Zale's New Stock Buyback is Bad for Investors.

Implications: The market continues to  reward bad behavior as Zales stock traded slightly higher on news the company was diverting additional cash to buy back stock.  Here's why a bigger stock repurchase is  a bad idea.

Analysis: Zale announced its board had authorized management to buy back an additional $100 million in stock.  That increases the total FY 2008 stock buyback to $300 million. Originally Zale had used the proceeds from the sale of Bailey, Banks, and Biddle to fund the initial $200 million buy back.  According to Zale the company has actually repurchased $140 million in stock as of March 2008.  That leaves $160 million when added to the new authorization for the company to repurchase over the next 5 months.

The company probably plans to fund the remaining stock purchase with the proceeds of its $100 million inventory reduction program and a $45 million reduction in capital expenditures.  Meanwhile, Zale’s CEO Neil Goldberg is telling analysts that the company needs to get back to basics, but just how the new CEO plans to pay for his “back to basics program” remains to be seen.  

While Zale may be over inventoried in absolute terms, its entire diamond assortment is out of touch with its core customer, both in terms of taste level and category mix.  Then there is the gold pricing issue.  Most of Zale’s inventory was engineered for gold when it was priced at the $550-$650/toz.  Now, with gold at nearly $1000/toz., current designs are unlikely to have the perceived value necessary to compete with new product.

Many of Zale’s stores are tired and unappealing when compared to their major competitors such as Signet Group’s Kay and Jared stores.  According to Goldberg, one of Zale’s problems is its marketing message.  Assuming he knows what that message should be, and that is a big if, he should also know that the biggest contribution to the company’s marketing message comes from the store and the company’s sales associates.  However, with cap-ex reduced by at least half, there will be little cash left over to invigorate either store appearance or its communications capability. 

Communications is also a problem at Zale, both from the Home Office to the stores and the stores to the consumer.  The $65 million in cuts in HO staff and marketing costs won’t make that communications any easier, especially between the store and the customer.  Zale needs to use its stores as the principal tool to communicate its marketing message and product offer to the consumer.  That’s not going to happen if the cash generated from the expense cuts is diverted to stock buybacks.

I could elaborate further, but I think the point is made.  While better positioned competitors can afford to slow down their rate of store growth and trim expenses, Zale can ill afford to continue to lose market share to the competition.  The spread between its fixed costs and operating margin is growing smaller as each quarter goes buy.  The company needs to make the right investments in its stores, people, and inventory to drive profitable top-line sales and steal share form the competition.  But that isn’t going to happen with the plan Breeden and the board has in place.

The most likely scenario for Zale is that sales will continue to decline, operating margins will decrease further, and the stock buybacks won’t do anything to improve earnings per share for investors as earnings drop faster than the rate of stock reductions.  Unfortunately the market continues to reward bad behavior.  Zale stock traded slightly higher on news that the company would divert more badly needed cash to repurchase additional stock.