Singapore-listed luxury watch retailer The Hour Glass (SGX: AGS) has frustrated shareholders for a few years now. Its share price peaked at S$0.88 in 2015 and has been bouncing sideways since. Today, Hour Glass’s shares trade at just S$0.80 each.
The curious thing is that Hour Glass’s business fundamentals have actually improved since 2015.
While many traditional brick and mortar retailers have struggled due to the introduction of e-commerce, this luxury watch retailer has bucked the trend. The reason is that the supply of Swiss luxury watches is tightly controlled. Hour Glass has long-standing relationships with brands such as Rolex and Patek Phillipe, giving it near-exclusive rights in Singapore to sell their highly coveted models.
As such, watch collectors who want to buy first-hand watches in Singapore have little choice but to come to Hour Glass. This has been reflected in its financial statements.
Profit has increased from S$53.5 million in FY2016 (fiscal year ended 31 March 2016) to S$77.5 million in FY2020. Because Hour Glass retains much of its earnings, its net asset value per share has similarly increased from S$0.62 as of March 2016 to S$0.90 as of 30 September 2020.
Hour Glass’s business is also very resilient. A good exhibit is its strong performance from April 2020 to September 2020, a period that included Singapore’s COVID-19 lockdown. In these six months, despite having to close its shops for two months during the circuit breaker we have here in Singapore, Hour Glass still managed to be profitable, generating S$38 million in profit, down just 15% from a year ago.
So what is holding back its share price?
Despite all of this, Hour Glass’s share price is still short of its all-time high price reached way back in 2015. Even the most patient shareholders will likely be getting frustrated by the lacklustre performance of the stock. I was one of these investors, buying its shares in 2014 and holding it till early 2020.
In my view, one of the reasons why its share price has fallen is that there is a lack of cash-reward for investors to buy its shares.
Although the company has grown its profits substantially over the years, it has not used the cash it earned to reward shareholders. In fact, Hour Glass has only been paying out a very small portion of its earnings as dividends to shareholders, opting instead to retain its cash on its own books.
Retaining cash can be a useful thing for a company that has the option of using the cash to generate high returns on capital. Unfortunately, in Hour Glass’s case, this cash has been left in the bank, generating very little returns to shareholders.
With little capital appreciation and a relatively low dividend yield of just 2.5%, there has not been much reason for investors to hold shares of the watch retailer.
I think there is a solution to this problem: Hour Glass can simply start to reward its shareholders by returning some of its excess capital to them. One way to do this is to pay a higher regular dividend or a fat one-time special dividend.
Returning cash to shareholders as dividends give investors confidence that they will be paid while owning the company’s shares, hence giving investors a reason to pay up for those shares.
Another way for Hour Glass to reward shareholders is to use its spare capital to buy back its shares.
Share buybacks result in a lower cash balance, but it also reduces the outstanding share count. Remaining investors will end up with a larger stake in the company after the buybacks. This can be hugely rewarding for shareholders, especially when share buybacks are made at depressed prices.
The power of share buybacks
A great example of the power of share buybacks is the story of one of Warren Buffett’s investments, RH, formerly known as Restoration Hardware.
There are many similarities between RH and Hour Glass. Like Hour Glass, RH is a specialist retailer that has generated consistent free cash flow and profits despite the emergence of e-commerce. RH’s share price was also hammered down back in 2017 and 2018 – market participants shorted the company because they were skeptical about the longevity of such a retailer in the face of the emerging threat from online retailers.
The management team of RH were, however, confident of the company’s brand appeal and the strength of its business. Believing that the market was discounting the value of its business, RH began an aggressive share buyback spree. Within three years, RH had used all of its net cash to buyback shares and even borrowed money to acquire more shares. In all, RH reduced its share count by a staggering 59.8%.
This resulted in RH’s remaining shareholders owning close to 2.5 times the stake that they previously had. As a result of the buybacks, the company’s earnings per share skyrocketed and investors started to sit up and take notice. RH’s share price is today up 15-fold since the start of 2017 when the company initiated its share repurchase program.
So what if Hour Glass repurchases its shares?
Hour Glass could do something very similar to RH. It could potentially use a large chunk of its net cash to buy back some of its shares. As of 30 September 2020, Hour Glass had S$136 million in net cash sitting in its coffers. Using just 70% of its net cash to buy shares, at current prices, will result in a 17% decrease in its outstanding shares. In addition, by keeping 30% of its current net cash as reserves, it will still have plenty of firepower for working capital and expansion needs.
Such a buyback plan will not just increase Hour Glass’s earnings per share, but will also increase its book value per share, as Hour Glass is currently trading at an 11% discount to book value. It is also worth noting that Hour Glass trades at just 7.4 times FY2020 earnings.
Share buybacks will, in turn, give Hour Glass the ability to pay a much higher dividend per share in the future (since the total dollar outlay will be lower with a lower share count).
The importance of good capital allocation decisions should never be underestimated. Even though its business fundamentals have improved, Hour Glass’s reluctance to return capital to shareholders, and its inability to generate good returns on retained earnings, has resulted in an extremely disappointing share price.
I can’t fault market participants for being reluctant to pay any higher for Hour Glass’s shares given the lack of impetus for sound capital allocation and a dividend yield of just 2.5%.
But I think there is a simple solution to the problem. With a resilient business that generates cash year after year, copious amount of excess cash on its books, and a chronically depressed share price, share buybacks seem like a rather easy problem-solver in my view.
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Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.