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Why Bronte Capital Is Shorting A Luxury Company And Terrified About China


richemontAt my hedge fund we usually short frauds. Stuff with dodgy accounts and dodgy prospects promoted by people who would be car salesmen if stock promotion were less lucrative. But sometimes, just sometimes we find ourselves aching to short a real company with fine management where business prospects are going south very fast.

Richemont - the mega-luxury good maker with a focus on watches and jewellery is the latest example. We are waiting for a highly valued high quality company producing spectacular goods to have a similarly spectacular earnings miss.

The company describes its brands as "Maisons" (French for houses) harking back to some long established tradition in a Swiss-French mountain chalet surrounded by snow where they produce fine (if somewhat pretentious) luxury goods. Still these brands have taken over the world - and now if you walk through Venice or Hong Kong or Shanghai or around the areas frequented by Asian tourists in Hawaii or Sydney you find the global standard set of luxury goods. The fact that they could make their product both ubiquitous and exclusive somewhat amazes me - but they have achieved that. These are amazing companies.

With amazing profits too. The Jewellery Maisons [CartierVan Cleef & Arpels] in the (March ended) 2012 financial year produced €4.59 billion in sales with €1.51 in operating profit. The growth rate has been almost Apple-like. In 2007 sales were €2.68 billion, profits €742 million. In 2004 the Jewellery Maisons had only €367 million in profit. This stuff did unbelievably well out of the rising of a new plutocracy - but particularly out of a new kleptocratic Asian plutocracy.

Watches did similarly well. I find watches strangely redundant (a smart phone is both more accurate and more useful and you probably carry one anyway). However they have become the only really acceptable piece of male jewellery by which the elite can show their status. In these days of business casual (and the studied casual of Ralph Lauren) an Italian tailored suit does not do it.

An iPhone or a Galaxy IIIs shows status amongst the middle and upper middle income. A ten thousand dollar or five hundred thousand dollar watch will do a (far) worse job of telling the time - but screams in only the way stupid-money can. I am not (at all) interested in watches so I had to look up the Maisons. These are houses like Vacheron Constantin of Geneve and A. Lange and Söhne from Glashütte (Saxony, Germany). Sort of glad I don't fancy their products because looking around Vacheron Constantin sell relatively plain gold watches at fifty thousand a pop:


A. Lange and Söhne sells similarly plain watches at prices marginally lower - but also sell less plain watches at prices closer to half a million dollars:


Remember both these products are inferior for purpose to the smart phone already in your pocket. But they do say "look at me" the latter in a particularly Rococo fashion.

It is the Rococo stuff that is winning. The Federation of the Swiss Watch Industry publish export data from Switzerland (not sales to end consumers). June data shows a 4.1 percent reduction in volume, a 21.7 increase in value. The average price of a watch is going up sharply. This has been the case for years. The Federation published this graph which shows that (relatively accurate) electronic watches have been flat in value for years - but that mechanical movements (inaccurate but reassuringly expensive) have gone skyward:


Moreover a disproportionate amount of the volume - and an even more disproportionate amount of the value has gone to Hong Kong. Hong Kong is the destination for a quarter of Swiss watches by value and an even higher proportion of the most expensive stuff.

Why Hong Kong? Because the sales tax rate is lower than China. If you are buying a thousand dollar watch you can buy it in Shanghai. But if you want a half-million dollar watch (no, not kidding) then the sales tax differential makes it worthwhile to fly to Hong Kong, get a nice hotel room and go shopping. That is why the value is in Hong Kong. The Hong Kong market is it - it is the biggest pile of value and the biggest place for the super-pretentious stuff - the stuff with fat margins. This stuff is really Rococo - and Rococo is a style beloved only by rappers and kleptocrats.

The Chinese kleptocracy has been very good to Richemont. Indeed they famously love their watches. And it is not only watches. Van Cleef & Arpels is Rococo too. Try this ring:


Or this hair clip:


As I said - this is the stuff of rappers and kleptocrats. And there are far more kleptocrats in China than rich rappers anywhere.

Data sources

There are several data sources I watch to keep tabs on spending by Chinese elite. The Swiss Watch data is obvious.

Exports to Hong Kong in June were up 21.2 percent. It was about the same in May (but the monthly data has disappeared from the web). It was about the same every other month this year. They keep upping the exports to Hong Kong.

But Hong Kong also has sales tax data which comes from the sales tax receipts. There is in the data a series for "Jewellery, watches, clocks and valuable gifts" by both value and volume. The value series - relatively flattering, has monthly sales (versus previous corresponding period) for the last six months as:

  1. +18.3%
  2. +14.1%
  3. +18.4%
  4. +15.1%
  5. +2.9%
  6. +3.1%
Sales growth stopped. However exports to Hong Kong kept up (note that 21.2 percent figure above). 
The volume growth actually went negative - being negative 3.4 and 3.1 percent for the last two months.
What do you do with an inventory glut of hundred thousand dollar watches. You can't really discount them - so they just sit there, looking a little stale and slowly devaluing your brand.
And that is why I am short the stock. It is a trading short really - this company is likely to miss earnings and it will miss it in an unfortunate way - they are going to be swamped with inventory.
It is not just watches either. Anecdotally a Van Cleef and Arpels show that was huge last year was distinctly quieter this year. 

The company has given a hint of this. Bernard Fornas - the chief executive of Cartier - gave an interview to the Wall Street Journal. To quote:

"After a phenomenal year last year, there's been a bit of a slowdown in mainland China," he explained. 

"Mainland China is still holding for us. One month is worse, one month is better. The curve is not yet clearly defined.” 

Fornas added that while Cartier’s watch sales are still increasing, it is not at the same rate as 2011. He declined to reveal figures or percentages, however.

But that quote is misleading. He says it is one month worse, one month better. But it is one month worse and the next month bad too. 

My guess: this company is not being entirely straight with market about how much tougher things are getting. The company will guide down and the stock will be singled out for "special treatment". I am short - just waiting for the bullet.

So why did the slowdown happen so sharply? 

The slowdown in Hong Kong (super) luxury goods is a faster decline than other Chinese data. Why so fast?

I have a theory given to me by a China watcher. The theory - it turned bad sharply with the ouster of Bo Xilai and now the murder charge on his wife Gu Kailai. Gu Kailai is going to have a hard time avoiding a mobile execution unit. This changes the stakes and it is structural. A half million dollar watch no longer says "look at me". It says "look at me, I am a kleptocrat". Thoughts of that beautiful Van Cleef and Arpels hair clip become the last thing that runs through your brain before the bullet.

The optimists - and there are many - think the super luxury good market in China will return when the political situation stabilizes. To quote Bernard Fornas in that WSJ article:

"When you talk to the people over there, they are all waiting for a new president to come in. That will fuel the economy with fresh money and lower interest rates."

But who said the new kleptocracy will love Rococo just as much as the old kleptocracy? Maybe party self-preservation will require less ostentatious displays of wealth. After all ostentatiously showing off wealth to an oppressed billion people does not seem like a way to preserve your power.

We know what a completely collapsed luxury good market looks like. Brazilians like a bit of bling. But in the late 1980s and into the 1990s the kidnapping rate in Brazil went skyward. (There is an horrific documentary about that called Manda Bala which translates "send a bullet".) After kidnapping became a major industry (particularly in São Paulo) carrying a $3000 handbag no longer said "look at me", it said "kidnap me".

A collapsed luxury good market in China may - if the Gu Kailai case is a guide - look different. Bling will mark you as an enemy of the people. This is a company about imagery - it sells a dream. Here is the nightmare:


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