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Summary

  • I am initiating on TIF with a DCF-backed target of $115, 15% implied upside to Friday's close.
  • The right mix of business segments allows the entry-level consumers to trade up while the high-end business to benefit from the lower price elasticity of the high-income earners.
  • China continues to be a key growth area for APAC on the back of rising store counts and increasing brand awareness.

I am initiating on Tiffany & Co. (NYSE:TIF) with a DCF-backed $115 price target, implying 15% upside in the next twelve month from Friday's close. TIF remains a premier brand in the global jewelry space and commands tremendous pricing power and brand equity. The company's unique business segments allow it to capitalize on all consumer income tiers. I expect the high-end products to be the key driver given lower price elasticity within the higher income group, a view that is consistent with my thesis on North American QSRs (Link: North American QSRs: Avoid The Low End, Stick With The High End). Finally, I believe Asia could continue to be a key topline driver on the back of rising disposable income and increasing brand awareness. Despite the incumbents such as Chow Tai Fook and Lao Feng Xiang having slightly more brand awareness given their history in the region, I expect the younger working professionals who have better awareness of western brands to drive TIF's revenue growth in the region.

I project revenue to grow at a 12% CAGR in the next five years, driven mostly by Asia and other emerging markets (mid to high-teen growth) as North America and Japan are expected to grow at mid-single digit. I expect operating margin to be at a normalized 25% with the help of higher margin fashion products and lower opex spend on better brand awareness.

My target price of $115 is based on a 5-year DCF model, which assumes a 9% WACC% and a terminal multiple of 24x.

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Growth via diversification

TIF is one of few jewelry companies in the world that has the ability to capture all tiers of consumer income groups without having to risk brand dilution thanks to the unique positioning of its four business segments, namely 1) fashion jewelry, 2) engagement jewelry, 3) high-end "statement" jewelry and 4) accessories. As of 2013, the mix between the four segments is 40%/30%/23%/7% respectively.

In my view, fashion jewelry will be critical for TIF to attract entry-level jewelry buyers given their sub-$500 price tag. I believe the selection of gold, silver and designer products are appropriate for college (or even high school) students to gradually engage with the TIF brand, so that they will likely trade up to higher-end products as they climb the income ladder. The author of this note can contest the experience of trading up from the TIF silver collection in the college days to the Atlas collection in the early years on Wall Street. On the flipside, had TIF not introduced the lower-end fashion product line, such transition and brand engagement would not have occurred, in my view.

While the fashion jewelry segment carries higher margin than the other business segments and has the potential of attracting entry-level jewelry buyers, I see the higher-end (but lower gross margin) statement and engagement segments to be the key drivers going forward due to lower price sensitivity within the higher income group and the growing wealth in emerging markets and Asia. As I have noted in my North American QSR initiation note, the decline of the overall employment rate in the US masks the severe underemployment issue, which is explained by the decline of median household income since the great financial crisis. The middle class will likely to cut back on spending, but I expect high-end oriented companies that have global growth exposures to ride through the trough and TIF certainly fits the profile.

I am particularly positive on the engagement segment that will most likely to be the key driver given TIF's strong brand equity within this vertical by leveraging superior shopping experience and proven quality. However, I also see the statement lineup to be the main beneficiary of emerging wealth trend in regions outside of North America. I note that sales from Asia are gaining momentum, accounting for 38% of TIF's FY13 sale compared with 11% five years ago.

China will drive TIF's Asia Expansion

China accounts for over half of TIF's APAC ex-Japan sales and sales have been accelerating on the back of increasing store counts (26 at the end of 2013) and brand awareness. Management expects to double the store count over time and the planned opening of stores in Hangzhou, a tier-2 city home of Alibaba, indicates that brand awareness of TIF outside of Tier-1 cities (ie. Beijing, Shanghai, Guangzhou, Shenzhen) is progressing smoothly. I see significantly more upside to store expansion as TIF is still in its early days of growth in China with minimal competition from western brands. While the incumbent brands, such as Chow Tai Fook and Lao Feng Xiang, may intensify the competitive environment, I continue to see TIF has a better (and global) brand advantage over the local brands.

Valuation

I value TIF with a DCF-backed price target of $115, implying 15% upside to Friday's close. I forecast a 5-year revenue CAGR of 12% driven by the high-end product lines and sales from Asia. I also expect the fashion jewelry to maintain a steady gross margin, while EBIT will increase to a normalized 25% due to less opex investment after TIF has accumulated solid brand awareness outside of North America.

My DCF model assumes a 9% WACC (11% cost of equity and 4% cost of debt) and a terminal multiple of 24x, which derives to a price target of $115/share.

Source: Power Breakfast At Tiffany's; Initiating With $115 Target