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A Troubled Company With A Solid Business

A Troubled Company With A Solid Business

Traders trade stocks. This seems like an obvious statement but it is an important point to remember. Sometimes, the stock will not reflect the company’s underlying business performance. At other times, the stock price will reflect concerns about a worst case scenario.

That seems to be the case with Signet Jewelers Limited (NYSE: SIG). Let’s start with a chart of the stock price going back three years.

The stock traded as high as $150 in 2015. That year, revenue topped $5.7 billion. The company reported earnings per share (EPS) of $4.77.

This year, analysts expect revenue of $6.17 billion. EPS are expected to reach $6.68. Despite the substantial operational improvements over the past few years, the stock is down more than 60%. The current stock price indicates there is more to this story.

An Undervalued Opportunity?

Signet Jewelers sells jewelry, watches and associated services in the US, Canada and the United Kingdom. Signet’s brands include Zale Jewelry, Piercing Pagoda, Kay Jewelers, Jared and several regional mall-based brands.

Through all of its brands, Signet operates more than 3,500 stores and kiosks. The company also has an operation that allows it to keep its costs down. Another division of the company is involved in purchasing and converting rough diamonds to polished stones.

Like many retailers, the company also offers financing to customers. This financing facilitates large purchases, an important selling point for jewelers. For example, an engagement ring will be a significant purchase that many customers could not afford without financing.

The different parts of the business seem to work well together from a financial perspective. But, that is not reflected in the market price.

Based on the current stock price, SIG is trading at about eight times this year’s expected earnings. This is well below the stock’s five-year average price-to-earnings (P/E) ratio of 17. SIG is also trading well below its industry average P/E ratio of 15.

At first glance, this stock appears to be a bargain. But, there is more to the story of Signet than sales and profits. There are some significant concerns weighing on the company.

The Rest of the Story

The company is facing a massive class-action arbitration case in which 69,000 women who worked for Sterling Jewelers alleged that the company discriminated against them in pay and promotion practices.

A number of former Sterling employees alleged in sworn statements and in interviews with The Washington Post that company leaders had presided over a culture of sexual “preying” on young saleswomen at company events.

The company has said the allegations have no merit. Signet has retained a former federal judge to review company “policies and practices regarding equal opportunity and workplace expectations” and established a special committee focused on “respect in the workplace.”

The company’s CEO abruptly resigned last month and was replaced by a female CEO. This is obviously a move intended to address the culture at the company.

The legal action could continue to weigh on the company. Many of the allegations are lurid and will be repeated in the press as frequently as reporters can mention them. Given the sheer number of allegations, it is best to assume there will be a penalty to the company.

Any penalty could be funded with cash flow from operations. This amount topped $620 million in the past twelve months.

There are also questions related to the company’s accounting. These have been extensively covered in the media as well.

The company finances a significant portion of sales, more than 50%, in the Sterling Jewelers division which includes Kay Jewelers, Jared, and smaller regional brands. This percentage has been rising over the past few years.

The large percentage of sales that were financed led some analysts to worry that these stores are using financing to make sales to customers with subprime credit. They point out that there is less financing at the Zales division which outsources its financing. Outsourced financing requires higher credit standards.

In addition to concerns about subprime lending, analysts also question Signet’s accounting method. Signet uses a standard known as “recency accounting” which classifies an account as current as long as a customer has made one full scheduled payment over a 90-day period.

The more commonly used accounting rules classify an account as delinquent whenever a single payment is missed. Even with the looser standard, Signet still has a high delinquency rate with more than 20% of its account imperiled. With the stricter standard, that figure could be more than 50%.

To address the accounting concerns, the company took several steps since May. That month, the company announced it was selling $1 billion of its prime-only credit quality accounts receivable to Alliance Data Systems Corporation at par value.

The company entered into a preliminary agreement with Genesis Financial Solutions to service its non-prime accounts receivables. Signet also partnered with Progressive Leasing, a subsidiary of Aaron’s, to improve its internal operations. Over time, Signet intends to fully outsource its secondary credit programs.

All of this is expected to boost EPS and improve the company’s cash flow profile and capital efficiency with only a slight decline in operating income from sale of primary credit program.

What This Means for Traders

These are all positive steps for Signet and show that the company is focusing on its problems. Investors are about to receive an update on the progress of the company when earnings for the most recent quarter are announced before the open on August 24.

That announcement presents a potential trading opportunity. It is likely the stock will make a large move after the news is released. On average, SIG has lost 4% in the week after an earnings announcement. A larger move is certainly possible since this will be the new CEO’s first chance to address analysts in an earnings call.

To profit from a large move, traders use an iron butterfly strategy. The risks and potential rewards of this strategy are shown in the diagram below. The strategy profits from a large move in the stock but doesn’t require the trader to choose a direction for the move.

Source: The Options Industry Council

This strategy combines four options contracts. The trader will buy a call option and a put option with an exercise price that is close to the current price of the stock. The trader will then sell a call with an exercise price above the current price of the stock and also sell a put option with an exercise price below the current price of the stock.

All options will have the same expiration date. The options that are sold will have exercise prices that are an equal distance from the exercise price of the options that are bought.

For SIG, options expiring on September 15 are available. The following trades can be used to create a long iron butterfly:

  • Sell September 15 $50 puts at about $1.80
  • Buy September 15 $55 calls at about $4.00
  • Buy September 15 $55 puts at about $3.70
  • Sell September 15 $60 calls at about $2.10

This trade will cost about $380 to open since each contract covers 100 shares. The maximum possible gain on the trade is $120, the difference between the exercise prices less the premium paid to open the trade. The maximum possible loss is $380, the amount paid to open the position.

This trade offers a potential gain of more than 31% of the amount of capital risked. It is also possible the size of the gain or loss could be less than the maximum. Overall, there is a high probability of success in this trade given the likelihood of a large move in SIG next week.