Tiffany Continues to Face Challenges – But Shareholders Continue to Buy

An extensive article in the Wall Street Journal Online today, points out some of the challenges that Tiffany & Co. (TIF) is facing as the company struggles to remain competitive in the current global economy.  The company has increasingly turned to integrating a larger portion of its supply chain by taking interests in overseas miners and opening factories for cutting and polishing its diamonds.  The strategic decisions over the past few years have led to difficulty as the global demand begins to dry up at the same time that Tiffany has built a costly supply structure.

Tiffany is  one of the featured shorts in the ZachStocks Retail Fail sector report.  As the market continues to make new highs on a weekly basis, investors should begin to develop defensive strategies for protecting gains.  Many professional investors initiate short positions in sectors in which prices have advanced much more quickly than the fundamental improvement seen in the businesses.  This strategy can be effective in protecting gains that have been accumulated as the market has rapidly advanced.

The current retail environment for Jewelry remains difficult despite a few positive signs pointing toward economic stabilization.  Over the last three quarters, Tiffany has seen earnings decline by 39%, 58%, and 37% respectively, and the company is expected to report full year earnings of $1.74 this year which is down 24% over last year.  Analysts are handicapping next year’s returns at $2.04 representing a 17% increase for fiscal year 2011 (Tiffany works with a Jan 31 fiscal year end).

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Global sales of jewelry have been constrained with the total market for diamonds expected to fall by 16% this year.  The number of specialty jewelry retailers declined by 1,500 last year and another 900 stores are expected to close in 2009.  With unemployment remaining stubbornly high, and some of the highest earning industries facing compensation scrutiny by regulatory bodies, it is unlikely that the outlook for this industry will turn higher in the next few quarters.

Tiffany has accumulated a significant amount of long-term debt which could eventually turn into a much larger problem if the economy continues to be soft.  At the beginning of the year, long-term debt was roughly $425 million.  But as of the last reporting period, Tiffany now has more than $710 million in long-term debt, plus pension and other liabilities bringing the total long-term liabilities to well above $1 billion.  As a result, interest expense is several times the level seen last year which is becoming a material drain on earnings.

One of the most dangerous issues for the financial health of the company is its surging inventory level.  The second quarter earnings release showed that the company is sitting on $1.5 billion in inventory which is an expensive prospect considering the interest expense along with an unstable sales outlook.  But with significant investment made in the supply chain, it is difficult for management to make the decision to cut back on purchases.  So the options are relatively difficult no matter which direction the company’s leadership decides to take.

Currently, stockholders seem relatively oblivious to the challenges facing this company.  Tiffany is trading at a multiple of more than 20 times aggressive expectations for 2011.  Given the low amount of growth expected, and the uncertainty which surrounds the luxury goods environment, I would not be willing to pay more than 12 times earnings for this mature company.  If the stock traded with this multiple, the price would drop below $25.  This decline seems to have a reasonable chance of occurring over the next 9 months.

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With all of the concern over economic recovery, and the financial and strategic risks involved in this stock, I would recommend closing any long positions and potentially shorting the stock.  Alternative measures could be taken including selling calls against a long position, buying puts which will increase in value as the stock declines, or setting up a pairs trade by shorting TIF and buying another instrument such as a market or sector ETF.  Please understand the risks and the trading instruments before putting any strategy into place.  Tiffany is a well known and loved company and stock.  But the price pattern is likely to disappoint many investors over the next several months.

FD: Author does not have a position in TIF

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