Is the Blue Box In the Red Again?

Shas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In February 2013 Zale Corporation (NYSE: ZLC) posted shining results, with 2Q12 net income jumping 42%. Similarly, in January 2013 Blue Nile (NASDAQ: NILE) posted a 4Q12 net sales increase of 21.2% and a net income increase of 17%. However, in contrast, Tiffany & Co (NYSE: TIF) posted weaker 3Q12 results, with sales increasing by a hair's breadth of 1% and net income declining 30%. Does this mean that the famous diamond retailer is in the red again?

Tiffany & Co is specialty retailer whose principal merchandise offering is jewelry. It mainly operates through its wholly owned subsidiary Tiffany and Company. Its main product is jewelry (91% of FY11 sales), and the company operates across the Americas, Asia-Pacific, Japan, Europe and other regions.

Tiffany has seen some excruciating times when the economic recession dampened the premium buying penchant of aspiring middle-class Americans. However, after its nadir in 2009, it was able to revive its sales and posted a 14% sales increase in FY11, with 54% of the sales coming from outside the US, mainly in Asia, according to company filings.

5 year performance

<img src="/media/images/user_14377/5-year-performance_large.jpg" />

The company's weak 3Q12 results left many investor wondering if it is facing overwhelming pressures again. Lower 3Q12 results led to the company lowering its FY12 profit forecast to $409 – $435 million and EPS of $3.20-$3.40, versus the previous guidance of $454-$473 million in profit and an estimated EPS of $3.55-$3.70. Lower 3Q12 profitability was blamed on rising precious metal and gemstone prices, as well as a poor economic climate.

Apart from its weak results, Tiffany has been in the news recently. On Valentines day, Tiffany gifted Costco a lawsuit, alleging trademark infringement, counterfeiting, and false and deceptive business practices. Tiffany is suing Costco for $2 million per infringement, along with triple the amount of Costco’s profits from selling the engagement rings that were wrongly labeled 'Tiffany' rings.

Competition from online retailers

Brick and mortar retailers continue to face strong competition from online retailers. Due to price transparency and extensive information available on the net, consumers are armed with knowledge and strong price comparisons. As a result, traditional retailers are facing increasing pressure from showrooming, as online retailers like Blue Nile and Amazon have been able to lower diamond prices by up to 40%.

Furthermore, despite having lower gross margins (Blue Nile's FY12 gross margin was 18.7%), online retailers are able to post acceptable operating margins (Blue Nile's FY12 operating margin was 3%) due to low overhead costs. On the other hand, brick and mortar retailers like Zale and Tiffany are able to post high gross profit margins of ~50% (Zale's profits margin in 2H12 was 51.5%, Tiffany's 3Q12 was 55.9%), but post comparatively lower operating margins due to higher occupancy and store costs (Zale's: 2.7%, Tiffany: 16%).

Continuing in the future, Tiffany is expected to experience cannibalization of its brick and mortar sales by online retailers like Blue Nile. Furthermore, Tiffany is also witnessing increasing competition from designers such as Ralph Lauren, which have also expanded in its own luxury jewelry and watch collection.

Losing its sparkle

Tiffany posted weak quarter results, as compared to its key competitors Blue Nile and Zale Corporation.  As seen in the below chart, although Tiffany gains on size, its sales as well as margins have been declining versus its peers.

Blue Nile, a leading online retailer of diamonds and fine jewelry, reported sparkling 4Q12 results, with sales increasing 21% due to increased profitability from its investments made in 2012, as well as strong growth in the US and internationally.

Zale Corp, a leading specialty retailer of diamonds and other jewelry products in North America, announced its 2Q12 results, with sales increasing 1.1% and strong Comparable Same Store Sale (SSS) of 2.8%. Its profit jumped up 43% due to an increase in revenues and lower expenses. The company has seen its revenues increase in the past quarters as efforts to raise prices, improve core inventory, and roll out of new branded products helped bolster its business.

<img height="185" src="/media/images/user_14377/sales-vs-peers_large.jpg" width="343" />


<img height="231" src="/media/images/user_14377/operating-margins_large.jpg" width="392" />

3Q12 results

3Q12 total revenues increased 4% to $853 million, and on a constant-exchange basis increased 5%, along with a SSS increase of 1%. Lower sales were mainly due to the slow recovery in the economy, as well as challenging comparisons vs. last year when sales increased 21% and net income increased 52%.

Segment-wise performance can be seen from the adjacent chart. It's important to note that the company is increasing its focus on expanding its international presence, mainly in Asia.

Margins were lower due to headwinds in precious metal and gemstone prices (gross margins declined 160bps to 54.4%) and higher store occupancy and marketing costs (selling, general and administrative margin de-levered 57bps to 40.6%). Management cited a sales mix favoring higher-priced, lower-than-expected sales of silver jewelry and difficulty in pricing (it was unable to increase prices due to consumer resistance) as the main reasons for margin pressure. As a result of the above, net income declined 30% to $63 million.

Inventories increased 11%, reflecting new store openings, expanded product assortments, and higher product acquisition costs.

$345 million in cash sufficiently covers its short term borrowings of $196 million by 1.8x. Furthermore, debt levels of $978 million remain acceptable, with a Debt/EBITDA ratio of 1.14x.

<img src="/media/images/user_14377/sss_large.jpg" />

Conclusion

The factor that differentiates Tiffany from others is that it is the most respected and recognized brand names in jewelry. For this recognition and growth potential, the brand commands a premium, and currently has a PE of 20.02.

Some catalysts for Tiffany's are its revenue growth, an increased focus on emerging markets as it plans to increase its global square footage by 6% per year (vs its initial focus on US and Japan), expanding profit margins, and a strong financial position with reasonable debt levels. On the downside, Tiffany's shares have increased only 3.2% in the past year, as compared with a 25% surge at Zale. Its performance also lagged the 15% gain of the S&P Retail Index during the same period. Furthermore, there remains mixed views on the luxury sector.

I would recommend a “HOLD” on the stock, but keep a watch for its upcoming 4Q results on March 22. The stock price may remain range bound as sales continue to underperform its competitors, and the probability of a profitability inflection may be seen only in 2013.


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