Zale Corporation ZLC W
March 18, 2001 - 11:47pm EST by
2001 2002
Price: 14.25 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 0 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Rarely do investors have the opportunity to buy a high quality, growing and dominant retailer at a bargain price. Because of a series of temporary events, investors have that chance today with Zale Corporation (ZLC).

Zale is the dominant player in the estimated $40+ billion jewelry industry. Several factors have led to this stock being put "on sale" by Wall Street that will be discussed below. The 52 week range is $51 - $23.38. The stock closed at $28.50 on Friday.

I believe the company has earnings power of $4+ in the next couple of years based on a reasonable operating margin and ROIC and that the stock should trade for at least 12-13x earnings given a 12-15% LT growth rate. This would be at the low end of its historical range (11x-21x). Thus, a target price of $48-52 seems very acheivable with very limited downside, in my view--book value is roughly $24 (and it's basically diamonds and gold) and the company has an active stock buyback program in place. You're not paying much for the franchise at this price.

Reasons For The "Sale"

First, there are obvious concerns about an economic slowdown. Jewelry is often thought of as a highly discretionary purchase but there is actually a very stable core business related to bridal. This probably represents around 40% of the business. No doubt that the softer economy is having an impact on sales but it's likely already factored into the numbers, as I'll discuss later.

ZLC has had some incredible years up until Christmas of 2000 and likely will have negative same-store sales growth for the next couple of quarters in light of the softer economy. However, over the long-term, jewelry has proven to be a great business--otherwise, I don't think Warren Buffett would have made such a substantial commitment to it. In addition, demographics should really have a favorable impact as baby boomers continue to age. The time to buy stocks like this is when it's darkest.

Second, the company changed management and recently ran into some operational issues. The good news is that the old management is back and the issues are fixable. Bob DiNicola was the CEO of ZLC until September of 1999 and the chairman until August of 2000. Bob has a strong history of under-promising and over-delivering. Under his leadership and vision, the company made significant advances. Bob turned the reins over to Beryl Raff who was his President when he was CEO. Unfortunately, Beryl made some strategic mistakes (focusing too much on sales growth at point and time when sales growth, by definition, was difficult to come by--and therefore sacrificing product quality in some areas). Given ZLC's strong Board and its quick action, Beryl was asked to leave in early February of this year. Importantly, Bob DiNicola agreed to return as Chairman and CEO under a three year contract.

After a strategic review upon Bob's arrival, the decision was made to take a $25mm charge to inventory (related to quality issues at Zales and Gordons) and to substantially lower the guidance for the remainder of the year. Obviously, Bob has the incentive to lower the bar as much as possible upon his return. The current guidance is now for $3 for the FYE 7/01 and $3.30 for FYE 7/02. In addition, beginning in calendar year 2002, management expects to resume a 15% growth rate. Bob seems to take great pride in over-delivering. In fact, momentum investors fell in love with Bob and this stock in the late 90s. Almost all of them have since exited the stock, contributing to its cheap valuation.

Overview of Zale Corporation

Zale operates the following retail concepts:

Zales - lower price points
Gordon's - middle price points
Bailey Banks & Biddle - upper price points
People's - similar to Gordon's but located in Canada
Zales Outlets
Piercing Pagoda - mall-based kiosks, very low price points

ZLC has 1,239 stores and 943 kiosks. Piercing Pagoda is the most recent addition and the integration seems to be going well. About a year ago, ZLC sold its credit operation to The Associates for a nice premium and removed all receivable related risk from its balance sheet.

ZLC has consistently improved ROIC over the past several years (until the recent stumble) and ROIC now approaches the upper teens--quite impressive for a retailer. The financial statements are clean and the accounting is straight forward. The company has a very low debt level and generates very strong free cash flows.


Execution under Bob DiNicola--Bob has a well-deserved reputation for executing. Execution is, of course, the key to success in the retail business.

ZLC is a great acquisition candidate (Buffet?) or an ideal LBO candidate (high ROIC and strong free cash flows).

A "good value stock" - Investors seem to be looking for value stocks these days (can you believe it?) and ZLC makes for a perfect value play. The retailers have made quite a move upward this year but ZLC really hasn't done much in light of the management issues. I have found investors to be quite forgiving (see Federated and its Fingerhut issues) and I expect investors will find their way back to this stock over the coming months.
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