SIGNET JEWELERS LTD annual report, FY2015

Business context and reporting period

Signet Jewelers Limited’s FY2015 Form 10-K covers the 52 weeks ended January 31, 2015; fourth quarter was the 13 weeks ended that date. Signet operates specialty jewelry stores in the U.S., Canada and U.K. On May 29, 2014, it acquired Zale Corporation for $1.458 billion, including repayment of Zale debt. FY2015 includes Zale only from the acquisition date, so year-over-year consolidated comparisons are materially affected by the transaction.

Financial performance and condition

For Q4, sales were $2,276.4 million, up 45.5% year over year, with same-store sales up 4.2%. Net income was $228.0 million versus $175.2 million, and diluted EPS was $2.84 versus $2.18. The reported Q4 gross margin was 40.1% versus 41.5%; operating margin was 14.6% versus 17.3%.

FY2015 adjusted operating income, a non-GAAP measure excluding specified acquisition accounting, severance and transaction costs, was $682.3 million (11.8% of adjusted sales); adjusted diluted EPS was $5.63. Reported results included $105.7 million of purchase-accounting, severance and transaction costs. The lower consolidated margin reflected Zale’s lower-margin business and acquisition-related items; the adjusted gross margin rate was down 60 basis points.

At January 31, 2015, cash was $193.6 million, working capital $3,069.0 million, total liabilities $3,517.2 million and shareholders’ equity $2,810.4 million. Long-term debt was $1,363.8 million; total debt, loans and overdrafts were $1,461.3 million, resulting in net debt of $1,267.7 million versus net cash of $228.3 million a year earlier. The company reported $374.6 million of additional availability under credit agreements and was in compliance with debt covenants. Adjusted leverage was 4.0x. Inventory rose to $2,439.0 million, primarily due to Zale. The Sterling in-house credit portfolio had $1,660.0 million of closing receivables; net bad debt was 4.2% of Sterling sales, up from 3.9%.

Material changes versus the prior period

• Zale added $1,215.6 million of sales for the post-acquisition period and expanded the store base to 3,579 stores and kiosks. Excluding Zale, Signet’s net store space increased 4.4%.
• Operating income rose only 1.1% despite the sales increase, while operating margin fell 350 basis points. Interest expense increased to $36.0 million from $4.0 million following acquisition financing.
• Operating cash flow improved, but free cash flow declined as capital spending and working capital needs increased. Capital expenditures were $220.2 million versus $152.7 million.
• The effective tax rate declined to 29.5% from 35.0%, principally reflecting the financing and capital structure associated with the Zale acquisition.
• FY2015 included $59.8 million of transaction, integration and severance costs within Other, as well as $45.9 million of Zale purchase-accounting operating losses.

Outlook, commentary, risks and contingencies

Management’s FY2016 priorities include Zale integration, profitable market-share growth, supply-chain development, digital and marketing initiatives, and cost control. Signet targets $150 million to $175 million of cumulative three-year Zale synergies through January 2018, with at least 20% expected in FY2016. Planned capital investment is $275 million to $325 million. Management expected diamond costs to rise at low-to-mid single-digit rates and said it intended to open new stores and remodel existing locations.

Capital policy targets adjusted leverage of 3.5x or below, distribution of 70% to 80% of annual free cash flow through dividends or repurchases absent other strategic uses, and $100 million to $150 million of share repurchases by FY2016-end. Year-end adjusted leverage was above target at 4.0x. The Board raised the quarterly dividend to $0.22 per share in March 2015.

Key risks include discretionary consumer demand and pronounced holiday-season dependence; consumer-credit regulation, collection performance and bad debts; diamond and gold costs and supply; foreign exchange and variable-rate debt; inventory and supplier execution; cybersecurity and information systems; and successful Zale integration, synergy delivery and goodwill valuation. The company reported substantial Zale-related goodwill and indefinite-lived intangibles and warned that impairment could materially affect earnings.

Contingencies include employment discrimination proceedings involving Sterling, Zale wage-and-hour claims, litigation challenging the Zale acquisition and appraisal petitions by former Zale shareholders. Management stated that loss outcomes or ranges for the principal litigation matters could not be estimated. The financial statements received an unqualified audit opinion, and management and the auditor concluded internal control over financial reporting was effective.

Most important facts for investors to verify

• Whether Zale integration delivers the targeted synergies and improves its operating margins without further material integration costs.
• Whether Sterling’s rising receivables, credit-sales penetration and bad-debt rate remain manageable, and how credit-related cash needs affect free cash flow.
• Debt reduction progress toward the 3.5x adjusted-leverage target, alongside debt maturities, variable-rate exposure and covenant headroom.
• Inventory quality and sell-through, especially acquired Zale inventory and exposure to diamond and gold cost changes.
• Developments in acquisition-related appraisal and shareholder litigation, employment cases, and potential goodwill or intangible impairment.