Summary
Zale has been one of the best performing stocks in the recent market rally. But does the increase signal a stronger company and a strengthening industry or just an irrational market. Here's why investors may need more than technical tools and fundamental analysis to decide.
Analysis
Zale was ranked as one of the best performing stocks during the March-April stock market rally. According to one analyst, Zale’s stock price outperformed the S & P 1500 by nearly 900%. That’s pretty impressive. Indeed, its price performance ranked 12th out top 25 performers which on average increased about 51%, while the S & P 1500 only climbed about 31.3%. However, does the huge increase in stock value reflect a strengthening of Zale Corporation or the jewelry industry for that matter? Probably not!
The fact is the specialty jewelry retailers have been scrambling to trim costs and inventory since January 2008. However, the real cuts didn’t begin until after the dismal 2008 Christmas season when holiday sales declined about 18%. The magnitude of the sales decline sent a shock wave through every segment of an industry that typically earns between 85% and 100% of its profit during the holiday sales quarter. The industry wide earnings decline, in combination with continued weak sales after Christmas, forced some companies into immediate bankruptcy.
For instance, Christian Bernard, Fortunoff, Robbins Brothers, and Shane & Co filed for protection from their creditors during the first quarter. These filings followed earlier going out business sales by Friedman and Whitehall Jewelers in 2008 and coincided with the silent liquidation of parts of Finlay Enterprises which continues today in both its remaining jewelry departments and specialty jewelry stores. For instance, Congress Jewelers, Finlay’s prestigious branded jewelry chain located in South Florida is offering, with few exceptions, 30% to 50% off the entire store inventory.
Meanwhile, large and small firms alike began to reduce store coverage, change opening and closing times, eliminate store operation, buying, and merchandising staff, cut cap-ex, and close stores. For example, Signet Jewelers said it would reduce costs by about $100 million. Similarly, Zale announced it would be closing 115 stores, liquidating another $75 million in inventory, and eliminating about 245 positions. Likewise, independent jewelry store owners and small chain operators began making the same kind of cost-cutting decisions hoping to improve profitability. I say hoping, because with jewelry sales continuing to decline and margins in flux, many jewelry retailers still aren’t certain if today’s cuts are enough.
Clearly, sales forecasting is a problem for the industry today. Current estimates suggest sales could decline by another 4%-10% this year. But, that may be overly optimistic. Recent surveys indicate luxury buyer’s attitudes toward discretionary purchases, especially fine jewelry, have changed for the worst. Moreover, some recent data show consumers have postponed, perhaps indefinitely, some of their jewelry purchases, while others now reject jewelry as a gift for some occasion’s altogether and that may not be the worst of it.
Other surveys of recent jewelry buyers show they expect to pay a lot less for their jewelry, as much as two-thirds less in some instances. Simply put, even if there is some economic recovery in the fourth quarter and that’s still a “big” if, it’s problematic whether consumer discretionary spending habits will revert to pre-recession norms. On the other hand, continued high unemployment, in combination with increased energy and food prices could cause fourth quarter jewelry sales to plummet again this fall. Which brings us back to cost cutting.
The fact is jewelry companies, especially the publicly traded ones like Zale, Signet, Tiffany, Blue Nile, and Birks & Mayors have told investors that they were making many changes to improve cash flow and strengthen earnings. Still, many questions remain. For instance, have jewelry companies actually implemented the changes, will they achieve their targets, and what’s the collateral damage from the changes? One large survey of manufacturers and retailers completed in the first quarter of 2009 indicated that nearly 60% of the businesses surveyed had not completely implemented their cost cutting plans. That’s probably the biggest reason jewelry firms won’t meet their targets, they drag their feet, which is a distinct possibility given everyone’s desire for the economy to improve materially. However, what if it doesn’t?
Another reason jewelry businesses may miss their cost reductions goals is that the targets weren’t achievable to begin with, at least not without reducing the firm’s ability to plan and implement their sales plan. In effect, either cost reduction targets are missed or sales productivity declines, something management seldom accounts for when slashing overhead.
The first glimpse of jeweler’s progress will come when Blue Nile reports earnings on May 7 followed by Zale, May 27, and Signet June 4. In the meantime, analyst and shareholders would be well served if they developed a rigorous list of questions for management to answer regarding jewelry business in general and each brand specifically. For example, the following list illustrates some of brand specific questions serious investors might want Zale CEO Neil Goldberg and acting CFO, Cynthia Gordon to answer:
1. With three quarters complete, how much will total costs decline year over year? Store for store?
2. Has the magnitude of planned cost reductions be achieved. If, no, when does management expect to achieve its target?
3. Are current cost reductions sufficient in view of realistic sales and margin objectives for Christmas 2009?
4. How much lower are continuing store operating costs Ty versus Ly?
5. What has been the change in hours of coverage at the branch level?
6. Have changes in store coverage affected the rate of sales growth?
7. Has the sales associate compensation/ bonus/commission structure changed?
8. If yes, what has been the effect on small, medium, and large store sales growth? Branch costs?
9. Has changes in compensation increased or decreased employee turnover?
10. How many manger positions are unfilled? How does that compare to last year. Full time? Part time?
11. Has the consolidation of lifetime warranty and cash repairs to regional third party repair shops reduced total repair costs?
12. How do actual warranty repair costs compare with performa assumptions before the benefit of cash repair sales?
13. Does the current accounting methodology reflect actual lifetime warranty sales and claim trends?
14. What is the warranty repair turnaround for Zale’s regional repair services versus local services? Kay Jewelers? Walmart? Sears?
15. How many of the 105 stores identified for closure has been closed? How many will be closed by fiscal year end? Are more than 105 stores now slated for closure?
16. What percentage of total mall leases has been renegotiated? Are the new rates temporary or permanent for the remainder of the exiting lease?
17. Are there any future implied or implicit agreements beyond the changes in current rent and occupancy costs? How will they affect future occupancy costs?
18. What is the impact on 2009, 2010 earnings if Finlay defaults?
19. What has been the effect of H.O. staff reductions on planning and plan implementation including order placement, product delivery, and fulfillment?
20. What percent of the Zale division’s running lines are in stock? Gordon? Peoples? Mappins?
21. How much more or (less) discontinued inventory is on hand this year versus last year.
22. Is the company melting merchandise? If yes, how much? What is the recovery and is the loss reserved for on the balance sheet?
23. What is the current market value of loose diamond inventories versus book value? How much of the company’s loose diamond inventory is usable in current and running lines?
24. What percentage of the company’s self-manufactured inventory is in stock at the branch level, in the distribution center, and on order?
25. What percent of the company’s business is done on Zale’s credit? How does that compare to last year? The competition?
Wow! That’s a lot of very direct questions. The kinds of questions, CEO’s don’t like to answer and the type of information usually reserved for private meetings. Nevertheless, regardless of the venue, these are very unusual times and business as usual is the exception not the rule, especially the investment business.
Realistically, so many changes are being made in all parts of the luxury goods business both current and prospective investors need to understand their implications in the short term as well as in the future. Simply put, investors need to do rigorous “due diligence” on companies in industries that are experiencing radical change or that need to be restructured such as those in the specialty retail jewelry sector. Neither technical tools nor fundamental analysis alone are probably sufficient to minimize risk and maximize returns in today’s volatile market place for such companies.
