Short Sellers Expect Zale Stock to Decline in Price-Big Time

Implications: Despite out performing the Dow, S & P, and the Nasdaq, short sellers are betting Zale's share price to significantly decline.  Here's why.

Analysis: Zale stock has fallen from a high of $22.35 on March 24th to a low of $16.06 on July 11th.  Currently trading around $19.80, the stock is held by approximately 238 funds and institutions.  Most recently some firms have begun to liquidate their positions in the company.  For instance, Huntington National Bank “dumped” their entire 35,200 share position in Zale, while larger investors like Cooke and Bieler Lp sold about 9.9% of their holdings or 347,459 shares.  All told, the number of funds selling Zale stock out number buyers by about 2 to 1.  Still, Zale’s share price has outperformed all of the major indexes over the last six months.  Since January 2nd, Zale has increased 38.1% while the S & P, NASDAQ, and Dow have declined (12.9%), (12.6%), and (12.2%).  Similarly, Zale’s stock price has outperformed all its public jewelry competition.  The question is why?   

Most of the stock’s price performance can be traced to the company’s huge stock buy backs over the last 12 months.  Since August 2008, Zale has repurchased $350 million of its stock or about 28% of the outstanding shares. That reverse dilution has had the effect of maintaining share price, despite the company’s operating loses. But that’s only part of the story.  The other, Zale’s Enterprise Value has actually declined about (20.4%) or about $357 million when comparing stock prices and balance sheets as of 2007 YE and 3rd quarter 2008.   

In effect, management’s aggressive buy backs have been a slight of hand.  Using reverse dilution, Zale’s share prices have declined only (2.4%) for the first three quarters of FY 2008 as the DJI dropped by about (4.0%)  That looks pretty good to short term traders seeking to maximize quarterly returns in a volatile market.  Even better, Zale has continued to outperform the market during its 4th fiscal quarter as the company’s per share price declined (7.7%), while the Dow decreased nearly (14.0%).  

However, a growing number of traders think Zale’s shares are over priced.  According to ShortSqueeze.com more than 46% of its stock float has been ‘sold short’; meaning a lot of speculators are betting the stock is going to decline.  Just what’s driving these short sales isn’t certain.  Part of the reason may be pure speculation, another, the economy.  With the dollar declining and energy prices escalating, the consequence of “real” inflation has been reduced spending in combination with changes in consumer’s shopping behavior.  That’s bad news for middle market jewelers like Kay (Signet Group Plc) and even more so for Zale (Zale Corporation) which was bleeding market share long before the economy softened.  But, I suspect the real reason traders are shorting Zale stock to such a degree is their overwhelming belief that the huge buy backs are at an end and with no top-line sales turn around insight, the stock price has no place to go but down as future loses increase.  

What Zale’s final numbers for FY 2008 will be is anybodies guess.  Analysts estimate the company will lose ($0.58) for the 4th quarter ending in July for a cumulative lose of ($0.32) for the fiscal year.  But, those numbers could be better depending on the success of the company’s up to 70% liquidation sale.  But better numbers won’t mean Zale’s operations are improving; at least not in this situation.  The fact is the company’s current off-price strategy isn’t sustainable and what’s worse future sales will suffer significantly as the company returns to regular margins in 2009. 

Nevertheless, the industry continues to estimate FY 2009 earnings will be about $0.92 per share.  That expectation of a 200% increase in earnings per share may be another reason why the stock’s price has held up so well.  But realistically, it’s hard to find a compelling story why the company’s performance will improve anywhere close to that figure and that’s the short sellers play.  

Unfortunately, what ever the story, it won’t be the first time shareholders will have heard it.  Regrettably, Zale’s performance has been a disappointment for some time.  Since 2003 Zale has significantly under performed the market in spite of countless plans by the board to turn it around.  During that time there has been constant management change in the company; including three Chairman, five CEO’s, one COO, 3 CFO’s and countless division presidents, operations officers, general merchandise managers, and buyers.  The only other company in the industry that has experienced that degree of senior management change in such a short period of time is Whitehall Jewelers and it’s currently operating in bankruptcy.  

Now a hollow shell of what was once called [America’s] Diamond Store, the companies strategy has been reduced to closing stores, selling divisions, consolidating operations, foregoing new store growth, and reducing marketing spend to fund the huge stock buy backs, while increasing company debt.  Most of that strategy has been at the encouragement of Richard Breeden, Chairman of the hedge fund, Breeden Capital, which owns about 22.8% of Zale’s equity.  But, part of the responsibility lay with the company’s new CEO, Neil Goldberg too.  

When Goldberg came to Zale, he was quoted as saying the pricing structure was too complicated, something he would change.  Now the company’s pricing strategy is much simpler; that is, up to 70% off.  At least that has been the message to consumers for the last 7 months.  Granted, his pricing strategy has enabled the company to liquidate about $100 million in inventory that has funded the stock buy backs, but at what cost to the Zale and Gordon consumer franchise. 

While it’s true consumers like jewelry sales, recent research suggests they view jewelry store names as the primary brand, not the product they sell.  If true, Goldberg’s 213 day liquidation sale probably has done more damage to the Zale and Gordon brand names than all the company’s mistakes combined in the last half decade. Then, there’s the innumerable product and merchandising mix problems that Goldberg inherited, but by all the evidence to date, problems he neither has the knowledge nor the working capital to fix.  Lastly, there are the strategic issues of off mall retailing and e-commerce jewelry marketing, to a lesser degree, that he isn’t addressing at all.  

Five years ago, the company could take the position that some of those issues weren’t immediate problems.  That may have been true then, but not now.  For instance, mall jewelers have become isolated from a large segment of consumers.  Meanwhile, mall occupancy costs have increased, while foot fall has declined.  Many mall jewelers are spending almost twice as much, as a percentage of sales, on advertising than they were 15 years ago to generate less traffic.  All the while occupancy costs have increased and merchandise gross margins on strategic products like diamonds have declined.  

Zale’s largest competitor Signet Group has been increasing selling space at more than 10% per year, much of it off mall.  Concepts like Signet’s Jared, Galleria of Jewelers will contribute more than $500 million in sales to Signet’s top line from customers that will probably never step foot in a Zale owned jewelry store, especially now that they have divested their high end, luxury jewelry division.  

Most recently, the company elected Yuval Braveman, a specialist in rough and polished diamonds to its Board of Directors.  That suggests a company priority is to strengthen its diamond resourcing capability.  But with cutting and polishing margins collapsing, the only profit centers left in the pipeline are at the mines and in retail.  Reverse integration isn’t a solution for Zale’s margin problems and even if it were, the added net margin benefit wouldn’t be sufficient to offset the company’s chronic decline in sales.    

All told Zale stock has offered the best of things to short term traders looking to beat current market trends and it now looks like it has become a ‘favorite son’ of short sale speculators.  What it isn’t, is the stock of a company  teetering on sustainable growth.  While chairman, John Lowe continues to insist the board wants to turn the company around, it’s now clear that he is either posturing, hoping a buyer will save him from the fate of his predecessors or he (the board) doesn’t know how to fix it.  Either way, it’s sad because with both the industry and the customer is in a state of change, the here and now may be a once in a century opportunity for Zale to reinvent itself and just may be the industry too.