Todd Lebor began our search into the jewelry industry yesterday by comparing the mysteriousness of the diamond business to Warren Buffett's mystifying investment analysis. Todd failed to mention, however, that Berkshire Hathaway (NYSE: BRK.A) has a sizeable stake in the industry through three subsidiaries, Borsheim's and Helzberg's Diamond Shops and Ben Bridge Jeweler. Like Warren, we can't get enough of emerald diamonds and South Sea golden pearls.
As Todd stated, we need to carefully consider the threat of competition from De Beers, which controls 70% of the market for rough diamonds, before investing in Tiffany's (NYSE: TIF). The inventory requirements in the jewelry industry have also caught our attention. Seventy percent of Tiffany's current assets, for instance, are made up of inventory. High inventories lead to lofty Foolish Flow Ratios and poor working capital management, which we don't like.
The importance of the Foolish Flow Ratio has been well documented in this space before. Its significance centers on the importance of cash. We want Rule Maker companies to use their cash efficiently, which means bringing money in quickly and paying it out slowly. The more money a company has at its disposal, the more effectively it can run its business, with additional research and development spending on next generation technologies, for instance.
Inventory represents finished and unfinished products that haven't been sold. In most cases, inventory sits in a warehouse somewhere, which costs companies money. We'd prefer products were brought to market as soon as possible, sold, and then turned into cash. The problem is that many companies are forced to carry inventory to satisfy increases in demand. That's risky, but a practice many businesses are unfortunately forced to employ.
Tiffany's Flow Ratio falls well above our benchmark of 1.25. In its most recent quarter, inventories increased 27% year-over-year, propelling its Flow Ratio to 3.76, compared to 2.96 in the year-ago period. On an annualized basis, the results aren't much better, but as you can see, this is an industry-wide epidemic. Zale (NYSE: ZLC), the second biggest jeweler as measured by sales, also misses our 1.25 target. (Wal-Mart (NYSE: WMT) is the world's largest jeweler.) Here's a comparative look at Flow Ratios for the two companies over the past three years:
Flow Ratio '00 '99 '98 TIF 3.02 2.59 3.21 ZLC 2.19 4.48 4.83
In Tiffany's latest 10-Q, the company said its finished goods inventory increased primarily because of lower-than-expected sales. Tiffany also said new store openings, new product introductions, and expanded offerings were to blame. This explanation begins to spell out the nature of the beast. The jewelry business is built on having an extremely broad selection. When you go shopping for an engagement ring, for example, you want the widest selection possible.
Management goes on to say in the report that raw materials inventory increased in order to support jewelry manufacturing, as well as shortages in diamond supplies. To compensate, Tiffany has reduced the amount of finished goods purchased from outside suppliers and may decrease internal production. As for raw materials, it has put steps in place to improve demand-forecasting, display of inventories in each store, and warehouse management.
Tiffany's inventory has less risk than technology companies, however. In April, Cisco (Nasdaq: CSCO) warned of lower-than-expected earnings for the second time ever. The real damage was done when it took a $2.5 billion inventory charge. That wasn't that surprising, considering in the prior quarter sales grew 55% year-over-year, while inventories increased 262%.
That disparity prompted me to write the following in a Rule Maker column one month before the company warned: "In some cases, inventory is a necessary evil because businesses must have the ability to deliver finished goods on demand. Too much inventory, however, can be risky, particularly in high-tech industries, where rapid technological change breeds product obsolescence. That could force Cisco to take a charge for its excess inventory and slash prices."
Cisco was unable to gauge demand, and with the rapid change of networking products, it was stuck with droves of worthless inventory. While high-tech products like network routers have a short life, diamonds and jewelry do not. That's why I'm more comfortable with Tiffany's large inventory balance. It's unlikely a diamond ring, for example, would become obsolete. There is some fashion risk involved, but that's nothing compared to high-tech products.
The inventory requirements of the jewelry industry suggest the Foolish Flow Ratio might not be an appropriate measurement. We might be better-served using inventory turns. Tiffany has managed to turn its inventory in exactly one year, slightly down from years past. And as you can see, Zale has managed to turn its inventory slightly faster.
Turns '00 '99 '98 TIF 1.0 1.2 1.1 ZLC 1.3 1.3 1.4
The high inventory balances in the jewelry industry will make it impossible for Tiffany to ever have a Foolish Flow Ratio below 1.25. The industry dictates jewelry stores display lots of products at the point-of-sale. The glitz and glamour of diamonds excite customers, who also want the widest selection possible. But it's also important to remember jewelry inventory doesn't face the same risks of becoming obsolete that tech products do. These reasons lead me to believe we shouldn't eliminate Tiffany from further consideration because of its high Foolish Flow Ratio.
Mike Trigg spends his days offering readers what Gordon Gekko called "the most valuable commodity": information. Mike's holdings can be viewed in his personal profile. The Motley Fool is investors writing for investors.
