Signet Jewelers (SIG, Financial) is the worldâs largest retailer of diamond jewelry. The company does business under various brands including Kay, Zales and Jared among others. As you might expect, there is a limited market for expensive (as in expensive compared to a Big Mac) items with no tangible function. Signet Jewelers, however, seems to have found a âsolutionâ to that problem. As Connâs (CONN, Financial) did, it appears that Signet has decided to create demand out of thin air by providing financing to customers.
Loans growing faster than sales
Financing the purchase of something expensive such as a house, vehicle or even an engagement ring is business as usual and generally nothing to be alarmed at. What is worrisome is when loans begin growing faster than overall sales and loan quality begins to decline.
The following table was copied from Signetâs latest 10-K and shows the results of its Sterling Jewelers segment, which accounts for 61% of the companyâs overall sales.
As you can see, credit sales as a percent of sales have been steadily increasing. To make it even more obvious what is happening, weâve reproduced the numbers below and calculated the year over year growth of total sales, credit sales and non credit sales.
Not only have credit sales grown much faster than overall sales, but sales growth in 2015 would have been negative if it hadnât been for an expansion of credit sales!
It is hard to believe that somehow Signet found a previously undiscovered market of credit worthy customers who wanted to buy jewelry and the increase in credit is being driven by prime borrowers. Instead, what is highly likely is that Signet is lowering its credit standards to drive sales.
Credit quality is deteriorating
Indeed, when looking at two important metrics of loan quality, we can see a marked deterioration.
During the companyâs latest conference callĂ CFO Michele Santana said ââŚour underwriting standards are proven and have been consistent over a long period of time. This consistency in our underwriting also is demonstrated in our weighted average FICO score for the portfolio. For FY â16, our weighted average FICO was 662 and have been in the mid 660s for numerous years. The FICO scores of the new customers in our portfolio in FY â16 at 684, was higher than the average for the total portfolio.â
Signet discloses the credit scores of its borrowers in their 10-K.
We can see that the credit scores of new customers have been steadily trending down as has composite credit score for the entire loan portfolio. While the CFOâs comments are technically correct, we can still see the portfolio weakening.
Even more alarming is that the loan portfolio is essentially subprime. To get the best credit terms, you need to have a credit score in the 50th percentile (or around 720). Signetâs credit portfolio doesnât even come close to meeting the definition of prime borrowers. Now add in the fact that the weighted credit scores have been declining and it raises some serious questions about just how good the loans Signet is making will be.
Taking at a look at the metrics Signet disclosed, we can see bad debt expenses, net charge offs and non performing loans are all increasing. We also took a look at Signetâs receivables turnover.
Receivables turnover has been steadily decreasing and the average duration of their receivables has risen from 246 days to 262 in just two years. This should be an alarming trend given that receivables made up over 25% of Signetâs assets.
It also raises questions about what the CFO was talking about when she said the following during the latest conference call âwhat I mentioned in the prepared remarks, we are seeing stability in our credit metrics and very confident in terms of our credit portfolio performance, all of which is factored in our Q1 and our annual guidance.â How can the credit metrics be stable when we can see them weakening no matter what metric is used?
Summary
We are very cautious about the future of Signet Jewelers and believe the company could encounter substantial problems in the next few years with slowing organic sales growth and serious issues with its credit portfolio. Turning to loaning your customers money to drive sales is never a good strategy. As loan growth begins to accelerate faster than sales growth, you need to generate ever greater credit sales in order to keep total sales growing. This inevitably leads to a decline in underwriting standards. Eventually the entire scheme collapses either when credit growth slows or when serious problems begin to develop with the loan portfolio. We donât know when that will be, but Signetâs strategy will surely fail eventually. Indeed, we can already see the cracks beginning to form as the loan portfolio deteriorates in quality.
