a weak 3Q12 for Tiffany (TIF)

the results

Before the New York open on November 29th, TIF announced 3Q12 earnings results (the company’s fiscal quarter ended October 31st).  Sales were up 4% year on year.   Profits for the three months, however,  were down 30% yoy at $63 million, or $.49 per share–lower than the company had guided to during its 2Q12 conference call.  TIF also revised down its expectations for the full fiscal year to eps of $3.20-$3.40 vs. its prior guidance of $3.55 – $3.70.

What’s behind the earnings miss?

Business was better than expected in Europe and Japan. It was so-so in Asia-Pacific—comparable store sales down 4% yoy—but in line with management’s view. In the US, however, which still comprises about half the company, sales weren’t as good as TIF had expected.

Not only that, but product mix was a problem. Purchases of items costing over $500 each held up well. Sales of less expensive silver jewelry, however, flagged. And they carry higher margins at the moment.

 How can sales be up and profits still fall by almost a third?

As I interpret TIF’s actions in preparing for 2012, the company expected a sales advance for the year of around 10%. So it increased sales space and added staff with that kind of increase in mind. Those extra costs are now acting against the company (negative operating leverage) because sales aren’t yet high enough to absorb them fully.  That cost the company about $6 million in operating profit in 3Q12, I think.  More important,

TIF also build its inventories aggressively. The fundamental choice a firm makes is between:  do I keep inventories small and risk losing sales?  …or do I keep the shelves full, at the risk of having too much?  Based on its sales forecast, TIF picked the second.

In addition, in carrying out its strategy TIF appears to have acquired or made goods containing gold when the yellow metal’s price was relatively high. That decision has two consequences that have also turned into temporary negatives. Because their costs are high, those pieces carry lower gross profit margins than TIF has shown in recent quarters. This wouldn’t be a big deal if sales were growing as rapidly as TIF thought. Better to lose a couple of points of margin on a necklace or ring rather than have a customer walk out empty-handed because there’s no merchandise in the store. But when sales are slow, as they are now, lower-margin merchandise can end up being a big chunk of sales for an entire quarter or two.  As I reckon it, this cost the company about $30 million in operating profit in 3Q12.

At some point, however, maybe in 4Q12 or 1Q13, TIF will have sold all these items and gross margins should rebound.

Finally, to carry out all its plans and still continue to buy back its stock, TIF’s debt has gone up by about $250 million yoy.  Interest expense is $4 million higher in 3Q12 than in 3Q11, as a result.

Do TIF’s quarterly earnings matter at this point?

Yes and no. The stock dropped by about 10% in the pre-market Thursday before rebounding to close down 6% or so. To my mind, that’s not much of a negative reaction, considering how big the earnings shortfall was vs. expectations and how strongly the stock has performed in recent months.

To my mind, investors have clearly been betting that we’re at or near a business cycle low point for high-end jewelry sales. They’re buying TIF in anticipation of a significant upturn in profits. For these investors, the overall story is still intact. Their timing may have been a bit off, but they’re not worried.  And, in my view, TIF’s management didn’t do anything crazy.  It carried out an intelligent plan for 2012 that’s been undermined by a weaker than expected world economy.

On the other hand, I suspect it will be difficult for the stock to advance from the present level without the company demonstrating that the low point is behind it.

One other note: it seems to me that the area of concern for Wall Street based on 3Q12 results can’t be China, even though sales there were down yoy. Why do I say that? Chow Tai Fook Jewellery, which caters solely to the China market, was up 4% overnight in Hong Kong.

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