It should come as no surprise that the quality of Sterling’s in-house customer credit portfolio has shown some modest deterioration, especially in the past three months. In the face of higher energy prices, mortgage woes, financial market uncertainty, and economic softening, consumers have slowed payments on their jewelry accounts.

 

Historically, the typical Sterling Jeweler’s credit customer has paid off his or her account in about seven months; in recent months, the account payoff period has risen to nearly eight months.

 

This news comes on top of weak sales and sharply lower profits for the third quarter ended October 2007 for Signet Group, the parent company of U.S.-based Sterling Jewelers with 1,383 stores. Sterling represents about 72 percent of Signet’s sales through the first nine months of 2007; it represents 98 percent of trading profits, excluding group central costs. The balance of Signet’s revenues and profits come from its 570 stores in the United Kingdom.

 

In addition, since the end of the quarter, company management disclosed that its U.S. same-store sales were down 7 percent for the first 25 days of November, including Thanksgiving weekend which is the traditional start of the all-important holiday selling season.

 

Customer Credit Quality Slips

Sterling reported that it is not only taking longer for its credit customers to pay off their accounts – nearly 8 months versus about 7 months in recent quarters – but it has experienced lower approval rates for new credit applicants over the past three months or so.

 

Despite these weakening trends, the company’s financial ratios associated with its credit business are still broadly in line with historic ranges over the past ten years.

 

About 51 percent of Sterling’s sales are made on in-house credit, a ratio which is largely unchanged over the past few years. It is down modestly, however, from a decade ago when about 56 percent of the company’s sales were made on in-house credit.

 

Sterling management emphasized that there has been no change in its lending standards: credit has been neither loosened nor tightened.

 

Sterling’s bad debt provision is up, but the methodology for calculating this provision is unchanged. However, there are more customer accounts which are 90 days or more past due than in the recent past.

 

Further, management says it does not use credit to chase sales. In repeated tests over many years, the company’s research has found that different credit programs do not create new sales. Rather, customers transfer their demand between credit offers. In short, Signet Chairman Terry Burman said that customers shop for jewelry, not credit, when they come into a Kay or Jared store.

 

Sterling is one of the few remaining chain jewelers which utilizes in-house credit. Most of the major chains have outsourced their credit operations. Credit is a capital-intense business, and most chains claim they would rather be in the jewelry business rather than the banking business. There are no signs that Sterling may be considering a change in the management of its credit operations. Further, we believe that management utilizes sophisticated financial evaluation tools to determine if its return on capital is adequate to continue to maintain in-house credit operations.

 

When credit is out-sourced, the customer typically sees virtually no change. However, for jewelers who use credit as a marketing tool, they have far less control over credit availability for specific customers.

 

Sales Weaken This Fall; Gross Margin Slips

While Sterling’s same-store sales were up 2.5 percent in the three months ended October 31, they were stronger in August and September than they were in October. Between November 1 and November 25, Sterling’s same-store sales fell by 7 percent. Thus, the four-month sales trend indicates a continual weakening.

 

Sterling management noted that there has been no material changing in timing of promotions year-to-year which would help explain the weak sales.

 

In addition, management noted that Sterling’s gross margin continued to decline in the third quarter by a greater amount than the gross margin deterioration which had occurred in the first half of the year. Sales mix and commodity costs were the primary culprits which hurt the company’s gross margin.

 

Versus Zale: A Song, A Dance, A Dodge, A Disclaimer

During the company’s conference call, one analyst asked a rambling and oblique question about Sterling’s sales trends; Signet Chairman Burman answered the question with an equally rambling song, dance, dodge, and disclaimer.

 

The essence of the analyst’s question was this: Is Sterling’s sales performance in November [down 7 percent] better than Zale? Our interpretation of Burman’s answer was this: Yes. It would appear that Zale’s sales are down worse than Sterling’s in the November period, according to our interpretation and analysis of Burman’s comments.

 

Unfortunately, it took several minutes of discourse between the analyst and Sterling management to arrive at this conclusion. The analyst knew he could not ask the question directly, because the answer would have to be something along the lines of “We don’t get a copy of Zale’s daily sales results.” Instead, the analyst asked essentially if Sterling thought it was continuing to maintain its industry-leading position of increasing its market share versus other major chains. (Again, we note, we have boiled down his rambling discourse to a few words.)

 

Burman came back with caveats and disclaimers, but essentially said that he had isolated every factor that could be affecting Sterling’s sales, and he didn’t see anything that told him Sterling was not continuing to maintain its industry-leading sales position.

 

Independent research by  IDEX Online, including queries of Zale vendors, seems to indicate that Zale’s sales were very weak in November, and that Burman appears to be correct in his assessment of Sterling’s industry position.

 

When queried about sales guidance which historical trends might provide – does a soft start always lead to weak holiday sales – Sterling management said that sometimes a soft start is followed by a rally, and sometimes sales never rally. In other words, it is not possible to predict what the American shopper will do in today’s market.

 

Look for Higher Retail Prices In Second Quarter of 2008

Signet management noted that it plans to raise jewelry prices, beginning in the period following Valentine’s Day 2008. Even basic pieces will be re-priced. Management noted that it has been several years since basic jewelry pieces have increased in price, despite higher commodity costs.

 

We agree with that assessment: retail jewelry prices in the U.S. market have fallen in nine of the past eleven years, as the graph below illustrates. Simultaneously, jewelers’ gross margins have also fallen. Retail price increases are long overdue in the American market.

Source: BLS

 

The key question is this: will Sterling re-price its goods to get back to its traditional gross margin levels? Management dodged this question, but answered instead that it planned to recoup increased commodity costs via higher retail prices.

 

With pressure from online jewelers’ economic model, it seems to us that it is likely that jewelers must learn how to conduct their business with lower margins and a higher inventory turn. Implemented properly, this strategy will inevitably lead to greater profits.