Has Zale's Stock Fallen Enough to Represent Fair Value?

Nov.26.07 | About: Zale Corporation (ZLC)

I listened to Zale Corporation's (NYSE:ZLC) first quarter conference call on Tuesday 20th of November; read the company's press release, and Seeking Alpha's transcript.

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

  • A net loss of $28.4 million or $0.58 per share;
  • For the same period last year, the company lost $26.4M or $0.55 per share;
    • I believe the loss last year included $4.8 million or $0.10 per share because of the derivative accounting treatment of its gold and silver contracts;
  • Revenues for the quarter ended April 30, 2007 were $377 million compared to $382 million last year, a decrease of 1.3%;
  • Comparable store sales for the third quarter decreased 0.4%;
  • The sale of Bailey Banks & Biddle was completed on 9 November 2007;
  • Cash warranty sales, Bailey Banks & Biddle, increased $9.5 million over the first quarter last year and revenues recognized were $6.1 million less than in the prior year as a result of the change made in the warranty offering; and
  • Company has embarked on a $200 million share repurchase program.

I will quote from the Company's press release regarding its forward guidance.

The Company updated its second quarter guidance to reflect the sale of Bailey Banks & Biddle, anticipated share repurchases and sales trend. It now expects comparable store sales of flat to slightly negative. Earnings from continuing operations are expected to be in the range of $1.60 to $1.65 per diluted share. There was an approximate $0.27 reduction in earnings expectations due to the sale of Bailey Banks & Biddle with the remainder of the adjustment being the benefit of any share repurchases offset by the Company's cautious outlook for the Holiday season.

For the full year ending July 31, 2008, the Company now expects earnings per diluted share from continuing operations of $0.86 to $0.91 after adjusting for the Bailey Banks & Biddle sale and the cautious outlook for Holiday. The Company continues to expect the increase in unrecognized revenues on the balance sheet to be approximately $80 - 90 million for the fiscal year which represents approximately $1.00 in future earnings per share before the benefit of any share repurchases.

By looking at Yahoo's chart of Zale's year-to-date stock price, we know that this has not been a banner year for Zale. A couple key questions for me, who has a short position in the stock, are as follows: one, has the company's outlook changed; and two, has the stock fallen enough to represent fair value?

With regard to the first question, I do not see any fundamental changes. Yes, the company sold Bailey Banks & Biddle, but the rest seems to be status quo. Indeed, from Seeking Alpha's transcript, we have the following:

Let me now give you a quick update on our various strategic initiatives in progress to date. The first component of our strategy is the focus on our core mall business. We have identified three key initiatives to drive improvement. The first is a pilot to build a best in class customer experience which we believe can result in significant growth in same store sales. First and foremost is the focus on the customer. Areas of emphasis include product knowledge training and training in consulted selling. Next are changes in work flow to free up the associate's time to spend with the customer. Then, there are product assortment improvements, policy changes and tools to support an overall improved experience. The test is currently live and on track for the pilot stores to deliver increased sales of a trend for holiday.

The second initiative is focused on increasing gross margin through continued growth in direct sourcing, refinements in pricing and improvements in our supply chain strategy to drive cost savings. We also see an opportunity to improve store return by focusing on assortment optimization and gross margin return on investment in space and inventory. This includes a shift in assortment mix toward core diamond summaries, decreasing investment and non-core summaries and a reduction in the gap in SKU count between high volume and low volume stores in the diamond wedding categories.

The third major initiative is a continued emphasis on a return on capital. This means putting a sharp lens on all real estate decisions and evaluating store-by-store performance based on return on capital. This focus applies to new and existing stores. We will close stores that are not meeting their cost of capital and where it is unlikely operational improvement would get it even close to the hurdle. We will also scale back investment in new stores for the Zales and Gordons brands until we have made progress in making operational improvements. Where we will invest is in those brands and formats that produced the highest returns on capitol: Canada, outlets and .com.

Let us take a look at three strategic initiatives. The first initiative on focus on mall business sounds to me a typical blocking and tackling. I do not see anything strategic about running the business with good business practices. In my view, this initiative signals sloppiness on the part of management for past sins. Moving along to the second initiative, again, I think focusing on SKU and supply chain management is just sound business practices. There is nothing extraordinary, nothing new or novel—just more blocking and tackling. And the third initiative of focusing on a return of capital is nothing new or novel either. In fact, I wonder if Zale's will scale back at the wrong time. Just as the housing crisis deepens and opportunities present themselves to secure long term inexpensive mall leases, does the company leave because of a temporary dip in consumer spending in the housing affected regions? Indeed, the company references the housing debacle later in the question and answer section of the call.

Betsy Burton

I clearly believe that it is macro. I think if you talk to vendors, we are tracking actually, slightly better than some of our competition. But, clearly mall traffic is down anywhere from 4-6% is what I hear. So, I think clearly, this will be a challenging macro environment, in particular, for mall jewelry. But again, we believe that we have opportunity because of some of the executional issues last year. But, clearly we are feeling the same trend. You know, the Middle American customer has been hit hard by whether it is the housing market bubble, whether it's being overextended in credit in general, the high cost of gas, all of that is hitting our core customer which, you know, let's say income in the $50-$100,000 range. So, clearly it's a phenomenon that is affecting all retailers that have, especially have purchases that are discretionary. Then, on top of that you're fighting for dollars with the iPod and flat screen TVs.

The second question concerning whether the stock price has fallen far enough to represent fair value is more interesting, at least to me. The company has a market capitalization of roughly $1 billion and an enterprise value of about $1.3 billion. Just prior to the question and answer section of the conference call, the company indicated that it expects $125–150 million in operating cash flow. In my view, the company is at or near fair value.

Rather than discussing all the details of the conference call, I am taking a macro view. In short, nothing has fundamentally changed with the company's business model. In the near term, the company will struggle as will many other retailers with the housing debacle. Longer term remains a question. Does the company make substantial changes to its business model over the next few years or will stay with the status quo?

Given that the stock price has fallen to levels where the stock is no longer a raging short, I must decide what to do next. I am inclined to wait until early in the New Year. Perhaps after the weak retail sales, the share price will be weaker too. Offsetting that is the share repurchase program. I do not see any drivers for creating a substantially lower or higher stock price. Thus, I am inclined to close my short position in the near future.

Disclosure: I am presently short Zale stock.