Tiffany Shines On

In general, we believe investors should think about jewelry as a healthy-return business if a company has pricing power and adjusting for inventory. Small and undifferentiated retailers suffer lower gross margins, buying from wholesalers and competing with undifferentiated products. Brands such as Tiffany use brand image, location, customer experience, selection, and design to stoke demand despite high prices. Given that Tiffany has been in business for more than 150 years, we are optimistic that its success will continue.

Tiffany has strong growth prospects abroad and has also been successful opening stores domestically. The company has been able to expand its store base about 6% a year for the past 20 years and has leveraged comparable-store sales growth and operating efficiencies into profitability gains above its core square footage growth. Compared with other luxury retailers, Tiffany is underpenetrated in China and is now securing key locations in Europe.

Overall, we believe Tiffany's engagement business has some insulation from business cycles--engagements fall during a crisis and rebound when the crisis is over--but over the long run, we find no reason to extrapolate beyond the current growth trajectories. Square footage growth may be slower as smaller stores are added compared with previous larger formats, but returns on capital should remain strong or even improve as per-square-foot metrics should improve in smaller stores.

Operating margins can go higher over time, in our view. Cost control and conservative inventory and merchandising practices during the recession were followed by the gross margin tailwind from the diamond price increase in 2010-11, but margins then fell in 2012. We believe that in a normal-input environment, gross margin and fixed-cost leverage should improve with scale over the long run.

Stellar Brand Digs a Wide Moat Premium pricing through branding, marketing, and design as well as store locations is the source of Tiffany's wide economic moat and supports our view that Tiffany's competitive advantages are likely to endure. Changing the consumer perception of a brand that has been around 100 years or more is hard to do, and thus we view Tiffany's moat as among the most defensible of the luxury firms we cover, or even more broadly among all consumer companies. Tiffany's wide moat rating is earned despite the fact that there are some continual fashion and design elements to its products that are subject to changing tastes and preferences, as well as the recent increase in competition from the online marketplace, which we view as fairly remote from Tiffany. The company is very aware that its brand image is what allows it to charge a premium price; thus, we are confident that management will work hard to preserve the brand's premium positioning even as stores and sales expand. Also contributing to its moat, Tiffany's historical and continued use of popular culture such as movies, or even cultural icons such as the Vince Lombardi Trophy, to continually highlight the brand should serve to solidify the brand's luxury positioning on a global scale.

Returns on invested capital have been solid for this profitable company but remain constrained by the long inventory cycle in diamonds. Although Tiffany's returns on capital are somewhat lower than luxury companies that have dominant leather goods segments, its vertical integration strategy is a contributor to our wide moat view, since it allows Tiffany to insure it always has access to the best-quality jewels. The strategy causes Tiffany to own inventory and even production throughout the value chain, which in turn affects returns. But the strategy also diversifies Tiffany's sourcing of diamonds and processing, protecting its ability to always have the best-quality stones and jewelry, which in turn perpetuates its brand intangible asset. This strategy could prove more important in a scenario where demand for quality diamonds outpaces supply.

Product Expansion Could Bring Risk Tiffany risks overextending its brand as its smaller stores in smaller markets continue to grow and as new products are offered. Tiffany also sells a wide range of gifts, lower-priced fashion and designer jewelry, and nonjewelry items. Attempts to grow more aggressively in nonjewelry areas could hurt the image of the core business in the long run. Although some lower-priced items carry higher gross margins, the expensive diamonds for which Tiffany is known extend throughout the company's offerings. Yet somewhat ironically, selling the most expensive diamonds can lower gross margin percentages on average, and although exclusive high-end sales can enhance the brand, there is a risk that an overreliance on high-end sales could affect gross margins. Historically, however, new product positioning and volume are carefully controlled by management with thought to protecting the core businesses and Tiffany brand. We've assigned Tiffany a medium fair value uncertainty rating, denoting our view of a narrower range of outcomes.

Competition in the domestic diamond market is not insignificant, and the jewelry retail market has traditionally been very fragmented. In addition to the market entry and growth of Internet specialists such as Blue Nile NILE, all retailers are increasing competition online, where comparing ring prices is faster and easier. Blue Nile has also put more focus on the high end of the market, although our wide-moat rating for Tiffany suggests we believe this risk is minimal. Competitors such as Richemont CFR (parent of Cartier) and LVMH MC (parent of Bulgari) compete for premium positioning and high-end consumers' loyalty, but not on price.

Over the long run, Tiffany runs the risk that marriage rates could continue to slow and even decline or that the custom of offering a diamond engagement ring to brides-to-be changes.