By The Valuentum Team
Tiffany's Investment Considerations
• Tiffany (NYSE:TIF) is a jeweler and specialty retailer, whose merchandise offerings include an extensive selection of jewelry (90% of net sales), as well as timepieces, sterling silverware, china, crystal, stationery, fragrances and accessories. Its name speaks of brand strength. The company was founded in 1837 and is headquartered in New York, New York.
• The global jewelry industry is competitively fragmented. Tiffany's retail price for diamond jewelry reflects the rarity of the stones it offers and the rigid parameters it exercises with respect to diamond quality factors which increase the beauty of the diamonds, but which also increase the company's cost.
• Tiffany's executive suite is undergoing change as it modernizes its collections. Long-time CEO Michael Kowalski retired March 2015, and the firm recently put in place a new Design Director, Francesca Amfitheatrof, who will oversee the design of all Tiffany product categories. The changes have resulted in accelerated same-store sales growth.
• Tiffany's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
• Tiffany pays a healthy dividend, and the company's share repurchase program extends through March 2017. We think management is shareholder friendly, though we'd prefer a greater focus on dividend growth than buybacks.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Tiffany's 3-year historical return on invested capital (without goodwill) is 17.4%, which is above the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Tiffany's free cash flow margin has averaged about 2.5% during the past 3 years. As such, we think the firm's cash flow generation is MEDIUM.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Tiffany, cash flow from operations increased about 83% from levels registered two years ago, while capital expenditures fell about 18% over the same time period.
This is where we feel our research truly shines. Below we outline our valuation assumptions and derive a fair value estimate for shares.
Our discounted cash flow model indicates that Tiffany's shares are worth between $58-$86 each. Shares are currently trading at ~$64, in the lower half of our fair value range. This indicates that we feel there is slightly more upside potential than downside risk associated with shares at the moment.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $72 per share represents a price-to-earnings (P/E) ratio of about 19.3 times last year's earnings and an implied EV/EBITDA multiple of about 9.2 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 2.3% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.3%. Our model reflects a 5-year projected average operating margin of 21.6%, which is above Tiffany's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 4.7% for the next 15 years and 3% in perpetuity. For Tiffany, we use a 10% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $72 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
In the graph above, we show this probable range of fair values for Tiffany. We think the firm is attractive below $58 per share (the green line), but quite expensive above $86 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Tiffany's fair value at this point in time to be about $72 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Tiffany's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $92 per share in Year 3 represents our existing fair value per share of $72 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Wrapping Things Up
It's impossible not to like Tiffany's diamonds, and the retail price of its jewelry speaks to the rarity of the stones and strict parameters with which the firm evaluates its products. The Tiffany name speaks of brand strength. Though its dividend yield is about average, we think its payout has plenty of room for growth, based on its solid Dividend Cushion ratio. This strong ratio is an indication of reasonable financial leverage and solid free cash flow generation. All things considered, however, we're not ready to rush out to pick up shares of Tiffany at the moment. A slightly better price tag and strengthening technicals would be our preference. The firm currently registers a 3 on the Valuentum Buying Index.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.