Implications
Dollar averaging down, Breeden Capital reduces its break-even point for its stake in Zale as it considers alternative exit strategies.
Analysis
Has Zale’s stock price bottom out? That was the question many investors were asking earlier as the stock reached new lows almost every day of trading last week. In part, the decline could be attributed to investor’s pessimism about 4th quarter earnings for Zale specifically and the retail sector in general. But Zale’s stock price didn’t just decline during the week, it was in free fall; decreasing faster that either the Dow Jones Industrial Index or the DJ Retail Index; suggesting there was other problems at Zale.
Now with news that Breeden Capital has increased its stake in Zale to about 15.9%, the price decline has reversed itself; climbing to $16.00 in morning trading on Tuesday. Breeden’s announcement was the second one regarding its share of Zale. Earlier, the company had reported increasing its ownership from 7.9% to 13.1% of the 44.6 million shares outstanding. Clearly, Breeden Capital is accumulating the stock, but for what purpose.
One purpose could be defensive. It’s debateable whether Richard Breeden was fully aware of just how big a mess Zale was in when his hedge fund made its initial investment. Since that time he has watched Zale’s value decrease by about 37%. By increasing his positioning in Zale at the recent fire sale prices he may have significantly lowered the hedge funds average share cost and made an eventual exit strategy less costly.
Another possibility, he bought into Zale’s official strategy of streamlining the business to reduce costs, while growing sales in its Zale and Gordon branded mall stores. That’s an easy sell to many in the investment community; especially hedge funds. That’s because they believe retailers are inherently inefficient operators that under utilize both capital and marketing assets. Zale’s divestment of Bailey, Banks, and Biddle for about $200 million in September would have fit neatly into any hedge funds play book; as would have the reorganization of its division operating, buying, and merchandising structure. What’s next?
Find a buyer or take the company private; with a strong emphasis on ‘find a buyer’. That attitude is what’s likely propelling the recent increase in the stock price. Some of the work to sell the company has already been done. Since their initial investment, Zale has replaced its Chairman and hired a new CEO with a compensation package that has a rich front end payout; at least for a Zale CEO.
Also, the number of directors was reduced to seven at the November 14, 2007 annual meeting. Now, with 15.9% ownership, Breeden Capital will probably nominate at least two members to the board during the 2008 annual meeting. Assuming their election is almost a certainty and that the board doesn’t increase the number (nine is the maximum); they will probably have significant influence over at least 4 of 7 directors. All Richard Breeden needs is a willing buyer, but that may be a problem.
For almost two years, Signet Group PLC has been touted as the likely buyer for Zale. Now, with the stock trading at about 52% of its 52 week high, it would be a more attractive takeover candidate than it was in June 2006 when merger discussions were discontinued between the two companies. Still, there remain numerous impediments to any deal. For instance, Signet remains highly leveraged which was a problem for the company in the early 1990’s. Whether creditors would welcome a leveraged buyout is uncertain, especially with credit markets collapsing. Another problem is valuation because of Piercing Pagoda. Despite Zale’s attractive stock price, no retailer would offhandedly assume the liabilities of that business given its poor performance and even poorer likelihood of improvement.
The painful truth, there aren’t too many buyers for the company, even at its distressed share price. One reason, like some other troubled specialty retailers such as RadioShack, Toys R Us, Pier 1 Imports, and Sharper Image, Zale is a strategic turn around situation. That’s a lot more problematic for a potential buyer than restructuring a balance sheet. Another reason is synergy, or put another way, the companies lack of synergy with most other retailers. There’s a good reason why most large department stores lease their jewelry departments to specialists like Finlay Enterprises.
That leaves Breeden Capital in the position of either taking the company private in the hope of doing a future IPO or selling its interest in Zale at the first profitable opportunity. Neither is a good choice for Richard Breeden, but taking a quick profit as soon as possible is probably a better choice than committing another $500 million to take the company private.
