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Stock Strategist

Settlement Doesn't Dim Tiffany's Sparkle

Premium pricing through branding, marketing, and design provides a wide economic moat.

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A dispute between  Tiffany (TIF) and Swatch over the poor performance of a joint venture to produce Tiffany-branded watches has ended, with an arbitration panel in the Netherlands rendering a verdict in favor of Swatch and assigning liability to Tiffany. Based on the arbitration panel's decision, Tiffany will pay Swatch roughly $450 million in damages; Tiffany has disclosed that it will record a charge of approximately $300 million after tax in the fourth quarter of 2013. The charge is expected to affect earnings for the fourth quarter by roughly $2.33 a share, with a similar impact on full-year earnings. Although the charge is an accrual for the end-of-year period, the actual cash payment is expected to be transferred sometime in 2014. Although a cash payment immediately would reduce our fair value estimate, the payment will be offset by the time value of money since our last update and the future improved cash flows from any increases in Tiffany's watch business that are now expected. Tiffany's current watch business is about 1% of sales and less than 1% of earnings, but the company's plans to develop its own watches with Swiss suppliers are already underway.

At the heart of the dispute, Swatch believed Tiffany did not give enough space and marketing attention to watches in its stores; Tiffany argued that there was no space requirement in the agreement. Sales were lower than both parties anticipated at the outset of the joint venture in 2007. We believe the size of the award, while perhaps surprising, indicates that a third party agreed that the size of the market opportunity was significant. Although a negative for Tiffany and a corresponding positive for Swatch, we believe the swiftness of the decision should be welcome for both companies, as management attention will now be focused on the core businesses and not the legal dispute.

Pricing Power Brings Healthy Returns
Tiffany's strong brand, high sales per square foot, and ability to price above the competition lead us to believe that the company's position in the marketplace is very sustainable, and strong returns on capital should continue for the long run. We believe Tiffany's advantages are defensible from competition, and thus rate the firm as having a wide economic moat.

In general, we believe investors should think about jewelry as a healthy-return business if a company has pricing power. Small and undifferentiated retailers generate poor gross margins, buying from wholesalers and competing on price. Brands such as Tiffany use brand image, retail locations, customer experience, selection, and designs to attract consumers 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 7% a year for the past 20 years and has leveraged comparable-store sales growth and operating efficiencies into profitability gains above the core square footage growth. Compared with other luxury retailers, Tiffany is underpenetrated in China and is now securing key locations in Europe.

Overall, 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.

Over time, operating margins can go higher, 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 then fell in 2012. Now, we believe in a normal input environment, gross margin and fixed cost leverage should improve with scale over the long run.

Tiffany's Competitive Advantages Likely to Endure
Returns on invested capital have been consistently solid for this profitable company. Premium pricing through branding, marketing, and design are the sources of Tiffany's wide economic moat and support our belief 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 in our luxury coverage. 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, for example, Tiffany's historical and continued use of popular culture such as movies to highlight the brand, which should serve to further solidify the brand's luxury positioning on a global scale.

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 impacts 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.

Risks Include Overextension, Aggressive Growth, and Competition
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. Although some lower-priced items carry higher gross margins, the sparkle of the expensive diamonds for which Tiffany is known extends throughout the company's offerings. Attempts to grow more aggressively in nonjewelry areas could hurt the image of the core business in the long run. We note, however, that historically new product volume is carefully controlled by management with the aim of protecting the core businesses and Tiffany brand. We've assigned Tiffany a medium 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. De Beers, for example, known for its influence over the price and supply of rough diamonds as well as its marketing campaigns, competes in the retail market with the help of a partnership with LVMH (although its share of diamond production has declined as other sources of diamonds have been discovered). In addition to the market entry and growth of Internet specialists such as Blue Nile, all retailers are increasing online competition, where comparing ring prices is faster and easier. Blue Nile has also put more focus more on the high end of the market, even mentioning Tiffany specifically in the media.

Tiffany also has the risk that some of its designers and licenses might not be able to be replaced with lines that will experience the same success rate. For example, Elsa Peretti has been a designer for Tiffany exclusively since 1974 and accounts for 10% of Tiffany's sales.

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 changes.

Paul Swinand does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.