One of my top recommendations, Signet Jewelers (SIG), lost close to 30% on Tuesday after releasing disappointing Q3 earnings results. The quarterly loss was hard to predict because most of the loss was due to unforeseen circumstances, including hurricane-related incidents and systems disruptions associated with the outsourcing of its credit portfolio.
While undergoing a $1 billion sale of in-house credit to ADS, Signet faced a large-scale server outage. Most analysts, including me, failed to take into account the possibility of such a loss, and the market reacted sharply to the news. On the conference call, management clearly regretted that it was unprepared to handle such a massive transaction.
My buy recommendation was broadly based on two trends: Signet’s increasing online presence since its acquisition of JamesAllen.com, and increasing profit margin at Zales Jewelry, which Signet acquired in 2014.
I expected that Signet would become the leading online diamond jewelry retailer by leveraging its 15% overall market share and the online expertise gained from the acquisition of JamesAllen and R2Net.
Around 25% of Signet’s revenue comes from Zales, however the operating profit margin of Zales Jewelry is only 4% relative to 18% of Sterling Jewelers (which includes Kay and Jared Jewelers). I expected Zale’s margin to increase to the Sterling’s level in the long term.
In addition to these two growth expectations, the company’s cash flow yield provided a good margin of safety. Our investment was long term in nature, with an investment horizon of three to five years.
As I examine the results of Q3 earnings, I’ve become concerned that Signet may not be able to increase Zales’ margin as I had expected earlier. It would be premature to make that conclusion based on one quarterly earnings report, but given the decrease in sales of both the Zales and Sterling divisions, and management’s revised earnings estimates, I am changing the rating from Buy to Hold. HOLD.