Summary: Tiffany's August 12 earnings miss was due to weak sales in Japan. But contrary to the consensus view, Tiffany's future growth could be threatened more by Internet-based competitors than Japan's economy.
This has not been a sparkling time for Tiffany's stock. Tiffany announced on August 12th that its sales and earnings badly missed analysts' estimates. Its stock (NYSE:TIF) fell by over 13%.
What went wrong? Tiffany's U.S. sales were fine. They increased 11% year over year, and same-store sales rose a healthy 10%. Tiffany's Asia-Pacific sales did even better: 19% higher than last year, including a 3% currency gain.
The bomb-shell was Japan. The Japanese market is Tiffany's second largest, and analysts had expected healthy sales given Japan's consumer-led economic recovery. But Tiffany's Japanese sales declined by 3%, and same-store sales were down 4%. That's even worse than it looks, because a strong yen boosted dollar-denominated earnings by 6%. In yen terms, Tiffany's Japan sales fell by 5% in May, 19% in June, and 5% in July. Ugly.
Expectations for future performance, reflected in Tiffany's lower stock price, are now more reasonable. Earnings estimates have been lowered to about $1.55 for 2004 and $1.75 for 2005 (from $1.63 and $1.87 respectively). With TIF currently trading at just under $31, or 20 times 2004 projected earnings and 18 times 2005 projected earnings, some value investors are getting interested.
Tiffany is still on track to open new stores in the US and Japan this year, and the company has improved its supply chain by sourcing rough diamonds directly. Most important, they argue, Tiffany has enormous brand value; and that brand value allows it to charge a premium for its jewelry and reap outsized profits.
The problem with this viewpoint is it ignores the true source of Tiffany's growth. Tiffany expects to grow through store expansion. It's rolling out new stores, called Iridesse, that focus entirely on pearl jewelry. And the company is still opening new branches of the traditional Tiffany store.
But if you look carefully, Tiffany's growth is mainly dependent on same store sales growth. Tiffany's updated guidance to financial analysts assumes 10% year over year sales growth in the second half of 2004, based on high single-digit growth in same store sales in Tiffany's U.S business.
Where is that same store sales growth coming from? First, high-end retailers are generally doing better than budget retailers. Middle-income American households are being squeezed by tepid wage growth, poor employment growth, higher gas prices, and soaring medical and education costs. In contrast, high income households have been less affected by the slow pace of the economic recovery, and have benefitted disproportionately from President Bush's tax cuts.
According to the non-partisan Congressional Budget Office, a third of the entire value of President Bush's tax cuts went to the richest 1% of taxpayers (those who earn over $1 million annually). They will pay $78,460 less income tax this year on average, more than 70 times the reduction received by the middle 20% of taxpayers. Remember also that most middle and low-income households pay a far higher proportion of their incomes in social security taxes, which haven't been cut at all. This clearly explains why high-end retailers, like Tiffany and Coach, are seeing higher same store sales growth than budget retailers.
Will high-end retailers continue to benefit from disproportionate income growth among affluent households? That partly depends on the outcome of the presidential election, as John Kerry plans to reverse the Bush tax cuts if he wins the election.
But there's another factor at work in Tiffany's same store sales growth, which has gone almost unnoticed by analysts. Listen to what Tiffany Vice President Mark Aaron said on the conference call about Tiffany's sales mix:
"In terms of a few overall global merchandising highlights, our sales growth continued to be fueled by sales of higher price point jewelry. Specifically, engagement jewelry continued to post above average sales growth in the U.S. and modest growth in Japan. Sales of statement and other fine jewelry are strong."
(The quote is from the the CCBN StreetEvents Transcript at www.streetevents.com).
In other words, Tiffany's growth is currently driven by rising sales of high end jewelry, particularly diamond engagement rings. And in Japan, where Tiffany's sales slumped, sales of diamond engagement rings actually grew.
To understand the impact of diamond ring sales for Tiffany, consider this. The average diamond engagement ring purchased in a Tiffany store probably costs at least $25,000. (When I visited Tiffany's New York flagship store as part of my research for this piece, the starting price of the engagement rings on display was about $20,000.) In contrast, most Tiffany silver and decorative gifts sell for $150 to $600. That means that a customer purchasing a diamond ring brings in the same revenue to Tiffany as twenty to fifty customers purchasing lower priced items. And while the gross margin on a diamond ring is probably lower than on the cheaper items, the overall profit is far higher, particularly given the lesser floor space and sales effort required per sales dollar.
No surprise, then, that rising sales of diamond rings should have a dramatic impact on Tiffany's sales and profit growth. But is that growth sustainable?
In a May 2004 cover article titled E-Biz Strikes Again!, Business Week argued that the Internet was poised to revolutionize the jewelry business. The beneficiaries, according to Business Week, will be Blue Nile, eBay, Amazon and Diamond.com. "While Tiffany is more insulated because it sells image and cachet", the article read, "Zale and neighborhood stores face trouble".
That view - that Tiffany is immune to competition from Internet jewelry retailers - is the ubiquitous consensus in the financial community. Alan Abelson wrote a column in Barron's arguing that low-end jewelry retailers, specifically Zale, would be hit by Internet competition. But not Tiffany. Similarly, every portfolio manager I've spoken to argues that Tiffany will be immune to competition from the Internet retailers.
The Internet jewelry business is developing rapidly. When it launched its jewelry store, Amazon stated that margins in the jewelry business were high, and that it could offer compelling value to shoppers with significantly lower mark-ups. Amazon is pushing jewelry sales hard. Many of its "Gold Box" offers, for example, are for jewelry. ICE.com's business is growing rapidly, and in a few months it will roll out its own "build your own ring" capability. Blue Nile (NASDAQ:NILE), which is focused on the high-end of the market completed its IPO and Diamond.com's parent has filed to go public too.
Meanwhile, as the number of Internet jewelry retailers grows (just take a look at some of the companies whose ads come up next to this article), the comparison shopping engines have expanded into jewelry. Comparison shopping technology is tougher for jewelry than for, say, computers or flat panel TVs, because rings with comparable stones and settings don't share the same product number and are harder to categorize. Shopping.com does the best job in jewelry of the mainstream comparison shopping engines, and you can see its listing of jewelry retailers offering engagement rings, and how easy it is to compare diamond rings by price and feature. Comparison shopping engines devoted specifically to diamonds, such as Pricescope, are also growing. The key point here: comparison shopping tools intensify competition and compress margins.
Investors make most money in stocks when they bet against the consensus view and turn out to be correct. The ubiquitous confidence among portfolio managers and analysts that Tiffany is immune from Internet-driven price competition is therefore an inviting target. And I'm convinced it's wrong.
Here's the key point: Diamond engagement rings, even if they cost $25,000, are a commodity. Their value is defined by cut, color, clarity, weight (carat) and shape. There are no other distinguishing features. Since they don't require after-sales care or a warranty, it makes no difference where you buy a diamond ring from. For any given quality diamond, once the ring is out of the blue Tiffany box and on your fiance's finger, it makes no difference - and no one can tell - whether the ring came from Tiffany's, Blue Nile, or Diamonds.com. Note that this is not the case for other types of jewelry or gifts, where differences in design and style mean that products are not commodities.
The key issue for most shoppers is confidence. How do you know you're getting a genuine diamond when you buy off the Internet? And would you really spend $20,000 without seeing a ring? The answer is independent diamond certification. Most high-end diamonds sold by Internet retailers are certified by the Gemolocial Institute of America. Diamonds are sent with a certificate of authenticity, and the certificate number is micro-engraved into the side of the diamond.
Two other factors help with confidence and credibility. First, high-end Internet retailers like Mondera, Diamonds.com and Blue Nile are succeeding in building brand, aided by the added scrutiny of being public companies. Second, most Internet diamond purchases are made with credit cards, and they offer protection against fraud.
The availability of certified diamonds leaves shoppers with a simple choice. You can buy a diamond ring from Tiffany, or you can spend perhaps 30% to 75% less and avoid the 8.5% New York City upfront sales tax by buying a certified diamond ring from an Internet retailer. If you have any doubt about this, do what I did: go to a Tiffany store, write down the specification (cut, color, clarity etc.) of a $25,000 diamond ring, then go online and specify and design a certified diamond ring with the same features. It'll be a lot cheaper. And if you think you're being a cheapskate, you can spend the same amount as the Tiffany ring for a much higher quality or larger certified diamond.
Although it's a no-brainer to buy a diamond engagement ring from an Internet store rather than Tiffany, analysts inexplicably cling to the view that Tiffany is immune to Internet competition. Instead of considering whether they themselves would buy from Tiffany, they conjecture that "other people" will continue to purchase from Tiffany.
Remember that Business Week story cited earlier, that claimed that "Tiffany is more insulated because it sells image and cachet"? Remarkably, its discussion of Internet jewelry retailers starts with this anecdote:
Amy Smith is what happens when true love meets the Internet. The 31-year-old admits she oohed and aahed over engagement rings at the Tiffany & Co. store near her Potomac Falls (Va.) home. But when she got engaged last October, Smith checked out other stores, including online jeweler Blue Nile Inc. After using Blue Nile's guides to master the Four Cs of diamonds (color, cut, clarity, and carats) and picking out a $10,000 ring there, Smith had one question left. "Blue Nile beat them by almost $6,000," she says. "I thought, 'Why are these so much more expensive?'"
Two other points about the Internet jewelry business. First, the Internet jewelry retailers have a better business model than their traditional competitors: the Dell model in the diamond ring market. Build-to-order diamond rings eliminates inventory risk and offers the possibilty of being paid by customers before having to pay suppliers. Namely, Internet retailers could have amazingly low working capital requirements, higher return on capital, and faster growth.
Tiffany, in contrast, was holding $1.03 billion of inventory at the end of July, 27% higher than a year earlier, and wrote down the value of its inventory by $12 million in the first half of 2004.
Second, the impact of eBay on the jewelry market has yet to be seen. Diamonds don't decay, and can be reset and cleaned. There's presumably some quantity of unwanted diamonds in private hands which remain unsold because the cost and bother of selling jewelry has been excessive. But eBay could change that.
Consumer to consumer sales via web sites like eBay could perhaps lower demand, and thus prices, for new diamonds. Remember that consumers to consumer transactions don't incur sales tax. Confidence and certification are the key to consumer to consumer jewelry sales. Once those issues are adequately addressed by eBay, as they have been by the Internet retailers of new diamond rings, the impact could be interesting.
Will Tiffany's brand and focus insulate it from Internet-driven margin compression in the jewelry business? I don't think so. And for that reason, even after Tiffany's recent earnings miss, I don't think its stock is cheap. I shorted TIF in early May, (my average price is $37.87), and I'm not covering yet. Too much of Tiffany's sales and growth come from engagement rings, which ultimately are a commodity - albeit a $20,000 commodity.
I'm happy to bet against the consensus view that Tiffany's engagement ring business will be unscathed by Internet-based competitors. If the Internet has driven down margins for other commodity products, there's no reason why it won't do the same for diamond engagement rings.
It's early days for the Internet jewelry business. As far as I see it, the engagement party has hardly started, and Tiffany isn't invited.