Description

Opportunity: Long Signet Jewelers (SIG).

Thesis summary: We believe that SIG’s recently-completed transformational acquisition of Zale will drive huge upside to Street EPS estimates over the next few years.  SIG was already the #1 specialty retail jeweler in the US with 11% market share and just bought #2 (Zale) with a 5% market share.  Jewelry retail is a highly fragmented industry with ongoing opportunity for share gains from shuttering independents.  There is nothing structurally wrong with Zale in our view, but the business was mismanaged for over a decade and was generating only a 2%-3% operating margin at acquisition vs. SIG at 14%.  There is a significant opportunity to clean up and improve the operations and margins at Zale to SIG standards, plus the benefits of reduced competition and additional economies of scale as SIG is now a 50% bigger company.  We see $11-$12 of EPS power in FYE Jan-18 vs. the Street at ~$8.60.  At a 16x forward P/E (suitable for a category-dominant retailer with a long share gain runway ahead of it), we believe this suggests a mid-$180s stock in ~2-3 years vs. $113 today, or an IRR of over 20%.

• Store concepts – legacy SIG
  • US: Kay Jewelers.  1076 stores.  Middle to lower middle class customer.  1,400 square feet average.  Average transaction $382.   Sales psf around $1,450. “Every kiss begins with Kay.”
  • US: Jared the Galleria of Jewelry.  240 stores.  Off mall.  Upper middle class customer.  4,800 square feet average.  Average transaction $541.  Sales psf around $1,100.  “He went to Jared.” 
  • US: regional brands, mall based.  171 stores.  About half of these will be closed over time.  Minor.  Roughly $1,100 sales psf.
  • UK: H. Samuel.  304 stores.  Lower middle class customer.  1,100 square feet average.  Average transaction £72.
  • UK: Ernest Jones.  189 stores.  Middle to upper middle class customer.  900 square feet average.  Average transaction £255.
• Store concepts – Zale acquired
• US: Zales.  723 stores.  Lower middle class customer.  Very similar to Kay Jewelers.  55-60% store overlap between Kay and Zale (from either perspective).  Regular Zales average 1,650 square feet, outlets 2,400 square feet.  Sales per foot about $900 ($950 mall stores, $650 outlets).
• US: Piercing Pagoda.  611 kiosks.  Average 190 sqft.  Tiny but highly productive; $2000 sales per sqft.
• Canada: 191 stores under Peoples and Mappins banners.

The industry is extremely fragmented but SIG is the market leader (even before adding Zale) with scale advantages in sourcing, advertising, development of exclusive brands, negotiations with mall landlords, etc.  After SIG+Zale at a combined 16% share, the next largest player is TIF with 5-6%; however, TIF focuses on a much more affluent customer and, in our opinion, is not a direct competitor for the vast majority of SIG business.  After that, you have NILE just north of 1% share and then a myriad of even smaller players.  In other words, more than ¾ of the industry consists of mom-and-pops who are slowly donating market share.  Also note these shares are for specialty jewelry – and do not include jewelry sold through department stores, Costco, etc.  So, the market is even more fragmented than these numbers indicate. 

Separately, while many brick and mortar retailers are having their lunch eaten by AMZN, we do not believe that online sales pose a significant threat for jewelry.  Why?  1) High purchase price relative to customer’s income – seen as risky to do online; 2) Too emotional a purchase to do online; 3) Want to see product in person first – not sure enough of the whole process to just say, “I’ll buy online and return it if I don’t like it”; 4) Infrequent purchase – so not a huge convenience benefit of not going to a retail store; 5) Segment of somewhat clueless customers needing sales help; and 6) Financing may be needed – Kay/Zale are selling mostly to lower middle class consumers.   Online penetration in jewelry is very low and increased by only 10bps from 4.9% to 5.0% over the period 2007-12 vs. hugely higher penetration of online sales across many other merchandise categories.

• Zale did a 2.4% operating margin in CY13, but they’re in the same business as Kay which generates operating margins of 14%; Zale sells the same shiny baubles to the same lower-middle class consumers, often in many of the same malls as Kay.
• We believe that Zale was historically mismanaged and that basically everything is broken.  They had seven CFOs since 1997, and six CEOs since 1999.  The last Zale CEO (before he was fired by SIG shortly after the deal closed) was literally their old HR guy.
• Zale sales per foot MUCH lower – $900 for Zale vs. $1450 for Kay.  We believe Zale average transaction is in the high $200s vs. $382 for Kay so it appears a large part of this is on ATV, not total number of transactions.
• Zale merchandise margins lower – Zale sourcing is worse; our checks indicate a ~600bps cost disadvantage.
• Zale credit penetration lower – A lot of these lower-middle class customers cannot buy without store credit.  Zale is clearly losing sales based on lower credit penetration of mid 30%s vs. high 50%s at SIG.  SIG runs credit in-house and, in our opinion, the metrics are extremely solid.  Zale’s is outsourced, currently to Citi with a better deal with Alliance Data Systems on deck for 4Q15 (expected $22mm EBIT benefit).  It is unclear if SIG will try to keep this deal or get out of it, but even if they keep it, SIG’s in-house credit operation can still look at those customers who don’t pass muster with ADS.
• Zale’s exclusive brands are at less than half the penetration of total sales vs. SIG.  Exclusive brands: 1) get customers in the store for something they cannot get anywhere else, 2) eliminate the ability to comparison shop for lower price, 3) as a result carry slightly higher margins.  Zale is in the low-teens vs. SIG in the 30%s.
• We believe Zale seriously underspent on capex from FY09 thru FY13 at just 46% of D&A.
• In our opinion, Zale had much worse management of store employees than SIG, with far less control from corporate.  Our checks indicate that the training/motivation of Zale employees is dramatically worse.  In particular, we believe that individual salespeople have too much discretion to discount and underperforming sales people are kept around for too long.  This contrasts with Kay where everything runs smoothly and is highly standardized.
• Zale has weak advertising/marketing (i.e., “The Diamond Store” not really equivalent to “Every kiss begins with Kay” or “He went to Jared.”) and is outspent on advertising by SIG by 2.5x.

KEY POINT: We believe that there is nothing structurally wrong with Zale; everything is fixable.  We think Zale can ultimately earn the same operating margin as Kay today (~14%) or very close to it. 

In our view, the integration is already off to an extremely strong start.  Since closing the Zale acquisition at the end of May, SIG has:

• Cleaned house at Zale.  Within weeks they replaced the entire Zale C-suite and some of the SVPs (with the exception of the CFO).
• Beat Street expectations for the Zale business in their reported results for the first two months of ownership, with a comp acceleration and breakeven operating result (during what was historically a seasonally money-losing period for Zale)
• Increased synergy guidance from their initial $100mm to $150mm-$175mm.  A 50%-75% increase in expected synergies just three months into the deal.  We think there’s much more to come here.
• Begun the process of removing weak merchandise from Zale stores (either by returning to vendors or blowing it out through the outlet channel).  This has already been reserved for and will be done in time for the Holiday season.
• Used the acquisition to restructure some legal entities and take better advantage of their Bermuda domicile to reduce their long-term tax rate from 35% to 28%-29%.

Where does this leave the financials?

• We think SIG will be generating a bit over $7.5bn in revenue, a 15%-16% consolidated operating margin, and about $11.50 in EPS in FYE Jan-18.
  • This assumes that on average over the next few years, SIG’s legacy US business comps approximately 4%, the UK approximately 2%, and Zale approximately 7% (Zale’s comps should be higher in our opinion given very low sales productivity currently).
  • We note that SIG was already expanding margins and mgmt independently had a 15% operating margin target (i.e. for US and UK combined) before they acquired Zale; we see no reason they can’t ultimately reach this target for the legacy business.
  • For the Zale division, we assume they achieve a 14% operating margin, almost getting to the corporate average and in-line with what we believe Kay generated last year.
• When SIG mgmt talks about $150mm-$175mm in synergies, this all relates to Zale, and will all flow through the Zale segment operating margin.  We think it is more constructive to think about the top-line and margin opportunity at Zale as outlined above, rather than with an absolute dollar figure of synergies.  But in their terms we would have about $250mm-$300mm in synergies – leaving plenty of room for management to raise synergy guidance again.
• Notably, SIG mgmt includes NOTHING in their synergy guidance for any merger-driven improvement on the SIG side of the business (such as from the elimination of a competitor) or general scale economies from the whole enterprise being 50% larger.  Obviously this will carry some benefit, although it is more difficult to quantify; we assume an approximate 100bps benefit to consolidated margins.
• Finally, we assume SIG buys back stock with excess FCF at roughly their historical average pace.

Catalyst