Friday, August 24, 2012

Focus Media: My new obsession - original version with annotations

There are days I should not be allowed to hang around a spreadsheet. This post had not one but two - nearly identical mistakes in it. I simply read off the wrong line in my tables and quoted gross margins not operating margins. I have corrected below and put in an addendum with the original sources of the correct data in it. I have also republished the post as it should have been in the first place.  
Just to make it clear - phrases removed from this post are in strike through and additions are in italics. 
If you have not read this post - just go straight to the corrected versions.

The announced "go-private" transaction for Focus Media has me obsessed. It seems to cover a whole gamut of my interests, Asian private equity, alleged Chinese fraud, connections with major property developers and numbers and accounts I find surprising. The whole works! It may not be the most important thing in financial markets this year - but it is one of the most interesting.

Readers might need some background here. Focus Media is a display advertising business in China which has analogue and digital poster frames in elevators and shopping centers as well as LCD screens placing advertisements more generally. Most of these adverts are small (the LCD screens are mostly 17 inch according to the annual report and many of the posters are smaller). Here are pictures of a few...

(My source for these photos is a Seeking Alpha bull on the stock here...)
A lot of what used to be counted as LCD screens are simple posters:

The reason for using posters is inconveniences like having no available power supply. There has been some dispute about the number of screens and posters but there is no doubt that the company has a lot of these - they are visible around major cities in China.

The company also claims to have the right to sell advertising on a large number of movie cinema screens. Again there is a dispute about the number of these screens.

The mechanics of Focus's business

Focus Media is a relatively simple business. They rent sites (for instance by entering a lease with the managers of a large tower with elevators they wish to place adverts in). They sell the advertising space and they maintain all their screens and update your posters and deal with the inevitable things like vandalism, theft and the like. For the number of sites that Focus deals with they would need a fairly large number of lowly paid staff for maintenance and another group of staff selling advertisements and a third group negotiating lease arrangements with building and cinema owners. The second and third group will have higher salaries.

The maintenance cannot be neglected because it devalues adverts when kids scrawl little goatie-beards on the pictured women (or worse).

The profitability of Focus's business

The most notable thing about Focus from the accounts is their startling profitability. Their last annual report shows revenues (net of business taxes) of USD793 million and operating gross profit of 503 million, operating profit is 259 million. This is an operating of margin of 32.7 percent in a which is at the high end for a media business. In my experience media businesses are 10-35 percent margin businesses - with the high numbers reserved for very special franchises. A monopoly newspaper in a city of a million people (say Perth Australia) used to have a 35 percent margin before the internet threatened the monopoly. Most businesses are closer 20 percent. Most display advertising businesses (which are without strongly identifiable franchises) earn closer to 10 percent margins.

Moreover, this is a 63 a 33 percent margin where the company itself describes the landscape as "competitive" in their annual filings. The margins are surprising – but China is a surprising place in many ways – and it is possible that margins are fat because the landlords who lease the space to Focus are stupid. The fat margins may be possible for other reasons I don't understand.

First let me stress though just how fat these margins are. The largest player globally in display advertising is JCDecaux (the French multinational founded by Jean-Claude Decaux). They have - according to their last accounts - €2463 million in revenue and 23.6 percent operating gross margins. The 63 percent gross margin at Focus is fully 40 percentage points higher than the gross margin of JCDecauxThe net margin of JCDecaux is a mere 8.7 percent - Focus Media margins are 3.7 times higher than JCDecaux.

Moreover JCDecaux has fatter and thinner margin businesses. It has a mid teens operating gross margin outside their (franchise) street furniture business.

There are several possible explanations for the very fat margins at Focus. The most obvious explanation is that they were early... when you go around to a landlord and offer to rent their space they don't know what that space is worth (because the idea is new to them) and they lease it to you for too little. Over time margins contract because the landlords "wise-up". This is certainly true in the street-furniture business at JCDecaux where the company goes to the local government and offers to maintain their bus-stops for "nothing" and the local government (with the intellectual panache that describes that sector) just accepts. But local governments have wised up over time.

The bears in this stock - and there are many (see the many seeking alpha articles) - would suggest the margins are made up. As an outsider that is pretty hard to test - but going through the claims and counter-claims with a fine comb is the sort of thing that excites a guy like me. (Any private equity party doing thorough due diligence can check those claims.)

The main fraud allegation

The main allegation against Focus came from Muddy Waters - the same firm that exposed the fraud at Sino Forest. MW gave us an 80 page report (that is freely available on their website). Sino-Forest was deep within my area of expertise and I was more-or-less instantly convinced that the whole Sino Forest story was made up. Focus Media is a much harder target for Muddy Waters because the company clearly exists. Their LCD screens and picture frames are pervasive in many large cities in China.

Whilst I was instantly convinced by the Sino Forest case (and hence was happy to short the stock to zero) it is harder to be convinced when the business so clearly does exist.

That said Carson Block and his Muddy Waters firm comes with some credibility because they predicated the complete demise of Rhino International and Sino Forest (both multi-billion dollar firms). Given Carson's street-cred I was surprised that Focus Media stock held up so well after Carson's attack.

Some people clearly saw a lot of value in Focus even if some part of Carson's allegations was correct.

The private equity bid for Focus

The people who saw value in Focus Equity include some of the most important private equity firms operating in Asia who are bidding for the whole company. Here is the release:
Aug.13, 2012 -- Focus Media Holding Limited ("Focus Media") today announced that its Board of Directors has received a preliminary non-binding proposal letter, dated August 12, 2012, from affiliates of FountainVest Partners, The Carlyle Group, CITIC Capital Partners, CDH Investments and China Everbright Limited and Mr. Jason Nanchun Jiang, Chairman of the Board and Chief Executive Officer of Focus Media, and his affiliates (together, the "Consortium Members"), that proposes a "going-private" transaction for $27.00 in cash per American depositary share, or $5.40 in cash per ordinary share... 

The bidders are a who-is-who of reputable private equity firms. FountainVest is run by Frank Tang who used to head China investments for Temasek (the Singapore Sovereign Wealth Fund). He represents Singapore Inc as much as a private individual can. The Carlyle Group is one of the largest private equity firms in the world. I have had my doubts about their China investments before - but they are large and reputable. CITIC Capital is a private equity firm associated with China International Trust and Investment Corporation which is effectively the Chinese sovereign wealth fund. CITIC Capital however is not the Sovereign Fund - rather an associated private fund. By all accounts it is Princeling Central. China Everbright is a Hong Kong listed financial firm clearly with links to the Chinese establishment. Bo Xilai's brother recently quit as a director. This group is a mix of Chinese, other Asian and Western establishment firms.

One bank mentioned in the press release is DBS - which again represents Singapore Inc. The only other bank mentioned is Citigroup - and they have provided a "confident" letter.

So where are we now?

What we have are some high-profile but rat-bag shorts on one side squealing fraud. And on the other side we have a who's who of Asian business wanting to take this private for the not-so-trivial sum of USD3.5 billion.

You see why I am obsessed? Right up my alley. And perhaps a test of my Guanxi vs Analyst thesis.

Is this a done deal?

This sounds like a done-deal. The largest shareholder in Focus is Fosun International - an HK conglomerate. They have publicly called the bid "attractive". The bid team contains Mr. Jason Nanchun Jiang - the CEO/Founder of Focus - and a man critical to the running of the business (apart from anything he controls the variable interest entity). Given that it contains the critical person and the main shareholder wants to accept it is likely the board will go along. And the bid is cheap enough that it is unlikely that - absent absolutely grotesque fraud - nothing that is found on due diligence will dissuade the buyers.

The parties are rich enough that $3.5 billion is a big - but not an intolerably large bite. They are up for it.

It is however subject to due diligence. The letter sent by the buyers to the company is attached to the press release. The last paragraph says it clearly:
13. No Binding Commitment.  This letter constitutes only a preliminary indication of our interest, and does not constitute any binding commitment with respect to the Acquisition. A binding commitment will result only from the execution of Definitive Agreements, and then will be on terms and conditions provided in such documentation.
And so we have a due-diligence period in which some of the most reputable and largest private equity firms will do due diligence on a company that one of the most famous rat-bag short-sellers asserts is a fraud.

Oh to be a fly-on-the-wall

I would love to be a fly-on-the-wall as they work out how to test the Muddy Waters allegations. Due diligence is sometimes (incorrectly) treated as a formality. But in this case the stakes are real. Billions of dollars are on the line and the very credibility of some firms (especially Carlye) are on the line with it. Carlyle has been burnt by some frauds in Asia before. If - after warning by Muddy Waters - Carlyle were to buy this firm and it turned out to be fraudulent the question would arise as to whether Carlyle staff were deliberately buying frauds to loot the Carlyle funds. My guess is that the very existence of Carlyle is at stake.

But Carlyle have competent staff laced throughout their organization. They will do their due diligence - and if the deal closes I think you can presume that Muddy Waters was wrong.

If the deal doesn't close with the backing of the the largest shareholder and at this pricing then you probably have to conclude that Muddy Waters is right. If Muddy Waters is right then the revenue and the margins of this firm are grotesquely overstated and the stock is probably going to settle somewhere below two dollars.

And with that you understand my obsession.


Disclosure: I think there is a reasonable chance that Carlyle - and perhaps some of the other firms in this syndicate will walk. In all honesty I have no idea whether they will or not but as the stock will wind up at $2 (or less) if they walk the bet is worth taking. So I am short and risk losing the difference between the current price (25 and change) and the bid price (27) if the deal does close.


Data sources for the addendum:

Here is the P&L for Focus Media from the last annual report:


  For the years ended December 31,
  (In U.S. Dollars, except share and per share data,
unless otherwise stated)
Net revenues
  $397,164,522  $516,314,697  $792,620,177  

Cost of revenues
  241,073,203  221,690,034  289,644,266  

Gross profit
  156,091,319  294,624,663  502,975,911  

Operating expenses:
General and administrative
  88,833,305  79,759,757  127,012,894  
Selling and marketing
  79,786,861  103,722,237  147,716,437  
Impairment loss
  63,646,227  5,736,134  —    
Other operating expenses (income), net
  13,111,043  (14,143,945(16,137,695

Total operating expenses
  245,377,436  175,074,183  258,591,636  

Income (loss) from operations
  (89,286,117119,550,480  244,384,275  
Interest income
  4,945,946  7,259,508  15,538,943  
Interest expense
  —    —    716,956  
Investment loss
  —    1,287,881  —    

Income (loss) from continuing operations before income taxes
  (84,340,171125,522,107  259,206,262  
Income taxes
  13,780,065  22,335,579  54,761,394  
Loss from equity method investment
  —    —    43,632,613  

Net income (loss) from continuing operations
  (98,120,236103,186,528  160,812,255  
Net income (loss) from discontinued operations, net of tax
  (111,612,42083,077,575  —    

Net income (loss)
  (209,732,656186,264,103  160,812,255  
Less: Net income (loss) attributable to noncontrolling interests
  3,524,388  1,990,626  (1,864,783

Net income (loss) attributable to Focus Media Holding Limited Shareholders
  $(213,257,044$184,273,477  $162,677,038  

Income (loss) per share from continuing operations — basic
  $(0.15$0.15  $0.24  

Income (loss) per share from continuing operations — diluted
  $(0.15$0.14  $0.23  

Income (loss) per share from discontinued operations — basic
  $(0.17$0.12  $—    

Income (loss) per share from discontinued operations — diluted
  $(0.17$0.11  $—    

Income (loss) per share — basic
  $(0.33$0.26  $0.24  

Income (loss) per share — diluted
  $(0.33$0.25  $0.23  

Shares used in calculating basic income (loss) per share
  651,654,345  707,846,570  671,401,000  

Shares used in calculating diluted income (loss) per share
  651,654,345  731,658,265  693,971,258  

The accompanying notes are an integral part of these consolidated financial statements.

And here is JCDecaux's P&L - snapshot picture from their annual report...

Monday, August 20, 2012

Good due diligence is defined by the deals you walk away from

As regular readers of this blog know - I don't much like buying stocks where I am competing with potential private equity (PE) buyers.

PE buyers have two advantages over me. Firstly they are able to borrow large amounts of money often at mid single digit rates. I don't think a mid single digit rate of return is worth getting out of bed for - certainly I will not invest my client money on those returns because the mistakes I make (and there are plenty) would wipe out any profits.

The second advantage is more important. That is private equity firms get to do a proper-due-diligence before they close any transaction. They can talk to staff throughout the organization. They can open the books up on any part of the business. They can talk with suppliers and customers. They can sit in on business meetings. They can even talk to critics and investigate the claims of those critics. In fact competence requires that they understand (and hence can investigate and dismiss) the claims of critics.

That is a pretty big competitive advantage. If I sought that advantage it would be called insider-trading and I would be sent to prison for it.

For a PE firm - its called good business practice.

Due diligence (or legal insider trading) is the main thing that makes it attractive to be a PE investor.

However if a PE firm always closes the deal then - almost by definition it is forgoing the main advantage of being a PE firm. A PE firm that eschews that advantage is - in my view - not a worthy investment.

This is especially true in China. Private equity investors have been involved in some egregious frauds in China.

Probably the most prominent example is how Richard Heckmann, a normally a very competent deal maker, was utterly defrauded when he invested in a Chinese water company. He now tells the world he was swindled. But other examples abound - such as Carlyle investing in China Forestry - a company which can now verify less than 1 percent of its previously reported sales.

I have a test for the competence of a private equity firm. A private equity firm is to be judged by the deals they walk away from.

What you really don't want as a PE investor is for them to announce a deal subject to due diligence and then close a bad deal because they get "deal fever".

Competence is the ability to walk away. It is what defines a really good PE firm.

I collect examples.

One recent example of a PE firm dropping a deal (though we will never know why) was Texas Pacific which bid for CNInsure (CISG:NASDAQ). They dropped out. Whilst we never know why they dropped it shows a willingness to drop out - and hence demonstrates a culture of competence.

Texas Pacific have also walked away from other deals.

Closing a deal on a fraud in China where the closure was subject to due diligence is the very definition of incompetence. I have a few examples at least as nasty as the Heckmann case. However there is no need for name calling here.

Just saying to potential PE firm investors: if a PE firm is known for always closing a deal you probably should not invest in them.


Thursday, August 16, 2012

Pricewaterhouse Coopers - the see-no-evil audit firm

A short post written in frustration.

I wrote to PWC (via their email-contact service) asking for an email address to send a large dossier alleging fraud at a company Pricewaterhouse Coopers audits.

I received no reply. It may be because PWC does not want the dossier and is happy to audit the firm regardless.

I presume PWC will remedy this (and I will report back when they have).

If they do not remedy it then I will dub PWC the audit firm that chooses to "see no evil".


It took about 24 hours - but I have now been contacted by PWC. Thanks for roughly 10 people who sent this to contacts at the firm.

Monday, August 13, 2012

T-Mobile to go private with the Sole True Hero!

Fierce Wireless is reporting that there is a private equity bid in the works to buy T-Mobile led by none other than my least favourite telecom executive, Mr Sol Trujillo.

As an Australian I have had some experience with Sol Trujillo - he was CEO of our local incumbent teleco - Telstra.

At first Sol looked to be a great salesman - but he systematically undermined any political and eventually customer goodwill with Telstra. He then took a me-against-the-world view as the business crumbled around him. That was a head-in-the-sand display that matches Microsoft's original dismissal of iPhones as laughable.

Sol Trujillo eventually asserted that his problems were caused by Australian racism - but they were not. They were caused by his personal intransigence and his tone deafness. The wags took to calling him the Sole True Hero simply because he could not build any coalition of support around his positions.

When he left the Prime Minister welcomed the news with a single word: adios. That was asserted as proof of Australian racism - and maybe it is indicative of such. However telecoms are ultimately a regulated business and an executive who makes a populace and a Prime Minister so angry that that is reasonable response has not succeeded as a teleco exec.

This is a warning to the capital markets. Anyone seriously contemplating backing that bid should look at Sol Trujillo's record at Telstra in Australia.

That record is subject of a previous blog post.


Friday, August 10, 2012

Advice from the gardening column: XP Power edition

I have a friend - a journalist - who refers to the stock-tipping parts of his newspaper as "the gardening column": full of plants he says.

But the Financial Times is not any ordinary newspaper - and its stock tipping columns should be a little better than that. So I read David Schwartz column on how to manage your investments on holiday with great interest. Fantastic stocks - ones you can put in the bottom drawer and know they will deliver - they are the stuff I need to take the stress out of my life.

Here is what he recommends:

Turning to my own portfolio, I have just bought shares in XP Power (XPP), a designer and manufacturer of power converters. These are devices that allow electronic equipment to operate efficiently.
XP Power shares were in the 1,600-2,000p range during the first half of 2011. But investors ran for cover after the level of new orders began to slip in mid-year. The slowdown eventually caused lower profits in the first half of 2012. 
But the company’s order rate is now spiking higher. I expect second-half results to be much higher than last year’s figures. 
Even better, XP Power is quite optimistic about its future. It recently launched 10 product lines. It brags about its strong design win record in the current year. The share of revenues derived from products manufactured internally is rising. These are more profitable than those manufactured externally. Its new factory in Vietnam has just come on stream, which will also help to increase margins. 
The dividend has just increased and now approaches 5 per cent.

Power converters - the things you plug into your laptop or into the life-sign monitoring equipment in a hospital to feed them nice stable DC current - don't seem to me to be a massively prospective business. There are lots of suppliers. I am not particularly fussed about which one I use. If I want power reliability then I get an "uninterruptable power supply" and even those are a competitive market. I would expect a story of thin margins made good only by lots of product development and fairly large sales.

XP Power confounded my expectations. Completely confounded them. The accounts were nothing like what I expected to see. Here is the P&L from the last annual report:

Revenue was £103.6 million. Gross profit was £50.9 million. The gross margin was 49.1 percent.

Operating profit was £25.3 million. Operating profit margin was 24.4 percent.

Research and development expenditure of a mere £4.2 million pounds. Not a big number - but a moderately healthy 4.1 percent of revenue.

These ratios looked strangely familiar. But I could not quite put my finger on why. And then a light went off in my brain. A light from Cuppertino. Apple! Yes that company.

Here - and on an entirely different scale - is Apple's P&L for the last three years:

The sales last year were $108.2 billion. Gross margin was 43.8 billion. Gross margin was 40.5 percent - a little lower than our humble XP Power. But Apple's operating margin (31.1 percent) is higher than XP Power.

But hey - David Schwarz - writing for the esteemed Financial Times - tells us that XP Power is going to increase its margins. Apple like numbers here we come!

XP Power history

By now I am seriously impressed with XP Power. It makes a seeming commodity electronic product but has a higher gross margin than Apple. Surprisingly despite the fact that it does not advertise much or run all those fancy stores it manages - after SG&A to wind up marginally - and only marginally less profitable than Apple.

Pretty darn impressive.

If it just turned up this way - a new entrant into the realm of super-profitable electronic hardware companies - then I would be surprised - but not stunned. But XP Power has been pushing out astounding numbers for a decade. Larry Tracey - Executive Chairman - is quoted in the last annual report as follows:

Our strategy and its execution  resulted in earnings per share of 106.4p for 2011, an increase of 27% over 2010. The compound average growth rate of earnings per share has been 27% over the last 5 years and 18% over the last 10 years.
It is not Apple - but this is way more impressive than most companies. 18 percent for 10 years is more than 500 percent growth. Previous years are also at very high margins.

Wow. Now I am really wondering why it took a share-tipping column to alert me to this wonder stock.

XP Power products

By this stage I had found a nearly unknown electronics company with margins nearly the match of Apple and with a hugely impressive growth rate. And it did what looked to me like a commodity business.

I had to go looking for their products.

Alas they were harder to Google than you would think - if only because XP Power got mixed up in articles about the Microsoft XP operating system and computer power requirements. Here however is a typical example:

It is a simple 15 watt DC converter (about a quarter of the capacity of the converter for my laptop). It is priced at 28 quid - cheaper in quantity. Still this is more expensive than the cheapest laptop computer DC converters suggesting that higher than normal margins are possible.

The balance sheet puzzle

An electronics company with a proud history (rapid, continuous growth) and margins within a whisker of Apple would normally - I expect - have a balance sheet similar to Apple. Maybe not in size - but I would expect to see a lot of cash - cash being the tangible representation of past profits.

But XP Power does not look like that at all. Here is the balance sheet:

The balance sheet has on it lots of assets representing past profits. Notably it has 31 million pounds of goodwill (they have purchased very well as acquisitions have not diluted profits). They also have 22 million pounds in inventory.

But they have that very un-Apple like thing. Net debt. Strange given their profitability - but with this record - well - you just have to trust them.

But I will not be buying the stock

David Schwartz "holiday buying case" for XP Power is that it will have increasing profitability. That is for a company that is already trading with Apple-like margins.

I am an old fashioned kind of investor. I like to think what a company will look like in five years before I pull the trigger.

To buy this stock I would need to be able to finish the following statement: I believe XP Power will in five years time have margins similar to Apple because...

I can't answer that. Indeed I can't imagine that you can stay this profitable in a seeming commodity business - so I shorted the stock. Maybe I need to find another gardening column.


To clear up confusion with my North American readers who forget there is a stock market in Old Blighty - this stock trades in London measured in pounds. [The Americans who forget there is a world outside the lower 48 know who they are!]

Monday, August 6, 2012

Something is happening here and you don't know what it is - do you Mr Hempton: Richemont edition

I am wrong often enough to hurt - but rarely this fast. Richemont just pre-announced a big sales increase. I expected at best low single-digit sales increases and the company to guide down. I blogged about it only on Friday. Richemont was a modest sized short position and I was trading it for what I thought would be an earnings miss.

This company sells very fine jewellery and high end watches. By high-end I mean up to half a million dollars.

Richemont is - as I said in the original post - an amazing company that has managed to make super-luxury goods ubiquitous whilst they remain exclusive.

The sales rise during the first four months is 24 percent (16 percent in constant currencies).

We have a broken thesis rule at Bronte. We search for things that falsify our thesis - and when we find them we close our position. This big sales increase tells me that something is happening in this business that is outside my thesis and not obviously consistent with the thesis.

So we just covered. Loss to clients was about 40bps of our funds under management. It was not the first time and it will not be the last time we make a mistake...


As of about five minutes ago we no longer have any interest in Richemont, long or short. But that won't stop me trying to work out what we did wrong. The sales increase is enormous given current economic trends. Lets think this through by jurisdiction...

I would expect a (big) sales increase in Japan because the previous corresponding period includes the earthquake and tsunami.

I would be startled by anything other than a sales decline in Europe. There is an economic crisis there and as one of my correspondents put it - the one percent are becoming the half a percent.

North America is doing OK - so I would expect a sales increase - but low single digit.

South America will - like Australia - be beginning to feel some commodity price anxiety - so sales increases will be small.

The anecdotal stuff out of China and Hong Kong is all bad. Correspondents sent me many anecdotes - all supportive of my thesis - and the plural of anecdote has always been data.

None of this allows for a twenty percent sales increase.

I have heard only one alternative thesis - and that is that sales within Mainland China are increasing - not because they want the watches and jewellery but because they are portable wealth that you can move over a border with or store like gold. It might be true - but watches and jewellery strike me as poor stores of value. The anecdotes in my email suggest that the gray market is weak - but those anecdotes are so thin that I doubt them.

Any other thoughts - because I am at a loss.


Friday, August 3, 2012

Richemont: waiting for the bullet

At 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:

Just saying - when it turns it can get uglier than you ever imagine.


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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.