Signet Jewelers Ltd.: A Rough Diamond That Could Shine Again

Cameron Smith profile picture
Cameron Smith
2.64K Followers

Summary

  • Pessimism in retail is creating opportunities.
  • Outsourcing of credit portfolio will create value for shareholders.
  • Signet is trading below intrinsic value.

It has been easy to put down Signet Jewelers (NYSE:SIG) recently between the stories circling the company of employee harassment scandals and analysts framing it as a pay-day loan company that just happens to sell jewelry. However, in my opinion, these stories have overshadowed a company that has only had one year in the past ten where they had an earnings deficit (during the financial crisis in 2008) while also earning an average ROE of 11.2% over the same period (Morningstar).

The pessimism surrounding the company compounded with the pessimism of retail in general these days has opened up the door to a potential value opportunity.

Update On Credit Portfolio

In May’s Q1 fiscal year 2018 conference call, management finally gave into the pressure to outsource their credit portfolio (Conference Call). The intended result is that Signet will be able to focus on their main business, selling jewelry, while still allowing customers multiple financing options in order to drive sales (Q1 FY2018 Investor Presentation). As outlined in the Q1 FY2018 conference call and presentation, the outsourcing will be done in phases with phase one being the outsourcing of their prime account book (around $1B) to Alliance Data through a seven-year agreement to provide credit to prime customers (Pg. 15 of Q1 FY2018 Presentation).

Also in phase one, Signet will retain non-prime receivables on their balance sheet and continue to originate new loans to non-prime borrowers while outsourcing the services of all loans to Genesis. As part of this outsourcing of services on the non-prime book to Genesis, the accounting treatment for bad debt expense will change from the recency accounting method to the contractual aging accounting method. The use of the recency accounting method has been a big thorn in the side of Signet for analysts but management has said they expect the change to the contractual method to have no material impact on the financials.

Also, in phase one, Signet will start a new Lease-Purchase option through a new partnership with Progressive Leasing, which will give customers another avenue for buying from Signet if they do not wish to pursue or qualify for a credit program. Phase two will see Signet deal with the non-prime accounts so that all credit programs are fully outsourced. Management has stated that they intend to be patient and take their time to find an appropriate partner to deal with the non-prime accounts and that they would be fine running off the book themselves.

Financial Implications

The planned result from management of the $1B sale of the non-prime book and outsourcing of all credit portfolio services is that it will be EPS accretive in the first full year of operations. This planned result will come from two main items with the first being the use of the $1B sales proceeds to repay a $600M securitization facility associated with the receivables and then using the remaining $400M for share repurchases (Pg. 16 of Q1 FY2018 Presentation).

With a current market cap around $4B, this would represent around 10% of shares outstanding. Share repurchases are something I like to see in a company as they show management has faith in the long-term prospects for the business and believes its shares are trading below their intrinsic value. Since year-end 2010, management has shown this belief by having already bought back 14.9% of shares outstanding. These coming potential share repurchases will continue that trend at what I see as an attractive repurchase price.

The second large impact from the credit portfolio transition will be the removal of net interest income from the prime portion of the portfolio (55% of total net interest income) which will be partially offset by 2% to 3% savings in SG&A expense as guided by management due to a reduction in headcount from outsourcing the operational functions of the credit portfolio (Pg. 22 of Q1 FY2018 Presentation).

With net interest income of $101.5M, $95.9M and $89.2M over the 2017–2015 period and conservatively taking the low 2% guidance of management for the reduction in SG&A, the net impact on operating income from this 55% reduction would have been a decrease of around $18.2M, $13.0M, and $14.8M respectively (2017 Annual Report).

With operating income of $1,598M, $1,737M, and $1,498 over this period respectively, this represents an approximately 1% decrease in operating income. These numbers go to show the $1B of capital tied up in receivables can be put to much greater use through investing in share repurchases and other areas of the business to earn a return more in line with Signet’s average 7.2% return on invested capital over the past 10 years (Morningstar).

Valuation

With an average return on invested capital (ROIC) of 7.2% over the past decade, Signet looks able to earn their weighted average cost of capital (WACC) over a business cycle which I have calculated as being approximately 6.5%. While not earning a ROIC above the 9% average which might indicate a potential moat around the business and that I look for in a high quality company and a long-term or indefinite investment, the ROIC is high enough to qualify for a mid-term investment if it can be purchased at a margin of safety.

This is because as the business is able to earn their WACC and thus able to maintain its value, potential investors could purchase and wait for the market to recognise this value (while, of course, always watching the business for a deterioration in fundamentals).

With an average return on equity of 11.2% over the past decade, Signet is able to earn shareholders an appropriate level of returns on their equity. While not over the 15% ROE I normally like to see in a high quality business, the coming changes from the credit portfolio sale and outsourcing of services should help drive a better return on invested capital and thus equity employed by shareholders in the business. As Signet’s equity is currently trading around a price to book value of 1.6x, this average ROE could be adjusted to reflect a projected 6.9% return to investors purchasing at a $60 share price and assuming no growth in the business.

Putting these factors into a valuation model and discounting at a WACC of 6.5%, I would estimate the intrinsic value of Signet to be $79.41. At a price of $60, this would represent a margin of safety of 24.4%.

Risks

There is uncertainty surrounding the effect this change in the credit offerings will have on the company’s sales as, like many businesses, Signet has used financing options to drive sales through the door. While management has taken the time to find what they believe are appropriate financing partners and alternate financing solutions that will be as favourable and seamless to customers as before, the impact on sales of this change has yet to be seen.

Signet’s financial position has become more leveraged in recent years due to increased debt from the acquisition of Zale’s in 2014 which increased the financial leverage of the company from 1.57x in 2013 to 2.54x today. However, interest coverage to free cash flow from operations remains healthy at 8.1x. But looking further, as a retailer with a lot of leased stores if we add rental expenses ($534M in 2017) to interest expenses and exclude rental expenses from free cash flow from operations, this ratio falls to 1.36x. While still above 1, this coverage ratio including rent is very low.

The last risk I would like to highlight is one present throughout the whole retail sector these days and can best be described as the “Amazon factor.” While Amazon (AMZN) has entered the jewelry space with gold and diamond pieces ranging in price from the $100s into the multiple of $1,000s, larger threats in the industry are in my opinion currently coming from the likes of online stores Blue Nile and James Allen. These companies allow customers made-to-order customized rings where customers can even pick out their certified diamond by SKU# online.

To highlight the risk these new online sellers are in the industry, I would like to share that I actually purchased my fiancés engagement ring through James Allen last year. While I realize not everyone is as comfortable researching diamond specifications themselves, the movement of sales to online platforms represents a large change in the industry and is a large reason the business could not be described as having any moat around it. Signet’s management recognizes this threat and continues to invest heavily in their online platform but the effects down the road on sales from this trend remain a large risk (Conference Call).

Conclusion

The pressures surrounding retail in general these days combined with the company specific issues and uncertainty around the credit portfolio have created a potential value opportunity in the shares of Signet. With an estimated intrinsic value of $79.41, investors at a $60 share price would have a 24% margin of safety.

Disclaimer: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience, and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.

This article was written by

Cameron Smith profile picture
2.64K Followers
Through always enjoying the concepts of value creation and business management it has allowed me to explore potential investments at an academic and strategic level. My investment ideas are presented through two sides; with the most important being financial performance and the second most important being valuation. In my opinion, if a company does not meet certain financial criteria, a valuation of that company can only mean something if you are investing in the senior debt at best or if you are purely speculating at worst. Focusing on return on invested capital (ROIC), I classify potential investments as either long-term/indefinite investments, medium-term investments, or value traps. 1) Long-term/Indefinite: ROIC of greater than 9% and able to grow intrinsic value 2) Medium-term: ROIC of 6 – 9% and able to maintain intrinsic value. 3) Value Traps: ROIC of less than 6% and not able to meet their cost of capital My investing philosophy stems from Warren Buffett’s focus on long-term moats and value creation while expanding to include potential growth opportunities from the approach of Peter Lynch. At heart, I am a long-term investor that looks to buy value opportunities at a 30 per cent discount to intrinsic value with the potential to earn over 9 per cent return on equity (ROE) adjusted for the equity value per share that is paid at purchase. I believe growth is always a subjective variable but can be estimated through a product of retained earnings and the companies return on equity given the variability of both in the past decade.Disclaimer: While the information and data presented in my articles are obtained from company documents and/or sources believed to be reliable, they have not been independently verified. The material is intended only as general information for your convenience, and should not in any way be construed as investment advice. I advise readers to conduct their own independent research to build their own independent opinions and/or consult a qualified investment advisor before making any investment decisions. I explicitly disclaim any liability that may arise from investment decisions you make based on my articles.
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Disclosure: I am/we are long SIG. 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.

Additional disclosure: Long Signet with an average cost base of $57.58

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