What Does the Future Hold for Tiffany & Co.?

Tiffany & Company (TIF) has a 180 year history as a luxury brand, and the stock has jumped 30% in the last year.

In this episode of Industry Focus, Vincent Shen is joined by Asit Sharma as they look at one of the most famous names in high-end retail. Despite the bullish market performance, Tiffany is now facing major challenges with shifts in consumer tastes and spending.

They also look at the latest acquisitions from leading consumer brands this week, including Coca-Cola's (KO 1.50%) $220 million purchase of Topo Chico and Wal-Mart's (WMT 1.32%) acquisition of a New York City start-up.

A full transcript follows the video.

This video was recorded on Oct. 3, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, Oct. 3. Joining me on the show today via Skype is senior Fool.com contributor, Asit Sharma. Hey Asit, great to have you back!

Asit Sharma: Hey, Vince! Thanks as always for having me back!

Shen: Sure. Fools, we're going to turn our attention to the high-end luxury corner of the consumer retail world for this episode. If we watch the clock and we have enough time, we'll also offer some quick updates on the back half of this show as well.

For high-end retail, this is not something we cover very often on Industry Focus. We want to look at Tiffany & Company, ticker TIF. This is a luxury brand with a lot of history and cachet. Charles Lewis Tiffany founded the business 180 years ago, and I'm sure many Fools are familiar with the reputation of the company has when you think about the legendary blue box, and how regularly the company is featured in popular culture decade after decade.

The company states outright in its 10-K that the brand is its single most important asset, and it'll invest heavily to maintain it brand perception. That means premium customer service, paying for spots for its stores in high-end malls and luxury areas, selling lots of expensive diamonds and precious stones. Jewelry makes up 90% of the company's business, specifically products with diamonds make up almost 60% of annual revenue. Asit, the stock is up about 30% in the last year, handily outperforming the broad market. Can you tell us about some of the latest developments at the company?

Sharma: Sure. The most important development begins with the top line. Sales have dropped about 6% over the last two years. In 2015, Tiffany & Company booked $4.25 billion in sales, and that's dropped over the last two years to about $4 billion in 2016. So as a result, Tiffany replaced its CEO Frederic Cumenal, who was only there for 22 months, with Alessandro Bogliolo in July.

Shen: Good timing there.

Sharma: Tiffany & Company, the next CEO you hire, can you please give us a name that's easier to pronounce? But having said that, Bogliolo is the former CEO of Italian jeans and fashion house Diesel Clothing Company, and he also had a long stint in Bulgari & Company, which, for those of you who love high-end fashion and maybe live in a big city, New York, Chicago, you've certainly seen these beautiful stores and their beautiful products, a worthy competitor to Tiffany & Company.

So Bogliolo's mission is to expand Tiffany's cachet, as Vinyce mentioned, to a younger demographic, to millennials, to revitalize the brand without impacting that strong resonance it has as an aspirational brand, and a brand that, at the end of the day, stands the test of time. So those are the most recent developments for Tiffany & Company.

Shen: I would say, the timing there, by the way, you mentioned, of the CEO was perfect, because his official start date happened to be yesterday. As we watch the progress the company makes, it's really starting day one right now. Some big opportunities that you see management mention and see them play out in the numbers a bit, there's this new leadership change, they talk about new product categories that are intended to appeal to some of those younger consumers that you mentioned, they talk about the growth of their online sales, which are still a small portion of the company's business at this point, I believe 6% as of the end of their physical 2016. Then, they also have their international footprint to lean on.

You'll see that going back to some of the quarterly reports, you'll notice a trend in that the Asian markets, which the company breaks down into Japan and Asia Pacific. And for that Asia Pacific region, China makes up over half of that, those regions have tended to deliver strong results, either flat or positive growth compared to some of the declines in the company's biggest market, the Americas and the U.S. specifically, which makes up almost half of all revenue. 

I feel like a company like this will face some cyclical challenges in that economic downturns will often hurt luxury sales. The company struggled a bit during the financial crisis. But another long-term headwind that I want to focus on is something you mentioned, and it's kind of topic on people's minds right now, and that seems to be decreasing interest in diamonds, especially among younger consumers. With some of the controversies surrounding sourcing for precious stones, for example, with conflict diamonds, and in general, we've talked in other industries, whether it's with restaurants, consumer packaged goods, snacks, beverages, whatever it may be, people are worried about environmental concerns, sourcing, sustainability. And that seems to be flowing into this business as well. What is the company really facing here?

Sharma: The company is facing a similar problem that we've seen in many industries that we talk about here where consumer goods stands. We'll talk about Coca-Cola a little bit later in this show, but that's a great analog. Coca-Cola has been impacted by changing consumer tastes, the fact that if you have small children and you've grown up in this society and have a more sustainable bent about you and are more health conscious, you're not necessarily going to give your kids as much of that beverage, Coca-Cola, as you drank when you were small.

The same with Tiffany -- we have these mini cycles ... larger ways where consumers' perceptions of the brand and what's behind the brand evolve. And for Tiffany, it has to be careful about the sourcing of its diamonds, and it has to show the consumer that they can enjoy the products, that is the aesthetic quality of the product, the brand cachet, but also feel good about the provenance of that. Where did the diamond come from? Is it responsibly sourced? Is it a blood diamond? So that's a drag that Tiffany is going to have to meet and continue to have a brand perception that customers can feel good about. I think they can beat that challenge. 

What's interesting to me is, it's going all the way to the other extreme to deal with a little bit less high-margin revenue from the retail diamonds in that it's in the wholesale diamond business. This is something that I really wasn't as much aware of until I was doing prep for this segment. The company has a fast-growing business, particularly in Asia, in the wholesale diamond trade. Now, that's got a much smaller margin than the luxury jewelry, the pendant necklace that you buy at their flagship stores. However, in these last two quarters, the company has booked $61 million of revenue from wholesale diamond trade. Now, that's only 3% of Tiffany & Company's total revenue over the last two quarters, of that $1.8 billion I mentioned. But it's growing at a 50% clip year over year. So you can see how, within a few quarters, if it can maintain that focus, this low margin part of the diamond trade will be a bigger portion of the company's bottom line, a little bit of a drag on earnings but it's a smart way, just as Coca-Cola has moved away from only selling those sugary sodas, and as we'll talk about a little bit later, and is moving into some other types of products that customers can feel better about.

Shen: Why don't we just jump right into that, Asit? I think this is going to be a focus for the new CEO as he heads up the operations for the company. Can you tell us a little bit about what the company is expanding into, but also trying to help, in terms of appealing to the young consumers that it wants to bring on board?

Sharma: Sure. It's two big picture avenues that Tiffany & Company is taking. One, like other companies of its ilk in many industries, it's firming up its approach to e-commerce. And this is one industry which, you can see Amazon.com is not as much of a threat as it is with so many companies we talk about on this show. It almost seems that, whatever segment we have, Vince, Amazon looms large.

Shen: Yeah, absolutely.

Sharma: Tiffany & Company has a really nice e-commerce portal that tries to recreate the experience of being in the stores. It's difficult, let's be honest, to match the experience. If you've had the opportunity to walk into one of their larger stores, it's impossible to actually recreate that. But you can recreate some of the ambience, some of the desire around the product. And what I love about this is, Tiffany & Company has done a smart job of breaking its products into different pricing. Very quickly, when you visit the homepage after a click or two, it just flat-out gives you the choice -- here are products under $250, then it gradates up to $1,000, $2,500, and beyond, sort of like when you sort on Amazon, which, I'm somewhat cheap on some things, so I will often sort by price.

You don't feel like you've lost luxury of experience, but you can quickly go to the price point that interests you, and I think that's a really good approach on their part and will increase the flow of millennial traffic. Millennials as a whole, I don't think they're cheap like me, I'm a bit older, but I think they're thrifty. They know what they want, and they know how much they're willing to pay for certain products, especially luxury items of the type that Tiffany sells. So that flow going through their portal to completing that, converting that customer, is pretty well done.

The other thing that the company is also pragmatically undertaking is its product line. They're moving more into products like watches. This year, they will improve and expand their women's line of watches, which is a huge market. The current CEO has experience with that. For those of you who are into the fashion house of Diesel, you know that they have very attractive watch offerings. So not simply price points, but looking at what millennials buy, what's important to them. They may not be in the market for a beautiful diamond or heart-shaped brooch like your grandmother was, but they could use a watch because they're tired of staring into their phone for hours a day.

Shen: Sure. I think that's a piece of the strategy the company will have going forward. At the same time, I'm a little bit skeptical, when we were doing research for this, I found a lot of headlines talking about how high-end jewelry, diamonds are on this strong downward trend in terms of popularity, like we mentioned, with millennials and younger consumers in general. But I feel like, with a company like Tiffany, with a very aspirational brand, they talk about how they will invest in their inventory to have lots of very pricey and extravagant diamonds and precious gemstones, because they want customers to go into the store and feel like there are things that they cannot afford. It's aspirational.

And I feel like that's something for young consumers that they will grow into over time as their tastes change and mature, as they grow older. I think the long-term picture for this company, there are always going to be people who appreciate what Tiffany represents in terms of the luxury world. So it will always have that moat. Any final thoughts from you, Asit, in terms of this challenge the company faces, and thoughts on what the outlook might be?

Sharma: I think the company will be able to meet the challenges we talked about earlier. And also, these declining trends of interest in diamonds. That's somewhat geographically based. In the United States, we have a very advanced society on the curve of industrial development. But again, in China, if you look at India, which has a burgeoning middle class, and they love to buy gold objects, diamonds are the next step up. There is a market out there. It depends on where their focus is, and the company avidly seeks locations in Southeast Asia to expand. So they know where their future customers, who will still be interested in diamonds, exist. And I think that's simply numbers for them, that's one way they'll be able to counteract the trends that we see in places like Europe and the United States, where that interest is somewhat declining.

And a last point on Tiffany, I really do buy management's approach in saying that their name is their most important asset. It's one of the few brands that you can think about that's had staying power for decades and decades and decades. Listeners, many of you have seen Breakfast at Tiffany's, or read Truman Capote's book. Both of those are excellent. If you haven't, I recommend it, it's great for this weekend, watch Breakfast at Tiffany's. But Truman Capote wrote that book in 1958. And to me, the name is just as bankable as it was some 60 years ago. So I think they can parlay that asset and really overcome any near-term challenges, and that's what you want to see as a long-term investor.

Shen: Perfect. Thank you, Asit. For our next update here, we have two stories. The first is with Coca-Cola. They opened the week with the news that the company would be acquiring Topo Chico for over $200 million. I've never had a chance to try its products myself, but Topo Chico is an imported sparkling water brand from Mexico that's very popular in selected regions of the country, especially Texas, which makes up about 70% of Topo Chico's sales. The brand has a long history dating back over 100 years to 1895, and it seems to be a big part of its allure and popularity with consumers. Asit, this deal is made as part of Coca-Cola's Venturing & Emerging Brands unit. We've talked about this unit before, it's a really interesting part of the company. Can you tell us about this unit within the Coca-Cola umbrella?

Sharma: Sure. VEB, Venturing & Emerging Brands group, functions as a venture capital arm within Coca-Cola. Their mission is to go out into very far reaches of the soft drink or beverage world and find companies that are developing brand which Coca-Cola can buy. Now, for Coca-Cola to buy a brand, it really has to have $10 to $20 million in sales. Then, it can scale those sales up to $200 million and beyond. But VEB doesn't necessarily have to find companies that are selling that much from the outset. They really take an ear-to-the-ground approach and try to meet with small companies when they're just forming up in start-up phase, and keep in touch with them, as many venture capitalists do with technology companies, in the hopes that they find a brand or label just starting to gain traction, and they have the advantage of the first-mover, they have a relationship with the entrepreneurs and can write a big check, acquire the rights, and then scale.

I think this group has been effective. Some of you drink Honest Tea, that was a transaction that the VEB Group consummated. And this week's transaction, also consummated by the VEB Group, they did it with the Mexican bottler ARCA Continental for $220 million. 

And this is interesting for those who are wondering how Coke will parlay the strategy of small, tuck-in acquisitions. Previously, Coca-Cola was buying up some small labels and manufacturing product. But the company has sold its bottling operations over the past year to bottling partners in North America and throughout the world. And by next year, Coca-Cola is going to exist more as a marketing company than an actual manufacturer. And this is one of the first transactions we see how great that business model is, because Coca-Cola actually acquired the rights to Topo Chico rather than buying all of the manufacturing and trying to go bottle this product itself.

Shen: Yeah. I want to mention a few other aspects of how the Venturing & Emerging Brands unit approaches its investments, and kind of apply that to this latest purchase that they've made for about $220 million. So the unit was established in 2007, and they're looking for these potential billion-dollar brands. But the thing is, they're focused on products that are outside of Coca-Cola's traditional carbonated soda and sugary beverages, because the business unit claims to think five to 10 years ahead about where the beverage industry is going, and the signs of the leaves seem to point away from some of those traditional Coca-Cola sodas. And you mentioned Honest Tea, for example, this was a pretty early success for the company. They made an initial investment of over $40 million in 2008 when the company had less than 100 employees and just $30 million in revenue. Almost a decade later, Coca-Cola has totally taken over the Honest Tea brand, and the latest number from 2015 puts Honest Tea sales at almost $180 million. So the formula here is, they have Phase I, they identify the opportunities. Phase II, they take a venture capital role and make that initial investment. And that seems to be where we are here with Topo Chico.

The next phase, then, is when they start taking a greater role and usually a bigger investment as the brand grows its reach. This seems to be a pretty standard formula for the company, in terms of what options they have for Topo Chico. It has 70% of its sales in Texas, it has really strong market share there, and management has actually spoken to this idea about recreating this success and building more "Texases", basically growing Coca-Cola's share of the still-growing sparkling water industry, which at this point is still dominated by private label store brands that you might see at the grocery store, for example. Estimates I found pinned Topo Chico revenue at less than $70 million for 2016. So we know this is not exactly moving the needle for a company this size. Coca-Cola, keep in mind, despite the fact that their revenue is going down because of this restructuring they've done, you mentioned in terms of the bottling operations, they still had almost $40 billion in sales in the last 12 months. 

I think, basically, you have to think about what the company is going to be able to leverage, and I think Coca-Cola is legendary in terms of its ability to leverage its marketing machine, and allow Topo Chico to ride that and scale. Even though it's only available in 35 states and regions of Northern Mexico already, the brand is not that familiar outside of Texas. And I'm sure Coca-Cola will be working a lot to remedy that. But if you are a Coca-Cola shareholder or you're considering a position in the company and you're trying to adopt a Foolish long-term perspective, I guess the question becomes, do these satellite brands and venture capital-like investments have the ability to eventually offset some of the major declines that are expected with traditional soda consumption? What do you think, Asit?

Sharma: In this case, it certainly does. Very interestingly, as you mentioned, revenues for Topo Chico are 70% in Texas. You can visualize a small band on the map of the U.S. border, this drink is actually manufactured in Northern Mexico, and it's sold in Northern Mexico. South of Northern Mexico and north of Texas, there's tremendous potential. Some of our listeners may know, Mexico is the second largest market for Coca-Cola outside of the United States, and Coca-Cola has been hit hard by Mexican government tariffs on sugary soft drinks. So this is an excellent way for Coca-Cola not just to take an exciting brand and scale it but to make up for lost revenue. It's exactly what you want to see as a long-term shareholder. What's the strategy to replace the declining revenue? And that is such an opportunity that falls into Coke's hands.

I don't how many of our listeners, maybe you can tweet to us if you've tried it, those of you who are down deep in the South -- I've tried it. I've got my hands on some several months ago from my local Latin American store. It's an interesting drink. It has a very colorful label. Effervescence is a little bit higher than sparkling waters you might buy here, at least to me. It's got a little bit of a salt taste to it. So it's something that offers a different segment opportunity for Coca-Cola, a new brand that they can push out there, and it's beloved by hipsters in Texas. So, there's that cachet that we talked about with Tiffany. They may have some hipster cachet that they can expand on. I think it absolutely does fulfill that problem that you mentioned, Vince. We'll watch this one to see how far they can scale it in the next few years, for sure.

Shen: I think it's interesting, that popularity that it has in Texas, has a lot to do, I think, with the heritage of the brand itself, again, dating back over 100 years. The company, in the release, there's a Q&A with some executives from the Venturing & Emerging Brands unit talking about how important it is for them to maintain that heritage and tradition for this brand, despite the fact that they're going to be putting it into the machine and expanding its presence across the country. We'll be watching to see what kind of success they have, whether this can be a next Honest Tea for them. But ultimately, this unit within Coca-Cola has invested in over something like 40 different brands at this point. Not every single one is going to be a major success, but if we know anything about this company, they certainly have the resources and the experience in beverages to experiment and test and find these small labels and help turn them into enormous successes.

For our last story, it's yet another recent development from Wal-Mart. I know we've been hitting a lot of Wal-Mart coverage on the show lately, so I'll tentatively promise that this will be the last bit for the king of retail for at least a few weeks, if not a few months. But I won't deny that it's been pretty fascinating to follow along with the various experiments and new initiatives that Marc Lore has rolled out as the head of the company's e-commerce efforts. That's not to mention what Wal-Mart has done with the Jet.com business itself. The company actually announced this morning that it would be acquiring a small start-up called Parcel. What's the story here, Asit?

Sharma: Parcel is, like you say, a small company that focuses on last mile and same day delivery in New York City. The transaction size was not disclosed, but it is said to be about $10 million. So you can imagine, this is a very tiny company. What would Wal-Mart want to do with a company that it can purchase for $10 million that's located in New York City of all places, a very dense city?

The answer is that last-mile services are the hardest part of the logistics supply chain, the most expensive part pound-for-pound. Amazon.com, a fierce competitor to Wal-Mart, has partnered up with the United States Postal Service to solve last mile problems. But what's so interesting is, in New York City, there's a lot of opportunity for Jet.com to basically be a test kitchen for different ventures. And Parcel helps Jet.com, which Wal-Mart acquired, listeners will remember, for $3 billion. Parcel helps Jet.com test delivery services within dense populations like New York City. So we should talk about Uniquely J, which is Jet.com's answer to the Whole Foods-Amazon.com partnership. Uniquely J is a service developed by Jet.com to offer high-end food products and also products such as cleaning supplies, bath tissues, to customers for delivery, probably within that same two-hour window that Amazon.com promises. Parcel lets Jet.com make that last mile delivery, and it gives this experimental template for Wal-Mart to go into big cities where it doesn't necessarily want to put a Supercenter -- places like New York, Los Angeles, Chicago -- and have a supplemental business model while also trying to kick Amazon.com in the shins.

Shen: I think this is where everything comes together. We have this small start-up logistics company to help organize same-day deliveries for New York City. It has some of the infrastructure, the staff, and experience in the city to ramp up the potential same-day shipping efforts for Jet.com and Wal-Mart.com in that market. At the same time, I believe that Parcel is already handling some of the deliveries, for example, for Bonobos, which also happened to be acquired by Wal-Mart earlier this year. And that becomes part of this overall plan where everything is starting to come together a little bit for the company's e-commerce efforts. They talk about the Bonobos and Modcloth acquisitions, these are men's and women's apparel companies. Now, Wal-Mart has recently announced that they intend to make both those brands available on Jet.com.

So Jet.com previously having more of a discount reputation, they're starting to offer those two brands on there, raising the cachet, again, another time that we're using that, the brand premium that's associated with the site. And with Uniquely J, they've also mentioned that this private label Jet.com brand that's going to roll out with consumer staples in the next couple of months, they want it to target some of these urban-based millennials. So they'll get a similar theme here, because these Uniquely J products are supposed to be higher-end to appeal to that target market. Again, as you mentioned, this really follows closely on the heels of Amazon, which has made its 365 by Whole Foods products available online, and the initial reports for that said it was met with great success, a lot of items selling out very quickly.

So we've spoken previously about the solid growth Wal-Mart is enjoying in its digital business. I ultimately believe this is still a marathon. These are all small moves on the chessboard for the company. Ultimately, Wal-Mart wants to widen its appeal with the help of Jet.com, and its reputation as a younger, cooler brand while establishing the necessary infrastructure and logistics it will need to provide greater convenience to customers in these various urban markets, obviously starting first with this one Parcel deal right in New York City. Any other takeaways for you, Asit, in terms of what this spells for the future, in terms of this arms race between the big retailers?

Sharma: Sure, one last point. And by the way, what a great example, because these are two grand masters that are playing a very long game of chess. I was really intrigued by this acquisition, because Wal-Mart is taking such a different approach than Amazon. Everyone knows Amazon builds fulfillment centers every year all across the U.S. from the ground up, supplies them with amazing automation and technology. Wal-Mart is picking up on something that I was actually reading about in Supply Chain Newsletter several months ago, that there's a ton of warehouse space in cities like New York, in Brooklyn, where I believe Parcel is based, in Chicago, in almost any big city you can think of. You've seen how urban drift has created this. It's space that's unleased, perfectly usable, and very capital-lite for a company like Wal-Mart. So it's developing a model where it can have its own quasi-fulfillment centers which are just in big cities to deliver that last mile much more cheaply than if it tried to compete with Amazon and think of itself as a company that's going to build a bunch of its own fulfillment centers. Of course, Wal-Mart thinks that its super stores themselves are quasi-fulfillment centers, and they have a point, because they're so large. But I'm intrigued from the real estate aspect of this. Again, if this is a chess move, to me, this is equal to a threat on the chessboard. It's like calling check, and the other opponent over time is going to have to make sure that his king is well-protected. So we'll follow that as well.

Shen: Thank you very much, Asit, for joining me on the show today. Thank you, Fools, for listening. If you have any thoughts on Topo Chico, if you've tried it, we'd love to hear from you. Or if you have any other questions, you can hit us up on Twitter @MFIndustryFocus, or you can send us an email to [email protected]. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!