Summary
It’s problematic whether Zale is a good quarter to quarter play during the current down turn. But it ‘s even more uncertain if it will be a successful turn around in this decade. Here's why.
Analysis
Reuters recently published a Barrons’ article titled “Zale May Prosper in Down Turn”. The article suggested that Zale might benefit in the current economic slow down because its brands were positioned at the low end of the specialty fine jewelry sector. While not addressed directly by Barrons, the implication was Zale brands might do more business as customers traded down market to stretch their disposable income further during this economic slow down.
According to Matthew Kaufler, a portfolio manager at Clover Capital quoted in the commentary, “[Zale] shares will go at least 25% higher”. Based on Monday’s closing price, that means Zale share price could exceed $26 if Kaufler’s prediction is correct. However, opinions about Zale’s prospects differ.
For instance, Steven Cheng, a novice investor, disagrees. From his perspective, declining margins, inexperienced management, strong competition, brand name dilution, and lack of competitive advantage makes Zale a risky investment. Cheng is especially skeptical about Zale’s new CEO. According to Cheng, Neil Goldberg’s tenure at Children’s Place was “unsuccessful”. In particular, he points to Goldberg’s failure to deal with the pressure from activist investor Carl Ichan and his botched turn around initiative to operate Disney’s specialty stores. Cheng thinks Goldberg will face similar challenges from Richard Breeden who controls about 18% of the company through Breeden Capital Partners, one of three hedge funds that cumulatively control about 28% of Zale.
Nevertheless, the market remains bullish on Zale. Since January 2008, shares in Zale have appreciated about 48%. According to Cheng, Standards & Poor’s estimates the company will lose ($0.61) per share for the fiscal year ending July 2008. However, the stock is currently trading at approximately a 27X multiple, meaning speculators are betting the company will do a lot better or be bought out.
Other analysts covering Zale are less pessimistic than Cheng. They think Zale will lose ($0.22) per share in FY 2008. That assumes the company will lose ($0.47)/share in Q3 and ($0. 41)/share in Q4. Those same analysts think Zale will earn $1.05 for FY 2009. That’s predicated on the company performing much better this Christmas (Fall 2008). That earnings estimate is up from $0.42/share, a 150% increase, 2 months earlier.
Just what has changed at Zale to warrant such a large revision? First the company announced it was cutting about $50 million in expenses. That’s equivalent to about $1.32 per share on a diluted (after stock buy backs), annualized basis. However, that assumes the company can actually bank those savings. It also assumes, despite the recession, Zale can achieve FY 2007 Christmas sales levels and margin rates in 2008, after being on sale up to 70 % off for most of the year. Those are high risk assumptions.
What else has changed? Zale will be closing about 100 stores, clearing approximately $200 million at retail in inventory, and cutting capital expenditure by about half. Except for carrying costs, that won’t immediately improve the bottom line materially, but it will generate cash which according to Zale will offset a 500 base point decline in gross margin due to the inventory liquidation.
Much of that cash will be siphoned off to buy back an additional $100 million in shares that the board authorized in November 2007. That’s a lot of cash to take out of the business during a recession. It’s also a diversion of cash from growing sales space which will be necessary if the company expects to compete with Kay Jewelers in the future. While Signet announced it would slow growth, the company said it expected to continue to grow new sales space about 5% in 2008.
Regrettably, what hasn’t changed at Zale is its capability to drive top-line sales. Much of today' cost cutting is because the company has been losing market share to its core competitors for the last seven years. That’s why operating margins have declined by more than 60%. Sadly, none of Zale's recent changes will reverse that trend. In fact, most of the current marketing activity will serve only to further dilute Zale’s brands with consumers and weaken its sales base.
Barron’s has suggested Zale may gain sales from customers trading down. That’s highly unlikely for several reasons. First, if consumers do trade down as Barron’s suggests, Zale would probably lose as many of its current customers to discounters like Wal-Mart as it gains new ones from higher end competitors. Second, most of Zale’s competitors have better assortments of lower price point merchandise which means if customers do trade down, it probably won’t be to another specialty jeweler, but to a non-jewelry discounter. Friedman is a good example of why this assumption is wrong. Now in liquidation, the company was positioned as the poor mans alternative to Zale, picking up the spill over from Wal-Mart. It didn’t work for Friedman and the theory probably won’t work for Zale either.
Zale also has other disadvantages, especially in a declining economy. For instance, Zale has lost significant market share in the recession resistant bridal business. This means the company’s sales will be more vulnerable to the continued slow down in the economy than its stronger bridal competitors like Kay Jewelers (Signet Group Plc), Helzberg (Berkshire Hathaway ), and Fred Meyer (Kroger).
Except for Richard Breeden and his hedge fund partner, most of Zale’s board is the same ones that got the company into this mess to begin with. It was the board’s decision to move the company into low quality fashion diamond merchandise at the detriment of its core bridal business in 2005. It was also their choice to replace Mary Forte’ with outside director Elizabeth Burton to carry forward their flawed strategy; only to replace her 18 months later. Unfortunately, their choice of Neil Goldberg as CEO may be as wrong as was the selection of Elizabeth Burton.
Up to now board impatience, not strategy has been what’s driving the company. Now with hedge fund manager Richard Breeden on the board, that’s not likely to change. Unfortunately, retail strategy is what the company needs in terms price, quality, style, mix, and positioning. But board members have demonstrated time and time again they don’t’ have that knowledge and the new CEO clearly has neither skill nor experience in jewelry.
For traders interested in a quarter by quarter play, Zale may be as attractive as it is speculative in the short term. But for a business that counts its profitability once a year in December, long term prosperity, if achievable, is a lot of December's off for Zale.
