Summary
Zale reported SIGNIFICANTLY lower than expected sales and earnings for its third quarter in the face of higher stock prices only a day earlier. Either faith in Zale springs eternal or traders got surprised by the dynamics of the jewelry business in general and Zale specifically. Here’s more.
Analysis
This is a follow up to an article posted in early May about the market dynamics affecting Zale’s stock price and earnings. Since that post, Zale announced a decline in both sales and earnings for its third quarter that was significantly below the Street’s expectation as well as industry trends. This should come as no surprise to shareholders and prospective investors that understand what is happening in the jewelry industry in general and to Zale specifically.
For its third quarter, Zale’s sales declined about 20%, which equated to a loss of about $0.73 per share this year versus a loss of $0.42 per share in 2008. Part of the loss can be attributed to the reduction in the number of outstanding shares by about 10 million over the previous year. Still, excluding the share buyback, the loss per share was $0.56 per share or about 30% higher this year despite the company’s higher margins as well as its advertised improvement in assortments, new brands, and compelling displays.
Zale’s reported gross margin for the period was 50.1% versus 47.5% last year. Last year’s low margin was a consequence of management’s effort to liquidate excessive inventories in light of the company’s poor Christmas 07 (FY 2008) sales performance. Then, incoming CEO Neil Goldberg believed he could slash margins, lower inventory, and build a creditable value image too. In all respects but one, Goldberg’s strategy was successful. The company liquidated more than $120 million in inventory while continuing the deep discounts for most of the first quarter of FY 2009.
Unfortunately, less inventory was about all Goldberg got for his deep discount strategy as Zale solidified its image as just another discount jeweler in the midst of a lot of other troubled big jewelers running going out business sales. Now the company is paying the piper as it calandarizes its earlier tactical missteps during the last half of FY 2008.
What’s in store for Zale, probably lower sales and bigger losses despite the company’s efforts to normalize margins and reduce costs? Higher margins mean more gross profit per sale, but that’s being more than offset by the decline in sales and that will continue through most of the first quarter of 2010. Then the company is up against its catastrophic promotional program during the Christmas quarter last year when Zale led a price war cutting margins to about 44%.
While Goldberg has said that he won’t make the that mistake again. The fact is the market is much more promotional now than then and current trends suggest that on average specialty jewelry sales could decline by another 10%. Just how far could Zale’s Christmas quarter sales decline? That depends on a lot of factors, but if third quarter sales dropped 20% against last year when margins were 47.5%, just how much could they fall when up against the sales generated from 44.5% margins?
Of course, pundits may counter that the company unit sales were flat with the previous year’s Christmas quarter, meaning Zale could have sold the same number of items at a higher price. Actually, that logic doesn’t follow, nonetheless, a more likely interpretation is that Zale’s deep discounting did successfully increase both traffic and closure rate relative to higher priced competitors, yet not enough to overcome the loss in gross profit.
Assuming it will be almost impossible to increase average selling prices this year for discretionary items like fine jewelry, Zale will have to figure out how to sell the same number of lower perceived value items (higher margin, same selling price as last year) in the face of lower demand, less credit, and higher unemployment too. That’s just the macro economic factors facing Zale.
The company also has to overcome execution problems stemming from fewer employees, reduced service because of less coverage, higher attrition from changes in compensation programs, longer service times because repair services have been consolidated, less absolute inventory per store, and fewer new products to name just a few. Simply put, Zale’s performance today is much less the consequence of the recession than it is a from a long list of both strategic and tactical errors, which have now combined to materially reduce sales and earnings in 2009 and in 2010. That begs the question of whether this board or this management team can ever learn enough on the job to turn Zale around?
Frankly, the answer to that question is problematic. On the one hand, about 28% of the company is controlled by hedge fund manager and Zale director, Richard Breeden. Clearly, the financial tactics of hedge fund managers to “wring” shareholder value out of troubled companies has had mixed success. In fact, it has been a disaster for troubled jewelry retailers. On the other, retail executives with no professional jewelry retailing experience have proven incapable of mastering the intricacies of merchandising and marketing fine jewelry.
That’s probably truer now than before because consumer attitudes are changing, slower growth is redefining discretionary spending, and the jewelry industry mechanisms are changing. Specifically, leadership defined by innovation and integration of the new dynamics in the industry is what is called for, something that is uniquely lacking at Zale today.
That mismatch between the leadership the company needs and what current management can provide is the primary reason Zale is likely to lumber on in strategic mediocrity until it eventually succumbs to its self-inflected wounds. Meanwhile, speculators will participate in this self-assisted suicide until the company is either sold off or sold for parts. Clearly, Zale is worth more dead than alive, something that isn’t lost on current players. The stock closed at $4.01 per share, down about 20%
