Tiffany: First Thoughts After Q3

Summary

• Q3 showed mixed results with no big surprises.
• I'm a bit disappointed by the company's failure to re-ignite the business in Europe.
• Further upside may be generated, but I don't see TIF as an attractive long at these levels.

Tiffany’s (NYSE:TIF) Q3 results looked mixed, especially considering the levels its stock is trading at. Despite the 3% increase in sales, it’s never good to see comparable store sales declining, although the 1% decline in comps is still a sequential improvement from the 2% decline in Q2. Anyway, the market doesn’t like companies with falling comps, and investors are very afraid of the detrimental effect that lower sales per stores have on margins, considering the fixed costs ("negative operating leverage"). Similarly to what happened to Signet Jewelers (SIG), Tiffany wasn’t able to take advantage of the improving environment in retail and failed to turn total comps into positive territory. That’s not because the business is not showing improvements in North America, but because the 1% increase in comps in the Americas region was largely offset by weakness in other parts of the world, such as Japan and Europe. While in the previous quarter Japan and Europe reported comps up 9% and flat, respectively, they reported a significant contraction in Q3, with an 8% and 3% decline, respectively. While Japan surely faces the difficult comparison with Q3 2016, when comps rose 20%, we can’t say the same for Europe, which reported a 14% decline in Q3 2016. I'm very disappointed by the performance in Europe and, in general, I see that Tiffany’s results show high volatility across regions and not a clear path toward a clear improvement. Look at comps variation per region in the past five quarters:

Source: Author's Elaboration

Here is the same data in a table, where you can notice the high volatility and the frequent comps declines regardless of which region we look at:

Source: Author's Elaboration

It’s a good sign that comps are back into positive territory in the Americas. But it’s not so great to see that while the improving environment in North America is helping sales, the rest of the business is showing weakness. The consumer spending environment in Europe may not be great, but it’s not worse than it was last year. Softer concerns about terrorism and the revival of tourist spending should have helped sales but they didn’t. The weakness in the Asia Pacific region was attributed to declines outside China, which management attributed largely to lower Chinese tourist spending, which may be a sign that despite the favorable economic conditions in the region the brand is failing to penetrate those markets and relies too much on Chinese consumers to drive sales.

Despite the weakness in comps, sales grew and helped the bottom line. Earnings increased 5% to $100 million, or $0.80 per diluted share, from $95 million, or $0.76 per diluted share, in Q3 2016. Anyway, margins didn’t show particular strength. Gross margin of 61.3% was slightly below analysts’ expectations of 61.4%, but still a bit above the 61.0% in the prior year. Operating margin increased a bit to 16.4% from 16.3% a year ago. It’s a good sign that the company managed to improve margins a bit in spite of a decline in comps but nothing we could be so excited about. Actually, we should take into account the fact that both gross margin and operating margin are not far from the highest levels reported in the past 10 years from Tiffany (62% and 21% respectively), leaving me to wonder how much margin expansion can be further unlocked in a context where further efficiencies are very difficult to generate due to the high investments in digital capabilities that basically every retailer has to make to thrive in the new omnichannel retail world.

Besides these considerations, management’s guidance for the full-year includes the following:

• Diluted EPS up high-single-digit percentage over 2016’s earnings per diluted share of $3.55 and by a mid-single-digit-percentage over 2016’s adjusted EPS of $3.75.
• Free cash flow of approximately $450 million, or $3.60 per share based on 124.4 million shares outstanding.

Even if the high-single-digit increase translated into a 9% increase, the stock would currently trade at minimum 24x EPS, almost 24x adjusted EPS and almost 26x FCF per share. I think that this valuation is fair at best, considering that the company hasn’t shown any particular ability to grow the bottom line and that such multiples would already reflect a future of at least mid-single-digit growth in perpetuity. I think that what could be taken from this stock has already been taken and I would see a further multiple expansion as another iteration of the market’s typical exaggerations.

This doesn’t mean this is a bad company nor that TIf is a sell here. There are reasons to like Tiffany. Besides the well-known and almost iconic brand, the company has a very solid balance sheet that may include some growth optionality. With a current ratio of 5.44, cash and cash equivalents of $1,009 million that almost cover financial debt entirely ($1,072 million), you can easily understand why I say Tiffany has an extremely solid balance sheet. Should the company find interesting growth opportunities, it wouldn’t lack the flexibility to pursue them for sure.

The buyback policy and the rising dividend make us understand that the company is committed to returning cash to shareholders as well, but frankly speaking, I find it difficult to rely on these factors to justify a long at these levels. Balance sheet optionality and buybacks supported by large free cash flows can probably be reasons to be bullish on a stock trading at EPS multiples in the mid teens, while I don’t see how they can help a bullish case on a stock already trading at 26x full-year FCF expectations.

In conclusion, I wouldn’t say that Tiffany’s results were bad but they did nothing to change my neutral view on the stock. There also would be two catalysts that can help drive the stock a bit higher but I don’t think they are powerful enough to make a long on TIF worth the risk. I'm referring to:

• The overall strength of retail in the Americas, which could drive Tiffany’s results higher if the rebound continues into Q4. Let's remember that jewelry is one of the categories most exposed to holiday sales, as a really big chunk of annual sales is generated between November and December.
• The tax reform could help the bottom line, as Tiffany already reports an effective tax rate above 34%. Anyway, I have to say that considering the recent market reactions to the matter, it’s likely that the benefits are in large part already priced in.

These factors may help the company and drive valuation multiples a bit higher, but I continue to see the upside capped not much above the current levels. Let’s consider that French luxury companies such as LVMH and Kering SA are trading at 25x full-year EPS expectations but report much better top line trends and an overall higher stability of the business. I don't see how Tiffany can be worth more than that in the current conditions. I would say TIF is a hold at best and I don’t see company-specific reasons to expect further upside from these levels.

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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.