Are Zale Optimists Missing the Point?

It's official -- hell has frozen over. For the first time since the recession, shareholders of Zale (NYSE: ZLC  ) actually have a reason to celebrate following the company's third-quarter results.

Zale appears to have come a long way after dangling the bankruptcy card in front of shareholders during the height of the recession. Prior to the market opening yesterday, Zale reported a 15.2% increase in same-store sales, which drove revenue up 14.5% and helped the company reported a smaller-than-anticipated quarterly loss of $0.31. That's how bad things have gotten; we're rewarding $0.31 per-share quarterly losses with an 18% gain!

This quarterly report -- the first of many jewelry companies set to report this week and into the next -- only solidified my current thesis on $1,500 gold, my near-term outlook on Blue Nile (Nasdaq: NILE  ) , and my long-term outlook for Zale.

Gold crunch
A little over a month ago I proposed that $1,500 gold prices would do more harm to jewelry stores than good. Based on the news out of Zale yesterday, this appears to be true. What little benefit the jewelry stores are receiving by raising prices and boosting revenue is being stripped out by the need to pay higher material costs for newer merchandise. In short, higher revenue is translating into lower margins.

Comparative disadvantage
Zale's success sheds more light on the notion that Blue Nile is falling behind the curve. What once seemed like a fantastic idea to carry little inventory and simply purchase diamonds once a customer made a decision to buy is now a nightmare. As gold and labor prices continue to rise, and the U.S. dollar falls, the cost of buying merchandise at market prices is putting Blue Nile at a distinct disadvantage to Zale and Signet Jewelers (NYSE: SIG  ) who make lump-sum purchases and carry large inventories.

Still a struggle

Zale did light a fire under the feet of staunch optimists, but it also raised a few recurring concerns.

High debt levels continue to be a burden on the company. Zale was forced to take a $150 million loan from Golden Gate Capital one year ago. The company now has $375 million in debt, an increase from the $299 million it had at this time last year, and it doesn't exactly have a rock solid plan to resolve this vicious debt cycle.

Same-store sales growth may have returned, but profitability has not. The grace period that Wall Street will extend Zale while it attempts to turn itself around isn't very long, and continued losses aren't helping the company's cause. Zale hasn't turned in a full-year profit since the year ended July 2008, and based on analysts' projections, it won't do so again until at least two more years.

Foolish thoughts
Jewelers are going to find themselves struggling through rising prices and shrinking margins as metal and labor costs continue to rise. Companies that have a stranglehold on their inventory and are able to maintain squeaky-clean balance sheets are going to be the true winners in this sector. As for Zale, it has a long way to go before it makes me a believer in its turnaround story.

Do you think this turnaround in Zale is for real or full of fluff? Share your thoughts in the comments section below and consider adding Zale, as well as your favorite companies, to the free and easy-to-use My Watchlist.

Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong. The Motley Fool owns shares of Blue Nile. Motley Fool newsletter services have recommended Blue Nile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that's as good as gold.


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  • Report this Comment On May 27, 2011, at 4:19 PM, Duke5343 wrote:

    When GOld crashes ZLC may survive if it remains 4X over prices

  • Report this Comment On May 27, 2011, at 4:22 PM, Duke5343 wrote:

    Sorry ment to finish- Gold is X4's its real value way too high

  • Report this Comment On May 31, 2011, at 5:34 PM, baselineace wrote:

    How the heck are they able to maintain such high margins when they've been on the verge of bankruptcy? Something seems a little fishy to me...

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