A Brass Ring at Zale?

With the Fourth of July behind us, it's time for major clearance sales as retailers offer steep discounts on summer apparel. So I wandered into the mall madness and ended up purchasing a BCBG shirt that originally retailed for $75 for a mere $15. For such a prestigious brand, this was a good buy -- I was paying 80% off face value.

My new shirt wasn't the only brand-name deal I came across. Recently, Zale (NYSE: ZLC) has been looking pretty inexpensive. Despite the company's powerful brand name in a decent industry, shares are languishing near three-year lows. So, could Zale be a bargain, too? Let's take a closer look.

Company snapshot
Zale is North America's largest specialty retailer of fine jewelry, with more than 2,300 locations. Its brands include Zales Jewelers, Gordon's Jewelers, Bailey Banks & Biddle, Peoples Jewellers, and Mappins Jewellers. Bridal sales make up 45% of sales, with fashion jewelry and watches accounting for the rest.

The downside of upscale
A couple years ago, Zales committed the cardinal sin of retailing and forgot who its core customer was. The company tried going upscale, which is kind of like Tiffany (NYSE: TIF) trying to sell to the masses -- obviously a mistake. In retailing, trying to change your customer base is a herculean task. Success is rare and only happens over long periods of time.

Thus, it's hardly a surprise that the strategy fell flat on its face. Sales growth has been lackluster over the past five years, and profit margins fell to 2.2% in 2006 from 6.6% in 2002.

New blood
Luckily, there's still a lot to like at Zale. The company has a strong distributional presence, with stores across the country. Zale also might benefit from a revamped management team. In 2006, board member Betsy Burton, who has a reputation as a turnaround specialist, became the CEO. Her plan is simple: Get back to basics. That means refocusing on middle America and giving Zales customers what they want -- high-quality diamonds and solitaires at a reasonable price, with a steady helping of great customer service.

Also, John Zimmerman became president of Zale North America. Under Zimmerman's leadership, Zale's Canadian business grew sales more than 20% annually over the past five years, nearly tripled operating earnings, and sported the company's highest operating margins.

I've also liked many of Burton's other moves. To try to get margins back up to speed, Zale has ramped up direct sourcing (which boosts gross margins by removing a layer of markup costs) and implemented initiatives to cut inventory and overhead in selling, general, and administrative expenses.

Valuation
In trying to estimate Zale's potential worth, I simply assume that under Burton and Zimmerman's leadership, Zale will be able to get back to the 7% to 8% profit margins it earned a couple years ago, which gets me to $100 to $110 million in net income, or not much more than what Zale earned in 2004-2005. After slapping a 14 multiple on those earnings, I calculate that Zale's stock could be 30% undervalued.

Keep in mind, I'm only assuming that Zale gets back to a previous level of profitability: Anything on top of that is gravy -- and I like gravy.

Risks
It would be foolhardy to look at the potential rewards without understanding the risks. The past year has not been a great one for Zale -- if it were, the stock price would likely be much higher and I wouldn't be writing this article.

Comparable-store sales have been down lately, due to adverse commodity prices -- mainly for gold and gas -- and an unfavorable retail market. The same economic trends have been hurting competitors such as Signet (NYSE: SIG) as well. So I think investors who buy into Zale will have to be patient and give management a chance to work through some of the headwinds.

Catalysts
At its current valuation, Zale could certainly be a private equity candidate (the chief financial officer was at PETCO during its buyout). While I don't advise investors to purchase shares solely in hopes of a buyout, the possibility of Zale going private makes the company a more attractive investment.

Related Foolishness:

• Greeted With Profits
• Signet's Icy Conditions
• What Is Zale's Density?

Lead analyst Philip Durell of The Motley Fool's Inside Value newsletter is always digging up undervalued stocks. Spend the next 30 days checking out his latest bargain stocks for free.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.