When you're a public company, investors' appetite for growth has to be taken into account when it comes to business strategy. I suspect this is part of the reason so many publicly-traded luxury brands have spent the last two decades targeting that "mass affluent" market. While that approach has generally earned these companies quite a lot of money on balance, it may have been part of what tripped up Tiffany (NYSE:TIF) this quarter. Even with the disappointment, though, this is still not what you'd call a cheap stock.

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Third Quarter Results Trip up on Silver
While Tiffany reported 4% revenue growth and a 1% overall comp growth, the revenue mix this quarter was a big story. High-end products ($500 and up) did well, with unit growth across pretty much all categories. On the lower-end, though, sales were not nearly as strong, and Tiffany saw weak sales in silver jewelry.

Because silvery jewelry is some of Tiffany's highest-margin merchandise, that mix shift was bad news for the margins. Gross margin fell three-and-a-half points, with mix, fixed cost deleverage, and legacy diamond costs doing their damage. Operating income fell 20%, as management had basically no chance of offsetting that sort of gross margin pressure (and operating costs as a percentage of revenue actually rose a half-point).

Geographic Breakdown
While foreign markets are important to many other higher-end American merchandise companies ((like Coach (NYSE:COH) or Michael Kors (NYSE:KORS)), it's not quite to the same extent as for Tiffany.

For the third quarter, Tiffany saw comps in the Americas rise 1% on higher average prices. Asia-Pacific comps fell 4% despite higher volume; China and Hong Kong continue to see weaker consumer spending, though it's worth noting the year-ago comp of +36% was an extremely challenging one. Japan saw comps rise 5%, and I wouldn't be surprised if some legacy earthquake issues helped the comp. Last and not least, comps in Europe were up 8% on higher pricing and volume, suggesting perhaps that you can't always tell what shoppers are going to do by just reading the papers.

Can Tiffany Polish up the Silver Business?
Tiffany is a pretty well-run company and it usually seems to have a pretty good understanding of its customers. So, I'm a little surprised that the silver business rose up to bite them this quarter.

I'm not surprised that economic pressures took a bite out of the aspirational/entry-level shopper group. Rather, I'm surprised that management didn't seem to realize that hiking prices (by 50% or more in some cases) in response to higher commodity costs would create sticker shock, and that the company needed to have some sort of value-priced assortment available to lessen the blow.

Looking at other luxury players, LVMH (OTC:LVMUY) seems to be managing its assortment better, and so too with Richemont and Coach. For PPR (OTC:PPRUY), Puma seems to be dragging down a lot of the good things going on at Gucci, while Ferragamo needs to start delivering on the idea that better margins can propel results higher.

In any case, while I think Tiffany will respond to this issue (particularly in terms of its product assortment/offerings), it won't be in time to help the next quarter. Consequently, while I think Tiffany will do alright on the higher-end merchandise, I think trouble on the lower-end is probably going to create some margin pressure for at least one more quarter.

The Bottom Line
I rarely find Tiffany stock to be bargain-priced, and today is no exception. I completely agree that Tiffany has a world-leading brand and that such brands offer quite a lot of hard-to-calculate value. But I also know that brand value that doesn't translate into good free cash flow, and that just isn't worth much to me. And when it comes to free cash flow, Tiffany's history is just not all that good.

Even if Tiffany can start to consistently convert revenue to free cash flow at a high single-digit clip (something it's never done), the stock is no bargain today. That tells me that the market is either expecting a pretty remarkable degree of financial improvement at Tiffany, or it is too enamored of Tiffany's brand value and its status as a luxury/mass affluent barometer and trading vehicle. Either way, I'd rather be spending my money on Tiffany's products today than its stock.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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