The stock picked for the latest Singular Diligence issue was Swatch. Each issue of Singular Diligence includes articles on: 1) Overview, 2) Durability, 3) Moat, 4) Quality, 5) Capital Allocation, 6) Value, 7) Growth, 8) Misjudgment, and 9) Conclusion.
Here is one of those 9 articles – the moat article – from this month’s issue on Swatch.
Swatch, Richemont, and Rolex Will Always Dominate Swiss Watchmaking
Swatch’s moat varies depending on the price category. Swatch’s moat is widest for brands that retail between $800 and $10,000. The moat is narrower for watches that cost more than $10,000 or less than $800. This is because there are several distinct sources of moat in the watchmaking business. The greatest combination of moats happens in the watches in the middle price categories. These watches are expensive enough that the “Swiss Made” label and the brand name are important. However, they are inexpensive enough that manufacturing still involves mass production in some sense for some of the parts. This is not true of very expensive watches. Some watchmakers who focus on watches over $10,000 can make very, very few watches each year. So there are few production advantages in this category. The watches are also so expensive that a boutique mono brand store can be opened in just a few high end retail stores in cities around the world. So distribution power is not as important. Swatch has more production advantages than any other Swiss watchmaker. Rolex also has strong production capabilities as will be explained in a moment. Some other companies – like Richemont – have some production capabilities. They are much more than mere assemblers. But they are not as self-sufficient as they might appear. Swatch is vertically integrated. It does not need any outside company to exist for it to be able to produce its brands.
Let’s start with production. There are no production advantages in low-end mechanical movements that are not “Swiss Made”. A Japanese or Chinese company or a manufacturer of licensed brands that does not care if the watch carries a “Swiss Made” label can easily get a supply of foreign (non-Swiss) mechanical movements. The governments of both China and India encouraged the production of mechanical movements in the hopes of stimulating a domestic watchmaking industry. So, if a watchmaker does not care about the “Swiss Made” label they can buy movements from a Japanese company like Seiko or Citizen or from a movement maker in China or India. As a result, there is no production advantage – no moat for Swatch – in watch categories that do not rely on the “Swiss Made” label. For watches that do rely on the “Swiss Made” label, Swatch has a big production moat. To earn the “Swiss Made” label a watch must meet several requirements. One of these requirements is that the movement must be made in Switzerland. There are very few Swiss movement makers. It is difficult to get information on mechanical movement market share in Switzerland. But a 2011 analyst report provides a good guess. That report estimated that the market is about 5.5 million mechanical movements. Swatch’s ETA makes about 55% of those movements. Sellita has an 18% share. Sellita uses a lot of expired ETA patents. It also uses parts it gets from ETA in about half of its movements. So, ETA’s indirect share of the market – based on everything it provides critical supplies for – might be closer to 65% than 50% of the market. Rolex has a 16% share. However, Rolex uses its movement manufacturing for internal supply purposes. Rolex is supplying its own watches. It is not selling to outside companies. Soprod has 4% of the market. Everyone else combined would have something like 5% to 10% at most. So, ETA supplies about half to two-thirds of all movements in the sense that watches using these movements include parts from ETA. Rolex is actually vertically integrated and separate from the rest of the industry in this particular aspect of watchmaking. So, the 55% estimate of ETA’s role in mechanical movement making is actually an understatement in two respects. One, Sellita uses ETA as a supplier. Two, Rolex supplies itself – not external customers. If you take half of Sellita’s supply out and all of Rolex’s – you are left with Swatch being the key supplier of movements.
And movements are actually easier to make than assortments. The technical requirements of movement making is minimal. Technical knowledge is not the barrier to entry. Most watchmakers don’t make their own movements because it is too much overhead to absorb. It’s a volume based business. So, the cost of having the capability to produce good movements is similar regardless of how many movements you are making. There is an initial investment requirement for even a small manufacturer. The more volume a company does, the lower its per unit cost for movements will be. So, it would cost a small watchmaker more per unit to make its own movements and there would be no quality improvement. Mass production is helpful in movement making because it reduces cost without reducing quality. If a company like ETA is willing to sell you mechanical movements – it is in the interest of everyone except those companies of the size of Swatch, Richemont, and Rolex to buy the movements. You can make your finished watch for less. And you couldn’t build a better movement yourself.
The technical bottleneck is in assortments. Swatch has another subsidiary called Nivarox that makes assortments. Nivarox’s share of assortments is greater than ETA’s share of movements. And unlike movements, the barrier to entry here is not just an initial investment in property, plant, and equipment. Even other movement makers like Jaeger-LeCoultre and Patek Philippe get assortments from Swatch. Rolex is one of the very, very few companies that makes assortments like the hairspring. Assortments are regulating elements like the balance wheel, hairspring, escapement, and pallets. A watch’s accuracy depends on these regulating elements. For example, the hairspring is what causes the balance wheel to oscillate. The constant rhythm of the oscillation is what ensures the accuracy of the watch. Swatch makes assortments which it sells to others. Rolex makes assortments. And then some small manufacturers make only tens of thousands of assortments a year.
Swatch’s use of its market power was restrained through much of the 2000s by Swiss regulators. In 2011, Swatch was finally allowed to reduce deliveries of finished movements to 85% of its 2010 levels and bring that number to as low as 0% in 2019. So, Swatch will be allowed to completely cut its competitors off from their supply of ETA movements by 2019 if it wants to. Swatch was also allowed to cut its supply of assortments by 5%. This change will be tough on Sellita. The difficulty in obtaining assortments will probably be more of a problem than the difficult of obtaining movements. Movements just require some sort of alliance that provides for sufficient scale in production to spread the costs for the customers of that manufacturer to a level that would be lower than if each company went it alone. Assortments actually require technical knowledge. The problem is more than one of cost. It can mean that the supply is not of sufficient quality. Overall, the future is likely to be grimmer for Swiss watchmakers other than Swatch, Richemont, and Rolex once Swatch is allowed to cut its supply of movements and assortments as low as it wants to.
The three biggest players in Swiss watches are: Swatch (34% market share), Richemont (29%), and Rolex (22%). All other companies have just a 15% share. Swatch has strong production capabilities. Rolex is capable of supplying itself better than any other company besides Swatch with everything it needs. So both of those companies have certain vertical integration strength. Brand strength is also important. But distribution is about more than just having strong brands. These three companies – Swatch, Richemont, and Rolex – have the greatest distribution power of any watchmakers.
Distribution is less important at the highest and lowest ends. Cheap watches can be sold around the world online and in department stores. One reason Swatch is weak in the U.S. is probably because of the power of department store chains and online outlets for affordable luxury watches. A company like Movado is simply better at selling to Americans than Swatch is because it is not focused on a different model in the rest of the world. So the $800 to $10,000 categories are where Swatch’s moat is greatest. This is where brand, distribution, and production capabilities are all important. Watches in this price range need a lot of points of sale. Tissot has 13,500 points of sale. Longines has 4,000. Omega has 1,800. Big groups like Swatch, Richemont, and Rolex have power over distributors and retailers. LVMH has trouble getting distribution equal to these companies because it does not have as big a watch business. These companies usually ask retailers to carry multiple brands from the same group. Having several strong watch brands at different price levels can be an advantage. These companies can also offer after-sales services. Quartz watches are easy to repair (you just replace the battery). Mechanical watches using ETA movements can also be easier and cheaper to maintain. The less common the parts in a watch are the more expensive it can be to maintain. Longines has over 1,000 service centers. Omega has 450. Very high end watches have very few service centers. Patek Philippe has 57. Bregeut has 45. And Richard Mille – a super expensive brand – has just 3 service centers. Swatch’s moat in true luxury watches is not as great. Each brand has a moat around it. But the distribution moat is narrow. And there is no production moat. The $800 to $10,000 category is the widest moat part of the business. In this category, Swatch has a wide moat in production, brand, and distribution. It has strong brands. It can mass produce the parts – movements and assortments – needed in these brands. And it has the distribution clout of a Richemont or Rolex. For these reasons, it is likely that the fattest Swiss watch companies – Swatch, Richemont, and Rolex – will get fatter over time in the $800 to $10,000 price category. It is less clear what will happen in the under $800 category. In the over $10,000 category, old brands with a strong heritage should continue to do well. But it is possible for new brands to pop up and get distribution as Richard Mille proves. Hublot is another example of a successful entrant into very high end watches. This category does not require either mass distribution or mass production. The hardest category to enter and succeed in is $800 to $10,000. This is where Swatch excels. And it should now be able to use the market power from its production monopolies or near monopolies in movements and assortments to squeeze competitors. So, this is a wide moat business. And the moat could get wider if regulators allow it.