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In terms of profitability, it was again a disappointing quarter. Gross margins fell 240 basis points y/y to 57.1%, resulting in part from higher gem stone and diamond costs it has yet to pass through to customers. TIF hopes direct diamond sourcing should help minimize these costs. In addition, weak sales in Japan and increased sales of higher priced, but lower margin diamond products weighed on margins. On the operating level, margins dropped significantly from 24.5% last year to 17.3% due to a 26% rise in SG&A costs. There was a meaningful rise in finished goods inventories up 17% y/y, which co attributed to new store openings and product offerings.

Japan will continue to be a thorn in Tiffany's side throughout the year. The country has reentered a recessionary environment with personal spending down for the third consecutive year. Management stated during its conference call that Q1 is off to a bad start with comps worse than it expected. Considering Q4 sales trends and continued weak Japan sales, it was not a surprise to see downside guidance for Q1. It sees EPS of below $0.25 vs. Reuters Estimates consensus of $0.28. For FY06, it sees EPS of $1.55-1.65, ex items, consensus $1.62.

Despite what first appears as a headline beat, TIF's Q4 results lacked inspiration. As such, the stock is likely to experience downside pressure amplified by its downside guidance. As we have stated in the past, TIF's declining profitability trends continues to be worrisome due to cost headwinds. Also, considering Japan makes up almost a quarter of its total sales, we would suggest caution until comp trends flatten out and TIF gets back on track.
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