I was in New York recently and I had the opportunity to see Stephen Mandel of Lone Pine Capital give a talk to some students from my alma mater, Kellogg business school. Mandel very generously shared a number of lessons he's learned from his decades of managing money. Two of them in particular resonated with me and made me reflect on my own career, as well as some of the things I've read and written here on Seeking Alpha.
The first lesson Mandel recounted was the danger of going what he called "excel crazy"; that is, becoming so obsessed with a company's numbers that you fail to see clear, even glaringly obvious problems facing it. Every experienced investor or money manager has made this mistake at one time or another. I know I have. Numbers can be seductively malleable, and it's all too easy to shape them so that they tell a story you want to hear.
A few weeks ago, I wrote about my short position in Dex Media (NASDAQ:DXM). I believe the company is headed for a rare "Chapter 33," or third bankruptcy. It still derives most of its revenues from a product (Yellow Pages) that everybody agrees will cease to exist in the near future. At the same time, it is drowning under a staggering debt load and revenues from its transition to digital advertising have been decelerating. In my experience, high debts and shrinking revenue growth almost always lead to one outcome: bankruptcy. And yet, a recent article on DXM analyzed the same numbers I had and concluded that its stock would not only turn around, but become a "multi-bagger." After that article's publication, DXM staged an impressive rally, rising roughly 50 percent in a matter of days.
Several readers have written to me asking if I have covered my short position or changed my outlook on DXM. The answer is no. Investors tend to get most "excel crazy" about companies like DXM, those with sub-$10 stocks at or near their 52-week lows. They want to believe that they've uncovered the stock market equivalent of a discarded lottery ticket--the exceedingly rare stock that the market has neglected or wrongly sold-off--so they bend and contort and wrangle the figures in a company's balance sheets until those numbers prove their thesis. To be sure, troubled businesses turn around all the time. But the large majority of companies with low stock prices are overvalued, not undervalued--and way more of them go broke than go to $20, let alone $80 or $100. DXM, in my opinion, will almost certainly wind up in the former category, which brings me to the second lesson Stephen Mandel shared at his recent talk:
My first boss in the investment industry used to chide me for spending too much time buried in financial reports and not enough time meeting the actual people in charge of the companies I was studying. To him, face-to-face contact with executives was as important or even more so than running screens and crunching numbers. Mandel reminded me of the wisdom of this philosophy when he pointed out that a great company can easily be ruined by mediocre or poor management. The opposite is true, as well, of course. Struggling businesses don't recover because of some figures on a spreadsheet--they do so because the people in charge make smart decisions.
Just a couple of years ago, jewelry retailer Zale Corporation (NYSE:ZLC) was in even worse shape than DXM. Its former management team had crushed profits by stocking low-priced merchandise and taking on too much debt to open new locations. Then its board cleaned house and its new managers implemented four strategies to revive the company's flagging margins:
- They began offering exclusive, higher-end merchandise, most notably Vera Wang's LOVE Collection.
- They reduced their inventory of cheap "fashion" jewelry.
- They closed hundreds of unprofitable stores.
- They signed a much more favorable in-house credit card agreement with Alliance Data Systems.
Thanks to these initiatives, unlike with DXM, there is no need to hunt for good news in Zale's recent earnings announcements. The company has seen twelve straight quarters of positive same-store comps. Its last quarter, announced this past Tuesday, was particularly impressive, with comps rising 4.4 percent compared to 3.9 percent in the same quarter the previous year. "Zales" branded stores, which account for almost half of the company's locations, saw an even bigger jump in comps to 7.5 percent from 4.8 percent last year. Most importantly, ZLC's operating margins and earnings-per-share are both moving strongly in the right direction. EPS went from -.81 cents in F2012 to +.24 cents in F2013, which ended in June. The company's stock price has followed this upward trajectory. It's risen from less than $5 when I bought 200,000 shares this past April to the $15 range today.
With its stock tripling in less than a year, one of the company's largest creditors, Golden Gate Capital, is likely to exercise up to 11 million warrants in the coming weeks. Despite this imminent and highly dilutive event, and the fact that the stock is consistently pushing upwards towards 52-week highs, I am not going to sell my Zale stake. I am even strongly considering buying more of the stock. Why? Because a high stock price is often a byproduct of the most important asset a company can possess, competent leadership. In fact, rather than scouring the troughs of the market searching for dubious bargains like DXM, I often scout companies with stocks at their peaks. As Stephen Mandel said, "managements matter," and I trust ZLC's managers to continue to lead the company higher.
The new credit card agreement alone, which will not come into effect until late-2015, should have a significant positive effect on operating margins. Transactions on the store's branded credit card account for a third of the company's sales, and yet the previous management team had outsourced those operations to Citibank. By bringing them back in-house in the deal with Alliance, ZLC can recapture a large chunk of the two percent Citibank had been siphoning off. A two percent boost on one-third of the company's revenues could add up to three-quarters of one percent to ZLC's operating margin--and that's just one of the strategic initiatives ZLC's managers are undertaking.
Wall Street expects ZLC to earn .48 cents per share on $1.9 billion in revenues for F2014 and .75 cents a share on more than $2 billion in revenues the following year. I believe ZLC will outperform these estimates. In fact, in two to three years, I expect ZLC's operating margin to more than double from the 1.8 percent it disclosed at the end of F2013 in June. It could even approach the company's peak margins of nearly eight percent before the financial crisis. Even with the millions of new shares coming onto the market from the Golden Gate warrants, those kinds of margins would easily boost earnings-per-share above $2. A modest multiple of 15x earnings would bring this stock to at least $30--double where it stands today. Throw in the fact that, because of its recent operating losses, the company will face very little tax exposure in the coming years and Zales Jewelers, aka "The Diamond Store," glitters even more brightly.