Contributor: MC

Intro

In this blog I’ll discuss why I’ve taken a small (~ 5% of my portfolio) speculative long position in Signet Jewelers (SIG) – thanks thanks to a buddy of mine who, as he puts it, was “dumpster diving” the other day and brought this to my attention. You likely haven’t heard of them, but almost certainly have heard of their trade names: Sterling Jewelers (Kay and Jared), Zales, Piercing Pagoda as well as a few other smaller brands. Though SIG is a leader in the mid-market jewelry space (products from $50 to $10,000), they’ve recently fallen out of favor with Wall Street and have seen a large price decline in their stock price thanks to some credit transitioning woes. These credit issues, in my opinion, are likely to be resolved with a little bit of time and I expect to see the price rebound nicely by year’s end. At that point I’ll re-evaluate the position and either take all profits from the trade and close the position or take some profits off the table and let the rest ride depending on how well the business does.

The key takeaways from this blog are:

• SIG has taken a beaten (and rightfully so), but risks are short-term in nature and are expected to be resolved before mid-year
• SIG has remained profitable over the years and has taken key initiatives to increase operational efficiency and enhance customer experience which are expected to boost sales and the bottom line over the long-term
• I expect an almost 100% increase in price by year’s end to $89~$100

Short-term Risks Over-inflated

SIG suffered a 21% decline in its share price in late November after Q3 earnings reported sales difficulties from weather-related events and credit services transition issues – see below price chart.

The company subsequently lowered its guidance for Q4 2017 as well as FY 2018 (EPS down to $6.17 to $6.22 from $6.10 to $6.50), taking a toll on investor sentiment. My opinion is that while the impacts of the credit services transition and weather have indeed affected sales, these are only temporary issues that can be resolved by management with a little bit of time and will not overshadow the key initiatives the company has taken to create longer-term value for the customer. Before we get into those initiatives, let’s talk about the elephant in the room:

Credit Servicing Transition

Late last year, SIG decided to transition its credit services to a third-party, Genesis, who will provide credit servicing functions to SIG for all non-prime customers looking to finance a jewelry purchase.  Essentially, all existing and future non-prime credit accounts (the servicing and administrative activities involved in handling these accounts) will be processed and handled by Genesis while SIG keeps these credit originations on its balance sheet until transition is completed. When this transition began in late 2017, the company experienced technical difficulties during this time resulting in a drop-off in same store sales (as a result of issues in signing customers up for credit), which they admitted was responsible for approximately 66% of the decline in those sales over the holiday period. Here are a few key things to know about the transition and the latest results:

• Kay and Jared (making up their Sterling Division) account for 59% (40% and 19%, respectively) of SIG’s sales volume
• Historically, 75% of Kay’s engagement ring customers elect to go with Kay’s in-house financing and usually spend $300 to $350 more than customers who pay in cash
• Over the recent holiday period, Kay same store sales fell 10.8% compared to last year while Jared fell 5.9%
• SIG overall holiday same store sales fell 5.3% year-over-year
• System disruptions are now “largely resolved” and the company claims  application volumes and approval rates have returned to pre-conversion levels
• Transitional issues remain, but those are primarily operating processes for which employees need to be educated on
• Management is fully aware of the problems in transitioning and are prioritizing resolving these issues
• Summary slide from their latest presentation below:

The key here to understand is that the credit servicing issues had a large negative impact on holiday sales and the company’s share price is being punished right now for poor execution. In my opinion however, this presents a unique opportunity to create a position in a company whose long-term fundamentals are in-tact and who’s making key business changes to not only just remain relevant, but also thrive in this digital age of e-commerce and social media.

A Deeper Dive into the Fundamentals

A look closer into the fundamentals of the company will reveal some key items why I’m bullish this particular company, the primary one being consistent, increasing profitability over the years. Below let’s hit on a few key metrics:

• Return on Invested Capital
  • SIG’s ROIC, which is calculated as (Net Income – Dividends) / Invested Capital, has accelerated over the past several growing 51% year-over-year and 123% over the past three years
• Free Cash Flow per Share
  • FCF/share has also accelerated growing to $6.02 in 2017, up 182% YOY
• Current assets > 3 * current liabilities
  • The amount of current assets compared to current liabilities is great enough that we don’t have to worry about the company having trouble meeting its financial obligations in the short term (and potentially any further price decline).
• EBITDA >> Interest Expense
  • SIG pays 0 interest expense while EBITDA is approximately $900 MM giving us confidence that the company has properly managed its short-term debt liabilities and is not overly-concerned with paying its debts and can allocate capital efficiently (either through dividends, capital investments or share re-purchasing)
• Share repurchase program
  • Speaking of share repurchasing, the company has authorized a $510 MM share repurchase program for YE 2017 and are expected to continue that going into 2018

In addition to these metrics of profitability, it is also worth noting the numerous initiatives SIG has in place to enhance customer engagement and reduce it’s “Amazon Effect” risk.

Customer Facing Growth Initiatives

Though the company has faced some issues with the credit transitioning, lawsuits, decline in mall foot traffic and competition from e-commerce, they have been catching up quickly with the times and have kicked-off some key initiatives to become more relevant in the eyes of their consumer. To start, they really know their customer, breaking them down into 1 of 5 categories/price points: The Sentimentalist, the Gifter, the Influencer, the Stylish Shopper and the Practical Shopper. By knowing consumption habits of their customers, they have been able to craft a very savvy marketing campaign based on research and data to cater to Zales’ clients which boosted same store sales 4% YOY in the latest quarter. Below are some key ways I believe SIG will be able to stage a comeback and see growth in sales numbers this year:

• More targeted social media campaigns and SEO optimization (increased spending to 35% of revenue from 29% a year ago) that boosted e-commerce sales 42% in the latest quarter.
• This also resulted in an increase in impressions (up 55% YOY) and click through rates (up 146%).
• Emphasis on building a seamless omni-channel (in-person retail and online store visit) presences for customers. This already seems to be working at Zale and are rolling it out to the Sterling Division.
• Development of Segoma Diamond Photography Studio in Ohio which will allow the company to take extremely high resolution photos of diamonds to enhance online purchasing experiences for customers.
• Integration of R2Net (JamesAllen.com) – an online engagement ring store purchased in August 2017. James Allen was an innovator in the diamond e-commerce space that revolutionized how people shop for diamond engagement rings online.

Leadership Change and Key Stakeholders

• Virginia Drosos, the new CEO as of mid-2017 (also Board member since 2012), has extensive experience in the beauty industry and a successful track record in brand building and strategy execution. I expect she’ll be able to turn the company around given the recent negative press the company has been receiving and pivot to more innovative sales/marketing strategies.
• Edelman Oded, R2Net (JamesAllen.com) founder, will remain President of James Allen and has chosen to stick around to oversee the integration of R2Net. He’s even invested a portion of his earnings from the sale into SIG. To me this is a sign of his faith in the acquisition and commitment to seeing the integration go well.

Major Downside Risks to Owning

Given the recent plummet in price, I believe there is little risk for further downside at this point. The company is already trading at a P/E of 9.6 and P/CF of 2.1 (lower than market average) and Wall Street is pricing the stock at 0% growth for the next six months. Additionally, given it’s current ratio of almost 3 to 1, the only thing that could really pressure SIG’s current price is poor execution or a major economic downturn, both of which are unlikely to happen in the immediate term.

Conclusion and Price Target

Given the above, I’m a buyer of SIG and have a price target (i.e. intrinsic value) of $89 to $100 at YE 2018, assuming a modest 3% to 4% growth rate. However, I’m only a buyer at sufficient margin of safety, which in this case would be 75% or less of estimated intrinsic value, or anything $67 and lower.

Disclosure: I own shares of SIG

Sources:

1. https://www.forbes.com/sites/rachellebergstein/2017/10/18/signet-bought-diamond-retailer-jamesallen-com-for-328m-back-in-august-whats-next/#6d74cf066f14
2. https://www.forbes.com/sites/anthonydemarco/2017/07/17/signet-jewelers-appoints-virginia-gina-c-drosos-as-ceo/#6ccdad263f0a
3. https://seekingalpha.com/news/3313856-signet-plunges-27-percent-earnings-cut-guidance
4. https://seekingalpha.com/symbol/SIG/earnings/transcripts