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In the opening scene of Breakfast at Tiffany’s, Audrey Hepburn appears with the Tiffany & Co logo etched into the Fifth Avenue granite behind her. Product placements don’t get better than this.
Tiffany & Co already had a lot going for it before the 1961 movie. Its ‘Tiffany setting’ rings have been a huge hit ever since Charles Tiffany invented them in 1886 – and they’re still the world’s most popular today. The company has even trademarked the colour of the little boxes that house its $1.5m engagement rings.
You’d expect the jeweller to the rich and famous to show fat gross profit margins, and it does. But it might come as a surprise to learn that Michael Hill International, the discount jeweller from New Zealand, has even better gross margins.
You heard right. Michael Hill International makes more from each sale than Tiffany & Co does. And it's growing more quickly and makes a higher return on shareholders' equity as well.
Behind this conundrum is a business worth understanding.
The first Michael Hill International store was opened in Whangarei, New Zealand in 1979. Its founder, Sir Michael Hill, had worked at his uncle’s jewellery store for 23 years until his entrepreneurial spirit was sparked when his house burnt down.
The start-up did away with stocking silverware and clocks, which was customary at the time, to focus exclusively on jewellery. Seven stores in seven years was the initial target.
After that a rapid expansion followed, initially throughout New Zealand, then Australia, Canada and finally the US. Michael Hill International now operates the largest jewellery manufacturing plant in Australasia which supplies its 332 stores.
Rapid growth often requires funding from a string of capital raisings, but Michael Hill International’s hasn’t. In fact, apart from a smidgeon of new shares issued to list on the ASX in 1987, total shares on issue have barely budged in three decades.
Herein lies a true owner operator. Some chief executives drive their company like a rental car, whereas Michael Hill International has been carefully garaged and serviced. And the company’s ambition hasn’t faltered, with a current target of 1,000 stores by 2022.
Michael Hill International is also dually listed on the ASX and NZX and insider ownership is high. So even though its market capitalisation approaches half a billion, it might not get the attention it deserves from index creators and institutional investors.
Back to the comparison with Tiffany & Co. Michael Hill International makes higher gross margins, but Tiffany & Co's net margins are higher, and they're what really matter. It achieves this with lower costs.
Who would have guessed the discount operator has higher gross margins and the upmarket operator has lower costs? Unpacking this gives an important insight into the jewellery business.
Like any retailer, a jeweller’s main operating costs are rent and labour. A jeweller’s inventory, though, is different in that it is physically small but high in value. An entire store’s worth could fit into the boot of your car – something furniture retailers like Nick Scali can only dream about.
This means store formats can be relatively small, saving on rent as well as warehousing and shipping costs. The risk of obsolescence may also lower because inventory can be refabricated. Compared to other specialty retailers, Michael Hill International generates healthy gross profit in relation to what it spends on rent.
A jewellery store doesn’t need an army of salesman either, reducing labour costs. In fact, Michael Hill International generates 65% more gross profit per employee than Woolworths and JB Hi-Fi.
Tiffany & Co has lower costs because its sales are on steroids. The pair has about the same number of stores: 332 for Michael Hill International and 313 for Tiffany & Co. But each Tiffany & Co store generates seven times as much revenue, so its operating costs are proportionately lower.
That's not to say Michael Hill International is a bad business; it's just that Tiffany & Co is better. But at 24 times earnings (versus ~14 times for Michael Hill International) the market already knows that.
It's no secret that Michael Hill International wants to be more like Tiffany & Co. After saturating Australia and New Zealand, as Chart 1 shows, Michael Hill International’s growth depends on North America and its new sister brand, Emma & Roe
Things are going well in Canada. Michael Hill International first entered in 2002 and after 15 years it finally looks like it's getting things right. Canada now produces 14% of group operating earnings and it's growing strongly. The allure is a footprint much larger than Australia’s.
But to reach its 1,000 store target Michael Hill International needs to win in the US, and that seems a long way off.
It first entered in 2008 by purchasing 17 stores from a bankrupt competitor. It spent up on super bowl advertisements and even partnered with Kim Kardashian to build awareness; not quite Audrey Hepburn but worth a try. But so far this has proved to be no more than a costly experiment.
After $28m of cumulative US losses the company now recognises that it must become a brand to be successful in the US and remain strong elsewhere. Michael Hill International wants Tiffany & Co's clout and the financial returns it brings. This means dropping third-party products in favour of proprietary collections. It means shifting the advertising message from price to emotion.
Greater brand value will also help in the upcoming fight with Amazon, which already sells jewellery online. The physical shopping experience seems to be highly valued by jewellery consumers, but as Signet Jewelers' recent share price crash shows, lower foot traffic in shopping centres makes life very difficult for a retailer. So the jury is still out on how they'll be affected.
We've been on the hunt for an opportunity to buy a decent retailer cheaply, and Michael Hill International could be it. It's currently priced at 13.8 times next year's earnings which doesn't seem overly expensive.
We particularly like having an owner-operator at the helm as well as its geographic diversity.
But we're new to the business and, with retail downgrades a dime a dozen these days, it pays to not rush in. So onto the watchlist it goes, but we'll hold off for a better buying opportunity as we get to know the business.
InvestSMART Staff members may own securities mentioned in this article.
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