Zale Board Ignores Opportunities

UPDATE 3-Zale posts loss after charges, to close stores
| Nicholas White – White & Co


Implications:


With the industry in turmoil, Zale’s board ignores an opportunity to reinvent the company in the wake of an industry shake out that began after Christmas 2008.  Here’s more.


Analysis:


Zale stock closed under $1.00 as the DOW fell about 281 points to 6,594.44.  Zale’s decline in value comes a week after Finlay Enterprises announced that it was vacating the department store business and closing about 40 of its specialty retail stores.  Clearly, the $65 billion dollar fine jewelry industry is undergoing a major restructuring that is affecting large and small retail jewelers alike.  Yesterday, Robins Jewelers, a 16 store chain with stores in California, Texas, and Illinois, filed for bankruptcy.   That brings the number of retail jewelry bankruptcies to four including Christian Bernard, The Shane Company, and Fortunoff, with any number of firm’s financial viability in doubt including Finlay and Zale. 


After the hype subsides, the reality of what Finlay’s restructuring plan really means to bond holders and creditors will sink in.  that will lead to the inevitable conclusion that the company will probably be liquidated for a lot less that the secured creditors are owed.  Whether what remains of Finlay can survive is problematic at best, especially in this economy.   Let’s face it five local clientele stores in South Florida, thirty-five regional, up scale guild stores in the south east, and about 30 disparate Bailey Banks and Biddle stores , all operating under three different trade names,  doesn’t constitute much of a base for a national guild jewelry chain in the best of times.


Then there’s Zale.  Now trading at penny stock prices, the market has clearly written off the countries second largest jeweler after its dismal Christmas sales performance.   While the entire jewelry industry is suffering, it’s obvious to investors that Zale will lose a lot of money in 2009 and that current management is unlikely to turn the company around now or in the foreseeable future.  That investors have lost confidence in CEO Neil Goldberg, Chairman John Lowe, and major shareholder and director Richard Breeden is understandable.  After all under the leadership of these three new executives, Zale has lost more than 39% of its shareholders equity over the last four fiscal quarters.    It’s a simple accounting identity, shareholders equity is equal to the difference between assets and liabilities and on these three new leaders watch that has declined by about $324 million in 12 months.  Moreover, it could decline by another 20% to 25% by fiscal 2009 year end if last years performance is the measure. 


According to its second quarter balance sheet, Zale had $847.26 million in inventory.  That equates to a liquidation value of about $508 million at current estimates of recovery from a “going out of business” sale.  That more than covers the $390 million debt the company has outstanding.  But that margin could decline quickly as more distressed jewelry enters the marketplace and demand continues to plummet.  For instance, at 50% recovery debt holder’s liabilities would just be covered and 50% recovery values aren’t out of the question in this depressed economic environment.


What should Zale do?  Well the market has seen Goldberg and Breeden’s best shot.  So any management combination which includes these two executives won’t get much of an endorsement from the market.  Certainly, about the last thing shareholders need is a hedge fund manager ruling the board.  But that isn’t likely to change since Breeden Capital Management has lost about $200 million on Richard Breeden’s decision to invest in Zale about 18 months ago.   On the other hand, the company could change CEO’s, something they have done all too frequently over the last decade.  But it’s improbable an executive capable of turning Zale around would submit to either the board’s micro management or Breeden’s likely interference. 


That’s unfortunate, because no other company in the jewelry industry is in as good a position to lead the industry as Zale is today.  Many would take exception to that idea, but the logic is quite simple.  Zale has no where to go but up.  Granted a big change in direction could hasten a bankruptcy if it were wholly unsuccessful.   But if current trends continue, and they probably will, Zale’s slide into financial oblivion is almost a certainty anyway. 
 

Some analysts would argue that Signet Jewelers is model for the future, but I would disagree.  While it’s true Signet financial performance has been superior to most of its competition over the last decade, its superior performance wasn’t due to innovation as much as it was to meticulous management and dogmatic execution of a jewelry profit model that was pioneered by Zale in the 1960’s.  Simply put, they took Zale’s original model and out did them at their own game. 


But the industry is facing a completely new set of challenges in the 21st Century, tantamount of which is liquidity.  Few other retailing segments are as cash intensive as jewelry.  To say these businesses are “cash hogs” is an understatement.  In fact, liquidity has been a serious strategic problem for the entire industry including diamond cutting, polishing, manufacturing, wholesaling, and retailing for years.   Nonetheless, the industry has prospered, in part because cheap consumer credit kept good selling at the retail end and subsidized credit filling the pipe line.  How else could billions of dollars worth of large diamonds and finished goods set idly in diamantaire’s safes and retailer’s showcases.  But that has all changed, a fact industry participants are well aware of, but uncertain what to do about it.


Clearly this is a turning point in the industry and the innovation necessary to solve its problems will have to come from every part of the supply chain.  But the reality is the jewelry industry is all about small retailers and manufacturers which lack both the visibility and resources to foster industry wide change.  To quantify the fragmentation of the industry, current estimates indicate there are about 22,500 jewelry retail companies in the US and another 4,500 manufacturers/wholesales.  In terms of sales, the average jewelry retail company does less than $3.0 million, while the typical manufacture sells about $14 million per annum.   Those numbers are wildly distorted, but they are accurate insofar as they suggest the small size of jewelry industry participants compared to big department store retailers and non-jewelry manufacturers.  


Anyway, the point is there are only a handful of large jewelry retailers and even fewer manufacturers that could reinvent the industry, which includes Zale Corporation.  However, whether results to date will jolt Zale’s board into constructive action isn’t clear.  What is certain is that the company is in death spiral, much like an airplane that’s in a stall and the only thing that is going to prevent a crash is a pilot that not only knows how to fly, but is also is proficient in flying that type of plane. 


Zale closed at $0.92 per share having lost 95% of its value since March 6th 2008 when it closed at $18.22 per share.


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The founder and president of Diamond Cutters International, is one of the world’s top diamond experts, as well as a three-time Guinness Book record holder in jewelry design.
Fred The Diamond Guy
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