioned in the Chairman’s Statement in the Annual Report 2018, particularly mentioning e-commerce as a new epicentre emergence and relevance to their business. He had special mention for French retailer Richemont, who had acquired YNAP as an integration online distributors to their omni-channel distributions. Sales for YNAP increased by double digits growth rate and alone contributed 2 billion euros in sales just through this channel.
Interestingly, there was an earlier interview with the Managing Director, Michael Tay in January 2017 where he mentioned for THG going into online retailing will not help to scale up their businesses due to the lack of pricing disparity amongst the Asia region. He felt that online retailing will pick up in the market only if there are global pricing parity in bigger countries such as UK, USA and Australia. In a dense urbanscapes like Singapore, he doesn’t feel that it will be a major contributing factor to sales pick-up.
Following that interview, on Jul 6, HK based Sincere Fine Watches, the third largest authorized watch retailer in Singapore, rolled out its digital online platform.
Adding on to that, on Aug 29, another competitor Cortina Watch, who is the second largest authorized watch retailer in Singapore, similarly took the same route and rolled out its own digital online platform as well. Cortina feels the online market will bring sales to the internet-savvy people who will give shoppers peace of mind (fake goods) in the online arena when buying luxury watches.
Given all that into considerations, it is likely that THG will focus their attention into this area of potential organic growth which will boost their sales and margins even further, especially after being tailed by competitors Cortina and Sincere respectively.
I wonder if they regret not going into it earlier to boost their market share.
For companies that are listed in SGX, the only available information for competitors is Cortina Holdings, which is the second largest luxury watch distributors after The Hour Glass.
Cortina appears to have the upper hand in maintaining a higher gross margin than THG but net margin seems to be lower.
Apart from that, all other metrics are almost similar to THG, and they’ve similarly done really well in terms of performance this year.
Interestingly too, Chairman Henry Tay is the second largest shareholder of Cortina Holdings.
From the way the management has stinge on the dividend payout policy, I believe it is only a matter of time before the management decide to delist the company.
One of the main reason for companies to get listed is to be able to access public funds in order to grow.
For THG case, it doesn’t seem like they will have any issue with this since the company is generating a lot of cash flows year on year and the cash keeps on accumulating on the book.
Management also doesn’t seem to have an intent to distribute the excess cash out to shareholders.
Secondly, the obvious corporate action shows that the CEO has been increasing his controlling of the shares, which now stands at 66.39%.
Earlier in April this year, he bought over 500k shares at the price of 67 cents and then added another 9m shares soon thereafter.
Third, the balance sheet has never looked better than before.
My guess is that in the next financial year, they will repay all borrowings that they have on the book, which is about $14m, then be debt free thereafter.
My hunch is then the management might initiate a GO takeover in after 2020 since there is no reason to keep the company listed with that much cash that they are not willing to distribute out.
The offer is likely to be using a methodology of premium to book value rather than the intrinsic value of the company using DCF which is much higher.
As investors, it’s hard to keep on guessing on whether this catalyst will play out given that their dividend yield to wait is not high enough to entice, plus the uncertainty of the earnings if it will keep up.
That is just some of the random thoughts I have in my head when I decide whether to keep or to sell.
Obviously, with tantrum on the market, it’s important to keep cash powder dry and the last thing you want is to get stuck to a company that does poor return on your capital and you suffer either a capital loss or an opportunity loss elsewhere.
I’ll continue to monitor this company along with the other companies I have in my watchlist and may look to enter again once there are better margin of safety.
Thanks for reading.