Zale Still Speculative After Share Rebound

| About: Zale Corporation (ZLC)
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Over the last year, Zale (NYSE:ZLC) has traded in a range of $2.30 to $9.44, and is now trading just under that high. Anyone entering in June of 2012 would have made some serious profits if they held till today. Even an entry point in the latter part of February 2013 would have resulted in doubling your investment. Now the question is whether or not Zale's performance is sustainable or it is close to peaking.

Zale has a total of 1117 stores operating under the Zales & Zales Outlet and Gordon's Jewelers brands in the United States and the Peoples Jewelers and Mappins Jewelers brands in Canada. The company also has a presence in Puerto Rico operating under the Zale brand. It has an additional 652 locations under the Piercing Pagoda brand, which sells ear piercing and inexpensive jewelry. It also has websites for each of the brands.

The Gordon brand sells merchandise of a slightly higher quality and price than its Zale counterpart.

Latest Earnings

For the third fiscal quarter ended April 30, 2013, revenues were $443 million, a slight drop from the $445 million generated in the third quarter of fiscal 2012.

Net earnings for the period were $5 million, or $0.13 per diluted share. Last year in the same quarter, net earnings were at a loss of $5 million, or $0.14 per share.

Gross margin on sales was $233 million during the quarter, or 52.6 percent, a gain of $5 million from the same quarter last year. Operating margin was $10 million, up 2.2 percent.

Overall same-store sales climbed 1.4 percent, excluding February 29, 2012 (leap year). On a constant currency basis (minus the extra day), that was a gain of 2.6 percent.

For the first nine months of the fiscal year, revenues were $1.47 billion, a gain of $11 million over last year in the same period. Same-store sales were up 2.7 percent, down from the 6.5 percent gain last year in the same reporting period. Operating earnings stood at $38 million, or 2.6 percent of revenues, up from the $27 million, or 1.8 percent of revenues in the first nine months of fiscal 2012. Net earnings came in at $18 million, or $0.45 per diluted share, after a net loss of $8 million or $0.23 per diluted share in the first nine months of the last fiscal year.

Income Statement

Cash Flow Statement

Brand Results

Comparable store sales at Zales Jewelers and Zales Outlet jumped 3.0 percent in the latest quarter. Minus February 29 same-store sales were up 3.9 percent. That was still significantly below the 12.4 percent in the same quarter last year.

Comparable store sales including Gordon's Jewelers and Zales Jewelers and Zales Outlet were up 1.8 percent. Last year in the same quarter, same-store sales were up 10.9 percent. February 29 same-store sales at the three brands were up 2.7 percent.

Comparable store sales in the Canadian market, including Peoples Jewelers and Mappins Jewelers, were down 0.9 percent. Last year same-store sales were up 3.8 percent in the same reporting period. Including constant exchange rates, comparable store sales gained 1.0 percent. Adjusted for February 29, sales were up 1.8 percent.

The large disparity in comps in part came from the shutting down of underperforming stores last fiscal year.

Comparable store sales at Piercing Pagoda climbed 2.1 percent. Last year in the same reporting period, comparable store sales were down 1.1 percent. Take away February 29 and comparable store sales were up 2.9 percent.

Company Turnaround Strategy

After the banking collapse in 2008 and accompanying recession, people cut back on buying non-essential items, and consequently Zale got crushed. Fighting back against the plummet in sales, the company put together a three-year plan to turn things around.

Here's the basic outline as defined by Zale:

• Fiscal 2011 (Year One): Stabilize the Business
• Fiscal 2012 (Year Two): Establish Sustainable Growth
• Fiscal 2013 (Year Three): Return to Profitability and Create Long-Term Shareholder Value

In the first year, stabilization meant securing capital in order to put the plan into action. From there the firm worked on adjusting its core merchandise mix and strengthening its store teams.

For the second year of its turnaround strategy, Zale focused on laying a foundation for sustainable growth. Included with that was the refinancing of debt, which brought the borrowing cost from 8 percent to 4 percent at existing interest rates. Savings was about $17 million.

The company also continued its work on its core merchandise mix, with the goal of bringing it back to 85 percent of its total inventory.

It also boosted its omnichannel business model so visitors could find and interact with the brand at any preferred touch point, including physical stores, Web stores, mobile and social media.

Another good move was to provide an alternative source of financing from its Citi credit program, which is more stringent and disallows a lot of potential customers to buy merchandise at the company outlets.

Finally, the company raised its training level and support for its people, boosting the organizational effectiveness of the firm.

The numbers reveal the steps taken are bearing fruit and making a material difference in the results. Revenue grew 7.1 percent in fiscal 2012, ending at $1.9 billion. Comparable store sales in 2012 rose 6.9 percent, after jumping 8.1 percent in fiscal 2011. Operating earnings in 2012 reached $19 million, up $47 million over the previous year. That was the first operating profit since the 2008 financial crash.

The company has also maintained gross margins at a solid 50 percent, has 9 straight quarters of same-store sales growth, created three private label brands, shored up its website, has had a positive EBIDTA on a trailing 4 quarter basis since the 2nd quarter of fiscal 2011, and has boosted its ability to buy from vendors on memo.

Now into fiscal 2013, it appears the company has laid a good foundation for sustainable growth, even though sales were flat year-over-year for the latest quarter (probably from store closures as well). Earnings, margins and same-store sales were all up, suggesting Zale is returning to profitability, although we'll need to look at the next two or three quarters for confirmation of that. But that's the stated goal, and the jeweler looks like it has a very good chance to achieve it.

High-Income Consumers Now Prefer Zales to Tiffany (NYSE:TIF)

A recent survey from Unity Marketing found that by a slight margin, Zale is now the preferred brand by high-income consumers as measured against Tiffany.

"It's something I find very interesting," says Unity Marketing president Pam Danziger. "It's a small percentage, and they are real close, but Zales is higher, and that's never happened before. Tiffany has been the leading retailer as long as we have been doing jewelry brands."

The conclusion is affluent consumers are trading down from premium luxury brand names. People surveyed had incomes of $250,000 or more annually.

Since rivals Jared and Kay weren't included in the survey, it's not certain the percentage of those consumers Zale has been getting, but it is a good sign for their business that a market segment the company didn't have before is looking at the type of merchandise Zale offers. It's also not certain if they were included in the survey, how many respondents would have answered they prefer Jared and Kay over Zale against Tiffany.

Nonetheless, it's still a positive for the company, as it will definitely get a percentage of those trading down, as it also has a brand that has been around for a long time.

New Board Chairman

Another important move made by Zale was the appointment of Terry Burman as the board chairman. Burman was the very successful CEO of Zale's major rival Signet Jewelers Ltd. (NYSE:SIG) from 2000 to 2011.

Not only was Burman able to grow Signet through the strong economic years, but when the economy went into recession, the company continued to do well. During that same period Zale had to close over 100 stores.

At a time when the turnaround strategy is at the growth stage, Burman is as good a person to have in the chairman position as Zale could have gotten. He replaced John B. Lowe, Jr., who remains on the board.

"I am delighted to assume the role of chairman of the board at Zale at such an important point in their turnaround program," Burman said. "I am looking forward to working with Zale's management and board to refine the company's strategy and priorities to drive profitable growth and create shareholder value."


Much of the preparation for growth has been completed by Zale, and bringing on Terry Burman as board chairman was an excellent move to fit the final piece into the growth puzzle.

This doesn't mean Zale has moved out of the speculative category, but it has done the necessary things to position itself for potentially strong growth in the years ahead. While not a certainty, it is likely it will return to profit in fiscal year 2013.

Inflation and interest rates are more subdued, which should help Zale keep costs lower. That was one of the major challenges in the overall jewelry industry, where inflation jumped close to 20 percent for precious metals and diamonds in recent years.

The fact that Zale was able to survive after being brought to the brink is a testimony to its strong brand, which still resonates with consumers. That, as much as anything, points to the probability of a profitable future.

Zale looks like it has positioned itself for success, but growth will be largely organic in the near term, as the financial position of the company disallows a strategy of starting a lot of new stores.

Balance Sheet

It's internal store growth that will be the primary focus, as well as a push in its web business, which is considered an increasingly strong part of the company, and customers really like the website.

The jeweler has a good chance at future growth, but it will probably take several years to benefit fully from the steps it has taken. For now growth will come mostly from existing stores, but as the company becomes stronger financially, we should see a push towards new store openings. The possibility of selling Piercing Pagoda is an option Zale may consider in that area.

In the short term, I'm a little leery of Zale at its current price of over $9.00 a share, but if it pulls back it could be considered a buying opportunity.

Assuming a sustainable and improving American economy, Zale should perform very well over time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.