Summary
Zale traded margin for sales growth and still expects to lose 40 cents to 45 cents per share in its third quarter. The question for investors is can the company improve sales and profitability during Christmas 2008 (FY 2009) using the same underlying tactics? Here's why investors may be disappointed.
Analysis
Zale announced its store for store sales increased 5.8% in the third quarter and that it would lose less than the market expected in the process. Analyst had estimated the company would lose 49 cents per share in Q3, but Zale said EPS would likely be slightly better ranging from a loss of 40 cents to 45 cents a share.
Frankly, I was surprised at the size of comparable store increase. Earlier, Signet Group, Zale’s largest competitor in the US had said sales were trending down about (4%). Of course, the big difference between the two companies sales line is discounting. Unlike Zale, Signet is running Kay and Jared to maintain margins and build confidence in the brand. In contrast, Zale is in liquidation mode.
From a consumer’s point of view, it makes a big difference. On the one hand, Kay customers look at the prices of the jewelry they bought in previous years and see that it has appreciated in value. On the other, Zale’s customers see the same or similar styles they bought last year at much lower prices today. The obvious conclusion is Kay’s diamonds and jewelry is a much better value.
Granted, every customer likes a sale, but there is a big difference between clearing old, shop worn merchandise and the wholesale liquidation of hundreds of millions of dollars of diamond and gold jewelry that was advertised nationally at prices 10% to 25% higher just three months earlier.
If Zale’s retailing logic is a good one, then every large retailer from Kay to Tiffany should be cutting margins to compete with Zale. But they aren’t. Most recently, Blue Nile announced much lower first quarter sales growth while improving margins slightly. Clearly, the company could have improved its domestic sales by lowering margin on its price sensitive large diamond jewelry products, but that would have devalued the brand. Imagine a customer's anger if they paid $10,000 for solitaire engagement ring last Christmas, only to find it $2,500 cheaper on the Blue Nile site several months later.
Among other things, that’s Zale’s biggest problem. It appeals to the price customer, that shopper who primarily buys because of price alone. Those customers aren’t very loyal; they auction their business to the lowest bidder each time they buy. Now Zale stands a good chance of losing them too.
Eventually, the company has to return to higher margins as it can’t lower costs sufficiently to make a profit at 45% selling margins. That may be difficult since Zale’s traditional customers are a custom to seeing much lower prices in absolute terms in their show cases. Then there is the added effect of higher gold prices.
Zale is buying many products for what they used to sell them for several years ago. So, it’s inevitable consumers will have ‘sticker shock’ when Zale applies normal margins to current replacement costs on new product. That’s just one of the problems Neil Goldberg faces as he enters the 4th quarter of 2008 ( 2nd of Zale’s fiscal year 2009). Another, is the company’s weak sales base.
By weak, I don’t mean ‘low’ previous years sale growth, but high discounts. Last year, Zale discounted more than most to drive sales. This year the company is against those same discounts, higher gold prices, and a weaker economy too. In addition, the company will have been liquidating inventory of at least 9 months. That liquidation will not only have cannibalized future month’s sales, but set consumer’s price expectation for the critical holiday sales season. That leaves the company in an untenable position from the board’s point of view, since any sales strategy probably means a material reduction in gross profit from the previous year. Sadly, that scenario continues in the 3rd and 4th quarters of 2009 because of the Goldberg’s inventory sell off strategy.
The company says that decreased overhead costs, reduced marketing spend, and less cap-ex will offset shortfalls in gross profit and cash flow. But it remains to be seen just how much of the $50 million in cost savings will flow to the bottom line. Also, less marketing in combination with tired stores will likely retard sales growth; especially if the company returns to normal margins.
One military historian once commented that the seeds of victory or defeat were sewn early in the battle. Goldberg’s decision, if it really was his decision, to put Zale on liquidation immediately after his appointment is probably just such an example. If Christmas profits are unfavorable and history is any judge, an impatient board will begin to lose confidence in his leadership early in 2009. That means the cost cutting, discounting process will replay itself as it has for the much of the last half decade.
Meanwhile, prospective investors have a 5.8% sales increase and slightly better than expected earnings per share to decide if Zale warrants its current valuation. For a company that counts its profitability only one month a year , the question for investors is can Zale grow sales and profits in December 2008 (FY 2009) using its current underlying tactics or is this a prelude to another round of asset sales, cost cutting, and more discounting?
