ANNUAL REPORT

Annual Report 2017

Chairman’s Statement

DEAR FELLOW SHAREHOLDERS,

For the financial year ended 31 March 2017, the Group registered a marginal drop in sales of 2% to $696.1 million and a 7% contraction in profit-after-tax to $49.6 million. Though challenging of late, our aim is to ensure we consistently grow the underlying earnings capability of the business and attempt to overcome the cyclicality and vagaries of the luxury watch sector. After an immensely intense and turbulent twelve months, it is with a measure of satisfaction that we delivered this latest set of results. This financial performance belies the severity of the market conditions and I repeat what I have been maintaining when queried on the state of our business over this period. That our management and sales teams have been running twice as hard just to remain in the same place. This pace of activity has become our new normal and our teams have adjusted to this present state of play.

In last year’s Chairman’s statement, I once again placed emphasis on our operating and financial objectives – improving our inventory turns and raising the quality of our free cash flow generation. Both of which were competently managed throughout the year with strong results. Stock turn ratios rose to 1.8 times from the prior year, inching closer to our aspirational target of two times, whilst free cash flows surged 450% to $57.1 million. We reduced our borrowings by $12.3 million which meant our financial leverage at year end stood at a healthy 10.7% and cash and cash equivalents closing at $124.8 million.

On a consolidated net asset basis, our corporate net worth rose by $38.6 million to $478.5 million or $0.68 per share. In view of the Group’s overall operating performance, the Board of Directors is pleased to recommend a first and final dividend of 2 cents per share amounting to $14.1 million.

GENERAL COMMENTARY

Swiss watch exports continued into their third consecutive year of contraction with year-on-year declines accelerating to 9.9% in 2016. Not a single key watch market was spared with the world’s number one market Hong Kong leading this global slide, falling by 25.1%. Even the United States, held out by some watch producing groups as a market that could potentially pick up some slack, contracted 9.1%. Singapore similarly experienced a 10.4% decline, keeping pace with the global average. It is in the most recent financial year that the industry’s travails have started to bite at the source.

The two largest Swiss listed luxury watch conglomerates saw profits for the latest financial year fall by almost a half. And without exception, all the major watch groups effected sweeping C-suite overhauls as a new generation of leaders are entrusted with the responsibility of injecting a fresh approach to tackling the challenges at hand. The last time the serene world Swiss watchmaking suffered such a jolt was after the dotcom bubble burst of 2000.

Taking Stock

We had previously drawn caution from the precipitous decline in Swiss watch exports and the escalation of inventories worldwide. Fatefully predicting last year that it would take another 12 to 18 months for that excess to be absorbed by the market. From where I sit today however, that outlook might have been optimistic for three reasons.

We continue to see authorised retailers the world over face a downdraft in sales and too many with outsized inventories to manage. As a point of reference, our Hong Kong peers are turning over their inventory once a year. All this in turn leads to reduced forward orders for both new and existing products. While some brands aptly executed inventory buybacks in the corresponding period with promises to destroy the goods on their return to manufacture (buybacks accounted for 2% of Richemont’s sales in FY2017), these re-purchases are in a magnitude of several orders smaller than the several billion Swiss Francs of aging inventory sitting in all the distribution and retail channels.

The Swiss watch industry is clearly capitulating from an over-construction of production capacity entered during the aftermath of the post-GFC era. The ramification of buoyant optimism the industry overdosed on when all businesses were experiencing double digit growth rates in the preceding decade. With inventory in all the channels at their peak, the question remains why these watch factories continue to churn production? The answer is the same as it is for any other large scale manufacturing industry. Production typically lags demand and keeping the machines running reduces average fixed costs and hence ensures two things. Lower unit prices and hence higher overall margins as well as ensuring that watches can be priced more competitively. Right-size the unit output and the overall gross margins collapse placing even greater financial strain on the groups. Secondly, and peculiar to Switzerland is that the watch industry is loath to reduce headcount, stemming from both a labour-centric culture and the fact that hiring of specialist watchmakers and technicians when demand escalates will be difficult to accomplish. So the prognosis for now is that the watch groups will continue their current course in the hope for global demand to tick up thereby returning the industry to a semblance of its former self.

The Watch Industry’s Dilemma – Digitalise or Die?

The global retail landscape is littered with casualties of the changing profile of consumers and consumer behaviour. Baby boomers are all but retiring and those Millennials born in the year 2000 will by 2020, account for 40% of the luxury market, exerting their influence on global shopping habits with their minute to minute updates on social media of what’s hot and what’s not. Shoppers are online hunting for the lowest prices and shopping malls and traditional retailers are struggling to attract customers through their doors. Even what were once considered mainstay brands that controlled both their own stand-alone boutiques and webstores are facing the threat of the online retailer undercutting them on pricing (excess inventory strikes again!). Other trending observations we have made are that in 2016, in mature retail markets such as the U.S., consumers spent 31% of their discretionary income on goods and 69% on services and experiences. Three decades ago, 45% of their spend went towards goods products. To compound matters, by 2026, it is estimated that 25% of all luxury goods consumption will be online leaving physical retailing of all goods products with only 20% of the overall discretionary spend of this consumer. And with an increasing number of independent dealers starting up new businesses by way of establishing a social media account, the battle traditional retailers will have is to either define and demonstrate their relevance to luxury shoppers or face their fate of retail redundancy.

The watch industry is notoriously slow to adapt to change and their recent embrace of the digitalization of the world is approximately fifteen years behind the rest of the luxury goods sector. But now that the inevitable is firmly at forefront of everyone’s strategic agendas, manufacturers and retailers are wasting little time in playing catch up. Richemont is an example of a watch company whose leadership is embracing this digital transition with aplomb with the Board regrouping all their digital assets under a single executive. And after almost a decade of ceaseless openings of ever-larger boutiques, the tide has turned and those net openings are now net store closures with 38 internal boutiques shuttering in the last twelve months and capex for further direct-owned-stores suspended. Rolex too has internalised an entire digital division staffed with the best technology minds and have begun collaborating with their key specialist retail accounts to develop bespoke solutions to combat grey marketeers online and drive a superior omni-channel experience.

The implications are obvious and twofold. First, digital will be a key pillar of the industry. In the past year, several established brands owned by Richemont, LVMH and Swatch Group have sold limited edition, capsule collections direct to consumer online, reportedly with tremendous success. These early wins will embolden them to further develop more such projects. What this informs us is that the conquest of the digital landscape is only just beginning because as recent as last year, the battle for sales still existed exclusively in the physical domain. Key luxury groups are now recognising that online retailing is all but an additional channel of distribution and act as a complement to their bricks and mortar operations.

The second implication is that to survive, bricks and mortar retailers should be differentiated and specialised. The future is not solely predicated on how watches are sold but who will sell them. The demise of multi-brand specialist watch retailers has been bandied about for a near decade now. But if anything, the current crisis enhances the strength of retailers with scale, reach, tech savviness and who have teams with deep specialist knowledge of the fine watch domain. While brands have been consolidating their distribution networks, the culling has been primarily on what the industry defines as “B” and “C” retailers. Networked retailers such as ourselves will be required to play a more important role in this transmutation of the watch ecosystem. The rise of e-commerce is advantageous to multi-brand retailers because by virtue of our business model, we offer choice. And choice is clearly one of the key tenets of online retailing. The world leaders in luxury fashion are not the brand’s own webstores but instead e-tailers such as Sephora and Yoox Net-a-Porter – the beauty and fashion industry’s digital equivalents to The Hour Glass.

Success in this realm of online multi-brand retail is far easier imagined than accomplished. Our reading of the manoeuvring in the online luxury space is that developing a full price, multi-category, multi-brand platform is a challenge that even the most cash rich luxury goods conglomerates have admitted difficulty in navigating. Two years ago, Richemont divested themselves of online luxury fashion juggernaut Net-a-Porter, merging it with its direct rival Yoox and at the same time declaring that their rationale was because with CHF 5.0 billion in cash, they (Richemont) did not have the resources to become a winner in this space! It is too early to speculate on LVMH’s second attempt at building their multi-category, multi-brand e-commerce platform 24 Sevres but it is worthwhile recalling that as early as 2000, LVMH was an early adopter and acquired a substantial stake in then the world’s leading e-commerce platform – eluxury.com only to shutter its operations several years after the dotcom bubble burst.

With the watch industry, we recognise that there are tremendous opportunities to be exploited and the debate to engage online is evidently stronger than the arguments to remain on the side lines. But we see three key challenges for any authorised watch retailer intent on developing a global e-commerce platform for new, primary market watches.

Firstly, the notion of global pricing parity. Watches are not priced the same all over the world. Retail prices vary with historical market conditions, import duties, consumption taxes and foreign exchange rates. And the possible arbitrage between markets could be up to 25%. Several brands such as Rolex, Cartier and Omega are addressing this issue by geo-tagging prices based on the prospect’s and lead’s IP addresses. A recent case of Omega releasing exclusively for sale, online, a special 2,012 piece limited edition watch was met with such overwhelming demand that Omega’s servers crashed several times in the span of a few hours. All the watches were sold to clients with the geo tagged retail price of their home country and the difference were as much as 20%. However, due to the limitation of the offer, clients accepted and many were not even aware of the difference. We cannot discount the novelty effect of such launches but should they occur more frequently, the results will most certainly not be as robust.

Secondly, the issue of cross-border selling. Brands continue to assign the privilege of online retail to themselves whilst restricting their traditional specialist retail partners to the geographies that they operate within. However, with the rise of omni-channel commerce and a desire to lever off pure play internet re-sellers, this model may soon be put to the test. Specialist watch e-tailers with large common markets that embrace online buying such as the United States and the EU may eventually give rise to the next Bucherers, Wempes and The Hour Glass’ of the digital world. Such a development however, will take time to manifest.

Finally, logistics. The single biggest logistical challenge for all watch brand owners and resellers is their ability to have a returns policy when selling online. Unlike other fashion and leather goods, the cost of refurbishment of a returned watch can be in the range of 2% to 10% of the retail value of the new watch depending on its price. Additionally, when volumes increase, it is within reason to anticipate that a separate after-sales division needs to be created to accommodate the servicing of returned watches.

Restructuring, Reconfiguring and Reorganising

Disintermediation and disruption allows for the levelling up of smaller players, making it easier and faster for more nimble enterprises to scale. So what does that mean for a traditional organisation like The Hour Glass? How do we continue to be forward facing? How do we position ourselves as the disrupters instead of the one being disrupted?

The first positive news about the internet is that it never pays to be first. The second is that owing to the apparent lateness of the watch industry to embrace the online realm, the real winners of the game have yet to be determined. That in this quest to discover the digital El Dorado, there will be a room for several players to securely entrench themselves and even more ways to eventually disrupt and dislodge them.

Two years ago, I had declared that The Hour Glass was facing an inflection point in its phase of business and organisational development. That for us to respond to the digitalization that was taking place in the watch retail industry, to be future ready, we had to unshackle ourselves of our incumbent mindsets and broaden our views of where the world and the watch industry were headed. In the past 18 months, we saw to that. We reorganized our senior management ranks and flattened our organisation structure, reallocated resources to bolstering our technology, customer experience management and engagement marketing teams, signed off on a series of course altering technological capital investment programmes and most important of all, engaged in a process of augmenting our organisational culture to meet the new demands of our business and clients. Without this effort to influence an internal cultural shift, all of which we seek to introduce will fail because we recognise that we are at our core, traditional retailers and do not embody a digitally native start-up culture. But though that is the case, that does not mean we cannot be digital immigrants. Immigrants who succeed integrating into a foreign land do so because they make an effort to embrace and assimilate themselves to the norms and practices of their new world. In that same vein, it is our ambition that all members of The Hour Glass will transform from being digitally naïve to digital immigrants and finally, in the coming three years, eventually become naturalised digital natives.

Part of this journey is our emphasis on developing an Omni-channel, Omni-commerce model that humanizes the shopping experience every step of the way. Starting with our online engagement with clients to their offline interactions with our corps of watch specialists. When we think about the consumer, we must consider that the new consumer is one that survives in an ever present connected social environment. The merging or blurring of online and offline does not exist as they are no longer mutually exclusive realms. A shopper whilst engaged in a physical retail store and dialoguing with one of our watch specialist will be concurrently online chatting with a friend, a group of friends or engaging in product and pricing research. Appreciating all these developments, our team had invested considerable grey matter in architecting our technology roadmap and rigorously assessing, analysing and evaluating numerous CRM solutions. I am delighted to announce that come September 2017, The Hour Glass will finally ‘Go Live’ with our inaugural customer experience management platform. A solution that will form the backbone of our Group’s Omni-channel strategy.

ROUNDING OFF

I wish to take this opportunity to thank my fellow Board members, senior management colleagues and retail teams for committing themselves to securing the future for The Hour Glass. At the Board level, I am delighted to announce the appointment of a new independent director Mr Liew Choon Wei. Choon Wei was a former Audit partner with Ernst & Young LLP and will serve on The Hour Glass’ Audit and Remuneration Committees. He is no stranger to us having had the experience of being the Audit partner responsible for The Hour Glass’ account. Choon Wei brings with him decades of corporate governance experience and I’m confident will contribute significantly to the business too.

Beyond bytes and building leases, the future will also be shaped by the decades-long relationships we at The Hour Glass have forged with our key brand partners. Although many have been subsumed into listed luxury conglomerates, most of the important houses are still independently owned. Notably Patek Philippe, Rolex, Audemars Piguet, Richard Mille and independently managed Hublot. While we aim to build the store of the future, we will continue to develop even closer bonds with these partners.

As I was browsing through Patek Philippe’s retailer working catalogue from 1976, I came across the foreword by the late Henri Stern, owner and the then President of Patek Philippe. The words he penned were as follows: “Isn’t it true that respect for principles and ideals is of special importance when times are difficult?”. That “… a firm can only be a leader by constantly introducing new ideas and by being inspiring without forgoing any of its philosophical principles”. These sentences reverberated loudly in my mind. In 1976, as it is today, the watch industry required much soulsearching.

I believe the pathway out of our industry’s present troubles can be found in the sagely message of Henri Stern. That we must hold true the patrimony and values of the watch industry, believing in the culture and history of the watchmaking art that had come before us and furnace the desire to continue innovating and searching for new methods within each of our metiers – whether it be producing watches or selling watches. We must as an organisation, as members of The Hour Glass, continue to look forward and blaze new pathways to the destiny we intend to create for ourselves. Anticipating changes before the rest of the industry does and engaging in difficult internal restructuring efforts to ensure that our spirit of enterprise remains that of an innovation leader.

HENRY TAY YUN CHWAN
Executive Chairman
2 June 2017