Description

Investment Thesis

Zale Corporation (ZLC), the largest fine jewelry retailer in North America, currently trades at a two-year low of $23 and is conservatively worth $40 in two years (70%+ upside). Zales operates a good stable business with excellent brand recognition, significant economies of scale and a 19 million customer database. ZLC has historically generated $100 million plus of annual free cash flow, which has been returned to shareholders through $800 million of share repurchases over the past nine years. Gross margins will expand 50 basis points annually over the next three years as the company implements its direct sourcing of diamond merchandise at its Zales division. SG&A expenses, currently bloated at 42% of sales due to lack of management expense control and $45 million of one-time charges, will be reduced to a normalized level of 39.5% of sales in 2008 with the absence of store closure & severance costs and as new management initiates cost cutting initiatives. ZLC is worth $40 based on a 13x multiple on 2008 projected EPS of $2.86 and 8 times 2008 adjusted EBIT (EBIT plus D&A minus maintenance CAPEX) of $245 million.

Capitalization as of 1/31/06 Valuation Multiples

Shares Outstanding 47.9 P/E (2005) 11.2x
Options 2.9 P/Sales 0.5x
Fully Diluted Shares 50.8 P/Book 1.4x
Market Price (5/30/06) $23.07 EV/EBITDA (2005) 4.9x
Equity Market Cap. 1,105 EV/EBIT (2005) 6.5x
Plus: Debt 120
Less: Cash & Invest. 61
Total Enterprise Value 1,164
Operating Income (2005) 179
Pre-Tax Earnings Yield 15%


Company Description

Zale Corporation is the largest fine jewelry retailer in North America with 1,448 mall-based stores and 906 kiosk locations, including 82 carts. The company’s brands include Zales Jewelers (767 stores; $870 sales psf; quality/value/style), Zales Outlet (138 stores; $488 spsf; brand conscious value in outlets), Gordon’s (287 stores; $765 spsf; moderately-priced, regional assortments), Bailey Banks & Biddle (104 stores; $816 spsf; upscale/exclusive assortments & environment), Peoples/Mappins Jewelers (168 stores; $768 spsf; traditional jewelry at reasonable prices) in Canada and Piercing Pagoda (906 kiosks/carts; $1647 spsf; inexpensive bracelets, earrings, charms). The company’s core Zales brand has earned a reputation of quality and trust for its superior product selection and customer service for over 80 years. Zale’s jewelry business is highly seasonal with 41% of sales and 90% of profits coming in it 2nd fiscal quarter (November – January; July 31 is fiscal year). Bridal merchandise represented roughly 45% of 2005 sales while fashion jewelry and watches comprised 55% of sales.


Zale’s Historical & Projected Operating Results
FY 7/31 (in mms)2002 2003 2004 2005A 2006E 2007E 2008E
Total Revenue $2,191 $2,212 $2,304 $2,383 $2,406 $2,455 $2,504
% Growth 5.0% 0.9% 4.2% 3.4% 1.0% 2.0% 2.0%
Gross Profit $1,100 $1,103 $1,175 $1,219 $1,204 $1,240 $1,277
% Margin 50.2% 49.9% 51.0% 51.2% 50.0% 50.5% 51.0%
SG&A Expenses $871 $882 $941 $980 $1,014 $982 $988
% Sales 39.8% 39.9% 40.9% 41.1% 42.1% 40.0% 39.5%
EBITDA $228 $220 $233 $239 $189 $257 $289
% Margin 10.4% 10.0% 10.1% 10.0% 7.9% 10.5% 11.5%
EBIT $170 $164 $177 $179 $129 $195 $225
% Margin 7.8% 7.4% 7.7% 7.5% 5.4% 8.0% 9.0%
Diluted EPS $1.47 ($0.63) $1.99 $2.05 $1.47* $2.43 $2.86
Shares Out. 67 55 52 51 49 48 47

* 2003 earnings include impairment of goodwill of $136 million. 2006 earnings include severance, store closure and impairment charges of $45 million.


What Went Wrong at Zale's?

In light of losing low quality diamond business to Wal-Mart, J.C. Penney’s and Kohl’s, Zale’s management team decided to reposition the brand in early to mid-2005 to get “out of the direct fire of mass merchants”. Going into the critical holiday selling season, Zales raised the quality of its merchandise and hired a new ad agency, which placed less emphasis on the company’s well-known “value” pricing position and changed the company tag line from “The Diamond Store” to “Be Brilliant”. The assortment changes led to late supplier shipments resulting in shortages in key categories such as diamond fashion and solitaires as well as $800+ ticket items. Zale’s three leaders, including its CEO, President and COO all resigned in the first quarter after a disappointing holiday season. To make matters worse, all three executives received sizeable severance packages after signing new employment contracts in late 2005 and some sold large blocks of stock before leaving. The company received a subpoena from the SEC in April 2006 related to various accounting issues, executive compensation & trading, earnings guidance & vendor payments.

What Steps Is Zale’s Taking Now?

Board member Betsy Burton is serving as interim CEO. Betsy also serves on the Board of Aeropostale, Rent-A-Center and Staples. The Board initiated an executive search in January of both internal and executive candidates for the CEO role. They could announce a new CEO as early as the next few weeks or as late as this August. Management has indicated they are looking for a well balanced executive and speculation is that he/she will be from outside the jewelry industry. Betsy, Zale’s new President, John Zimmerman and their team have spent the last few months re-evaluating the Zale’s brand positioning, assortments, advertising and various cost cutting initiatives. The company will most likely provide a more detailed update on their next conference call. On May 5, Zale calmed concerns regarding the SEC investigation by confirming the failure to disclose deferred vendor payments would be no more than $8 million. Zale also appointed a new CFO, George Mihalko, who had tremendous success in trimming expenses and paying down debt at Sports Authority. In addition, John Zimmerman is credited with turning around Zale’s Canadian Peoples division through increased sourcing and expense management, and he will apply similar techniques to streamline the Zales brand in the US.

Competition

The jewelry retailing business is a competitive yet stable business with just three down years in last two decades. Wal-Mart is the largest US jewelry retailer with an estimated 10% of the $27 billion US retail market. Zale and Signet (Kay’s & Jared) currently hold 9% of the US market. According to Zale’s most recent conference call, “J.C. Penney’s has really become a big player in the jewelry market, and they clearly have become an increasingly viable competitor." Kay’s has been gaining market share in recent quarters as sales grew 10% in 2005 to $1.3 billion with 781 stores. Kay plans to open 60 new stores in 2006 (35 in malls, 25 off-malls) and 300 net new stores over the next five years. Signet’s higher-end Jared concept had sales grow 29% (18% from store growth) to $530 million in 2005 with 110 total stores. Jared plans to open 20 new stores in 2006 and double its US store count over the next five years. Jared expects to leverage national TV advertising for Christmas 2007. Finally, most investors comparing Signet and Zales’ operating margins assume that Signet is a better business. However, Signet already benefits immensely from direct sourcing of its diamonds, which is estimated to give them a 200-300 basis point edge. In addition, Signet receives the benefit of servicing their receivables in their operating earnings. Zales operating margins were above 11% before they sold their receivables to Citigroup in 2000. Market share gains and operating leverage in recent years have also helped Signet, despite declining sales in its UK operations. On a comparable basis, it is fair to assign an equal multiple of 13-14x P/E for Signet and Zales.


Comparable Company Analysis

EV/ EBIT
Company Mkt Cap EV EBITDA P/E Margins Stores
Tiffany's (TIF) $5.1B $5.2B 10.6x 20.6x 16% 154
Claire's (CLE) $3.5B $3.0B 10.3x 20.2x 18% 2,878
Signet (SIG) $3.4B $3.5B 9.3x 14.7x 10%* 1,183
Blue Nile (NILE)$588MM $474MM 24.0x 48.0x 9% N/A
Zale's (ZLC) $1.1B $1.2B 4.9x 14.2x 7% 1,448

* See note above addressing difference in EBIT margins between SIG and ZLC.


Zale’s Condition of Store Base, Capital Expenditures & Growth Plans

According to the company, Zale’s mall-based stores are generally in good condition as the company invests $30-40 million annually to upgrade signage, lighting and displays. The company looks to replace older stores or leases that are coming due with new stores. During fiscal 2006, Zales plans to spend $85 million on capital expenditures by opening 65 new stores under the Zales and Gordon’s brands and 60 new kiosks. Of the $85 million, roughly $34 million will be allocated towards growth investments, $38 million will be spent on store maintenance and $13 million will be used to upgrades its IT and point-of-sale (POS) systems. The company believes investments in POS systems will provide store associates with the tools to grow sales. Zales has grown sales an average of 2-3% over the past three years as it has grown its square footage. Zale just announced 2.5% comparable sales growth year-over-year despite management turnover and poor assortment decisions. The company is experiencing double digit sales growth in its Zales Outlet segment as well as its Canadian Peoples division. Although this is far from a “growth” company, Zale will benefit in the next three years from square footage expansion and operating leverage as management improves the brand positioning and assortments at Zales.


Direct Sourcing Will Boost Gross Margins 50 Basis Points Per Year

Zale Corporation has maintained gross margins of 49.6% over the past ten years and 50.5% over the past five years. The company has looked to expand margins through supply chain improvements. Specifically, the company’s strategy includes the continued expansion of direct sourcing of diamond merchandise at existing brands, as well as implementation at the Zales brand in 2006. Signet’s Kay’s concept and Zale’s Peoples division have already made large strides in this area. The company will also increase efficiency and cost savings of basic purchases through direct importing of finished product. The company’s goal for direct sourcing is to achieve 50 basis points of gross margin improvement each year for the next three years. My valuation assumes a conservative 50% gross margin this year growing to 51% in 2008. In addition, the improved supply chain will also result in less inventory on hand, conservatively freeing up $10-15 million in working capital over the next couple of years (Note: my valuation does not include cash flow gains from reduced working capital).


SG&A Expense Reductions Will Flow to Bottom-Line

SG&A expenses, currently bloated at 42% of sales due to lack of management cost control, increased rent expense and $45 million of one-time charges ($24 of inventory write-downs and lease settlements, $8 in fixed asset impairments and $12 in severances), will be reduced to a normalize level of 39.5% of sales in 2008 with the absence of store closure and severance costs and as new management initiates cost cutting plans. Key areas of expense reduction include modifying the sales associate commission structure, reducing corporate overhead and reevaluating leases which are coming due. George Mihalko, Zale’s new CFO, had success at Sports Authority trimming the SG&A line and positioning the company to be sold. John Zimmerman was also known for being very P&L focused when he previously ran Zale’s Peoples Jewelers in Canada. The company will most likely identify specific cost saving initiatives in advance of new leadership. A majority of sell-side analysts have SG&A expenses constant at 42% of sales leading them to overlook roughly $1.00 per share in pre-tax earnings power.


Hidden Assets Add to Margin of Safety

Zale holds roughly $24 million in U.S. government bonds and corporate securities in the Other Assets section on its balance sheet. In addition, Zale had $59 million of net operating losses which can be carried forward through fiscal year 2008. Although these facts aren’t deal makers, they provide an additional level of margin of safety in the valuation process.


Share Repurchases Remain a Priority

The company’s Board has authorized sizeable share repurchase programs for the past nine years. In total, the company has repurchased over $800 million of its stock since 1997, decreasing the share count from 73 million to below 48 million in March. Although the Board historically authorizes programs at the start the company’s fiscal year (August), the Board took advantage of the weakness in its stock in 2002 and 2003 by acting outside of its traditional buyback schedule. After buying back $50 million of stock in March 2003, the company took on debt and announced a Dutch tender offer for $225 million of stock in July 2003, providing a major booster-shot to the stock. With the stock currently at a two-year low, one would assume the Board will authorize a sizeable share repurchase program to confirm confidence in the business as new management comes on board and cost reductions are announced. In addition, the company is aligning shareholder interests with Zimmerman, Mihalko, and the Board by recently offering time-vested stock units.


Zale's Generates Substantial Free Cash Flow

2002 2003 2004 2005A 2006E 2007E 2008E
EBITDA $229 $220 $234 $239 $189 $257 $289
-CAPEX ($54) ($44) ($61) ($83) ($85) ($85) ($85)
EBITDA-CAPEX $174 $177 $173 $156 $104 $172 $204
-Net Interest ($8) ($6) ($8) ($8) ($15) ($10) ($10)
-Taxes (37%) ($59) ($55) ($62) ($63) ($42) ($69) ($80)
∆ in WC ($128) $19 ($20) ($23) ($16) $0 $0
Free Cash Flow ($21) $134 $83 $159 $31 $94 $115

Y-E Net Debt $2 $149 $134 $74 $143 $99 $35
Stock Repurch. $54 $278 $143 $50 $100 $50 $50
Shares Out. 67 55 52 51 49 48 47


Valuation & Assumptions

Revenue assumptions included growth of 1% in 2006 and conservative 2% growth in next two years based on square footage expansion and improved branding and assortments. The gross margin discussion above confirms the moderate increase from 50% to 51% given improvement in supply chain and direct sourcing within the Zales brand. The SG&A expense decline from 42% to 39.5% of sales is based on payroll, corporate overhead and rent expense reductions. D&A expense remains constant at 2.5% of sales, or $60-64 million. Operating income grows from a depressed level of $129 million (after charges) in 2006 to $225 million in 2008. Capital expenditures of $85MM ($40MM maintenance) remain constant to fund store growth and maintain existing store base condition. Interest payments remain constant to slightly down as free cash flow is partially used to pay down the $120 million in debt. A 37% tax rate is applied, in-line with the last several years (but not budgeting the benefit of net operating losses). Net working capital is kept constant despite potential inventory reductions through direct sourcing initiatives. Free cash flow will be used to repurchase $50 million of stock annually (between $27-30 per share; added 1 million of annual share dilution from options). Any excess free cash flow is assumed to lower net debt. As a result, my valuation is based off of net debt of $35 million (minus $24 million of investments) and 47.4 million shares outstanding. ZLC is worth $37 based on a 13x multiple on 2008 projected EPS of $2.86. Zales has historically traded at a 13x P/E multiple over the past ten years, within a range of 9x times on the low end in 2001 and at 20x on the high side in 1999. On a comparable basis, a 13x P/E multiple is appropriate as ZLC deserves a discount multiple to Tiffany’s 20x but a multiple in line with Signet as detailed in the Competition section above. Alternatively, ZLC is worth $41-42 applying a 12x after-tax multiple on adjusted earnings (assuming an 8% weighted average cost of capital) or 8x pre-tax multiple to 2008 adjusted EBIT (plus D&A minus maintenance CAPEX) of $245 million. ZLC has historically traded at an average 8x EBIT and in a range of 6x to 11x EBIT over the last five years.

Earnings Power Valuation

FY 2008 EBIT 225
-Taxes (37%) -80
NOPAT 145
+Excess D&A 20 D&A - Maintenance CAPEX (60-40)
Adj. Earnings 165
Equity Value (12x) 1,986
2008 Net Debt 11 $35MM minus Investments of $24MM
EPV 1,975
EPV / Share $42
Discount to Market 81%

EBIT Multiple Valuation

Adjusted EBIT 245 225 + 20 of Excess D&A
8x Multiple 8x
Equity Value 1,960
2008 Net Debt 11
EPV 1,949
EPV / Share $41
Discount to Market 79%

Earning Per Share Valuation

FY 2008 EPS $2.86
13x Multiple 13x
Value / Share $37
Discount to Market 61%


Business and Operational Risks

One risk lies in Kay’s Jewelers, Wal-Mart and J.C. Penney’s continuing to steal market share from Zales. This may require Zales to drastically alter their long-term strategy or make significant investments towards their stores, training or branding. Management remains a question mark as a CEO has not been announced yet and Zimmerman needs to prove himself in the US, a market with a lot more competition than the Canadian Peoples unit he ran. By continuing to change the company’s marketing and assortments, Zales risks losing some of its long-term mall customers. Also, rising interest rates and a downturn in the economy could result in reduced discretionary spending on jewelry for Zales’ middle-America mall-based customers. Finally, direct sourcing efforts could lead to more inventory shortages or inferior/inconsistent quality products.

Catalyst

Continued free cash flow generation will be been used to pay down debt and aggressively buyback stock. New share repurchase program announcements will serve as powerful catalysts, as they have in the past. New management will provide investors with comfort as well as a fresh vision to the Zales brand. The settlement or passing of the SEC inquiry will eliminate uncertainty and bad press for the company. Negative sell-side ratings will turn positive as analysts gain visibility in the turnaround with new management. Finally, rumors circled that Zales’ former Chairman, Robert DiNicola, would be backed by Apollo Advisors in a LBO of the company (Apollo General Partner, Peter Copses, used to serve on Zales’ Board). However, Apollo target, Linens ‘N Things appointed DiNicola as their Chairman and CEO in February. Ultimately, ZLC operates a good, stable business with strong free cash flows and therefore remains an excellent acquisition or LBO candidate.