Pricing power has become one of the strongest weapons for retailers under attack from rising inflation. Watches of Switzerland’s armoury is particularly well-stocked as a luxury watch seller. Rolex buyers, who have been on a waiting list for months, don’t grumble at having a bit more squeezed out of them in exchange for the Swiss-made status symbol.
After a stuttering start on London’s main market, Watches of Switzerland’s shares are set to end the year as the biggest riser of the FTSE 250, gaining almost 150 per cent and trading more than four times higher than its 2019 offer price.
In keeping with its bent towards high-priced products, the group is valued more like a luxury goods group than a retailer. A forward price-earnings multiple of 36 is loftier than that attached to the French luxury conglomerate LVMH or its British rival Burberry. The valuation reflects considerable earnings growth potential.
The Leicestershire-based group is looking stateside to propel sales, a market that is highly fragmented and under-invested by retailers that operate no more than three stores. Sales of luxury watches per capita are 40 per cent lower than the UK.
The US store estate has grown to 36 since the group entered the market in 2017 and it has agreed to buy five more shops in four new states. Sales from the US, which were two thirds higher than pre-pandemic levels during the first half, now account for around a third of the group total.
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Bank of America this week upgraded its recommendation on the stock from “hold” to a “buy” rating and raised its target price on the stock to £20, from £14.10. The investment bank reckons the retailer could notch up annual compound earnings growth of 22 per cent over the five years to 2027, as margins improve and US sales per square foot of shop space rise.
Opening glitzy stores in prime locations isn’t cheap and capital expenditure has been raised to a planned £45-£50 million this year. Growing store sales, a high level of cash generation and minimal debt should put investors’ minds at ease.
The group has not been immune to the pandemic, store closures aside. Before it struck, tourists and airport sales accounted for just over a third of revenue, which has shrunk to 2 per cent in the 26 weeks to the end of October. Brian Duffy, chief executive, thinks that Covid and the post-Brexit removal of VAT-free shopping for buyers taking goods overseas mean that tourist sales in the UK will never get back to record levels.
UK domestic demand, however, has so far offset the sharp decline in sales to overseas buyers, resulting in sales over the first half of the year that were almost a third higher than the pre-pandemic level. That’s been helped by constraints in the supply of Rolex, Pattek Philippe and Audemars Piguet watches, which accounted for 59 per cent of revenue during that period.
There are several potential avenues for margin improvement. Lower rents make US sales higher margin, which should benefit at a group level as stateside revenue rises. Online sales, bereft of store costs, have also continued to grow, rising by more than a quarter compared with the same period last year.
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There’s also scope for price increases to benefit margins, as the watch seller’s supply agreements include a fixed formula between wholesale costs and the retail price. Rising metals and jewel prices could well seep through.
Like its wares, Watches of Switzerland doesn’t come cheap, but the shares offer quality growth worth paying for.
Advice Buy
Why Expansion into the US luxury watches market could accelerate earnings growth and is backed by a strong balance sheet
Chemring
Defence specialist Chemring has been through the wars. The FTSE 250 constituent’s attempt to reinvent itself as a technology company that operates in the security and defence sector, rather than just a military contractor, has been hard fought.
But it is making progress. The higher-margin sensors and information business is being eyed as the real hope for long-term growth. Underlying operating profit here rose 15 per cent last year, helped by another improvement in the margin. That also helped the group post a 5 per cent increase in underlying operating profit despite revenue shifting into reverse due to a devaluation in the US dollar, in which just over half of the group’s revenue is denominated.
Establishing an arm of the cybersecurity arm, Roke, in the US could provide one way of boosting the group margin further. More broadly, management thinks Roke’s technology could also increasingly be applied for commercial purposes.
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Strong cash generation, coming in at 105 per cent of earnings last year, means that despite rising capital expenditure and the acquisition of the artificial intelligence specialist Cubica, net debt declined by almost half and stood at only 0.35 times adjusted earnings before tax and other charges at the end of October.
That raises the potential of M&A. The cybersecurity and biological threat detection markets look the most interesting to management.
There are some risks. The US government accounts for almost half of group sales and a change in the country’s administration and the pandemic has meant a slowdown in the procurement process with some agencies. Some orders that were expected in the first half were delayed until the second half of this year. That said, the order book at the end of October covered 84 per cent of expected revenue for the current financial year.
Two serious legacy issues remain: a Serious Fraud Office investigation over allegations that include money laundering, and a Health & Safety Executive investigation into a fatal explosion at its Salisbury chemical plant. Provisions for costs have been recorded but there is the potential that more could be needed.
Advice Hold
Why Procurement and price challenges must be addressed
