Zale Loses One-Third of Investor’s New Worth-Revised

Frankly, management’s announcement that they had lost $189 million in FY 2009 took me by surprise. Having written a week earlier that estimating Zale’s performance was tantamount to guess work, I knew the numbers would be bad, but I wasn’t prepared for that number and neither were investors. By the close of business, Zale’s stock had lost over 25% of its value, closing at $4.73/share. Bad as that was, consider the stock closed at $8.20/share only ten days earlier. Using that as the measure, the stock lost more than 40% of its value in eight trading days.


Still, trying to put the loss in perspective is difficult, especially so, since large losses and the even larger negative numbers associated with them have dulled investor’s senses.  After all General Motors lost $30.9 billion in 2008 and by some accounts the government bailout of the US auto industry will cost $130 billion. By those measures, $189 million loss is almost a rounding error, except in Zale’s case the rounded number equaled one-third of the company’s net worth. 


According to CEO Neil Goldberg, “Our financial results for fiscal 2009 reflected the most difficult year in retailing in memory", which hardly captures the seriousness of the results or how years of management’s mistakes, more than the recession, brought Zale to this point.  In his defense, he and his inexperienced management team is figuratively the last person standing and shouldn’t get all the blame. Nonetheless, they bear a measure of the responsibility for this debacle.

  

Moving forward, it’s reasonable to be skeptical of anything they say. Goldberg’s assertion that “we believe we have positioned the business for much improved performance” suggests the last thirty-six months of selling 73 Bailey, Banks, and, Biddle stores, closing 399 stores, terminating 2,400 staff, and selling off about $163 million in inventory was part of a grand strategic plan to reposition Zale for growth. But, nothing could be further from the truth. Rather, most of these decisions were about a quick fix to patch up Zale’s weak earnings per share, while scrambling to compensate for sales declines as management ignored the company’s underlying strategic issues.

Of course, the final factor contributing to the Zale’s huge losses was the recession, which still remains a convenient scapegoat only in so far as it undeniably impacts the top line sales of every jeweler. However, it was the effects of serious misjudgments about the efficacy of discounting, gross profit break-even  points, and blurred merchandising that culminated in the company’s panic attack that lead to the termination of 1,000 employees and the costly closure of 153 stores in the third quarter. 

The fact is, Zale never began a strategic turnaround and as incredulous as it sounds in the face of these huge loses, probably still believes it’s just one Christmas away from reviving its “Diamond Stores” to robust profitability. That was the sentiment of Betsy Burton, Goldberg’s predecessor when she commented the company didn’t need a change agent. Just better execution, otherwise the strategy was fine. That was just after Christmas 2005 (FY2006). Strategically, very little has changed since then. For instance, the $200 million from the sale of BB &B could have been reinvested in the Zale brand and an off-mall jewelry concept to compete with Jared’s Galleria of Jewelry, Signet’s billion dollar free standing jewelry business. The $150 million in new debt could have been invested in Gordon Jewelers, a stronger e-commerce platform or in new technology to reengineer the companies cost structure. Instead, $350million, $150 million of which was borrowed, was used to buy back stock to prop up short-term earnings per share, which never materialized.
 

While shareholders may get some comfort from the knowledge that Zale now has its version of the Jane Seymour heart and that DeBeer’s Everlon jewelry will be prominently marketed in the company’s Christmas communications programs, the undeniable truth is Kay Jewelers owns the consumer’s mind for celebrity heart jewelry and an ad for Everlon is as much an ad for J.C. Penney’s, hardly a strategic advantage. What’s more, with 30 items in the Everlon assortment averaging $717 at retail, it remains to be seen how the company can support such breadth in 865 stores, even using graded ranges, without sacrificing even more variety and selection in their current jewelry line. That’s assuming they intend to hit reduced inventory targets. But the point may be moot; it’s likely a jewelry price war will fully envelop the industry after Thanksgiving, overwhelming any aspirational advertising. 
  

To that point, Zale may have the advantage of additional markdown reserve of about $8.3 million at cost for inventory impairment. According to the financial statement, the company wanted to expedite the sale of remaining clearance goods. In short, Zale can use that reserve to mitigate the effect of discounts on margin this fall. For instance, one “hypothetical” example is stores could sell about $100 million of retail inventory with a book margin of 67% at “50% Off” and still achieve a 50% gross margin. Just what inventory Zale intends to use the reserve to clear is uncertain, however, whatever the short-term advantage, it’s more about accounting than retailing, which seems to be a recurring theme for Zale.

Immediately after Zale released its FY 2009 10K, the SEC served notice that it was investigating Zale’s accounting practices with respect to its restatement of previous year’s earnings. Subsequently, law firms Howard G. Smith, Finkelstein Thompson LLP, and the Kendall Law Group announced they were investigating certain public statements made by Zale management between 2006 and 2009 to its shareholder to determine if they misrepresented the company’s financial position. Mostly positioning now, the future of any such litigation will depend on the SEC’s finding. In the meantime, directors and executive management will be distracted from operating the company’s day to day business, to say nothing of the incremental cost of the investigation.

REVISED:  In a new development, SEC documents dated October 29, 2009, show four company officers, including CEO Neil Goldberg, “disposed” of stock totaling about 49,000 shares.  Contrary to my earlier article, there was no loss or gain attributable to the transaction. The change represented a cancelation of certain restricted options beneficially owned by the officers because the company failed to meet specific performance targets during the period. 

Nicholas White consults with leading institutions through GLG