Harry Winston: Looking Below the Surface for True Value

Jan.12.09 | About: Dominion Diamond (DDC)

Harry Winston (HWD) is a retailer and producer of diamonds, with high-end stores restricted to New York, Paris, London, Beijing, Tokyo and Beverly Hills. The stock has dropped from over $40 to its current price under $5, despite earning $1.17 per share last quarter. It has a book value of almost $800 million (including over $350 million in inventory), but the market values it at just $300 million. Does this stock offer investors a margin of safety? While the company looks great on the surface, this is a classic example of why investors must dig deeper than the surface numbers in order to truly understand and value a company.

First of all, most of the company's sales and profits come from its mining operations, not its retail business, which lost $4 million last quarter, on par with the comparable quarter one year ago. This means the company's profits will be heavily dependent on the commodity price of diamonds, which is a situation value investors prefer to avoid.

Furthermore, NWD operates just one mine, located in northern Canada. As discussed in Security Analysis, reliance on one location or one supplier or one customer is always a high risk. In the case of NWD, the investor must rely on highly subjective estimates of the lifetime productive capacity of the mine. Even short-term production is hard to predict - last quarter, diamond production at the mine was down over 25% because of lower grade material in the portion of the ground currently mined.

Finally, while the company's book value looks terrific, a closer examination reveals that much of its value is in the name of intangible assets. Removing these assets results in a tangible book value that is 25% lower than the stated book value.

This company's reliance on uncertain output from just one mine combined with the fact that the value of any units of output is highly uncertain due to volatile commodity prices results in a highly uncertain earnings power for this company. In addition, the value of intangibles is also highly uncertain. As a result, despite the great value this company appears to be on the surface, it's not the worth the risk.

Disclosure: None