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Is Tiffany a Diamond or a Cubic Zirconia?

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

Tiffany & Co. (NYSE: TIF), the jeweler best known for its iconic engagement rings and silver necklaces, has taken investors on a wild ride over the past year. In this article, I'll examine some key factors to see if Tiffany is as tough as a diamond or as prone to shatter as a cubic zirconia.

<img src="http://media.ycharts.com/charts/6780d1ac25a9cda2990139e13e46ba23.png" />

TIF data by YCharts

The big picture

The jewelry business has never been an easy one. Rising precious metals prices often squeeze profits as sales slow, making the maintenance of stable operating margins a tough challenge. The industry is directly tied to discretionary spending, and any increase in tax rates or an economic downturn hits its top line. Due to the high number of window shoppers compared to actual ones, inventory turnover is often so sluggish that jewelers are disparagingly referred to as “museums.”

Affordable luxury vs. high-end luxury

Investors should notice that many high-end luxury brands have struggled against a new wave of ‘affordable luxury’ competitors. For example, comparatively cheaper handbag retailers Michael Kors and Coach have posted far higher same-store sales growth than high-end retailers Burberry and LVMH’s Louis Vuitton. Luxury jeweler Harry Winston was also recently humbled when it sold its flagship operations to lower-end competitor Swatch.

However, Tiffany cannot be defined as either affordable luxury or high-end luxury. It uses a multi-tiered pricing system, similar to Coach, that attempts to capture the largest share of the market with both cheaper and expensive items, ignoring concerns of cheapening its own brand.

Tiffany bulls have always believed that the was company impervious to economic downturns, due to its strong performance during the previous recession. Although that original thesis - that the most affluent customers will continue purchasing jewelry in times of economic turmoil - comforted investors for some time, recent considerations show that there are far more unpredictable variables at play.

Maximizing sales per square foot

Tiffany has a unique strength that its domestic rivals can’t touch -  the second highest sales per square feet in the retail industry trailing only Apple’s Stores. 

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Sales Per Square Feet (2012)</strong></td> </tr> <tr> <td><strong>Apple Stores</strong></td> <td>$6,050</td> </tr> <tr> <td><strong>Tiffany & Co.</strong></td> <td>$3,017</td> </tr> <tr> <td><strong><span><span>Lululemon</span></span></strong></td> <td>$1,936</td> </tr> <tr> <td><strong>Coach</strong></td> <td>$1,871</td> </tr> <tr> <td><strong><span>Michael <span>Kors</span></span></strong></td> <td>$1,431</td> </tr> </tbody> </table>

These figures indicate that Tiffany utilizes its available real estate extremely well, maximizing the potential of each store with minimal wasted space. This helps it in urban areas, where real estate is expensive and space is limited. 

Domestic rivals

Tiffany is widely considered to be the bellwether of the jewelry industry. Let’s compare Tiffany to its primary publicly traded rivals - Signet Jewelers (NYSE: SIG), Blue Nile (NASDAQ: NILE) and Zale Corporation (NYSE: ZLC).

<table> <tbody> <tr> <td><strong>Company</strong><br /><strong>1/29/2012</strong></td> <td><strong>Market Cap</strong></td> <td><strong>Forward P/E</strong></td> <td><strong>5-year PEG Ratio</strong></td> <td><strong>Debt-to-</strong><br /><strong>Equity</strong></td> <td><strong>Profit Margin (ttm)</strong></td> <td><strong>5-year ROE</strong></td> </tr> <tr> <td><strong>Tiffany</strong></td> <td>8.16B</td> <td>19.95</td> <td>1.83</td> <td>39.64</td> <td>11.08%</td> <td>17.36%</td> </tr> <tr> <td><strong>Signet Jewelers</strong></td> <td>4.99B</td> <td>12.86</td> <td>1.16</td> <td>N/A (no debt)</td> <td>9.01%</td> <td>16.04%</td> </tr> <tr> <td><strong>Blue Nile</strong></td> <td>422.02M</td> <td>35.93</td> <td>2.98</td> <td>8.95</td> <td>2.05%</td> <td>47.47%</td> </tr> <tr> <td><strong>Zale Corporation</strong></td> <td>167.95M</td> <td>13.66</td> <td>3.46</td> <td>344.93</td> <td>1.27%</td> <td>-14.40%</td> </tr> <tr> <td><em><strong>Best Value</strong></em></td> <td><em>N/A</em></td> <td><em>Signet</em></td> <td><em>Signet</em></td> <td><em>Signet</em></td> <td><em>Tiffany</em></td> <td><em>Blue Nile</em></td> </tr> </tbody> </table>

Signet, which operates stores in the U.S. and the U.K., stands out as a better value than Tiffany in most match-ups, and it is the only one with a clean balance sheet. Signet’s strong profit margin and low forward P/E and PEG ratios suggest that it is an undervalued growth stock that could be a better long-term investment than Tiffany.

Meanwhile, Zale - which is completely based in North America - has performed the worst, with soaring debt, dangerously slim profit margins and a sluggish growth forecast for the next five years.

Blue Nile, the world’s largest online diamonds retailer, has fared better, but its margins are surprisingly slim for an e-commerce retailer. Blue Nile's rising revenue and declining profit suggests that it may be overspending on promotions - a classic e-commerce mistake. Blue Nile’s high forward P/E also signals that the stock is overvalued, while its PEG ratio of 2.98 means that analysts aren’t expecting the company to grow by much. In other words, Blue Nile is an overvalued low-growth stock.

Let’s also compare their revenue and EPS growth over the past five years.

<img src="http://media.ycharts.com/charts/7fe60f8ccd1f5527fec2a15f3e57b0bb.png" />

<img src="http://media.ycharts.com/charts/ce2e6ee85dc5734f9b6284261faf6371.png" />

TIF EBITDA & Revenue data by YCharts

From these two charts, we can see that Tiffany and Signet have strong revenue growth, although Signet's profit growth has squeezed passed Tiffany's over the past three years. It’s also easy to see why Blue Nile and Zale should not be considered safe investments.

International challenges

China is considered a key market for multinational luxury retailers such as Tiffany. Chinese shoppers recently overtook U.S. consumers as the world’s largest purveyors of luxury goods, accounting for 25% of global luxury sales. The Chinese domestic luxury market was worth an estimated $17 billion in 2011, and is forecast to grow 7% when fiscal 2012 ends.

Therefore it is essential for Tiffany to capture a slice of the Chinese market. In that market, “China’s Tiffany,” Chow Tai Fook, reigns supreme. With a market cap nearly double the size of Tiffany’s, Hong Kong-based Chow Tai Fook is the largest jeweler in the world. While Tiffany mainly offers silver and diamond products, Chow Tai Fook offers a large variety of 24-karat gold jewelry, which is considered auspicious in Chinese culture.

In its third quarter, Tiffany posted a 4% decline in same-store sales in Asia. At the same time, Chow Tai Fook posted an 8% decline in China, its primary market. However, over the holiday season (November and December), Tiffany bounced back strongly, posting 10% same-store sales growth throughout Asia.

In my opinion, if Tiffany adds more gold items to its product line in China, it could capitalize on Chow Tai Fook's current weakness, claiming a slice of the more traditional Chinese market. However, high gold prices - which jewelers usually purchase through hedges - increase the risk substantially.

The bottom line

Simply put, there are better industries to invest in than jewelers. There are just too many factors to consider - metals prices, discretionary spending, shifting tastes, and foreign currency impacts make growth too difficult to accurately forecast.

However, in this tumultuous industry, Tiffany is a decent pick that will likely outperform its peers, owing to its fantastic revenue per square foot, strong same-store sales growth in Asia, and steady ability to keep growing its top and bottom lines. Just watch its operating margins and same-stores sales carefully for any signs of weakness and invest accordingly.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Blue Nile. The Motley Fool owns shares of Tiffany & Co.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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