Pull a Ratner

SIG's risks and rewards

May 18, 2019

Written by

Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He  serves as  Vice President in Capital Markets at Silvergate Bankand holds the Chartered Financial Analyst (CFA) credential.

Investing in the common stock of Signet Jewelers (SIG on Nyse) is not for the faint of heart. While the price to adjusted earnings ratio is less than 10 times and the price to adjusted book value is less than half, to buy the common stock of any jewelry company is to put a leap of faith that management will never mention (truthfully or jokingly, as it may) that the product is "total crap". Instead management must convince us that diamonds are forever.

In this essay, I write why I bought the common stock of SIG at $21 per share and why I believe the value of the stock is nearly twice as much.

Why I bought SIG

The company trades at 7 times the adjusted earnings per share. Let's assume that a year from today, the company will report on $5,950 million in sales, a 5% decline in sales compared to the latest financial filings.

We use ratio of cost of sales to revenue of 65% and a ratio of SG&A to sales of 30%. Signet's management expects that the interest expense this year will be $42 to $46 million, so we use a higher amount of $50 million to be on the conservative side. We arrive at pre-tax earnings of $247 million. After a 30% federal tax rate (we use a higher tax bracket that the 2019 tax bracket of 21%), the 2020 net earnings are $173 million or $3 per share.  

Table 1: What I estimate SIG will earn in 2019

Compare to both Signet's peers and compared to the company's market valuation in past years, a 7 times earnings ratio is cheap. Tiffany's (TIF on Nyse) and Fossil Group (FOSL on Nyse) trade at 20 times the earnings. Foot Locker (FL on Nyse) and Capri Holdings (CPRI on Nyse) trade at 12 times the earnings. Over the past decade, SIG’s earnings ratio was between 11 to 18 times.

The company is trading at a hefty discount to adjusted tangle equity book value too. While management reports to shareholders on tangible equity of $1,255 million, or $22 per share, investors are encouraged to adjust the equity balance. The adjustments are for deferred revenue and treasury stock.

The reported $966 million in deferred revenue, viewed as liabilities by the accountants, are a non-cash outlay. Signet offers its customers Extended Service Plans (ESPs) that are in effect lifetime warranty agreements. It collects cash from the customers when ESP is sold but reports the income slowly over the years (55% of the revenue is recognized within the first two years).

In 2019 the company sold $395 million of ESPs and the deferred cost (read: the cost to service those warranties) was $99.2 million. There is, in my opinion, about $666 million or $17 per share to be added back to the equity.

In 2019 management reported on a deficit of $1,027 million in the equity balance associated with the 18.1 million shares in treasury stock (read page 68 of the 10-k report.) But just as Signet bought back the common stock (the company a weighted average of $56 per share) Signet can sell the stock again. I consider Signet's treasury balance an asset. So I adjusted the equity the balance by adding back the 18.1 million common shares that Signet can sell at, say, $15 share. So $271 million or $5 per share can be added back to the equity.

Adjusting for the deferred revenue and for the treasury stock, we get an adjusted equity balance of $2,192 million or $42 per share. At $21 per share the stock traded at half the adjusted equity book value.

Before we move on to the Signet's risks, consider a comparison of peer companies’ valuation and Signet's past valuation. TIF trades at over 25 times the book value (an stark example of how the stock market values its remarkable brand). FOSL trades at 1.3 times the reported book value. FL trades at 2.7 times the reported book value. And CPRI trades at 3 times the book value. Historically, SIG traded at two times the reported book value.

Table 2: Peer group valuation comparison

The risks

A terrific book by Gerald Ratner's The Rise and Fall...and Rise Again is the true story of how a prosperous company, run by a dedicated manager, fell into oblivion. It is also the story of its demise largely because of Ratner's two words spoken to crowd in the Institute of Directors. The two words were Ratner’s description of one of the company’s products - a cherry glass that cost 4.95 pounds - and was "total crap" according to him. In short, In an industry where branding matters and customer perception is everything, the biggest risk is the one we have yet heard of.

In the final part of this essay, I will mention a few risks that we can understand and foresee.

The first risk is Signet's executive management's turnover and executive compensation. The two 'shake ups' in management were the departure of the CFO and the entrance of a new CEO, Gina Drosos. While she has been with the company since 2012 (on the board of directors), her compensation is just too much. She is paid 252 times the company’s median salary - a whopping $8.89 million per year. Only time will tell if she is worth it.

The second risk is that the industry is changing. Wall Street analysts deem buying diamond jewelry by visiting a local shop a thing of the past. And millennials are delaying marriage which hurts jewelry sales according to WSJ. E-commerce sales are only 11% of Signet's reported sales.

The third risk is Signet's Animal Spirits, which I will write more on next week. Signet acquired (and managed to write off) two large transactions in the past five years. It bought Zales in 2014 for $1.4 billion of which $1.2 billion was borrowed. It also bought Re2Net in 2017 for $365 million and borrowed $350 million. It also raised preferred equity of $619 million last year and sold the entire receivables portfolio. So to predict the journey the board will take current investors is a guessing game.

The fourth risk is the litigation risk. Over the past decade, CNN reports that the company has been charged with gender racial charges and of misleading consumers. The claims have yet to clear.

Essays about real-world investments
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