The mall-based diamond and jewelry retailer has rallied strongly from its recent financial distress. At the troughs of the 2009 stock market lows, Zale Inc (ZLC) traded down to less than $1 per share before bouncing back and trading up to nearly $7. Last Friday, the company's stock dropped 18% on trading volume 4x the average daily levels over the last three months.
SHAREHOLDER REDUCES STAKE
Breeden Capital Management has long been among the stock's largest shareholders. But more recently it has reduced its position. In its latest SEC Schedule 13D, Breeden reported a 5,935,414 share position, or 18.51% of the total shares outstanding. This is a sharp drop from the 7,784,764 share position reported in its Form 13F for quarter ending March 31, 2011. As of December 31, 2010, the fund owned 9,070,839 shares and had been steady at this level since December 31, 2008.
While it has a good reputation as an activist shareholder fund, its involvement in Zale Corp has not been a bright spot. It likely accumulated the stake well above current prices, probably above $15 per share. As such, the decision to reduce the stake could be for various reasons including frustration over the inability to impose control commensurate to the ownership stake.
DOWNGRADE WORSE THAN IT SOUNDS
While analyst downgrades from major financial institutions will almost certainly drive down the stock price, not all downgrades are created equal. Bank of America's latest downgrade is one such instance. While Bank of America changed its rating on the stock from "buy" to "neutral" it also increased the price target to $6.75. Despite the negative appearance of the headline, considering that the stock closed at $5.13 on June 10, 2011, the price target appears to be bullish.
The stock is in the process of a turnaround. With the help of $150 million of funding from Golden Gate Capital and a modest rebound in retail spending, Zale Inc is on much better footing. In the quarter ending April 30, 2011, the company produced revenue of $411.84 million. This was a year-over-year increase of 14.5%. During the nine months ending April 30, 2011, revenue increased only 7.4%, implying that the turnaround at Zale could actually be accelerating.
Still, investors should be cautious. The debt load, shareholder concentration and dilutive effects of warrants issued to Golden Gate Capital as part of the funding arrangement mean that future corporate decisions may not be in the best interest of minority interest passive investors.
Blue Nile Inc (NILE) - The online diamond and jewelry retailer has grown its revenues from $295.3 million in fiscal 2008 to $332.9 million in fiscal 2010. Despite the lower cost structure you would expect from an internet retailer, the company's profit margins are still modest at around 4.2%. The company has a trailing P/E of 47.57, a forward P/E of 35.29 and a price/sales of 1.97.
Signet Jewelers Ltd (SIG) - This company is the most comparable to Zale Corp. It operates more than 1,800 stores throughout the US and United Kingdom under the Kay Jewelers, Jared The Galleria of Jewelry, H. Samuel and Ernest Jones brands. Much of its success during the last few years has centered on the ability to control costs and gain market share, especially from distressed competitors like Zale Inc. It has a trailing P/E of 16.38 and a forward P/E of 11.37. It has a price/sales of 1.08 compared with a profit margin of 6.41%.
Tiffany & Co (TIF) - Like Zale, Tiffany also sells fine jewelry but this company operates on the opposite end of the retail diamond and jewelry spectrum. It has a global brand value that allows it to charge premium pricing for products. It trades at a trailing P/E of 23.81, a forward P/E of 17.55, a price/sales of 2.89 and produced profit margins of around 12%. As of January 31, 2011, the company operated 233 stores as well as a popular online store.
The company's negative headlines were certainly enough to move the stock price, but they do not change the fundamental story at the mall-based retailer. Zale is a very risky stock, not only because of its large exposure to the lower end of the diamond jewelry retail market, which is much more sensitive to the economy, but also because of the company's leveraged capital structure. The company is headed in the right direction but could be especially susceptible to any fundamental setbacks along the way. But for all of the reasons for investor caution, market participants should view the recent negative headlines as noise and they should not factor it into their stock investment thesis.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ZLC over the next 72 hours.