Is Signet's Decision to Tie the Knot with Zale All it's Cracked Up to Be?

                                         

Source: Wikimedia Commons

On Feb. 19, 2014, shares of Zale (UNKNOWN: ZLC.DL  ) , one of the largest jewelry stores in the U.S., soared over 40% in response to news that it was being acquired by Signet Jewelers (NYSE: SIG  ) for $21 per share. At that price, it implies a market capitalization of $690 million, quite small compared to Signet's $7.5 billion or Tiffany & Company's (NYSE: TIF  ) $11.3 billion, but nothing to scoff at. Given this move by Signet, is the company an attractive opportunity for the Foolish investor or is its strategic decision a harbinger of bad times ahead?

What's in it for investors?
In exchange for the high price of the acquisition, shareholders who own a piece of Signet will receive a business that made $1.9 billion in revenue in 2013. In aggregate, management expects that the sales of the two businesses will amount to $6.2 billion.

On top of seeing its sales rise significantly, Signet believes that the Zale acquisition will result in a great deal of synergies. Within three years of the completion of the transaction, the company expects to see $100 million worth of synergies per year. What this means is that this is the expected cost savings that will develop as a result of the company's ability to greater utilize its market position with suppliers, combined with reduced corporate costs.

Is the deal too rich for Signet?
Given the premium that Signet placed on Zale, shareholders might think they are getting a strong and attractive company in return. However, this doesn't appear to be the case. Over the past four years, Zale has significantly lagged both Signet and Tiffany in terms of revenue growth and net income growth.

Between 2010 and 2013, Zale reported revenue growth of 17% from $1.6 billion to $1.9 billion. Although this may appear strong, it actually falls quite short of the 22% rise in revenue experienced by Signet, which rose from $3.3 billion to $4 billion. While Signet's revenue growth was strong, even it pales in comparison to the 40% jump in sales reported by Tiffany. Over the past four years, Tiffany saw its revenue rise from $2.7 billion to $3.8 billion.

In terms of profitability, Zale has been at the bottom of the barrel but has seen some improvement over time. Between 2010 and 2013, the company's net income turned from a loss of $93.7 million to a gain of $10 million. On top of benefiting from rising revenue, the company saw its cost of goods sold decline from 49.6% of sales to 47.9%, while its selling, general and administrative expenses fell from 52.4% of sales to 48.5%. A four-year picture of each company's cost of goods sold and selling, general and administrative expenses in relation to sales can be seen in the two tables below:

Source: MSN Money

Source: MSN Money

In contrast to this, both Signet and Tiffany performed immensely better over this timeframe. Between 2010 and 2013, Signet saw its net income jump an impressive 129.1% from $157.1 million to $359.9 million. Despite seeing a slight uptick in its selling, general and administrative expenses, Signet's management reported that its cost of goods sold declined drastically, from 67.4% of sales to 61.4%.

When it comes to revenue, Tiffany took the cake but this wasn't the case when looking at profitability. Between 2010 and 2013, the company saw its net income rise 57% from $264.8 million to $416.2 million. Over this four-year period, the company saw most of its improvement come from higher sales, but also enjoyed a slight decline in its cost structure.

Foolish takeaway
Right now, Zale's financial performance looks to be less-than-ideal. Not only was the company the slowest growing of its peer group; it was also the least profitable. Typically, this combination might raise some eyebrows among shareholders, but Signet's plan moving forward is quite clear. By taking a business that will significantly increase its size, Signet's management is hoping to further leverage its resources to reduce costs in relation to sales, just as it has done with itself over the past four years.

While the risks are great, the rewards are tremendous. In the event that management can make Zale as profitable as the rest of its business was at the end of its 2013 fiscal year, then both a revenue multiple and a net income multiple suggest the purchase could be worth $3.6 billion. The real question is whether or not this will come to fruition. For the Foolish investor who believes in the future of Signet and in its ability to make Zale a stronger business, the acquisition could create a great deal of value. However, if you don't think Signet is up for the challenge, now might be an opportune moment to consider investing in Tiffany.

Could this make Signet the best prospect for 2014?
Based on the potential that Signet has with its acquisition of Zale, it's very possible that the business could continue to soar.  However, does this make the company the best stock to hold for 2014 or is there something better for the Foolish investor?

There's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.


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