How The Watch Industry Works (or doesn’t work)

On Tuesday night, I broke the news of the Patek Philippe price reductions. If you haven’t read that post, you should do so. It got me thinking that I’m not sure if most people understand the basic business of the watch business. For those of you who were TickTocking readers, you know that while I love watches, I can be fairly critical of the watch industry. I’ll do my best to explain how it works including the macro and micro economic factors I touched on in the Patek post, and where things break down. HOW IT WORKS

Let’s start at the most basic: a watch brand makes and sells watches. That will be the starting point for this post. It is step 0 of the business, although much could be said about all of the steps leading up to this (planning, production, outsourcing, etc). The first critical point is that the retailer is the customer, not the collector who is reading this blog post. The brand sets a margin for the retailer, which is the percentage off from retail that he will buy for. For example, if a brand gives 50% margins, the dealer will pay $50,000 for a watch that retails for $100,000. The setting of this margin is certainly not an exact science. The general rule is that the stronger the brand, the less of a margin they give. This obviously makes sense if you look at the extreme case of a brand which is so strong that every piece they make will eventually sell at full retail price to a final customer without ever sitting in a showcase (the sale from the retailer to their buyer is often referred to as “sell through”). In this case, a retailer would be happy to pay $90,000 for a guaranteed $100,000 back with no risk. However, this is merely theoretical as there are always risk factors introduced by time and markets.

The retailers order for the year at the Basel and Geneva shows. This — not PR as it sometimes seems — is the purpose of those shows. Of course, throughout the year there are reorders and changes, but in general, the year’s purchases are laid out here. Each company has different policies regarding payments, but the important thing to know is that for any decent brand, the retailers buy their inventory. Here is where things often start to break down. The retailer then has pieces in the store and more always on the way. Ideally a consumer for each watch shows up within a reasonable period of time, the pieces sell through, and everything continues. Everyone is happy.

THE PROBLEMS

First let’s look at some issues from the brand point of view, then the retailer, then how those affect the consumer. By the time a new watch is shown in Basel, the brand has already invested a lot of money into it, millions of dollars if it is a new calibre. They have all of the production costs, marketing costs, administrative costs, etc. Not only do they ultimately need the revenue, but they need the cash flow that the retailers provide. Having orders in bulk from retailers, who while they sometimes get up to shady business, have better credit than the general public, allows brands to tailor their production and manage their cash flows in a way that depending on individual watch purchasers could not. However, this distances them from the eventual sales prices of their watches and sets up all of the problems of currency issues, discounting, gray market sales, etc. The brand wants every one of their watches sold at full retail price all over the world and for their secondary market prices to remain as high as possible.

The retailer has less overhead than a brand and also has a diversified portfolio consisting of many brands. So their incentives are not necessarily aligned with the brand itself. This opens the door for major politics between the brands and retailers. Amongst the brands, some are obviously much stronger than others and even within a brand there are pieces that are much more desirable than others. A retailer, who has to actually purchase his inventory, has to be smart about the brand mix in his store as well as the pieces he stocks from each brand. Having a Patek or Rolex authorized retailer agreement is like a license to print money for most stores, and don’t think that Patek and Rolex don’t know that and use it to their advantage. Everything from twisting arms about store layouts and display cases to forcing a dealer to buy a bunch of less desirable pieces in order to get the hot stuff is commonplace. The penalty for noncompliance is the brand will cease to deal with that retail store.

The game of tug-of-war between brand and retailer sometimes causes devastating effects. For example, in the beginning of the financial crisis in 2008, the big brands forced inventory down the retailers throats. After all, this is their revenue at stake. However, it left the retailers short of cash and without the ability to sell through. The immediate victims of this were the less powerful brands. With all the unwanted inventory from the big guys, retailers cancelled almost all their orders from smaller manufacturers. This killed some great projects and nearly killed some cool companies. I know of one example of a very large brand handing retailers their orders already printed out and chosen for them and forcing them to sign or lose their authorized dealer arrangement with that brand. One particular retailer who I know and respect more than most told that brand to get lost (or perhaps something a bit more vulgar) and ended a 20 year relationship with the brand.

If you’re paying attention, you can see all sorts of problems starting to form. Ultimately, if a watch isn’t produced, sold to a retailer and sold through to a final consumer at full (or very close to) retail price in a reasonable amount of time, someone is going to be unhappy.

ECONOMICS AND THE GRAY MARKET

Now let’s look at some economics. First, on a micro level, luxury products and particularly luxury watches do not exhibit the usual, smooth, downward sloping demand curve that we are all taught in school. Most products have more demand the cheaper they are and less as the price rises. Luxury watches are luxury products and they are made to last more or less forever, both of which serve to create fairly strange demand curves. I won’t get into all the phenomena here, but you see such things as high prices creating demand and lowering prices destroying it. This is part of what makes the Patek announcement so interesting. Lowering retail prices can actually serve to cave in demand. As collectors fear that the watches are less desirable or less stable they can flee to other brands, the vintage or secondary markets, or leave the market entirely. This drop in demand at retail can lead to an implosion when gray market forces begin to act.

The gray market is a pejorative term coined by retailers and brands (not necessarily in this industry) for the market of new watches that are not sold by an authorized dealer. It is supposed to conjure images of a black market of stolen goods. In actuality, the gray market is the system set up to bring economic efficiency to this otherwise economically unsound system. Brands set retail prices arbitrarily, attempt to price fix in the retail store by threatening to pull product if pieces are sold at discounts, push inventory on retailers that they know will not sell at full price, and often even produce pieces that no retailer will buy at normal cost prices. No one likes to sit on inventory, and eventually the pieces need to find their way to a buyer. So, both brands and retailers alike sell their extra inventory to gray market dealers, all the while cursing their business.

The gray market is also fueled by currency arbitrage. These are worldwide brands that generally export from Switzerland. At a macro economics level, brands try to keep their prices at parity across markets. However, this is nearly impossible to do when selling in multiple different currencies. What really makes it impossible is that as mentioned before, brands are much more reticent to decrease prices than they are to increase them. Something has to give, and again that slack is taken up by the gray market. When the EUR crashes, making Pateks in Europe considerably cheaper than the US, gray market dealers buy from European retailers and resell in the US. What’s the problem, you may ask? If tons of product is available on the gray market at well under retail prices and yet retailers are not allowed to discount, who is going to buy from the retailer? All of a sudden they are stuck with inventory which ultimately can lead to them blowing it out on the gray market and so these cycles can go nuclear very easily.

Of course, in addition to demand, we have to look at supply. This could be a post of its own, but it’s possible that over supply is the single main cause of all these problems. Mechanical watches are made to last virtually forever. Production year after year is cumulative. Currently, watches are being treated like fashion items. Every several months or every year, the new collection comes out making the old collection “obsolete” and driving the ever growing sales of the industry. But watches are not fashion items that wear old or depreciate to near zero. Year after year, millions of luxury watches are produced and they add to the tens of millions already in existence. You don’t have to be a mathematician to see the writing on the wall. It is an unsustainable machine running at full throttle with drivers who get paid based on their fastest lap time and not whether they finish the race or not. Quarterly revenues, yearly growth and ever expanding bottom lines are all that is confronted, even though it is clear that this will end badly.

What Does This Mean For The Consumer?

The ultimate effect on the consumer is higher prices and lower long term values. There are many mechanisms at play here, but I will highlight a few.

In order to continue to sell this many new watches each year, these companies have enormous marketing budgets. Ads, celebrity sponsorships, lavish events, all of these costs are eventually passed on to the consumer. It is one of the major reasons why average retail prices across the industry are so much higher than they were 15 years ago.

In addition, the retail model double charges consumers. In the past, retailers were not only points of sale, but marketing agents for their areas. They got such large margins and earned them because they brought new consumers to the brand and created sales. However, the world does not work like that any longer. Very few retailers are able to really market and sell their inventory. Instead, the brand shoulders all of that cost, but the retailer still takes a huge margin. How many of you would gladly pay 30-50% less for your watch and not deal with a retailer? My hand is raised. This has only recently become possible, but almost all retailer functions have become obsolete.

Stuck In The Past

My main complaint is that this entire system is archaic, hypocritical and ultimately hurts consumers. The model was developed generations ago, when a network of brick and mortar stores around the world was unmanageable for even the largest of companies and communication was mostly localized. Also brand managers were much more conscious of the long term health of the business, rather than being judged by quarterly performance numbers. Unfortunately, virtually no one is willing to adopt a different model. The biggest change is the shift to brand boutiques for the big brands, rather than multi-brand retailers. Controlled by the brand, they can control their sales and cut out most of the other stuff. However, even without having to pay the retailers margin they keep retail prices the same so as not to hurt other dealers, and it does not solve the problem of overproduction resulting in numbers of pieces that the market simply will not bear. The internet solves a lot of these problems, and while luxury brands have been very slow to embrace the 21st century, eventually they will have to. Ultimately, while it appears solid and sales numbers are incredibly high, the current system is actually hanging by a thread if you look at it in its entirety. I expect to see a lot of interesting changes in the coming years.