Tiffany's Ring Gets Scratched

Back in February, I noted that Tiffany & Co. (NYSE:TIF) had not repurchased any shares under its existing authorization, and I made the conjecture that the reason this was so was that management thought buying shares at such a high price would be a poor allocation of capital. They were trading at $38 at the time. In the quarter just ended, Tiffany repurchased 625,000 shares at an average price of $34.11. I agreed that Tiffany had gotten expensive -- I sold a long-held position in October 2003, when it was trading even higher.

Right now, following a fairly grim quarterly report, Tiffany shares sit at $28 a stub, down over 12% today. Well, well, well.

I would imagine that Tiffany CEO Michael Kowalski is going to go to bed tonight thinking these three words: "I hate Japan." The luxury retailer's second-quarter results outside of Japan were not bad: 11% top-line growth in U.S. sales, a 10% increase in same-store sales, phenomenal 16% sales growth in its flagship Fifth Avenue store. Overseas in Europe and Asia excluding Japan, the company had similar growth, though it was wind-assisted with currency translation gains galore. And then there's Japan, Tiffany's second-largest market: a sales decline of 2%, but that includes an 8% translation gain. In other words, in yen terms, Tiffany's Japanese results for the quarter were abysmal, and though the company was dealing with a somewhat strong comparison from last year's second quarter, in the conference call (courtesy of CCBN; registration required), Tiffany noted that it expected its Japan comps to improve by the fourth quarter.

Another weak spot for Tiffany was its direct and online sales, which declined 5% over the first six months of 2004 versus 2003. Online sales were steady, but Tiffany's decision to discontinue an award sales program caused its direct sales to submarine. This, however, was not unexpected.

The brutality of the unadjusted level of decline in Japan is troubling. We've talked about the power of Tiffany's brand before (as reflected in its 55%-plus gross margins), but the company's name evokes near-mystical power in Japan. This is also an economy that has purportedly been rebounding over the last year, so it's not as though the overall environment for luxury purchases there has degraded in the last year. Tiffany pointed to the fact that Japanese tourist spending had increased in its stores in Guam, Hawaii, and New York as possibly having an impact on sales in Japan. If this had any impact at all, I'd suspect that it was minuscule.

Another element that could trouble investors is the rapid increase in inventories, from $814 million to $1.03 billion over the course of the year -- a rate that far outstrips sales growth. There are two mitigating factors here, beyond the fact that Tiffany inventory rarely spoils: First, last year Tiffany commenced a program of direct sourcing of rough diamonds that it purchased in part from the Aber (NASDAQ:ABER) and Rio Tinto (NYSE:RTP)-owned Diavik mine in Canada. Second, the company is opening or has recently opened several new stores, including two new larger-format stores in Tokyo and Osaka, as well as its new pearl store concept, called Iridesse, of which the first two stores will open this fall in Tysons Corner, Va., and Short Hills, N.J.

I see the most recent quarter, and I see a miss. I have to admit being a little troubled by the large drop in Japanese revenues, but not so much that I'd consider it to be a harbinger of a long-term problem. Tiffany's the same as it ever was. And man, oh man, does it seem to be getting cheap.

Bill Mann owns no shares of any company mentioned in this article. He has held Tiffany shares in the past and intends to in the future. Maybe the near future.