Signet's Economics

Summary

• Diamonds are expected to become more expensive in the medium and long term.
• Mother's Day will be a big teller of trend in the August financials release.
• Financing could allow Signet to gain some extra income moving forward.

Signet (NYSE:SIG) is a strong company in the luxury space with a historically diverse and consistent top line. This past quarter was disappointing by some measures and external factors have pulled down the stock. The coming quarter, as well as an evolving economy around the luxury business, could create an opportunity in the future for this firm.

In terms of economics, luxury goods are almost always the first to be cut out and last to be added to the average budget. The Federal Reserve and other indicators show it is reasonable to expect consumers to continue to increase spending. Below is the University of Michigan Consumer sentiment indicator, which is at all-time highs since the 2008 bust.

The other side of expenditures is money in consumer pockets. In come the mixed signals. The unemployment rate has been dropping overall, yet wages have not come under pressure and have not kept up with the increased employment. The last unemployment rate increased showing that either workers are less flexible with under-employment or companies are being stricter in employing new talent. Either way, this implies the market is getting tighter with and possibly will increase in wages in the future. As shown below unemployment has decreased past pre-2008 levels indicating we are past full employment.

However real wages, as shown from Payscale below, have not recovered and are still moving at a negative rate. Real wages measure the difference between wage growth and inflation. Effectively showing the difference between what is going into consumer pockets relative to what is coming out. As mentioned above, this trend may change in the coming months.

On one hand, sales for luxury products should pick up with this expected growth, but without the money to do so the consumer will start to cap off expenditure growth before it can significantly affect luxury goods. The economics make a strong bearish case for many retailers as shown from the decline of XRT. Moreover, many brick and mortar stores have been hit as online retailers take over. This may not be the same story for luxury products. Consumers have shown interest in being able to physically interact with knowledgeable employees and see luxury products before they purchase. Thus, luxury brick and mortar sales will not be hit as hard as they are planned expenses and often must be in store.

Fundamentals for SIG show an interesting story. FCF and EBITDA have been squeezed comparing 2017 Q1 to 2016 Q1. The decline is primarily due to a 50.3% decrease in operating cash. As cash flow shrinks less value flows down to equity pushing investors out. Moving up the balance sheet shows a similar story with operating income decreasing 45.61% Quarter over quarter. These decreases are also seen in same store sales which decreased 11.5% in Q1. In the 10Q it mentions that Mother’s Day was late this year pushing many of those sales into Q2. If Q2 is strong enough to compensate for the Q1 shortages the firm should be on track to finish up the year in-line with previous years.

On the yearly level, external factors become more apparent. “In Fiscal 2017, prices for the assortment of polished diamonds utilized by Signet decreased slightly compared to prior year. Industry forecasts indicate that over the medium and longer term, the demand for diamonds will probably increase faster than the growth in supply, particularly as a result of growing demand in countries such as China and India.” (10K) As one of the main inputs, Diamonds will put pressure on margins moving forward. The firm is able to combat this pressure with the promotion of synthetic diamonds and cost cutting. This past year, operating margins increased by 1.2% to 11.9% attributable to operating expense efficiency. Debt levels decreased while cash increased showing a net positive cash position over 2016. As this trend continues the firm should be able to leverage better, thus enhancing buying power to fight against increasing input costs. On the other side of the coin, gross margins have shrunk to 36.8% from 37.3%. The drop is attributed to lower sales and higher financing activity expenses. Moreover, the firm has increased its promotional budget and not seen incremental sales as of yet.

An option for Signet is to adopt a similar model to Ford (F) and amp up its financing department. Ford has an in-house financing department that represents 6.11% of total sales. Though this is a small percentage the main advantage of having an in-house department is control over these sales. Currently, in-house financing at Signet collects 97% of monthly payments. If this financing option was ramped up SIG could capture more customers who need financing for their luxury purchases. On top of retaining control of these financing activities, the firm could capture a small bump in interest income.

Overall Signet is a solid company with factors pushing it both ways. The economics need to get better before this is a safe long play. The quarter to quarter results are not phenomenal, but do not have any cause for concern (so long as Q2 shows the bump as expected from the last Mother’s Day). At this point, this stock is a hold. If the growth in economic forces can improve the position of top line growth than this firm has growth potential. The safe play here is to wait for next quarter results which will give a stronger view of the future. With strong results, the Mother’s Day shift will be confirmed and it may give enough time to paint a clearer picture of consumer economics.

Analyst’s 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.