The Hour Glass by SG Value Investor, The Value Edge
Est. in 1979, The Hour Glass Ltd (SGX:E5P) is one of Asia’s reputable luxury retail groups with 30 boutiques in nine key cities throughout the Asia Pacific Region. The Hour Glass prides itself as world’s leading cultural retail enterprise. They have been recognised by notable international publications such as Monocle and Vanity Fair as one of the most influential specialty retailers in the world. Furthermore, The Hour Glass has been accorded the ‘Best Watch Retail’ honours by Singapore Tatler in 2014.
The Hour Glass Ltd (SGX:E5P) operates across several countries – Singapore, Malaysia, Hong Kong, Australia, Thailand and Japan. The bulk of their profits, about 72%, come from their South East Asia and Australia operations. It may seem that The Hour Glass has minimal reliance on the Chinese spending power, however, their exposure to Chinese mainlanders actually account for about 20% of The Hour Glass’s sales. We would argue that this key clientele is responsible for The Hour Glass’s historical performance and it is evident that the past few years have boded well for The Hour Glass – profit attributable to shareholders increased at a 4-year CAGR of 13.9% while gross margins remained consistently above 20%. Similarly, net profit margins have been very consistent in the last 4 years. This reflects the management success in margin control by keeping operating expenses below 14% of sales.
Driven by Same-Store Growth
From FY2010 to FY2014, overall store count remained unchanged at 32 which indicate that growth has been due to same-store sales growth. We can attribute this to the spending power of Chinese tourists, with Hong Kong, Thailand and Singapore ranking among their top 5 travel destinations. While the The Hour Glass Ltd (SGX:E5P)’s Chinese story has weakened in the past year, exacerbated by the political situation in Thailand, it was offset by the effects of Abenomics, allowing The Hour Glass to eke out a slight growth in FY2014. Moving forward, recovery in Thailand is a source of growth; The Hour Glass plans to open another 2 boutiques in Bangkok and 2 Laduree points of sales. Looking at 1Q2015 results, recovery in Thailand has definitely begun, with results from Thailand increasing by 95% quarter on quarter. Unsurprisingly, the primary risk would be a China slowdown.
(II) Balance Sheet & Cash Flows:
Efficient Inventory Management
THG has a very high current ratio of 4.9 and cash ratio of approximately 2.9x (more on this later). Some might frown upon such abnormally high current and cash ratios as inefficient cash management. However in the case of The Hour Glass Ltd (SGX:E5P), we view this as a necessity given the relatively high 3-year average inventory turnover days of 192. This is typical of the luxury watch industry; in fact, companies like Sincere Watches and Cortina have even higher inventory turnover days at 313 and 258 days respectively.
Cash Hoard and Lumpy Cash Flows
We note the lumpy cash flows under Free Cash Flow (2) if we were to consider working capital changes and it is indeed a stark contrast to the FCF before working capital changes. We had 2 primary thoughts on this – one, why is this so? And two, is it a concern? To address the first issue, the disparity is due to large increases in inventory levels from same-store sales growth, as mentioned above. Also, Trade Payables/Trade Receivables has sharply increased from FY2010 to FY2014. What this means is that The Hour Glass is able to get more favourable credit terms with its suppliers. Now, as per our second concern, is this a serious issue? In some sense, this can essentially be perceived as a snowballing of liabilities. However, given that this is accompanied by increasing cash reserves, we see little risk in any liability implosion. As growth slows, the disparity between the two FCFs will also decrease. As such, we deem it appropriate to use FCF before working capital changes for our cash flow analysis.
From an asset perspective, there is upside in the valuation of their Thai associates held at SGD8.4m. For FY2014, it had ownership-adjusted profits of SGD2.9m, in spite of the political unrest in Thailand, and based on their recent FY2015 Q1 results, we expect profits to be maintained at this level at the very least. This gives us an ROE of about 34.5%. It is quite likely that their fair value is upwards of SGD8.4m, but of course there is always a question of unlocking value and it is highly improbably that management will be cashing out their stake anytime soon. Therefore, we do not account for any re-valuation but merely view it as a subtle positive note.
(III) Financial Ratios:
As a regional company, there is no escaping comparison with its regional competitors, of which only Cortina is Singapore-listed. The figures above are based on the latest annual reports except for the calculation of FCF-yield which is normalized on a 5-year average. To put it simply, there is no competition – The Hour Glass Ltd (SGX:E5P) triumphs the others by a fair margin. However, readers should be aware that this is a mere face value judgement; more detailed analysis on the other companies might yield new findings.
(I) Competitive Advantage/Moat:
If we were to be owners of The Hour Glass Ltd (SGX:E5P), one key question would be ‘How does THG compete?’ What makes The Hour Glass stand out from the rest? Inventory management aside, the core purpose of a luxury retailer, or any retailer at that, is to attract customers. We opine the following factors in evaluating a retailer’s ability to attract customers: 1) Pricing & Profitability Pricing is typically a key factor in differentiating retailers. However, for luxury goods, this is not so much an issue. In fact, THG increased their average unit retail sale price by 8% and was still able to grow their revenue and NPAT. This is does not mean that profitability is expected to be similar across the board – this is where efficient inventory management comes in in lowering costs. The Hour Glass stands out in this aspect, as evident by its superior net profit margins. However, higher profitability does not translate to consumer utility when price is relatively inelastic and therefore does not help to attract customers. 2) Number of Stores and Store Locations
Prima facie, The Hour Glass Ltd (SGX:E5P) has the third highest number of stores at 32. However, it is always important for us to understand the intricacies behind the numbers as numbers alone can be misleading. For example, 21 of Sincere’s 39 stores are exclusive Franck Muller boutiques which in my opinion, restricts its appeal to a very niche group of customers. And even though Hengdeli has the second largest network of stores, it has an uncomfortably high exposure to the Chinese market. We can see that Sincere, The Hour Glass and Cortina Holdings Limited (SGX:C41) are equally diverse in terms of geographical market exposure, with all of them