Description

I recommend Signet Jewelers Limited (NYSE: SIG, LSE: SIG LN) as a compelling long investment opportunity.  I believe the shares are worth $45-55/share, which represents upside of 70-100% from current levels.

The stock currently trades at ~$27/share.  This is well below Signet's share price pre- crisis, which ranged between $40/share and $50/share before Lehman's bankruptcy.  Importantly, I believe Signet's competitive advantages have expanded significantly during the downturn, and that the business will be far more valuable coming out the other side than it was going in.

The crux of the thesis is that Signet's competition has been materially weakened by the downturn, whereas Signet's already-dominant business has grown stronger.  In particular, a number of Signet's key competitors have recently liquidated or significantly down-sized their store bases, and Zale Corporation (NYSE: ZLC) - Signet's closest competitor - is on the verge of bankruptcy and/or significant store closures.  Mirroring Best Buy's gains following the bankruptcy of Circuit City, I believe Signet stands to benefit significantly from ZLC's problems.

From a stock perspective, ZLC's announcement of terrible November trading (a step-down from -10% two-year comps to -33% two-year comps) caused a meaningful pull-back not only in ZLC shares, but also in SIG's shares.  Short interest in SIG also materially increased on the news.  It is my view that (i) this pull-back is unwarranted, as ZLC's issues are company-specific rather than category-specific, (ii) Signet's comps will outperform conservative market expectations of flat-to-slightly-up same store sales as Signet takes advantage of ZLC's brand positioning mistakes and reduced competition, and (iii) that the current stock price is an attractive entry point for the value-oriented investor.

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Company and Industry Overview

Signet Jewelers is the world's largest specialty jewelry chain, operating ~1,375 stores in the United States and ~550 stores in the United Kingdom.  Signet's U.S. stores are primarily branded under the Kay (~925 stores) and Jared (~175 stores) trademarks; the company also owns ~275 regionally-branded stores.  In the U.K., Signet's trademarks include H. Samuel, Ernest Jones, and Leslie Davis.  Signet is the #1 specialty retailer in both markets by a wide margin, although approximately 75% of sales and profits come from the United States.

Kay is the largest specialty jewelry brand in the U.S., with annual revenue of approximately $1.4bn.  Kay is primarily a mall-based jeweler, operating ~800 mall-based stores and ~125 off-mall locations.  Jared, Signet's other large U.S. brand, is the largest off-mall specialty jewelry chain in the United States and the third largest specialty jewelry brand overall.

Signet created the Jared destination superstore concept from scratch in 1993 and now operates ~175 stores across the U.S.  The average Jared store is roughly four times the size of a traditional mall-based store; thus, Jared's ~175 stores are the equivalent of perhaps 700 mall-based stores.  Kay is a solidly mid-market brand (average annual household income from $35,000 to $100,000) whereas Jared is considered an upper-middle market offering (average annual household income from $50,000 to $150,000).

The U.S. jewelry market is approximately $67 billion in sales and, prior to the current recession, had grown 5.5% annually over the last 20 years (broadly in line with consumer incomes).  Roughly 45% of the industry's sales are made by specialty jewelers, which include companies such as Signet who specialize in selling jewelry at retail.  The remainder of the market is comprised of department stores, mass merchants, discount stores, online retailers, home shopping networks and others who typically sell other products in addition to jewelry.

Both the overall jewelry market and the specialty jewelry market are highly fragmented.  Despite being the industry's leading player by a good ways, Signet owns less than 5% share of the overall jewelry market and less than 10% share of the specialty retail jewelry market.  Signet's most important competitor in the U.S. is Zale Corporation.

One other important characteristic of the U.S. specialty jewelry market merits mention.  Approximately 40-50% of specialty jewelry sales in the U.S. are made on credit, which is provided either by the jeweler itself or via a third party bank under the retailer's brand name (i.e., a private label arrangement).  In Signet's case, the company underwrites and retains its own credit risk, which it views as a strategic advantage - particularly during periods such as today when many of its competitors are experiencing reductions in credit made available by their banks.

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Structural Competitive Advantages

Going into the recession, Signet was already the #1 specialty retail jeweler in the U.S. with 30% more stores than the #2 (Zales), 3x the number of stores of the #3 (Helzberg), and a 650-700bps margin advantage over the competition:

The drivers of Signet's structural margin advantage are threefold.

First, Signet's scale is helpful in a wide range of functions such as purchasing, real estate, product selection/merchandising, distribution, and marketing.  As an example, when a new product is brought to market Signet always receives the "first-look" at taking on the offering as Signet has the widest distribution and the most money to concentrate behind worthwhile merchandise.  Signet's reputation and strength is such that if another specialty retailer launches a new product, Signet almost certainly "passed" on it first.

Second, the company's large store base allows for national TV advertising, which has a step-change better return-on-capital than regional or non-TV (radio, print) advertising.  In my view, a specialty retail jeweler needs a minimum of ~550 stores (or store-equivalents, in the case of Jared) to achieve the density necessary for national TV advertising.  The only other brand (aside from Kay and Jared) with sufficient scale is Zales - more on this below.

Third, Signet's in-house credit division allows the company to react quickly to changing consumer trends while avoiding the problems many other jewelers have recently encountered with reactionary credit restrictions imposed by outsourced lending institutions.

In addition to Signet's structural advantages, Signet benefits from a conservative, disciplined, and outstanding management team.  Capital allocation decisions are rigorously assessed and only move forward if projects or new store openings meet strict ROIC hurdle rates.  Industry consultants and contacts frequently describe Signet's operations as "best-in-class."  I'm a strong believer that "A's hire A's, and B's hire C's" - Signet has an "A" management team leading an "A" organization.

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A Dominant Business Getting Stronger

Signet's cost advantage is valuable at all points during the economic cycle but is particularly valuable when demand is weak, as Signet remains meaningfully profitable while much of the industry is losing money.  As the old saying goes, "when Signet catches a cold, the rest of the industry catches pneumonia."

That is exactly what is happening today.  While the last year has been difficult, over the most recent four quarters Signet has achieved a consolidated EBIT margin of 7.7%.  Meanwhile, faced with the same operating environment, numerous competitors have ceased to exist (including several of the industry's biggest specialty jewelry chains).  A conservative estimate is that 5-10% of industry capacity has left the market, with more closures on the way:

In addition to the companies mentioned above, many other jewelers including Shane & Co., Robbins Bros., Fortunoff, Bailey Banks & Biddle, and Christian Bernard have left the market.  These closures have allowed Signet to increase market share at the expense of reduced competition.  At the same time, Signet has taken advantage of additional opportunities in real estate, personnel, and distribution that we believe will further increase the company's margin advantage going forward.

The issues concerning Zale Corporation, owner of Signet's key competitor Zales, are of particular interest to this investment.  While Signet competes with a little more than 20,000 specialty retail jewelers across the country, Zales - as mentioned above - is the only competitor with the scale to do national TV advertising.  Zales also goes head-to-head with Kay Jewelers in the vast majority of Kay's mall locations.  While Zale Corp. owns ~1,900 locations across North America under a variety of brand names, the 700-800 "Zales"-branded stores are Signet's most direct competition.

Zale Corp. is currently under tremendous financial stress.  For the second consecutive year I expect that ZLC will negatively cash flow.  As a result, the company will likely soon be forced down one of two paths: either (i) bankruptcy, or (ii) the liquidation of a significant number of Zales stores to pull working capital out of the business and pay down creditors.  My belief is that a real possibility exists that Zales could fall under the critical 550-store "national TV advertising threshold", leaving Signet as the only remaining company with this critical competitive advantage.

In my view, Zales's problems are not easily correctable.  ZLC's balance sheet issues have been exacerbated by a large leverage increase / share buyback program executed immediately prior to the downturn.  This left the company with little financial flexibility in the midst of the worst retail jewelry environment in recent memory.

Even more importantly, I believe Zales has lost focus of what its brand proposition should be to the consumer.  It's a classic story in the jewelry industry: a lower-end jewelry retailer looks across the aisle or street at some higher-end jeweler with higher price points and bigger margins, and says, "I can do that too!"  Small rotations to higher-margin merchandise and slightly higher price points, almost imperceptible at first, begin to layer one on top of the next - within a few years, the store is catering to a different clientele yet it lacks the customer base and brand name to justify the more premium positioning.  As soon as a down year arrives, the store discovers its brand is not strong enough to hold onto a more affluent consumer, but its price points are unaffordable to its traditional customer.  A round of last-minute price cuts follows, leaving all consumers confused and the brand tarnished.

This Christmas, Zales compounded the problem by deciding to climb back up the ladder a few rungs instead of returning to Zales's traditional, promotional brand positioning.  While Kay stores were exciting and high-energy over the holidays, advertising discounts of 20-50% on banners and easels and balloons throughout its stores, the typical Zales store I saw had no easels, no balloons, and only a single banner that read "the more you buy the more you save...get an extra $25-$1,000 off."  In an environment where customers are increasingly value-focused - playing right into Zales's historical "sweet spot" - this was an almost embarrassing effort.

In short, this Christmas Zales focused on higher margins and fewer promotions.  I view this as a strikingly incorrect strategic decision.

Zales is not, nor has it ever been, a high-end jeweler.  In a mall, it should play to its strengths - being the mall-based value specialty retail jeweler with merchandise priced below not only Tiffany and Jared, but Kay as well.  For the last few years, Zales seems to have forgotten who it is and decided to take on Kay Jewelers head-on.  This is a bad strategy for Zales, and a key reason (in my opinion) why Zales announced a meaningful deterioration in November sales in a recent regulatory filing:

http://online.wsj.com/article/SB10001424052748703323704574602242693837038.html

http://biz.yahoo.com/e/091204/zlc10-q.html

Zales's strategy is unsustainable and will change - either via bankruptcy, restructuring/store liquidation, or a takeover by Signet so that Zales can be properly run.  However it happens, I believe that Signet will soon face a significantly improved competitive landscape.

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Valuation

Signet currently trades at $27/share, which is ~16x this year's "bottom-of-the-cycle" EPS.  Following this Christmas season, the company will have almost no debt.  Based on my estimates, Signet is trading at just above 6.5x trailing EV/EBITDA, 1.3x year-end book value, and less than 0.7x current-year EV/sales.  This is a significant discount to historical trading multiples of 8.0-8.5x EV/EBITDA, 1.8x book value, and 0.9x EV/sales.

These "trough" multiples on "trough" earnings significantly under-weight the value of Signet's franchise, the scope of Signet's competitive advantages, and the earnings power of Signet's business.  Should the company's earnings power normalize to its average through-the-cycle historical ROIC, Signet will earn roughly $3.50/share in EPS.  However, given recent changes to the competitive landscape, Signet's earnings power should be enhanced from historical levels and the business's "future" earnings power is likely greater than its "past" earnings power.  Going forward, Signet should be capable of generating north of $4.00/share in EPS.

My view is that Signet will eventually get credit for its outstanding business.  This will lead to a double-pop from a rising multiple on rising earnings.  I conservatively assign a 13x EPS multiple on through-the-cycle earnings, which leads me to my $45-55/share estimate of intrinsic value.  This would be roughly in-line with Signet's historical valuation multiples of 1.8x book value, 13x earnings, and 9x EBIT.

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Risk Factors

• Health of the U.S. Consumer.  Another leg down in consumer confidence and consumer spending would impact sales and bad debt expenses.
• Credit Risks.  Should there be a material increase in the bad debts of Signet's customers it would have a negative impact on the company's profitability.
• Lawsuit.  A group of female ex-employees has alleged, among other things, that Signet's U.S. subsidiary discriminated against them with respect to pay and promotions vis-à-vis male employees.  A Federal judge recently upheld an arbitrator's ruling that this case could be certified as a class action.
• Key Employees.  Both CEO Terry Burman and CFO Walker Boyd have announced that they intend to retire in the near future.  The company is currently evaluating potential candidates to replace them at the helm.

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Disclosure

We are long shares of SIG.  We may buy additional shares, or sell some or all of our shares, at any time.  We have no obligation to inform anyone of any changes in our view of SIG.  VIC members should do their own work before deciding whether to buy or sell shares.

Catalyst

1.  Zale Corp announces bankruptcy / significant restructuring

2.  Signet beats consensus comp store sales expectations

3.  The business cycle turns, allowing Signet to demonstrate its enhanced earnings power