Rahul Bhatia of Willow Investment Management presented his investment thesis on KDDL Limited (India: KDDL) at Asian Investing Summit 2023.

Thesis summary:

KDDL comprises two distinct yet complementary businesses — Ethos and KDDL Standalone (S/A).

Ethos is India’s largest Swiss luxury watch retailer and a publicly listed company, catering to a rapidly growing and affluent market segment. With its exceptional competitive advantages, Ethos stands head and shoulders above its peers in the luxury watch retail industry.

On the other hand, KDDL S/A is a well-established manufacturer of high-quality hands and dials for some of the most prestigious Swiss luxury brands, having a legacy of over forty years. The business has a strong track record of generating steady cash flows and offers multiple optionalities.

Ethos and KDDL S/A are steady compounders and, as a combined entity, they represent an undervalued investment proposition with low downside.

The following transcript has been edited for space and clarity.

Rahul Bhatia: It’s an honor to be speaking here at MOI. Since this is my first presentation, I figured I’d pay homage to MOI’s Swiss roots by presenting an Indian company that happens to have an extremely strong Swiss connection.

Before I get into it, let me note that this presentation is not a recommendation of any sort to buy or sell. We own the stock in the fund and in separate accounts. We may buy some or sell some without any notice. All of this is for informational purposes only.

A quick word about our firm. We are a U.S.-domiciled, India-focused fund. We are a little over 10 years old. We invest in select Indian companies – mostly mid and small caps – and we tend to hold these companies for a long time. Among the people who run the firm, I’d say by far the biggest asset is Jean-Marie Eveillard, who is a mentor and a senior advisor. He sits on the board and also happens to be one of our earliest LPs.

Let’s move to today’s stock pitch. The company I’ve chosen to present is called KDDL. It has a market cap of 13.7 billion rupees, or about $165 million. It’s a 40-year-old company that has two distinct businesses. It owns 61% of another publicly traded company called Ethos, which is India’s largest Swiss watch retailer, and it also owns a few manufacturing businesses. A large part of what these businesses do is make hands and dials for luxury Swiss watches.

I’d like to spend a few minutes talking about the Swiss watch Industry, specifically the brands. The first thing you notice when you look at the Swiss brands is how old some of them are – Breguet existed before the French Revolution; Vacheron predates the American Revolution; and Blancpain is almost a 300-year-old brand, older than the Industrial Revolution. There are a lot of older businesses, but it’s very hard to find brands that are this old – think about the sheer resilience they have and how much volatility they must have endured. They are still here, and they are getting precious as time goes by.

The second thing you notice is how long the tail is in these brands. Swatch sells about 3 million units a year. Rolex sells about 800,000. Chanel and Patek Philippe often sell no more than 1,000, 2,000, 10,000, max 20,000 pieces. At the tail end, you have F.P. Journe, which sells 650 pieces globally in a year. Imagine you are a watch brand that sells about 10,000 pieces, and you want to enter this high-growth country called India. You know you’re going to sell 50 pieces or 100 pieces a year max. The question is who you partner with.

Obviously, you can’t have a discussion about Swiss watches without talking about the effect smartwatches are having on this market. There’s no doubt that smartwatches are a threat. They outsell Swiss watches by about four times. Apple shipped almost twice the number of units in 2019 compared to the entire Swiss output. The smartwatch is functionally lightyears ahead of Swiss watches, and it keeps getting better.

Is it game over for Swiss watches then? The answer is it’s complicated – yes and no. The low end of the Swiss watches market is obviously getting decimated. These are watches that cost below 500 Swiss francs. They were selling about 18.5 million units in 2015. Seven years later, that number is down to about 8.38 million. The trend has stabilized a bit in the last two or three years, but that’s neither here nor there. With high-end Swiss watches (watches priced at over 3,000 Swiss francs), you see a steady increase in the number of units as well as a steady increase in the average selling price. Overall, the total number of units shipped has gone down quite a bit over time – a 44% decline over the past seven years – but total sales have grown by 17% during this period.

That’s the global scenario. Let’s see what India looks like. First of all, the last few years have been absolutely awful for the Indian luxury market, or at least they should have been on the face of it. In 2016, you had tax rules come in that said you had to tax collect at source. You need tax IDs for any transaction above 200,000 rupees (about $2,500 to $2,800 at that point). There was a big demonetization of currency. Customs duty went up a couple of times. There was a fairly large banking crisis. By 2019, we had the lowest growth rate in the last 10 years. By the time we thought we were coming out of this crisis, COVID hit, and we had supply chain disruptions. In short, there were all kinds of bad things.

However, Swiss watch imports have held up fine coming into India. There’s been about 65% growth all the way from 128 million to about 200 million Swiss francs as of now. That’s the context in which Ethos operates.

Let’s look at what Ethos is. It has a chain of stores selling high-end luxury Swiss watches, a few internet properties, and an e-commerce business. It also has a fledgling certified pre-owned luxury business called Second Movement.

Starting with physical retail, the company has about 50 stores and sells 60 brands – 39 of those brands happen to be exclusive, which means they are only available at Ethos in India. Why would a brand restrict itself to Ethos? The reason is preferential treatment. It gets all kinds of preference in terms of the customer list, shelf space, locations, and so on. What Ethos gets in return is double the gross margins. That’s the physical retail – it’s head and shoulders above any of the Indian competitors the company has.

Let’s look at the online business next. Ethos made a bet very early in its life that watches can be and should be sold online. The reason it did that was because Pranav Saboo – who’s the CEO now – has a content marketing background. At this point, Ethos has a fairly seamless omnichannel online buying experience. You can buy online and get the watch delivered to your home or to your office. You can schedule a viewing in store or in your office. You can do all kinds of things online. About 15% of the workforce is now focused exclusively on this effort. The company generates about 40% of its sales from these properties.

Ethos is active all over the internet space. Regardless of where you look – Instagram, Facebook, website ranking – it is head and shoulders above its Indian comps and, in many cases, above global comps as well.

Obviously, you can burn a bunch of cash and buy your way into dominance. The real question for us as investors is whether Ethos can do all of this profitably. Let’s look at the financials. The answer is “yes, absolutely.” The company has already reported some of the fiscal year 2023 numbers (this is the March ending this year). A few of these numbers will be reported in a couple of weeks, when Ethos gets its official filing.

The business is making about 7.88 billion rupees in sales, which gets us to about a billion in EBITDA. That billion in EBITDA was the fiscal year 2024 goal (meaning the end of March next year), so Ethos has already blown past that goal. On the store level, the breakeven happens fairly early, but by the time we get to year three or four, we’re already talking about 25% ROIC. The company has about 15% ROIC right now. That ROIC is steadily growing over time. In the next two or three years, we think we will get very close to 20%, if not higher.

How does all of that look compared to its competitors? It doesn’t matter how you look at it. You can look at the market share, brand relationships, or margins. Ethos is way ahead of the competition, and it has gained ground over time. How does it do all this, and, very importantly for us, can it keep doing it? In other words, is there a repeatable process at the core of it?

Let’s talk about that process – the business model. It is essentially an access business. That’s what Ethos is at its core. What do the buyers get access to? They get access to the biggest selection, the exclusive brands, the online experience, a very large and generous loyalty program, and access to some special events that Ethos keeps hosting and sponsoring. What do the brands get in return? They get the largest HNI customer base in India, strong physical and online visibility, a very large footprint, and the best locations. Very importantly, they also get highly trained staff, which is extremely important in this business.

How does Ethos keep this wheel turning? It does it by spending on a bunch of items – digital, ads, sponsoring special events. It keeps deepening its Swiss relationships, making its loyalty program better, and improving its in-store experience. It has a very nice training program for its employees. The reason it can outspend its competitors is because it can deploy these fast over a much larger customer base and a much larger brand base. That’s the feedback loop at the center of Ethos.

The feedback loop is fine, and the moat is fine, but is there future growth? Let’s see where that’s coming from. The future growth is a bet on the growth of India’s wealthiest, highest-income cohort. A lot of businesses will often focus on the middle or the lower tier, but I want to draw your attention to the very top tier of the income groups in India. There’s a very high growth rate there. This cohort – the rich people in India – has grown about three to five times in the last 10 years. We don’t think the next decade will be any different. It’ll be about the same, which means the luxury watch market will grow at about the same rate – 12%, 15%, 17% CAGR. We expect Ethos to grow more than that simply because it will grow market shares.

We don’t think we will just stop there. There are some other margin growth levers as well. First of all, the number of exclusive brands has grown all the way from 15 to 39. Every quarter, every year, Ethos keeps signing more and more of these exclusive brands, which have twice the gross margins of the regular brands. As we keep going, the gross margins keep going up.

Online billing keeps going up over time as a percentage of total billing, and the average selling prices are going up over time as well. Back in 2019, 75,000 rupees used to be the average selling price. At this point, it’s sitting at $150,000 – double in those last four years. Due to the loyalty program, the number of repeat purchases is also steadily going up. Every one of these items will add to the bottom-line growth number.

Finally, I want to talk a bit about the certified pre-owned (CPO) business, which is called Second Movement. There are many advantages to running a certified pre-owned business. First of all, globally, it’s about half the first-hand market. In India, it happens to be less than 1%. Almost all of that business is done by Ethos, which started it three years ago, I think. Now this makes up about 5% of Ethos’ revenue. The business has a much higher ROI profile. It also happens to be a wider moat business. It’s likely going to be a winner take all. Whoever has liquidity will get more liquidity in this business. It also has a lot of synergies with the existing business – loyalty, financing, servicing, sales, and marketing – all of that you can use across the first-hand business and the certified pre-owned business.

The problem with the certified pre-owned business – and the reason a lot of other competitors are not able to do it – is that it is challenging. Authenticity and proper documentation are a huge problem. Records of legal purchase – whether the taxes and duties have been paid – is also a big problem, as is restoration. You need trained watch technicians, certification, after-sales support – all of that is a problem.

There’s a big threat the brands perceive in this business. They think it is a competitor to their first-hand business. What you have to do as a company is set up a completely different venue, a completely different business, which is exactly what Ethos has done with Second Movement. It does that with separate physical locations in some pre-owned-only lounges. It has opened one and will open a few others. These are nice swanky lounges where you can come, hang out, have some drinks, and look at the watches. At the back end, it is also leveraging its financing and after sales and all the other functions.

The internet properties are also kept completely different – separate websites, separate socials – but again, at the back end, they are sharing their digital scale. The customer lists and the loyalty program are shared, and there are a bunch of cross promotions.

The other clue that tells us Ethos is serious about the business that it has made some key hires. One of them happens to be Patrik Hoffman, the current EVP of Watchbox – one of the largest certified pre-owned online businesses in the world. Patrik also happens to be the ex-CEO of a very prominent watch brand. He sits on the board of Ethos at this point, so the company is fairly serious about this business.

Given all of these growth levers and the fairly wide moat, the question is, “How much should we be paying for this business?” Let’s go to the valuation piece next. The company trades at a market cap of 23.5 billion rupees. It does have a tiny bit of debt. The Enterprise value of 24.5 billion rupees. We think the steady state ROIC will be about 20%. We are modeling in 15% to 25% growth., which we deem absolutely possible for the five years. In fact, if anything, that might be a little conservative.

Keep in mind that all of its real competitors in India are private, so I’m comparing the company to some other luxury retailers. Based on the global comps, we think it trades at a fair multiple of 23. That’s where Ethos trades right now, and we think that is fairly valued on pretty conservative assumptions.

Is there a way you can buy this company at a discount right now? The answer is absolutely yes. KDDL – the company I’m going to talk about on a standalone basis – owns 61% of Ethos. Ethos’ current market cap implies 14.36 billion rupee in equity value for KDDL, which itself currently trades at 13.6 billion. The question is, “What does that negative 760 million in value you see for KDDL standalone get you?” That brings me to KDDL’s standalone business.

It’s a manufacturing business and one of only five non-captive hand makers for Swiss watches. It’s the sole supplier from India, serving more than 50 Swiss brands. It has over 90% market share in the domestic markets for hands and dials. It does all of Titan’s business. It also owns a fairly high-growth precision engineering business called Eigen and a company called Estima – a 100-year-old Swiss company that makes hands and dials in Switzerland.

I want to start with the financials for this company. From 2014 to now, it has grown at about 11% CAGR despite a lot of headwinds. What are these headwinds? First of all, there’s the Apple Watch onslaught that started in 2015. Year after year, the unit sales for Swiss watches kept coming down. Once that trend stabilized, we had COVID and a supply chain situation that affected the company for a good two to three years. Despite all of that, we had 11% revenue CAGR with a fairly steady ROIC profile of an average of 18%. Right now, by the way, the ROIC is clocking at around more than 33%.

Let’s also look at the gross margins. They are a little weird for this business. It’s a fairly steady 75%-ish gross margin business, which is weird if you compare it to the other manufacturing businesses that have much lower gross margins. The question is, “How come? What gives? Where are these margins? Where is this stable ROIC and pricing power coming from?”

We think it’s coming from a few different sources. The first one is that hands and dials happen to be extremely low in price when compared to the watch itself. Yet, they add tons of value. They have very high visibility. It’s extremely hard to sell a watch if these parts are imperfect. These are small-price but very high-value items. There’s very little incentive for the customer to change suppliers. We think that’s one source of moat.

The other source of moat is that even though these are small parts, they require high precision and are largely handcrafted, especially on the higher end. According to industry insiders, making high-end hands involves about 30 or so operations, and most of these require human intervention, and high-end dials have even more operations that require human intervention. This is quite clear if you look at KDDL’s employee margins or employee cost as a percentage of sales. This is double the next manufacturing sector, which is bearings – far higher than any other manufacturing business. We think hands and dials are high-value items. Again, the client has very little incentive to change suppliers once it becomes sticky.

For a second, let’s imagine that you wave a magic wand and learn to make these high-precision handmade hands and dials. Let’s say you can poach a bunch of employees from KDDL as well. The question is, “Can you still recreate KDDL, which is a very lucrative business?” We think it is unlikely. The reason for that are these very long relationships the company has with the Swiss. It has a 40-year track record and at least 30 years of very close relationships with the Swiss. In fact, one of its hands-making units is entirely devoted to one of the largest luxury houses in the world. It’s now been asked to make other components for this house. For many of its clients, it’s talking to both the front and the back of the house, meaning it’s talking to the retail function. Ethos is talking to the retail function, and KDDL is talking to the manufacturing function or the procurement function. It’s the same family that is talking to this one Swiss family, in many cases and for many years. We see these relationships as one of the biggest moats this company has.

We think there’s a fairly wide moat, but let’s look at the growth levers and the valuation of KDDL. We expect a very large part of the next few years’ growth to come from the precision manufacturing business. This contributes about 26% to the top line at this point. The EBITDA and ROI or ROE profiles are very similar to the hands and dials – very healthy. It’s growing at a much higher pace, at 25% annually. What KDDL is trying to do here is leverage its existing precision manufacturing expertise in hands and dials and apply it to parts in aerospace, automotive, electronics, and consumer durables. It has an extensive list of marquee clients and a great business going here.

There are some other growth drivers. There’s some organic expansion that we think it will absolutely see as the Swiss luxury watch industry itself grows at 3%, 4%, 5%. We think the company will take market share, partly by capitalizing on a China + 1 strategy. “Land and expand” is another strategy that works for it. This means it’s already making hands and dials for these companies, and it now wants to make indices or bracelets for the same manufacturers.

There’s a very good example of that. In recent times, the company put up a bracelet plant. It spent 92 million rupees or so on it. More than that cash it has already received from one of the clients and this entire production line is already spoken for for the next two, three, or four years. The customers are kind of pre-paying KDDL to set up these plants. It is absolutely going to move up in the luxury chain like it has been moving so far. Average selling prices are going to go higher.

Finally, we have Estima. There’s a turnaround going on with this small purchase KDDL made in 2018. There used to be 60-plus watch hand makers at the beginning of the 19th century in Switzerland. Now, only six remain, and Estima happens to be one of them. I’m talking about independent hand makers.

This acquisition was basically a hedge against the Swiss-ness norms – the Swiss have this rule that 60% of the value of the watch must come from Switzerland (it used to be 50%). As a hedge against that, KDDL bought Estima, which is a Swiss company. It makes about a million Swiss francs in losses right now. We think it’s going to break even this year and start adding to the bottom line from next year. All of these are my additional growth drivers for KDDL.

Given the moat and the growth, let’s see how much we should be paying for it. For the KDDL standalone model, the steady state pre-tax ROE is at about 20% (this is currently at 38%). The 2023 estimated pre-tax earnings are going to be right around 600 million rupees. We think the five-year growth rate can easily be 10% to 15% for the reasons we just discussed, which means the fair multiple should be somewhere between 20x and 25x and the fair value between 12 billion and 15 billion rupees. This fair value is almost the same as the fair value of the Ethos stake. What we are saying is that KDDL the package trades at a 50% discount to its intrinsic value when you add both these items together.

Now, the question is, “Can this discount go away? Can there be an unlock in value?” Before I talk about an unlock in value, let me pose the question whether we do want an unlock in value. It’s not clear to me whether an unlock is that important here. First of all, these businesses themselves, the NAV itself of this package, will compound at a fairly nice rate with a fairly high ROI. It won’t require a lot of capital and it’ll keep growing. There’s some compounding here.

Secondly, there is a bunch of synergies between these two businesses. That’s one part of it. However, is there a possibility of unlock? Can we make something over and above the compounding? The answer to that is yes. Carving out and listing Ethos was step one for the firm. It did that in 2022. The management have already always been interested in spinning Ethos out to existing shareholders. The question is, “Why not take step two?” This is a little complicated, so I’ll try to simplify it.

In 2015-2016, KDDL raised 500 million in primary capital from a PE firm, which got a 16% ownership and the investment was accounted for as FDI in the company. FDI rules in India are weird, but they prohibit the PE firm from directly owning a substantial stake in Ethos. I won’t go into details of what substantial means, why the FDI rules are what they are, and whether there are some workarounds, but the idea is that that PE company can’t own any sort of substantial stake in KDDL. After multiple sales, the PE firm now owns only 3.85% of this company. Is there a chance of unlock? We think there is a fair chance. They keep unloading. They’re already a few years into the age of the fund. In the next two or three years, we are probably going to see the unlock as well.

This brings me to probably the most important aspect here, which is management and corporate governance. This company is run by a father-son combo. Yasho Saboo is the chairman and MD of KDDL, as well as the MD of Ethos. He set up KDDL back in 1983. In 2003, he set up Ethos, and in 2006, he set up Eigen Engineering – the precision manufacturing business. He’s fairly used to incubating businesses and creating value by launching and maturing these businesses again and again. He currently looks after the brand relationships at Ethos, and the entire Ethos business is slowly transitioning over to his son, who became the CEO in 2018.

The founding family controls the business and owns about 51% of KDDL. This is up from 45% in 2020. This means they periodically buy stock. Very recently, they bought some stock in the open market as well. I’m talking about KDDL stock.

We find them to be very transparent, very approachable, and extremely investor-friendly. Their financial disclosure is excellent, especially for a firm of this size. Here’s a good example: Since 2014, when the company was very small ($15 million microcap), they have been regularly doing investor calls and publishing the transcripts and all of that good stuff. We love the financial disclosure of this firm.

The management have a fairly good track record of capital allocation. They’re used to incubating businesses and making them bigger. They spend most of their money on organic expansion. Recently, they received a bunch of proceeds from the Ethos IPO which they used to buy back stock. These are all good things in terms of being shareholder-friendly.

Of course, there are always going to be some risks. The biggest one probably is the constant attack on the industry by smartwatches. We can’t deny that. There’s also the risk of Swiss protectionism increasing over time, which might affect KDDL’s future growth prospects. The Estima purchase was a hedge against this risk. As we know, luxury is a cyclical business, and luxury retail is even more cyclical. There’s very high operating leverage, which means you have to be highly conservative with financial leverage. That’s exactly how Ethos operates. So far, so good, but there are risks in there. There is always a threat from pureplay e-commerce and from horizontal luxury retailers. By horizontal, I mean luxury retailers that do a lot of different things – fashion, bags, watches, pens, luggage, and all the other stuff. There’s always that risk.

In conclusion, we have two unique businesses with their own moats and growth levers run by a solid management team with decades of experience and very sticky client relationships. The businesses are available together as a package at half the fairly conservatively calculated fair value, and the package steadily compounds, but there’s also a chance for unlocking additional value over the next two to three years.

The following are excerpts of the Q&A session with Rahul Bhatia:

John Mihaljevic: Thank you so much for the presentation, Rahul. Could you talk about the key data points in each of the two businesses to keep an eye on going forward to gauge how they’re performing and how the thesis is playing out?

Bhatia: For Ethos, the key data point is same-store sales growth. That is by far the top one.

I would also keep a very close eye on the margins. The reason for that is the margin levers we talked about, and I want to see all of these things manifest over time. So far, it seems like it has, but every one of these is going to add to the margin. We want to keep an eye on the growth rates, especially same-store sales growth, but we also watch closely the margins here.

With KDDL – the one I’m really interested in – I don’t think there’s any real risk to the existing business, but what I want to keep an eye on is the growth rate of the precision parts business. In my view, that is the next leg of growth. It’s growing at 25% annually. I don’t think the ROI is a big risk and the moat in the existing business are a big risk. The biggest piece here is going to be the growth of this segment.

Finally, they’ve been trying to turn around Estima for a couple of years now. I want to see this through in the next six to nine months. Those are the three or four things I would keep an eye on going forward.

Mihaljevic: You talked about the risks of competition – horizontal and vertical or pureplay e-commerce. What would be the main companies you watch to see what the competitors are up to?

Bhatia: Most of the competitors that look similar are private companies. It’s hard to find data on these companies – Kapoor, Johnson Watch, and Zimson. These are also old companies. It’s sometimes hard to get data on these companies, but it’s fairly clear that they are on a downtrend. That’s the downtrend happening in the overall unit sales of luxury watches.

The real threat is perhaps not so much from the pureplay e-commerce operators. If there is a threat from there, I would keep an eye on Reliance, which does have a luxury business to the side. I would also keep an eye on Tata, which has a luxury business called CLiQ. Those are two companies I would watch closely.

Right now, brands cannot enter India and start opening their own stores. It’s not possible. If that becomes a possibility, it’s another risk I would keep an eye on. It’s not an issue as of now, but that could very well be a future possibility.

In terms of the global companies for Ethos – The Hour Glass, Watches of Switzerland, or Bucherer – I don’t see those as real risks. I don’t think they have plans of entering India anytime soon. Still, you never know, so that would be the third thing I would keep an eye on.

Mihaljevic: How do you see the capital allocation mix going forward? Is there anything you might prioritize differently from what the management is doing?

Bhatia: I think the capital allocation mix is going to change a fair bit compared to what it was in the past. In the past, KDDL was a cash-making business, and it was plowing a lot of this cash into building Ethos. It was incubating Ethos and trying to grow it, and it was highly successful at that.

All of that capital has basically been free. KDDL has shown its true colors by doing a very large buyback. I think the buybacks will continue. There’s a chance that dividends might go up. How quickly can management grow Eigen on the KDDL side? How quickly do they want to grow, especially this certified pre-owned business? That will tell us how much capital they are going to require for the incubation, creation, and maturity of these businesses.

All in all, I think the capital allocation mix will change from more money thrown behind incubating, creating, and raising these new businesses to more organic growth, especially within Ethos. On the KDDL side, there will be more buybacks and possibly more dividends. That’s what management have indicated. I have no good reason to doubt them. I think that’s the right strategy going forward.

About the instructor:

Rahul Bhatia serves as the Managing Principal and Portfolio Manager at Willow Investment Management. He has more than 15 years of investing and risk arbitrage experience. His primary areas of focus are deep value and event driven trades. Prior to founding Willow he was managing a portfolio of Equities and Equity Derivatives at Citigroup. Rahul is a graduate in Mechanical Engineering from IIT Delhi and MBA from the University of Chicago, Booth School of Business.