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Chasing Upscale Customers Tarnishes Mass


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Chasing Upscale Customers Tarnishes Mass-Market Jeweler
By Ann Zimmerman and Kris Hudson
http://online.wsj.com June 26, 2006

DALLAS – In early January last year, after a disappointing Christmas
season and amid worries about competition from discount retailers,
Zale Corp. decided to shake things up: The self-proclaimed jeweler to
Middle America was going to chase upscale customers.

In a few months, Zale drew up a plan that involved replacing almost a
third of the merchandise at its Zales Jewelers division. To dodge a
battle with retailers such as Wal-Mart Stores Inc., Zales dropped
inexpensive, low-quality diamond jewelry for fashionable 14-karat
gold and silver pieces with higher margins. It started buying direct
from overseas dealers, cutting out U.S. middlemen, and even dumped a
decades-old marketing slogan: “The Diamond Store.” The move was a
disaster. The Irving, Texas, retailer lost many of its traditional
customers without winning the new ones it coveted. A second poor
Christmas badly dented the company’s annual profits. Within weeks,
Zale’s chief executive officer, Mary FortC3A9, was forced to resign,
according to people familiar with the matter, and the U.S.
Securities and Exchange Commission started investigating Zale’s
accounting.

Sensing weakness, Zale’s archrival, the United Kingdom’s Signet
Group PLC, made an unsolicited merger approach this spring, which
Zale rebuffed. Signet last year passed Zale to become the U.S.'s
largest retailer specializing in jewelry. (See related article).

Throughout its 82-year history, Zale has mirrored and occasionally
led changes in American retailing. In the 1920s, it kick-started the
mass-market jewelry trade. After World War II, it moved out of
cities and into burgeoning suburban malls. Now it’s joined the ranks
of businesses that, spooked by competition from mass retailers, have
struggled to go upscale.

J.C. Penney Co., the quintessential middle-class merchant, ran into
trouble a decade ago when it turned to pricier designer clothes and
home furnishings that alienated customers. Last holiday season,
Limited Brands Inc.'s Bath and Body Works unit suffered slumping
sales as it struggled to determine the right mix of merchandise and
promotions to convey its shift upscale. And Pier 1 Imports Inc., the
home furnishing retailer, this year introduced sleeker products to
combat discount operators, but the changes have yet to boost sales.

Founded in 1924 in Wichita Falls, Texas, by M.B. Zale and his
brother William, the company grew through the brothers’ decision to
offer friendly service and liberal credit terms to the working class.
The deal they offered: a penny down and $1 a week. After World War
II, Zale furiously bought up other stores and smaller chains.

The company’s divisions include Piercing Pagoda, which runs mall-
based kiosks selling jewelry to teens, Zales Jewelers, for working-
class mall shoppers, the upscale Gordon’s, and Bailey Banks & Biddle
Fine Jewelers, which sells even pricier products out of fancier
malls.

In the late 1980s, the Zale family cashed out, giving up control of
the company. In recent years, discounters such as Wal-Mart and J.C.
Penney were grabbing an increasing amount of the jewelry business. At
the same time, Internet retailers and TV shopping networks were
selling more diamonds and other fine jewelry, encroaching on Zale’s
turf.

Ms. FortC3A9, now 55 years old, headed the company as the industry
shifted. She had come to Zale after stints at home-shopping channel
QVC, a unit of Liberty Media Corp., and Federated Department Stores
Inc. At Zale, she headed Gordon’s, where she successfully introduced
pricier watches and other items. “Upscale products were in Mary’s
DNA,” says a former colleague.

While Zale was losing its momentum, Signet, its chief rival, was
doing well. Signet’s roots stretch to 1949, when Leslie Ratner opened
his first jewelry shop in Richmond, just outside of London. The
retailer entered the U.S. in 1987 with its purchase of Sterling Inc.,
a 117-store chain. It bought Kay Jewelers in 1990 and launched Jared
the Galleria of Jewelry in 1993, which was designed to appeal to
people who don’t like malls.

Key to Signet’s success was its decision to buy less expensive cut
diamonds and finished products directly from overseas suppliers,
rather than relying on the middlemen that long characterized the
jewelry business. Tapping new diamond centers in countries such as
India, Signet now buys directly more than half the products it sells
to consumers. The Zales Jewelers division – which accounts for the
majority of the Zale Corp.'s sales and profit – by contrast, buys
only about 5% that way.

With the savings, Signet ploughed money into marketing and staff
training. It blanketed the airwaves with commercials equating
jewelry with romance through the tag line: “Every Kiss Begins With
Kay.” “Signet continued to evolve and get stronger, but Zale hadn’t
evolved or changed with the landscape as much,” says David
Sternblitz, Zale’s current treasurer.

When Zales Jewelers missed its 2004 sales plan for the Christmas
season – the year’s most important period, accounting for more than
half its sales and almost all its profit – executives concluded it
was time to do something drastic. Discount retailers like Wal-Mart,
they worried, were dominating sales of low-priced jewelry.

Early in 2005, Ms. FortC3A9 moved to cultivate a higher-income
clientele. “We are in the process of really tearing things apart
now,” Ms. FortC3A9 told Wall Street analysts in February.

She proposed dumping many of the company’s $99 diamonds as well as
Zale’s long-running TV ad campaign promoting those pieces. Ms. Fort
also wanted to get rid of promotions on holidays such as Veteran’s
Day and Columbus Day, when Zale slashed its prices and saw sales
soar, albeit at low margins. After sprucing up Zales Jewelers, Ms.
Fort also began doing the same to Zale Corp.'s existing upscale
divisions. Bailey Banks & Biddle, she thought, could be like Tiffany
& Co., say several former employees.

Pamela Romano, who headed Zales Jewelers for seven years, told Ms.
Fort it was a mistake to move so radically, according to several
former employees. Her division lost millions in sales that fall when
Ms. Fort cut out the Columbus Day sale. Ms. Romano argued that
changes in a business with a base of established customers had to
happen slowly. After all, the company sold thousands of $99 diamond
earrings each year.

Through a sympathetic board member, Ms. Romano asked to talk to the
board of directors. The board, however, refused, saying it didn’t
want to meddle, according to people close to the situation. Ms.
Romano left the company shortly afterward, in early 2005.

Betsy Burton, a board member and Zale’s interim chief executive,
says the board didn’t understand the magnitude of the changes
proposed by Ms. Fort. “Everything that was told the board sounded
like a solid plan…It was perceived as more of a subtle change as
opposed to what was in actuality a very radical change,” she said.

Ms. Fort says the board was fully briefed on the new strategy.
Previously, Zales Jewelers grouped together similar items of varying
quality – a common strategy know as offering good, better and best.
For example, diamond stud earrings were sold for $99, $199 or more
than $400. The price varied according to the size or quality of the
diamond (low-quality gems have a yellowish tinge). By showing the
improvements as the price rises, stores try to persuade shoppers to
spend more.

Zale couldn’t do much to improve the quality of its diamonds –
better gems would cost too much for some of its clientele. Instead,
it stopped selling inexpensive diamond pieces, leaving only items
that cost more than $200.

Filling the gap last Christmas in Zales’s light-brown wooden display
cases were fashionable, chunky sterling-silver and 14-karat-gold
necklaces and rings – some adorned with lemon-quartz or pink-
sapphire Some of the pieces, which ranged in price from
$99 to $199, were designed to mimic designer jewelry sold at
department stores such as Neiman Marcus.

Zale also started grouping jewelry into matching sets of necklaces
and earrings, for example, rather than by categories. That’s the
approach of better jewelry stores that rely on customers buying whole
ensembles. In total, Zale changed 30% of its merchandise and replaced
15% of its suppliers, says Ms. Burton, the interim CEO.

Ms. Fort also overhauled the holiday catalog, axing details about
monthly payment plans. And for the first time in 50 years, the
company switched ad agencies for its Zales division, launching a
series of arty commercials. Their tag line – “Be Brilliant” – was
designed to reflect the store’s new, fashionable image.

Two Big Problems

Two big problems immediately surfaced. Male shoppers in particular
didn’t consider the new jewelry appropriate for a romantic Christmas
gift. Diamonds are a bigger hit that time of year. Other customers
were put off by the suddenly higher prices.

Zales Jewelers says its typical customer is male, between 25 and 65
years old, with an average income of $40,000 to $75,000. Robert
Callihan, a 43-year-old from Cleburne, Texas, for example, says he
shops around for the best price when buying jewelry for his fiance.

Last January, he noticed that the quality of Zales’s merchandise had
improved and its prices had risen. “But you want a sale,” he says.

Zale also placed many orders too late, and some merchandise didn’t
make it to stores in time for the holidays.

By mid-December, the company changed course in an attempt to rescue
Christmas and bedecked its stores with "lowest prices of the season"
banners. Sales in the November-December period slid 4% from the prior
year at Zales stores open at least 12 months. For the whole company,
same-store sales inched up 1%. By contrast, sales at Signet’s U.S.
stores were up 5.5% during the same period.

Ms. Burton says “the big mistake, and how we really broke Zales going
into a key holiday season,” was changing the product line-up,
especially in diamonds. Describing the company’s line-up, Ms. Burton
says, “we literally had a broken category going into the all
important quarter, the one where you make all your money.”

Defending the Strategy

Ms. Fort defends her strategy and argues that the company was
beginning to work through its problems. “You don’t have to go
inexpensive to show great value,” she says. She says Zales was able
to offer better quality jewelry at a discount because it had finally
started to buy products directly from overseas suppliers.

“We were working to improve the business and these things take
time,”

Ms. Fort says. “We were starting to hit our stride, but direct
sourcing was still new and was just beginning to infiltrate the
inventory.”

In January, Ms. Fort was asked to resign, just four months after
signing a one-year employment contract that included a severance
agreement worth more than $8.5 million in cash and stock. Ms. Burton
says Ms. Fort was on thin ice even before Christmas because the
company missed earnings guidance and sales plans for numerous
quarters. Ms. Fort’s severance payment has been frozen by Zale
pending the outcome of the SEC’s investigation.

News of that probe broke in April, when the jeweler disclosed that
regulators had subpoenaed documents from the company and former
executives. The SEC was interested in a laundry list of topics,
including executive pay and severance, extended warranties, earnings
guidance and the timing of payments to vendors.

Less than a month later, Zale put Chief Financial Officer Mark Lenz
on indefinite administrative leave. The company said he failed to
tell auditors that roughly $8.2 million in payments to vendors were
made in August, at the beginning of the company’s new fiscal year,
even though they were accounted for in July.

Zale said the shift didn’t affect sales and net income. But by
shifting costs into the next financial year, the move boosted net
operating cash flow and free cash flow for 2005. Mr. Lenz didn’t
return calls seeking comment.

It’s unclear what sparked the investigation and whether it is
related to the fallout from Zale’s upscale strategy. SEC officials
decline to comment.

For the first time in two decades, Signet passed Zale as the largest
U.S. jeweler. For the year ended Jan. 28, 2006, Signet posted sales
of $2.31 billion in the U.S., compared to Zale’s $2.17 billion for
the year ending July 31, 2005.

Zale’s executives feared big-box competitors, while Signet CEO Terry
Burman chose to compete with mom-and-pop jewelers that make up 70% of
the market. Big discount stores, he argues, cater to a market that
jewelers shouldn’t want: indiscriminate shoppers buying from a
limited selection of low-end merchandise.

“If you go to Wal-Mart, you’ll see this much in diamonds,” Mr. Burman
said in a May interview, holding his hands about five feet apart.
“You go into our stores, you’ll see 60 running feet of diamonds. Are
we really competing with Wal-Mart? I don’t think so.”

About two months ago, Signet approached Zale about the possibility
of a merger. Signet reasoned that such a combination made sense if
the two could combine operations and trim costs, according to people
familiar with Signet’s strategy. The new company could retain only
the best locations in malls where stores overlap, these people say.

Zale representatives describe the merger talks as “informal” to the
point that they didn’t progress to serious discussions about price.
Indeed, people familiar with the talks say the two sides seemed, if
anything, to be drifting apart when word of the talks leaked to the
press.

On June 12, Signet confirmed the existence of talks, spurring the
Zale board to quickly convene a conference call. The board was
already leaning against a deal and feared that the news reports would
upset Zale employees as they planned the 2006 holiday season. After
two hours of discussion, the board rejected Signet’s advances,
reasoning that Zale could do better as an independent company.

Until a full-time replacement is hired, the task of righting the
ship falls to Ms. Burton, 54, a Zale board member since 2003. Ms.
Burton has been CEO of a chain of discount hair salons called
Supercuts Inc., a printing company and a chain of cosmetic stores.
She also sits on the boards of Staples Inc. and Aeropostale Inc., a
retailer of teen apparel.

Since taking charge, Ms. Burton has scrapped much of last year’s
strategy. The Zales Jewelers division has returned to stocking more
everyday diamond jewelry and bridal fair such as solitaire
engagement rings. The division once again is grouping merchandise by
category.

Ms. Burton also jettisoned the “Be Brilliant” marketing campaign.
Zales Jewelers plans to soon unveil a new campaign with a familiar
tag line: “The Diamond Store.”