Has Management Lost Creditability at Zale (ZLC)?

Summary

After a year of superficial changes and a cosmetic make over, Zale is in more jeopardy than ever.  Here's more...

Analysis

Zale’s stock was among the biggest specialty retail gainers in early morning trading the day after New Years.  Increasing about 23%, the stock was $4.10 per share in mid-day trading.  For day traders and speculators alike, that was a rally, but it doesn’t represent any significant change in Zale’s doomed turn around strategy.  However, some large investors and industry pundits don’t see it that way, at least not yet.  According to Barrons, Richard Breeden purchased an additional one million Zale shares for about $6.29 per share in early December.  That brings the Zale director, former SEC chairman, and manager of Breeden Capital Partner’s stake in Zale to about 9,070,839 shares or approximately 28% control of the company. 

Breeden Capital Partners is a hedge fund that currently owns significant positions in six companies including Zale.  To date, the hedge fund has lost about $114 million on its Zale investment.  What’s more, as of a November filing, Breeden had lost more than $65 million of his partner’s money on the company’s portfolio, the biggest loss, Zale.  Whether Breeden’s partners will be patient and wait and see if Goldberg can turn Zale around remains to be seen.  A bigger question is: Will the new CEO stay and risk failing as he confronts one of the most difficult challenges in specialty retailing today.

One year into his tenure, it’s déjà vu for Goldberg, since he must mollify another impatient board, as well as, an activist shareholder, a challenge that eluded him at The Children’s Place.  Then there’s the jewelry business, an industry in disarray for which he is woefully ill prepared.  Granted, Goldberg talks like a merchant.  But it’s one thing to talk the talk and quite another to walk the walk.  He’s was right when he said there was too much sameness in industry, but how you turn that into a competitive advantage requires knowledge and skill that neither he nor his inexperienced cadre’ of new EVP’s have, at least if his first year on the job is any measure.  

For example, Goldberg launched the company’s new solitaire diamond collection “Celebration” only to find it over priced, its position in conflict with other diamond merchandise, and attributes too esoteric for sales associate and shoppers alike.  Now the company is being sued for false advertising.  Not that Celebration was a brand anyway.  Zale is the brand and management’s mistakes with Celebration has probably further damaged it through the careless marketing and sloppy execution. But, that’s not the first time Goldberg has damaged the Zale brand. More than 9 months of deep discounts didn’t create the “good value” image that the CEO thought.  Quite the contrary, Zale is now, more than ever, just another discounter, whose jewelry is overpriced compared to Walmart and under valued when compared to the likes of Kay.   

Some industry analysts will point to a long list of Goldberg achievements over the last year that could position Zale for future profitability such as increased inventory turnover, streamlined merchandise offering, reduction of vendors, improved customer experience, new product offerings, new store prototypes, and improved sales associate training and compensation.  The list reads like the table of contents from a consultant’s handbook, not a strategic plan to turn around a jewelry company.  Turn arounds are about creating a sustainable, competitive advantage and frankly, scratch below the rhetoric and you find little that is sustainable and even less that is strategic. 

For instance, inventory turnover did increase in the first quarter, but it appears to be driven by increased sales from deep discounting not large reduction of inventory.  For the period ending October 31, 2008, inventory decreased only $21.4 million or (2.1%) lower than a year earlier. That’s neither a strategic change in how the company manages inventory nor a sustainable advantage unless management can demonstrate the ability to operate profitably at 48.5% gross margins.

Another example of Zale’s ineffectual efforts is the Pace Setter stores.  Management’s numbers suggest these stores were about 10% more profitable than the remainder of the chain, but that’s only half the story.  According to Goldberg, the stores were merchandised with 40% larger assortments.  What that translates to in terms of cost inventory isn’t clear, but if it’s much more than 10%, then the result is unfavorable.  It’s problematic if the increase in operational store profitability (Δ6% sales, Δ2% margin) translates to a net gain when additional interest, distribution, and markdown costs are added to the store’s P & L.  That aside, the results were from the company’s best 135 stores, which by definition isn’t the kind of effect that can be replicated in the average store. 

Perhaps most the most glaring failure in Goldberg’s initiatives was the company’s plan to reduce expenses.  In February 2008 Zale announced that it was going to cut $65 million in expenses as a part of an “operational efficiency program”.  According to management the majority of the savings would be realized by cutting overhead costs.  As of the end of the first quarter of FY 2009 (October 31, 2008), Zale SG&A was “flat” with the previous year.  Apparently, the planned reductions were framed in terms of earlier budgeted expenses and not a decrease in the actual expense base in February 2008. 

By now it’s clear that the jewelry sector was down double digit over the November 1^st-December 24^th period.  Moreover, increased discounts after Christmas haven’t overcome higher returns and lower gift card redemptions.  Investors may have to wait until mid March for Zale to report 2^nd quarter sales and earnings.  Even so, the fact that much of Zale’s planning over the last year emphasized quick fixes rather than solid changes designed to build strategic advantage seems apparent.  Now both Breeden and Goldberg have a creditability problem. More stock buy backsbacks aren’t likely to drive share prices higher.  In fact, since the company is likely to lose money in FY2009, reducing shares would only drive per share losses higher.  That’s provided Zale could borrow the cash to finance them in today’s restricted credit markets. 

Then there is the recession.  Not only is Zale up against the “unprecedented freefall” of the economy, but it is also facing FY2008 year’s second half inventory liquidation event which means previous  year’s sales are probably unachievable even at last years low gross margins.  That pits Zale against Signet, its largest competitor, as well as, the rest of the industry that has a relatively softer numbers, meaning Zale’s performance could be much weaker this spring compared to its competitors, adding more risk to the value of a stock that is already trading at a dismally low value.

If Goldberg had really restructured the company’s cost base and reengineered the supply chain to be profitable at much lower margins, Zale could have been the big winner this year despite the recession.  That may have been what investors thought was happening, but it’s now clear quick fixes were the tool of change not new strategies. Now both Richard Breeden and Neil Goldberg have little choice other than to reinvent Zale or risk losing everything.  The question is: Without the quick fixes and magician's tricks, does either one have the slightest idea how to it?