Will Zale's Luck Continue?

Implications: By most measure Zale got lucky in its third quarter posting higher sales and a lower than expected loss.  Now investors are rewarding the company with higher stock prices betting Zale will achieve its estimated FY 2009 earnings.  Here's why it may not be such a good bet.

Analysis: Don’t you like when a plan works.  Take Zale Corporation for instance.  Management said that they would permanently liquidate $100 million in inventory in the second half of 2008, while reducing margins by about 500 base points. In fact, they reported selling about $55 million of its redundant inventory, more than plan, with a margin reduction of about 460 base points.   

Also, Zale gained market share on its largest competitor posting a 5.8% sales increase, while Signet’s US sales declined about (4.7%).  Earnings were also better than management expected as higher clearance sales and lower discount rate left shareholders with a loss of only ($0.42) per share from continuing operations on a fully diluted basis.  

Earlier, the company had said it would buy back $300 million in stock during FY 2008.  To date management has repurchased about $249.2 million in stock at an average price of $18.06.  That’s about 8.8% higher than the company’s current book value of $16.47.  

Zale’s stock climbed about 14% above its previous days close on the good news.  Still, analysts expect the company to lose between ($0.10) and ($0.16) per share this year.  So investors are betting the company will achieve its FY 2009 estimated earnings of about $1.11 per share.  That equates to a P/E of about 19.1 based on forward earnings  The question is just how good a bet is it?  

As it turns out, not such a good one if winning is defined as sustainable top-line sales growth at a profitable gross margins.  The fact is Zale’s new management has done very little to restore the company to future profitability.  Here’s why.  

First, Zale’s current margin reductions have either confused customers or made previous buyers angry.  It’s one thing to clear old shop worn merchandise, yet another to liquidate tens of millions of dollars of salable inventory that was nationally advertised months earlier at 10% to 25% higher sale prices.  Granted, current buyers may be getting a good deal, but past customers feel cheated.  Unfortunately both situations work against Zale as angry consumers tell friends they were deceived and new customers find future prices higher than what their friends paid.   

Management will refute this, saying consumers have short memories, jewelry is infrequently purchased, and national advertising will drive new traffic into the stores.  But these rebuttals aren’t supported by the facts.  Years of research have shown that the vast majority of customers that spend less than $1,500 on jewelry chose the place they shop because of a friend’s recommendation, not media advertising.  Also, good experiences are frequently forgotten, after all customers take for granted they will be treated fairly.  However, customers that feel they've overpaid for a gift as memorable as a diamond, never forgets or forgives the store, namely Zale.  

Second, Zale’s assortments didn’t produce adequate sales results before they accumulated the additional inventory.  Less total inventory won’t change that.  In reality, a careful inspection of the styles offered reveals little breadth in variety of designs offered.  Moreover, Zale’s assortments are broken and incomplete; missing any number key price points and product categories.  Absolute reductions in inventory won’t resolve these problems either.  That means the stores will either be at a competitive disadvantage this fall (FY2009) or the company will have to increase its inventory investment.  That probably means increased working capital and higher interest costs since the Zale has used its cash reserves to buy back stock.

Again management will disagree suggesting the assortment problem is one of visual merchandising.  In other words, the product is there, it's just not evident to consumers because the show cases are cluttered with too many signs and too much redundant merchandise.  They're right about the number of signs and the duplication of inventory, but problem of mix, price points, and product variety remains as it has for over five years.    

Third, Zale’s management still thinks jewelry is bought by consumers.  But that’s not true.  Jewelry isn’t bought; it’s sold across two and one-half of counter space by sales people.  That’s the big difference between selling jewelry and most other product categories.  Presently, Zale has one of the least motivated and least trained field organization in the industry.  That should worry investors since the sales associate is the most important part of the communication process with consumers.  Unfortunately, endless sales and weak assortments would make a well trained sales organization's task difficult.  In Zale’s case, the challenge is probably impossible near term.   

Of course management will disagree.  They will point to the company’s new EVP and Chief Stores Officer as one reason to expect early improvements in the field organization.  But optimism aside, revitalizing a field organization of nearly 12,000 sales associates and 2,300 managers, whether by retraining or recruitment, isn’t an event, but a way of doing business that has to be embedded in a company’s culture.  Moreover, it’s almost impossible to recruit and keep a field organization the size of Zale’s that's statistically better than the average in the industry. So Zale will have to look for other ways to achieve a competitive advantage in its stores and that isn’t going to happen in the next 6 months.

Fourth, new management has created a sales base that will perpetuate more discounting.  As eager as analysts are now to embrace Zale’s third quarter sales results, their enthusiasm will likely dampen when the company matches off 47% margins, higher inventory levels, and store wide clearance sales with higher margins, lower inventory, and less discounting next year.   

It’s problematic at best whether higher margin rates could off set the magnitude of the sales decline the company will likely experience.  The only thing that could mitigate such a decline would be a substantial strengthening of the company’s assortments, supported by a focused marketing campaign, and improved execution in the stores; all of which would have to come together in the next 6 months to make a difference in FY 2009.  

I’m not sure if management would agree or disagree with this point.  I doubt they are looking that far down the road and that may be the biggest detriment to the company’s success of all.  An impatient board of directors, hedge fund shareholders looking for a cash returns now, and a market that sometimes rewards short term results, in spite of unfavorable long term consequences, tends to discourage operators from long term planning. 

Zale may achieve its FY 2009 earnings estimate if it gets lucky.  But I was always taught the luck was when preparation meets opportunity and Zale doesn’t look very prepared to me.