Signet Buys Zale: Does Tiffany Need to Worry?

Source: Tiffany.

Signet Jewelers (NYSE: SIG  ) announced on Wednesday that it's buying rival Zale (NYSE: ZLC  ) for $1.4 billion. The deal makes a lot of sense for both companies, and it also raises an important question for Tiffany (NYSE: TIF  ) : Does the high-end jeweler need to be concerned about this fusion?

A jewel of a deal
Both Signet and Zale were rising steeply after the announcement, in the area of 18% and 40%, respectively. This puts the price of Zale above $20.90, quite close to the $21 per share Signet is paying, and shows that the market believes there is a high probability of the deal being completed as announced. As for the rise in Signet, that's most likely signaling that investors believe the purchase is a smart move by the company.

The enterprise value of $1.4 billion, of which Signet will be paying $690 million in cash and the rest in assumed debt, represents an adjusted EBITDA ratio of 7.4 for Zale, and will generate combined sales of $6.2 billion for the new company. Management estimates it will extract cost synergies in the area of $100 million over three years from the deal.

From a strategic point of view, the deal looks like a good idea for both companies. Zale has made a remarkable turnaround over the last several years: The company has improved its operations by closing unprofitable stores, and management has done a sound job in enhancing merchandise and repositioning the company's brands.

In 2013 Zale reported profits for the full year for the first time since 2008, so Signet is buying a company with strong operational and financial momentum.

Besides, the combined company will offer huge geographical exposure, covering not only the U.S. but also Canada and the U.K. Signet owns more than 1,400 stores in the U.S. and nearly 500 in the U.K., while Zale owns a total of 1,680 stores and has the leading market position in Canada with its 146 Peoples Jewellers locations and 53 stores operating under the Mappins Jewellers brand.

In addition to geographical reach, the deal offers many other advantages, like opportunities for cross-selling, optimization of the brand portfolio, product-sourcing synergies, economies of scale, and increased financial resources. Considering all these aspects, it's not hard to see why the market is reacting positively to the announcement.

Tiffany still shines
Two major competitors are joining forces, so investors in Tiffany need to monitor industry dynamics just to make sure there is no major shift in each company's position. However, Tiffany benefits from solid and durable competitive advantages, and it's unlikely that this new agreement will inflict much damage on the company.

Tiffany is arguably the most valuable brand in the business; image differentiation, exclusive designs, and high-quality retail locations generate superior performance for Tiffany versus the competition.

The company is in second position behind Apple when it comes to sales per square foot in the U.S. retail industry. In addition, Tiffany's pricing power is reflected in the company's profit margins: Tiffany has an operating margin above 19% of sales, versus 14% for Signet and 2% for Zale.

Tiffany is increasingly becoming a global growth play lately, and Asia is looking like a particularly promising market for the company. Sales in the Asia-Pacific region increased by a whopping 18% on a constant exchange-rate basis over the 11 months ending in December 2013, and same-store sales in the region jumped by a remarkable 11% over the same time frame.

Booming global demand for Tiffany's products is an unequivocal reflection of the company's unique brand power, and that will hardly change because of the new Signet-Zale fusion.

Bottom line
The acquisition of Zale by Signet is a smart move that will probably benefit investors in the combined company; however, that's not enough for investors in Tiffany to fear. Considering the company's competitive differentiation and international growth prospects, Tiffany looks strong enough to continue generating solid performance for investors, even in the face of increased competitive pressure.

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