CASE STUDY: Swatch Group
The Investment company you are currently working for,
is interested in investing in the watches and jewelry
industry. Swatch Group, a Swiss manufacturer with
international operations, is on your watch list. The Group
is active worldwide and represented in all market and
price segments in the watch sector with 18 brands
including luxury (e.g. Omega), high (e.g. Longines),
middle (e.g. Tissot), and basic (e.g. Swatch) range
watches.
You have been asked to provide a thorough financial
analysis including analysis of profitability, solvency,
efficiency, and liquidity. An internal report on the global
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players / peers of the watch and jewelry industry, has
provided some benchmark figures that can be used in the
analysis.
The financial statements along with some useful notes
are provided below. Please note that Swatch Group is
listed in the Swiss stock market and applies Swiss GAAP.
Some financial ratios have been calculated for you based
on the financial statements provided below. You are free
to compute any additional ratios that you consider
relevant.
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Group 1:
(1) Have Swatch’s revenues grown or shrunk over the
last five years? By how much in percentage
terms? What is your expectation for the year
2020?
Except for the years 2018 and 2017 (increase by 6,5% and
5,4% respectively), sales have generally declined (-2,7% 2019, -10,6% - 2016, -3,0% - 2015).
Sales are expected to dramatically drop in the year 2020
due to the covid crisis. Luxury products are expected to
be heavily affected. The luxury industry is dependent on
customers’ willingness to spend – the so-called ‘feel good
factor’ which is at its lowest during the covid crisis period.
(2) Comment on Swatch’s gross profit margin. Is it
what you would expect? Explain why.
Swatch has a stable gross profit margin of approximately
45%. It might look quite high, if compared to other
industries, but it is not. Luxury products enjoy very high
gross profit margins. If Swatch was reporting revenues
and costs across the different watch ranges (luxury, high,
middle, and basic), we would probably observe much
higher gross profit margins for the upper two.
It seems that the production costs are controllable, the
product mix remains largely unchanged and that
competition does not drive gross margins down.
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(3) Evaluate Swatch Group’s profitability.
On the basis of the overall summary measure of
performance, ROE, Swatch Group is generating a return
that is far worse than that of its peers. In order to
understand better why, we decompose ROE into its two
component pieces (ROA*LEV: TA/SE). Swatch Group is
generating lower ROA than its competitors. We also
observe very low Leverage suggesting that Swatch Group
is not taking advantage of the financial leverage effect to
boost its profitability – something that competitors might
be doing. On the other hand, Swatch Group is not taking
any financial structure risk. Although Gross Profit Margin
is relatively high, it falls below the industry average. This
also depends on the selections of the peers. If the peers
group consists primarily of luxury players with higher
gross profit margins, then Swatch Group might not be
really comparable. We also notice that Swatch stands
quite well with respect to its Net Profit Margin suggesting
that the company is able to control its operating and
financial (they are immaterial) expenses. In this respect,
it would be worth checking its sales, marketing and
distribution expenses and compare them with the peers.
We should also note that Swatch Group has relatively
stable profitability across the years, almost unaffected by
transitory / one-off items. The same applies for the
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core/operating profitability making its profitability highly
sustainable and persistent.
(4) Footnote 33 refers to the acquired goodwill.
Assuming that the peer group you are using for
the analysis follows IFRS, how would you adjust
your ROA and ROE calculations?
The accounting treatment under Swiss GAAP to offset
acquired goodwill against retained earnings (followed
here by Swatch Group) leads to lower Total Assets and
lower Equity compared to similar firms applying IFRS that
capitalize goodwill on the Balance sheet. This treatment
obviously decreases the denominators of ROA and ROE
and boosts the ratios. At the same time, no amortization
expense and no impairment are recognized in the
income, boosting further the ratio through the
numerator. So, the weak profitability of Swatch Group
discussed above seems to be even more alerting. The
footnote disclosure number 33 allows us to incorporate
the effect of goodwill treatment into our calculations and
make meaningful comparisons.
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Group 2:
(5) Does Swatch have any non-wholly-owned
subsidiaries? Support your answer.
Yes it does. They show a non-controlling interest on
their B/S and their I/S.
(6) Did the companies in which Swatch holds an
active minority, but non-controlling interest (i.e.,
investments which give them significant influence
over the equity method investee) declare profits or
losses over the last six years? Support your
answer.
Except for the years 2019 and 2016 (losses of 9 and 4
respectively), investments in associates are generally
profitable as shown on the income statement (“Share of
result from associates and joint ventures”)
(7) Is Swatch financed primarily by their creditors or
by their shareholders? Support your answer.
More by their shareholders (11493 vs. 2199) – pretty
stable across the years
(8) Evaluate Swatch Group’s solvency status.
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Swatch Group has extremely low gearing. They have very
low levels of external debt as evidenced by the
immaterial financial debt accounts. Also, their ability to
cover interest expense through income is surprisingly
high. Had this analysis showed signs of concern regarding
Swatch’s ability to service their debt, we could take the
analysis one step further and look at their debt-servicing
ability on a cash basis (since debt is, in fact, serviced with
cash, not with accrual earnings). So we could consider,
e.g., cash generated from operations before interest and
tax payments divided by cash interest paid.
The solvency status of Swatch Group is probably
associated with its ownership structure where the family
Hayek controls more than 40% of the equity of the
company. This keeps their financial / credit risk low.
However, they don’t take advantage of the financial
leverage effect (low cost of debt, external funds invested
in operations that earn higher level of return – Return on
Net Operating Assets). Given the overall stability in sales
and profitability over the years, it would be potentially
advisable to increase the level of debt if favourable
investment opportunities are out there to be pursued.
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Group 3:
(9) What are Swatch’s two most significant classes of
(recognized) assets? What is their valuation basis?
Inventories: Inventories are valued at the lower of
Acquisition or Production cost and Net Realizable Value
(fair value less cost to sell).
PP&E: Property, plant and equipment (including
investment property) are recorded in the balance sheet
at historical cost less accumulated depreciation and any
impairments. Revaluation model could also be allowed
under IFRS.
(10) What is the most critical asset account that you
would probably like to dig into further? Explain
why.
The valuation of inventories is the most critical asset for
Swatch Group for the following reasons:
1. It is highly material (about 50% of total assets)
2. Valuation of inventories involves some subjectivity
with respect to impairment and recoverability. Sales of
watches and jewellery are subject to market fluctuations.
These fluctuations along with the complex structure of
inventories – raw materials, components, finished goods
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and spare parts – mean that there is significant scope for
judgement in testing inventories for impairment and
recoverability. Also, the different raw materials used and
the durability of the value of each brand’s products have
to be considered in the light of the differing product life
cycles. Particularly during crisis periods, we should
carefully look for slow moving, obsolete inventories and
check whether sufficient impairments are recognized.
(11) Is Swatch maintaining its productive capacity over
the last six years? Support your answer.
Depreciation expenses are stable (between 350 to 450)
and systematically lower compared to investments in PPE
(399, 437, 396, 504, 602, 1040). This suggests that the
company expands its productive (i.e., reinvesting at a rate
that greatly exceeds their “using up” of these assets) and
technological capabilities.
(12) Evaluate Swatch Group’s efficiency.
Total assets turnover is low suggesting a substandard
ability to generate sales from the asset base. This is not
surprising though, given that the firm has quite high
margins (typically low margin firms tend to have high
asset turnover). A firm needs to do well on one of these
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two dimensions, margins or turnover, (or modestly on
both) in order to compete. Luxury products have
generally high margin but rather low asset turnover.
Regarding A/R and A/P turnover, Swatch Group seems to
manage quite well. It takes on average 40 days to receive
cash from customers (double than the peers, though)
while they take longer to repay their suppliers (70 days of
av. Age of A/P versus 33 days for the peers). This is a
cheap form of financing and creates the so-called
operating liability leverage. Finally, with regards to the
inventory turnover, the firm could perform better as it
takes much longer to sell their inventory compared to the
competitors. This increases the risk of obsolescence, the
risk of damage, and selling price drop.
Group 4:
(13) Is Swatch generating enough cash from
operations to cover their net CapEx (tangible and
intangible assets) + acquisitions over the years
shown on the financial statements? Support your
answer and explain its economic implications.
Yes, it does. Operating Cash Flows (2019: 1224, 2018:
943) are consistently positive and higher than the CapEx
(2019: -399, -47, -13 = -459, 2018: -437, -44, -222 = -703).
This is the reason why external financing is very limited.
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Internally generated cash are enough to cover CapEx and
dividend payments (2019: -413, 2018: -394) – slightly
lower in 2018.
(14) Comment on the Research and Development
activities of Swatch Group.
Swatch seems to consistently invest more than 2% of
sales on R&D activities (almost 3% in 2019). This is much
higher than the average R&D/Sales of this industry
(1,5%). Investing in R&D allows Swatch to develop new
products, secure more patents that will ultimately
increase future sales.
(15) Evaluate Swatch Group’s liquidity status.
Based upon current and quick ratios that exceed one (as
well as industry averages), Swatch does not appear to
exhibit any short-term liquidity problems. The stricter
cash ratio is again higher than the industry norms
although lower than one. We should also note that
although high levels of cash might provide some
assurance and comfort particularly during crisis periods,
cash is generally considered as a non-productive asset
that does not contributed to profitability and sales.
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Furthermore, the consistently positive operating cash
flows that are of similar magnitude to profitability
suggests that the operating activities of the company
generate sufficient cash to cover CapEx, and dividend
payments.
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Internal Report / Analysis of peers (hypothetical numbers)
ROA
ROE
R&D /Sales
Net Profit Margin Ratio
Sales Growth
Gross Margin
Debt-Equity Ratio
Interest-Coverage Ratio
Asset Turnover
A/R Turnover
Av. Age A/R
A/P Turnover
Av. Age A/P
Inventory Turnover
Av. Days Sales in Inventory
Current Ratio
Quick Ratio
Cash Ratio
Cash Flows Ratio
8,9%
12,3%
1,5%
9,5%
2%
63%
38,1%
6,5
0,85
20
18
11
33
0.90
405
3,5
1,8
0,6
0,4
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