Signet Makes Progress

As the largest seller of affordable diamond, gold, and silver jewelry in the United States, and with significant operations in Canada and the United Kingdom,

By using its solid balance sheet and financial clout, Signet is able to offer customers of the Sterling division (principally Kay and Jared) the ability to purchase higher-ticket items--typically bridal and engagement jewelry--on credit for which it services the receivables. Because many independent jewelry stores cannot offer credit, this gives Signet a competitive advantage. The firm also buys many of its goods directly from international vendors at a price advantage compared with independent stores, which are still a large majority of the $75 billion U.S. retail jewelry industry. In diamonds and finished jewelry, Signet has buying power compared with many smaller vendors.

Signet is also one of only a few national advertisers of jewelry, and it's the only national/international jewelry retail chain in the geographies in which it operates. In the U.S., Signet has less than 10% market share, and its growth has been outpacing that of the industry. As a national retailer, it is offered better terms on leases by landlords.

As the firm continues to expand, new store openings should account for low-single-digit growth; acquisitions are not in our model but are still possible. Increased penetration of branded and limited-edition jewelry can increase average prices, which are currently around $400 and modestly higher in the Sterling division, owing to a greater penetration of engagement jewelry. Sales increases can also come from better conversion, so commissioned salespeople engage customers in the credit approval process.

No Moat Yet Although we believe Signet has a number of competitive advantages and the management team and the firm as a whole have worked hard to improve existing operations and returns for shareholders, we don't see the competitive advantages as delivering enough pricing power and high enough returns on capital to earn an economic moat rating at this time. One area to monitor to judge the power of Signet's competitive advantages will be competitors exiting and the industry consolidating. If others cannot copy Signet, market share gains and eventually returns on capital will improve.

We take a constructive view of Signet's competitive position in a fragmented market, and we also view its store portfolio and scale relative to most market competitors as relatively distinctive and hard to equal in the short to medium term. However, we would like to see higher gross margins, faster improvements in operating margins, and higher returns on invested capital. Signet's decision to retain consumer receivables reduces returns on capital, but this is part of the overall portfolio of competitive advantages that have contributed to the firm's profitable growth and distinctiveness.

The major acquisition of Zales (closed May 2014) is clouding returns on capital and reducing operating margins, although improvement is captured in our forecast. If successful, the integration and improvement of the combined operations will strengthen the scale advantages of Signet as a whole. Although Signet was already large enough to achieve scale advantages, the acquisition ensures that no new competitor can use Zales to approach Signet's size and sales levels.

Among Signet's many competitive advantages, being the largest and only national firm (targeting the affordable diamond segment) in an otherwise fragmented industry gives it advantages with vendors and in overall pricing. Selling, general, and administrative overhead leverage, advertising costs, and better terms with landlords are also significant relative to independent retailers. The firm's selling, training, and credit underwriting process also combine to form additional advantages, although these are process advantages, not structural. Although Signet may be better than the rest, it is not impossible to imagine that these advantages could not be copied in the medium to long term. Signet's size is already equaled by department and discount chain stores, for example, even if those firms do not focus exclusively on jewelry and do not have a focused proprietary jewelry credit process.

Internet retailers are also a competitive threat but thus far have not significantly consolidated the jewelry industry. Sight, touch and feel, and trust (that goods are genuine) are all factors in jewelry retail, but both the positive and negative aspects of brand trust in Signet and Internet growth are already present in Signet's competitive position. In addition, Internet-only retailers have thus far found it difficult to reach similar credit uptake rates and underwriting standards, although this area could show increased competition in the long run.

Competition Among Risks As a retailer, Signet runs the risk that competition in the industry will intensify. Although current business trends and strategies have sought to enhance customers' in-store experience, there is the risk that low-cost Internet-based retailers will continue to enter the market and take share, even at low returns on capital. In addition, some Internet retailers have begun to offer short-term credit; if successful, this poses a competitive threat. Signet also competes with department stores and discount stores' jewelry counters and with local independent jewelry retailers, which could cut prices if consolidation intensifies or liquidate inventory in an economic crisis.

Signet has grown via acquisition, and its store base is made up of a number of different brands. There is the risk that one or more of the brands may suffer a loss in brand equity and a decline in brand image, causing a deterioration in operating metrics.

The integration of Zales entails significant risk in the long and the short run. Acquired stores may fall in productivity or require a greater level of investment than anticipated.

A significant portion of the firm's business is in diamonds and products linked to engagements. Demographic trends in formal marriage have shown modest declines in the U.S. and in Europe, while the jewelry industry has grown only at GDP-like rates. Signet runs the risk that consumers may change preferences for marriage rates or the practice of giving diamond engagement rings. Signet is also subject to changes in tastes and preferences for its brand and for its fashion and gift pieces.

In addition to investing in training and merchandising, Signet is opening new stores to expand. Store openings have inherent risks, such as finding the right location and forecasting sales and operating costs. Fixed rent costs can deleverage when sales decline.

Signet has good cash flow and a solid balance sheet. Although it does finance working capital internally, retaining receivables, buying inventory, and investing in new stores, it manages those cash needs mainly with existing cash and short-term facilities. We also believe that although the inventory may be less liquid than raw commodities, gold, silver, and diamond jewelry are assets that generally retain some value even in a distressed situation.