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After Triple Digit Returns in 2013, Can Zale Keep Delivering for Investors?

By Robert Hanley - Sep 11, 2013 at 11:55AM

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Value-priced jewelry chain Zale's stock price has been on fire in 2013 as investors bet on the company's resurgence as one of the sector's long-term winners. Are investors getting ahead of themselves?

While jewelry sales took a hit during the financial crisis, consumers are back to spending their discretionary income in this specialty product category.  According to data provider Rapaport, domestic jewelry-store sales rose 9.1% in the first six months of 2013, to $15 billion. 

The industry's rising sales have lifted all boats, none more so than value-priced retailer Zale (NYSE: ZLC), which received $150 million of much-needed financing from investment firm Golden Gate Capital in 2010 to stay afloat.  As the chart below shows, Zale's trailing twelve month stock price performance has outshone its primary competitors, Signet Jewelers (SIG 0.79%) and Tiffany & Co. (TIF), as well as the market as a whole.  With its first annual operating profit since 2008 under its belt and a rising stock price, can Zale provide investors with more gains?

What's the value?
Zale's ultimate value comes from its ability to potentially leverage the volume buying power of its national domestic network of stores, further complemented by a leading market share position in Canada. While the company has been pruning its overall network, with 84 net store closures over the past year, it maintains almost 1,700 locations led by the 600-plus stores in its namesake store chain. Zale also has a strong presence in the outlet arena, which counter-intuitively enjoys the highest average transaction value of all of the company's segments.

In fiscal year 2013, Zale continued its resurgence with rising comparable-store sales, up 3.3%, helped by a double-digit increase in online sales. More importantly, its greater focus on its exclusive brands, including Vera Wang Love and the Celebration Diamond Collection, brought higher volumes of customers to its stores and an improvement in its gross margin. Combined with the closure of under-performing stores, the net result was that Zale's operating margin nearly doubled versus the prior-year period. 

Looking ahead, the company plans to shut an additional 50 to 55 stores in FY 2014, which should hopefully lead to further margin expansion.

The competition
Despite Zale's clear financial improvement, its relatively low operating margin and relatively high leverage puts it at a disadvantage to its stronger national competitors, including Signet Jewelers(SIG 0.79%) and Tiffany(TIF).  Both companies enjoy double-digit operating margins, partially due to their direct relationships with diamond miners, and retail networks that reach customers at higher price points.

Greater profitability has allowed Signet and Tiffany to expand operations over the past year, while Zale continues to downsize.

Signet is a more direct competitive threat to Zale, with its comparably sized Kay Jewelers chain that markets to the same middle class customer base. Signet has been targeting Zale's outlet business. This initiative gained traction through Signet's 2012 acquisition of the Ultra jewelry chain, primarily found in the nation's outlet malls. 

Signet also has the ability to upgrade customers to its Jared upscale brand, which focuses on the bridal segment, with free-standing locations and more personalized customer service.

In FY 2014, Signet has continued to grow, with rising comparable-store sales and a strong 36% gain in its online segment. The company's operating margin has slipped slightly versus the prior-year period, but it remained above 13% thanks to a solid financing business, accounting for roughly 57% of sales.  Signet's strong profitability is also allowing it to build inventory and expand its retail network, with management targeting 75 to 85 new stores in the current fiscal year.

Meanwhile, Tiffany's name may be synonymous with high-priced fine jewelry and its trademark blue box, but it is also finding success in the value-priced arena through its Rubedo and designer product lines. Like Signet, Tiffany is enjoying rising comparable-store sales in FY 2014 as well as a strong double-digit operating margin that is a function of internally designing and manufacturing a majority of its products. The company's consistent profitability is also allowing it to selectively expand, with management forecasting 14 new stores globally in the current fiscal year.

The bottom line
Zale has finally maneuvered its way to positive annual operating income and financial stability, although its operating margin significantly trails that of its main competitors. A higher future market valuation is likely contingent upon the company's ability to further increase its razor-thin operating margin, which would allow it to pay down its heavy debt load, currently tipping the scales at over $400 million. 

Zale's new private-label credit card agreement with Alliance Data Systems should help it achieve that goal, as it gains more high-margin financing income. Until the proof shows up in the numbers, though, investors might want to trade in this work in process for one of its growing competitors.

Robert Hanley owns shares of Zale's. The Motley Fool has no position in any of the stocks mentioned. 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.

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Stocks Mentioned

Tiffany & Co. Stock Quote
Tiffany & Co.
TIF
Signet Jewelers Limited Stock Quote
Signet Jewelers Limited
SIG
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