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Only Buy Luxury At A Deep Discount

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Ken McGaha
Apr 01, 2015
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Most readers of this article will already be quite familiar with the theory of efficient markets which contends that the stocks that trade in the public markets are always fairly valued as the markets act “efficiently” to incorporate all of the information available into the price of any given stock at any given moment. However, if that contention were correct, there would have been no place or success for famed value investors such as Benjamin Graham,

Warren Buffett (Trades, Portfolio), John Templeton and David Dreman (Trades, Portfolio).

These men, along with scores of others less known, made huge fortunes by having the patience to wait until they were presented with the opportunity to acquire extraordinary brands and businesses at unjustly depressed values. They were able to look beyond the short-term pessimism and emotionally driven fear that drove share prices to absurdly low levels and then, as the legendary Jim Rogers described it: “I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime.”

Warren Buffett (Trades, Portfolio) once was quoted as stating: “My investment style is best described as lethargy, bordering on sloth.”

The greats make it sound so easy and, if you can learn to evaluate stocks without attaching the emotion of money, it is. Emotions, mainly fear and greed, are what drive stock prices to ridiculous levels, both high and low. The ability to make investment decisions based upon fact and simple numeric calculations is what separates the greats from the rest of us. They sell when a position is ridiculously overvalued without fear of losing out on further gains, and they buy when prices are ridiculously undervalued without fear of the price moving a few points lower, as long as they are certain the value at which they acquired a position is exceptional. Several have even publicly stated the excitement they feel when an existing position moves lower in price as it allows them to continue building their stake at better prices.

Why do stocks become seriously undervalued?

The emotion of fear; that’s why. It really is that simple. A piece of bad news comes out and as shareholders get scared and begin to sell, more shareholders get scared and begin selling. It doesn’t take long in today’s wired world for word to spread that a stock is falling hard and more shareholders will sell, in many cases, without even knowing why they are selling, other than the price is falling.

History is replete with examples of this exact circumstance, along with the record of the fabulous opportunities created by this fearful reaction of panic selling on one piece of bad news. In some cases, the news is really not all that bad when taken within the context of the overall business.

Think back just a few years ago when Walmart (

WMT, Financial) shares fell from over $60 to around $45 when news broke on the bribery scandal in Mexico. Without any consideration as to what level of exposure or harm to which the business could be subjected, shareholders began selling in a panic and the more of them that sold, the more that were scared into selling. In the end, the penalties involved turned out to be relatively minor within the scope of Walmart’s total business and those “brave souls” who stepped in a bought the shares at the peak of the panic made returns over 30% in just a matter of months.

Or take the lesser known example of Questcor Phamaceuticals (

QCOR, Financial) in 2012 when shares fell 48% in one day on the news that Aetna announced it would “limit” coverage of Questcor’s lead drug, H.P. Acthar Gel. The company stated it did not anticipate “material adverse affects” from the decision, but the share price collapsed as investors rushed for the exits. An unemotional analysis of the event would have revealed that Aetna accounted for only about 5% of the reimbursements for Acthar Gel AND that the company’s decision related to only about 20% of the actual reimbursements they were making for patients receiving Acthar.

The shares languished in the mid-$20’s for several months even though it was trading a a single digit multiple to earnings. Value investors who overlooked the fear and focused on the fundamentals while building a position in the middle $20’s were quite handsomely rewarded last year when Questcor was purchased by Mallinckrodt PLC (

MNK, Financial) in a cash and stock transaction valued at around $140/share.

We have seen similar moves more recently as shares of Target (

TGT, Financial) were hammered during a series of problems that, while somewhat embarrassing, were relatively minor in relation to the overall business and would have only a very temporary adverse effect on the business. Shares plummeted from $73 down to $55.07 on February 5, 2014, as fear replaced reason in the hearts of shareholders. The stock has since posted a gain of 48% (not including dividends) to close at $81.56 last Friday. Once again, investors who were able to remain focused on long-term intrinsic value and ignore short-term fear were richly rewarded. The chart below clearly displays the dramatic move.

03May20171131441493829104.png

So much for the efficient market theory.

Why does all of this matter to us today?

Today, I believe I have found a similar situation where a panic ensued after an exceptional business brand reported some short-term issues. I do not believe the issues facing this business are insurmountable. Nor do I believe the create a permanent impairment to the intrinsic value of the business or its brands. Although, one would never know it from the reaction of shareholders who fled in fear on the news and created a great opportunity for value investors to once again reap impressive gains over the coming years.

Movado Group, Inc. designs, markets, and distributes fine watches. It also sources the manufacturing. The company operates in Wholesale and Retail segments. It offers its watches under the Coach (

COH, Financial), Concord, Ebel, ESQ, Scuderia Ferrari, Hugo Boss (BOSS, Financial), Juicy Couture, Lacoste, Movado (MOV, Financial) and Tommy Hilfiger brands to jewelry store chains, department stores, independent regional jewelers and other retail and wholesale channels of distribution. In addition, it operates its own retail outlet stores. As of January 31, 2014, the company operated approximately 35 retail outlet stores. It maintains a presence in the United States, Europe, the Americas, Asia, and the Middle East. The company was originally known as North American Watch Corporation and changed its name to Movado Group, Inc. in 1996. Movado Group, Inc. was founded in 1961 and is based in Paramus, New Jersey.

On November 14, 2014, the company management issued a press release that, among other things, stated the company was “… disappointed in our third-quarter performance and our expectations for this trend to continue into the fourth quarter, which combined has caused us to reduce guidance for the full year.” The press release went on to state that our expectations for this trend to continue into the fourth quarter, which combined has caused us to reduce guidance for the full year. For fiscal 2015, our net sales are now expected to increase by approximately 1% to 2% and operating profit is expected to be down approximately 7% to 10% as compared to last fiscal year.” It appears that this is where most investors ceased to listen.

I am always on alert for this type of news from businesses that own established brands with loyal followings as they often result in a short-term panic that creates a long-term opportunity. On November 13, shares of Movado ended the trading session at $38.51/share. The next day, after the press release from the company that revised its guidance downward for revenue and earnings, the shares closed down 31.84% or $12.26/share. Ouch. That is a huge drop for an announcement projecting a 7% to 10% decrease in earnings for the coming year compared to the current year. The chart below provides a stunning visualization of the real impact of this move.

03May20171131451493829105.png

Sometimes the market only hears what it wants

But there was more to the announcement that the average investor seemed to overlook. Chairman and CEO Efraim Grinberg went on to say: “Our brand portfolio remains strong as does our balance sheet. We have strong plans in place for the upcoming holiday season that should continue to drive increased sell-through at retail. As we begin planning for next year, we are confident that we will return to sustainable profitable growth.”

Vice Chairman and Chief Operating Officer Rick Cote added, “We nevertheless remain pleased that we continue to gain share in our key global markets in both our largest brand, Movado, and also several of our largest licensed brands as evidenced by our retail sell-through. We will continue to invest in our infrastructure and growth initiatives, such as the addition of Ricardo Quintero as President of Movado Group, and we remain focused on our long-term business strategies and our ability to deliver sustainable profitable growth.”

This was the information I was looking for as I reviewed the announcement and compared the market’s reaction to it. As is often the case and was previously illustrated in the example above, a short-term problem that was in the process of being effectively recognized and addressed by the management.

Then on November 25, the company issued another press release announcing the expansion of its existing $50 million share buyback program to $100 million. This is an excellent move considering the currently depressed value of the shares and will benefit the remaining shareholders disproportionately as the business and share price recover. At the current share price, a $100 million repurchase of stock would reduce the share count by 16.1% and provide an exceptional tax deferred yield to current shareholders.

So, we have an extreme reaction to what appears to be a short-term problem that is currently being addressed by management. This is beginning to look like “money lying in the corner.”

What is the current fair value of this business?

While there are many metrics that can be applied to any business in an attempt to establish a reasonable assessment of “fair value,” I like to use the basics such as P/E ratio, Price to Earnings Growth Ratio (PEG), Price/Cash Flow, Price to Sales and Price to Book. I also like to compare these valuation numbers to the industry averages. These metrics and the comparable industry valuations are shown in the table below.

VALUATION COMPARISON MOVADO TEXTILE/APPAREL

LUXURY GOODS

Market Cap

$620.66M

$5.55B

 

52nd

P/E (Trailing Twelve Months)

12.91

21.78

 

18th

P/E (5-Year Average)

--

25.05

 

--

PEG Ratio (5-Year Projected)

0.86

2.45

 

13rd

Enterprise Value

$462.38M

$50.19B

 

47th

Price/Cash Flow (Most Recent Quarter)

6.14

24.69

 

40th

Price/Cash Flow (TTM)

10.11

24.18

 

17th

Price/Sales (Most Recent Quarter)

0.82

2.62

 

41st

Price/Sales (TTM)

1.07

2.71

 

48th

Price/Book

1.32
03/27/2015

5.87

 

30th

Book Value

18.83
10/31/2014

14.25

 

84th

By comparison to the overall industry, Movado is surprisingly cheap. In each metric I evaluated, with the exception of the Trailing Twelve Months Price To Earnings Ratio, the business is priced at less than 50% of the broader industry’s value. That means the stock would need to double to simply be valued on par with its overall industry.

Currently we have a stock that represents luxury brands that are recognized around the globe. It suffered a 31.84% drop on a negative adjustment of 7% to 10% in anticipated earnings. It also appears that the management of the company is moving aggressively to reduce the outstanding share count by expanding the existing buyback program while they are priced at the current depressed level.

It is difficult to imagine that the fair market value of this stock is not 50% higher than the current price as that would still leave it valued at a 25% discount to its industry and approximately the same discount to the S&P 500.

Is there a sufficient margin of safety protecting our capital?

Investing is always about making a profit; but rule #1 is: “Never lose money.” While we know that we have no way of achieving perfect adherence to rule number 1, we certainly want to come as close as possible. In striving to meet that objective, we always look for the downside protection in our capital allocation decisions. Movado provides exceptional protection for our capital.

A quick glance at the balance sheet of the company reveals that it holds cash and short-term investments of $259.5 million against total liabilities of only $115.3 million. This leaves a net cash balance of $144.2 million free and clear of all liabilities on the balance sheet. With a total outstanding share count of 25,179,000, the net cash on hand is worth $5.72/share or 23.2% of the current market value of the business.

This is what is meant by value oriented investors when they speak of a “fortress-like balance sheet.” This is just one more piece of evidence indicating that previous shareholders sold in panic without truly understanding the intrinsic value of the asset they owned. This is also one more piece in the building of a truly compelling opportunity just waiting to be seized by careful value investors waiting to see that “money lying in the corner” that Jim Rogers told us to pick up.

Compelling present value is nice; but what about the future?

Future performance of a business is the most difficult aspect of valuation in my opinion. I think anyone who claims to be able to predict it with accuracy would mislead me about other things as well. Even though I used to be responsible for establishing five-year budget and capital plans for manufacturing companies under my oversight, I always thought of it as being nothing more than an educated guess. This is also one area where I do tend to lean a bit on opinions of analysts who earn a living studying a particular industry as well as my own life experiences.

The table below shows the growth history of the business and the industry as well as the projected future performance.

Growth

 

MOV

Textiles, Apparel & Luxury Goods Average

Industry Percentile

EPS Growth (Last Qrtr vs. Same Qrtr Prior Year)

-2.25%

+38.04%

 

38th

EPS Growth (TTM vs. Prior TTM)

-4.50%

+16.66%

 

36th

EPS Growth (Last 5 Years)

+85.37%

+20.87%

 

100th

Projected EPS Growth (Next Year vs. This Year)

+3.80%

+16.37%

 

10th

Forward EPS Long Term Growth (3-5 Yrs)

+15.00%

+11.93%

 

74th

Revenue % Change (Last Qrtr vs. Same Qrtr Prior Year)

-0.59%

-7.65%

 

39th

Revenue % Change (TTM)

+3.33%

+10.73%

 

50th

Revenue Growth (Last 5 Years)

+4.35%

+12.13%

 

36th

Capital Spending Growth (Last 5 Years)

-5.93%

+15.52%

 

28th

Book Value per Share Growth (Last 5 Years)

+3.04%

+14.93%

 

25th

Free Cash Flow (TTM)

$26.95M

$1.69B

 

63rd

Cash Flow Growth Rate (Last 5 Years)

+25.20%

+18.86%

 

75th

Cash and Cash Equivalents Increase/Decrease (TTM vs. Prior TTM)

$-0.07

$0.20

 

33rd

Cash and Cash Equivalents Increase/Decrease (Last Qtr vs Prior Qtr.)

$-0.03

$-0.24

 

35th

In the case of Movado, I have already established that the stock could rise by 50% and still be trading at a discount to its industry’s average valuation. We have also identified an announced share repurchase program that would reduce the outstanding shares by 16% if fully implemented. In real terms, this provides us with a potential upside of 66% just to reach a valuation comparable with the industry overall. I have also established that the stock has a tremendous amount of downside protection provided by the cash hoard on its balance sheet, equaling another 23.2% of its current market capitalization.

Now I want to see what the forward returns should be even without any improvement in the current valuation measures. Since I have already stated that I do not trust my own ability to predict the future any more than I trust the ability of others to do so, I am going to apply a downward adjustment of 33% to the forward earnings growth rate used by the analysts covering the stock and estimate forward growth at 10%/year. The stock current has a dividend yield of 1.62% and if the earnings grow at 10% per year and the valuation remains at the current low multiples, the combination of share appreciation and dividends should produce annualized returns of 11.62% for the foreseeable future.

Final thoughts and actionable conclusions

I always find it exciting when the pieces of an investment puzzle start to form a compelling picture. There are times that I get right down to the end of my analysis and then find the rotten apple in the barrel. That has not been the case with Movado. This is one of those situations where two of my favorite things come together, luxury and profits. Buy Movado shares today and, with your generous capital gains, you will be able to take your pick of luxury products by Movado or whatever brand you choose. This stock is a serious candidate for a double in the next two years.

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