Zale Shareholders Ignore Hedge Fund Failures

Implications: Zale cuts employees and operating expenses again for the 2nd time in as many quarters, but with top line sales declining, hedge fund tactics may once again fail to drive profitability at Americas second largest jewelry retailer. 

Analysis:  Zale’s share price soared to a 4 month high on news that the company was cutting expenses by about $65 million.  The company said it planned to streamline operations by reducing HO staff by 225, including 85 currently unfilled positions, saving about $15 million.  The company also said it would cut another $8 million in non-selling sales staff bringing the total staff savings to about $23 million.  

In addition, the company said it was cutting another $40 million in non-payroll costs which included such items as consulting, marketing, travel.  Cap-Ex would also be reduced by nearly 50%; freeing up about $40 million in cash. That adds up to $203 million in incremental cash flow when combined with a $100 million inventory reduction announced earlier in the week.   

This is the second time in almost as many quarters that the company has said it was stream lining operations.  The first was in July, when Zale eliminated the division president management layer and downsized its B & M staff.  Subsequently, Zale sold off its Bailey, Banks, and Biddle unit to Finlay Enterprises for about $200 million.  Cost cutting as a part of restructuring the brand is understandable.  While I thought the timing was poor, the consolidation of the buying and merchandising structure made operational sense.  So did the elimination of division president layer of management.  Now, Zale is further reducing costs again after its third turn around plan failed with sales declining by about (7.3%) in the company’s all important Christmas quarter. 

In part, a reaction to bad results, the plan is consistent with the impatient, reactionary management style of a board that has recently hired its 3rd CEO in as many years to turn Zale around.  However, its architect is certainly Zale’s new director, Richard Breeden, Chairman of Breeden Partners, a hedge fund, which owns about 18% of Zale stock.  Breeden Partners along with several other hedge funds including Citadel Investment Group, and SAC Capital Advisors LLC control about 27% of the company.  Across the board cuts are a typical strategy used by activists investors like hedge funds to spike short term earnings and increase share prices.  However, hedge funds have had spotty results in producing sustainable, long term profit improvement; especially in the jewelry industry.    

Nonetheless, with the stocking trading at a 28X multiple, investor’s obviously think this round of cost cutting will enable the company to beat current industry earnings estimates.  But that’s far from certain.  With the US economy teetering on recession and inflation rising, jewelers will experience declining demand in the face of rising precious metal prices.  Successful jewelers will be the ones that can steal market share from weaker competitors, not just cut costs.  Unfortunately for investors, Zale will be more vulnerable to competitors like Signet Group PLC, Helzberg / Ben Bridge Jewelers (Berkshire Hathaway), and Fred Meyer (Division of Kroger) after this kind of cut and slash down sizing.  Such a competitive mismatch translates into more store closing and deeper cost cuts as this hedge fund strategy plays out.  

There are plenty of examples where hedge fund management has decreased value of retailers.  For instance, at the top of end of the retail sector, Sears Holding is probably the best example of how this kind of cost cutting can go wrong.  The highly publicized “Lampert strategy” was to cut staff, inventory, and capital expenditures at Sears believing cross branding with K-Mart stores would increase sales and leverage margins.  It didn’t work and Sears’ stock is selling for about one half of its 52 week high. 

At the other end is Friedman Jewelers, a 500 store jewelry chain which recently filed for Chapter 11 protection from its creditors for the second time in 3 years.  Friedman was brought out of bankruptcy by the hedge fund Harbinger’s Investment in 2005.  Now in Chapter 7 Liquidation, Friedman is yet another example of how hedge fund tactics have failed to drive top line sales.  Whether Sears or Friedman, hedge fund tactics have seldom been successful in driving profitable top line sales growth and sustainable profits.  Regrettably, for investors and employees alike, that will probably be the outcome for Zale as Breeden’s gambit unfolds.