Zale's Troubles More Than Breeden Capital Expected

Implications: Activists investors like Breeden Capital, Citadel Investment Group, and SAC Capital Management thought Zale's stock was undervalued.  Now they may realize they have bigger troubles than they expected.  Here's why.

Analysis:

Zale is in a free fall now. Unable to grow sales in its key Zale Division for about 9 quarters, management expects sales will be flat to negative as it begins the 2007 holiday season. That makes it ten dreadful quarters with no turn around in sight. Operationally, CEO Burton is hoping expense control, lower markdowns, and an accelerated share buy back will be enough to eke out $0.86-$0.91 cents per share for FY 2008, less than one-third the company’s FY 2000 EPS of $3.11. But that guidance is by no means certain.

Meanwhile leading competitors like Kay Jewelers (Signet Group PLC), Helzberg Jewelers (Berkshire Hathaway), Fred Meyer (Kroger), Samuel Jewelers (Gitanjali Gems/BSE India), and Finlay Enterprises continue to grow sales; all be it at a slower rate and add square footage too. For example, Kay, in the 3^rd year of its billion dollar expansion, continues to increase selling space at about 10% per year. Several other competitors are growing at an even faster rate, including Gitanjali Gems which recently acquired about 46 Rogers jewelry stores for its Samuel Jewelers brand and Finlay’s purchase of 75 Bailey Banks, and Biddle stores. When the economy turns around, these competitors will have a significant market share lead over Zale regionally and in the case of Kay, nationally.

When hedge fund Breeden Capital Management announced its nearly 3.8 million share investment in Zale, it said it was because the shares were under valued. Paying slightly over $22 per share, Richard Breeden must see extra value now as the company’s stock closed at $19.74 after Zale’s earnings announcement. The question is how to extract that value.

Having sold Bailey, Banks, and Biddle for a loss of about $1.2 million, the company created little value for its shareholders. In fact, a case can be made that management under priced the division significantly and gave a major competitor a strategic advantage too. That’s not maximizing shareholder value, but destroying it. Granted the guild division’s sale enabled the $200 million buyback authorized by the Board, but Zale’s operational leverage has been declining so fast that the buyback won’t mean much in terms of improved EPS and price appreciation for current investors.

What remains to be sold is Piercing Pagoda, a chain of about 800 kiosks located in the common area of malls that specializes in fashionable gold and silver jewelry. A strategic albatross, Pagoda was the wrong acquisition at the wrong time when it was purchased in August 2000 at the end of Robert J. DiNicola Chairmanship.

Then, gold was $277/toz and silver was $4.98/toz. Now with gold and silver prices nearly three times higher, US demand for the precious yellow metal dropped by about 16% in 2006 and as of the end of the 3^rd quarter 2007, it had slipped by another 13% year over year. With the Italian gold manufacturing business stagnant, there is little likelihood of reviving the business and even less likelihood there will be an eager buyer. That leaves the leases to sell and the inventory to dispose of which suggests the possibility of bigger losses and more markdowns in 2008 and 2009.

Zale sold its home office, surrounding real estate, accounts receivables, and credit management facility in the 1990’s, so hedge fund activists either must orchestrate a viable retail turn around or insists the board continues to piece meal the company’s brands to competitors.

That probably isn’t what Citadel Investment Group, SAC Capital Management, and Breeden Capital bargained for when they made their investment. But it’s what they’ve got. Short-term, Zale has only one way to go, but down, so long as it continues to implement its current marketing and merchandising strategy. A strategy formulated by its board of directors, promulgated by a former outside director and current CEO, and endorsed by its operating management; at least what is left of them.

With so much ‘skin’ in the game, changing strategy now probably means not only changing the board, but bringing in new operational management too. Otherwise, the best strategy for the hedge funds is to force the sale of the company, and let another retailer deal with the mess. Either way, most of the current board probably has to change.