Hedge Funds Look For Zale Exit Strategy

Implications: Dismal results, inexperienced management team, and pecuniary strategy points to a quick exit by hostile hedge funds.  

Analysis:  Zale announced its profit dropped (32%) to $1.16 per share from continuing operations for its second quarter of FY 2008.  That’s the most profitable quarter for the retailer where it expects to make the majority of its profit for the entire year.  First quarter results for America’s second largest retailer was a loss of ($0.54).  

What FY 2008 earnings will be is anybodies guess.  Last year the company lost ($0.08) per share in its third quarter and reported a $0.03 per share profit in its final quarter ending July 2007.  Most of that $0.03 profit was not operational, but a financial benefit because of a change in how profits retained in its Canadian operation was taxed.  

If Zale matched of last years numbers, FY 2008 profits would decline about 55%.  But that’s just arithmetic.  Neil Goldberg, the company’s new CEO said he expected margins would decline by about 5 percentage points for the second half.  With about $1.0 billion in sales remaining to be achieved for the fiscal year, that equates to a loss of about $50.0 million in gross profit.   

According to the new Chief Executive the cash lost from that reduction in margin would be offset by a $100.0 million reduction in inventories in absolute terms.  That means Zale will have to sell at least half that distressed inventory at better than cost to recover the GP lost from lower margins.  But that assumes the company can maintain its previous years underlying sales and margin rate which is a big if.   

So much for financial strategy, now let’s look at this strategy from a retail point of view.  First, Zale assortments are already broken and unproductive.  The company began a limited replenishment program last year after its duplicate style, multiple size diamond assortment strategy failed to produce results.  This inventory was merged with Gordon and Peoples assortments as a part of its merchandise consolidation program while two year old inventory was still being liquidated in-store at prices up to 70% off.  This was a formula for failure during the second quarter taht was only made worse by the economy.      

A case could be made that its sales results would have been significantly better last quarter if the company had the right goods in store rather than older unproductive inventory.   However, some would argue that better inventory would have made no difference pointing to the equally poor result of its better run and better inventoried competitor Kay Jewelers.  But that ignores the fact that Kay was up against much harder comparisons and that Zale had under performed the market for nearly four years.  That suggests it could have picked up relative market share by taking advantage of its weaker comparisons in spite of a declining economy.  Now, veteran retailer Neil Goldberg seems intent on repeating the boards earlier mistakes.   

In conrast, he could have taken advantage of the situation by stabilizing margins and strengthening the sales base during the spring season while establishing relevant assortments and a franchise building price structure for next fall.  Fall 2008 should have been a building season for the retailer with the expectation that spring and summer 2009 would represent two strong quarters leading to turn around during the fall.

Unfortunately, that’s not going to happen.  In part, because management either doesn’t know how to do it or they just can sell it to hostile shareholders like Breeden Capital.  The current scenario, increased cash flow, lower inventory and weak sales base doesn’t lead to a turn around, but to the inevitable sale of the company, in whole or in part; which really doesn’t mean maximum value for shareholders as much as it is an acceptable exit strategy.