Diamond Retailer Isn't Investors' Best Friend

Investors put the stick before the carat Tuesday and sent shares of troubled jewelry retailer Zale (ZLC) 8% lower following an analyst's downgrade of the stock.

Adrianne Shapira of Goldman Sachs dropped the flagging shares to Sell from Neutral in a report published Tuesday, writing that the wider retail and recent management troubles will crimp profits at the company, which operates about 2,300 jewelry stores under several names in the U.S. and Canada.

Zale will report its fiscal fourth-quarter earnings Thursday. Wall Street analysts polled by Thomson Financial expect the company to lose 16 cents a share for the three months ended July 31 and earn $1.13 a share for all of fiscal 2007. The company reported a fourth-quarter same-store sales drop of 0.5% from the same period a year ago, with revenue of $488 million compared to last year's sales of $491 million, a decrease of 0.6%. The dip in recognized revenue was due in part to changes Zale made to its guarantee policy on purchases. Zale runs stores under the brands Zales Jewelers, Zales Outlet, Gordon's Jewelers, Bailey Banks & Biddle, Peoples Jewellers and Mappins Jewellers of Canada, and Piercing Pagoda.

The company on Aug. 6 announced that John Zimmermann, president of Zale North America, stepped down, effective immediately, as part of a reorganization that eliminates separate brand presidents and centralizes management. It also announced it was seeking a chief operating officer, a new position.

It's a combination that tarnishes Zale's turnaround prospects. Shapira wrote that "growing macro headwinds, management upheaval, and poor strategic positioning will likely further pressure earnings," and added that the company's earnings guidance for fiscal 2008 "could materially disappoint," and fall well below the Street consensus of $1.52 a share.

Zale's stock has already fallen 22% since May 1, and while its earnings call likely will see the company lose less than analysts expect — Shapira forecast a loss closer to 11 cents a share than the 15 cents projected at the low end of the company's range — its prospects for next year are a larger concern.

"We expect a guidance range between $1.01-$1.10 as compared to current $1.52 consensus. This accounting change [related to guarantees] coupled with continued weak fundamentals should pressure shares through holiday. We expect Zale to cede share at an accelerated rate as management focuses on its gross profit dollar maximization strategy and competitive pressures mount," Shapira wrote.

Those competitive pressures are coming from all sides, says Antoinette Matlins, author of "Jewelry and Gems: The Buying Guide."

"The major thing impacting retailers such as Zales is the increasing success of Internet retailers," she says. "The Internet provides consumers with an opportunity to shop and compare prices quickly and easily, and if a diamond is accompanied by a laboratory report from a gem testing laboratory, they think they can make sound decisions."

And while a middle-market player such as Zale retains a certain cachet when it comes to wedding and engagement jewelry, discount retailers such as Wal-Mart Stores (WMT) and Costco Wholesale (COST) have notched market-share gains on other facets to the diamond jewelry business.

"There is a certain emotional connection with popping the question with a diamond from Zales, and there isn't that same emotional connection with a diamond from Wal-Mart," Matlins says. "But for everyday jewelry, Costco and Wal-Mart are marketing their products as better value than you can get elsewhere. They're definitely having an impact on Zales."

Johnson Rice & Co. analyst David Mann wrote in an Aug. 10 report that while traffic was slightly down in June and July, spending increased, though both its lowest and highest market segments saw the bulk of the improvement, while Zales Jewelers and Gordon's Jewelers declined.

"The company's more targeted promotional stance has resulted in improved gross margins," he wrote. "The company is taking steps to centralize merchandising and operations of business divisions, which should help to reduce costs."

But the timing of the reorganization comes as the company's midmarket customer segment is thinking more about housing costs than brooches, and that's the main flaw in an optimistic take on fiscal 2008.

"In good times or bad times, wealthy people still have money, and they're interested in quality and the status connected to a particular name," Matlins says. "It's the middle market retailer like Zales which faces a greater challenge."