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Tiffany & Co. – Investment Thesis (27 Sept 2019)

I’d like to own either Hershey’s or Tiffany’s if it’s the right price, wouldn’t you? It’s just a question of price. Of course they are good companies …”

Charlie Munger, 2018 DJCO ASM

What does the company do?

Tiffany & Co (“TIF”) manufactures and sells jewelry, watches, leather goods, sterling silver, china, crystal, stationery, fragrances and other luxury accessories. TIF is one America’s few heritage global luxury jewelry brands, with a storied history that started in New York City over 182 years ago (founded in 1837). TIF is also one of the few vertically integrated jewelers globally, ensuring enduring perception of quality and luxury to products and services. TIF operates four segments including Jewelry Collections (53% FY18 sales), Engagement Jewelry (26% sales), Designer Jewelry (12% sales) and Other (8% sales). TIF currently operates 317 company owned stores (90% of sales are offline) with total sales of $4.4bn in LTM Jul-19. TIF store footprint is split 40% U.S., 28% Asia, 18% Japan and 14% Europe; with LTM Jul-19 sales split 44% U.S., 28% Asia, 15% Japan, 1% Europe, and Other c.2%.

How does the company operate into its industry, both positively and negatively?

90% of TIF sales are through its own-store footprint with the remainder through a growing online channel, wholesale distribution in emerging markets, diamond wholesaling and licensing agreements. TIF’s industry position is defined by its brand moat, immortalized by the 1961 movie ‘Breakfast at Tiffany’s’. It is currently ranked #6 most valuable global luxury brand by Interbrand (2018), and #1 American luxury brand, with an estimated brand value c.$5.6bn (c.50% of equity value). TIF’s product range is dependent on old-world classic jewelry designs (expensive ‘traditional luxury’), as well as new innovative designer collections (‘inclusive luxury’), which enables customers to start purchasing Tiffany at a young age. The entry-level designer collections are a recent introduction since 2017/18 and have been successful in increasing new customer engagement, leading to higher sales growth in FY18 vs. prior two years. This is also beneficial over the mid-term as new customers return as loyal customers, upgrading the value and frequency of purchases. Within the TIF product range, Jewelry Collections (c.56% of FY18 sales) are a higher proportion of sales vs. Engagement Jewelry (c.26% sales) which naturally acts to lower earnings volatility by enabling more frequent product refreshes and higher purchasing occasions.

Core to TIF’s proposition is market leadership in ethically produced jewelry and traceability, however, this comes with increased cost of operations and lower margins compared to luxury peers (LVMH, Richemont, Tapestry, Capri Holdings, Sotheby’s). Competition for Engagement Jewelry is increasingly intense and TIF’s emphasis on quality increases costs further. As a luxury retailer, TIF’s business is also seasonal, with over one third of sales and net earnings occurring over Q4 holiday season.

What are the key drivers for profitability?

Global luxury consumer spending is a key driver for TIF sales. The industry is currently two years into a recovery with organic sales growth up 10-15% since H1 2016. The sector is also surprisingly resilient to economic cycles. Over the last 20 years, organic growth has been positive every single year since 1996 except for one year (2009) following the global financial crisis, as measured by the Credit Suisse Luxury & Spirits Index. The sector is not immune to recession with an organic decline of c.-8% in 2009, however the sector also rebounded quickly with c.+15-20% organic growth in 2010 and 2011 (the years after the global financial crisis) and sector organic growth has remained positive since.

The largest single driver of growth and profitability for TIF is its direct access to domestic China consumers, the largest and fastest growing luxury market globally. TIF’s 35 owned domestic China stores delivers its luxury proposition directly to consumers and supports its China online channel – a new partnership with Alibaba in 2019 to provide access to a huge new and untapped consumer base outside Tier 1 cities. Domestic China sales and Chinese tourist sales (outside China) represent c.16% and c.13% of total sales respectively. There is ample opportunity to grow store footprint in China (currently only c.13% of total TIF stores are in China despite China’s leading market size) and introduce new higher priced products from the global range which are not currently sold in China. Analysts covering TIF focus on Chinese tourist spending, which is declining for several reasons including poor US-China trade relations, weakening RMB and the Chinese government encouraging domestic spending (i.e. lowered luxury taxes). However, declining tourist spending is more than offset by re-direction to Chinese domestic spending, as tourists now stay home and purchase at typically c.10-20% higher RMB domestic prices vs. USD prices. This significantly benefits TIF’s growth and margins – domestic China sales are growing at 25% CAGR L2Y vs. relatively flat growth across all other regions. In addition, as TIF ‘moves east’ it will benefit from higher ASP plus lower retailing, manufacturing and logistics costs. The size and combination of these impacts have been underestimated by current consensus estimates. For example, 10% of total sales repatriated from tourist to domestic China spending would represent an incremental c.$350-500m NPV of equity value (assuming 20% higher ASP and earnings valued at 25-35x P/E). This quantum of repatriation could be easily achieved in the short-term by the Chinese government’s current crack-down on shadow (‘illegal’) imports, forcing Chinese domestic consumers to purchase from official stores.

How do you value the company? – Current Price: $91.88. Target Price $120 (+31% upside to current)

TIF’s current valuation has been dislocated by recent events unrelated to business fundamentals, with its share price down c.30% since June 2018. This decline has been impacted by (i) concerns over global recession resulting in lower sales growth estimates of c.2-3% p.a., (ii) decline in Chinese consumer spending due to the ongoing US-China trade war and Chinese government anti-grafting policies, and (iii) analysts’ focus on Chinese tourist spending rather than a holistic view of total Chinese consumer spending (i.e. domestic repatriation of spending at higher ASPs).

Maintaining sales growth remains a concern for TIF. Whilst sales have been slowly recovering from negative growth in FY16 and FY17 to growth of 6.5% FY18 (up from 4.5% in FY17), there has been a recent slowdown with LTM Jul-19 growth of c.-2.5%. TIF’s ability to leverage its China platform should alleviate these concerns. In addition, EBITDA has remained flat around c.US$1bn since 2015, with margins stable c.22-26%. TIF maintains a strong balance sheet, has accelerated share buy-backs, grown dividends 16 times over the last 15 years and currently yields c.2.3%. There is c.$700m of cash in the business (c.6% market cap) and $500-700m of FCF generated per year equivalent to c.4-6% of the market cap.

TIF appears undervalued based on several metrics. Broker consensus DCF models yield a share price between US$100-120 per share. Accounting for further upside from repatriation of tourist sales back to China (as described above) yields up to an additional US$500m equity value, or c.US$4 per share. On top of this, an accelerated growth in China domestic offline (Tier 1 cities) and success in developing the China online channel (Tier 1/2/3 cities) would lead to a game changing uplift in earnings and multiple re-rating. On a multiple basis, TIF currently trades at c.18.1x NTM P/E, a substantial discount to historical averages of c.19-21x over the last 1-3 years, with peak multiples in the range of 25-30x P/E prior to renewed US-China trade tensions in 2018. In addition, TIF has historically traded at a premium to luxury peers although in recent months this has narrowed – TIF currently trades at 12.6x NTM EV/EBITDA and 18.1x NTM P/ E vs. 11.6x and 16.5x for peers). The most recent period where TIF’s multiple premium to peers compressed in a similar fashion was in December 2018, which was then followed by significant outperformance of TIF shares (+40% over 3 months), re-establishing TIF’s historical average c.+3x P/E multiple premium to peers. Finally, TIF also represents a right-sized target for buy-out by private equity (e.g. Asian PE funds which can leverage existing Chinese retail and big-data portfolio companies to achieve synergies, for example Hill House and C-Trip), or Euro/Chinese luxury strategic peers seeking mono-brand acquisitions continuing the trend of consolidation in the luxury sector. Notably, the current CEO Bogliolo (joined 2017) was previously COO of Bulgari during its sale to LVMH in 2011 for 21x EV/EBITDA. Over the last decade luxury sector consolidation has occurred at an average M&A multiple c.17x LTM EV/EBITDA. At this multiple, TIF would be valued at c.$133+ per share (c.$16bn equity value) using consensus earnings. There are multiple levers for price appreciation in TIF stock with mid-term catalysts being resolution of US trade tensions, strong Chinese domestic sales in H2 2019 and above-consensus sales from refreshed product lines released in H2. Co-operative activist shareholder base is also a positive for the stock.

Key risks

US dollar strengthening impacting sales to tourists and operating costs, a sharp deterioration in global luxury consumer spending, Chinese government retaliatory policies against US retailers (including tariffs which cannot be passed on to consumers), an inability to capture online sales growth in China, and a rapid shift in consumer preferences for highly discretionary and large ticket purchases.

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