Are we there yet?

A look at Signet's operations

Published on:
July 21, 2019
Last Update:

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

Corporate America cannot stand still. Executive management reports to shareholders on growth expectations and on future strategy. Middle management reports to executive management on upcoming changes to processes and to efficiency measures. And each employee, as anyone who has worked in an office knows, is permanently busy.

This phenomenon, the need to act, can be seen in balance sheets. Consider the balance sheet of Signet Jewelers (SIG on Nyse), a company whose common stock I bought this week, is a prime example.

Signet's main balance sheet changes

First, between 2015 and 2014, the goodwill and intangible accounts increased to $966.3 million from $26.8 million. On the right side of the balance sheet, Signet’s long-term debt increased to $1.3 billion from practically nil. These changes occurred because Signet had bought Zales, an online jewelry store. Forbes magazine described the acquisition in February 2014.

Second, 2016 and 2017, Signet reported on a preferred stock of $611.9 million. It also reported that it would be selling the receivables portfolio (read: the loans Signet provides, partly through third parties, when customers purchase jewelry). And indeed a year after the receivables dropped to $779 million from $1.9 billion. The cash flow from the receivable sale was used to pay down the long term - it dropped to $688 million from $1.3 billion.

Third, between 2018 and the first quarter of 2019, Signet continued to sell the receivables portfolio. As of its recent public filing it reported on $96.2 million in receivables, down from $779.7 million the year prior. Another major balance sheet change was that that goodwill and intangible accounts, dropped to $561 million from $1.3 billion. The drop in the goodwill account was due to an impairment loss related to the Ret2Net purchase. Read about the acquisition here.

These are my notes: taken while sifting through Signet's reported financial results. Bolded with exclamation marks are three milestones in Signet's life over the past five years

Signet over the past five years

How should we understand this pace of activity? One group of investors cheers for Signet's Animal Spirits while the other prefers if the company would operate in a conservative fashion. What is worrisome to both groups is probably the company’s long-term trend.  

Five years ago when Signet traded as low as $75 and as high as $151 (at an average earnings multiple greater than 15 times the trailing earnings per share), investors argued that Signet's market share of the bridal segment was increasing alongside the consumer’s demand for jewelry. The conventional wisdom was that, in the long-term, shareholders would be awarded.

But in the long term we are all dead*. Signet is not the same company it was five years ago. In numbers: the pre-tax return on tangible assets ratio was 15% in 2014. It has steadily declined to a minuscule ratio of 3% in 2019. The pre-tax profit margin, defined as pre-tax net income divided by revenue, was 10% five years ago. It is now less than 2% (even after removing the non-cash impairment charge related to Ret2Net acquisition).

The balance sheet tells a similar tale: in 2014 for every dollar of common equity, Signet reported 57 cents of liabilities. Today the ratio increased by fivefold: for every dollar of common equity, Signet now reports $2.60 of liabilities. Another way to look the company's leverage is that Signet had zero long-term debt five years ago. It now has $650 million. For the long-term investor, in short, Signet in 2019 is not what Signet was in 2014.    

2019 leverage ratios compared to 2014

Active management

Three lessons present themselves. First, investors with an investment outlook of three- to five-years must allocate time, perhaps quarterly, to review management decisions. They should review and question management's capital expenditures decisions, find out what the business strategy is and closely monitor how management reports on operations in the each of the quarterly earnings calls.

Second, Investors should look for industry trends and for regulatory changes. For those who invest in jewelry companies, or more broadly, in consumer discretionary segments, the regulatory environment greatly matters (Signet's sales are largely driven by the consumer's ability to take personal loans).    

The third lesson is that whether to buy a stock should be based on present circumstances, using historical financial statements so that future estimates and pro forma projections should not sway the attention. And why I bought the common stock of SIG, based on the present conditions, will be the topic of s future essay.  

***

In our business environment, which reveres Andy Grove, former Intel CEO, chronicler of paranoia in the Only the Paranoid Survive, executive management will make poor decisions due to hasty decisions driven by a need to act.

In the case of Signet, by merely looking at the balance sheet, we see an executive management that has been wearing too many hats. They wore the financier hat when they replaced long-term debt with preferred equity. They wore the visionary hat when they acquired Zales in 2014. Too bad that they recently had to wear the accountant's hat, the least attractive of the three, when they took an impairment loss of $740 million this year.

In this article, my main argument was to highlight that investing for the long-term is no excuse to let stock investments idly sit in the the portfolio. Corporate America’s behavior is such that every few years a large transaction will occur**. That transaction will dramatically change the business fundamentals and the company’s outlook, be it a restructure, an acquisition or a change in capital structure. More so, it is the nature of capitalism, in which yours truly is ardent believer, that in a free market system, profitable enterprises will lose competitive advantage***. Often too quickly. And brutally often.