All That Glitters At Tiffany's

Earnings and shares are up. But look beneath the surface

At Tiffany & Co's. (TIF ) flagship store on New York's Fifth Avenue, a huge clot of people waits for the elevator to the second floor, where some of the priciest baubles reside. Once they arrive, couples ogle display cases featuring items like the rose-cut diamond Fleur necklace (that'll be $110,000, please) and the green-tourmaline-and-aquamarine bracelet ($86,500). Customers sip Perrier while jazz plays in the background.

Shopping at Tiffany's is a seductive experience, particularly in the high-end realm: Sales growth in items costing $20,000 and up is outstripping that of cheaper goods. But it was a sparkling 23% earnings gain that caught investors' eyes recently. Tiffany's Nov. 29 earnings report showcased a 9% jump in U.S. retail sales, with the Fifth Avenue store boasting a 13% rise in sales from a year ago. Numbers like that, coupled with an upward revision to earnings guidance for the year, have sent Tiffany's stock up 9% in six days.

A closer look at earnings reveals a less lustrous picture. A one-time gain from the sale of investments accounts for three of the quarter's 4 cents-per-share gain. A high level of share buybacks--some $100 million worth--supported earnings per share. Operating earnings rose 10.7%, but the operating margin was flat and is down for the first nine months of the year. Tiffany executives declined to be interviewed, citing a quiet period.

Easy comparisons year-on-year also helped earnings. The latest quarter marked the first time in years there was no remodeling in the New York store, likely helping sales. Remodeling also plays into the 21% gain in same-store sales in Europe, where sales fell 1% a year ago. London accounts for half of European sales, and half of London sales come from Tiffany's main shop, on Bond Street. A year ago the store was undergoing an extensive renovation, depressing sales. The revamp increased store selling space by 60%, so some of the recent strength reflects sales in new square footage, not higher sales in existing space.

A worrisome issue is Tiffany's struggle with product mix. The big-ticket bias is an attempt to bolster brand image, which began to suffer in 2001 after Tiffany started promoting a low-priced, highly profitable silver jewelry line. It took off, but Tiffany worried that its very popularity damaged the brand's exclusive allure.

Problem is, glam items aren't as profitable as cheaper adornments. The cost of materials and labor to make a diamond-and-platinum necklace is high relative to the price Tiffany can charge; it can mark up less expensive jewelry more. In general, diamond jewelry has a gross margin of about 50%, vs. 70% for silver goods, estimates JPMorgan Chase. With Tiffany saying the "greatest growth" is coming from products with precious stones, lower-margin items likely account for a bigger slice of the pie. That helped send Tiffany's gross profit margin to 53.5%, from 54.1%. It doesn't sound like much, but in the jewelry biz, every fraction of a point counts.

Yet another challenge comes from Japan, which accounts for 20% of sales. Same-store sales there fell 5%, marking the first quarterly decline since early 2005. The retailer is working to rebuild buzz amid fierce competition. Once Tiffany does that, the trick will be to translate it into high-quality profits.

By Louise Lee, with Megan Tucker in New York

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