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Tiffany Looks Overvalued

Japanese sales, price of silver and confident competitors are key factors in the jeweler's outlook.
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faces challenges on a number of fronts, but one area in particular bears close watching on its earnings call Tuesday morning: Japan, which accounts for 22% of the company's sales.

In fact, unless something momentous happens to its Japanese sales in the next year or two, I believe Tiffany's stock is overvalued. It's possible that this is not captured in sell-side consensus numbers, which are generally optimistic to begin with. I'm basing my view on a three-stage earnings discount model, with a 6% risk discount (as I do for most retailers) and a 3% terminal growth rate in EPS. At $39, Tiffany stock assumes five-year earnings growth of 16% from a base level of $1.81 for fiscal 2007, which ends in January 2007.

I consider fiscal 2007 earnings to be normal for the middle of the economic cycle. So knowing nothing else about the company, you could plug in consensus EPS and a 12% long-term growth rate and get a fair value of $34. This would make you fairly certain that Tiffany shares are at least 15% overvalued, even before you did your homework.

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After some analysis I identified key catalysts that could make the stock fall.

For starters, the stock was up over 25% to the $42 to $43 area after positive talk in August by management about Japanese business. But management also reduced the comp guidance for the year from low single digits to flat, and it said it was still too early to predict a full turnaround. Japan accounts for 22% of sales, and the brand is in some trouble because of rising competition. In addition, the diamond solitaire engagement rings Tiffany has sold for years in Japan are going out of style there, so Japanese sales will soon have to accelerate rapidly to justify the stretched valuation.

The U.S. accounts for half of Tiffany's sales, and 30% of those sales are for silver items. Silver has the highest gross margins of all Tiffany's products, so I'll assume that this 15% chunk of Tiffany's sales contributes 20% of overall earnings. Although silver products are highly profitable, the average price point is under $200. So I think it's reasonable to assume that lower-income households account for a sizable portion of demand.

Silver is up 50% or so from last year, and gold is up substantially, too. Because Tiffany's costs are up, I believe price increases on these items will be announced soon, and this will hurt sales. Incomes for the bottom two-thirds of Americans have not grown as fast as metals prices, so something has to give. I'm watching this as a potential catalyst.

A related issue is the question of whether gross margins can hold up for gold and silver. If high prices hurt sales, then it's possible that Tiffany will have to eat part of the increase in metals prices. So something's got to give, whether it's falling sales or shrinking margins.

There are several other factors that could affect consumers' ability to buy jewelry. Could gasoline get more expensive? What about heating costs? Are we really out of the woods yet on energy prices? Rising energy prices cut disposable income, and this is likely to pinch Tiffany's sales.

Then there's the slowdown in housing. I learned early in my economics training that sustainable income is a bigger factor than any change in wealth when it comes to consumers' willingness to spend. But housing has been a big factor in consumer spending for at least 10 years now. Over the last three years consumer spending has grown 3.5% annually, and studies show that it would have risen only 2% annually had it not been for the appreciation in housing prices and related refinancing activity.

These factors, coupled with rising debt and a negative savings rate, have given an artificial boost to consumer spending. I believe that some of this has worked its way into Tiffany's sales and is likely to unwind during the next few years as housing-price appreciation fades and financing costs swell. These changes happen slowly, however, so I'm not relying on them as a near-term catalyst for a lower stock price.

Jewelry rivals are an important consideration for Tiffany shareholders, especially Harry Winston and



. DeBeers is quite competitive in many of the lower price points of Tiffany's market, and this has to hurt margins eventually.

For now, though, the effect may be limited to the reaction from some pure momentum portfolio manager who sees a new Harry Winston store open near the local Tiffany store. Perhaps then the hot money will reconsider a long position in Tiffany stock. In the meantime, I am going to focus on margin pressure, diamond sales in Japan, silver sales in the U.S., and growing pressure on consumer spending.

Ron Thomas, CFA, was most recently with Colonial Management Associates (one of the mutual fund subsidiaries of Liberty Corp.) as an analyst covering consumer stocks. Colonial Funds was named by Barron's as its "Mutual Fund Family of the Year" for 2000, based significantly on its consumer staple stocks selection performance. From 1990 to 1999, Thomas was employed at ASB Capital Management in Washington, D.C. as an analyst and later as a co-portfolio manager with absolute discretion over stocks in the financial, consumer staples and consumer services sectors. Prior to that, Thomas was with First City Bancorp. in Houston following financials and consumer companies. He holds a B.A. in economics from Rutgers College and an MBA in finance/marketing from Cornell University.