Tiffany and Signet - A Long/Short Pair Trade in the Making

Includes: SIG, TIF
by: Adnan Zaman

Tiffany (NYSE:TIF) and Signet (NYSE:SIG) both enjoyed strong share price performance last year, especially during the second half, as investors became increasingly excited about the return of the retail customer, and specifically the high-end retail customer. Bolstered by an improving retail outlook fueled by a number of positive macro factors, Tiffany surged 38% in the second half of 2010 while Signet gained 42% versus the S&P's gain of 17% during the same period. In the first quarter of the year, Tiffany gained 6% while Signet once again outpaced its rival with a rise of 8%, both respectable versus the S&P's gain of just over 3%. In recent days, while I started writing this report suggesting it may be time to go long Tiffany and short Signet despite the recent trading history, Tiffany has already started to show better performance than Signet, though it may not necessarily be the start of a long-term trend.

There are a number of reasons I think Tiffany will outperform Signet in the coming year. In my opinion, both companies will find it difficult to acheive their profitability targets, but among the two, Signet will be in a much tougher position. The first factor that few analysts are taking into consideration is the rapid rise in commodities prices last year. Given both companies turn their inventory about once a year, it takes about a year for rises in input prices to affect margins. Commodities prices began rising in Q1 2010 and went on to rise at a torrid pace during the rest of the year. There is historical evidence of this inverse relationship. Looking back to 4Q08 through 4Q09, Tiffany's gross margin contracted an average of 133 bps year-over-year in each of the quarters while four quarters earlier, between 4Q07 and 4Q08, diamond prices increased an average of 17% year-over-year in each of the quarters. Of course, Tiffany was dealing with the impact of the recession as well, but the relationship between input prices and margins is a pretty clear one. Tiffany has been able to implement price increases every year since 2005 to combat the continual rise in input prices, but it maintains its margins by bringing more manufacturing in-house, entering into better deals with mines, finanancing and entering into forward purchase agreements with mines, etc. Despite all that, the company will find it quite difficult to increase margins a year after diamond prices rose over 20%, silver prices were up approximately 80%, gold prices were up 30% and platinum prices rose even more. After no price increases in 2009 due to the recession, Tiffany increased prices by 5-10% across the board last year. On top of that, Tiffany reportedly increased most of its prices outside of Japan again in January. Assuming another 5-10% price increase, Tiffany may be able to come close to last year's margins, though lower priced product, especially silver jewelry will feel margin pressure without further price increases this year. Signet, on the other hand, is estimated to have increased prices on only about a quarter of its products last year. Both companies run a fine line of balancing price increases to maintain margins while keeping prices competitive to maintain growth. Tiffany's stronger brand and higher-end customer base has enabled the company to implement price increases every year since 2005 other than 2009. Its customer, especially those buying diamonds (over half of revenue), are less price conscious that those at lower end jewelry stores like Zales or even Kay (Signet's U.S. brand).

Besides stronger branding and stronger pricing power, Tiffany boasts a number of other advantages that should propel the company ahead of its weaker competitor. Tiffany's higher-end customers should be less affected by potential macro headwinds such as higher gas prices, a housing market stuck in neutral, a weak employment environment and potential impacts from the end of QE2. Tiffany's geographic distribution provides greater opportunities for growth, given its exposure to Asia, besides a possible short-term hiccup in Japan. All of Signet's stores are concentrated in the U.S., U.K. and Ireland, giving Signet more exposure to weaker markets. Furthermore, Tiffany is just now starting to see the benefits of its recent launch of handbags and accessories, which have been well received by the market. Not only are these products a driver of new revenue, it is high margin revenue that is minimally by the rise in precious metals prices.

Some may argue that Signet is a bargain, trading at a trailing P/E of about 17x versus Tiffany's 22x and a forward P/E of just 14x versus Tiffany's 19x. However, Tiffany's premium is well deserved - the company boasts gross margins around 60% versus Signet's margins of about 40%, its EBITDA margins are twice Signet's and its revenue growth rate is also expected to be double Signet's growth of ~5%. Tiffany typically commands a premium to its competitors due to its superior financial profile and its manufacturing and operational excellence. Compared to historical valuations, Tiffany is trading in line with its 5 year historical EV/EBITDA multiple of 9.8x and below its 10 year average of 11.3x; its P/E multiple is in line with its 10 year average of 20x. These next few quarters will be telling as the impact of the commodity price increases will filter through both companies' financials. Given Tiffany has already implemented two price increases across the board, I feel much more comfortable that the company will meet its targets or at least come quite close. However, given the wide range of Signet's analyst estimates, it is clear that some analysts doubt Signet's future performance more than others. On average, analysts expect Signet to post a 20-25% year-over-year increase in earnings in the next two quarters while revenues rise only 5%. I'd rather bet on Tiffany improving earnings 10-15% year-over-year on a revenue growth estimates in the same range.

Expecting Tiffany to outshine its weaker rival, I think this sets up the perfect pair trade. To keep a positive bias on the trade, one could short 100 shares of Signet for every 100 shares of Tiffany, providing a ratio of about 3:2 long/short. More aggressive investors who are comfortable with options could sell Tiffany's January 2011 puts with a $65 strike price and buy Signet October 2010 puts with a $45 strike price for a net credit of about $3. If both companies have the same price performance, this trade should prove profitable even if both companies fall up to 20% and if my thesis proves correct and the performance of the two companies begins to diverge, the returns will be even greater.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.