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Danger Zone 2/18/2013: Zale Corporation (ZLC)

Tuesday, February 19th, 2013

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Zale Corporation (ZLC) is in the Danger Zone this week.

Too often investors allow their emotions about a company or stock to cloud their financial judgment. Up 17% year-to-date compared to the S&P 500 (up only 6.5%), the stock is starting to turn a lot of heads. For many investors, “the trend is your friend” when a stock is up so much in a short time.

I am here to warn investors that beauty here is only skin deep. Big red flags hidden in the financial footnotes make this stock much riskier than many investors may realize.

Even on the surface, ZLC is troubling. The income statement for 2012 shows a GAAP net income of -$27 million. Still, this is significantly better than the 2011 net income of -$112 million. With ZLC trading at ~$4.90/share, up 19% year-to-date, investors seem to be buying that this upward trend in accounting earnings will continue.

What investors might not notice, however, are liabilities and red flags hidden in the financial footnotes. Many companies hide negative information in the financial footnotes, and ZLC is not an exception.

The company has $454 million in off-balance sheet debt due to future payments on operating leases. This liability is nearly 60% of reported net assets, and more than twice its market capitalization.

More worrying are the $203 million in accumulated asset write-downs since 2001. At 25% of net assets, these write downs reflect a quarter down the drain for every dollar of investor capital.

Per Figure 1, write-downs have risen steadily since 2001. This trend is not an investor’s friend.

Figure 1: Destroying Shareholder Value Since 2001

Zales_Fig1Sources: New Constructs, LLC and company filings

Write-downs, as I have underscored in the past, are a clear sign of management failure.

Even without these red flags in mind, the valuation of ZLC is writing checks the company can not cash. To justify its current share price, ZLC would have to grow after-tax profit (NOPAT) by 4% compounded annually for the next nine years. Such expectations are out of line with historical performance.

ZLC has a -2% NOPAT compounded annual growth rate (CAGR) since 1998 when our model begins. For the past 10 years, its NOPAT CAGR is -5%. This long-term decline in NOPAT, combined with growing asset write-downs and consistently large off balance sheet debt, indicates a company with serious issues.

Accounting data alone is not useful for investors. GAAP net income tells only part of the story for any company. For ZLC, the recent improvement in accounting earnings is hiding some very serious issues hidden in the financial footnotes.

This is a company with off balance sheet debt that is over 60% of its net assets, write-downs that are over 25% of net assets, and after-tax profits that have been declining. Investors should focus on the truth behind the accounting numbers and avoid this stock.

Note there are no ETFs or mutual funds that I cover that allocate significantly to ZLC.

Sam McBride contributed to this post.Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector or theme.

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3 Comments

  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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