On his first earnings conference call with Wall Street analysts, Zale president and chief executive officer Neal Goldberg sounded like a true retail merchant, a refreshing change from the parade of financial types who have attempted to “rescue” Zale over the past several years.

 

Goldberg reiterated what every good merchant knows: customers come first. Not Wall Street and its financial demands. Not its employees. Not anyone else. Customers are the company’s number one priority. He reiterated this theme throughout the conference call: Zale will be customer-centric in the future.

 

Unlike his predecessors who generally stayed in the corporate office, Goldberg has spent most of his time in Zale stores, since he joined the company late last year. He asked questions and got plenty of answers; in fact, he noted, the store employees had answers to questions that the company had never asked in the past. If Goldberg can change the culture at Zale to be more shopper-friendly, it could keep the company from plummeting into a financial abyss with no hope of recovery.

 

Goldberg, 48, has 27 years of experience in the retail industry, including senior roles at Macy’s, Victoria’s Secret, and the Gap. Most recently, he served as president of The Children’s Place retail chain, a specialty retailer of high-quality, value-priced apparel and accessories for children.

 

Key Initiatives Cited

Goldberg cited three key initiatives in his prepared remarks, and he kept coming back to these initiatives in the question and answer session:

 

• Focus on Zale’s core value-oriented customer
• Focus on streamlining Zale’s operations
• Focus on achieving financial stability

Here are some of the strategies and tactics that the company will implement to achieve these three key initiatives.

 

• “We over-stimulate the customer” when they come into the store, Goldberg observed. There is too much visual clutter in store signage; the cases are over-assorted with too much product, he asserted. Zale’s “good, better, best” pricing strategy is not evident to the customer, he noted. How will he fix this problem?

• Goldberg says that he plans to reduce overall inventory levels by $100 million over the next six-to-nine months, and there are no plans to replace that inventory. Almost all categories will be affected by the liquidation program. Special sales events will move some of the inventory; the balance will be liquidated through third party specialists. If he reduces Zale’s inventories by $100 million, that will represent just over a 10 percent reduction from current post-holiday levels of around $1 billion, a level that the company has maintained for some time.
  
  When asked about the recent liquidation program that Zale had in place (some $70-80 million), Goldberg said that his $100 million liquidation program was in addition to the liquidation that has already taken place. The newly announced inventory liquidation program is expected to depress Zale’s gross margin by about 500 basis points (5 percent); thus, rather than reporting about a 50 percent gross margin, we look for a 45 percent gross margin over the next two or three quarters. A portion of the gross margin decline is due to an increase in the sales mix of liquidation merchandise; a portion is due to the expected cannibalization of sales by the low-margin liquidation goods which will occur when the customer makes comparisons to full-margin in-line merchandise.

• Overall, Goldberg says that as many as 30 percent of the company’s SKUs (product breadth) may be dropped. Most of this will occur by dropping merchandise that is only slightly different, depending on the store brand where it is sold. The company plans to merchandise its line across all store brands, rather than maintain a different merchandise lineup for each of its stores brands. This relates to his comment about the company being over-assorted. Thus, he clearly plans to stock deeper on the company’s best-selling pieces.

• Goldberg has already implemented a pilot program in more than 30 stores to re-train employees and improve the store shopping experience. Is it working? Sales are up an incremental 10 percent in the stores in the pilot program, according to Zale management.

• A new marketing message will be created. Goldberg said the current marketing message just doesn’t “cut through” to the customer. Zale’s marketing message must be clearer and understandable, he said. He also said that this doesn’t mean the company will throw money at marketing; rather, he believes that Zale can spend its marketing budget more wisely and more efficiently. Goldberg is right: we believe the marketing message lacks clarity. Zale went from being “the diamond store” to something else, then back to “the diamond store”, but in a half-hearted way. There are numerous examples of these mixed messages. Every time top management changed, the marketing message changed.

• Goldberg says he will continue to focus on Zale’s “clarity of the offer” to its value-oriented customers. This means that there will be some changes in the company’s product mix, breadth, and depth.

• Goldberg indicated that the company’s direct marketing efforts (mostly direct mail with some dot.com promotions) also over-stimulate and confuse the company’s customers. Changes are forthcoming in its advertising, in our opinion.

• Goldberg’s operating theme is “back to basics.” Citing various examples of successful merchants, he said that Zale had lost focus of “who its customer is and what she wants.” While financial capital (Wall Street) and human capital (employees) are important components of any business, without the customer there is no business. Zale will become customer-centric in the future.

• Zale has no plans at this time to further trim its portfolio of store brands – Zale’s, Zale’s Outlet, Gordon’s, Piercing Pagoda, Peoples (including Mappins), and its dot.com business. Goldberg said that in malls with two or more of Zale’s existing brands, business is very strong on a per-store basis.

• Goldberg plans to focus on the bridal business. Not only does the bridal business generate a higher average ticket, but it is a more stable business. It also allows the company to establish a long-lasting relationship with the customer early in their life cycle; in other words, the lifetime value of the bridal customer is immense. With the number of weddings expected to ramp up 30 percent or so over the next decade, it is no surprise that Goldberg wants to focus on this market.

• Goldberg plans to develop a larger mix of proprietary and private label merchandise. This should lead to greater differentiation in the company’s merchandise offerings, and it should help boost its gross margin.

• Goldberg was clear that there are no plans to re-position its brands. He hammered on the lack of a clear marketing message as the core challenge. The stores are well-located, the employees are good, he said. Rather, it’s the confusion message that has chased away customers.

• Goldberg plans to narrow Zale’s vendor base. He said that he plans to partner with those vendors who will help Zale develop proprietary products and who are willing to work with the company on a long term basis.

• Goldberg plans to keep Zale’s direct-sourcing efforts on track. He believes that this is one way of creating proprietary merchandise and boosting the company’s gross margins.

• Zale plans to implement selective retail price increases over the near term. Unlike Sterling which has said that almost its entire line is a candidate for re-pricing, Zale plans to re-price jewelry based primarily on precious metals cost increases. Goldberg said that the diamonds which Zale sells really haven’t risen significantly in price. Based on the IDEX Online Global Diamond Price Index, we concur with Goldberg’s comments about diamond prices for the size and quality of diamonds that Zale normally sells.

• Goldberg implied that Zale has too much of a bureaucracy. He plans to remove even more of the administrative tasks from the stores. We think he will also make changes at the corporate level – perhaps flatten the organization chart.

• Further store closings are possible, but there won’t be a dramatic number of them, management said. The company is evaluating each store for both positive cash flow (a requirement, unless the cost to get out of the lease is too high) and a reasonable return on investment (something most merchants don’t focus on).

• The corporate organization continues to evolve into a single entity, serving all of its store brands. In the past, each store brand had its own president and operating team.

• As a company, Zale will focus on generating free cash flow. Much of this cash is being used to repurchase ZLC shares. By later this year, the company’s share count will be down 20 percent from levels just a year or so ago, as a result of the share repurchase program. This strategy helps boost earnings per share for Wall Street’s benefit (and the benefit of the shareholders), but really doesn’t do anything for the corporate operations (other than to make it easier to take the company private at some point).

Financial Results Disappointing

Financials for the three-month period ended January 2008 were disappointing. Here are the highlights of the quarter:

 

• Total sales declined by 7.2 percent (after adjusting both years for the divestiture of Bailey Banks & Biddle on November 9, 2007); same-store sales declined by 7.3 percent. By brand, Zale’s, Gordon’s, and Piercing Pagoda had sales which were below the average; Zale’s Outlet and Peoples posted sales that were above the average, but we believe all store-based divisions posted a decline in sales during the quarter ended January 2008.
  
  
  Zale’s dot.com operations posted an average ticket of $211 in the quarter, about in line with other mass market online retailers. Lack of mall traffic and the lack of a compelling merchandise/marketing offer hurt Zale’s sales during the all-important holiday selling period.
  
  Management did note that the sales trend began to show a positive bias in January, and trends remain more positive in February. We think this means that sales comparisons are “less bad.” Management said the improved sales trend is not coming at the expense of margins. Further, Zale management said it had seen no decline in the credit approval rate. There was a slight increase in proprietary credit usage in the quarter.

• The gross margin fell to 49.3 percent from last year’s 51.5 percent. Roughly 200 basis points of the decline was due to the sale of liquidation merchandise, some to third parties. The company implemented unplanned price-based promotions in December, and had an aggressive clearance sale in January. The balance of 20 basis points was related to the new accounting treatment of its product warranties. The company’s raw merchandise margin was flat for the quarter.
  
  Despite these efforts to reduce the company’s inventory levels, inventory turns declined to 1.1 times annually on a trailing 12-month basis, down from 1.3 times turn last year. A higher inventory turn is more desirable.

• The company’s operating cost ratio rose by 130 basis points to 36.7 percent from last year’s 35.4 percent mostly due to de-leveraging by weak sales.

• In a nod to get things done at a reasonable pace without someone breathing down his neck, Goldberg told Wall Street analysts that Zale would no longer provide quarterly financial guidance. That’s a smart move on his part, in our opinion.

• The change in accounting for Zale’s product warranty program continues to negatively affect reported results. In the past, Zale’s product warranties were for a two-year period; now, they are for a “lifetime” which is defined as five years for accounting purposes. Zale has found that most warranty claims are made in the first few months of the warranty period – broken clasps, ring sizing, etc. Rather than amortizing the revenue over a two-year period, the company must book the revenue over a five-year period. This has a negative impact on reported revenues and profits in the first couple of years, but it evens out in the second half of the five-year period. Merchandise warranties carry a profit near 70 percent, after all costs.

• When asked about how the bankruptcy of Friedman’s and other chains might affect Zale (those chains will be running their own liquidation sales and are expected to offer huge discounts on merchandise), Goldberg replied that he was focusing on Zale. He wished his competition “good luck.”

We haven’t seen this kind of merchant at Zale’s helm since the short-lived tenure of Beryl Raff, who went on to better (if not bigger) things. Raff was handed a sinking ship; rumors continue to circulate that she was set up for failure, though it is not clear why. Since then, the company has had a parade of financially oriented leaders who really didn’t have a grasp of what it means to be a retail merchant. Goldberg is the board’s best selection in recent years, in our opinion. We only hope that they give him time to turn this huge company around. It is time to bring stability to Zale’s employees, and most importantly, to its customers.