RBCCM forecasts positive Diamond fundamentals despite credit crunch

LONDON, RBC Capital Markets, the corporate and investment banking arm of Royal Bank of Canada (RY on TSX and NYSE), has published a research report that concludes that despite the worsening global economic climate, the fundamentals for diamonds remain positive.

Des Kilalea, Analyst, Global Mining Research at RBC Capital Markets commented:

"While the world economy lumbers through one of its worst periods in modern history, with central banks reducing interest rates to stave off recession, diamond prices remain surprisingly firm.

"While the possibility of recession in the US might put the upward move under threat, the long-term prognosis is good, with supply of rough gems likely to fall short of forecast demand pushing prices well above inflation rates.

"The major beneficiaries will be producers of better quality and large gems. Here prices are likely to rise at well above inflation rates simply because the stones are in very short supply.

"Investors are placing a premium on current producers over explorers. The result is that companies looking to fund exploration campaigns will find fund-raising difficult and expensive in the short term until risk aversion among investors dies down. This is likely to encourage increasing consolidation in the junior diamond sector.

"The area offering the greatest potential to capture additional margins is in better quality rough diamonds of the type produced by some junior miners listed in London and Canada. But Government intervention, be it in the form of higher taxes and royalties, increased ownership, or pressure to beneficiate in the host country, is increasing. All listed companies will have to adapt to this."

These and other topics will be discussed at RBC Capital Markets' second annual Diamond Conference "A Jewel of an Opportunity" on Thursday 15 May 2008 at HM Tower of London.

The conference brings together the senior management of the world's leading diamond corporations, from exploration to mining to polishing and retailing. Speakers include: De Beers, Rio Tinto, Harry Winstons Diamond Corporation and Apollo Diamond (producer of synthetic diamonds).

The conference contents will be available via audio-only webcast from Friday 16 May via RBC Capital Markets' website at http://www.rbccm.com/

Gold weakens on U.S. dollar rise

LONDON — Gold ended sharply lower after hitting a three-month bottom Tuesday on the back of a firmer U.S. dollar, declining oil prices and weak sentiment ahead of an interest rate decision by the U.S. Federal Reserve Board.

Gold often takes its cue from movements in the dollar because of its role as an alternative investment to currencies, stocks and bonds. The outcome of the Fed meeting would set the tone for currencies and precious metals, dealers said.

“Strength in the U.S. dollar is clearly a major factor, plus we have seen a quite bit of money coming out of the StreetTracks exchange-traded fund. Both these things are weighing on the market,” said Dan Smith, analyst at Standard Chartered Bank.

“There is some indication of consumers starting to come back in at these lower prices, but we are waiting to see how powerful that would be. I am looking for prices to recover somewhat from where we are now,” he said.

Gold held in StreetTracks Gold Shares, the world's largest gold-backed ETF, fell more than 50 tonnes in less than a week to about 591 tonnes as of Monday.

Spot gold fell as low as $868.80 (U.S.) an ounce, the lowest price level since Jan 22.

It was at $873.55/874.75 at 2:15 p.m. EDT, against $891.65/892.65 late in New York on Monday, when it hit an intraday day high of $895.50 on speculative buying driven by record high oil.

Jonathan Jossen, an independent floor trader in New York, said that gold's fundamentals remain firm in spite of a recent selloff due to the U.S. dollar's strength.

“The only thing that I can see why gold should slip is that we get deeper into a recession, and maybe that will bring commodity prices down and bring inflation down,” Mr. Jossen said.

The dollar hit its highest level against the euro in nearly four weeks, on track for its largest monthly gain in nearly a year, amid expectations the Federal Reserve will signal the end of its easing campaign.

The Fed will begin its two-day meeting later on Tuesday and analysts expect the policy-setting body to cut key borrowing costs by a quarter percentage point to 2 per cent and indicate that its rate-cutting campaign is finished for now.

A firmer dollar makes gold costlier for holders of other currencies and often lowers bullion demand. The metal is also generally seen as a hedge against oil-led inflation.

Oil fell more than $3 a barrel, retreating further from a record high hit on Monday. U.S. crude futures ended down $3.12 at $115.36 a barrel.

George Gero, vice-president with RBC Capital Markets Global Futures in New York, said that the Fed meeting will be closely watched.

Mr. Gero also cited a lower open interest in the U.S. gold futures market, larger gold delivery notices and chart-based selling below $880 an ounce for bullion's drop.

Spot gold has been trading well below its lifetime high of $1,030.80 an ounce hit on March 17, with attempts to revisit the level resulted in heavy profit-taking by investors.

U.S. gold futures for June delivery on the Comex division of the New York Mercantile Exchange settled down $18.70, or 2.1 per cent, at $876.80 an ounce Tuesday.

In industry news, Penoles, Mexico's largest producer of refined silver, declined sharply on Tuesday, falling 6 per cent one day after the company posted a slight drop in first-quarter net profit.

Silver fell to $16.48/16.57 from $16.96/17.02 an ounce late in New York on Monday.
Other precious metals also fell, with spot platinum dropped sharply to $1,909.50/1,929.50 an ounce from $1,964.50/1,974.50, while palladium dropped to $419/427 an ounce from $432.50/438.50 in the U.S. market late on Monday.

Luxury Buyers Tighten Purse Strings

Retailers who serve the highest income consumers have always thought that they were immune to a recession. Historically, that has been true, more or less.

“Old-money” consumers traditionally have kept spending, regardless of economic cycles. But this time around, high-end merchants are reporting that their wealthy customers are cutting back.

Among jewelers, Tiffany & Co., the world-renowned jeweler, reported that sales of jewelry above $50,000 were modestly lower in the fourth quarter of 2007 versus the same period a year ago. Historically, this has been the fastest growing price range for the company.

Other jewelers report that their customers are shopping down. That is, they are buying a three-carat diamond when they would normally have purchased a four- or five-carat diamond. Or, those customers are re-working a piece of estate jewelry, rather than simply buying a new piece.

Other luxury merchants have reported sales slippage. Coach, Nordstrom, Saks, Neiman Marcus and others have reported either a sales decline or only a modest increase. Overseas, even brands associated with the super rich are under stress. PPR, which owns Yves Saint Laurent, Stella McCartney, and Balenciaga, as well as Compagnie Financiere Richemont, the Swiss parent of Cartier and Baume & Mercier, report that the pace of growth has slowed.

Most economists and industry watchers don’t expect the current soft retail climate to firm up until after the November presidential election. Most say that regardless of who ends up in the White House in 2009, the prospect of change will likely boost affluent shoppers’ spirits, and thus increase their appetite for luxury goods.

Niemira, the economist, points out that luxury shoppers have a more direct relationship to the stock market than other consumers. The market’s gyrations are worrisome to those consumers. “Worry is not good for the psychology of spending,” he says. In other words, luxury shoppers can still afford to spend $400 on a handbag, but they are feeling less wealthy, so they delay the purchase.

Which Merchants Benefit?

Some merchants will continue to post solid sales gains during this recessionary period. One obvious example includes retailers with international exposure. Tiffany & Company, which derives 41 percent of its sales from international markets, expects overseas stores to post significantly larger sales gains than its U.S. stores in 2008. Further, the company plans to accelerate the opening of new stores in overseas markets.

Despite some weakness at the high end, most retailers of high end goods continue to post sales gains well above mass market merchants who target middle-income consumers. If a merchant is considering moving upscale, this might be a good time to do it, according to business consultants.

Zales vs. Peers: Possible Difficulties Ahead

Filed under ZALES :- Today I would like to call attention to specialty retail jeweler, ZALE Corp, (NYSE:ZLC) and the difficult challenges it must overcome to successfully outperform the market. After a brief analysis, I have come to the conclusion that it will face many uphill challenges in the coming year. A weakening economy coupled with an inflationary environment will hamper efforts to revitalize the retail jewelry market, especially where specialty brick and mortar retailers already face stiff competition from all fronts including: booming Internet sales from as Blue Nile (NASDAQ: NILE) and Ebay (NASDAQ: EBAY), discount retailers such as Wal-Mart (NYSE:WMT), and high end retailers such as Tiffany's (NYSE: TIF).

Investors looking into Zales must keep in mind that the majority of its sales and profitability comes from the holiday season centered around Christmas. The remaining quarters are loss leaders, and produce no positive earnings per share. It will be difficult to access Zales true performance until the early 2009, when the results of the future holiday season are to be posted. Investors need to be prepared for the fact that for the next three quarters, a negative earnings per share of -.54 to -.62 is to be expected, according to a Standard and Poor report based upon forcasted operating EPS. That is a long 9 month wait for any positive news to come from Zales, where alternatively, capital could be allocated to more effective uses.

Along with the recession, and weakening consumer demand I'd like to address several issues that Zales faces in the next three quarters.

MANAGEMENT

The question of Zales' success hinges on whether management has the ability to turn around an already fledgling retailer and stimulate consumer appetite amid a difficult retail environment. On the heels of Zales management is Richard Breeden, a former SEC chairman turned shareholder activist who recently acquired a 13.5% stake in Zales. There is immense pressure for Zales management to improve results, or face the prospect of a buyout. With the appointment of Neal Goldberg, former CEO of specialty apparel retailer, Children's Place NYSE: PLCE, it is difficult to say so. His new appointment at Zales retests many of the same challenges which he oversaw at the Children's Place, including a weakened demand for premium retail products, and pressure from activist shareholders such as Carl Icahn, like Breeden who have short timeframes for turnarounds. Under his previous management position as President of The Children's Place, NYSE: PLCE, he oversaw the unsuccessful merger with Disney Stores, which floundered for several years, resulting in its eventual divestiture, along with attracting a lawsuit accompanying the Children's Place and its breach of contract for non-performance. Could a disastrous turnaround plan, again, under pressure from activist shareholders tempt Zales management to pursue an opportunity of opposite synergies? A Catch-22 situation can only serve as a distraction to management as they seek to realign their core competencies towards the middle jewelry market.

EARNINGS

Zales, being a specialty retailer, recognizes the majority of its revenue during its quarter ended Jan 31th. Earnings from continuing operations totaled just 59.2 million dollars for 2007,or an EPS of 1.21 for fiscal year 2007. Investors should note that the to a sale of bloated inventory accounted for 13% of the net income applicable to common shares for 2007. In the future, I expect that Quarter 2 results, which should be released sometime around May 31st, will undoubtedly have charges due to discontinued operations, and the planned closure of 105 stores. Severance costs which will immediately be charged to income could possibly hamper second quarter earnings, as well as a $100 million share buyback program announced on March 27th. Any savings from closures will take time to recognize as leases are broken, and payrolls are shaved due to attrition. According to an Standard and Poor report, earnings from continuing operations for 2008 are forecasted to be a negative -.61 per share.

COST OF SALES

The cost of sales category includes cost of merchandise sold, as well as receiving and distribution costs. Cost of sales as a percentage of revenues was 50.7 percent for the quarter ended January 31, 2008, compared to 48.5 percent for the same period in the prior year. According to management, this increase of 140 basis points resulted from the decision to liquidate certain discontinued and damaged inventory in lieu of refurbishing and selling the inventory through store channels. A 60 basis point charge was associated with excess inventory and a decline in revenues was recognized, associated with lifetime warranties. Interestingly the effect of gold prices may not materialize in the cost of sales. While Gold is near record high, their inventory is likely to be purchased in advance, and may therefore not materialize into higher prices one year forward, assuming an inflationary environment. However the weak dollar may also effect Zale's purchasing power, as its suppliers most likely originate from overseas, including South Africa for raw materials, and China for its labor in producing jewelry. It should be noted though, according to management's opinion, changes in revenues, net earnings, and inventory valuation that have resulted from inflation and changing prices have not been material during the periods presented (2007). And although currently not material, as stated by management, recent increases in gold prices have negatively effected the cost of merchandise inventory. In a report of risk factors in their annual report, "the trends in inflation rates pertaining to merchandise inventories, especially as they relate to gold and diamond costs, are primary components in determining their last-in, first-out inventory. There is no assurance that inflation will not materially affect us in the future". Management's success in using forward hedging contracts for inventory purchases has yet to be seen, as it will depend on them successfully speculating on the price the gold in the future, no easy task given the volatile commodities market.

Inventory and Fixed Costs.

Average inventory turnover for Zales is acceptable and in line with industry averages, yet other financial ratios indicate industry weakness. Zales has a respectable inventory turnover inline with competitors of 2.5. Compared with the Signet Group of 2.6, Tiffany's of 2.46, it is effective in managing inventory. However there are significant fixed costs which Zales shows weakness in.
Calculating revenue per employee however, shows some startling results. Revenue per Employee at Zales of $143,352 which lags behind competitors by a large margin, where Signet is able to enjoy $221,964 per employee and Tiffany's of $290,909 per employee. The heavy concentration of physical stores and mall kiosks also weigh in on margins when compared to online retailers such as Blue Nile, or big box retailers such as Walmart which can utilize retail space to adjust to seasonal demand. Clearance Items: Coupled with their recent $100 million divestiture of inventory, a casual browsing of their website will reveal some 1604 items sold at discount or at clearance prices, the largest of any category. Their aggressive buy one get one 1/2 off inventory reveals and additional 360 items. For comparison's sake, top selling items at Zales reveal 221 items, Wedding items reveal 585 items, Journey jewelry or "love jewelry" reveals 295 items. The abundance of clearance inventory relative to other categories suggests a lack of pricing power and the need to quickly reduced tied up capital in inventory. Competitors such as Tiffany or Blue Nile do not even offer clearance items which may possibly dilute the brand name.

These are some factors which I have so far considered. In closing, I prefer to look for companies which have a wide, sustainable competitive advantage, or as Warren Buffet would prospect for, a "Wide Moat". Discretionary spending of jewelry faces stiff competition, not only from the razor thin margins of Walmart and its jewelry department, but from digital competitors as well, including Internet jeweler Blue Nile, which has the advantages of having tighter inventory control as well as low fixed costs. Only the holiday of season of 2008/2009 will reveal the success of Zales management as they seek to improve upon operations. In the meantime, high valuations of Zales, and implications that it is a growth stock need to be examined carefully.