Like most U.S. jewelers, Signet’s sales and profits were down for its second fiscal quarter ended July 2008. The good news is that the company posted a profit; many jewelers do not generate a profit until the all-important fourth quarter selling season.

 

However, Sterling, the company’s U.S. division which represents about three-fourths of the company’s total revenues and profits, was aggressive in its cost-cutting and revenue generating programs.

 

While most jewelers cut costs, Sterling aggressively raised prices – perhaps more than any of its major chain competition. The idea was simple: implement retail price increases when traffic is slow (most people really won’t notice) and boost gross profit dollars (and if you are lucky, boost gross margins, too). In Sterling’s case, this concept worked, more or less. Its gross margin rose and gross profit dollars were strong; however, unit sales were down modestly.

 

Sterling’s management noted that its second quarter performance in both the U.S. and the U.K. was affected by three key factors:

 

o       Retail trading conditions were very challenging. While management noted that they did not appear to be worsening, there is no sign that they are getting better.

 

o       In both its U.S. and its U.K. operations, the company has taken action to realign costs, inventory and new store growth rates to reflect the weak economic conditions. In short, the company has reduced its workforce, scaled back inventory levels and cut new store openings.

 

o       Management’s goal is to at least maintain gross merchandise margins level with the prior year, after implementation of new (higher) prices earlier this year. As noted earlier, gross margins during the second fiscal quarter (April-July) were higher in the U.S. and the U.K.

 

As the table below illustrates, same-store sales were down in the second quarter, both in the U.S. and the U.K. Profits were also lower in the period primarily due to lack of sales leverage related to relatively fixed costs.

 

 

Sterling Jewelers (U.S. division of Signet Group)

Our analysis below focuses on Sterling Jewelers, the company’s U.S. operating division.

 

• Sales were down in the U.S. in both the first half and the second quarter. In the U.S., unit sales declined somewhat, but the average transaction value was up.
  • The average transaction rose by 7 percent in the company’s mall brands and by 6 percent in Jared during the first half of the year.
  • The average transaction rose by 8 percent in mall brands and by 7 percent in Jared during the second fiscal quarter, reflecting increased retail prices. The company implemented a new pricing architecture (management’s code words for “raised prices”) in February and March of this year.

Management noted that “going out of business” sales by Friedman’s and liquidation sales by Zale had hurt its revenue in the first half of the year by an estimated 2 percent or so. Both of these events are now essentially over. However, there will be some impact from Whitehall’s liquidation sales in the second half, but it should be mostly over prior to the all-important 2008 holiday selling season. Further, we believe that Whitehall simply isn’t as large a factor in the market as Zale or Friedman’s. It has fewer stores, and its goods have already been picked over, so there really isn’t much to sell.

 

• Sterling’s U.S. division gross margin was up solidly in the second fiscal quarter and first half of the year. During the first half, its gross margin rose by 90 basis points, and during the second quarter, it rose by 110 basis points. The company’s “gross margin” is not calculated on a comparable basis to the typical U.S. jeweler’s gross margin, so it is not meaningful to show it. However, the company’s underlying unreported “raw merchandise margin” is similar to most other jewelers, in our opinion.
  
  While unit sales were down modestly, management believes that its Sterling (U.S.) division generated greater gross profit dollars than it would have without the price increase which was implemented in the first quarter.

• Advertising spend has been reduced modestly. Signet’s gross advertising-to-sales ratio will drop to about 7 percent of sales for the full year from 7.5 percent last year. National television advertising for Kay and Jared has been least affected. However, due to advertising price inflation, Kay television impressions will be down by about 6 percent while Jared’s impressions will be about flat.

• The company’s bad debt level has risen above its historic range. In the first half, bad debt represented about 3.9 percent of total sales, up sharply from last year’s 2.8 percent. Management noted that higher finance income helped offset some of the bad debt expense. Customers are making smaller monthly payments and taking longer to pay off their accounts, so finance income has risen. The typical credit account now turns in about seven and one-half months, up from a prior level of seven months.
  
  The company noted that its credit sales mix has risen. For the full year ended January 2008, credit sales were 52.6 percent of total sales. While there is some seasonality to the company’s credit sales mix, it would appear that credit sales represent over 53 percent of total U.S. revenues. It also means that bad debt as a percentage of credit sales, a very important measure, has risen to near 8 percent. Based on historical levels for other credit-driven merchants, this is still at or below the industry norm. (For example, we can remember when Heilig-Meyers, a credit furniture retailer, reported bad debt levels in the mid-teen range, and Friedman’s reported bad debt levels approaching 16 percent earlier in this decade, prior to its demise.) When a credit account at Sterling has made no payments for 90 days, it is totally written off. This is a conservative approach, something that Friedman’s and others should have adopted, in our opinion.
  
  Management also noted that it had hired an outside consultant to examine its entire credit operation for potential problems, either operational challenges or flaws in the financial process. Essentially, the consultant found no material problems, according to management. However, Sterling has adjusted how it grants credit to some segments of its customer base. Even after the economy begins to recover, we expect Sterling’s bad debt levels to continue to rise before retreating to historic levels, since bad debt expense is a lagging indicator of the economy.

• Store closings will rise this year. During 2008, Sterling will close about 60 of its 1,400 stores; normally, it will close 15-20 units in a year. At the end of the fiscal year (January 31, 2009), we expect to see about 1,415 Sterling stores in operation, up a net of just 16 units from the beginning of the year. Thus, we are projecting about 76 openings, offset by about 60 closings. About ten of the closed stores are currently regional brands; those units will be rebranded “Kay” stores. Thus, the true gross closings will be closer to 50 units, with 66 units opening. Of the total closings, about 40 percent are Kay stores and 60 percent are regional brands.
  
  The net increase in new store space this year for Sterling will be about 4 percent; this is roughly half of its normal net new store space increase of 8-9 percent or so.

• Management addressed three key issues affecting the jewelry industry currently:

• Store closings – Management estimates that between 1,000 and 2,000 net closures of jewelry stores will occur in the U.S. this year, with most of the closures coming out of the middle market. We concur with this projection. There are just under 23,000 jewelers with about 29,000 doors. With the closing of Whitehall and Friedman’s, the market has lost just under 1,000 doors. The balance of the closings are occurring among specialty independent jewelers who think they can compete with Kay, Zale, and other middle market merchants.

• Industry capacity and consolidation – This is closely related to jewelry store closings, but is a “bigger picture” concept. While it may be tough on merchants, those retailers and suppliers who are forced out of business take capacity out of the industry. With reduced capacity, those merchants who survive are in a better position to capture market share when the recovery occurs.

• Online sales – Estimates of online jewelry sales vary widely. The latest numbers from the Department of Commerce indicate that just over 7 percent of all jewelry sales occur online. However, about half of those sales are made by bricks-and-mortar jewelers through their own websites, over eBay, or through some other online distribution channel. Thus, we believe that about 3.5 percent of all jewelry sales are made by “pure” (or relatively pure) online jewelry merchants who have no traditional stores. Sterling says it “can make a profit” (this is code for “we haven’t made a profit yet”) with its online sales model (remember, Sterling just implemented e-commerce in the fall of 2007). Currently, Sterling’s online sales are just under 1 percent of total revenues in the U.S. market. Our best guess is that Sterling’s online business will be about $25 million this year, or just under half of Zale’s online revenues of $55 million for the fiscal year ended July 2008. Sterling’s online business is growing “at a very healthy rate,” according to management.