Hedge Funds Will Dominate Board as Zale Disappoints Again, Again, and Again

Implications: Zale stock has appreciated more than 40% since reaching a historical low about three weeks ago.  Whether there is greater upside for shareholders will depend on the board's next moves.  Here is one way it may play out.

Analysis:  Zale performance continued its decline for the third consecutive year when the company announced 2nd quarter sales had decreased by about (7.3%) during its second fiscal quarter.  That was a slight improvement over the company’s December revised forecast.  According to Zale, January results were slightly better than expected because a previous years Valentine’s Day promotion was moved forward into the 2nd quarter this year.  Otherwise, the company’s second quarter sales results would have been nearer its previous forecasts of a (9%) decline for the quarter.

Despite the dismal results and the continuation of the long term negative trend in company performance, Zale’s stock price moved forward trading as high as $18.43 on Friday, closing at $17.85 on moderate trading.   That’s up about 43% from its January 15th low of $12.48.  What’s propelling stock price increase?  In part, the price rise is an adjustment.  Clearly the market over penalized it because of recession fears. Currently trading at 20% of its book value, that fear is all the more real a month later.

Another reason is ‘wishful optimism’.  I say wishful because after all the changes at Zale in the last 18 months, it’s problematic whether either a wish or a prayer would be sufficient to turn the company around.  For instance, John Lowe has assumed Chairmanship of the company and Neal Goldberg has replaced Elizabeth Burton as CEO.  Bailey, Banks, and Biddle was sold, while the divisional operating presidents were eliminated to simplify the buying and merchandising structure.  For anyone knowledgeable about the inter workings of a large, multi-brand, chain store retailer like Zale, these changes were the equivalent of separating several sets of conjoined  twins simultaneously, only to have the surgeons replaced with interns midway through the operation.

Some shareholders point to hedge fund manager, Richard Breeden’s investment in Zale as another reason to expect the stock to appreciate even more over the near term.  Owning slightly more than 18% of the company’s stock, Breeden Capital currently controls 25% of the board seats.  Breeden has expressed an interest in facilitating a ‘big transaction’ at Zale.  He has also said there are opportunities to improve operating margins.  Analysts have always thought a Signet Group PLC-Zale Corp merger was inevitable.  However, that’s all the more unlikely given Signet’s current performance, problems in its UK market, and tightened credit markets.   

Just what Breeden knows about improving operating margins in a 2,200 store mid-market jewelry business remains to be seen.  After years of repeated reorganization by the current board, there certainly is little resident knowledge remaining at Zale about operating a mid-market jewelry chain; including the new CEO which hails from fashion apparel industry.  That begs the question does the current management team have the skill and acumen to plan and implement a viable ‘Breeden margin improvement’ strategy; assuming he has a viable one. 

Given Zale has lost much of its skilled middle management, its new, inexperienced, executive management, and hedge funds typical investment horizon, a more likely scenario is that Breeden Capital will pressure the board to sell off more of the company piece meal in order to maximize cash flow. Only this time, instead of executing a fast track buy back as was the case after the BB & B sale, the proceeds would be distributed as a special dividend to shareholders, with Breeden’s hedge fund the largest single beneficiary.  Accordingly, Peoples Jewellers in Canada would likely be sold, as would Gordon Jewelers in the US.  That would leave Piecing Pagoda to be disposes of, probably at a whopping lose, and a much smaller Zale branded business to take private for a future IPO.  If true, how investors would value these cash flows is uncertain. 

However any way you divide it or sell it, Zale eventually needs someone with a vision for business, the skill to articulate it, and the jewelry knowledge to operationalize it, if shareholders are going to realize greater upside from this business.