Signet Jewelers (NYSE: SIG) is the world’s largest retailer of diamond jewelry, currently operating Jared, Zales, and Kay Jewelers. While many of these stores have seen double digit profit growth in the past few years, they are increasingly promoting in-house financing to drive sales. Currently 75% of SIG’s book value is comprised of these “questionably performing receivables”, according to Zander Rosenbluth of Lone Star Value Management. SIG has become more of a non-bank lender rather than a pure-play jeweler. With high delinquency-rates that continue to grow, as well as poor sales performance, Rosenbluth believes SIG is a compelling short. With SIG’s unconventional recency style of accounting, he argues the true crumbling state of the company can be seen beneath deceiving numbers and figures of their financial statements.
SumZero: What about Signet Jewelers (NYSE: SIG) initially caught your eye as a value investor?
Zander Rosenbluth: A little over a year ago, I started to notice this theme of companies promoting in-house financing for consumers (as opposed to 3rd party lenders). Many of these companies had seen their top and bottom line grow double digits in recent years. In a zero interest-rate policy environment, companies were essentially driving sales and earnings through easy credit. When a company finances its own sales and becomes a non-bank lender, the credit worthiness of the consumer becomes a discretionary decision by management. This set off an immediate red flag in my mind because management could easily be tempted to relax lending standards in order to beat analyst estimates and achieve individual performance targets. At the same time, I had also been looking at specialty retailers whose stores were primarily based in malls, where foot traffic had been declining and has continued to do so as evidenced by the recent media attention during the holiday season. These two themes aligned perfectly when I started to take a look at Signet. At the time, SIG was trading ~20x earnings, which was a slight premium to a pure play comp like Tiffany and Co (NYSE: TIF).
Signet had a little bit of everything when I took a look under the hood. The SIG thesis was like a concoction of prior short theses I had seen play out in the past. In addition, in my opinion, as time has gone on, it was evident that their management are very poor capital allocators. During fiscal year 2017, the Company repurchased ~14% of its outstanding shares (not including the dilutive effect of the Leonard Green convertible preferred stock transaction) at an average price of ~$89, well above the current stock price. In my opinion, the Company has been trying to catch its own falling knife (in the prior year, they repurchased approximately $130 million worth of shares at an average price of $128).
SumZero: What is the market missing?
Zander Rosenbluth: The main bull arguments I’ve heard most often is that the stock is cheap, they generate free cash flow, and because SIG is the largest retail jeweler in the world, they have started to face less competition as mom and pop jewelers have closed down. I’m not disputing these arguments, but there’s much more to the company when you look under the hood. For example, Signet highlighted in its Q4 2017 earnings release that free cash flow (FCF) nearly doubled in FY 2017. However, the Company did not note that FCF declined 21.4% during Q4 2017, the most significant quarter of the year (~54% of earnings).
One of the largest risks, is the credit risk associated with the company’s credit portfolio. SIG’s questionably performing receivables accounts for ~75% of book value and ~120% of tangible book value. Any impairment risk to the credit portfolio could significantly impact the balance sheet (and equity) – and there is risk, a lot of it. Aside from Signet’s credit portfolio being nearly (22.9%) delinquent (past due receivables as a % of gross receivables), they use a very rare accounting method for portfolio aging.
I also believe the market does not realize how much revenue SIG’s extended service plans/warranties (ESPs) make up as a % of total sales. While Signet does not disclose the profit margin on these plans, it is likely they make up a decent portion of the Company’s operating EPS. Last year, SIG recognized $347.8 million in ESP revenue, or 5.3% of total sales. Through the first 3 fiscal quarters of 2017, SIG has recognized $287 million in ESP revenue, or 6.9% of sales. During Q3 2017, SIG recognized $92.2 million in ESP revenue, or 7.8% of sales.
I also believe the market is missing the cannibalization risk that was accentuated with the Zales acquisition. Although my thesis originated pre-Brexit, they are the #1 retailer (tied with Michael Kors), in terms of UK exposure at 11% of sales. I additionally feel Signet is employing financial engineering and accounting tricks that do not reflect the actual state of the company.
SumZero: What will catalyze the stock to be priced correctly in your view?
Zander Rosenbluth: What I’ve loved about this short is that there are several catalysts that could propel the stock towards fair value. I have listed some below:
- Further same-store sales, revenue, and earnings declines.
- SIG coming clean on the credit portfolio and providing contractual accounting metrics, in addition to their recency metrics (World Acceptance Corp. (NASDAQ: WRLD)does this).
- A negative outlook for FY 2018 (SIG’s guidance track record doesn’t have a whole lot of credibility after last year – see chart below)
- FY 2018 Comps/EPS guidance – this is the first time SIG did not provide quarterly guidance in an earnings release. However, it is largely assumed that Q1 2017 comps were very poor. Management did not provide a firm range for FY 2018 comps (guided to “low to mid single digits comp declines) and $7.00-$7.40 EPS range (vs. street estimates of $7.65)
- Increased loan loss provisions.
- Formal end to the strategic review process: basically admitting the company’s inability to sell or monetize the credit portfolio in a way that will increase EPS. Most strategic reviews are usually formally terminated after a year if the review does not result in anything. The 1 year mark is coming up in May 2017.
SumZero: Is SIG primarily a jewelry company or a consumer financing company? Is its reliance on credit for sales growth dangerous?
Signet is most certainly not a pure play jewelry company and it certainly does not deserve to be valued like one. I like to call Signet a bank that just likes to finance jewelry. Today, Signet still trades at ~2x book value and ~3.5x tangible book value. During fiscal year 2017, Signet financed 62.0% of its sales in the Sterling Jewelers (vs. 61.5% during the same period last year), which includes Kay Jewelers, Jared, and smaller regional brands. The percentage of sales financed has been gradually increasing in recent years.
There is no doubt that the Company’s reliance on credit to drive sales growth is dangerous and you have started to see that risk reflected in the stock price recently. One reason this made Signet an attractive short was that the Company was between a rock and a hard place, especially once they announced a strategic review of the credit portfolio. If SIG chooses to outsource its consumer financing activities to a third party (which the Zales segment does with Alliance Data Systems), a third party would likely have tighter lending standards, which, in my opinion, would likely result in a credit penetration rate as low as 40%. It is no secret that the top and bottom line would likely take a large hit.
SumZero: SIG acquired Zales a few years ago: has the integration played out well or has there been detrimental effects?
Zander Rosenbluth: The Zales integration has not played out in a way that I’m sure many investors had hoped it would. Most acquisitions look great on paper when they’re in the works. However, one thing I believe Signet missed when they acquired Zales was the potential cannibalization of their Kay and Jared sales. Have you ever understood why Kay and Zales stores are often located right next door to each other in most malls? Yeah, me neither. We’re approaching the three year anniversary of the acquisition. When the acquisition closed in mid-2014, the Zales segment had an operating margin of 2.5% vs. Signet’s 13.8%. According to management, synergies from the deal have been greater than initially expected, yet Zale’s operating margins were supposed reach mid to high single digits by now. Well…now we’re 3 years out and the synergies have barely moved the needle on Zale’s operating margins (conveniently, SIG does not report segmented gross margins). At the time of the acquisition, management had stated that “operating efficiencies will drive margin and expense reduction opportunities and drive value creation.” The most recent Zales development, and perhaps one of the most alarming developments for investors is that Signet reported a negative 3.9% SSS number for Zales Q4 2017. This was the first negative holiday season SSS number for Zales since 2010.
SumZero: You mention 11% of their sales take place in the UK. Looking back, has Brexit had a large impact on its European sales?
Zander Rosenbluth: Without a doubt, albeit Brexit was not something I took into account when I first started developing my thesis on the stock. In my opinion, Brexit was sort of a gift (or another way to win) when it comes to this trade, especially when it relates to the value of the pound. FX has played a role in Signet’s sales recently (in both the UK and Canada). While retail sales had already been weak in the UK pre-Brexit, UK retail sales (ex-Auto) declined 2.2% this past December vs. a decline of 0.6% in December 2015. When Signet reported its holiday results in early January, the UK division’s sales had declined 19.8% year over year, but only declined 3.2% on a constant currency basis, which was in line with Signet’s other segments on a constant FX basis.
SumZero: What contributes to your view of SIG having a weak credit portfolio? How could SIG improve upon this situation concerning selling or holding it?
Zander Rosenbluth: The chart below kind of speaks for itself. The Company’s total delinquency rate, in addition to Non-Performing Loans (NPLs) and Net Charge-offs (NCOs), has been consistently increasing in recent years. To add insult to injury, these numbers are calculated on a recency basis, so they are likely understated by a pretty hefty margin. Renowned journalist, Gretchen Morgensen, recently pointed out that according to analysts, recency accounting tends to understate delinquencies by approximately 50%. (https://www.nytimes.com/2017/03/03/business/how-signet-jewelers-puts-extra-sparkle-on-its-balance-sheet.html). For context, the last reported average FICO score for Signet’s credit portfolio was 662 at the end of fiscal year 2016.
The only way Signet could improve upon this situation, is to significantly tighten lending standards and pull-back on financing all together. It should be clarified that most of Signet’s in-house financing is done within the Sterling Jewelers segment (Kay and Jared), while the Zales segment used a third-party lender (Alliance Data Systems). Zales credit penetration is ~40%, more than 20% lower than Sterling penetration rate. One likely reason the credit sales are significantly lower in the Zales segment is because ADS has stricter lending standards. However, Zales can also opt to use to Sterling’s in-house financing arm as a “second-look” financer (i.e. if a customer doesn’t qualify for financing through ADS, Sterling will likely lend to that customer). Of course this all comes at the expense of boosting SIG’s top and bottom line.
On the Q4 2017 earnings call, SIG’s Chairman stated: “[we] are currently deeply engaged in negotiations supported by Goldman Sachs to outsource our credit business. After evaluation of the various options available to the company, outsourcing is our preferred option. Let me repeat, outsourcing is our preferred option.” In my opinion, this was basically the Company admitting to shareholders that we were unable to sell the credit book outright because no bidder could get a solid grasp on the performance of the portfolio.
SumZero: Could SIG complete any sort of securitization that could be accretive to EPS?
Zander Rosenbluth: My simple answer is that it’s highly unlikely. I’m not a securitization expert, and I certainly don’t know all of the tricks on that side of the business, but I know the facts. First off, SIG already has its highest quality receivables securitized in a $600 million asset-based security facility through JPM. That facility expires in May 2017 – I have no idea whether or not JPM will agree to renew it. The advance rate on the ABS facility is 60% meaning it’s collateralized by $1B worth of receivables/loans on SIG’s balance sheet. Based on the numbers from the most recent fiscal quarter (Q4 2017), that leaves $858.1 million worth of loans that could be securitized in a new ABS facility. However, the remaining loans are all likely the lower credit quality receivables that have a ~23% delinquency rate using the recency accounting method (who knows what the true delinquency rate is under contractual accounting?). That leads to the next question of what advance rate could SIG receive for its lower quality receivables? And more importantly, what interest rate would an ABS lender offer SIG? Certainly not the 1.5%-2.0% that they received from JPM for its higher quality, performing loans.
SumZero: Do the recent sexual harassment allegations surrounding the company affect your position on SIG?
Zander Rosenbluth: No, they do not. While they may accelerate the timeline on my position and put a further dent in the brand’s reputation, I do not consider the sexual harassment allegations as part of my thesis. While I believe there is a lot more to this story, it is not something I consider in my fundamental analysis.
SumZero: SIG uses recency style accounting which is not common among major companies. Can you explain what recency accounting is and how it impacts an investor’s view of SIG?
Zander Rosenbluth: There are two primary accounting methods for determining when a loan is delinquent and how a company calculates loan provisions: contractual and recency. The contractual method is fairly straightforward. Under the contractual method, delinquency is calculated by the numbers of payments that were due and a customer has failed to pay. For example, if I missed 2 consecutive monthly payments on my car loan, my loan would be considered to 60 days past due. However, if during the 3rd month, I make my normal monthly payment, in addition to the previous month’s payment, my loan is still not current. In other words, just because I was able to make a late payment, it doesn’t make my loan “current”. Most companies use the contractual method because, as the Federal Reserve states, “in general, the contractual method provides a more accurate reflection of loan performance and, therefore, is the preferred methodology, especially from the standpoint of financial statement transparency and public disclosure.”
In comparison, under the recency method, my loan would be considered current because I was able to make a qualifying payment. Under Signet’s recency-aging method, my loan is considered current as long as I make a qualifying payment (which, as defined by Signet can be no less than 75% of the scheduled payment). To quote James Grant (that of Grant’s Interest Rate Observer, not Signet’s Head of Investor Relations), “A layman might call it forgiving”. I might call it slightly deceiving to the average Joe, despite recency accounting is permitted under GAAP.
Just how understated are Signet’s delinquent receivables? We likely won’t know the answer to that until Signet chooses to disclose that information. Even the SEC recently asked Signet what its delinquent receivables would look like if it used contractual accounting, but Signet largely evaded the question with technicalities (https://www.sec.gov/Archives/edgar/data/832988/000162828016020105/filename1.htm). Some auditors have even refused to sign off on a Company’s financials if they use recency accounting. In 2014, KPMG resigned as WRLD’s auditor because “World did not have adequate policies in place for how it determined allowances for loan losses, nor did it have a control in place as to whether renewals were booked according to GAAP.”
What was the Chairman’s explanation for the Company’s use of recency accounting? “In reality, the recency method actually enables customers to better maintain their credit rating. And we are, after all, interested in serving our customers.” I was personally baffled by this statement.
SumZero: Can you see SIG possibly bouncing back from its decreased sales and earnings numbers? Is the poor performance reflective of the company or the industry as a whole?
Zander Rosenbluth: Signet has a long way to go before it can organically recover sales and earnings without loosening credit standards to an even greater extent and repurchasing a whole lot more shares. Total sales for FY 2017 were down 5.1% (-3.3% on constant Forex basis). In my opinion, if Signet is to eventually bounce back, it will have to provide more transparency into its credit portfolio and will have to weather the negative PR storm regarding the recent diamond swapping and sexual harassment allegations. I also believe that SIG would likely need to gut the entire management team, not just the CEO, for any turnaround to be effective.
While I wouldn’t say the jewelry industry is particularly strong right now, it historically has a CAGR of approximately 3-4%. However, Signet’s performance is more of a company specific issue. While Tiffany’s (TIF) is not a perfect comparison, it is Signet’s closest publicly traded competitor. Year to date, Signet has significantly underperformed Tiffany’s. SIG is down ~33%, while TIF has risen ~19%. In addition to the obvious underperformance, it is important not to forget the fact that the top and bottom line has likely been artificially inflated by overextending credit.
SumZero: What key metrics should investors be paying attention to as your thesis matures?
- Comps/Same Stores Sales (SSS)
- Adj. EPS (how much longer will SIG continue to adjust EPS for Zales “integration” costs, which are consulting costs associated with information technology ("I/T") implementations? After 3 years, that’s not exactly a one time-charge)
- Non-performing loans/allowance for loan and lease losses
- Credit participation rate
- Total Delinquencies (past-due receivables as % of gross receivables)
- Net-charge offs
SumZero: What are the biggest risks associated with the trade in your view?
Zander Rosenbluth: The biggest risk to the short is the company being able to complete some kind of sale of the credit portfolio. This would likely lead to significant multiple expansion as they would revert back to more of a pure play specialty jeweler. However I believe that any sale of the credit portfolio is unlikely, without Signet’s receivables taking a significant write-down or being sold at a significant discount to book value. For a bit of perspective, Nordstrom sold their credit portfolio to TD last year at exactly book value, but 79% of Nordstrom’s receivables were considered prime at the time. Signet’s portfolio quality is nowhere close to being 79% prime. I could also see a buyout scenario where a PE firm acquires Signet, but I still believe the share price has a good amount of downside before that would occur.
SumZero: Tell me about your investing background and investing mentors and heroes.
Zander Rosenbluth: I have been investing in stocks since the day I was allowed to open my first brokerage account. I have always had this drive to seek out value in places where other investors weren’t seeing it. I also have this crazy desire to consume as much information and learn as much about a specific topic (or in this case, company) as possible. Some might call this “FOMO” or a “genetic defect”, but I like it call it “attention to detail”. I consider myself somewhat of Philomath.
Upon graduating from college, I started my professional career at a long/short value fund that takes a hands on approach to its investments via shareholder activism. I learned more than I ever expected in my first year and began to research potential short ideas for the fund. Short selling came somewhat naturally to me as the research experience I gained on the activist side of the business translated very well. The skill sets are not all that different. However, I want to be clear that I consider myself, first and foremost, an investor – I like investing in good companies and shorting bad ones, simple as that.
I could name dozens of mentors on both sides of the trade, but one particular
“character” that stands out on the short side is Marc Cohodes. The most important lesson I’ve learned from Marc is that it’s imperative to have multiple ways to win the trade, or as he so lovingly phrases it “I prefer to have five shooters on the target than one.” In reality, he usually has more of an army of shooters. He’s one of a kind, not your typical Wall Street investor. It’s been an honor to learn from a man like MC. There are very few individuals of his caliber out there who are willing to openly discuss ideas and help mentor what he calls the “next generation.” I highly suggest everyone read the recent Bloomberg feature on Marc, written by Tom Redmond. It’s a learning experience in and of itself. (https://www.bloomberg.com/news/features/2017-02-09/the-world-according-to-free-range-short-seller-mark-cohodes)
SumZero: What advice would you give to someone interested in pursuing investing?
Zander Rosenbluth: I like to read as much as possible. Get familiar with financial statements, read lots of 10-Ks. My favorite thing to do is read about different investors and their approaches to both the long and short side. On the short side, I’ve found it particularly helpful to read case studies of successful short theses. Another important piece of advice is that emotional intelligence is key in investing, don’t risk becoming your own worst enemy. Always be open to reevaluating your thesis and hearing the other side of the story, but just because the stock price moves against you, does not mean your thesis is wrong.
When you go through the investment decision process, always have high conviction and make sure there are multiples angles at which you can “win the trade”. As a value investor, a cheap valuation doesn’t necessarily mean it’s a good investment. Some stocks look cheap for a reason (i.e. SIG). And especially with regards to short selling, overvaluation alone is not a reason to short a stock. You have to ask yourself what am I missing that the market isn’t (and vice versa)? In other words, it’s important to differentiate between a value stock and a value trap.
Lastly, leave no stone unturned. Something doesn’t look or seem right to you? Do your homework, find out where to look, and dig until you find your answer.