Summary
Zale liabilities for BB & B leases are real, quantifiable, and an imminent threat to future earnings and cash flow. But will the company recognize them? More importantly, does it matter in today's neurotic market? Here's more
Analysis
Will Zale recognize it $76 million liability for the Bailey Banks and Biddle leases? That’s one question of many investors need to ask management as the company’s third quarter ends. Zale management refused to make an allowance on its balance sheet last quarter for its contingent liability for BB & B leases despite evidence that Finlay was quietly liquidating its business. If I remember correctly the company said it didn’t know what store leases Finlay would default on or when the default would take place. Still, given Finlay’s liquidity crisis, prudent accounting practice would have been set up a reserve representing the company’s liability. After all, Finlay’s probability of defaulting on the leases was as certain as much of most of the litigation the company is engaged in for which they typically set up reserves. Now, Finlay has said it has hired “liquidators Gordon Brothers”. That in combination with the company’s “going concern” warning should leave little leave little doubt about the prospects of Zale being liable for the bulk of the BB & B lease liabilities.
How many leases and how much? That remains to be seen, but Finlay hasn’t reported selling any of the 67 or so leases that remain from the original acquisition which means Zale will be on the hook for most of the $76 million. Granted, that isn’t an upfront cash cost. But, it’s a quarterly hit to earnings that will further reduce cash flow and increase losses at a time when the company’s long term prospects for earnings growth, under current board direction, are very much in doubt. Realistically, the only solution is for Goldberg et al can dispose of the leases as quickly as possible, but that could be easier said than done.
For instance, developers won’t be so quick to discharge Zale’s lease obligations, even if they can find a buyer and that’s a big if. Clearly, property owners may well choose to run out the existing lease terms at current rent values rather than face the prospects of releasing the space to smaller, high risk businesses at lower rents. Add that even if Zale can find a buyer, landlords will probably demand that Zale continue to guarantee future lease payments.
Moreover, Zale has little leverage to get mall management to reduce rents on BB & B properties since it’s also looking for lower rents on its Zale locations as well as close about 105 of its own stores. Indeed, the BB & B leases could over sour relations with developers at a time when it wants to restructure its on going portfolio of mall locations; a prospect that could have unwanted, long term strategic implications for the company.
Some pundits have suggested Zale could reopen selected locations which at best is a pleasant fiction. Others have said the company could remerchandise and operate the BB & B stores. But that assumes Zale has the right to use the BB & B trademark, which it probably doesn’t…just the obligation to pay the rent if Finlay defaults. Anyway, the company demonstrated long ago that was incapable of operating a guild jewelry business and that hasn’t changed.
Bottom line, Zale is going to loss a lot more money in 2009 and probably 2010 than shareholders think. It has been that way for the better part of decade. A Zale turn around is always, “mañana” and that isn’t likely to change. Meanwhile, Zale stock was recently rated as one of the best market performers with a 308% increase in price since March 9. Now selling for just over one-quarter of its book value, years of misdirection, management immaturity, and poor fundamentals doesn’t seem to account for much in valuing this stock, just market psychosis.
