Although we did slightly reduce our position last July in the $13-14 range to fund other purchases, we continue to hold the majority of our initial stake. It's important to remember that just because a company's share price has a large run, an investor who keeps holding isn't necessarily a "pig" nor do "pigs [always] get slaughtered!" (as Jim Cramer likes to say). Let's explain.
Per our Sonic Foundry (SOFO) and Key Investment Musings post the other week, we always need to separate a company's market price from our reasonable estimate of fair, or intrinsic, value. If fundamentals are poor/negative and the outlook is unclear -- as it was back in late 2008 and early 2009 for most companies -- this estimate can be informed by balance sheet strength (e.g. net tangible value) and normalized earnings power (e.g. average earnings over a full economic cycle). Later, assuming a share price recovery on the back of better fundamentals and improved visibility, we continue to watch the balance sheet but really need to keep tabs on valuation as a multiple of earnings (which is what garners the Market's attention). In this case, current, expected, and normalized earnings all come into play, as well reasonable assumptions around valuation multiples.
With Harry Winston, we estimate that normalized earnings power might be anywhere from $1.00 to $2.00 ($1.50 mid-point), depending primarily upon rough diamond prices and retail segment performance. What multiple is appropriate for one of the world's premier luxury brands that also happens to own a 40% stake in one of the world's most valuable diamond mines? Maybe 15-20 times? Assigning this to the mid-point earnings estimate of $1.50, we have a fair valuation range of $22.50 to $30.00. This is somewhat similar to our Sotheby's (BID) analysis in 2009, except that we never purchased this company (primarily because of our concerns around Sotheby's large debt burden coupled with poor luxury fundamentals at the time - unfounded worries in hindsight = our mistake!).
While past performance is no indication of future performance, it's amazing how many companies now trade around pre-crash levels. Psychology in the "Market" and around particular stocks also plays a role here. We can see that shares of Harry Winston formerly traded in the $30s and $40s pre-recession - five-year chart from Yahoo! Finance (YHOO):
Looking at prior financial results, we can see former operating income levels were significant before the downturn - from Google Finance (GOOG):
Okay, the next question: how are fundamentals tracking? We detailed key elements in our August post:
- Healthy Luxury Market? Harry Winston (HWD) Says Rough Diamond Prices Above Prior Peak; Provides Glimpse of Earnings Power
Another question: what can we learn from the results of luxury peers? Here's one large, well-diversified luxury company to review for a broad look into global luxury trends: Compagnie Financière Richemont SA.
- Richemont owns several of the world's leading companies in the field of luxury goods, with particular strengths in jewellery, luxury watches and premium accessories. The Group’s luxury interests encompass several of the most prestigious names in the luxury industry including Cartier, Van Cleef & Arpels, Piaget, Vacheron Constantin, Jaeger-LeCoultre, IWC, Panerai and Montblanc.
Noteworthy - Americas retail "nearly back" to where it was and "close to peak":
AND, drilling into the company's "jewellery" business:
- in € millions 30 September 2010 30 September 2009 Change
- Sales 1 619 1 222 + 32 %
- Operating results 541 349 + 55 %
- Operating margin 33.4 % 28.6 % + 491 bps
- The Jewellery Maisons' sales increased by 32 per cent overall, with stronger growth in the Maisons' own boutique networks. Sales of high jewellery pieces were good and the more accessible jewellery ranges also performed well. Sales of watches, from Calibre de Cartier editions in precious metals to classic models in steel, were very strong, benefiting from the Maison's position in premium watchmaking. Cartier's leading position in growth and established markets provided a base for double-digit sales growth, albeit against weak comparatives. Van Cleef & Arpels also saw double-digit sales growth during the period. Due to the Maison's relatively high exposure to Europe and the US, the comparative sales growth was lower than the business area as a whole.
So, based on Richemont's results, we can surmise that the luxury market continues to chug along nicely despite ongoing macroeconomic concerns. Side-bar: the strong results are consistent with better fundamentals across numerous sectors, a positive sign for the broader economy.
Finally, what about the global supply/demand dynamic for mined diamonds? An October Bloomberg article provided thorough insights on this topic, including commentary from Harry Winston's Canadian partner, Rio Tinto (RIO):
- Rough-diamond prices will extend gains through the next decade as dwindling production fails to meet rising demand from India and China, Rio Tinto Group said.
- "We have seen a rapid recovery and prices are back to pre- crisis levels," Harry Kenyon-Slaney, chief executive officer of diamonds and minerals at London-based Rio, said in an interview. "What we see going forward is a long decline in production and a significant growth in demand."
- Diamond miners are struggling to keep pace with growing consumption in emerging economies as older mines are exhausted and producers lack new discoveries. Prices of rough, or unpolished, diamonds have risen as much as 91 percent from a six-year low in early 2009 as jewelry sales collapsed, according to data compiled by WWW International Diamond Consultants Ltd.
This week, we'll learn first-hand about market fundamentals directly from Harry Winston, which reports fiscal 3Q 2011 results on Thursday after market close. Based on the above and commentary from other luxury vendors, our expectation is that trends remain favorable for Harry Winston.
Importantly, we believe key risks are mitigated and continue to hold our shares with a margin of safety. In fact, we're hanging onto our shares and see reason for meaningful, incremental upside.
Disclosure: long HWD, GSL, EBAY, SOFO, YHOO.
© 2010 Jeffrey Walkenhorst
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