FOOL ON THE HILL
The Power of Tiffany's Blue Box

In spite of the rapid downturn over the last three months of 2000, luxury goods maker Tiffany & Co. returned net profit increases of 31% for the year. Tiffany is case-in-point of how a superior brand can help a company weather all sorts of economic environments. Tiffany's trademark blue box evokes strong, positive emotions among consumers. This is neither by accident nor chance.

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By Bill Mann (TMF Otter)
April 11, 2001

Let's start with a quick image association. What company's hallmark is a robin's-egg-blue box?

Did Audrey Hepburn just flash through your mind?

What are some of the words you associate with the blue box? How about luxury, exclusivity, expensive, and desire?

These are some common words affiliated with the company in question: Tiffany & Co. (NYSE: TIF), one of the oldest jewelers in the United States. Tiffany now operates more than 100 locations in 16 countries, and though it is not the largest purveyor of luxury goods, its brand name is second to none.

That's good news for Tiffany today. Discretionary luxury items such as china, jewelry, watches, and pens are dependent upon the economic climate. A company lacking a strong brand may thrive during the high times, but when the sea goes back out, those no-clothes-wearing poseurs often wither up and blow away.

And in the luxury goods market, about the biggest differentiator is brand. Consumers demand the brand names because they stand for exclusivity and quality.

Although Tiffany is not immune from the swings in the economy, I suggest that its gilt-edged brand provides it with a buffer against even stronger fluctuations in its business. Just as importantly, the premium that the Tiffany brand allows the company to charge should make it attractive as a business. I say "should" because the world is littered with companies with incredible product advantages that also happen to be run horribly.

Still, just as there is a difference between a watch labeled "Made in Switzerland" and one labeled "Made in Thailand," the Tiffany brand allows it to add superior status to something that is, at its core, a commodity.

Tiffany has, naturally, felt the pinch of the tightening economic belt along with most other purveyors of high-end discretionary luxury items. Yet Tiffany has been in business for more than 160 years and has survived through every sort of economic swing imaginable. In fact, it has thrived. Its success as a brand can be traced to its fanatical protection of its image. Its success as a company centers upon its careful management of other, less obvious components of its business as well.

I started looking at Tiffany as an investment several years ago. I was accompanying a friend who was buying an engagement ring, and he had one hard and firm rule: The ring had to be from Tiffany. For all he seemed to care, it could have been a child's spy decoder ring, just so it came out of that robin's-egg-blue box. As an investor constantly looking for differentiated companies, this struck home with me. So did the fact that the Tiffany store in Manhattan that day was mobbed with couples doing just the same thing. Sure, the Tiffany flagship store on Fifth Avenue is a magnet for tourists and window shoppers, but there was a lot of buying going on as well.

Here's what else I noticed: Tiffany's products were expensive. Certainly some of this had to do with superior craftsmanship, quality control, and service. But just as certain was the fact that Tiffany, the name brand, had a premium attached to it. Tiffany the company was not at all opposed to charging for it, and customers seemed all too willing to pay it. If you've ever witnessed someone receiving a Tiffany gift -- or even better, been the recipient yourself -- you know the palpable excitement that comes at the mere sight of the blue box. It exudes luxury, it bleeds importance. It just seems, somehow, more special.

Brand awareness like this does not come by accident or by default. It comes only after enormous investment by the company that owns it, both in the brand itself and in the characteristics that underpin the brand. In Tiffany's case, much like Swiss watchmakers or German auto manufacturers, the core characteristic is impeccable quality.

Mark Aaron, a spokesperson for Tiffany, explained that their market research has shown over and over again that customers and non-customers alike equate the Tiffany brand with "trust." It's the same way that Volvo is synonymous with "safety" in automobiles. If you, as a consumer, want to be absolutely sure the jewelry you buy is of absolute top quality, you go to Tiffany. So complete is Tiffany's brand image that Aaron practically bristled when I listed some large-chain jewelers as its competition. Tiffany considers its true competition to be family-owned relationship-based local jewelers, as these are the types of outfits that can engender the same feeling of trust from customers.

The ultimate benefit of the Tiffany brand is in its ability to achieve higher gross margins on its products than companies that lack the same prestige. If the company is capable of translating this into superior net margins and cash flow, well, you've got yourself a company worth looking into as an investment. I found this to be the case with Tiffany.

For the fiscal year 2001, Tiffany's gross margins were 57%, or $948 million on sales of $1.66 billion. Tiffany's net margins for the year were 11.5%, meaning that for every dollar of top-line sales, the company earned more than $0.11. That's good stuff. As importantly, though, is the fact that the total profits have more than doubled since 1999. Given that the last quarter of fiscal 2001 was fairly anemic, this is an excellent result.

Still, where a great brand transcends into a great company is not in sales, but on the balance sheet and cash flow statement. For Tiffany, both are generally sparkling. The company has a debt-to-equity ratio of .26, which means that the company has very little leverage. The only balance sheet knock is that Tiffany's business requires that it hold a large amount of inventory, more than 4.7 months' worth of sales.

Tiffany's inventory, however, is decidedly low-risk. Diamonds don't spoil, nor is there much seasonality or fashion risk involved. To a certain degree, a large inventory is a cost of doing business in this sector, and the Foolish investor would be better served to focus upon inventory turns. In Tiffany's case, it turns over its inventory almost exactly once per year, a slight improvement over years past.

The cash flow statement holds some additional concern. Rapidly deteriorating economic conditions left Tiffany with $182 million more in inventory at the end of fiscal 2001 than fiscal 2000. Had that figure better reflected its five-year average for inventory expenditure, an account on the cash flow statement, the company would have created free cash flow in the range of $1.20 per share for the year. At current prices, this would put Tiffany at a price-to-free-cash-flow ratio of about 23, which does not put it in the camp of "cheap."

But Tiffany also has something most every company lacks: an enormous moat around its business. The likelihood of another company knocking Tiffany off of its pedestal is slight, and in fact Tiffany has held its position of pre-eminence so long in the luxury goods market that the most likely culprit in a degradation of Tiffany's brand advantage is Tiffany itself. Given the company's near-paranoid protection of its brand, I don't consider this to be a high-percentage bet.

Fool on!

Bill Mann, TMFOtter on the Fool discussion boards

Bill Mann bought Tiffany for his one-year-old daughter's college fund, meaning that in his house, diamonds truly are a girl's best friend. Bill's least favorite words are "some assembly required." To see all of Bill's holdings, please consult his profile. The Motley Fool is investors writing for other investors.