Theo Killion, Zale president and interim CEO, dominated the conference call. His goal was to instill confidence in suspicious Wall Street investors, restless vendors, nervous bankers and unsettled employees. As a result, he acted more like a “real” CEO than the typical interim officer. But the simple fact is this: he is “interim.” We don’t think he’s in the running for the permanent CEO job, though he would likely be a strong team member for any new management regime at the jewelry retailer.

 

Killion reported on activities that would occur in the normal course of the business, but he highlighted them as if they were something novel or unusual. So, we don’t read too much into what he said.

 

However, here are the highlights of Killion’s comments, along with Matt Appel, Zale’s chief financial officer. While we’d argue that there isn’t a whole lot that’s new and different in these comments, the following provides a summary of where the company is and where it might be going short term.

 

·        Fewer Stores . . . More Closings Likely – Zale now operates 1,907 units, down 180 from a year ago. For several years, the company had over 2,300 units, with a peak of 2,366 in October 2006. Part of the decline in units is related to the sale of Bailey Banks & Biddle, the balance is related to closing of stores and kiosks. Management would not comment on future store closings or openings; these decisions will be left up to the new CEO, or perhaps to someone who infuses new capital into Zale. However, the size of the store impairment charge in the January quarter suggests that a significant number of stores could be closed. We note, however, that a store whose “value” has been impaired will not necessarily be closed.

 

·        Vendors Mostly Paid . . . For Now – If you untangle all that was said on the conference call about Zale’s borrowing power, it is clear that the company needs an infusion of capital to keep the banks – and vendors – happy. Currently, the company can probably more or less keep reasonably current with its vendors, but without relief from the banks, it will be difficult to finance inventory needs for the all-important holiday 2010 season, in our opinion. Management made no mention of its tactics that were used to get vendor concessions post-Christmas, but management did note that vendor “terms have expanded.” This is code wording for extended payment terms and other concessions that vendors offered. We are not clear if all vendors have actually been satisfied.

 

·        “Merchants [Are] Singularly Focused on Analyzing Their Businesses” . . . We Hope So! – Killion spoke those words as he cited the fact that Zale’s merchants have evaluated each SKU (merchandise item) based on historic performance, turn, gross margin, and other key metrics since Gil Hollander took over as chief merchant. IDEX Online Research would hope Zale’s merchants are focusing on their business; after all, that’s their job. Our opinion: if this is the first time Zale’s merchants have done this, they should be replaced; it would explain much of the sales shortfall in the 2009 holiday selling season. In fact, we think Killion’s comments were simply meant to allay fear that the company is drifting while the CEO search and capital raising is underway. In other words, this is really not anything new.

 

·        Inventory Sufficient . . . Barely – Zale CFO Appel noted that Zale’s inventory levels are “sufficient” at the present time, and that “no excessive clearance actions” will be implemented. Based on our estimates of Zale’s per-store inventory levels, we believe they are at least $75,000 below desirable levels in each store. Currently, we believe Zale’s per-store inventories (not including kiosks) are about $590,000 or so; in contrast, Sterling’s per-store inventories are running $650,000 - $700,000, depending on the season. Zale will need more inventory in its stores, if it expects to boost sales and meet potential demand in the 2010 holiday selling season. If a merchant doesn’t have inventory, they can’t make sales.

 

·        Back to Basics . . . Again – Zale’s core merchandise categories will primarily be things that “have sold for us in the past and that are currently being sold by our competitors,” according to Killion. We’ve heard the “back to basics” message in the past; this is nothing new, in our opinion. It might take some of the risk out of Zale’s merchandising offer, but it also might turn customers off, especially those who are seeking something new and different. In addition, a desire for something “new and different” seems to be the message of the “new normal” consumer. Zale’s “safe” approach could backfire.

 

·        Capital Infusion . . . Needed – Killion said it could take 2-3 months to find a source of capital for Zale. In the meantime, rumors rage about who might be about to make a substantial investment in Zale Corporation. Legally, Killion can’t say much, but he has signaled Zale’s intent by hiring an investment banker to evaluate all alternatives and opportunities for Zale.

 

·        Online Commerce Performing Well . . . But It Doesn’t Matter Much – Killion said that Zale’s online business is performing extremely well. For the most recent fiscal year, Zale’s online commerce was just over 3 percent of sales; that’s not a meaningful level. Even if online sales doubled, it would not have a meaningful impact on Zale’s future financials, in our opinion.

 

·        Valentine’s and President’s Day Weekend Same-Store Sales Positive . . . Against Easy Comps – Management said that for the four-day period Friday through Monday for Valentine’s / President’s Day weekend that its sale-store sales comparisons were positive. In the same quarter of the prior year, same-store sales were down 20 percent. With such easy comparisons, we would expect to see positive sales comparisons this year. However, it is important to understand that total sales in this year’s Valentine’s / President’s Day period – while showing positive comparisons – were still well below the levels in 2008.

 

·        Margins Up . . . Is This Really the Way to Capture Market Share? – Management reiterated several times that its reported gross margin was up. One of Neal Goldberg’s strategies was to boost Zale’s gross margin, a strategy that both Killion and Hollander appear to have embraced for the near term. We assume that the underlying raw (merchandise) margin was up also, but some of the margin improvement could have come from reduced costs included in the “cost of goods” calculation which include receiving and distribution expense.

Here’s the key question: Should Zale try to raise margins in a recessionary environment? Consumers are seeking value. Price-based promotions seem to be working for many retailers. Zale’s prices were clearly above of most of its key competition in the all-important 2009 holiday selling season; that’s the primary reason for its weak sales, in our opinion.

There is a further issue: jewelers are going to be forced to look at adjusting their economic operating model in the future. It will call for faster inventory turns with lower gross margins. Zale seems to be going in the opposite direction.

 

·        Other Comments . . . Interesting, But Mostly Not Particularly Meaningful – Here are some other comments by Zale management:

 

o       “The marketing team, led by Rich Lennox, has looked at every catalog, booklet, brochure, and insert that we have produced over the last five years. We have looked at content, quality, volume and distribution, and they too have been studying what has been working for the competition.” Sounds like they are just doing their job.

 

o       “The planning and allocation team which Matt [Appel, CFO] leads has looked at our total inventory and has mapped out a plan that will over the next year allow us to reposition our inventory . . .” We don’t know what “reposition” means, but we’d guess it means that Zale will attempt to generate more sales with less inventory, at least until more capital becomes available.

 

o       “The best way to be able to impact SG&A is to raise sales...” – It is a given: higher sales will leverage operating costs. We like this, though: it is one of the few explicit examples where Killion talks about boosting sales. That’s the right answer for Zale.

 

o       “Th[e] leverage between the internet and our stores . . . is powerful, and we will continue to increase our presence in internet advertising a well as more traditional media.” – There is no question that online advertising and commerce offerings will drive customers to retailers’ stores. Zale’s strategy makes sense.

 

o       “...those two divisions [Peoples and Piercing Pagoda] are ones that have performed quite well and have distinguished themselves in our portfolio.” – Arguably, either of these two divisions could be sold to raise capital, especially since they are the best performers. The Piercing Pagoda division, acquired in August 2000, is probably not a fit for Zale. Thus, it could be sold to generate capital. Peoples may be a fit, but doing business in Canada is different from doing business in the U.S. The problem: who would buy this Canadian chain?

But, here’s the key question relating to a potential divestiture: if Piercing Pagoda and Peoples are sold, what is left? The answer: Zale and Gordon’s, neither of which is performing particularly well. It will take a super turn-around artist to boost Zale and Gordon’s performance.

 

The Bottom Line: Zale Is Important to the U.S. Jewelry Industry

We said it before: it is not in the best interests of the jewelry industry for Zale to fail. Vendors appear to be doing their part to help the company. Employees seem to be staying on, if for no other reason than the job market is still dismal. Wall Street isn’t part of this equation, at this point, so the price movement of ZLC shares is not meaningful, other than to reflect the latest rumor. Savvy investment bankers who might make a substantial investment in Zale aren’t watching the price of ZLC shares; they will put their own value on Zale.

 

The Zale board of directors has one last chance to “get it right” with its next move – which could be any number of alternatives: 1) hiring a new CEO; 2) raising venture capital; 3) selling one or more divisions; 4) taking the company private; 5) bringing in a turn-around team; 6) merging with another company; 7) allowing a new board and management team to take over, especially if a venture capital banker puts up money; and 8) exploring other opportunities. If they don’t “get it right” this time, Zale will be in serious trouble.

 

No matter what happens, we think the current directors will likely be voted out of office, when the next shareholders’ meeting comes up in late 2010. IDEX Online Research owns 100 shares of ZLC; a dissident slate of directors will get our votes.

 

The U.S. retail jewelry sector lost three major jewelry retailers over the past couple of years: Friedman’s, Whitehall and Finlay. There has been an increase in the number of failures among independent specialty jewelers. Consumers are shopping more frequently at multi-line merchants and discounters like Wal-Mart, Kohl’s and J.C. Penney. If Zale fails, consumers will have one less top-of-mind high profile specialty jeweler where they can shop. If they don’t think about specialty jewelers first for their jewelry needs, they will shop elsewhere, and the consolidation among specialty jewelers will accelerate.