Zale Goes On The Defensive As Competitors Continue To Inflict Damage

Tuesday morning I listened to Zale Corporation's (ZLC) third quarter conference call. Using Seeking Alpha's transcript, I will provide my thoughts and analysis.

Before launching into the company's conference call, I will provide highlights in point form from its third quarter earnings release.

• A net loss of $3.1 million or $0.06 per share;
  • Included are a reduction of $6.9 million because of the adoption of its lifetime jewelry protection plan and a benefit of $1.6 million for the net impact of derivative versus hedge accounting on its gold and silver contracts;
  • Excluding these items, the Company reported earnings of $2.2 million, or $0.05 per diluted share;
• For the same period last year after various adjustments, the company earned $11.6M or $0.24 per share;
• Revenues for the quarter ended April 30, 2007 were $511.9 million compared to $526.9 million last year, a decrease of 2.9%;
• Comparable store sales for the third quarter decreased 3.4%; and
• Company projects a fourth quarter comparable store sales decrease of 2% to 3% and GAAP earnings per share in the range of ($0.11) to ($0.15). The guidance includes an estimated ($0.12) impact due to the decline in revenue recognized from the change to its jewelry protection plan offering and approximately $0.02 for the net impact of derivative versus hedge accounting. Excluding these items, the Company continues to expect earnings per share in the range of ($0.01) to ($0.05) per share.

I will work through the conference call and provide my thoughts, once again in point format.

Sales

• The Zales brand had a mid-single digit comp decrease, lesser transactions but higher average ticket;
• Gordon's brand had a mid single digit comp decrease, less promotional than Zales;
• Pagoda also experienced mid single digit comp decrease, lesser transactions but higher average ticket;
• Bailey, Banks, and Biddle experienced low single digit comp decrease because of a decline in average ticket. The trend has reversed;
• Outlet comps were flat;
• Peoples and Mappins in Canada were strong with comp sales up in the high single digits and total revenues up in the mid teens;
• dotcom was strong too with sales up over 50% versus last year; traffic was up 20% and conversion was up 30%;
• Lifetime jewelry plan generate $10M in cash.

Challenges for Fourth Quarter

• Tough macro environment;
• Retailing, especially jewelry is difficult;
• Higher energy prices are soaking up discretionary dollars;
• Jewelry is not a must but rather a want;
• Lower priced items are down, but larger ticket items (larger solitaire carat weights) are up with double digit growth;
• Company has about $70M in excess inventory, which it plans to eliminate by reduced replenishment cycles;
• Company also has $40M in clearance inventory to work through;
• Company reduced its inventory by over $30 million in Q3 and its goal is to reduce inventory even further by $50 to $70 million in Q4.

Financial Metrics

• Total revenues decreased 2.9% for the quarter and were flat year-to-date;
  • Total revenues negatively affected by a decrease of $8.7 million in recognized revenues from the sale of lifetime jewelry protection plans or JPPs;
  • Sales of lifetime jewelry protection plans were $28M compared $18M same quarter last year;
• Average transaction sizes for the quarter by brand:
  • Zales $367 versus last year $341;
  • Gordon's $411, $400;
  • Bailey Banks & Biddle $1724, $1763;
  • Outlet $427, $414;
  • Peoples $301, $283;
  and
  • Pagoda $38, $37;
• Gross margin declined from 51.7% to 51%%. Positive merchandise margin gains were offset by the decline in revenue recognized for lifetime JPPs. Moreover, SG&A was 47.7% for the quarter versus 45.8% last year as a percentage of revenues;
• The effective tax rate for the quarter was 38.3% versus 34.3% last year. Last year the effective tax rate included a tax repatriation benefit in the quarter;
• Store count:
  • Zales, 787;
  • Gordon's, 284;
  • Bailey Banks & Biddle, 72;
  • Outlet, 137;
  • Peoples, 189;
  • Peoples Two, 26;
  and
  • Pagoda, 797;
• The capital expenditures are expected to total about $95 million for the fiscal year;
• Merchandised inventory at April 30th, 2007 was $1.1 billion or $148 million and 15.8% higher than last year's level at $938 million;
• Ended the quarter with $53 million in cash and borrowings of $290 million under a line of credit compared to $60 million in cash and borrowing of $205 million last year;
  • The increased inventory levels and the decline in current receipts and merchandise payables resulted in increased borrowings and a significant reduction in free operating cash flow;
  • Estimated fiscal 2007 free cash flow to be in the range of a negative $70 to $80 million.

Question and Answer Session

I did not find anything particularly noteworthy.

Summary

In listening to the call, I got the sense that the executives were defensive. Business is difficult, and some of that difficulty can be explained with high energy prices and, although they did not mention it, housing. The executives seemed very focused on cost cutting, looking at various options to spin things out (portfolio review), and direct sourcing. While that is all good, I did not get the sense the company is going on the attack to attract and get new business.

I got a completely different impression when I listened to Blue Nile, Inc.'s (NILE) conference call. It was one of optimism and increased guidance. Zale is the polar opposite. It is fighting off its various demons in hopes of throwing off positive cash flow in the future.

I certainly do not have any magic bullets for Zale. I agree that retail, especially mall based jewelry retail, is darn difficult. I suspect that jewelry retailers with substantially less margins (Blue Nile, Costco Wholesale Corporation (COST)) are making life difficult for Zale. Unless Zale radically changes its business model, its competitors with their lower cost structures are going to continue to do damage.

All that said, the Zale stock closed up $0.31 to $27.91 for a gain of 1.12%. Possible explanations are investors feared worse or investors are hopeful that private equity will play a role in the portfolio review or something else entirely.

Disclosure: I have no positions in Costco, am long shares in Blue Nile, and am short shares in Zale.

ZLC 1-yr chart: