Big Jewelry Merger Outlook (NYSE: SIG)(NYSE: ZLC)

After furnishing countless couples with rings and jewellery to symbolize their love for each other, Signet Jewelers Ltd (NYSE: SIG) is looking to get married itself. Since February of this year, the $7.83 billion mid-cap jewellery retailer has been courting a little Texan named Zale (NYSE: ZLC), a $740 million small cap specialty jewellery retailer.

Zale has gone to great lengths to doll herself up for her suitor, dieting her operations and trimming the fat off her books, making herself look very attractive with quarterly earnings increases of 23.2% year-over-year. Signet wants Zale so badly, he is offering a dowry of $21 per share, some 3.6 times more than Zale’s operations are actually worth.

While Zale’s management team is urging her to say “Yes” to the proposal, her family of shareholders is not at all pleased with the arrangement. TIG Advisors LLC, Zale’s largest shareholder controlling some 9.5% of her stock, has publicly denounced the offer and is encouraging other shareholders to likewise reject the bid.

Does TIG have a case? Should Zale hold out for more? Or should she take what she can now, especially since no other suitor has expressed an interest in her hand? Zale can’t keep dieting her books forever. Something has to give.

Zale Under-Esteemed

In a letter to fellow shareholders, Zale’s largest investor, TIG Advisors, protests Signet’s undervaluing of Zale’s future prospects.

“The board continues to talk down the prospects of Zale, ignoring its own forecasts and improving performance,” TIG asserted yesterday. “Zale’s Q3 earnings results released today point to a strong and vibrant underlying business, with the Company beating street estimates for EBIT, EBITDA and EPS.”

In this, TIG has a strong case. Zale’s EBITDA (earnings before interest, taxes, depreciation and amortization) over the trailing 12 months of $76.99 million is 10.4% of its market cap, which is exceptional compared to jewellery giant Tiffany’s (NYSE: TIF) 8.6% EBITDA over market cap, Burberry Group’s (LSE: BRBY.L) 8.1%, and Signet’s own 6.5%.

While Zale’s earnings per diluted share were a modest 47 cents compared to Tiffany’s $1.41, Burberry’s 63 cents, and Signet’s stellar $4.56, Zale’s year-over-year quarterly earnings growth of 23.2% knocks the socks off of Signet’s 2%.

With such growth momentum already in place, TIG firmly asserts Zale’s value will grow significantly by the end of its three-year plan in 2016. “TIG Advisors believes that Zale is in the mid-stages of a turnaround, with substantial value creation ahead of it,” the firm proclaimed.

TIG next accused Signet of going to great lengths to pretty himself up for the proposal, resulting in a sharp increase in its share price to entice Zale.

“The board acknowledges an 18% jump in Signet’s share price on the day the merger with Zale was announced, but disingenuously attributes this value creation to a decision by Signet to increase the leverage on its balance sheet,” TIG accuses.

“TIG Advisors believes that the potential balance sheet enhancements by Signet were well understood, anticipated and largely priced-in by market participants. In fact, on 1/24/14, Signet issued a statement acknowledging a meeting with a significant institutional investor to discuss these items… We continue to believe the sustained value accretion in Signet stock since the announcement of the Zale merger is attributable to the unrecognized value in Zale and the potential synergies created by the proposed merger.”

In other words, TIG is asserting that Zale’s under-esteemed value is going to add so much wealth to Signet that it was already making deals with investors in anticipation of the windfall that Signet was about to enjoy from its under-priced acquisition of Zale.

From this standpoint, TIG labels Signet’s wheeling and dealing “disingenuous”.

Zale Corp Dolls Herself Up

But Signet is not the only one making himself more attractive in preparation for the proposal. Since Signet’s February offer, Zale has been focussing on trimming her operational expenses to make herself look like more of a catch than she really is.

While Zale’s quarterly earnings year-over-year grew by 23.2%, her quarterly revenues for the trailing 12 months have shrunk by 2.1%, as compared to Tiffany’s growth of 5.1%, Burberry’s growth of 16.9%, and Signet’s growth of 3.4%. So how did Zale manage to increase its bottom line while its top line was shrinking? Through cost cutting and operational “dieting”.

Even Zale’s management recognizes the company’s activities are not very healthy. The company’s quarterly report noted that “revenue fell 2.6% to $431 million”, which was attributed “to having 78 fewer stores than in the year-earlier period, as well as a decline in the Canadian exchange rate.”

While same-store sales rose 1.9% on a constant-currency basis during the quarter ending April 30th, in “the first 18 days of May, which included the Mother’s Day Selling period, SSS declined 2.2% on a constant currency basis and were down 3.4% on a U.S. dollar reported basis”.

In light of declining sales and revenue, Zale’s management believes that achieving its 2014 fiscal year revenue plan would require a jump of 10% in comparative store sales growth in the current quarter. But given the negative comparative sales for May thus far, a “meaningful shortfall to FY14 plan for revenue is expected”.

Zale’s management team, therefore, strongly urges shareholders to accept Signet’s $21 per share offer, which is $6 higher than the $15 per share that Zale’s stock was trading at when the buy-out was proposed in February – a full 40% higher.

Management believes Signet’s offer “provides certainty of value and eliminates the risks to Zale stockholders of failing to achieve the company’s three-year business plan”. What is more, no other party has expressed interest in Zale’s hand in marriage, meaning that there now exists a serious risk of stock price decline back to the original $15 level if Zale returns Signet’s ring.

Take What You Can When You Can

Given Zale’s book value per share of $5.82, and steadily declining sales and revenue, Zale’s shareholders would be better off taking Signet’s $21 offer. While TIG Advisors are doing their job as shareholders in trying to get the most for their shares as they can, they must be realistic and count their blessings when they come.

Zale’s stock price of $22.41 is already up to 26.68 times projected forward earnings, meaning that a $21 offer would be 25.0 times forward earnings, which is very strong compared to Tiffany’s 18.54 times, Burberry’s 0.19 times, and Signet’s own 17.0 times forward earnings.

Debt burden is another important consideration, especially when a wealthy suitor offers to take your debts off your hands. Zale is heavily indebted, having amassed $447.87 million worth of debt, some 60.5% of its $740 million market cap, a hefty 233.18 debt-to-equity ratio.

Meanwhile, Signet barely has any debt at all, just a mere $19.3 million, some 0.25% of its market cap, and a trim 0.75 debt-to-equity ratio. These compare to Tiffany’s debt-to-equity ratio of 36.71 and Burberry’s 10.84.

Shareholders should also consider the increase to their returns if they were married to Signet over remaining single. Signet’s profit and operating margins of 8.74% and 9.45% are vastly superior to Zale’s 1.09% and 2.4%. As for returns, Signet’s return on assets and equity of 6.42% and 15.04% also surpass Zale’s 2.22% and 10.65%.

Given Zale’s management’s lack of faith in its own three-year plan, as well as and the company’s falling sales and revenues, the obvious recommendation to shareholders would be to take what they can while the offer is still there.

The obvious recommendation for Signet is simply to stay put and let Zale’s shareholders flounder a bit. Zale’s operational dieting can’t be sustained, and the shapeliness of her earnings figure won’t last. A company can pretty-up its books only so long before losses force their way to the surface and burst through its girdle’s seams.

Joseph Cafariello