Description

SIG – cheap, high quality retailer.

Thesis

-          Cheap jewelry retailer 80% exposed to the US, 20% to the UK. while the UK is a bit of a drag, strength in the US, a newly consolidated industry and a large buyback support the stock.

-          I think it trades at a low valuation for three reasons. First, jewelry has more cyclical risk than most retailers. Many comparable retailer stocks are not performing that well. I think Jewelers are particularly hard hit by sentiment. The last cycle was awful for the industry with many going bankrupt. Even SIG declined 80% because it had debt. Second, the company has growth but not enough topline growth to attract growth investors. Finally, customer financing account for a larger share of EPS and the risk is that they are either engaging in low quality financing or that some of this excess return will normalize. There is a fourth potential reason, many funds bought SIG when they dropped to $30 last summer and sold early this year. they didn’t stick around for the buyback.

-          If we are heading into a recession you obviously don’t want to own this. However, I think the market is overestimating the impact of a recession. SIG is debt free and best positioned in the industry. I think the market is ignoring the value creation that comes from the buybacks. Their history shows that you can expect an 8% buyback on an annual basis. They have done nothing but fully pay down debt, issue large dividends and now buyback stock.

-          Valuation is compelling, trading at 10x TTM EPS ex cash with no debt. The normal range is 13x-14x. SIG has similar growth as did when it traded at 13x. the FCF yield ex cash is 9% and they can buyback over 8% of shares annually offering a 17% return before any growth. It’s also cheap relative to peers. Normally it trades inline. Under 6x EBITDA, under 7x EBIT.

-          They are the dominant Jeweler franchise in the US, with 10.4% market share, operating the Kay and Jared brands. They have 20% share in the UK. A couple big jewelers closed in the great recession. SIG is the lowest cost retailer with the highest margins. Mom and pop stores are in decline, online retailers have minimal impact on SIG’s customer, regional mall players and Zales have bad balance sheets that are hurting their ability to compete. SIG is expanding its competitive advantage by investing in its brand and stores…

• The few conversations I’ve had with private competitors and industry associations involve some of the highest praise for a management team that I have heard.

-          Growth – you can expect topline growth slightly ahead of GDP, approx. 5% (1% store growth, 4% SSS).

-          Capital allocation - In 2009, they raised debt to pay a bigger than normal dividend. Then in 2010 and 2011 they paid down debt. Now they are dedicating FCF to buybacks.

• They have a hurdle rate of 20%. Right now they find plenty of opportunity to reinvest in existing stores and grow the store count. Capex will be elevated relative to history because they feel now is a great time to widen their advantage over peers.
• They do consider acquisitions but they are disciplined about ranking uses of cash by IRR. It doesn’t seem too likely that they will make a meaningful acquisitions.
• If no acquisitions arise they will buy back shares or add to the dividend, depending on which offers greater IRR.

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Forecasts

-          The 200 bps rise in gross margins from their pre crisis high is sustainable in my view: it comes from greater sales per store and a shift in mix towards higher margin exclusive brands.

Explanations

-          Customer financing – “other income” on the income statement. This forecast measures “other income” as a share of total sales. The driver is the credit terms on customer financing. Bad debts show up in gross margin not here. As noted below, their ROIC on customer financing is 15% pretax. That seems a little high to me and I allow for a decline to a more fair ROIC. I don’t think the ROIC has to decline too much as current bad debt expense is elevated and that reduces the true ROIC.

-          Bad debt expense – this is included in gross margins and my forecasts under the gross margin line exclude this item. Allowances run at 6.8% of customer credit. Peak losses were 10.4% and are currently 6.1%. they are therefore over-reserving. I assume this is stable in my base case to allow for a potential deterioration in customer credit. I see no evidence that they are aggressive lenders. In the bull scenario, the excess reserves unwind. In a bad scenario, I forecast a return to peak loss rates which amounts to a 150 bps hit to margins.

-          Gross margins – excludes the impact of bad debt expense. In a recession, the hit to gross margins is 250 bps including bad debt. In the great recession it was 400 bps. I think it will be less this time because bad debt expense is already elevated and SIG confirmed it has not yet returned to normal levels. Gross margins should rise 35 bps or more in a base case as diamond prices are coming down and they continue to benefit from exclusive products in their mix. In the long term, there is room for margins to rise due to scale economies.

-          Base case is $4.86 EPS next year and $6.62 in CY 2015, assuming they buy back 27% of their shares over that time period (assumes most of FCF is sued for buybacks). at a 13x EPS multiple (12x ex cash) that implies a $64 share price next year versus the current $46 for a 40% return. in three years, the stock should trade at $85.

-          My best estimate is that the downside is $3.50 in EPS and a $40 share price. I can’t use 2008/9 as a comp because all companies had high debt back then and SIG is debt free now. Looking back to 2001, before SIG went public, the best comps seemed to trough at 10x normal EPS ex cash which implies a $40 share price or -15%.

Risks

-          The following are low risks

• 1) threat from the internet. NILE has 1% share and gone nowhere for years. Their margins are under pressure due to new entry. They have no cost advantage. AMZN has 1% share. The trend towards e-commerce is slow moving and SIG is adopting it. I don’t see risk of SSS declining. SIG has access to similar cost structure for their e-commerce platform. SIG is using tablets to offer in-store access to the bigger online product line. Kay’s average ticket is $370 versus $7k at NILE so there is minimal customer overlap.
• 2) other competitors. They are all weak because of bad balance sheets. Mom and pops are 50% of the industry and 15% exited in the past 5 years. They make most of their money now on things like cash for gold which hurts their brand and doesn’t provide enough cash flow to expand. Mass merchants like COSTCO are doing well but target a different customer. SIG is expanding its competitive advantage.
• 3) input cost pressure. Diamond Jewelry are 75% of sales and 55% of COGS. There is a risk that diamond prices rise in the very long run but right now spot prices are trending down as last year’s increase led to a slowdown in demand. BHP and RIO are trying to exit the diamond business which signals that they don’t expect a major increase.

-          Risks

• Macro/cycle. This is the biggest risk. This is clearly a risk but SIG is mispriced relative to other retailers that have more cyclical risk.
• Customer financing. There is no way to tell what the quality of their lending is. I ask industry executives and all I hear is that the management is very conservative and would not issue low quality credit.
• SIG is located in malls and traffic at malls is on the decline. They are slowly moving away from malls. I think the trend is slow moving.

Catalyst

Signposts

-          SSS in the US are key. They guide to “low to mid single digit” for Q3. That includes the UK. I think the main driver is the economy.

-          Margins and all of the aforementioned drivers

-          Details on bad debt expense. So far it is fine.

-          UK turnaround. I calculate that it impacts the share price 5%. Not a big driver.

-          Capital allocation – do they continue with buybacks….