Much ado has been made over Zale’s apparent woes. Not only have the recent financial disclosures sounded ominous, but the rumor mill about Zale’s prospects has had plenty of grist.

 

We take exception to most of these woes: they are largely not material nor particularly meaningful, in our opinion, and they almost certainly have little impact on the company’s current operations. More importantly, virtually all of those “problems” can be traced to earlier Zale administrations and executives, virtually none of whom are involved with the company today.

 

If anything, Zale’s current – new – management has been quick to recognize deficiencies in its financial operation. As required, it disclosed those deficiencies, and it implemented procedures to prevent similar deficiencies in the future.

 

But here’s what’s most important: the focus on the company’s alleged woes are largely obscuring what is really happening at Zale. The company is not sinking deeper into a financial abyss from which there is no return, in our opinion. Quite to the contrary, sales are “less bad.” The average ticket is up. Store visits confirm that the company’s sales training may be working. And, the company should get a lift from the recovering U.S. economy.

 

These Woes May Not Really Be Woes

The industry has been worried about Zale: sales have been weak, and profits have largely evaporated. Its net worth continues to decline. Excessive management turnover has been disastrous. So when Zale delayed the release of its year-end financial results twice – with the final announcement coming only hours before the time limit imposed by the Securities & Exchange Commission – the jewelry industry rumor mill had plenty of time to create both real and imagined scenarios about Zale’s future.

 

After nearly thirty years as a professional securities analyst working with retailers and jewelers – twenty years of which was spent on Wall Street – we believe that we are as qualified as anyone to dissect the company’s financials and try to explain what’s happening.

 

We use the financial analysis concept of “materiality” when analyzing a company’s financials. No company’s financials perfect; further, we typically can’t find two accountants who will agree on the same accounting treatment for every issue. Thus, our job is to determine if the financial deficiencies which Zale recently disclosed are actually “material” to the company’s operations. Do they really make at difference? Or, at the end of the day, has nothing meaningfully changed, despite these ominous disclosures?

 

The table below summarizes Zale’s key changes to its financial statements since 2005, based on the accounting revisions which the company and its independent auditors reported at the end of the current fiscal year – July 2009. As the table illustrates, there are no big swings in the numbers; no major trends changed, in our opinion.

Source: Zale Corporation legal filings

 

Here is the list of Zale’s financial disclosures and our opinion about their materiality.

 

• Impairment Accounting Charges – These special charges include the following: store impairments, Bailey Banks & Biddle lease reserve, closed store charges, inventory impairment charges and goodwill impairment.
  
  For all practical purposes, these charges are not meaningfully related to the company’s day-to-day business. Further, there is no meaningful cash outlay associated with these charges. Without going into a primer of Accounting 101, most of the GAAP accounting related to “impairment” charges is relatively new. If a store is under-performing, you “impair” it – write down the future value of the rent expense, leasehold improvements and assets. If the store performance improves, you cannot “un-impair” it. There is no cash associated with the typical impairment charge, whether it is for stores, inventory or goodwill.
  
  At some point, there could be cash charges related to making landlords “whole” on the Bailey Banks & Biddle leases; in fact, Zale may have already spent some cash to buy out those leases. For the remaining leases, Zale could find tenants who would pay rent at more or less the same rate as stated in the lease, netting no material expense to Zale. So far, Zale has taken only a “reserve” for its contingent lease liabilities for Bailey Banks & Biddle units.
  
  Our Opinion: Not meaningful. This financial housecleaning was needed, but it uses virtually no cash.

• Other Accounting Charges & Credits – Zale sold its interest in a venture called the “Incomparable Diamond” and booked a $3.5 million credit. In other words, management made a profit on the sale.
  
  Zale changed its vacation policy. Since this is related to personnel, we have not seen the actual change, but we believe it has to do with shortening a “use-it-or-lose-it” policy. This was a nice $7.7 pickup in income, and actually saved future cash.
  
  Our Opinion: Not meaningful, a one-time pickup.

• Deferred Revenue Changes – This is all related to accounting for the company’s “Lifetime Guarantee” of selected products. The issue relates to the length of time that the company must amortize expected revenues and associated costs. Under prior accounting rules, Zale matched revenues and costs of the program; the vast majority of revenues and costs were incurred in the first few months after the sale. Under new accounting rules, the costs are front-loaded in line with when they are incurred, but the revenues are taken on a straight-line basis over five years (one-sixtieth each month). Thus, changes were made to the deferred revenue accounts this year.
  
  In terms of materiality, when all the revenues and costs are added up, there is no change. The only change that has occurred is the rate of amortization of revenues (but not costs), and that’s what the item labeled “change in deferred revenue” has accomplished. No cash is involved.
  
  Our Opinion: Not material.

The graph below illustrates the impact of the accounting revisions listed above. This graph compares the company’s pretax earnings as originally reported versus the revisions which were made this year. The data on this graph comes from the table earlier in this report.

 

Source: Zale Corp

 

• Tax Adjustments –The U.S. Internal Revenue Service – the government bureaucracy charged with collecting taxes – allows individuals and corporations to file amended tax returns. We’ve seen multiple amended tax returns filed. Thus, Zale’s “tax adjustments” will be filed via amended returns, as lawfully provided by the IRS.
  
  Unfortunately, Federal and State governments are revenue-starved. Thus, adjustments of this size – even though they will result in additional tax revenues paid to the government – often trigger a tax audit, either from the IRS or the state and local taxing authorities. We would not be surprised if Zale is audited. The only good news is that financials prior to the fiscal year ended July 2005 are no longer subject to audit by the IRS (the state taxing authorities may be able to go back one more year). Our best guess, though, is that Zale’s financials are probably now “squeaky clean” and that a tax audit would probably not uncover any additional material charges.
  
  There are two parts of this $40 million tax adjustment for 2009.

• Canada/U.S. Tax Code Opportunities – Just under half of the tax adjustment relates to opportunities which have existed to reduce taxes because of tax code differences between Canada and the U.S. The tax credit opportunity was in a very narrow area. Apparently, the tax rules are no longer favorable to Zale, so the company revoked the use of these credits. Under the tax code, Zale must roll-back all of the prior credits which it took. This will likely result in an outlay of cash to the Canadian taxing authorities.

• Net Operating Loss Carryforwards – It appears that some of Zale’s net operating loss carryforwards will not be utilized. Thus, its tax bill will be higher than anticipated. This will likely result in an outlay of cash.

Our Opinion: Meaningful, but not dramatic. If the company is audited by the taxing authorities, it will be a distraction, but not the end of the world.

 

• Shareholder Lawsuit – A shareholder lawsuit, which will be a class action, essentially accuses Zale management of making misleading statements to shareholders about the financial condition of the company. Sounds serious? We see these suits all the time, especially when a company re-states their financials. Zale has dealt with them in the recent past.
  
  Be prepared: there are more shareholder suits coming. These suits generally go away, but only after the attorneys have collected fat fees and “damaged” shareholders are left with only a pittance. In our opinion, these suits will cost Zale some cash, but not have a material impact on earnings. If anything, they could be a distraction to management. Maybe management should counter-sue, asking the court for damages related to loss of management’s productivity while dealing with these attorneys. Now, that’s an interesting thought.
  
  Our Opinion: Mostly a distraction, but not material.

• Vendor Bankruptcy – In September 2008, one of Zale’s vendors filed for bankruptcy protection. As of the end of the most recent fiscal year – July 2009 – an affiliate of the bankrupt vendor held about 5,000 ounces of gold – worth about $4.4 million at the time – belonging to Zale. Although Zale owns the gold and has rights to it, it is clear that some of the gold will not be returned. During the most recent fiscal year, the company recorded a change of $2.9 million to account for the gold it will unlikely receive.
  
  Our Opinion: Unfortunate. But the expense reserve has been taken.

• Accounting Shortcomings – Although this was the second fiscal year’s financial statements that the company’s independent auditors, Ernst & Young, have examined, they apparently missed some material issues during their first audit year. During the most recent fiscal year, the auditors noted that Zale had two significant accounting shortcomings that extended back several years. Only fiscal years beginning with 2005 were restated, since the statute of limitations has run out for IRS audits of prior years. The material shortcomings noted by the auditors included the following broad areas:

• Zale did not maintain effective controls over certain account reconciliations, specifically related to advertising, depository bank accounts and inter-company accounts receivable. This is probably what caused the recent high turnover of Zale’s top financial executives; it is an area of concern, in our opinion. 

•  The company did not maintain effective segregation of duties and oversight with respect to its advertising programs. Sometimes this happens when a company cuts costs; cross-checks are eliminated, and it comes back to haunt them.

Our Opinion: Meaningful and material. The problem has been identified, solved and resolved.

 

• Proprietary Credit Issues – During the most recent year, Zale had some issues with its provider of third-party credit, Citibank. Essentially, neither its Canadian nor its American sales levels were as high as contractually agreed for the fiscal year. An amended agreement with Citibank calls for waiving penalties related to these sales shortfalls, reducing the minimum sales threshold, and the release of Zale from the bank’s requirement that the company purchase the U.S. receivable portfolio from the bank if the minimum sales threshold is not met. In exchange, Zale has given Citibank a $5 million letter of credit (raised to $10 million from mid-November to mid-February).
  
  Our Opinion: Not material, though the letter of credit cuts into Zale’s credit availability.

The graph below illustrates the impact on the shareholders’ investment – net worth – of Zale Corporation, after all of the accounting revisions, both pretax, post-tax, and the impact on equity. Net worth is an important measure, since not every accounting adjustment flows through a company’s income statement and affects pretax income. Net worth is what is “left over” for shareholders after all accounting adjustments, without regard to which financial statements were affected.

 

Source: Zale Corp

 

Beyond The Smoke Screen of Bad News

In our opinion, Zale management has articulated – and implemented – a potentially successful strategy to rebuild the company. We should have seen more progress by now, but the economy has not cooperated.

 

The following is a list of the strategies – and tactics – that Zale CEO Neal Goldberg and his team have announced publicly. Our major concern? We wonder how much tolerance Zale’s board of directors has. In the past, they appear to have reacted in haste: they have hired the wrong people, and they have let talent leave without giving them a fair opportunity to perform.

 

• Store Associate Training May Be Paying Off – It appears that Zale’s store-based training efforts may be paying off. Our visits indicate a higher level of professionalism among store employees. Further, sales people have been trained to promote add-on sales, product and credit insurance, and other programs to boost revenues and profits. If a retailer’s front-line sales people are not well trained and professional, the merchant is doomed.

• Rising Gross Margin – Management’s goal is to increase the reported gross margin to 50 percent. At Zale, the “cost of goods” includes receiving and distribution expenses. Thus, the company’s “raw merchandise margin” is above “keystone.” While the reported gross margin for the most recent fiscal year was below the prior year – 46.7 percent versus 49.0 percent - it would have been 47.5 percent if the impact of the impaired inventory is removed. Further, in the fourth fiscal quarter (ended July 2009), the company’s gross margin, ex-impairment charges, was 50.2 percent, up from the prior year’s 46.4 percent. Management noted that aggressive holiday markdowns in the November-December 2008 period also hurt the most recent fiscal year’s gross margins; it does not plan to be nearly as price-promotional this year.

• Cost Control Programs Implemented – In February 2008, management initiated a program to cut $65 million of operating costs, primarily selling, general, and administrative expenses (SG&A). At the end of the last fiscal year (July 2009), about $62 million of expenses had been eliminated, with the remaining cost reductions to occur in 2010. A year later, in February 2009, management announced another cost reduction of $65 million, of which $26 million has been achieved. The balance will come over the next fiscal year or two. For the fiscal year ended July 2008, SG&A expenses were about $985.0 million; by the end of the most recent fiscal year, SG&A expenses had fallen to $927.2 million. Other expenses have been similarly reduced including interest expense and depreciation/amortization costs.

• Reduced Inventory Levels – Zale management has systematically trimmed inventories over the past two years. The company announced a program to cut $75 million in February 2008; another $100 million cut was announced this year. Much of the inventory reduction has come from closed stores. On a per-store basis, inventories crept up by about 2 percent in 2009. However, we believe this was related to the sales shortfall in the current recessionary economy. At the end of the fiscal year ended July 2009, owned inventories were $740.3 million versus $799.2 in the prior year. The company also utilizes “memo” inventory; at year-end July 2009, memo or consignment inventory levels were $71.5 million versus $114.3 last year. This represents 9 percent of total owned plus consigned inventories in 2009 versus nearly 13 percent in 2008.

• Rationalized Vendor Base – Over the past two years, Zale has reduced its vendor base by two-thirds. In the past, it had far too many vendors, and control of inventory flow was difficult. The remaining vendors have partnered with Zale, and we have seen a marked increase in improvement in the company’s inventory flow.

• Poor-Performing Stores Gone – This year, the company closed almost two hundred units – 161 of them were stores; about 31 were kiosks. These stores generally had negative cash flow and all were a drag on earnings. Earlier, the company sold its Bailey Banks & Biddle division since it did not fit the company’s long term strategy. Further, this division had value as a stand-alone operation, so its sale generated cash for Zale.

• Reasonable Cash Flow – In the fourth quarter of the fiscal year ended July 2009, Zale generated $29 million of free cash flow and reduced debt by $22 million, despite the weak retail environment. However, for the full year, Zale was a net user of cash. Management’s emphasis is on generating cash flow from operations. During the current fiscal year, Zale will make only token capital improvements of about $20 million, mostly related to opening eight new stores, almost all of which will be in Canada. The company will spend about $6 million on technology and support operations. This modest level of capital spending should allow the company to generate significant free cash flow. The company still has a $350 million stock buy-back program outstanding. In the fiscal year ended July 2008, it repurchased $327 million of its stock; no stock was repurchased in 2009. Thus, there is still about $23 million of this buy-back available, though we don’t think Zale will exercise its rights until it is clear that we are in a “more normal” environment.

• Cleaned Up Financials – Zale received a “clean opinion” from its independent auditors, Ernst & Young. Our opinion: when the auditors say “clean,” they mean it. With the large number of adjustments which were made to the current year as well as prior years, Zale’s independent auditors probably scoured every nook and cranny for possible financial shortcomings and problems. We believe that the worst financial news is behind us. Further, this was Ernst & Young’s second year as auditors; they took over from KPMG in 2008. Ernst & Young has a solid reputation for its audits of retailers.

• Leverage Zale’s as The Diamond Store – Historically, Zale positioned itself as “The Diamond Store.” However, the company moved away from this strategy under previous administrations. Unfortunately, shoppers never understood or embraced Zale’s new market positioning. Goldberg decided to return to Zale’s original, highly successful positioning as The Diamond Store Since 1924.

• Leverage Gordons – Until recently, Gordons appeared to be a stepchild. In some markets, it targeted ethnic groups; in others, it was unclear who Gordons was targeting. Goldberg and his team are using Gordons to target essentially the same demographic consumer segment as Zale’s targets. While the merchandise mix is similar, Gordons targets consumers who, for whatever reason, may want a different store from Zale’s.

• Centralized Organizational Structure – Because Gordons and Zale’s target similar customers, they are essentially served by one support organization. This has eliminated redundancies in the corporate structure. Further, the company can buy better, due to volume discounts from vendors.

• Online Business Growing – For the fiscal year ended July 2009, Zale’s online sales were $56.2 million, up 1 percent from the prior year. Online sales are about 3.2 percent of Zale’s total sales. Despite the recessionary environment, online sales have continued to grow.

• Leverage Proprietary Credit – In the U.S., roughly 40 percent of the jewelry transactions in Zale’s stores are financed via its third party agreement with Citibank, a level which has been about flat for two years. We believe that credit participation might have risen, except that consumer credit has been very difficult to obtain in the U.S. In its Canadian stores, the number of credit transactions on the company’s proprietary credit program has risen to 30 percent in 2009, up from 25 percent in the prior year. Typically, the average ticket for a credit transaction is three times greater – or more – than the average ticket for a cash transaction. Further, Zale also offers credit insurance along with its proprietary credit; last year, 36 percent of those credit customers purchased some form of credit insurance, typically a highly profitable add-on.

• Increase in Average Transaction Value – The average ticket in the Zale’s/Gordons stores was $403, up nearly 9 percent from the prior year’s level of $370. In part, this was due to a lower mix of liquidation merchandise in the current year; in part, this was due to better selling skills of its sales associated. The Zale Outlet stores generated an average ticket of $464 in the most recent fiscal year, up just over 6 percent from the prior year’s $437. However, the average ticket declined in the Canadian stores to $268 from the prior year’s $306. The average ticket in the kiosks was $39, down marginally from the prior year’s $40. Despite these improved trends in the average ticket in the company’s U.S. operations, the total number of transactions fell by 20.8 percent during the fiscal year ended July 2009 due to the weak economy.

• Liability Associated with BBB Almost Resolved – When Zale sold Bailey Banks & Biddle to Finlay, it remained contingently liable for most of the store leases. We believe that this might have contributed to the demise of one or more of Zale’s top financial management. As a result, its original liability was over $62 million. As of the current quarter, 38 of the remaining 45 Bailey Banks & Biddle leases have been resolved, though the company has reserved to all 45 leases at a cost of $23.2 million, well below the full amount of the original liability. Because we believe the company used conservative accounting, there could be a very small reversal of reserves when the remaining seven leases are resolved.  

• Rent Reductions Achieved – Zale has gone to its landlords and asked for store rent reductions. According to management, it has achieved some “meaningful” rent reductions. Jewelers pay among the highest rent rates – per square foot – in malls versus other tenants.

Latest News from Zale: Generally Positive

For the upcoming holiday selling season and beyond, Zale has noted some positive trends, including the following:

 

• Strong 2009 holiday promotions planned – Zale has focused on three promotions for the upcoming holiday selling season; these promotions will continue into 2010. Management said that up to 20 percent of its sales in 2010 could be generated from these three concepts.

• Share-Heart Collection – With the theme, “two hearts beating as one,” the company will promote this highly emotional campaign during the 2009 holiday selling season.

• Fashion Watches – Zale is the exclusive reseller of Fossil watches, and it has deals with other fashion watch producers. Fashion watches are very popular with shoppers, since price points are relatively low. This category should help boost Zale’s gross margin, since fashion watches carry a notably higher margin than many of the high-end branded watches.

• Everlon – Zale is participating in De Beers’ Everlon promotion. We expect this promotion will help boost holiday diamond sales for all jewelers.

• October quarter same-store sales above expectations – For the fiscal quarter ended October 2009, Zale’s same-store sales were down only 8 percent. Same-store sales improved throughout the quarter. Not only is this better than management’s expectations, but it is well above the average for the most recent fiscal year – down 16.6 percent – and it is much stronger than the same-store sales for the prior quarter ended July 2009 – down 21.2 percent.

• Inventory inflow ahead of schedule – In prior holiday selling seasons, Zale has been plagued with vendors who did not ship goods – primarily “hot sellers” – on time. This year, inventory inflow is running ahead of schedule. Zale management believes that it has agreements with its vendors that will allow it more flexibility in controlling the flow rate and volume of incoming inventory this year.

• Higher average ticket in July quarter – During the quarter ended July 2009, Zale’s average ticket rose by 18 percent; however, the number of transactions fell by 31 percent. This is mostly due to comparisons against last year when liquidation sales were conducted – there were many sales, but at a low average ticket.

• Gross margin goal is 50 percent - Zale’s management reiterated its commitment to a 50 percent gross margin in the current fiscal year ending July 2010. If Zale achieves this level of gross margin and is able to hold its expenses in line, the company should generate significant cash flow and achieve a notable profit. During the October quarter, the company’s gross margin averaged about 49 percent; however, it was stronger at the end of the quarter than at the beginning, a hopeful sign.

• No large number of store closings in 2010 – Other than normal store turnover – opening a few stores and closing a few units – Zale does not anticipate any large number of store closings in the current fiscal year.

• Executive Salaries Reasonable – The table below summarizes salaries for the top five executives at Zale Corporation for the fiscal year 2009-2010. Based on salaries for similar size operations and other jewelers, these salaries do not seem excessive to us. 

Source: Company filings

 

Our Bottom Line Opinion

In our opinion, Zale CEO Neal Goldberg has articulated a strategy to not only keep Zale in business, but to also grow the company over the longer term. There are three factors that could derail his plans: 1) if he loses industry vendor support, he will be unable to move forward; 2) if the economy fails to cooperate, it will dampen his plans; and, 3) if the Zale board of directors continues to expect instant results – as they have continually done for the past decade – they could replace Goldberg before his strategies have an opportunity to have an impact.

 

Will Zale be relegated to the retail graveyard next to Whitehall, Friedman’s and others? In our opinion, no way. Given a chance, Zale will survive, and likely prosper.