Screw the Customer

Aside from watches, one of my other passions is contemporary art. There is a distinct form of art that offends me, however: art that makes fun of art collectors. Regrettably, this is not very uncommon. The main message communicated is usually some form of, “By the nature of you paying exorbitant sums for this, you prove that you are yuppy scum and I, oh great artist, am superior.” Perhaps this is inevitable in an industry where the creators often spend a large portion of their lives below the poverty line, and with any success the consumers are firmly in the 1%, but that reality makes it no less detestable to me.

The luxury watch industry is particularly vulnerable to a version of this mentality given the intrinsic uselessness of mechanical watches and their exorbitant prices. As the saying goes, “there’s a sucker born every day.” Sometimes I think this is the entire business model of some companies.

The question I get asked the most by watch-Muggles (that 99% of society who does not and will not ever understand why I pay $80,000 for a watch) is “What makes a watch worth $80,000?” Curiously, this is a question that we watch collectors very rarely ask ourselves. Perhaps ignorance is bliss and turning a blind eye to the absurdity of it all is necessary to the full enjoyment of the hobby. But there is a line, and sometimes it gets crossed, even by some of my favorite brands.

The newly released Richard Mille RM27-02 will run you a cool $800,000 (not a typo)

The newly released Richard Mille RM27-02 will run you a cool $800,000 (not a typo)

And so we cross the line from products to ethics. Capitalism, supply and demand, we are taught in business school that a firm can charge what the market will bear, with no judgments associated. I think this is wrong and short sighted. I believe that for the long term health of a company and the market as a whole, each product should be priced to provide as much value as possible to the buyer. It’s a simple concept actually: make the best product you can make and don’t fuck people over, even if they are complicit in it themselves and ultimately responsible for their own money.

And what of the media? We’ve read the same story countless times. “Watch X does such and such, is made of such and such, is really cool and a great achievement.” The last paragraph contains some astronomical price that is delivered with the dead pan of a congressional jobs report. Now, I am not naive. I understand the paradox of expecting outlets who are funded by the brands to be critical of their most indefensible crimes, but I do think that the stakes are higher than we think. Ultimately, these are not transactions in a vacuum. The pricing problem is the single biggest threat to the entire industry.

Over the last 15 years, average retail prices throughout the industry have consistently increased year over year, every few years discarding an entire “generation” of collectors. The sentiment expressed most often by the group of collectors I have known for the longest is that they are not interested in buying anymore, mainly due to pricing — not that they can’t afford what they want, but for those of us who are not new to the market, it is simply impossible to see the value at current prices.

There are some fantastic watches being made right now, and many have somewhat justifiable prices. One of my favorite posts on this blog is my thoughts on how to actually sell a $100,000 watch. I am not calling for an angry mob to burn the entire industry down. But when the most common question any sane person would ask is, “What makes watch Y worth $XXX,XXX,” I do think it is a point that we need to look at and have start the process of critical thinking toward. At least it would save me from having to spend an hour of my morning ranting on my blog.

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.

Patek Philippe Lowers Retail Prices as CHF explosion hits

I haven’t written in a while, but had to chime in here. Last month, the decision of the Swiss National Bank to unpeg the CHF from the EUR sent the CHF skyrocketing and left the watch industry in confusion. For an industry that almost hugely relies on exports from Switzerland, a sudden 20% increase in CHF is potentially devastating. It happened to come at a time when inventories are quite high, and new watch sales seem particularly slow as the market potentially (finally) nears saturation. Now we know how the most respected brand in the world, Patek Philippe, is going to deal with it.

In a letter (attached at the bottom of the post) from Thierry Stern, President, it was announced that Patek will be lowering retail prices in most markets, but raising them in EUR and JPN to attempt to reach parity around the world. In the US, retail prices will be lowered by 7%, a significant number when you figure the average retail price of a Patek Philippe is certainly over $50,000.

Lowering retail prices is an exceedingly uncommon move for luxury watch brands as it is feared that it calls into question the value of the product. Certainly at the very least it pisses off any customers who bought at the previous retail prices. Current collection Patek secondary market values have already been soft recently. Recently, I personally passed on a 5270G that was offered to me for $118,000 even though the same piece was selling for $140,000 not long ago.

It will be interesting to see how this affects the market for new Pateks as well as the vintage market. Also keep an eye on how the other brands deal with this situation, as it is a macroeconomic force that cannot be escaped.

Check out the original letter here:

Patek Letter

**unrelated note: perhaps I’m too used to the politically correct American media, but an American CEO would be absolutely shredded for that line about Asian tourists.

Lastly, here’s a quick video of my daily wearer Patek 3970:

YouTube Channel

So obviously I have not been updating the blog much in the last couple years. To have a great blog I really believe that it needs to be updated at least a couple times per week. I couldn’t keep up with it and don’t want to write junk posts.

However, I have been working on the youtube channel. I’m trying to post a new review video weekly. If you like them, please share. I know most of the big collectors and dealers in the country and plan on filming reviews of the coolest and rarest pieces out there, but in order to do so I want to show these owners that people actually care about the videos.

Here are my last two. Enjoy!

New feature: Candid Review Videos — first up Roger Dubuis Skeleton Tourbillon

Not long ago, I noticed that a silly, unedited, 5 minute watch video I recorded had gotten over 110,000 views on youtube. After rewatching it, I realized that a candid video is one of the best ways to really get a sense of what a watch is like “in the metal”. Since I have access to a lot of cool pieces, I figured I’d start making weekly videos on my Ticktocking channel. Please subscribe to the channel if you like them and share it; that way I know people are actually enjoying them and I’ll continue to make them. Here is the first:

Sorry Jony Ive, Switzerland Isn’t Screwed…Yet

Last summer I wrote a post on the dangers that smart watches could pose to the Swiss watch industry. It generated a ton of discussion on social media and within the industry, and ultimately even led to my consulting with a high end watch brand on a smart watch product line.

At the time, the uses and capabilities of wearables had not been defined and thinking was very much hypothetical. The thesis was basically that a company as influential and as innovative as Apple could literally kill the luxury watch market overnight with a revolutionary product. If there were a smart watch that everyone truly had to have, the mechanical watch would face an immediate extinction level event.

Apple WatchHowever, fortunately for Switzerland and unfortunately for anyone who loves revolutionary products, the uses and capabilities of wearables still remain largely undefined. Whatever you think of the Apple Watch, it seems clear at this point that it will be far from a must-have device. Without a use case so compelling that one wouldn’t think of leaving the house without it (think: all payments and identification only carried on a watch), smart watches will remain niche products — more fashion statement than productivity enhancer.

Given that Apple took their best swing and still fell far short of that mark, it seems safe to say that smart watches are not the way of the future. Instead the seemed destined to be a cool accessory with some interesting, specific use cases. So while I undoubtedly will buy one the day it’s released as I do most gadgets, the luxury watch industry can breathe a sigh of relief that I won’t hesitate to leave it in the drawer most days in favor of a beautiful mechanical watch.

Interview with Marc Andreeson

There’s a great interview on Forbes today with Marc Andreeson, venture capitalist and internet pioneer. You should read the whole thing. I found the section below particularly relevant to the watch industry — friction that has been created and eventually the direction things will need to go in. No one yet has really used the internet to “charge consumers less” in the watch business. It will happen at some point.

Jeff Bezos has this line where he says there’s really two kinds of businesses in the world: those that try to charge consumers more, and those that try to charge consumers less, or try to save consumers money. I think about that more broadly. I reframe it as: There are businesses that have the mentality of adding value, and businesses that have the mentality of extracting value. And the Internet, I think, is an enormous benefit to the model of adding value, and it’s an enormous danger to the model of extracting value.

I think you see that across the economy today. The music industry is a classic case in point. The whole piracy boom of music on the Internet really arose when music buyers essentially rose up in protest and said, “I want one song. Why am I being forced to pay $16 for the entire CD when all I want is one song that I can listen to online.” That’s when you had an earthquake hit the music industry. It was when consumers viewed the pricing to be fundamentally unfair.

Car dealers are going through another version of this. Carbuyers have never liked the process. Maybe a few have, but most carbuyers have not liked the process of having to go in and really get raked over the coals by a car dealer who takes advantage of the fact that consumers have no idea what the wholesale price of the car is. Now, after a little research online, you can walk in armed with a car’s complete wholesale information and get a much better deal.

In traditional business circles that kind of transparency gets viewed mostly as a threat. I think that’s unwarranted. I think the opportunities are just as large and probably larger, especially for businesses that have this view that their role in the world is to add value, is to bring consumers benefits.

The Wearable Tech Threat

Recently I have been thinking a lot about the watch industry again. Do I want to get back in? If so, in what sort of position?

Part of this exercise has been to analyze the industry in its parts and as a whole. I’ll write further about my thoughts and I have touched on them in the past, but perhaps the biggest threat was not even on the horizon when last I was authoring this blog. It seems clear that wearable tech is going to be the next evolution of technology, and likely that it will be widely adopted.

Google Glass is already being tested by early adopters around the world. But the real interesting twist came a few weeks ago. Tim Cook, Apple CEO, gave an interview where he said:

“I see [wearables] as a very key branch of the tree.”

“I think the wrist is interesting. The wrist is natural.”

If a company like Apple were to make a must-have tech product that occupies wrist space, it could mean a truly abrupt end to the wrist-watch.

It may be hard to imagine right now, but think about how necessary it is in 2013 to have a smart phone. What if there were an iWatch that was just as necessary? An everyone-has-one type of device like the iPhone. Within a year or two, the watch industry would be decimated. The wrist watch would lose its real estate, just like the pocket watch lost its waistcoat.

I wouldn’t have seen this as a very real threat even a year ago. But when Tim Cook is making statements like that, you have to take notice. This could make the advent of the quartz watch look like a blip in the road. It would be a true extinction level event and it is right on the doorstep.