Ultra Luxury Watches the Next Shoe To Plunge

A little over two years ago, Los Angeles-based private equity group Leonard Green acquired luxury watch distributor Tourneau, best known for its 57th street and Madison flagship New York store, in a $355 million going private transaction, which represented a then 12.5x multiple of its $28 million EBITDA. As part of the transaction, Leonard Green invested over $220 million of equity, and raised $130 million of debt. Looking at recent trends in luxury watch sales, it is safe to assume that if the equity invested in Tourneau is not currently worthless, then it will be very soon. It is also likely that GE Capital and TCW, which provided the debt financing, are also looking at losses on their investment.

Makers of luxury watches are staring at at an abyss, as marginal demand from U.S. bankers and Hong Kong tycoons has disappeared. The luxury watch industry business model has historically been one of roll ups, not so much organic growth, as until the hyperbolic wealth creation over the past decade (and current destruction), there was limited demand for $5,000 timepieces. Swiss export watch sales have more than doubled from CHF 700 million in 1998 to over CHF 1.4 billion in 2008. Assuming a full deleveraging cycle eliminates the excesses of the past decade, it is easy to see sales plummet rapidly by as much as 50% over the next several years

The conglomerate nature of the business is obvious when one considers that only 5 major companies own the majority of luxury Swiss watch brands in the world (excluding Rolex which is a one trick pony):

Now, as the marginal purchasers disappear, Swiss watch makers are left scratching their heads how to maintain the top line growth and prevent the bottom line collapse. One good indication of the sad state of the market is listening to what these companies themselves have to say:

"October was very difficult. November is very difficult, in line with October, no worse no better. We anticipate a bad Christmas. 2009 will be very difficult." (Bulgari CEO Francesco Trapani )

"I am not expecting an overall increase in the watch market next year. But I am not expecting a sharp drop either. I think it should be just sluggish. Stable to slightly negative. Asia used to be stronger, it is still pretty steady, but growth rates have come down from last year, but it is still growing pretty well." (LVMH CEO Jean-Christophe Babin)

“Since October, the real economy has begun to experience dramatic repercussions from the financial crisis. Demand for luxury goods...has fallen dramatically and Richemont is currently facing the toughest market conditions since its formation
20 years ago. Given the current economic climate and the uncertainties facing us, we see no cause for optimism. We must assume that there will be no significant recovery in the foreseeable future.” (Richemont Q309 trading statement, 19 Jan.09)

"Last year was an absolute record. We expect a decline this year and in 2010. As watch export data shows, we all suffered a decline in sales in the last two months." (Rolex CEO Bruno Meier)

"In addition to an unfavourable base effect, this decline clearly illustrates the curb on growth suffered by the industry as a result of the world economic climate. The annualised variation slowed to 8.7%, falling below the 10% mark for the first time in more than three years. At a monthly level the industry had not experienced a decline since March 2005." (Federation of the Swiss Watch Industry, November 08 commentary)

What do the statistics say: the drop is already being felt. While 2008 overall was a strong year, with Swiss watch exports growing 6.7% relative to 2007, mostly due to H1 strength, December demonstrated a substantial drop in export sales, down 7.6% from a year prior. Furthermore, the bulk of watch sales has been concentrated in the gold and platinum category, and the highest priced segment of the market (watches over CHF3,500) has yet to demonstrate a drop. This ultra-luxury segment has averaged 25% growth since 2006, compared to 1% for the CHF250-500 category and flat for the CHF500-3,000 segments.

Curiously, Swiss watchmakers are hoping the decoupling theory plays out as the U.S. accounts for only 19% of watch sales, while Asia is an impressive 46%. If recent Chinese import data is any indication, the bottom will fall out of the watch market with a vengeance.

While December 2008 finally demonstrated a drop in export sales in the US, Hong Kong, China, Singapore and Spain, the rest of the market, especially Japan, France, Italy and Germany, has yet to exhibit the drop that will inevitably occur.

The next chart indicates that the tide is only now just turning in the luxury watch sector, which, as a true lagging indicator, will present significant pain to public luxury watch makers such as Richemont, LVMH and Bulgari.

Of course, it is premature to declare luxury watches a dead concept. There will always be people willing to shelve out a lot of cash for that one unique collector's piece (regardless of what maintenance costs may end up being over the long run). And to see the fanatical dedication of an entire community of watch lovers, one should just observe the lengthy forums at http://www.timezone.com/. Regardless, for conglomerates which have already rolled up the market, with few profitable private brands left outstanding, growth through acquisitions will be complicated, while relying on organic growth at this point will be foolish. Thus, as investors we would be very cautious about bullish positions in such stocks as LVMH, Bulgari and Richemont (Zero Hedge has no positions in these securities).

The one industry which will undoubtedly suffer are undiversified distribution outlets, of which Tourneau is a prime example. As consumers trade down, very few if any will be willing to give the middlemen a 20% markup simply for holding inventory and providing brand legitimacy, as more and more vetted direct vendor operations arise.

In retrospect it is amusing to see just what the P&L assumptions embedded in the Tourneau acquisition were. Not surprisingly, sales were supposed to rise arithmetically in perpetuity as the company generated more and more free cash flow. Instead, it is likely that working capital at the company has ballooned, as Tourneau has been unable to unload inventory, having to fund the deficit with increasing amounts of debt, which has likely eradicated any invested equity value.

As the credit cycle turns, more and more tangential offshoots of the uncontrollable spending spree will be impacted. What is true for luxury watches, will easily apply to such market top-tick gimmicks as ultra premium Vodka, gold plated iPhones, $300 bottle service at trendy night clubs, and many more artifacts of a conspicuous consumption economy that is now unwinding with a bang.