(IDEX Online) - Zale needed to report some good news. So its January quarter financial results were a welcome breath of fresh air, after a string of disappointing reports over the past several years.

 

However, an analysis of the company’s press release showed that some of the news wasn’t really quite as good as it appeared.

 

Zale’s Troubled Financials

The last time Zale made any “real” money – not profits created by special circumstances – was for the full fiscal year ended July 2007.

 

Unfortunately, due to unusual charges which created a huge loss in the quarter ended October 2010, it is unlikely that Zale will report a profit for its fiscal year ended July 2011. That means the company could have an unbroken string of four consecutive years of losses.

 

January Quarter Critical

Any jeweler who does not make money in the January quarter – which includes the all-important holiday selling season of November and December – should consider finding another line of work.

 

Unfortunately, Zale lost money in the January 2009 quarter, and that resulted in another management shuffle. It made money in last year’s January quarter (ended January 2010), and it posted a stronger profit for the quarter ended January 2011. Clearly, the trend is now both encouraging and positive.

 

Zale’s after-tax margin was just over 4 percent for the most recent January three-month period. While some in the industry rejoiced, it is worth remembering that the company earned consistent 10 percent net margins in the January quarter earlier in the decade.

 

When the company announced its results recently, we heard from a few vendors who seemed to be irrationally exuberant (to borrow a phrase from Alan Greenspan). We, too, were pleased with Zale’s results, but not overwhelmed.

 

Analysis of Financials Reveals “Real” Performance

As we read over various reports lauding Zale’s performance, we decided to test the “spin” of the company’s press release versus the company’s actual financial results from operations. To be sure, Zale’s financials are reported using US GAAP (Generally Accepted Accounting Principles); they can’t cut corners or “cook the books.”

 

U.S. GAAP is supposed to insure transparency in accounting, and it is supposed to insure that a company’s results are reported correctly and accurately. We’ve been analyzing corporate financial results for thirty years, and, if anything, GAAP accounting has become more complex and less transparent, in our opinion. If GAAP is so transparent, why is the market flooded with financial analysts whose job is to untangle a company’s financials and try to understand what is really going on?

 

Zale’s GAAP Financials Versus Reality

We decided to test Zale’s financial results with the typical financial analysts tools. While we can confirm that the company reported its results in line with Securities & Exchange Commission requirements and in line with U.S. GAAP, we would argue that there is more to the story.

 

Here’s our story of Zale’s January quarter:

 

·        Zale says its same-store sales increased by 7.9 percent in the January quarter - Well, yes and no. Most companies, including Tiffany and Signet with multi-national operations, report same-store sales on a constant-currency basis. Zale’s same-store sales included a positive currency swing in its Canadian operations. If we eliminate beneficial currency swings, Zale’s same-store sales would have been up 7.0 percent. Both numbers were disclosed in the press release, but in the wrong order, in our opinion. Either number is much better than recent prior results. But only the 7.0 percent same-store sales gain is comparable to others in the jewelry industry.

For the record, management said Canadian same-store sales were up 8 percent in local currency, so U.S. same-sales were up by less than 7 percent, by definition.

Same-store sales include sales from stores open 13 months or longer, and they also include online sales. Sales of warranties and insurance are excluded from the calculation.

·        Total sales rose by 7.6 percent in the January quarter – Again, this gain includes a benefit from currency swings in its Canadian operations. Prior to currency benefit, total sales were up 6.7 percent. The table below summarizes sales ($ millions) by geopolitical region as well as by segment.

Total sales (all operating divisions) were boosted by a 1.5 percent increase in the total number of transactions and a 6.0 percent increase in the average transaction value. Total sales also benefitted from an increase in warranty sales and currency translation. These positives were offset by lost revenues from the closure of 36 stores.

For the November-December-January period, Zale’s sales were well-above average versus other specialty jewelers’ sales gain of 3.9 percent. We think Zale’s sales performance in the January quarter was noteworthy.  

 

·        Zale’s gross margin rose to 50.3 percent from 49.8 percent in last year’s January quarter – This is good news. But it did come with a cost – a hit to some merchandise margins. The following table summarizes the components of change in the company’s gross margin between the quarter ended January 2010 and the quarter ended January 2011.

 

 

 

 

 

 

 

 

 

These changes in the components of Zale’s gross margin were disclosed by the chief financial officer in the call with Wall Street analysts. They weren’t fully explained, but, clearly, Zale is making headway, even if it seems like two steps forward and one step backward.

Our sense is that Zale “bought” some of its business during the holiday selling season. That’s OK, provided the customers continue to return to its stores.

We are particularly impressed that Zale’s “core” merchandise mix moved to 78 percent from 60 percent last year. Hot-sellers must always be in-stock. And we are very impressed with management’s comment that inventory turn improved. We don’t calculate inventory turn the same way Zale does (we can’t since we don’t have access to their moving inventory levels). Our calculation shows that its annualized inventory turn in the January quarter was 1.60x, up from 1.59x last year. However, earlier in the decade, the company’s annualized inventory turn in the January quarter was over 2.0x consistently.

 

·        Selling, general, and administrative expenses rose by about $6 million – On the face of it, that would be bad news. As a percentage of sales, this works out to a reported 41.2 percent this year, a very favorable decline from last year’s 43.3 percent.

Management rightly noted that it is benefiting from sales leverage of operating costs. In other words, while operating costs rose modestly, sales rose at a greater rate, generating operating margin leverage.

Management noted that its operating expenses were affected by four significant factors:

 

o       Higher store-staffing levels during the holiday selling season – In prior holiday periods, Zale has been criticized for letting too many customers “walk” without getting sales attention. Zale’s average ticket increased and it appears that its conversion rate (browsers to buyers) was up; these positive trends appear to be the result of sales force training and staffing.

 

o       Higher performance-based compensation – The company performed well, and its store managers and corporate personnel earned larger bonuses. Well done! We always believe that there is no bonus check that is too large, provided the company’s profits improve.

 

o       More efficient advertising expenditures during the holiday selling period – Advertising dollars went further this year in most media, and that benefitted Zale.

 

o       Lower promotional expenses related to Valentine’s – This is mostly a timing issue. Zale concentrated its Valentine’s promotional budget closer to the holiday, which falls early in the second fiscal quarter ending April 2011.

·        Operating income was reported in the press release as $44 million this year versus an operating loss of $3 million a year ago. That’s the way U.S. GAAP requires the company to report its financials.

The problem is this: we need to strip out unusual items. This is where we have a huge disagreement with U.S. GAAP: it says a company must include unusual expenses along with other operational costs. Granted, the “unusual expenses” are real, but they aren’t always meaningful, especially if you are testing and analyzing a company’s operational performance.

This year, “other expenses” were $2.860 million in the January 2011 quarter, or 0.5 percent of sales. In the prior year’s January quarter, “other expenses” were $26.957 million, or 4.6 percent of sales. That’s a huge swing. What made the difference?

 

o       This year, the other expense consisted primarily of a non-cash charge of $3.7 million related to the impairment of certain under-performing stores (this is a complex GAAP calculation that cannot be recovered, even if the store performance improves). Note that it is “non-cash.” An impairment charge is reasonable, if it is associated with the on-going business, and it should rightfully be charged against continuing operations.

Obviously, there was an offset to that impairment charge, since it was larger than the reported expense. The offset was listed in the company’s legal documents as “store closure adjustments” which is a catch-all term for cleaning up prior accounting.  

 

o       Last year, the company incurred a charge of $23.3 million related to impairment of under-performing stores (that’s six times as large as this year’s impairment charge). In addition, the company took a charge of $3.7 million related to closing stores. We’re guessing that most of these two charges were non-cash, though Zale could have been required to pay cash penalties to landlords to break rents on some of its store closings.

 

o       Prior to non-recurring unusual charges, Zale’s adjusted operating margin was 7.4 percent this year versus 4.1 percent last year. That’s certainly an improvement, but not nearly the improvement that the unadjusted reported numbers show. Once again, it is important to note that Zale reported its financials in accordance with U.S. GAAP.

 

o       The table below summarizes Zale’s segment earnings ($ millions) by operating segment. Based on our analysis, the kiosks made a smaller profit, before unusual charges, this year versus last year.

 

·        Zale management noted that its inventory rose by $39 million to $777 million this year, an increase of 5.3 percent. The inventory increase was in anticipation of the Valentine’s selling period.

On the surface, an increase of 5.3 percent is below the sales gain of 6.7 percent (constant currency). However, a more useful measure of inventory levels is “inventory per store.” Based on both stores and kiosks operating in the quarter ended January 2010 versus this year’s same quarter, inventory per store was up 7.4 percent, slightly above the sales gain in constant dollars. So, Zale is doing an OK job – but not a great job – of managing its inventory.

 

·        There are other significant changes in Zale’s financials on a year-to-year basis. For example, interest expense is up dramatically – by nearly five-fold – due to a change in its debt structure. Its U.S. net operating loss carrybacks have been exhausted, so it will be paying income taxes, assuming it makes a profit.

 

·        Other notable highlights from the January quarter include the following:

 

o       Zale offered a variety of no-interest consumer credit programs. That resulted in an increase in the number of credit applications along with a double-digit percentage increase in the average credit sales ticket over the same period last year. However, credit penetration was slightly lower this year, and approval rates were stable.

Zale reported that its sales on in-house credit represented about 34 percent of total customer purchases. This is at the low end of the range for mass market jewelers’ in-house credit sales mix.

 

o       Zale continues to grow its warranty sales business. During the quarter, its total warranty sales were almost $36.8 million, up dramatically from last year’s $26.0 million, or a gain of over 41 percent. However, it is important to note that the company did not recognize all of these revenues in the quarter. During the period, a net of $22.9 million in warranty revenues were recognized versus $16.8 million last year. The balance of the warranty revenues were shown as “deferred revenue” on the company’s balance sheet.

Zale’s “lifetime” warranty revenues are recognized on a straight-line basis over five years. Apparently, the accountants think that Zale’s jewelry has a lifetime of about five years (we agree with this – after five years, most customers aren’t going to come back seeking warranty coverage due to a variety of reasons).

 

·        Zale management noted that its same-store sales rose by 12 percent during the Valentine’s selling period. We assume this does not reflect a constant currency comparison, which would likely result in a smaller percentage.

 

·        In response to a question about selling Piercing Pagoda, management said that “we’re not currently pursuing any asset sales in this business.”