As Time Goes, Buy

Alan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The 2008 financial collapse and subsequent recession decimated Zales (NYSE: ZLC), one of the oldest and most respected names in jewelry in the USA and Canada.  Since 2010 the company, with new management in place, has shown remarkable progress.  While still a speculative situation, the company is likely to return to profits this year.

Zales has been a fine jewelry retailer since 1924.  It currently is operating 1117 stores in the USA under the names of Zales & Zales Outlet and Gordon’s Jewelers and in Canada under the names Peoples Jewellers and Mappins.  It has a well-regarded website.  In addition, it owns Pagoda with 652 locations.  Pagoda performs ear piercing and sells less expensive jewelry, principally of silver and gold.  Pagoda is not an integral part of its fine jewelry business.  It is important to note that the general definition of fine Jewelry includes watches.  This can cause distortions in making comparisons. 

In 2008, the financial market collapsed and a recession set in.  The jewelry business suffered a severe decline.   As the industry recovered, changes came.  Companies considered the economy the catalyst and the major problem.  Unlike other industries, jewelry faced almost 20% inflation in its raw materials of precious metals and diamonds.  New technologies, particularly the web, opened sales channels and changed marketing approaches to make use of the web and social media.  Big box stores, department stores, chains and pure E-tailers established their footprints in their own ways.

The jewelry business has for the most part recovered and is growing moderately at around 3% or somewhat above in nominal terms.  The return to profitability, in part, is a result of changes in earlier business models as well as significant additions to these models.  Without reflecting on these, it is not easy to perceive the chances for Zales to fully recover. 

The major drivers in the industry’s recovery are:

  1. The major drop in interest rates.  Interest is a significant industry expense.
  2. The single most significant reason sales have increased is inflation.  Raw materials represent over 80% of cost. The price of precious metals and diamonds soared during this period.  Some studies suggest that on an inflation adjusted basis, the industry has still not fully recovered.
  3. Slowly improving consumer spending and optimism.
  4. Rapidly increasing use of the web.
  5. Eliminating unproductive stores and cautious increases in new stores.
  6. Good performance in watches. 

The major inhibitors of growth are: 

  1. Decline in marriage rate.
  2. Re-merchandising product lines to accommodate the increase in product cost.
  3. Also decreasing SG&A to right size costs and improve profit. 

There has been an increase in capital expenditures in the industry, but not in anticipation of rampant growth. Little has been spent on new stores.  Some investment has gone into remodeling existing stores.  A large portion has gone into systems for the web, inventory and other controls.  

Today, Wal-Mart is the largest jewelry retailer and owns the bottom end of the market.  Amazon is the most significant jewelry E-tailer.  Independent jewelers are continuing to close.  

The battle for market share in the higher side of the middle market is what Zales is engaged in.  Signet (NYSE: SIG) is Zales’ closest competitor because they own Kay Jewelers.  Signet has much more capital, stronger systems, and cheaper costs.  On the other hand, Zales appears to be more creative and aggressive with its merchandising.  Blue Nile (NASDAQ: NILE) has taken a total web approach.  They compete by holding diamonds in inventory and manufacturing on demand, eliminating markdowns.     

The old saying goes, “when the tide goes out, we can see who has their bathing suit on.”  Zales was as naked as the day she was born.  The company, with help from its Board, vendors and employees, managed to miraculously survive.  Zales not only had to survive the economic chaos of 2008, but also serious legacy issues, which had depleted its capital.

What made a turnaround possible was that the company had not yet lost credibility with the consumer.  Zales, “The Diamond Store”, was still there.  In 2010, a new team was brought in to turn the company around.  The first step was to bring enough capital to stabilize the situation.  This was accomplished and with extraordinary help from vendors, the inventory problems were corrected.

The next steps were to tackle SG&A, non-productive stores and leases, and reducing staff.  As a result of the loan they secured at a very high rate, interest too, became an issue.

PUTTING ZALES BACK ON THE ROAD TO PROFITS AND GROWTH

Management has in less than three years achieved all of the following: 

  1. Re-sorted inventory mix is at a current level of around 85% of core inventory.
  2. Maintained gross margins are at a healthy 50%.
  3. Continued to develop its website to a growing part of the business, as well as, being a premier site in the industry.
  4. Continued to close unproductive stores while maintaining growing sales in aggregate.
  5. Completed 9 consecutive quarters of same store growth.
  6. Aggressively developed three private label brands, most prominently and profitably, Vera Wang LOVE.  A partnership with Shaquille O’Neal has just been signed for a menswear collection. 
  7. Lowered effective interest rate from 8% to 4% by renegotiating lending agreements.  Strengthened its relationship with vendors to increase ability to buy on memo. This eases its financial burden and helps keep inventory fresh and properly assorted.
  8. The company has been running a solid positive EBIDTA on a trailing 4 quarter basis since 2nd quarter of fiscal 2011.  Pretax losses have also continued to decline.

The company needs to stay on current course, continue to innovate with its private label businesses (Vera Wang and others), cut costs, and invest in its web presence, social networking and management controls.  Lastly, the sale of Pagoda should be possible.  It would both help rebuild the balance sheet and help management focus on its main objectives. 

Zales can be a real winner.  AS TIME GOES, BUY.


sarah1000 has no position in any stocks mentioned. The Motley Fool recommends Blue Nile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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