Zale's Liquidation of Its Guild Division Leaves Shareholder Value Neutral at Best

Implications: The sale of BB & B leaves shareholder value neutral at best. Here is why.

Analysis: As predicted earlier, Zale Corporation announced the sale of its Bailey, Banks, and Biddle division. According to Reuters, Finlay Enterprises agreed to buy the prestige jewelry chain for $200 mlm. The sale is the first tangible results shareholders have seen after President and CEO Betsy Burton announced that the company had engaged Goldman Sachs to assist Zale with a strategic review of the company.

Commenting on the sale, Zale said “the deal is part of our plan to focus or its core mall based business. Just how selling one of the nation’s most prestigious ‘mall based’ guild jewelry chains is consistent with that strategy isn’t clear. What is clear is management didn’t understand how to operate a high end jewelry business and chose to sell it; possibly to placate activists shareholders like Breeden Capital Management and Citadel Invest Group which collectively now owns more than 12% of Zale Corporation.

Their guild jewelry business had struggled for most of the last decade resulting in the closure of about 47 stores; leaving about 73 locations as of the end of fiscal year 2006. The problem wasn’t that the higher-end jewelry business wasn’t growing. In fact, quiet the contrary. The ‘carriage trade’ jewelry business had been growing at about twice the rate of the mid-market business, yet BB & B sales remain stagnant for FY 2007. Another sign of BB & B’s poor performance was the price the chain sold for.

According to Zale, Finlay agreed to buy the business for $200 mlm. That equates to less than 10X EBIT-DA assuming BB & B achieved the corporate average of 6.8% which it probably didn’t. It’s incredulous that the nation’s second largest prestigious jewelry brand should perform so poorly and sell for so little. Was this was a good deal for shareholders? Probably, but not for the reasons Zale proffered. Keeping Bailey, Banks, and Biddle probably meant the shareholders would get an even lower price from a future sale since there was virtually no chance this management team could turn the prestige chains business around. That brings us to the question of what’s next.

Zale CEO Burton commented that the company was shopping around the Piercing Pagoda kiosk business. If BB & B was an easy sale at a low price, it’s problematic whether the company can find a buyer for it 800 plus kiosk locations at any price. From a strategic point of view, the product model that Piercing Pagoda was built on in the mid 1980’s is passé and that isn’t likely to change as gold prices continue climb passed $730/toz.

The business value is more in the package of leases the company owns than in the business model. Whether Zale brokers can find another retail business that could benefit from acquiring 800 kiosk locations in one deal isn’t certain. Otherwise, the company may have to try to either sell them off regionally or sublease them locally and retain the contingent lease liability on their balance sheet. In any event, Zale will probably lose as much the disposition of Piecing Pagoda than it made on the sale of BB & B which leaves shareholder position neutral at best.

Longer term, if Zale can dispose of both BB & B and Piercing Pagoda, it will benefit from reduced operating costs and lower inventory investment. A good portion of the $200 mlm should be reinvested in the company to stimulate growth; however that may not be a realistic alternative with hedge fund managers demanding a quick payday. Zale could buy back about 15% of its outstanding shares if the board decided to return most of the proceeds to shareholders, but that wouldn't do much to drive top line sales in the remaining divisions.

For that matter, nothing Zale has done or is proposing to do suggests that management has any better idea of how to grow sales in the Zale and Gordon brands than it did in Bailey, Banks, and Biddle. If that doesn’t change, the sale of the remainder of the company’s brands is the best shareholders can hope for.