Shares of SIG have pulled back in the past 10-days following ZLC’s 10-Q filing, in which Zale’s reported that November comparable store sales declined 18.6% YOY.  Historically, November sales have represented as much as 25% of total annual revenues. For Zale Corporation, this is nothing short of a disaster. The broader question from our perspective is: what are the implications of ZLC’s misfortunes on SIG and our pair trade: long SIG/short NILE?

First and foremost, it should be noted that ZLC’s comp store sales have underperformed those of SIG for quite sometime.  As we have stated in the past, SIG continues to gain market during the downturn due to the company’s well-known brands, effective marketing, compelling proprietary products, and strong balance sheet.  We continue to believe that SIG remains the best investment vehicle in the specialty jewelry space and will be the biggest beneficiary of the 2,000+ specialty jewelery retail locations that have been shuttered over the pas 18-24 months.  The magnitude of ZLC’s comp store weakness still warranted further investigation as to whether this was a ZLC specific problem or an industry-side problem. 

We have reached out to a number of our independent specialty jewelry contacts over the past 10-days in order to get a better sense of holiday sales trends, inventory levels, and any changes to the competitive landscape.  Here are some our key findings:

Fourth Quarter Comp Trends

• Prior to the start of the fourth quarter, most jewelers we spoke with had witnessed a 15-20% decline in sales on YOY basis for 2009
• However, a majority of the independent jewelers we contacted have witnessed flat sales thus far in the fourth quarter
• Traffic is flat to down high single digits, while average order value is a big driver of sales declines (to the extent comps are down)
• EVERY jeweler we spoke with has increased pricing at a minimum 5-10% in response to the recent rise in precious metals prices.  In many cases, jewelers have implemented 10-15% price increases.  (Positive for SIG, negative for NILE)

Inventory Levels

• Every jeweler we spoke with reduced the size of their inventory purchase  for this holiday season
• Jewelers continue to work-down their absolute inventory levels, although many still think their overall inventory remains “too high”
• Most jewelers are still holding inventory that was purchased prior to 2009, which continues to pressure gross margins
• There were a few jewelers that indicated that pricing on polished diamonds purchased thus far in the fourth quarter have actually increased.  As we have discussed here and here,  we think pricing in the US polished diamond market is poised to rebound in the near term.

Competitive Landscape

• Most jewelers are conducting the same level of promotional activity as they did a year ago and it appears pricing pressure remains relatively innocuous
• Most independent jewelers we spoke with continue to expand their ecommerce offerings in attempt to stave off market share gains for pure online retailers such as  Blue  Nile and Amazon
• Independent jewelers still expect ecommerce players to gain market share at a more rapid rate than traditional jewelers
• From a proprietary product perspective, the independents think that Tiffany’s, followed by Amazon and Signet have the most differentiated collections that have facilitated market share gains.

Overall the results of our channel checks suggest that ZLC’s issues are largely company specific.  It appears at this stage that bankruptcy is a distinct possibility.  While the short-term implications of a bankruptcy event could have negative implications on SIG in the short term (pricing pressure from inventory liquidation), the longer term impact would be enormously positive.

SIG’s Websites Continue to Generate Traffic Gains, While Bluenile.com Does Not

One of the principal elements of our short thesis on NILE is that the company will continue to face increased competition from traditional jewelers as they expand their ecommerce offerings.  The latest monthly traffic data from Compete.com indicates that the websites for SIG’s core brands continue to generate stronger unique visitor growth than does bluenile.com.  According to Compete.com, in November the monthly number of unique visitors to bluenile.com DECREASED 23% YOY, while traffic to kays.com and jared.com increased 16% and 43%, respectively.  Even ZLC’s website appears to be growing traffic at a faster rate than bluenile.com. 

Source: Compete.com

To NILE’s credit, the traffic data has suggested that the company’s revenues would be weaker than they actually turned out to be for a few quarters now. Management has stated that it thinks its traffic numbers are significantly understated.  Management has set a high bar for 4Q results (17-27% revenue growth) based on the data from Compete.com and the feedback we have received from independent jewelers we wonder if this is achievable.

We continue to view long Signet Jewelers/short Blue Nile as a compelling pair trade idea.  We view Signet Jewelers as the best investment vehicle in the specialty jewelry space based on its strong geographic footprint, well known brands, and growing web presence which has enabled the company to gain significant market share in the downturn.  Additionally, the company is effectively long gold, silver, platinum and diamonds, which should lead to margin expansion in an inflationary environment.   For Blue Nile, we think shares could see considerable downside if the Diascience Corp. lawsuit escalates.  Additionally, we think the fundamental short thesis is equally compelling: 1) the company has a significant operating margin conundrum, it is promotional in a downturn and squeezed by higher commodity costs in an upturn, and 2) the company will face increased competition from more sophisticated web-retailers and established onsite specialty jewelers that are expanding their web-presence.  Clearly, these concerns are not yet embedded in the valuation of NILE shares.  The stock now trades at 67.6x consensus FY09 EPS and 52.5x consensus FY10.  

We see downside in NILE shares towards $30 if investors embrace some of the fundamental flaws in NILE”s business model and/or the Diascience lawsuit creates a substantial amount of negative publicity.  At 15-17x our FY11 EPS estimates SIG would trade as high as $33-$36.

As always, please act accordingly….