Tiffany (NYSE:TIF) – Fundamentally attractive business with a timeless brand

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Fundamentally attractive business with a timeless brand

  • Market Cap and EV of ~$9.5bn, dividend yield c.1.9%
  • Fundamentally attractive business with dominant luxury position, global presence and pricing power
    • Timeless brand (est. 1837), enshrined in history through the 1961 movie “Breakfast at Tiffany’s” (priceless, wide moat)
    • Currently focused on improving store experience, refreshed marketing and advancing customer insights and product innovation to engage the global consumer
    • Store footprint 315 globally: 124 Americas / 87 Asia ex. Japan (of which 41 China/HK); not a significant proportion of online sales (c.7% of total)
  • Americas = 45% Revenues / 40% EBIT; Asia-Pacific = 25% Revenue / 29% EBIT (60% of these are Chinese domestic). The remainder is Europe and Japan
    • Chinese buyers account for c.30% of revenues, of which 16% are “domestic Chinese” purchases and the balance are “Chinese tourists abroad”
    • Majority of sales are jewelry (74% sales), vs. large ticket engagement items (26%) which acts to lower earnings volatility and enable more frequent product refreshes and broaden purchasing occasions
  • Consumer purchasing frequency is generally increasing as ‘feel good’ motivations (primary driver of millennial spending) increases the frequency of purchases vs. the traditional holiday gifting cycle. This acts to smooth the earnings cycle and increases the frequency of purchases
  • Track-record of attractive growth; and high-end luxury is surprisingly recession-proof – “wealthy people love to treat each other”
    • Last 10 years: revenue growth for 6 of the 10 years ranging from +4.2% to +18.1% p.a. (average +9.5%). Revenue decline only in 4 of the 10 years ranging from -2.5% to -4.5% p.a.; indicating growth years significantly outperform down years
    • Last 10 years: Revenue growth 6 years ranging from +4.8% to +31.0% p.a. (average +16% p.a.). EBITDA decline for 5 of 10 years ranging from -1.7% to -10.5% p.a.
  • During previous downturns, TIF’s business model has demonstrated significant resilience. The luxury sector as a whole, whilst not immune to the recession, only declined about -2% in 2008 and -8% in 2009 which was much more robust than other sectors, and furthermore bounced back in 2010 with +13% growth. This provides comfort that downside is limited, underwritten by a solid fundamental luxury business

Valuation: Long-term Share Price and Long-term multiple evolution

  • Current share price: $77 / share
    • Broker target price: $137 / share
    • DCF Value: $125-145 / share
  • Suggested target price: $125 / share supported by:
    • (i) Global consumer behaviours prior to a downturn (consumer spending peak yet to come, coinciding with holiday season 2018; plus, comfort purchases by price-insensitive luxury consumers ahead of a recession)
    • (ii) Shifting of international Chinese tourist purchases and unofficial import sales to higher priced domestic sales (+10-30% ASP increases)
    • (iii) China growth – offline and online potential currently being built-out

  • Share price return over last 10 years: +386% (17% CAGR)
  • LTM P/E multiple evolution over the last 10 years: an average of c.9x in 2008 to average YTD c. 34x in 2018
  • Current valuation: 12.3x EV / NTM EBITDA and 21.4x NTM P/E
    • Peers. TIF trades at a slight premium due to a fundamentally better business model, product focus on jewelry and strength in both the US and Chinese markets LVMH: 11.2x EV / EBITDA and 19.7x P/E
      • BID: 10.8x EV / EBITDA and 18.2x P/E
      • TPR: 9.1x EV / EBITDA and 14.2x P/E
      • KORS: 6.7x EV / EBITDA and 9.9x P/E
      • CFR: n/a EV / EBITDA and 14.2x P/E
    • Historical levels of TIF multiples (NTM). Still appears in-line with historical valuation levels c.21x P/E, however, note recent trading around 30-40x P/E prior to this year’s US-China trade tensionsL5Y: 11.2x EV / EBITDA and 21.7x P/E
      • L3Y: 11.2x EV / EBITDA and 21.9x P/E
      • YTD: 13.3x EV / EBITDA and 24.7x P/E

The recent stock price decline has provided an attractive entry point

TIF stock declined by 22.4% since July 2018. This decline was mainly due to (i) concerns over a global recession leading to lower consumer spending on luxury, (ii) decline in Chinese consumer spending due to the ongoing China-US trade tensions and clamp down in China on gifting through increased anti-corruption measures introduced by the Chinese Government.

For comparison the last time there was a Chinese clampdown on gifting was during 2012. Triggered by investor concerns around a Chinese slowdown in luxury spending, luxury sector multiples fell by c.23% over the course of 2012. We are already at that level in the last six months indicating the stock is potentially already oversold; this presents an attractive entry point.

On a multiple basis TIF trades at a slight premium to the peer average (12.3x EV / NTM EBITDA vs. 9.5x for peers; and 21.4x P/NTM E vs. 15.2x for peers) due to a fundamentally better business model, product focus on jewelry and strength in both the US and Chinese markets. Historically TIF has traded c.21x P/E, however, note recent trading around 30-40x P/E level prior to this year’s US-China trade tensions, showing the prior levels that the market valued the future opportunity.

In addition, there is c.$1bn of cash in the business (c.7% market cap) and $500m of FCF generated per year which is c.4% of the market cap.

Value of China Increasing Important

  • TIF is one of the most exposed (following Richemont and LVMH) to the Chinese consumer with 16% of sales generated by Domestic China and an additional 13% of sales generated by Chinese tourists abroad
  • The majority of TIF and luxury peers’ growth is coming from China consumers

Investment Catalysts:

Outperformance prior to the recession (consumer behavioral pattern) and resilience through downturn:

TIF’s current valuation has been dislocated due to recent events including the US-China trade war and an anti-corruption drive by the Chinese Government. This has provided an attractive entry point to invest ahead of peak earnings and holiday season spending to come during 2018 and Q1 2019.

Long-cycle events such as the assumption of a downturn in the near-term may oddly have a positive short-term impact on the stock price due to two consumer behaviors. The first behavior: Just before a recession (a point in time which the majority of the market believe we are currently at), consumers by definition should be a ‘peak spending’. This year peak spending (assuming a recession is now or near now), will coincide with the holiday season where TIF typically generates around 1/3 of annual sales; this combination will likely make it a bumper year for TIF and provide upside to consensus earnings at the FY results in March 2019 and Q1 in May 2019. The second behavior: At the start of the recession (i.e. when consumers are looking into the void), comfort spending typically takes place which manifests itself as (i) increased spending on coffee to increase productivity at work; and (ii) increased gifting for comfort and increased self-worth. This second ‘wave’ of behavior and increased spending should provide a bump to the following quarterly earnings during 2019. Of course, usually near or during recessions, going long on luxury stocks which are usually considered correlated with increasing disposable income is certainly contrarian. On the flip side, investing pre-recession usually implies acquiring at peak multiples.

Given the increasing likelihood of a recession at some point in the next 18-24 months, TIF should stand to benefit from two counter-intuitive consumer behaviors.

During prior downturns, TIF share price has demonstrated significant resilience. The luxury sector, whilst not immune to the recession, only declined c. -2% in 2008 and c. -8% in 2009 which was much more robust than other sectors, and furthermore bounced back in 2010 with +13% growth. This provides some level of comfort that a potential downside scenario is limited, underwritten by a fundamentally strong business model should upside from holiday or pre-recession sales fail to materialize.

Recent short-term events such as the US-China trade war and Chinese Government anti-corruption campaigns have lowered valuations in the luxury space, thereby providing a good entry point at a valuation below the peak, but importantly with peak earnings yet to come. TIF stock has declined by -22.4% since July 2018 which compares to an average fall for luxury stocks of -23% during 2012 when there was a similar concern around a Chinese clampdown on gifting.

China undervalued

Chinese purchases of TIF products represent a significant proportion of sales. Around c.15% of total sales are purchases in China and another 15% are purchased by Chinese tourists abroad. There is also ample room to grow in China as new product lines are being rolled out (these are existing products from the global range). China is also significant underpenetrated in terms of store footprint (currently only 13% of global TIF stores are in China – the largest global market for luxury jewelry). Both factors provide a significant runway for growing offline sales in China (c.90% of TIF global sales are offline) above consensus forecasts.

In addition, TIF has developed a partnership with TMALL (Alibaba’s online shopping portal) to drive online sales. This may seem counterproductive for a luxury good, but Chinese consumers are extremely familiar with online and mobile only shopping even for luxury goods (for example TUMI has a storefront on AliExpress). Most hype/brand awareness and marketing is done through online channels in China, therefore having an online storefront on Alibaba, JD or other platform has become a requirement for successful retailers. The online partnership whilst at present is a small operation, does provide upside (not currently valued separately) which may evolve to be a significant contributor to valuation over the long-term.

Shadow imports (Daigou channels) represent a large proportion of international purchases by Chinese consumers. These are undeclared ‘imports’ by groups of individuals who then sell through private networks in China. Daigou channels exist due to the pricing differential between domestic China purchases (+10-30% ASP) and purchases of the same item in the US or Europe. The Chinese Government is clamping down on shadow imports, which will begin to force Chinese consumers to purchase at domestic TIF stores. This represents an incremental upside as every additional $ spent due to ASP increases drops through to earnings. Chinese customers purchasing high-end jewelry tend to be less price sensitive therefore the risk of lost sales is small. On top of this, there will be manufacturing and logistics gains as the business increases volumes in China.

As the business moves East, margins will improve from higher ASP and cheaper retailing, manufacturing and logistics costs. There will also be a continued increase in Chinese tourists abroad (only 6% of the Chinese population hold passports vs. 42% for the US), which offers significant long-term upside.

The estimated potential incremental equity value is c.$1bn+ (c.$10-15+ per share if 15% of total sales can be moved back to domestic China stores (i.e. removing shadow imports); there is also significantly more upside from increasing volumes as more traffic enters domestic stores. Assuming a higher growth multiple on the Chinese business vs. the current multiple would also significantly increase the value that should be attributed to China.

Further improving the fundamental business

A number of recent changes have strengthened the core business: The October 2017 leadership change, and implementation of product innovation and marketing refresh have all been positive. In particular (i) effective marketing creating a larger brand halo (e.g. 11/17 Blue Box Café opening); (ii) improved training of staff under an inspiring CEO; (iii) product innovations such as the “paper flowers” launch in Q218.

These catalysts are likely priced in through consensus estimates but provide additional strength to the underlying investment proposal and further add to the fundamentally attractive business proposition.

The above outlines why TIF is an attractive business (sales growth c. 5-10% p.a.; EBITDA margins consistently c.25%; around $1bn of cash on hand (c.7% of market cap); and generating c.$500m of FCF p.a. (4% of market cap.); combined with significant upside created by an opportunity to invest at a discount (created by short-term dislocation in valuation), and await a peak earnings surprise in the next two quarters of 2019.

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