My deeper dive on Signet Jewelers

Today, let's pick up where I left off yesterday with jewelry retailer Signet Jewelers (SIG)...

In yesterday's e-mail, I took a first look at the company, whose stock crashed 22% on Tuesday to a multiyear low of $58 per share (it closed yesterday at $58.92 per share) after the company preannounced disappointing results during the all-important holiday season.

As I explained, Signet's sales and adjusted operating income missed the prior forecasts by about 4% and 17%, respectively.

However, I also said that with the stock nearly cut in half in only a month and a half, the sell-off could be overdone. There could be an opportunity to do some bottom-fishing here, so let's take a closer look at the company...

Signet operates approximately 2,700 jewelry stores across the U.S., Canada, and the U.K. under the brands of Kay Jewelers, Zales, Jared, and more. It also owns Blue Nile, the online jeweler that allows customers to pick out a completely customized diamond. The vast majority of its stores (84%) are in the U.S., with the rest in the U.K., Ireland, and Canada.

Signet's various brands cover roughly 80% of jewelry buyers – everything except the very high end.

Signet is also by far the largest jewelry retailer in the U.S., with a 10% market share – which is 3 times larger than its closest competitor.

As recently as its second-quarter investor presentation in June, Signet was touting the financial results of its "transformation over the last four years." Take a look at this slide from the presentation:

As you can see in this table from the presentation, the improved financial results have been driven by a shift away from mall-based stores (with their high rent and personnel costs) and toward e-commerce instead:

Signet has also shifted toward selling higher-priced "accessible luxury" jewelry – here's the relevant table from the presentation:

Driven by what Signet calls "premiumization," average transaction value in North America has risen 40%, driven by a 60% increase at its Jared stores – which you can see in this next slide:

So far, so good. But whenever you're buying the beaten-down stock of a company that has missed expectations, you must carefully analyze two things...

• First, you need to make sure you're not buying into a value trap, in which the business model has been permanently impaired by, say, a new competitor or technology (think newspapers, many retailers that got "Amazoned," paging companies, and check printers).
• Second, ideally there's a catalyst – something that will cause earnings (or at least investor sentiment) to turn around, driving the stock higher. This can be a new CEO, a decline in input prices, the launch of a new product, a regulatory change, or the easing of a short-term headwind.

When we recommended Signet back at my former firm Empire Financial Research (at a reference price of $62.51 per share) in the June 2023 issue of my prior newsletter, Empire Investment Report, we outlined a clear catalyst: a recovery from a post-COVID decline in engagements, which account for nearly half of its sales.

Before a couple gets engaged (and buys a ring from Signet), you would expect that they would have been dating for a while. And as you would imagine, COVID lockdowns crimped this.

As you can see in this chart my team and I at Empire showed of Google searches for "first date," dating plunged when the pandemic hit and took two years to recover:

As you can see from the chart, by mid-2023, dating had already recovered to pre-pandemic levels.

But keep in mind that the average couple dates for approximately two years before getting engaged... so Signet experienced a real "lag effect" in 2022 and 2023. Simply put, because fewer couples were dating in 2020 and 2021, Signet sold fewer engagement rings in 2022 and 2023.

But our analysis showed that sales were poised to recover – as the millions of young Americans who dated less during the pandemic but still wanted to find that special person and get married scrambled to make up for lost time.

Signet's research (and ours) revealed a coming surge in engagements – and therefore, the buying of engagement rings – in 2024 and 2025. Here's the chart we showed in that Investment Report issue:

We concluded that "it's clear that short-term factors that are set to reverse in the next few years are temporarily keeping a lid on Signet's business – and its stock."

It was a great call, as Signet quickly soared to more than $100 per share by the end of 2023. More recently, the stock was above that level this past November... before it started its big plunge.

The question today is: What's the catalyst that might reverse the company's (and the stock's) current decline?

Unfortunately, I don't see one.

And, worse yet, there's a looming threat that could turn Signet into a value trap: the rise of lab-grown (synthetic) diamonds ("LGDs").

LGDs were first manufactured by General Electric (GE) in the 1950s. But they have exploded in popularity in recent years as Chinese and Indian manufacturers have ramped up production, quality has risen (few people can tell the difference between real diamonds and LGDs), and many buyers (especially young Gen Z ones) prefer them because they are more "ethical."

By this last point, I mean that they don't fund conflicts in Africa (you might recall that this was the subject of the 2006 hit movie, Blood Diamond) or elsewhere... and they eliminate the need for harsh working conditions for miners being paid pennies an hour, etc. (For more on this, see this article from the International Gem Society: Conflict-Free Diamonds: What Does it Mean?)

According to this Business Insider article from November (which, strangely, is bearish on LGDs – wrongly, I believe):

Prices for lab-grown diamonds have actually been declining since 2015, the year they first started to become mainstream. Back then, a man-made diamond was priced at around a 10% discount to a natural diamond. Today, they're priced at up to a 90% discount...

And as the article also notes:

Lab-grown diamonds now make up around 20% of the total diamond market... up from nearly zero percent in 2015.

Sales of lab-grown diamond jewelry soared 51% in the 12 months leading up to November, while sales of loose lab-grown diamonds grew 47%.

This is having a huge impact on jewelers' bottom lines, as this April 2024 article from investment firm Gordon Brothers notes:

Lab-grown diamonds' low prices weigh on retailers' revenues and that pressure on the top line can hurt profits. Lab-grown diamonds generate gross margins of 60% to 65%, higher than the 40% to 45% gross margins on naturals.

But because they sell for so much less, manufactured diamonds produce much lower earnings in dollar terms for each unit sold. In fact, jewelers need to sell more than four lab-grown diamonds to match the earnings generated by the sale of a single comparable natural diamond.

In short, LGDs are a disruptive technology. And I can see the appeal for many folks... Instead of paying hand over fist for a real (and possibly "unethically sourced") diamond, you could now say to your partner, "Honey, I did the environmentally and ethically right thing – and now we can afford a nicer vacation/honeymoon!"

I think that's a winning argument for plenty of folks... and, as such, LGDs will continue to take significant market share. That's bad news for Signet and other jewelers whose businesses are heavily weighted toward diamonds.

Signet didn't even mention this threat in its June investor presentation, which speaks volumes – it's because the company doesn't have an answer.

I'm not sure if Signet is still doing this, but according to a New York Post article from last June, How the world's two biggest diamond companies are plotting against the rise of lab-grown gems: 'Buyer beware':

In May, Signet Jewelers – the world's biggest diamond retailer, with chains that include Jared, Zales, Kay and Blue Nile – began printing a "buyer beware" disclaimer of sorts on the receipts of all of its lab grown diamond sales, warning customers that the bauble they bought could plummet in value.

Lab-grown diamonds' "relative abundance may not ensure that their value will hold over time," Signet's receipts now state.

The retailer is also training its 20,000 sales associates to "educate" shoppers about "natural diamonds' unique attributes, including their enduring emotional and financial value," Signet spokesperson Katie Spencer told the Post.

The New York Post article also featured this image of the warning:

This is ridiculous. Folks aren't buying diamond jewelry as an investment that they plan to sell at some point later to make this "not holding value" concept an actual problem. And even if they were, I'm skeptical that they would be buying real diamonds – of which demand is likely to fall as they're increasingly replaced by LGDs.

One of my readers, who prefers to remain anonymous, confirmed this in an e-mail to me:

As you well know, the prices for natural diamonds collapsed, and many people expect them to follow the pattern of pearl jewelry.

Based on my calls with the executives of jewelry companies, profit margins on diamonds were the key driver of the underlying profitability.

I heard the same story from Zales to much smaller jewelry retailers.

My conclusion is clear...

The risk that Signet is a value trap is very high... so don't be tempted to bottom-fish the stock.

But what about playing it for a short squeeze? One of my readers, Peter W., brought up that question:

With 12% of the shares outstanding and 23% of the float sold short and 109% held by institutions, this looks like a reasonable business whose stock is set up for a short squeeze.

So why not pull a Reddit and suggest that all your readers pile in to squeeze out the shorts?

This is a bad idea for two reasons...

First, it's unethical and might land whoever is trying to engineer a short squeeze in hot water with regulators for market manipulation.

And second, while it occasionally works – think GameStop (GME), which was famously captured in the well-named book and movie, Dumb Money – it rarely does... saddling speculators with big losses.

Instead, you're better off just avoiding Signet outright – and not getting sucked into a likely value trap.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.