Tiffany Continues To Execute At A Higher Level

By Stephen D. Simpson, CFA | August 27, 2013 AAA

As premier jewelery retailer Tiffany (NYSE:TIF) continues to beat expectations, it's getting harder to argue that the Street overvalues the company's brand and future cash flows. Not only is the company outperforming in difficult markets like Europe, but efforts to improve operating performance seem to already be delivering results. Factor in an eventual improvement in the Americas and future growth in businesses like watches, and I can understand why Tiffany is a popular pick. I'm personally not willing to chase Tiffany up at these levels (particularly when it seems like 20% to 30% pullbacks are routine), but it's hard to argue with a company that is performing at a pretty high level despite what should be a tough global environment.

Another Strong Quarter In The Books
I'll admit that “strong” is a relative concept, but I think Tiffany's 4% revenue growth (8% in constant currency) for its fiscal second quarter is pretty solid. Expectations were already pretty high for the company, though, and while comps rose 5% on a constant currency basis, the Street was looking for 6%. Growth in the Americas was weaker than expected (flat), while Europe (up 7% cc) was stronger than expected, and definitely stronger than what LVMH (Nasdaq: LVMUY) reported.

Even though management continues to emphasize higher-priced, lower margin assortments, other factors (like commodity costs) are allowing the company to boost margins. Gross margin rose more than a point from the year-ago and quarter-ago levels. Tiffany did even better on an operating basis, with 14% operating income growth and a nearly two-point improvement in operating margin.

Tiffany isn't just about the health/willingness to spend of wealthier people, and I don't think Tiffany gets quite enough credit for some of the operating initiatives underway. Considering that inventory growth matched sales growth this quarter (up about 4%), I think the case can be made that better operating performance is playing a meaningful role.

How's The Market? Who Knows...
It's challenging to put Tiffany's results in context. On one hand, 4% reported growth is better than the scant growth reported by LVMH's jewelry business, but then the comp growth in the Americas was weaker than growth that high-end retailer Nordstrom (NYSE:JWN) (which has only a limited exposure to jewelry and accessories) reported in the U.S. And looking at the results of accessory retailers Coach (NYSE:COH) and Michael Kors (Nasdaq:KORS), Tiffany didn't really stand out as an outperformer.

Likewise, on the geographic distribution of sales. Tiffany seems to be producing better results in areas like Asia Pacific, Japan, and Europe than many of its rivals, but the performance in the U.S. isn't all that strong – perhaps due in part to that reallocation to higher-priced merchandise. At a minimum, I'd say conditions are “mixed” in Tiffany's core markets, but it wouldn't surprise me if comps in the Americas pick up later in the year.

Ongoing Efforts To Grow The Business Should Pay Off
Tiffany has long generated a large percentage of its revenue from jewelry, and alongside LVMH's Bulgari and Richemont's Cartier, I think you can argue that Tiffany pretty much defines the high-end jewelry space. But the company may yet be able to generate growth by expanding its product line. While the company's fight with Swatch over a dissolved partnership drags on, I expect the company to eventually look to build a significant business in the watch category. Watches are a sizable percentage of sales at both Bulgari and Cartier and I cannot see why the company would not pursue this line of business.

At the same time, the company continues to focus on the opportunities to leverage growing incomes in areas like China to boost its own sales potential.

The Bottom Line
As I've written before, conventional free cash flow doesn't really work with Tiffany because of the significant shifts in working capital. Neutralizing that and focusing on “structural” free cash flow, I continue to believe that Tiffany can grow at a low double-digit rate across the next decade. Unfortunately, even a very low discount rate commensurate with other companies that leverage top global brands doesn't produce a lot of slack in the fair value. While I don't expect Tiffany shares to sell off just because they're close to my calculated fair value of about $86, I won't seriously consider the shares unless or until there's a meaningful pullback that creates a little breathing room and margin for error.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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