February 2007 Archives

From a stock market perspective, Tuesday was an interesting day. Recently I have commented on three stocks—Blue Nile Inc. (NILE), Zale Corporation (ZLC), Pan American Silver Corporation (PAAS)—and I will now provide a quick update.

Pair Trade: Short Zale, Long Blue Nile

Both Zale and Blue Nile were down on the day. Zale was down $0.98 to $26.21 for a loss of 3.60% while Blue Nile was down $0.58 to $38.71 for a loss of 1.48%. Thus, I made money on that pair trade today. Zale has not been acting very well after its recent earnings conference call. I am somewhat surprised that Zale performed as well as it did today, falling just slightly more than the S&P 500 index at a loss of 3.47%. For Blue Nile, what I found interesting is that, although the stock is heavily shorted, it barely moved for most of day and only during the latter portion of the day did it actually fall. Indeed, Blue Nile stock was up slightly for most of the morning. The bears in Blue Nile were given a tepid guidance by the company and today they were given a horrendous market. Yet, the stock has held reasonably firm. Overall, I feel comfortable with this pair trade.

Long: Pan American Silver

Pan American Silver was down $2.48 to $29.22 for a loss of 7.82%. That is a whopper of a loss, especially considering that, according to Kitco, silver was only down $0.16 to $14.49 bid $14.59 ask for a loss of 1.09%. The stock price of Pan American Silver fell seven times more than the actual price of silver did. I find that interesting. I suspect that the simple logic is that China is slowing, do not need as much silver as before, sell silver mining companies. That still does not fully explain why Pan American Silver fell more than silver did itself, but rather it provides a simple explanation of panic that might have set in. As I write this article, I note that, according to Kitco, silver is down $0.20 to $14.20 bid $14.30 ask for a loss of 2.00%. I am curious to see how Pan American reacts tomorrow. While I certainly have no idea what silver prices will do in the short term, I do believe that in the intermediate to longer term, silver prices will be at present levels or higher. I was bullish on Pan American Silver yesterday and even more bullish today.

Disclosure: Long Blue Nile Inc. and Pan American Silver Corporation shares and short Zale Corporation shares.

I am providing my commentary on Pan American Silver Corp.'s (PAAS) fourth quarter conference all on 22 February 2007. I use Seeking Alpha as my source for conference calls.

I begin with some comments on the individual properties followed general comments and earnings information.

Alamo Dorado: Sonora, Mexico

Construction was completed this past November. Commissioning process was underway until January.

The company began pouring silver in January. The mine should produce 4.3 million ounces this year with an average cost of $3.27 per ounce.

La Colorada: West Central Mexico

Although silver production increased 13% during 2006 at La Colorada to 3.4 million ounces, the mine fell short by 400,000 ounces of its target. The company had difficulty with the sulphide plant, which was started a couple months late in June of 2006 and just recently reached design capacity 250 tonne per day capacity. Production costs should approach 3.8 million ounces for 2007.

The company discovered a new Amolillo vein and added 7.6 million ounces of silver. Depending on drilling results from the 2007 program, the mine might add further reserves.

Quiruvilca: Northern Andes in Peru

Quiruvilca produced 424,000 ounces in the fourth quarter and 2.1 million ounces for the year. Cash costs for the year were negative $0.04. Silver production rates are expected to drop slightly; however, zinc production should increase. This change is a result of the geology at Quiruvilca.

The company discovered important extensions to two vein systems containing gold, zinc, and silver. The 2007 drilling program should lead to more successes.

Huaron: 300 km (190 mi) Northeast of Lima

Huaron produced 891,000 ounces of silver in the fourth quarter at a cost of $2.15 per ounce. For the year, 3.7 million ounces, $2.41 per ounce. The company is working on projects to both lower costs and increase production, including a mine deepening program that will take at least 12 months to complete. Once this project is complete, the company will be able to access higher grade and wider ore zones.

The company increased reserves (proven plus probable) to 51 million ounces of silver.

Morococha: Peru

The mine produced 712,000 ounces of silver in the fourth quarter. Cash costs were a negative $4.09 per ounce as the results of high base metal prices, notably zinc. For the full year, 2.9 million ounces and cash costs were a negative $3.71. The company expects production to increase production from Morococha in 2007.

Reserves increased by 30% and silver reserves now exceed 120 million ounces. The company expects further increases in reserves after the 2007 drilling program.

San Vicente: Bolivia

Production was a modest 256,000 ounces at a cost of $3.49 per ounce. While this mine has the company's highest grade ore, it is located in Bolivia, which has a difficult political climate for miners. The company is taking a cautious approach until the political landscape becomes more favorable.

Manantial Espejo: Argentina

Construction continues to go well, with the completion expected in April 2008. Future annual production is expected to be 4.3 million ounces of silver and 62,000 ounces of gold.

General Comments

A quote from Geoff Burns:

Here is how I see our production unfolding in 2007. We plan to produce 17.6 million ounces of silver, up 35% from 2006. Estimated cash costs are just over $3 per ounce, using some pretty conservative base metal byproduct credit prices.

If we expect silver prices of about $14 per ounce, then the company should make roughly $200 million. Notice, I did not mention earnings, but rather making or cash flow. Market capitalization is $2.4 billion. If silver prices rise—I certainly hope that they do—the company will make that much more.

Earlier in the conference call, Ross Beaty stated:

Our share price is just off an all-time high and yet we are cheaper today than we have ever been, when our share price is compared to our net asset value by current metal prices.

Switching to reserves, the company recently announced a 20% increase in reserves (pdf). The company is confident that it will further add to its reserves in 2007. The silver discovery costs at the company's mines and projects are about $0.18 per ounce. Because the infrastructure already exists, the company can mine the new reserves with sunk capital, providing excellent value to shareholders. Furthermore, byproducts reduce the cash costs to mine the silver. As the company stated, silver is the primary focus.

While the company is always on the prowl for acquisitions, equity investors are fully valuing exploration stocks, making those stocks hard candidates for an acquisition, especially in light of the company's internal successes of adding new reserves at low costs at its mines and projects. In addition to buying reserves, the company is looking to discover new silver deposits in Central and South America. As stated by Ross Beauty, the company is exercising a disciplined approach to acquisitions.

Most definitely. I'll give you the best example. In 2006, the new ounces we added and these were not resource ounces, these were reserve ounces, these were at our mines and our advanced projects we're building mines on. $0.18 an ounce is what those ounces cost us to bring into reserves, $0.18 an ounce.

Compare that to, in some cases, acquisition of some silver companies, which we would have to pay $10 an ounce to acquire their ounces because that's where they are being valued at by the market. So, there's a heck of a gap there between buying ounces for $10 per ounce and discovering them for $0.18 an ounce.

Updated metrics are as follows:

• Earnings (q4: Dec-06): 0.39
• Earnings (fy: Dec-06): 0.79
• Average Revenue (q4: Dec-06): 82.6M
• Silver Production 2007 Forecast: 17.6 million ounces; and
• Expected 2007 Cash Costs: $3.04 per ounce of silver.

On balance, I am favorably impressed with Pan American Silver. My impression is that it is a well managed company that is able to contain its costs and exercise discipline in its business affairs. While the company is seeking to add new reserves through acquisition, it will only do so in a prudent manner. The company is having good success at adding reserves at its mines and projects. The company carefully monitors its political risks and consequently capital expenditures. For example, although the company has a promising mine in Bolivia, it is waiting for more clarity before making more substantial investments. At present, Bolivia represents a very small portion of the overall asset portfolio. Because I believe that the company is well managed, I then focus on my outlook for silver. Obtaining reliable and informative information on silver is difficult. But from what I have seen, I continue to be bullish on silver. Thus, I remain bullish on Pan American Silver.

Disclosure: I am long Pan American Silver shares.

I listened and read Zale Corporation's (ZLC) 2nd quarter 2007 conference call on Wednesday, 21 February 2007. Zale's fiscal year end is July 31st. This article is a follow-up to my earlier article. I use Seeking Alpha as my source for conference call transcripts.

I will provide an update to the earnings forecast table from my prior article. After, I will walk through the conference call and provide my commentary.

Earnings & Guidance

• 2Q Earnings Actual (2Q Quarter–Jan 07): $1.94;
• 3Q (3Q–Apr 07): $0.00 – $0.04;
• 4Q (4Q –Jul 07): $-0.05 – $-0.01; and
• FY (Fiscal Year): $1.46 – $1.52.

The company indicated that store comps for Q3 are expected to decrease 2% to 3% and for Q4 are expected to be flat to slightly positive. These figures exclude the impact of derivative accounting and the change from a two year to a lifetime jewelry protection plan. For the full year, the company is projecting a total revenue growth of 3% and flat store comp growth after adjusting for Bailey Banks & Biddle store closures. Excluding the jewelry protection plan, the company is projecting an improvement in full year gross margins by 40 basis points to 52.2% compared to 51.8% for the previous year. The overall guidance is less than what the market expected and thus the company sold off today, down $1.40 to $28.56 for a loss of 4.67%.

There was an interesting exchange during the question and answer session between Brian Tunick from JP Morgan and Rodney Carter, CFO.

Brian Tunick - JP Morgan

I was just curious how you would characterize your second half earnings guidance, because looking at the past five years, right, you have earned anywhere from $0.20 to $0.35 in the second half so breakeven for this year is a significant decline. So maybe you can just give us a little more color on kind of the thought process behind your guidance. Do you think it’s conservative, realistic, some thoughts on that?

Rodney Carter

I would say it’s very balanced. I think clearly the back half reflects, as Betsy talked about, the biggest difference is the investments in the infrastructure, some of the modest sales expectations as we rebuild traction, the impact from deleveraging, particularly of SG&A-related investments of new stores, of occupancy costs and of payroll. So I think we would expect to return back to more normalized trends, but the near-term guidance, particularly for Q3, reflects that deleverage.

From this brief exchange, we can see that the analysts are disappointed with the guidance.

Margins

I will quote from the conference call transcript.

Gross margin declined by 40 basis points, including the impact of gold contracts under hedge accounting, but excluding the impact of the lifetime jewelry protection plan, and the $6.2 million of charges in last year related to the disposition of Bailey Banks & Biddle inventory. The aggressive pricing strategy and breadth of Brilliant Buys in the diamond categories contributed to a decline in gross margin for the quarter of 51.2% of sales versus 51.6% last year. Direct sourcing of solitaire product and direct import of finished goods provided the ability to sharpen price points, thus lessening margin erosion.

Later, in response to a question from Janet Kloppenburg, Betsy Burton provided additional commentary on the margins as follows.

We recognized and I think the shift in strategy going into January, unfortunately because of holiday we were really locked into the pricing and promotional strategies that were in place. In January we went back to a strategy of clearly trying to maximize growth profit dollars which means that you give up a little bit of top line but you are able to get back more in terms of growth margin dollars. So our strategy will shift back to a more normalized growth margin strategy going forward.

These quotes indicate that the competitive landscape remains challenging. The company is attempting to strike a balance between market share and pricing. A key question is, Can the company maintain its margins without giving up too much market share?

Lifetime Jewelry Protection Plan

At the company's Zales and Canadian stores, the company replaced its two year protection plan with a lifetime protection plan. This change affects the company's accounting in that, while more money is charged for the plan, less money during the initial years is counted as recognized revenue because of the longer amortization period. For the past quarter, the company recognized a loss of revenue of $15 million while generating a $24 million in deferred revenue. Thus, the company gained $9 million from having switched to a different protection plan. While this transition phase is underway, expected to be about three years, the company will show less revenue. After the transition period, the company will show an increase in revenue. All these machinations are simply accounting effects. The reality is that the lifetime protection plan is a huge plus for Zales.

E-Commerce

The company's e-commerce initiatives continue to gain traction. Holiday traffic was up 23% over last year, with conversions up 50% giving rise to total revenues up 75%.

Average Selling Prices

I will provide the last quarter average transaction prices as well as the year ago values in brackets.

• Zales: $354 ($338);
• Gordon's: $381 ($394);
• Bailey's: $1,602 ($1,559);
• Outlet: $395 ($380);
• People's: $296 ($286); and
• Pagoda: $43 ($41).

Tax Rate

A quote from the transcript is as follows.

The effective tax rate for the quarter was 37.7% versus 28.3% last year. Last year, the effective tax rate included an $11.5 million or $0.23 per share income tax benefit, resulting from the repatriation of foreign earnings under the American Jobs Creation Act. Excluding the repatriation impact, the effective tax rate for the quarter was 37.7%.

Quarter End Store Count

• Zales: 790;
• Gordon's: 285;
• Bailey's: 73;
• Outlet: 136;
• People's: 187; and
• People's II: 72; and
• Pagoda: 810.

Zales plan to spend $90 million for the fiscal year to add 55 new jewelry stores.

Inventory

Merchandise inventory at January 31st was $1.1 billion, which was $161 million or 16.8% higher than last year's figure. This higher amount is the result of three primary drivers: First, $51 million in remaining clearance inventory; Second, $50 million are earmarked for holiday and future sales; and Third, $37 million are dedicated to ZAP (Zales Assembly Process).

Valentine's Day

The company reported that its Valentine's Day sales fell short of expectations. The shortfall was exacerbated by the storm during the last two days. As a note, I am always cautious when a company uses weather as an excuse.

Promotional & Sales Strategies

Throughout the call, the company referred to different initiatives that were underway to improve margins or sales or both in its various brands. I was left with the impression that the company is refocusing or reorganizing itself. I did not get the clear impression that the company has its strategy well articulated internally. That might be the nature of retail, one where the retailer must constantly evaluate and adapt to changing circumstances.

Well, we believe that in terms of translation, if you look at the merchandise assortment the strategy and in terms of promotional strategy, returning to the diamond store, all of these we believe were great successes. So we already believe that the strategy which we brought back, which it was interesting because when Zales Canada originally started their turnaround they basically took some of the things that Zales was doing right and took it to Canada. So basically we are bringing back a lot of the things that worked before and are obviously working now. So we feel very good that the merchandise assortment, the planogram strategy, the going back to the diamond stores, the TV creative and the TV strategy, we fell very good about all of that. So we believe that you can already draw the conclusion that there are far more similarities than there are differences between the two markets.

I am a bit confused by the above quote. Zales had a strategy in the U.S., exported it to Canada and simultaneously forgot about it in the U.S., and will be soon reimporting into the U.S.? I am not sure I have a proper interpretation, but the key point is that Zales appears to have some issues to resolve. I will be watching to see if the company can better articulate its strategy in future conference calls.

Information Not Discussed

I was hoping the company would discuss its share repurchase plans. But given that the company guided lower than anticipated, I am guessing that share repurchase plans were not at the top of its list of to-do items.

Summary

Overall, I thought the conference call was weak in that the company lowered its forward guidance and that its strategies and tactics seemed to be in flux. Zales appears to be wrestling with its margins and market shares. The company's inventory levels are still causing it grief and that deserves further monitoring. Investors will need to wait to determine if some of the company's initiatives take hold and provide some upward momentum. On the positive side, the company's decision to switch away from a two year to a lifetime jewelry protection plan appears to be providing much more uplift than the company and investment community had anticipated. Because the company lowered its guidance and was unable to cleanly articulate its various strategies, I remain bearish on the stock.

Disclosure: I am short Zale Corporation.

I have prepared my notes for Zale Corporation's (ZLC) 2nd quarter 2007 conference call on Wednesday, 21 February 2007 before the market opens. Zale's fiscal year end is July 31st.

For those unfamiliar with Zale, it is one of North America's largest jewelry retailers with about 2,400 locations in U.S., Canada, and Puerto Rico. It has four main brands in the U.S.: Bailey Banks & Biddle Fine Jewelers, Gordon's Jewelers, Zales Jewelers, and Piercing Pagoda. In Canada, it sports two major brands: Peoples Jewelers and Mappins Jewellers. The company also has an online store and sells jewelry insurance.

Estimates From Yahoo

Earnings

• Average Earnings Estimate (Current Quarter–Jan 07): $1.89 (see Recent Press Release);
• Average Earnings Estimate (Next Quarter–Apr 07): $0.25;
• Average Earnings Estimate (Current Year–Jul 07): $1.68; and
• Average Earnings Estimate (Next Year–Jul 08): $2.01.

Revenue

• Average Earnings Estimate (Current Quarter–Jan 07): $1.02B (see Recent Press Release);
• Average Earnings Estimate (Next Quarter–Apr 07): $550.67M;
• Average Earnings Estimate (Current Year–Jul 07): $2.52B; and
• Average Earnings Estimate (Next Year–Jul 08): $2.63B.

Comments On Past Conference Call

I will discuss some quick highlights from the company's last earnings conference call transcript. I use Seeking Alpha as my source for conference call transcripts.

The company began the conference call with a mixed bag of good and bad news.

On to Q1 results. Q1 operating results were on plan. Excluding the impact of derivative accounting, we delivered a net loss of $0.45 per share on overall revenue growth of approximately 3% excluding the Bailey Banks & Biddle store closures. Comp store sales increased 0.4%, impacted in large part by the mix of clearance sales at the Zales brand. While the number of customer transactions increased, this was offset by a lower average ticket.

This was consistent with our plan to move through as much non-program merchandise as possible in Q1, to make way for fresh assortments and selling of regular priced goods in the all-important holiday season. This resulted in the mix of clearance sales this year representing 20% of total sales, versus 5% last year. The good news is we moved through almost $20 million of clearance goods at the Zales brand, and are ahead of plan.

In terms of the other brands, both Canada and Outlet had an outstanding quarter, fueled by high single digit comp growth. Margins were also strong, with an 80 basis point improvement over last year. Canada experienced an almost 200 basis point improvement, due in large part to a new direct sourcing initiative for finished goods diamond fashion.

Good news: Q1 results were largely on plan and Canada and Outlet were doing well. Bad news: derivative losses, low comp sales increase, clearance sales, and lower average ticket prices. Unless a company needs to reduce its exposure—I mean needs to—I do not like seeing derivatives. These executives have little experience in trading and are likely to hedge just when they begin feeling some pain and just when prices are about to peak. Hedging is a zero sum game, and I do not see why these executives would outsmart the market and be on the winning side of the trade. Lower comp sales and clearance sales indicate problems with not moving merchandise and inventories.

The company announced $120 million in new inventory with $47 million in bridal and $45 million in diamond fashion.

The company mentioned that during the prior quarter, it had 5 million unique visitors to its online store and shipped over 20,000 orders. Later during the question and answer session, the company indicated that the average online purchase was about $240.

Gross margin last quarter was 52%. SG&A was 55.2% as a percentage of revenue. Think about those two statements for a moment. Effectively, the sum of cost of goods sold and SG&A equal revenue.

In order to plan our inventory purchases of gold and silver, for which commodity prices have fluctuated greatly, we entered into forward hedge contracts. We believe hedge contracts to be economically effective in establishing our purchase cost of inventory, and insulating us from significant cash flow fluctuations due to changing commodity prices.

..

The offsetting increase or decrease in product costs will flow through the income statement over time as the inventory is sold. For the first quarter, we recognized $5.4 million after-tax or $0.11 per share from the derivative loss.

When times are normal and commodity prices are stable, the company will have no desire to hedge. As I wrote earlier, when commodity prices are volatile and the company's executives are feeling some pain, the company will hedge, often much too late. I am curious to see if we see more hedging losses again this past quarter.

The company goes on to discuss its reasons for having a loss during its fiscal Q1 2007. Reasons include derivatives, hedge accounting, and impairment of the Bailey Banks & Biddle closed store assets.

Zales has earmarked $87 million in capital expenditures for the fiscal year with a target of 60 new stores. Recall earlier that the company invested $127 million in inventory as well.

In the question and answer session, the company that it started with about $80 million of clearance, non-going forward merchandise. In Q1, it moved about $20 million with about $15 million remaining. The company returned what it could and is doing its best to move the rest.

When asked about share repurchases, the company responded that company would assess its position after the holiday season.

Recent Press Release

The company recently issued a press release (SEC site) where it provided the following key metrics:

• Comparable Store Sales: Increased 1.4%;
• Total Revenue for Q2: $1.09B (higher than estimates—see Estimates From Yahoo);
  • Last Year's Revenue: $979M;
  • Increased Revenue by 4.1%;
• Year-to-Date Total Revenues (excluding store closures): $1.452B, an increase of 3.9%;
• Year-to-Date Total Revenues (including store closures): $1.421B, an increase of 2.2%; and
• Year-to-Date Comparable Store Sales (excluding store closures): 1.1%.

The company indicated that it was comfortable with the higher end of its previous guidance for Q2 of $1.85 to $1.90.

Summary Comments

My impression is that Zale is trying to fixing some broken strategies. The company has not been performing well and it is having difficulty moving merchandise. The company is spending on revamping its assortment of jewelry.

I am going to be listening to learn how the company performed over the holiday and Valentine seasons. I also want to learn how the company is doing with respect to its inventory. I also want to see if the company can reduce its cost structure. With online jewelry sales with lower gross margins becoming more commonplace, Zale might soon find that its gross margin of 52% is unsustainable over the longer term. I am also going to be listening to the body language—the general tone of the conversation. And, of course, I will be listening to the forward outlook and guidance.

Disclosure: I am short Zale Corporation.

I just finished watching The Apprentice Season 6: Los Angeles sixth episode. The prior link goes to NBC's site. A better site is Yahoo, which I reference at the end.

I agree with Trump's decision to fire Aimee (or is it Amy—it is spelled both ways on the NBC website). I am cautious about being too disparaging because, obviously, we only see a small portion of the overall task. But from what we saw, Aimee lacked maturity. Barking out order at the beginning without thinking the assignments and time allotments through was poor. What surprised me—as it did Trump—was, why did the team not simply hire some shoppers to assist with the translations? All the team had to do was hire a few people. Those people could have taken the relevant information on pen and paper and then passed the information along to someone to input. Asked the questions verbally in Spanish, translated and wrote on paper, handed off to a fast typist. It does not seem too difficult to me.

Over at Team Arrow, the team won in spite of their leader Surya. His over intellectualizing everything is driving his team nuts. He is not a strong leader and thus unlikely to be The Apprentice.

So far, Muna has impressed me. And I think Trump is watching her too. Although she has a quiet demeanor, I get the impression she is a smart focused cookie who is willing to roll up her sleeves and get the job done. Because of the show's format, however, the audience has been able to judge the leadership abilities of only a few candidates. On this important job requirement, Muna's strengths remain unknown.

I just learned that Yahoo is carrying The Apprentice. When I did not see the cab with Yahoo light on top, I thought, incorrectly, that Yahoo was no longer sponsoring or being a part of the show. I found Yahoo's site to be better that of NBC's.