Zale: A Hidden Gem

By Arthur Pinkasovitch - February 15, 2012 | Tickers: SIG, TIF, ZLC | 0 Comments

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Jewelry is a highly elastic luxury item. During economic booms shoppers flood stores to buy expensive necklaces, engagement rings and diamond earrings.  When the economy turns the corner, consumers hold off on extravagant purchases and will either temporarily postpone buying engagement rings or go for more affordable alternatives.  During the Great Recession, jewelry sales tumbled and the share price of retailers followed suit. Tiffany (NYSE: TIF), for example saw its share price collapse from $44 to $19 over a 6 month span. Likewise, Signet Jewelers (NYSE: SIG) had its share price fall by nearly 75% between September 2008 and January 2009. However, Tiffany has emerged as a stronger brand as stock prices now hover around $65 while Signet also currently trades with a higher market price than in the months prior to the economic downturn.  

Jewelry demand is particularly influenced by disposable income; with unemployment rates falling to 8.3% and bright prospects ahead, macroeconomic indicators suggest that U.S. consumers are back at work and willing to shop! Jewelry sales are highly cyclical, with the majority of purchases conducted around Christmas and Valentine’s Day. Last year, Valentine’s Day holiday jewelry sales recorded a year-over-year growth rate of 9.0%; this year sales are expected to continue the robust trend, jumping another 5.2%, according to IBISWorld. With U.S. median household income hitting inflation adjusted 4% growth, increasing to $51,500, jewelry stores stand to prosper above all other industries due to the high correlation between overall economic performance and expensive luxury item purchases.

Zale Corporation (NYSE: ZLC) can potentially be a huge winner within the jewelry industry. The retailer holds 6 unique brands and operates approximately 1,870 stores across North America through specialty jewelry stores and mall kiosk concepts. The chain also has a strong online presence, recently introducing two new launches of pagoda.com and peoplesjewellers.com to expand the e-commerce business segment across Canada. After trading at over $30 per share in 2008, its price collapsed, touching $0.97 per share in March 2009; unlike Tiffany and Signet, however, its shares are still trading well below pre-recession levels, hovering around $3.15.

During the recession, falling sales left Zale with growing balance sheet liabilities amidst a cash strapped position. The retailer was forced to cancel orders and even requested that vendors repurchase inventory for cash. After closing hundreds of nonperforming stores and facing burdensome liquidity constraints, the top 3 executives left the company following the release of disappointing 2010 holiday sales figured. High SG&A expenses and high industry comparable debt-to-equity ratios continue to be a cash drag on its operations and leave Zale at the brink of defaulting on its debt covenants. Between fiscal 2007 and 2011, Zale’s SG&A expense as a percentage of revenue has been significantly higher than that of its competitors – see Figure 1. Likewise, its long term debt is significantly higher than that observed with other members of the industry – see Figure 2. Both of these figures must be addressed by management.

Figure 1 – SG&A/Revenue

Figure 2 – LT Debt/Total Assets

Although it is unlikely to see the company trading at its pre-recession highs, especially seeing as how debt and SG&A expenses continue to inflate, Zale presents solid investment fundamentals. Firstly, Zale brands are well recognized across its various brand concepts. This strong brand equity affiliation introduces a major benefit to the otherwise fragmented market; Zale has a dominant market position in outlets and kiosks while the company grows at an average compounded annual growth rate of 4%. Secondly, management has committed to a debt reduction plan, lower borrowing costs and improving business efficiency as part of the 2013 Sustainable Growth agenda. 2012 will have a higher focus on strengthening the overall brand and product mix. After securing liquidity in 2011, Zale bought itself some time to turn its story around. Thirdly, Zale has seen improving trend with comparable store sales within the last year, growing at an average quarterly rate of 9%. During the Christmas season, holiday sales increase at a year-over-year rate of 5.8%, with comparable store U.S. Fine Jewelry brands growing at 7.5% and 9.0% over the last 2 years.

Finally, stable customer loyalty and prospects of additional store openings indicated that Zale is an ideal takeover target by a bigger jewelry retailer or even a private equity firm; the Zale brand is too valuable for the company to go completely under. Golden Gate Capital already holds a significant investment in the struggling retailer.

Conclusion

Trading at a price to sales multiple of 0.06 Zale has been left for dead by the investment community. The company has been losing money consistently for the last 3 years and is expected to turn another loss this fiscal year. However, the magnitude of the losses and the overall sales trend in recent years has been positive. If Zale is able to tighten its operations and operate with the same efficiency as its competitors, it can definitely make a comeback. I'm not saying that Zale shares should be once again trading at $30... but I believe they should be well higher than $3.

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