Image Source: Signet Jewelers Limited – FY2019 10-K
By Callum Turcan
Embattled Signet Jewelers Limited (SIG) is the leading specialty jeweler by sales in the U.S. and the U.K., with 90% of its sales and the vast majority of its operating losses generated in North America as of its 2019 fiscal year (which ended February 2, 2019). Its leading retail store brands include Kays, Jared, and Zales in America, H. Samuel and Ernest Jones in the U.K., People’s in Canada, and Signet Jewelers also runs kiosks in America under the Piercing Pagoda brand name. As of this writing, Signet Jewelers yields 7.0% and cautions that its relatively high yield is largely a product of very weak share price performance. The company's stock price has been on a downward tear since late 2015 and it’s easy to see why. Gross margins are eroding, same-store sales have been declining, and operating expenses as a percent of sales continue to rise, yet Signet Jewelers has been attempting to scale back.
Capital Allocation and Dividend Coverage Commentary
As Signet Jewelers generated $0.7 billion in net operating cash flow in FY2019 while spending $0.1 billion on capital expenditures, the firm’s $0.6 billion in free cash flow easily covered $0.1 billion in total dividend payments (common dividend payments plus dividends paid on redeemable convertible preferred shares). Share buybacks consumed $0.5 billion in FY2019, and we caution that due to the precipitous drop in Signet Jewelers’ share price over the past few years, that money could have been better spent. During the firm's latest quarterly conference call with investors, management stated that:
Moving on to cash generation. Our fiscal 2019 adjusted free cash flow was below prior year trends, driven by lower operating income and primarily due to higher levels of inventory. In fiscal 2020, we expect to improve our cash generation and are highly focused on lowering our inventory levels as we work through legacy product and implement a more enhanced planning process under our new leadership. We also expect our capital expenditures to reflect lower investments in new stores as we rationalize our physical store footprint somewhat offset by continuing investment in IT to support e-commerce and systems upgrades."
Signet Jewelers had $0.2 billion in cash on hand at the end of FY2019 versus $0.1 billion in loans and overdrafts and $0.65 billion in long-term debt, good for a net debt position of $0.55 billion (up marginally from year-end FY2018 levels). We would prefer Signet Jewelers consider using its free cash flow to pay down debt instead of repurchasing shares, and that appears to be the plan. Management noted in Signet Jewelers' FY2019 10-K that:
Based on projected investments and liquidity needs, the Company expects to maintain its quarterly dividend rate of $0.37 per share but does not anticipate share buybacks for Fiscal 2020. The Company has a remaining share repurchase authorization as of the end of Fiscal 2019 of $165.6 million.
If Signet Jewelers were to materially reduce its annual interest expenses via deleveraging, thus removing a major obstacle to future dividend growth, the company would likely represent a better investment opportunity. Note that Signet Jewelers’ outstanding diluted share count fell by 29% from FY2017 to FY2019.
Recently, we adjusted our discounted cash flow model for Signet Jewelers and derived a fair value range of $14–22 per share, with $18 per share as our midpoint. Even after the severe beating SIG has taken, we are still pessimistic as shares trade well above the midpoint of our fair value range. In order to justify trading at the upper end of our range, Signet Jewelers would need to show meaningful signs of improvement. As the company gets ready to report first-quarter FY2020 earnings on June 6 before the bell, keep in mind the various problems facing the company, and what it will take to revive its financial performance.
In particular, Signet Jewelers needs to show progress on reducing its operating expenses as a percent of revenue as its store count and employee headcount move lower. The company needs to also show that closing underperforming stores and revamping its remaining locations will eventually lead to same-store sales growth and gross margin expansion. At the very least, same-store sales growth needs to stop coming in negative and gross margins need to hold firm.
Signet Jewelers’ guidance for FY2020E calls for $6.0–6.1 billion in revenue (down from FY2019 levels), same-store sales growth of that ranges from negative 2.5% to flat (at the midpoint, that represents a decline from -0.1% in FY2019), non-GAAP adjusted EPS of $2.87–3.45 (down from $3.72 in FY2019 and $6.51 in FY2018), and the firm plans to maintain its $0.37 quarterly dividend payout.
Turnaround Still has a Ways to Go
While Signet Jewelers has been able to aggressively reduce its employee headcount, as you can see in the picture below, that hasn’t translated yet into improving margins. In FY2017, SG&A expenses represented 29.3% of Signet Jewelers’ sales on $6.4 billion in revenue. By FY2019, when Signet Jewelers’ average full-time employee headcount had dropped by almost 6,600 (equal to a decline of 22%), the firm’s SG&A expenses as a percent of sales had actually increased to 31.8% on $6.2 billion in revenue. Part of that increase stems from a modest decline in revenue, but most of the margin deterioration comes from Signet Jewelers not effectively controlling costs.
Image Shown: Signet Jewelers’ employee headcount has steadily moved lower over the last few fiscal years. Image Source: Signet Jewelers – FY2019 10-K
Even worse, Signet Jewelers’ gross margin has contracted from 36.8% in FY2017 to 34.6% in FY2019, putting a tremendous amount of downward pressure on its income-generating capabilities. As Signet Jewelers’ top-line shrunk by almost 3% during this period, it’s clear management is attempting to bolster revenue generation by accepting lower margins. In FY2017, FY2018, and FY2019, Signet Jewelers’ comparable store sales dropped by 1.9%, 5.3%, and 0.1%, respectively, versus the previous fiscal year. Signet Jewelers’ has a long way to go before growth returns.
The company is shutting down underperforming locations in a bid to bolster its financials. As of early February 2019, Signet Jewelers operated 2,760 stores and 574 kiosks, which represented a decline of roughly 6% for both categories versus year-end FY2018 levels. Closing down underperforming locations should in theory help reduce operating expenses and could potentially bolster the firm’s gross margins, but so far neither instance has been the case.
Image Shown: Declining same-store sales has been putting tremendous pressure on Signet Jeweler’s top-line and its gross margins. Image Source: Signet Jewelers – FY2019 10-K
Adjusted EBITDA has been on a steady downward trend since FY2017, declining by 59% through FY2019. Put it all together, and the last couple of years have been brutal for Signet Jewelers, which largely explains the poor stock price performance of SIG shares. After peaking in late 2015 (calendar year) at over $150 per share, SIG shares are now trading just above $21 per share as of this writing.
We will be monitoring Signet Jewelers' performance going forward, keeping in mind that the distressed company still has a lot of work to do as its Path to Brilliance turnaround strategy unfolds. During Signet Jewelers’ latest quarterly conference call management noted that:
Turning to margins. A key component of our Path to Brilliance plan is reducing costs customers do not see or care about to fund growth initiatives and improve our profit margins. In fiscal 2020, we expect to generate higher growth cost-savings to fund increased investment in OmniChannel and innovation, resulting in net cost savings of $60 million to $70 million. These include direct and indirect procurement savings, workforce reductions, consolidation of facilities, and lower corporate costs.
We continue to optimize real estate, working toward a portfolio of fewer better stores that deliver a fully connected OmniChannel journey that delights our customers and generate higher financial contribution. By the end of fiscal 2020, we expect we will have reduced our store base by 13% over a three-year period, materially reduced our exposure to lower-grade malls, and simplified our portfolio by exiting most of our regional banners. We expect overall store count at the end of the transformation plan to be lower than fiscal 2020 year-end levels.
As the store footprint is strategically reduced and repositioned, we believe we can increase productivity and make more focused impactful investments in compelling digitally-enabled new store designs, as well as a targeted store experience updates across the portfolio. In addition to our sales growth initiatives, cost savings and real estate efforts, we expect to drive operating margin expansion through adding more differentiated exclusive merchandise, modernizing and simplifying IT systems, and generating a greater mix of higher margin service revenue.”
Signet Jewelers aims to achieve double-digit, e-commerce growth in FY2020 by expanding its services business and improving the online customer experience. IT cost savings are also expected. Back in 2017, Signet Jewelers acquired online jewelry retailer R2Net for $328 million in cash to bolster its online presence and enhance its ability to cater to millennial demand.
Other than upgrading its digital capabilities and attempting to control costs, Signet Jewelers thinks it can revive its business by expanding its Piercing Pagoda offering. The only segment to experience growth during the final quarter of FY2019, Piercing Pagoda is likely one of (if not the) the best ways for Signet Jewelers to revive top-line growth.
What’s appealing about Piercing Pagoda is the services side of this business, which involves offering piercing services to its customers. One could imagine that there is a decent chance customers who receive Piercing Pagoda’s piercing services are also decently likely to purchase products from the store. Furthermore, services margins tend to be much stronger than retail margins and there is a chance for reoccurring revenue streams. Signet Jewelers plans to roll out Piercing Pagoda at several of its Kay stores during the second half of FY2020, and management is very optimistic on this business. Over time, Signet Jewelers hopes services will become a material driver of revenue growth. There is room for optimism but as Signet Jewelers is facing major headwinds across the board, Piercing Pagoda needs to do more than just grow, it needs to outperform.
As Signet Jewelers is still very free-cash-flow positive, we aren’t worried about its ability to keep paying its dividend anytime soon. The company’s high yield is largely a product of weak share price performance. Signet Jewelers should consider serious net debt reduction going forward as the firm is no longer planning on repurchasing a material amount of its shares. That would not only free up additional cash flow and bolster its bottom line at a time of great financial distress but would also remove a major cloud over its long-term trajectory. Investors are worried that Signet Jewelers’ free cash flow could decline as its financials weaken, but that would be less of a concern if the firm had a nice net cash position. We aren’t interested in Signet Jewelers as the market has richly priced shares of SIG, yet its turnaround story has yet to yield meaningful signs of improvement.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: Callum Turcan works as an independent contractor for Valuentum Securities.
Additional disclosure: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.