Signet Jewelers: Concerns Are Overblown

| About: Signet Jewelers (SIG)

Summary

Recommend long position with 20% upside and 1-2 year horizon.

In-house credit book concerns are overblown as both of Signet's choices will drive shareholder value.

Underlying business will remain solid despite recent brand weakness from bad news headlines.

Our recommendation is Long with a price target of $103.40 (+20.0% upside) and a time horizon of 1-2 years.

Proprietary Credit Program Overview:

Because of laxer lending standards, Signet Jewelers Limited (NYSE:SIG) has been able to increase sales at the cost of giving loans to people who cannot necessarily pay it back. Day Sales Outstanding is 10x longer than its competitor Tiffany's (NYSE:TIF), showing the difference in the quality of the credit book between the two companies. In addition, SIG's average FICO score is 662 for FY 2016, which is above subprime. However, net charge-offs as a percentage of accounts receivables has increased from 9.3% in 2013 to 9.9% in 2016, showing deteriorating credit quality.

Thesis

Our thesis has two parts:

  1. In-house credit book concerns are overblown as both of Signet's choices will drive shareholder value.
  2. The underlying business will remain solid despite recent brand weakness from bad news headlines (i.e. Kay diamond swap, gender-discrimination in employment).

Thesis 1a: Selling Credit Book Is Best Option

We believe that the sale of the credit book would monetize the portfolio immediately without largely hurting future free cash flows while also outsourcing credit risk. As per our projections, the loss in revenue as a result of a lower credit approval rate and interest income is largely offset by a decrease in bad debt expenses and capital inefficiencies associated with running the credit book. Thus, changes in future free cash flow is approximately 0 between selling credit book and optimizing credit book.

However, the monetization of the portfolio would also result in an additional immediate ~$20/share value increase over optimizing the credit book. To arrive at this number, we used Conn's (NASDAQ:CONN) sale in September 2015 of $1.4bn of receivables for $1.1bn (a 22.5% discount). If SIG sells the credit book in this upcoming quarter, the projected accounts receivables is $1.9bn. Assuming a sale of credit book in Q4 at a 20% discount, similar to CONN's, this results in proceeds of $1.6bn which, divided by 77m shares outstanding for SIG, yields roughly $20 per share in value.

We think using a 20% discount is conservative, as SIG's credit metrics are significantly better than CONN's.

Net Charge-Off as % of Average Gross AR FICO Score Average Bad Debt Allowance as % of AR AR 60+ Days Late
CONN 13.5% 608 13.0% 9.6%
SIG 9.9% 662 7.4% 7.4%

Source: Company filings

Thesis 1b: Optimizing The Credit Book Still Creates Shareholder Value

On the other hand, keeping the credit book allows the current business model to remain intact. Doing so would allow SIG to keep up its higher credit-driven sales along with its high interest income. We think that increased transparency in credit metrics will ease default concerns and catalyze value, if SIG chooses to go down this route.

A historical analysis of SIG to last credit cycle shows a discrepancy between reality and market expectations of SIG's credit book. We arrive at what the market is pricing in by using SIG's current share price and projecting revenue to grow at a 3% CAGR for the next 5 years.

Source: Company filings and own projections

Thesis 2: Underlying Business Will Remain Solid

2a: Sales over the mid-term will recover to due to capital investments in its stores, proven quality and size

Currently, SIG is experiencing record capital expenditures in new stores and remodeling. They are opening high growth stores (Piercing Pagoda, Zale's, Kay) and closing lagging regional brand stores. In addition, they are expanding to out-of-mall locations with expanded square footage (short term by Kay's, medium-term by Zale's). SIG owns the #1, 3, and 4 largest diamond retailers in North America in an industry where familiarity and presence is important for customers. Thus, we think sales should recover somewhere closer to the industry average growth rate within the next couple of years.

2b: Zale's integration will improve margins

Zale's compressed margins (1.9% operating margin in FY 2013 vs. 11.6% operating margin for SIG in LTM) when it was acquired in 2014 leaves room for margin expansion. SIG has already integrated ~30% of Zale synergies in 2016, actually surpassing its previous targets. Nearly all projected synergies are cost-based, not revenue-based, allowing for more accurate projections. Thus, we believe that SIG will successfully be able to integrate Zale and meet its projected synergies.

Valuation

We used a 5-year DCF model with a bull, base, and bear case to arrive at our weighted price target of $103.40, with an upside of 20% as of last market close of $86.12.

Price Target Probability WPP $103.40 (+20.0%)
Bull $147.92 20% Upside +71.8%
Base $98.28 60% Downside -28.2%
Bear $74.25 20% Reward/Risk 2.5x

Key Assumptions

Assumption 1 Assumption 2
Bull
  • Credit book sale with 20% discount
  • 2016-2021 Revenue CAGR of 3.7%
  • Midpoint of synergies guidance from Zale acquisition integration
Base
  • Optimize credit book
  • Net charge-offs as a % of accounts receivables increase from 9.9% in 2016 to 15.4% in 2019, then tapers down to 2016 levels
  • 2016-2021 Revenue CAGR of 3.0%
Midpoint of synergies guidance from Zale acquisition integration
Bear
  • Optimize credit book
  • Net charge-offs as a % of accounts receivables increase more than base case, including a one-time 20% charge-off of very low-quality receivables in 2019
  • 2016-2021 Revenue CAGR of 1.0%
  • Only 75% of midpoint of synergies guidance from Zale acquisition integration

Assumption #1:

  • Credit book sale: CONN, an appliance retailer, has a large credit book similar to SIG except with much worse quality (lower average credit score and higher net charge-off rate). CONN was able to securitize ~75% of credit book three separate times over the last year, while keeping the remaining ~25% that were lower quality as equity. Thus, we assume that SIG will be able to sell its higher-quality credit book at a 20% discount, especially if SIG agrees to a partnership with a third-party creditor to handle all credit financing in SIG going forward.
  • Optimize credit book: As stated earlier, net charge-offs as a % of accounts receivables increased from 9.3% in 2013 to 9.9% in 2016. Since we are nearing the end of the credit cycle, we conservatively assume a large increase in net charge-offs to 13.9% in 2019 (which is worse than CONN's rate of 13.5% in FY 2016 but lower than SIG's rate of 15.4% in FY 2010 during last year's credit cycle) for the base case, which then tapers down. For the bear case, we assume a one-time 20% net charge-off in 2019 to reflect if 20% of SIG's total credit book was so low in quality that it was virtually uncollectible.

Assumption #2:

  • Global diamond retail revenue CAGR is 4% according to IBISWorld. SIG's historical CAGR for the last 10 years is 7.6%. Thus, our revenue CAGR projections are conservative.
  • SIG has already integrated ~30% of Zale synergies in 2016, actually surpassing its previous targets.
  • Nearly all projected synergies are cost-based, not revenue-based, allowing for more accurate projections.

All other assumptions:

  • We use a perpetuity growth rate of 2% for all cases.

Hard Catalysts

  • Decision on credit book (over the next few months)
  • Q4/Annual call/Guidance (March 9, 2017)

Investment Risks

  • Kay's diamond swapping impact on brand and sales
  • Signet's exposure to oil-producing regions
  • Demand for diamonds outstripping supply
  • Luxury goods are most severely impacted in economic downturn
  • Credit book
  • FX risk

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. I have no business relationship with any company whose stock is mentioned in this article.

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