The Hour Glass

[dzwm87]

Hi ghcua,

Yes that's what I was alluding to -- that it's hardly a value trap given it is traded at a premium to book which IMO, is considered rich for its type of business.

[weii]

More competition from online authorized distributors selling Rolex could be coming in line of France's competition watchdog ruling.

According to the 2022 report, the Swiss watch industry represents production of around 16 million watches, with Rolex’s share coming at 1.2 million units in 2022. On the other side, counterfeiters pumping out an estimated 30 million to 40 million watches onto the black market, particularly popular models from Rolex, Patek Philippe, Audemars Piguet and Omega.

Given Rolex developed “a program for the online purchase of pre-owned watches, whose authenticity it guarantees” with one of its retailers, “an absolute ban on the online selling of its products cannot therefore be justified,”

Reference:
https://sg.finance.yahoo.com/news/france...25029.html

[weijian]

There have been quite a few points raised. Let's try to discuss each of them.

Just how much cash/working capital does THG require? 

1) That depends on how much THG wishes to grow. We don't know the plans that management has for the future, but the requirement of working capital can still be illustrated by looking at past figures.

($000)                 Revenue             Changes in working capital                                     
FY08:                   489,768              -7,334
FY09:                   441,908              -10,039
FY10:                   488,298              -22,262
FY11:                   521,834              -34,442
FY12:                   611,780              -43,827
FY13:                   607,758              -54,500
FY14:                   688,943              -6,599
FY15:                   740,804              -36,642
FY16:                   714,029              -45,480
FY17:                   703,952              1,314
FY18:                   691,645              9,802
FY19:                   727,315              -21,205

Growth in Revenue over 12 years: $237m
Total Change in Working Capital over 12 years: -$271m

As THG grew its revenue by $237m over the past 12 years, its increase working capital -- mainly inventory -- is $271m. So it looks like THG has to use an extra dollar to earn an extra dollar (and part of the reason is that it is holding inventory for longer periods than before). How much revenue growth does THG desire? Does its present cash balance represent a realistic amount of growth that THG may wish to achieve, in the near future?


2) But working capital is not all that THG requires for growth, although it constitutes the largest proportion. More retail shops means more PPE requirement. How much? I will spare readers the details and summarise the numbers.

Total Depreciation & Amortisation over 12 years:              $66m
Total Investment Cash Flow over 12 years:                      -$156
Difference over 12 years:                                               -$89m

Not all of its investment cash flow is being spent on PPE, but to save myself the trouble of digging for the numbers, the illustration here should not be too wide off the mark. Thankfully, the requirement on capital expenditure is not as high as for working capital.


3) So what does all these mean for THG? How much cash does it really need? How much cash does it really generate? In a previous discussion, I have mentioned how companies may allocate their capital into 3 broad areas: growth, financial security, and distribution. How much does THG spend on each of these?


Total Operating Cashflow before WCC:   $739m              (100%)

Total Change in WC:                            -$271m             (37%)
Total Investment Cash Flow:                 -$156m             (21%)
Total Dividends:                                   -$146m             (20%)

Remaining ‘Excess Cash’:                       $165m              (22%)


It should be clear that the bulk of the cashflow is spent on working capital and PPE; growth. And the remainder is split between distribution and financial security.

So if (prospective) shareholders are expecting to have a higher payout ratio, it has to either come at the cost of growth or cash accumulation. Certainly, the absolute amount of dividend can increase in proportion with the profits. But for THG to increase the payout ratio -- while it is certainly possible -- may signal a shift in management strategy, the effects of, which as previously mentioned, may or may not be favourable to shareholders.

Can THG distribute a bumper $50m or $100m special dividend? Sure, from its $165m 'excess cash,' which it accumulated over 12 years. Will THG do so? This is something for (prospective) shareholders to ponder over. Perhaps the real amount of 'excess cash' from management's perspective is the amount that they are holding in fixed deposits.

VB Karlmarx's post back in mid 2019 was my favorite post on THG and I will replicate it here. Full post (for those interested to re-read): https://www.valuebuddies.com/thread-258-...#pid152918

Some years have passed since FY19 and so i decided to check out how THG used its cash in the last 4 years (FY20-FY23). As a retailer, receivables turnover is only ~1 week and so changes in working capital are approximated to be inventory driven.

                                      FY23        FY22       FY21        FY20        Sum        
OCF (after lease)              132,232   194,122   148,926    84,957    560,237  (100%)
Real estate/PPE/business   87,933     44,973    80,814      117,256  330,976  (59%)
Inventory changes            35,137     -4,715    -28,307     -8,021      -5,906    (-1%)
SBB/dividends                  108,797    75,631    28,159      21,740    234,327  (42%)
Retained as cash/others    -99,635    78,233    68,260      -46,018    840        (0.1%)

Notes:

(1) The allocation of cash has seen a big change in recent years, in alignment with the luxury watch environment changing. Annual revenue has increased from 727mil (FY19) to 1136mil (FY23), an increase of 409mil (or 56%) with negligible/slightly negative inventory growth, all thanks to the bundling effect/waiting list gimmicks that previous VBs earlier described.

(2) With almost no inventory growth and little retained in the business, the cash has gone towards real estate/PPE/business (59%) and shareholders via SBB/dividends (42%). More has been used in real estate than returning to shareholders, which isn't a surprise as this had been previously communicated by Chairman Tay in AR22. With an increasing interest rate environment, will there still be enough "attractive real estate" opportunities?

(3) It is worth noting that returns to shareholders via SBB/dividends have seen a substantial increase in proportional usage compared to 2010s. It has however came at an expense of no inventory growth while business grew. With the luxury watch environment normalizing, or we could argue that the 2nd hand market hasn't found its bottom (based on subdial index), would we still see such similar levels of returning capital to shareholders?

--------------------------------------------

To Choon:

For something to be a "value trap", it first needs to have someone see the "paying pennies for a dollar" illusion (hence value), but been ignorant/not accepting the fact that the odds of extracting the dollar is dismay (hence "trap"). As VBs ghchua/dzwm87 mentioned, just based on NAV for a retailer, there isn't the first part illusion. We could argue that NAV undervalues THG because of its AD status/ relationships with the Swiss watch makers but that is an argument for another day.

Simply based on looking at "buying real estate and never selling it" alone is probably not enough. We need to look at the entire structure as well. At least with good business economics of the last few years, we have seen Chairman Tay giving to shareholders, returns above the historical norms, while also spending more on real estate. And because of this 2 things, Mr Market has responded via a market price above NAV, reflecting the fact that you can't really own THG by "paying pennies to the dollar".

[dreamybear]

@weijian : may I ask how to calculate changes in working capital ?

Taking FY2019 as an example, the post stated :
($000) (Revenue) (Changes in working capital)
FY19: 727,315 -21,205

Pg 52 of AR2019 - cash flow statement :
2019 ($000)
Operating cash flows before changes in working capital 87,550
(Increase)/decrease in inventories (4,730)
(Increase)/decrease in receivables (1,295)
Decrease/(increase) in prepaid operating expenses 41
Increase in amount due from associates (2,707)
Increase in payables 1,168
Cash flows from operations 80,027

Shdn't the change in working capital be $87,550 - $80,027 , i.e. around $7m ?

Thx.

PS : Apologies, I am not accounting trained.

-----------------

AR2019 : https://www.thehourglass.com/annualreport/2019/

[weijian]

@dreamybear, I am not accounting trained too, but sufficiently trained via VB and friends.

Karlmarx looked to have used the OCF (post tax/interest), rather than the OCF (pre tax/interest).

(A) Using OCF (post tax/interest), would be 87,550 - 66,045 = 21,505
(B) Using OCF (pre tax/interest), would be 87,550 - 80,027 = 7,523

Using (A) would have added taxes/interest costs to working capital (inventory, receivables minus off payables) and overestimated it. The correct one would be to do what you have, ie. (B). So Karlmarx overestimated the WC in his 2019 post.

[dreamybear]

@dreamybear, I am not accounting trained too, but sufficiently trained via VB and friends.

Karlmarx looked to have used the OCF (post tax/interest), rather than the OCF (pre tax/interest).

(A) Using OCF (post tax/interest), would be 87,550 - 66,045 = 21,505
(B) Using OCF (pre tax/interest), would be 87,550 - 80,027 = 7,523

Using (A) would have added taxes/interest costs to working capital (inventory, receivables minus off payables) and overestimated it. The correct one would be to do what you have, ie. (B). So Karlmarx overestimated the WC in his 2019 post.

Thanks weijian. Nice reverse engineering skills. 

-------------------------

Generally, I wonder if C-suite /key decision maker does such financial analysis(karlmarx's post) when mulling over capital allocation in the business.

I think it wld be good if i4value can help shed some light based on C-suite experience ! 

[Choon]

There have been quite a few points raised. Let's try to discuss each of them.

Just how much cash/working capital does THG require? 

1) That depends on how much THG wishes to grow. We don't know the plans that management has for the future, but the requirement of working capital can still be illustrated by looking at past figures.

($000)                 Revenue             Changes in working capital                                     
FY08:                   489,768              -7,334
FY09:                   441,908              -10,039
FY10:                   488,298              -22,262
FY11:                   521,834              -34,442
FY12:                   611,780              -43,827
FY13:                   607,758              -54,500
FY14:                   688,943              -6,599
FY15:                   740,804              -36,642
FY16:                   714,029              -45,480
FY17:                   703,952              1,314
FY18:                   691,645              9,802
FY19:                   727,315              -21,205

Growth in Revenue over 12 years: $237m
Total Change in Working Capital over 12 years: -$271m

As THG grew its revenue by $237m over the past 12 years, its increase working capital -- mainly inventory -- is $271m. So it looks like THG has to use an extra dollar to earn an extra dollar (and part of the reason is that it is holding inventory for longer periods than before). How much revenue growth does THG desire? Does its present cash balance represent a realistic amount of growth that THG may wish to achieve, in the near future?


2) But working capital is not all that THG requires for growth, although it constitutes the largest proportion. More retail shops means more PPE requirement. How much? I will spare readers the details and summarise the numbers.

Total Depreciation & Amortisation over 12 years:              $66m
Total Investment Cash Flow over 12 years:                      -$156
Difference over 12 years:                                               -$89m

Not all of its investment cash flow is being spent on PPE, but to save myself the trouble of digging for the numbers, the illustration here should not be too wide off the mark. Thankfully, the requirement on capital expenditure is not as high as for working capital.


3) So what does all these mean for THG? How much cash does it really need? How much cash does it really generate? In a previous discussion, I have mentioned how companies may allocate their capital into 3 broad areas: growth, financial security, and distribution. How much does THG spend on each of these?


Total Operating Cashflow before WCC:   $739m              (100%)

Total Change in WC:                            -$271m             (37%)
Total Investment Cash Flow:                 -$156m             (21%)
Total Dividends:                                   -$146m             (20%)

Remaining ‘Excess Cash’:                       $165m              (22%)


It should be clear that the bulk of the cashflow is spent on working capital and PPE; growth. And the remainder is split between distribution and financial security.

So if (prospective) shareholders are expecting to have a higher payout ratio, it has to either come at the cost of growth or cash accumulation. Certainly, the absolute amount of dividend can increase in proportion with the profits. But for THG to increase the payout ratio -- while it is certainly possible -- may signal a shift in management strategy, the effects of, which as previously mentioned, may or may not be favourable to shareholders.

Can THG distribute a bumper $50m or $100m special dividend? Sure, from its $165m 'excess cash,' which it accumulated over 12 years. Will THG do so? This is something for (prospective) shareholders to ponder over. Perhaps the real amount of 'excess cash' from management's perspective is the amount that they are holding in fixed deposits.

VB Karlmarx's post back in mid 2019 was my favorite post on THG and I will replicate it here. Full post (for those interested to re-read): https://www.valuebuddies.com/thread-258-...#pid152918

Some years have passed since FY19 and so i decided to check out how THG used its cash in the last 4 years (FY20-FY23). As a retailer, receivables turnover is only ~1 week and so changes in working capital are approximated to be inventory driven.

                                      FY23        FY22       FY21        FY20        Sum        
OCF (after lease)              132,232   194,122   148,926    84,957    560,237  (100%)
Real estate/PPE/business   87,933     44,973    80,814      117,256  330,976  (59%)
Inventory changes            35,137     -4,715    -28,307     -8,021      -5,906    (-1%)
SBB/dividends                  108,797    75,631    28,159      21,740    234,327  (42%)
Retained as cash/others    -99,635    78,233    68,260      -46,018    840        (0.1%)

Notes:

(1) The allocation of cash has seen a big change in recent years, in alignment with the luxury watch environment changing. Annual revenue has increased from 727mil (FY19) to 1136mil (FY23), an increase of 409mil (or 56%) with negligible/slightly negative inventory growth, all thanks to the bundling effect/waiting list gimmicks that previous VBs earlier described.

(2) With almost no inventory growth and little retained in the business, the cash has gone towards real estate/PPE/business (59%) and shareholders via SBB/dividends (42%). More has been used in real estate than returning to shareholders, which isn't a surprise as this had been previously communicated by Chairman Tay in AR22. With an increasing interest rate environment, will there still be enough "attractive real estate" opportunities?

(3) It is worth noting that returns to shareholders via SBB/dividends have seen a substantial increase in proportional usage compared to 2010s. It has however came at an expense of no inventory growth while business grew. With the luxury watch environment normalizing, or we could argue that the 2nd hand market hasn't found its bottom (based on subdial index), would we still see such similar levels of returning capital to shareholders?

--------------------------------------------

To Choon:

For something to be a "value trap", it first needs to have someone see the "paying pennies for a dollar" illusion (hence value), but been ignorant/not accepting the fact that the odds of extracting the dollar is dismay (hence "trap"). As VBs ghchua/dzwm87 mentioned, just based on NAV for a retailer, there isn't the first part illusion. We could argue that NAV undervalues THG because of its AD status/ relationships with the Swiss watch makers but that is an argument for another day.

Simply based on looking at "buying real estate and never selling it" alone is probably not enough. We need to look at the entire structure as well. At least with good business economics of the last few years, we have seen Chairman Tay giving to shareholders, returns above the historical norms, while also spending more on real estate. And because of this 2 things, Mr Market has responded via a market price above NAV, reflecting the fact that you can't really own THG by "paying pennies to the dollar".

Hi Weijian,

I think, for a non-real estate company to spend 59% of cash generated on real estate / PPE,  it's a lot of money (that could have been more efficiently used elsewhere).

What would a normal retailer have done? I think the default business model for a retailer would be to lease and avoid locking up so much capital in real estate.

Furthermore some of THG properties in Australia / New Zealand are prime real estate. Does one really need such prime properties to attract watch-buying customers? Like buying a vintage Mercedes to do Grab?

And the Chairman did say that should it be a case where THG does not have immediate use for a property, THG will continue to renew lease with current tenants. Buying without a plan/need to use it!

So my thought is THG's act of buying real estate, a part of it is motivated by wanting to create a unique environment for customers (which is wonderful), but the larger part of it is motivated by the desire to hoard capital (which is detrimental to shareholders).

So I think 59% of value created by THG in recent years is trapped in real estate. The additional value-add of retailing watches in one's owned real estate is just not proportional to the size of the capital that is tied up.

[weijian]

Hi Weijian,

I think, for a non-real estate company to spend 59% of cash generated on real estate / PPE,  it's a lot of money (that could have been more efficiently used elsewhere).

What would a normal retailer have done? I think the default business model for a retailer would be to lease and avoid locking up so much capital in real estate.

Furthermore some of THG properties in Australia / New Zealand are prime real estate. Does one really need such prime properties to attract watch-buying customers? Like buying a vintage Mercedes to do Grab?

And the Chairman did say that should it be a case where THG does not have immediate use for a property, THG will continue to renew lease with current tenants. Buying without a plan/need to use it!

So my thought is THG's act of buying real estate, a part of it is motivated by wanting to create a unique environment for customers (which is wonderful), but the larger part of it is motivated by the desire to hoard capital (which is detrimental to shareholders).

So I think 59% of value created by THG in recent years is trapped in real estate. The additional value-add of retailing watches in one's owned real estate is just not proportional to the size of the capital that is tied up.

hi Choon,

Even though a retailer should be asset light, it doesn't mean there are no exceptions. An example would be Walmart who owns all the real estate that their stores are built on. Real estate is all about location, location and location. If you are going to be there "forever" (don't forget THG are selling "timeless timepieces"), it may actually make sense to buy to pre-pay your rental for XX years, if you can do so. For example, if you can buy a good located property on Queen Street Melbourne, then you do it. Even if you are willing to pay double to buy the shopfront at Paragon main entrance, SPH will not sell.

Imagine you rent a retail unit where LV is on your left, and Prada is on your right. When you are between them, there are only 3 things you pray will not happen - (1) LV/Prada do not mess up and become premium brands. (2) LV/Prada do not move away. (3) Your landlord does not kick you out...Owning your retail unit removes (3).

Is McDonald a burger/fries company or real estate company? Is the location of Starbucks a lower consideration to its coffee/ambience, or just as important, or even more important? When you are paying a 5/6 figure for something, do you prefer to go Parkway Parade or Ion Orchard to buy?

That said, your grouses are expected and probably justified. A large majority of OPMIs will probably prefer the capital been returned than buying PPE, me inclusive. But as OPMIs, we play accordingly to the cards we are dealt with, not the cards we wish we could have.

Maybe you have also answered your own question (asked slightly more than 1 year ago) why WOS is more expensive than THG:
https://www.valuebuddies.com/thread-258-...#pid167315

[dydx]

In Oct2014, THG bought a prime, prime - located at the entrance of Pitt Street Mall - freehold commercial property (mainly for retail) at 192 Pitt Street, Sydney, in Australia, with net lettable area of 1,027 sqm (approx. 11,055 sft) comprising 5 levels of office and ground floor retail space which was then fully leased out, for AUD32.8m (equivalent to approx. SGD36.9m then)...
https://links.sgx.com/FileOpen/Property_...BWRTUM9RKR

The ground level and first floor has since been transformed into the iconic ROLEX BOUTIQUE Sydney (a large duplex store), and the entire building has also been refurbished (you can review an old Dec2009 Google street view photo and the current one taken on Mar2021)...
https://www.google.com/maps/place/192+Pi...?entry=ttu

If I were Rolex, I would be so happy with THG as a strategic business partner for Asia/Oceania for willing to invest in strategic retail locations and assets to promote/support building my brand and image, and be inclined to allocate more than a fair share of my limited production - including those prized watch pieces - to THG Group. This simply makes good and logical business sense!

[Big Toe]

There is a lot of truth in what dydx is saying. Not only for luxury watches but all types of dealership/franchises as well.
ie car dealership, food franchises etc

If your store front dont live up to expectations and when goods are scarce, what you get will be very limited. It will very much depend on the existing relationship and vendor's standing (store count, Store type, store locations, annual turnover, payment records etc) with the principal/supplier/brand owner.

If you have an outstanding dedicated flagship store at a super prime location. Preview/new limited launches are likely to be held at that location.