Key Drivers of Operating Profitability

The key drivers of operating profitability are:

• sales performance;
• achieved gross merchandising margin;
• level of expenses;
• balance between the change in same store sales and sales from new store space; and
• movements in the US dollar to pound sterling exchange rate, as about 22% of Signet’s sales and about 15% of operating income, including unallocated costs, are generated in the UK and Signet reports its results in US dollars.

These are discussed more fully below.

Sales

Sales performance in both the US and UK divisions is driven by the change in same store sales and contribution from changes in net store space.

Same store sales are a function of the number of units sold and the average selling price of those units. The average selling price can alter due to changes in the buying patterns of consumers or due to price changes. For example, historically Signet’s customers had been purchasing larger, higher quality diamonds, which had lifted the average selling price. However, in the second half of fiscal 2009 and in fiscal 2010, the challenging economic environment resulted in the typical consumer buying items with a lower average selling price. In early fiscal 2009, a new pricing architecture was implemented which resulted in a higher average selling price in both the US and UK divisions to reflect the increase in the cost of merchandise, primarily due to the higher cost of gold. Further price increases were implemented by the UK division in fiscal 2010. Such price increases usually result in an initial reduction in the number of units sold followed by a recovery in volumes, but not to the prior level, all other factors being constant.

A new store typically has sales of about 60% that of a five year old store, and will only contribute to sales for part of the fiscal year in which it is opened. Store openings are usually planned to occur in the third quarter and store closures in January. When investing in new space, management has stringent operating and financial criteria. Due to the very challenging economic environment, US net space decreased by 1% in fiscal 2010 and a broadly similar decline is anticipated in fiscal 2011. This is in contrast to net space growth in the US of 4% in fiscal 2009, 10% in fiscal 2008 and 11% in fiscal 2007. The majority of the historic space growth reflected mexpansion of the Jared format. In the UK, there was a decline in space of 1% in fiscal 2010, a 1% increase in fiscal 2009 and a 4% decline in fiscal 2008. Typically there is a small decline in UK space as the H.Samuel chain withdraws from smaller sized retail markets, and there are very limited new space opportunities for either H.Samuel or Ernest Jones to offset these closures. A 2% decline in space is planned by the UK division in fiscal 2011.

Net change in store space

In fiscal 2010, total sales fell to $3,290.7 million (fiscal 2009: $3,344.3 million), down by 1.6% on a reported basis and up by 0.6% at constant exchange rates; non-GAAP measure, see Item 6. Same store sales decreased by 0.4% and net change in store space contributed 1.0% to sales. See page 62 for further analysis. In the fourth quarter total sales increased to $1,203.6 million (fiscal 2009: $1,123.6 million), up by 7.1% on a reported basis and by 4.7% at constant exchange rates; non-GAAP measure. Same store sales increased by 5.2% and net change in store space had an adverse impact of 0.5%.

Cost of sales

Cost of sales, which is used to arrive at gross profit, takes into account all costs incurred in the purchase, processing and distribution of the merchandise, all costs directly incurred in the operation and support of the retail outlets as well as the net provision for uncollectible receivables. The classification of distribution and selling costs varies from retailer to retailer and few retailers have in-house customer finance programs. Therefore Signet’s gross profit percentage may not be directly comparable to other retailers.

Gross merchandise margin

The gross merchandise margin is the difference between the selling price achieved and the cost of merchandise sold expressed as a percentage of the sales price. In retail jewelry, the gross merchandise margin percentage is above the average for specialty retailers, reflecting the slow inventory turn. Gross merchandise margin dollars is the difference expressed in monetary terms. The trend in gross merchandise margin depends on Signet’s pricing policy, movements in the cost of goods sold, changes in sales mix and the direct cost of providing services such as repairs. In early fiscal 2009, management increased prices in both the US and the UK. Further price increases were implemented in the UK in fiscal 2010.

In general, the gross merchandise margin of gold jewelry is above that of diamond jewelry, whilst that of watches and gift products is normally below that of diamond jewelry. Within the diamond jewelry category, the gross merchandise margin varies depending on the proportion of the merchandise cost accounted for by the value of the diamonds; the greater the proportion, the lower the gross merchandise margin. In addition, the gross merchandise margin of a Jared store is slightly below the mall brands, although at maturity the store contribution percentage of a Jared site is similar to that of a mall store. The gross merchandise margin of differentiated merchandise is usually a little above average for that product category, while that of a value item is a little below average. A change in merchandise mix will therefore have an impact on the US and UK division’s gross merchandise margin and a change in the proportion of sales from Jared will have an impact on the gross merchandise margin of both the US division and Signet as a whole. In the US division, until fiscal 2008, the growth of Jared, the increase in sales of higher value diamonds (both of which had been helping to drive same store sales growth), and higher commodity costs meant that the US gross merchandise margin showed a small decline in most years. Since fiscal 2009, the gross merchandise margin has increased as these trends reversed.

Commodity costs
Important factors that impact gross merchandise margin are the cost of polished diamonds and gold. In the US, about 55% of the cost of merchandise sold is accounted for by polished diamonds and about 20% is accounted for by gold. In the UK, diamonds and gold account for about 10% and 20% respectively of the cost of merchandise sold, and watches for about 38%. The pound sterling to US dollar exchange rate also has a material impact as a significant proportion of the merchandise sold in the UK is purchased in US dollars. Signet uses gold and currency hedges to reduce its exposure to market volatility in the cost of gold and the pound sterling to dollar exchange rate, but does not do so for polished diamonds. For gold, the hedging period is normally a maximum of one year. For currencies, the hedging period can extend to 24 months, although the majority of hedge contracts will normally be for a maximum of 18 months.

The price of diamonds varies depending on their size, cut, color and clarity. The price of diamonds of the size and quality typically purchased by Signet showed little variation over the fiscal years 2007, 2008 and 2009. Due to the sharp decline in demand for diamonds in the second half of fiscal 2009, particularly in the US which accounts for about 40% of worldwide diamond demand (source: IDEX Online (“IDEX”)), the supply chain became overstocked with diamonds. Combined with the reduced levels of credit availability, the oversupply of diamonds resulted in a fall in the price of loose polished diamonds of all sizes and qualities for most of fiscal 2010. The IDEX Global Diamond Price Index is an independent source that tracks diamond prices in the IDEX inventory database. While IDEX tracks price movements in its database they are not representative of all transactions in polished diamonds and do not necessarily reflect prices paid by Signet. IDEX reports show that the price of diamonds over three carats, which is larger than Signet usually purchases, are more volatile than for sizes and qualities that are typically used in merchandise sold by Signet. In the final quarter of fiscal 2010, polished diamond prices increased a little, but remained below fiscal 2009 levels. Demand for diamonds is primarily driven by the manufacture and sale of diamond jewelry and their future price is uncertain.

The cost of gold has steadily increased during the last three fiscal years, primarily reflecting increased investment demand rather than changes in the usage for jewelry manufacture. During fiscal 2010, the cost of gold increased from an average of $943 per troy ounce in February 2009 to $1,118 per troy ounce in January 2010. Since the start of fiscal 2011 the cost of gold has been volatile, but has averaged above the $1,100 level. The future price of gold is uncertain.

Signet uses an average cost inventory methodology and therefore the impact of movements in the cost of diamonds and gold on gross merchandise margin is smoothed. In addition, as jewelry inventory turns slowly, the impact takes some time to be fully reflected in the gross merchandise margin. As inventory turn is faster in the fourth quarter than in the other three quarters, changes in the cost of merchandise are more quickly reflected in the gross merchandise margin in that quarter. Furthermore the hedging activities result in movements in the purchase cost of merchandise taking sometime before being reflected in the gross merchandise margin.

Operating income margin

To maintain the operating income margin, Signet needs to achieve same store sales growth sufficient to offset any adverse movement in gross merchandise margin, any increase in operating costs (including the net bad debt charge) and the impact of any immature selling space. Same store sales growth above the level required to offset the factors outlined above, allows the business to achieve leverage of its fixed cost base and improve operating income margin. Slower sales growth or a sales defcline would normally result in a reduced operating income margin. In exceptional cases, such as through the US division’s cost saving measures implemented in fiscal 2010 and described below, Signet may be able to reduce costs enough to increase operating margin. A key factor in driving operating income margin is the level of average sales per store, with higher productivity allowing leverage of expenses incurred in performing store and central functions. Therefore a slower rate of net new space growth is beneficial to operating income margin while an acceleration in growth is adverse.

The impact on operating income of a sharp, unexpected increase or decrease in same store sales performance is marked. This is particularly so when it occurs in the fourth quarter. However, the impact on operating income of short term sales variances (either adverse or favorable) is less in the US division than the UK, as certain variable expenses such as sales-related rent and staff incentives account for a higher proportion of costs in the US division than in the UK division. In the medium term, there is more opportunity to adjust costs to the changed sales level, but the time taken to do so varies depending on the type of cost. An example of where it can take a number of months to adjust costs is expenditure on national network television advertising in the US, where Signet makes most of its commitments for the year ahead during its second quarter. It is even more difficult to reduce base lease costs in the short or medium term, as leases in US malls are typically for ten years, Jared sites for 20 years and in the UK for five plus years.

The operating margin may also be impacted by significant, unusual and non-recurring items. For example, in fiscal 2010, the vacation entitlement policy in the US division was changed, see page 66 for details. This resulted in the selling, general and administrative costs being reduced while operating income increased by $13.4 million; this benefit will not be repeated in subsequent years. In fiscal 2009, there was a provision for goodwill impairment of $516.9 million, see page 70 of Form 10-K, and relisting costs of $10.5 million related to the move of Signet’s primary listing to the NYSE from the LSE, see page 71 of Form 10-K.